IMF Fears „Taper Tantrum“; Rear View Mirror Discovery

The totally useless and always late to the party, Christine Lagarde, just now warns of Emerging Markets Instability.
The head of the International Monetary Fund warned on Tuesday that emerging markets are set to face a renewed period of economic instability when US interest rates rise this year, forecasting a repeat of 2013’s damaging “taper tantrum” episode of capital flight and rapid currency depreciation.

The IMF chief said she feared that negative “spillover” effects from these increases would lead to a re-run of the crisis that hit developing economies such as India and Turkey nearly two years ago, following hints from then Fed chair Ben Bernanke about an early end to the institution’s bond purchasing programme known as quantitative easing.

“I am afraid this may not be a one-off episode,” Ms Lagarde said. “The timing of interest rate lift-off and the pace of subsequent rate increases can still surprise markets. The danger is that vulnerabilities that build up during a period of very accommodative monetary policy can unwind suddenly when such policy is reversed, creating substantial market volatility.”
Taper Tantrum

How did Lagarde arrive at her not so amazing prediction?

I believe she finally opened her shades and looked out the window.

She saw a currency crisis in Brazil, a currency crisis in Turkey, and capital flight out of China.

Turkish Lira vs. US Dollar

Brazilian Real vs. US Dollar

Chanos Sees China Capital Flight

Flashback October 28, 2014: Short-Seller Chanos says China Seeing Faster Capital Flight.
Hedge fund manager Jim Chanos, who has a long-running bet against China, said that the country's credit bubble was starting to cause capital outflows to accelerate and may ultimately lead to weakness in the nation's currency.

"It's safe to say it's accelerating," said Chanos, speaking of capital flight out of China, and said China's quarterly drop in foreign exchange reserves was "noticeable."

China's foreign exchange reserves fell in the third quarter by $105.5 billion, the first quarterly fall since 2012 and the largest dollar decline on record, according to People's Bank of China data.
Uncovering the Conduits for China’s Capital Flight

On March 6, Andrew Collier of Orient Capital Research wrote an excellent article on Conduits for China’s Capital Flight.
Chinese investors have discovered a new way to spirit money out of the country behind the backs of the country’s regulators.

In recent years, savvy investors have used false invoicing as a way to disguise their capital flight. A Chinese company pays $1m to a foreign company for a machine tool that is actually worth $500,000; the rest is invested in property or stocks in London or Sydney or New York.

In the fourth quarter of 2014, the China Banking Regulatory Commission (CBRC) became wise to the scheme and began requiring banks to provide more documentation when they allocated foreign exchange to such overseas transactions. As a result, this form of evading capital controls has become more difficult to pull off.

Instead, clever bankers have discovered a new way to move the money offshore for their clients: service payments. Instead of overpaying for an item, they simply pay for a service that never occurred.

Why is this capital flight occurring? With China’s property bubble coming to an end, the ability to generate quick profits through the Shadow Banks is no longer available to the country’s wealthier citizens. Many also are faced with President Xi Jinping’s continuing crackdown against corruption.

Fake companies

We interviewed bankers in China who were quite candid about how they evade capital controls. Currently, the State Administration for Foreign Exchange (SAFE) has the fewest document requirements for consulting and service fees. “It’s simple for our clients to get the proof of materials as long as they know an overseas company that is willing to write a receipt. In fact, a VAT invoice issued by a restaurant in China could have more legal power than the receipt provided by an overseas company,” one foreign commercial banker in Shanghai told us.

There are a couple of methods that have become popular over the past few months.

1) Study Abroad Schemes
2) Interbank Borrowing
3) Overseas Branches of Domestic Companies
4) False Joint Ventures

Many domestic companies have established joint-venture companies with their own overseas subsidiaries, even though this is technically illegal. The JV partner keeps the profits for overseas investing.

How Big is the Problem and What Does it Mean for China’s Economy?
The SAFE, CBRC and other regulators in Beijing appear to be unaware of how large these transfers are. Bankers involved estimate that as much as 40% of the larger service transactions do not involve actual services. This suggests close to $200 billion of all service payments are in reality permanent exports of capital. That number could double in 2015.
Rear View Mirror Discovery

The already well established "tantrum" is actually part of the "Dollar Shortage" thesis. For discussion, see Dollar Shortage Revisited; Is Japan Zimbabwe? Who's in Control? World Gone Mad.

Central banks, other policy makers, and the IMF only see problems after they are well established. Now, out of the blue, they warn of currency crises and emerging market instability that should have been easy to spot over a year ago.

Capital flight out of China has been accelerating for some time, a slowing China has had a huge spillover on Australia and Brazil, and even though it's obvious global growth has slowed to the point of recession, the IMF still has not figured that out yet either.

I have heard back from Anne Stevenson-Yang regarding her excellent presentation on China. Yang maintains China is barely growing if at all. (See Reality Check: How Fast is China Growing? Global Recession at Hand).

I have an excellent power point of hers to share, including a few updated slides. I hope to get this out later today or tomorrow.

Mike "Mish" Shedlock

From ZIRP to NIRP: Virtues of Germany vs. the Vices of Greece; What About „Speece“ and Gold?

Virtues of Germany vs. the Vices of Greece

At the heart of the constant bailout bickering in Europe is a fundamental, but seriously misguided notion that a battle is underway between the virtuous and fiscally responsible Germans and the irresponsible Greeks, Spaniards, and Portuguese.

In this incorrect view, the Spaniards have begun to see the light, but the Greeks need a serious lesson in morality.

If we step back and actually assign blame, we can find plenty of blame to go around.

"Speece" (my term for the Southern eurozone deficit countries of Spain, Greece, Portugal etc.) made many mistakes, but so did Germany.

It's logically impossible to believe "Speece" was a horrendously imprudent borrower, while simultaneously holding the view that Germany was a prudent lender.

More importantly, neither imprudent borrowing nor imprudent lending is at the heart of the eurozone problem.

Background Notes

Some snips from this post are from an email from Michael Pettis at Global Source Partners. Pettis' email contained a 32 page PDF that I will attempt to condense down to a couple pages, while adding a few pages of my own on topics he missed or went over lightly.

Except where noted, anything below in blockquotes is from Michael Pettis. Emphasis throughout is mine.

In regards to comments from Pettis, he says "As my regular readers know, I generally refer to the two different groups of creditor and debtor countries as 'Germany' and 'Spain', the former for obvious reasons and the latter because I was born and grew up there, and it is the country I know best.

Thus any comment from Pettis on "Spain" may mean "any eurozone debtor" and any comment on "Germany" may mean "any eurozone creditor".

I occasionally use the term "Speece" in the same way.

In context, sometimes Pettis says "Spain" and means "Spain". It's usually clear.

Moral Battle Update 

On February 27, the German Bundestag approved Greece's bailout extension request, but acrimony remains high.

For example, the Financial Times noted Germany’s biggest selling newspaper Bild attacked the Bundestag's decision to extend the bailout, with a front page on headline “Bild readers say No – no more billions for Greece.”

In the Bundestag, Klaus-Peter Willsch, a CDU legislator and longstanding bailout critic, launched a personal attack on the Greek prime minister and finance minister.

Look at [Alexis] Tsipras, look at [Yanis] Varoufakis, would you buy a used car from them? If the answer is no, then vote no today,” said Willsch.

And during the intense negotiations between Greece and Germany ahead of this vote, the parliamentary caucus leader of German Chancellor Angela Merkel’s Christian Democrats, Volker Kauder, told reporters "Germany bears no responsibility for what happened in Greece. The new prime minister must recognize that."

No Responsibility?

Does Kauder really believe Germany has "no" responsibility? Does finance minister Wolfgang Schäuble who has made similar-sounding statements believe that?

Whether or not Kauder and Schäuble believe their statements, people hear them again and again. Over time, such statements become conventional wisdom.

From Pettis ...

Nationalist Dreams
European nationalists have successfully convinced us, against all logic, that the European crisis is a conflict among nations, and not among economic sectors.

While distortions in the savings rate are at the root of the European crisis, many if not most analysts have failed to understand why. Until now, an awful lot of Europeans have understood the crisis primarily in terms of differences in national character, economic virtue, and as a moral struggle between prudence and irresponsibility.

This interpretation is intuitively appealing but it is almost wholly incorrect. And because the cost of saving Europe is debt forgiveness, Europe must decide if this is a cost worth paying (and I think it is).

Yet, as long as the European crisis is seen as a struggle between the prudent countries and the irresponsible countries, it is extremely unlikely that Europeans will be willing to pay the cost.
Savings Rate Distortions
From 2000-04 Spain ran stable current account deficits of roughly 3-4% of GDP, more or less double the average of the previous decade. Germany, after a decade of current account deficits of roughly 1% of GDP, began the century with slightly larger deficits, but this balanced to zero by 2002, after which Germany ran steady surpluses of 2% for the next two years.

Everything changed around 2005. Germany’s surplus jumped sharply to nearly 5% of GDP and averaged 6% for the next four years. The opposite happened to Spain. From 2005 until 2009 Spain’s current account deficit roughly doubled again from its 3-4% average during the previous five years.

The numbers are not directly comparable, of course, but during those four years Spain effectively absorbed capital inflows above its “normal” absorption rate equal to an astonishing 21-22% of GDP from 2005 to 2009, and of 31- 32% of GDP from 2000 to 2009.

It wasn't just Spain. In the 2005-09 period, a number of peripheral European countries experienced net inflows of similar magnitude.

In principle, it isn’t obvious which way causality ran between capital account inflows and current account deficits (the two must always balance to zero).

To put it differently, German money might have been “pushed” into these countries, as the “blame Germany” crew has it, or it might have been “pulled” in, by the need to finance their spending orgies, as the “blame anyone but Germany” crew insist. For those who prefer to think in more precise terms, Germany either created or accommodated the collapse in Spanish savings relative to Spanish investment.

If it were the latter case, however, it would be an astonishing coincidence that so many countries decided to embark on consumption sprees at exactly the same time.
Push vs. Pull

I think we can look at push vs. pull another way. To pull credit, one bids up the interest rate. To push credit, one pushes the interest rates down.

From the push-pull interest rate point of view, the "blame Germany" crowd has the better argument.

Arguments Against Debt Forgiveness

Pettis provides a number of widely used arguments against debt forgiveness.

The arguments boil down to a couple of primary beliefs. Most have heard one or both of the following.

  1. The German people provided Spain with real, hard-earned resources which Spaniards misused. It is not fair or honorable that Spain punish the German people for its generosity. To forgive debt would create a moral hazard.
  3. Spain had a real choice, and it chose to spend money wantonly on consumer frivolities and worthless investment projects. Had Spaniards acted more like Germans and refrained from excessive consumption — the result of a flawed national character trait — it would not have suffered from speculative stock and real estate market bubbles, wasted investment and, above all, an unsustainable consumption boom and a collapse in savings. It is unfortunate that ordinary Spaniards must suffer for the venality of its leaders, but ultimately Spain is responsible.
Question of Choice

Was there really a choice? Did Speece make these mistakes acting alone or because of  "venality of its leaders".

Pettis answers ...

Blaming Nations
Because German capital flows to Spain ensured that Spanish inflation exceeded German inflation, lending rates that may have been "reasonable" in Germany were extremely low in Spain, perhaps even negative in real terms. With German, Spanish, and other banks offering nearly unlimited amounts of extremely cheap credit to all takers in Spain, the fact that some of these borrowers were terribly irresponsible was not a Spanish "choice".

Couldn't Spain have refused to accept the cheap credit, and so would not have suffered from speculative market excesses, poor investment, and the collapse in the savings rate?
Not really. Pettis explains ...
"There is no such a decision-maker as 'Spain'. As long as a country has a large number of individuals, households, and business entities, it does not require uniform irresponsibility, or even majority irresponsibility, for the economy to misuse unlimited credit at excessively low interest rates. The experience of Germany after 1871 suggests that it is nearly impossible to prevent a massive capital inflow form destabilizing domestic markets."

As German money poured into Spain, with Spain importing capital equal to 10% of GDP at its peak, the massive capital inflows and declining interest rates ignited asset price bubbles.
Pro-Cyclical Feedback Loops

Spain could not stop these pro-cyclical feedback loops of massive proportion because Spain did not have control over its own interest rate policy or currency.

Instead, the ECB had an interest rate policy best described in my opinion as "one size fits Germany".

The bubble-blowing feedback loop fed on itself until it blew up. Who is really to blame for that?


No discussion of eurozone problems would be complete without a discussion of Target2, an abomination created by the eurozone founders and one of the fundamental flaws of the euro.

Target2 stands for Trans-European Automated Real-time Gross Settlement System.

It is a reflection of capital flight from the "Club-Med" countries in Southern Europe (Greece, Spain, and Italy) to banks in Northern Europe.

Pater Tenebrarum at the Acting Man blog provides this easy to understand example: "Spain imports German goods, but no Spanish goods or capital have been acquired by any private party in Germany in return. The only thing that has been 'acquired' is an IOU issued by the Spanish commercial bank to the Bank of Spain in return for funding the payment."

Also, if people in "Speece" no longer trust their banks, they pull their deposits and park them elsewhere.

Channel for Capital Flight

PIMCO explains Target2 as a Channel for Capital Flight.
​The EU’s loans to Greece, Ireland and Portugal are just the tip of the iceberg of a fledgling transfer system that is creeping into the eurozone via the back door. A far bigger and implicit subsidy is growing beneath the surface in the form of TARGET2.

When the European Central Bank (ECB) creates money, as it currently is doing in grand style, it must end up somewhere. The allocation of TARGET2 balances among the seventeen national central banks, which together with the ECB make up the Eurosystem, reflects where the market allocates the money created by the ECB. The fact that the Bundesbank has a large TARGET2 claim (asset) on the Eurosystem, while national central banks in southern Europe and Ireland together have an equally large TARGET2 liability, simply reflects that a lot of the ECB’s newly created money has ended up in Germany. Why? Because of capital flight.

Countries in southern Europe generated persistent current account deficits since joining the euro in 1999, some of them large. A current account deficit means a country spends more in total than it earns. That extra spending is financed by borrowing from abroad. The source for such borrowing comes from a current account surplus country, like Germany. Since the euro eliminated exchange rate risk among its member states, Germany has invested a substantial portion of its savings in Europe’s current account deficit countries. Some of those savings are now returning home. That’s the capital flight.

Enter the ECB. The ECB stepped into the void left by foreign investors pulling their savings out of these current account deficit countries by lending their banks more money. TARGET2 balances thus reflect intra-Eurosystem credits among the national central banks sharing the euro. When large capital flight to Germany occurred before the euro’s introduction, the deutschemark would appreciate against other European currencies. While pegged against the deutschemark, these exchange rates were still flexible. That flexibility disappeared with the euro.

When capital flight occurs today, the Bundesbank effectively ends up with loans to the other national central banks that are reflected in the TARGET2 claims on the Eurosystem.
Target2 Imbalances

Chart courtesy of Euro Crisis Monitor.

As of January 15, 2015, the Target2 numbers look like this, in billions of euros:

Germany 515.266

Key Target2 Numbers

  • Germany has a Target2 surplus of €515 billion.
  • Greece has a target2 deficit of €76 billion.
  • Spain has a target2 deficit of €192 billion.
  • Italy has a target2 deficit of €164 billion.

The ECB treats all of these surpluses and deficits as if they were equal and as if they don't matter. Clearly they are not equal, and they do matter.

Role of Attitudes

It's not entirely true that attitudes played no role in this mess. Germans tend to view things quite differently because of their experience with hyperinflation in the 1920s.

Today, socialists rule France, Greece, Spain and other countries. Greece has a history of defaults.

To completely dismiss such items is wrong. But who bears responsibility? The Germans, the Greeks, the Spaniards? Speece?

The answer is the eurozone founders and the eurozone aggregate members.

Greece lied to get into the eurozone. But every country knew Greece lied. If they didn't, they should have. And if Germany knew Greece lied, who gets the bigger share of the blame?

More fundamentally, the eurozone founders knew full well there were serious productivity differences, work rule differences, pension differences, etc., etc., between countries. The eurozone founders mistakenly assumed that all the countries would get together and solve these issues. 

Oops. That is damn near impossible now because rule changes require consent of every eurozone country. The more countries that are added, the more difficult it is to get rule changes.

Currently a mass of rule changes are sorely needed on agricultural issues, work issues, pension issues, and literally dozens of issues. Any country can block reform.

Gold Standard

Of all the laughable analogies made about the euro, at the top of the list is the notion the euro acts likes the gold standard. One can find many writers making such claims.

For example, please consider Actually, There Is A Gold Standard Today, And It's Causing An Economic Catastrophe.

The post is fatally flawed, yet it does reflect conventional wisdom.

Here is a short rebuttal: Only in the superficial sense, that countries cannot debase their currency in isolation, does the euro remotely resemble a gold standard. On a practical and far more important basis, Target2 and the common interest rate policy are the opposites of what would happen on a gold standard.

Prior to Nixon closing the gold exchange window, countries running perpetual currency account deficits would see an outflow of gold they would eventually need to do something about.

In the eurozone, the ECB set interest rate policy (primarily for the benefit of Germany) and Target2 said the deficits of Speece do not matter.

Under a gold standard, no one would have lent his own hard-earned gold to Speece, without much higher interest rates and good collateral to secure the loan. This of course would have dampened appetite for borrowing.

Simply put, the eurozone setup was the exact opposite of what would have happened under a gold standard.

Still No Enforcement Mechanism, Anywhere

Because there were no trade imbalance enforcement mechanisms, Speece imbalances grew until they blew up. And until they blew up, the IMF had nothing but praise for Spain! And every step of the way, the IMF underestimated the problems Greece faced.

We are headed into the third Greek bailout, and the IMF remains clueless about Greece's ability to pay back "bailout" money.

Worse yet, there still is no "enforcement" mechanism anywhere in the world, and the structure of the euro is such that imbalances in Europe are even harder to fix than elsewhere.


In the US, we see chronic trade imbalances with China, Japan, and oil producers. We also see constant bickering as to whether or not to label China a "currency manipulator".

Every country is manipulating currency now, one way or another. China does so with pegs, most countries manipulate via interest rate policy.

The mad race to ZIRP has now gone to NIRP. Zero interest rate policy has morphed into negative interest rate policy in a global beggar-thy-neighbor scheme.

EFSF and ESM - Short Term Stabilizing, Long Term Destabilizing

The European Financial Stability System (EFSF), was created  in 2010 as a "temporary" crisis resolution mechanism. The EFSF provided financial assistance to Ireland, Portugal and Greece.

The ESM is supposedly a "permanent" crisis resolution mechanism. The ESM has provided loans to Spain and Cyprus.

Risk is shared by all eurozone member states in proportion to their share in the paid-up capital of the European Central Bank. That risk sharing is in clear violation of Maastricht Treaty no-bailout provisions, but few care about rules in time of crisis.

The problem with "risk sharing" is that every county is partially responsible for problems elsewhere. In short, Spain is partially responsible for Greece, and vice versa. This can lead to cascade effects if a country defaults on bailout obligation.

Dr. Eric Dor, director of IESEG School of Management in Lille, has an update on exposure to Greek debt liabilities.

The details are interesting.

IESEGBilateral loansGuarantees on the borrowings of EFSF to fund its loansImplicit share of TARGET2 claims of the EurosystemImplicit share in the SMP holdings of bonds by the EurosystemTotal

The above table is from Exposure of European Countries to Greece by Dr. Eric Dor, IESEG School of Management.

Note: The above table was produced at a different time than the Target2 balances that preceded it. There may be slight differences.

Spain which is in its own ESM bailout agreement is supposedly liable for €32.744 of Greek exposure. How is that going to work, besides not?

Some disagree (or more likely say they disagree because it suits their short-term needs), but these bailout agreements as structured are in clear violation of the Maastricht Treaty. At some point, this will come back to haunt those who dreamed up those schemes.

Problem is Not Virtue vs. Vice

Let's return to a statement Pettis made much earlier: To the extent that the European crisis is seen as a struggle between the prudent countries and the irresponsible countries, it is extremely unlikely that Europeans will be willing to pay the cost.

Blame Assignment

Hopefully it is now clear the problem is not virtue vs. vice, but something far more complex. With that in mind, the question of the day is "how do we assign blame for problems in Speece?" In rough order, I propose ....

  1. No enforcement mechanisms
  2. ECB
  3. Target2
  4. Eurozone founders and eurozone rules
  5. Eurozone member states ignoring rules
  6. Attitudes

Most have attitudes at the top. I have attitudes at the bottom. I suppose one could summarize points 1-5 simply as the "eurozone flaws" or the "euro" but each is worth discussing separately.

Debt Dynamics

Pettis says "Even if the question of who is to blame, Greece or Germany, were an important one, the answer would not change the debt dynamics."

True enough.

In the end, Greece will not pay back, what cannot be paid back. Indeed, two haircuts have already been taken. The bickering now is whether or not there will be another bailout, and still further haircuts.

How do we know Greece cannot pay back the existing debt? The market tells us so. Ironically, by the time the market makes it clear there is a huge problem (yields soar for example), it's too late to do much of anything but assign costs.

Said Pettis, "My friend Hans Humes, from Greylock Capital, has been involved in more sovereign debt restructurings than I can remember, and he once told me with weary disgust that while it is usually pretty easy to guess what the ultimate deal will look like within the first few days of negotiation, it still takes months or even years of squabbling and bitter arguing before getting there. We cannot forget however that each month of delay will be far more costly to Greece and her people than we might at first assume."

Rise of Fringe Parties

Curiously, one of the biggest finger-pointers in this mess now is Spain. The Financial Times talked about it in Spain Keeps Hawkish Eye on Greece as Southern Solidarity Crumbles.

"In its fear of Podemos, the Spanish equivalent of Syriza, and its determination to be one of the
'virtuous' countries, it strikes me that Madrid is probably moving in the wrong direction economically. Ultimately, by tying itself even more tightly to the interests of the creditors, Rajoy and his associates are only making the electoral prospects for Podemos all the brighter," said Pettis.

Solidarity Where?

On Monday March 2, acrimony took another huge step forward as Greek premier Alexis Tsipras accused Spain and Portugal of sabotaging negotiations.
“We found opposing us an axis of powers ... led by the governments of Spain and Portugal which, for obvious political reasons, attempted to lead the entire negotiations to the brink,” Tsipras told party members on Saturday.

Their plan was, and is, to wear down, topple or bring our government to unconditional surrender before our work begins to bear fruit and before the Greek example affects other countries… And mainly before the elections in Spain.
Prime minister Rajoy responded "We are not responsible for the frustration generated by the radical Greek left that promised the Greeks something it couldn’t deliver on."

Spanish Prime Minsiter Mariano Rajoy is making a big mistake. Spain can use debt relief. And the citizens of Spain want debt relief.
By taking a hard stance in favor of Berlin, Rajoy adds fuel to the rise of Podemos. Siding with Germany is the wrong thing to do if Rajoy wants to win reelection.

Playing with Fire

Tsipras is a close friend and political ally of Pablo Iglesias, the former political science lecturer who founded Spain’s anti-establishment Podemos movement.

Podemos is currently in the lead in Spanish polls. Elections are later this year.

Rise of Extreme Parties

Check out the rise of "extreme parties".

  • Syriza in Greece
  • Golden Dawn in Greece
  • Podemos in Spain
  • Five Star Movement in Italy
  • National Front in France
  • AfD in Germany
  • New Fins in Finland

In that group there are leftwing and rightwing parties, but all have one thing in common: They are sick of something. Spain is supposedly in recovery. What are Spaniards upset about? Greeks?

Spanish Unemployment

Spanish Youth Unemployment

Greek Unemployment

Greek Youth Unemployment

Unemployment is a huge problem. Growth alone will not cure this problem. Both Spain and Greece are growing now.

High unemployment rates in Speece will remain for a long time unless there is debt forgiveness or Germany turns its current account surplus into a deficit for the express benefit of Speece.

Speece cannot become more like Germany, unless Germany becomes less like Germany and more like Speece.

Third Bailout or Grexit

I believe a third bailout and a third restructuring of Greek debt is necessary (See
Third Greek Bailout? Another €53.8 Billion Needed? Primary Account Surplus Revisited).

Will Greece go along? Slim chance, unless "bailout" truly means bailout, not more debt.

Will Germany go along? The answer is almost certainly no. That means a Grexit or a default in June when this extension ends.

Can the Euro Be Saved?

Pettis says "Europe must decide if this [debt forgiveness] is a cost worth paying (and I think it is)."

I do not believe it's that simple (and that is not by any means simple).

Here's a better way of looking at things: "Is the euro so fundamentally flawed, and tensions so high that the euro cannot possibly be saved at all?"

I believe the answer to that question is yes.  If it is yes, then discussion better begin soon on how to exit from this mess.

If the answer is no, then someone needs to explains what it will take to get Germany to forgive enough debt to allow Speece to grow without perpetually high unemployment rates.

There are only three possible paths at this point.

Three Alternative Paths

  1. Enough debt writeoffs to allow Europe to grow
  2. High unemployment and slow growth in Speece, with stagnation elsewhere in Europe
  3. Breakup of the eurozone

There are no other realistic choices. Interestingly, none of them fixes the fundamental problem of "no enforcement mechanism" anywhere in the world.

 Let's turn now to the source of that particular problem.

Nixon Closed the Gold Window

The last semblance of enforcement mechanisms vanished when Nixon "temporarily" closed the gold window in 1971, refusing to let foreign central banks redeem their dollars for gold.

What else happened at the same time?

If you guessed debt soared as did income inequality, you guessed correctly.

Income Inequality

The above chart from The Rise and Fall of US Income Inequality (annotations in purple added with a hat tip to zero hedge for the idea).

Gross Federal Debt

Beggar Thy Neighbor

Nothing is in place anywhere to stop "beggar thy neighbor", competitive currency debasement, competitive QE, negative interest rates, and all sorts of other amazing distortions brought about by central bank policies in general, not just in Europe.

History suggests nothing will happen until there's a crisis.

We did not use the last crisis well. Global debt went up $57 trillion dollars or so since 2007 (see Seven Years Later, Global Debt Keeps Piling Up, $57 Trillion More Than 2007)

There was no deleveraging anywhere. And the leveraging up was certainly not for the benefit of the 99%.

Consumer Price Deflation vs. Asset Deflation

In their inane attempt to prevent consumer price deflation, the world's central banks have spawned massive asset bubbles in equities, junk bonds, and housing.

When those bubbles burst, they will spawn the extremely destructive asset deflation that central bankers ought to fear, but never do because central bankers never see the bubbles they create until they burst wide open.

Currency Crisis Awaits 

Global imbalances are so extreme, interest rate policy so absurd, and unsound fear of consumer price deflation that a massive currency crisis is all but inevitable now.

The currency crisis could start in Europe. But it could also start in Japan, the UK or anywhere.

Meanwhile, as long as there is no enforcement mechanism on spending and on trade imbalances, the bubbles will grow and grow and grow until central banks can no longer stuff anymore debt into the system.

Good luck when the bubbles pop. Let's hope the next crisis is handled better than the last one.

Don't count on it, especially when ...

  1. Central banks do not see themselves as part of the problem
  2. The 1% want to keep the status quo
  3. The Keynesians believe more spending is the answer to too much debt
  4. The Monetarists believe more printing is the proper response to too much printing
  5. The academics blame the 1% instead of the Fed (central banks).

Mike "Mish" Shedlock

Steen Jakobsen Warns „Euro is Not a Good Idea and ECB About to Make Biggest Mistake in History“

Saxo Bank CIO and chief economist Steen Jakobsen warns the US is not Europe, the Euro is not a good idea, and the ECB is About to Make Biggest Mistake in History.

Via Mish-modified translation from El Economista.
Steen Jakobsen has never been less outspoken regarding historic moment that is about to live the Eurozone. He explains his particular vision of the economy, bluntly. This morning, visiting Madrid, Jakobsen warned that quantitative easing (QE), printing money to buy government bonds, will be the biggest mistake of the European Central Bank, making matters worse.

In his view, the ECB wants to get funding rates low for listed and public companies. However, big companies have taken much of the credit, while SMEs (small and medium size enterprises) remain unfunded. Funding goes to the 20% of companies that "never again will create jobs." Interest rates declining few tenths more will not improve the economy.

Europe is not USA

Jakobsen says success stories like the three QE Federal Reserve (Fed) cannot be extrapolated to the Eurozone. His reason? The US is a net debtor and falling interest rates affects international creditors and rising national income. In Europe the opposite is true. Citizens of the euro countries are net savers, which means that falling interest rates deteriorates their income and does nothing to activate the economy.

In addition, Jakobsen believes that monetary stimulus suffers from a glitch: "The negative deposit facility and buying sovereign bonds are counter each other." This means that banks will not be willing to get rid of their bond portfolio to deposit excess liquidity at the ECB when interbank rates are negative.

In the case of monetary policy in the US, Jakobsen believes the Fed will have a very difficult raising interest rates in 2015. In his view, unless wages start to increase steadily, neither the Fed nor other major central bank may tighten monetary policy.

Consequences of Poor Construction of the Euro

To Jakobsen, many of the current problems stem from poor construction of the euro. "I do not think that the euro is a good idea. It's poorly built, without a fiscal union, and without consolidation of common funding streams for all member states. As designed, the euro does not have sufficient foundation to support the Eurozone.

ECB Has Done Nearly Everything Wrong

So the ECB has done it all wrong? No ... but almost.

The great mistake of the European entity was to allow the economic cycle of the economy take its course. "They have not allowed the market to purge mistakes and now the situation is worse.

Had the business cycle been left alone, many broken banks would have been acquired by larger ones, reducing debt and generating a prone position to lay the foundations for recovery indicates. Instead, entities transferred bad debts from one place to another, from financial institutions to "bad banks", not solving anything in the process.
"Full-Board Bingo"

That's a "full-board" European bingo, with every square covered.

The euro cannot and will not work because it's fatally flawed as I have noted for years.

Fatal flaws include no fiscal union, wildly differing social agendas of member states, wide variances in productivity, wage discrepancies, and retirement benefit discrepancies.

Those problems make it impossible to conduct monetary policy. The "Target2" system of payments is icing on the fatally flawed cake. (See Eurozone Target2 Imbalances Rise Again, Led by Italy).

Finally, I maintain QE did not work in the US either, unless "work" means creating one of the biggest equity bubbles in history coupled with the absolute biggest junk bond bubble in history.

Nothing Fixed Anywhere

It's not just Europe. Nothing has been fixed anywhere.

Bernanke says letting Lehman fail was his biggest mistake. What a bunch of nonsense. Lehman failed in every sense of the word.

In effect, Bernanke wanted to bail out a failed institution at taxpayer risk and expense. The markets need to purge excesses. Instead, central banks refuse to allow just that, blowing bubbles of increasing amplitude over time in the wake.

Mike "Mish" Shedlock

Smoke and Mirrors Hide the Collapse in Corporate Profits

Did you notice the collapse in corporate profits?

John Hussman, Steen Jakobsen, and Albert Edwards at Society General did. Hussman tweeted the following chart this morning.

Steen Jakobsen, chief economist at Saxo bank passed on the above tweet this morning along with an attachment from Albert Edwards and this comment: "John – who I met at the Wine Country Conference – is not only great economist and fund manager, but also a remarkable Gentleman who lives to support Autism. This is his link Hussman Funds."

From Society General - No Link Available
Smoke and Mirrors Stop Us Seeing a Slump in US Profits

During the excitement of the downward revision of Q1 US GDP from +0.1% to -1.0% investors seem not to have noticed a $213bn, 10% annualised slump in the US Bureau of Economic Analysis’s (BEA) favoured measure of whole economy profits, defined as profits from current production. Also known as economic profits, the BEA makes adjustments to remove inventory profits (IVA) and to put depreciation on an economic instead of a tax basis (CCAdj). We show below the stark difference between the BEA’s calculation for post-tax headline profits (up 5.3% yoy) and economic profits (down 6.8% yoy). In this note we try to explain what is happening and why the 10% annual slump in economic profits really does matter.

Having spent the best part of 25 years following US whole economy profits I feel I have a good understanding on what exactly is going on. I was however most surprised at the divergence in the two key series shown on the front page chart. After a very long chat with a very helpful person from the BEA, she emailed me to “note this quarter, there is a substantial difference between profits from current production (that include IVA and CCAdj) and profits before tax (that exclude IVA and CCAdj) due to the expiration of investment incentives that allowed companies to accelerate depreciation over the past several years. As provisions of the tax acts from 2002, 2003, 2008, 2009, 2010, and 2012 expire, and as no new provisions are introduced, businesses are now expensing less depreciation for tax purposes. As a result, tax based depreciation expense, measured as CCA, is falling, while economic depreciation expense, measured as CFC, continues on a steady growth trend (see charts below). The difference between these two measures is the CCAdj. With economic depreciation expense higher than tax based depreciation expense, BEA’s measure of corporate profits with CCAdj shows a decline, while profits excluding CCAdj show an increase.

So headline reported profits are currently artificially inflated upwards to show a roughly 5% yoy increase, which is incidentally the same pace that the MSCI trailing reported stockmarket profits are rising by – both are misleading investors as to the underlying strength of profits.

Net cashflow with IVA ($bn)

The BEA press release itself describes net cashflow with IVA as “the internal funds available to corporations for investment (calculated as after tax profits with IVA and CCAdj, net of dividend payments but plus depreciation on an economic basis (CFC))”. We can see from the chart above that this decreased by $132bn in Q1 following a decrease of $43bn in Q4. This key measure of internal funds available for investment has stalled badly over the last two years (see chart above). No wonder US business investment has been struggling recently. The bottom line is that the US profits margin cycle has begun to turn down at long last (see chart below). It is doing so from elevated but not unprecedented levels – especially the nonfinancial part of the economy (my former colleague Leo Doyle always told me I had to add depreciation into the profits numerator as the denominator GDP was also measured gross of depreciation – i.e. the G in GDP!)

Thanks to Albert Edwards via Steen Jakobsen for the above charts.

There is more in the report, including a discussion of why a renminbi (yuan) devaluation will crush US and European corporate profits.

If I can get an online link I will post it.

Wine Country Conference Videos

Here is a link to the 2014 Wine Country Conference Videos. Steen Jakobsen's, Chris Martenson's, and my presentation will be out later this week.

Inquiring minds should also take a look at Hussman's post today, Market Peaks are a Process. John speaks of the Wine Country Conference Presentations and the cause.

Here is John's blurb on the cause.
Last month, the second annual Wine Country Conference was held in Sonoma California, this year to benefit the Autism Society of America. As many of you know, my 20-year old son JP has autism, so the cause is close to my heart. The conference website has both PowerPoint slides and videos of the presentations and Q&A sessions (and more will be added over the coming weeks). The title of my presentation was “Very Mean Reversion”

My hope is that if you appreciate the conference materials, you’ll consider making a donation – in any amount at all – to the Autism Society of America. The proceeds of the conference will go to support programs and chapters at the local level throughout the United States (we’ve also put up a $50,000 matching grant to encourage donations). I appreciate your generosity.

Thanks – John
Please Consider Making a Donation

More presentations are yet to come! And if you enjoyed the presentations (or even if you didn't), please Make a Donation to the Autism Society.

On behalf of John and the Autism Society, thanks to all who make donations. Any amount helps.

Mike "Mish" Shedlock

Clash of Generations – Boomers vs. Millennials: Attitude Change Will Disrupt Wall Street and Corporate America

As boomers and gen-Xers hand over the economic reins to millennials, a once in a multi-generational attitude shift comes with it.

Unlike boomers and gen-Xers focused whose primary focus was on money and "getting ahead" lifestyles, millennials have more of a depression-era survival mentality coupled with a completely different set of values.

The ensuing attitude change has profound implications, and that is the focus of the Brookings study:  How Millennials Could Upend Wall Street and Corporate America.

Let's start with a couple of demographic definitions then a look at the study.

  • Boomers: Born 1946-1964
  • Generation X: Born 1965-1981 
  • Millennials: Born 1982-2003

Brookings Study Excerpts
Millennial Dominance

Millennial Values

By 2020, Millennials will comprise more than one of three adult Americans. It is estimated that by 2025 they will make up as much as 75 percent of the workforce. Given their numbers, they will dominate the nation’s workplaces and permeate its corporate culture. Thus, understanding the generation’s values offers a window into the future of corporate America.

In the future, most Americans, taking their cue from Millennials, will demonstrate a greater desire to advance the welfare of the group and be less concerned with individual success. They will be less worried about being guided in their daily decisions by software and more intrigued by the opportunities it offers. Even without any major environmental disaster, they will display a greater reverence for the environment and less interest in the acquisition of things as opposed to experiences.

It will be a world that is radically different than the one those who wield power today have grown accustomed to leading. The Baby Boom generation, born between 1946 and 1964, has made confrontation the touchstone of its existence. In their youth, Boomers protested the Vietnam War, or fought against those who did. As they aged, both conservative and liberal Boomers polarized America’s politics, making compromise morally unacceptable. Throughout their lives, Boomers have honed conflict and competition to a fine art.

As Boomers begin to leave the corridors of power in Congress and the executive suites of corporate America, they are being replaced by members of Generation X, who are largely devoted to the pursuit of the bottom line—preferring speed over reflection and autonomy over collective decision-making.

Silicon Valley CEOs, many of whom are drawn from the ranks of Generation X, look with disdain on the good old boys network of their Wall Street counterparts and are eager to leverage the technologies they have developed to gain advantage in the marketplace over the older, more established titans of the media and telecommunication sectors.

This is not to suggest that Millennial CEOs are, or will be, any less interested than Boomers or Gen-X’ers in assuring the success of the enterprises they now, or eventually will, lead. Rather, it is to emphasize the importance of recognizing the differences in how Millennials define success and the way they make decisions in order to envision the future of corporate America.  

Millennials as Consumer-Workers

Cone Communications has been tracking the attitudes of American consumers toward businesses’ involvement in social issues. As Millennials became a larger and larger share of the marketplace, the idea of “cause marketing” has evolved from a nascent promotional strategy to the key differentiator, not only in deciding what to buy, but who to trust and reward with brand loyalty.

Cone’s 2013 survey of over 1,200 U.S. adults found Millennials to be the generation most focused on corporate social responsibility when making purchasing decisions.

Almost all Millennials responded with increased trust (91%) and loyalty (89%), as well as a stronger likelihood to buy from those companies that supported solutions to specific social issues (89%). A majority of Millennials reported buying a product that had a social benefit and 84% of a generation that accounts for more than $1 trillion in U.S. consumer spending considered a company’s involvement in social causes in deciding what to buy or where to shop. In 2013, 89% of all American consumers said they would consider switching brands to one associated with a good cause if price and quality were equal. That percentage was 23 points higher than when Cone first did its survey in 1993, at a time when no Millennials were part of the adult population.

Not only are Millennials creating the need for companies to pay attention to their corporate social responsibilities, but they are also leading a shift in buying behavior away from the glorification of consumerism to a more measured view of what’s important in life. Young & Rubicam’s brand attribute survey in 2009 of 2,300 adults found that a majority of Millennials belonged to a segment labeled “Spend Shifters.” Not only did three-fourths of the “Spend Shifters” say they “made it a point to buy brands from companies whose values are similar to my own,” almost all of them (87.5%) disagreed with the statement that “money is the best measure of success.”

The authors of Spend Shift, John Gerzema and Michael D’Antonio, pointed to a major shift between 2005 and 2009, just as the first wave of Millennials became adults, in what consumers were looking for in the companies with which they wanted to do business. Attributes such as exclusive (-60%), arrogant (-41%), and sensuous (-30%) fell from favor while values more associated with those of the Millennial generation rose dramatically.

Kindness and empathy rose 391 percent in these five years, the biggest shift in attitudes ever seen in the seventeen year history of the survey. Other values associated with the generation, such as friendly (+148%) and socially responsible (+63%), also rose dramatically. These shifts in consumer attitudes driven by Millennial values will give every American corporation that wants to attract customers, not to mention workers and investors, no choice but to deliver on a commitment to make the world a better place one cause at a time. Companies will also have to behave a lot more nicely than they are accustomed to in order to deliver those results, more like the characters in “Her” than those in “The Graduate.”

Evidence that these attitudes represent a generational shift, not one based simply on age, can be found in a benchmark survey of 1,250 insurance company employees conducted for LifeCourse Associates in 2012. Almost two-thirds of Millennial employees said they wanted their employer to contribute to social or ethical causes they felt were important. Only half of the Boomers and older Gen Xers surveyed felt the same way.

This desire on the part of Millennials for their daily work to reflect and be a part of their societal concerns will make it impossible for corporate chieftains to motivate Millennial employees simply by extolling profits, or return on investment for their shareholders, or even employee salaries. For example, a recent Intelligence Group study found that almost two-thirds (64%) of Millennials said they would rather make $40,000 a year at a job they love than $100,000 a year at a job they think is boring. 

Millennials Think About Money Differently

In its latest study of the Millennial Generation, Millennials in Adulthood, the Pew Research Center found that America’s youngest adults were the least trusting of any generation.

Only 19 percent of Millennials agreed with the statement that “most people can be trusted,” a percentage that was about half of all other older generations.

A recent survey by MFS Investment Management found that nearly half of Millennials “never feel comfortable investing in the stock market.”  The survey also showed Millennials keep more of their assets in cash, less in stocks, and, in spite of their relative youth, have a shorter time horizon—less than five years—for their investments than Boomers or Gen Xers.

A report by UBS Wealth Management in the Americas described Millennials as “the most conservative generation since the Great Depression” with regard to its savings habits. According to UBS’s research, the average investor aged 21 to 36 has 52 percent of their savings in cash, compared to 23 percent for other age groups.

Clearly, one reason for this avoidance of the stock market stems from the same experience of extreme volatility and risk that the Millennials’ GI Generation great grandparents experienced when they were coming of age during the Great Depression. A 2013 study by Accenture confirmed these attitudes, with 43 percent of Millennials identifying themselves as conservative investors, compared with 27 percent for Generation X and 31 percent for Boomers. But the survey also uncovered a deeper reason than just the Great Recession for this cautious investing behavior by Millennials.

The Accenture survey found high levels of mistrust of financial institutions among Millennials and a greater reliance on the Internet, social media, and personal networks for financial advice. As Kelsey Raycroft, a Boston-based Millennial put it, “The personal connection is important to me, especially with money stuff.... When I see these commercials with big companies, I’d rather go to somebody I trust.”

In fact, this deep level of distrust toward the banking industry led the authors of the Millennial Disruption Index to identify the financial sector as the industry most likely to experience severe disruption in its business model. Their three-year research study of more than 10,000 Millennials also found that of the ten least-liked brands among members of this generation four belonged to the nation’s most powerful banks—J.P. Morgan Chase & Co., Bank of America Corp., Wells Fargo & Co., and Citigroup. Seventy-one percent told the researchers that they would “rather go to the dentist than listen to what banks are saying.”
Report Merits a Closer Look

There is much more in the 19-page PDF that merits a closer look.

For example, the study contains a discussion of what working 9-to-5 means at a place like Goldman Sachs. The short synopsis is that for the first couple of years, 9-to-5 means 9AM to 5AM, seven days a week.

In the list of companies where millennials would like to work, there are some non-surprises like Google and Apple, but also some real surprises like the FBI and CIA.  St. Jude's Children's Hospital, also a surprise, was the number one choice.

Major Attitude Shift

I have been writing about the implications of changing attitudes since at least 2008.

Flashback June 25, 2008: This is what I said about attitude changes in Peak Credit
Secular Attitude Change Underway

There is a secular attitude change happening right now. Boomers close to retirement are now (finally) scared to death as the equity in their houses has been vaporized. School age children are seeing homes foreclosed, and families destroyed over debt. The American consumer, who nearly everyone thinks will be back as soon as the economy picks up are mistaken.

Secular shifts like these come once in a lifetime. Sadly it's too late for many cash strapped boomers counting on equity in their houses for retirement.

Lessons Of The Great Depression Forgotten

The lessons of their great grandfathers who lived in the great depression era were forgotten. Over time, everyone learned to ignore the dangers of debt, risk, and leverage. Belief in the Fed and the government to bail out any problem are ingrained. Bank failures are distant memories.

Anyone and everyone who wanted credit got it, and on the easiest of terms: subprime, pay option arms, reckless leverage, and covenant lite debt and toggle bonds that allowed debt to be paid back with more debt. That's what it takes to hit a peak.

Peak Credit

Peak credit has been reached. That final wave of consumer recklessness created the exact conditions required for its own destruction. The housing bubble orgy was the last hurrah. It is not coming back and there will be no bigger bubble to replace it. Consumers and banks have both been burnt, and attitudes have changed.

It took nearly 80 years for people to get as reckless as they did in 1929. 80 years! Few are still alive that went through the great depression. No one listened to them. That is the nature of the game. The odds of a significant bout of inflation now are about the same as they were in 1929. Next to none.

Children whose parents are being destroyed by debt now, will keep those memories for a long time.
Social and Stock Market Impacts

Peak credit has been surpassed, but a substantial portion of the rise in credit is in the form of student loans that cannot and will not be paid back.

Importantly, millennial attitudes towards cars and other material goods is not the same as their parents. Moreover, student debt and a dearth of high-paying jobs ensures that housing formation will stay depressed, even if attitudes did not change.

As boomers retire, they will need to draw down on both their stock market portfolios and their savings (assuming they have either). Economic support from relatively low-paid millennials so that boomers can maintain their lifestyles will be massive.

Millennials will assist aging boomers via taxation and by overpaying for Obamacare. Higher taxes coupled with increasing time commitments to help care for aging parents will take a toll. And because boomers live longer than ever, the economic drain and time commitment from millennials will increase every year.

This has downward implications on the economy and the markets, especially in light of millennial-mistrust in stocks and the massive amount of student debt many of them carry.

Wall Street is not prepared for the major attitude and demographic shifts that are now underway. Are you?

In a related post, particularly for millennials searching for jobs, please consider BLS Employment Projections Through 2022: How Many Jobs Require a College Degree?

Mike "Mish" Shedlock

Will emerging markets come back?

I don’t often make reference to these kinds of things in my blog, but Saturday’s terrorist attack in the Kunming train station – in which 29 innocent people were hacked to death (the toll was especially high among the elderly who were unable to run away quickly enough from the killers) – fills me with dread and dismay. This kind of brutal massacre is not about sending a message to Beijing or to the world but is rather aimed at getting the authorities to overreact so as to create hatred within the country.

I truly hope it does not succeed. There is a great deal of anger here in China but so far, I am glad to say, excluding some over-the-top responses in the internet world the authorities and Chinese people generally seem not to be overreacting. I wish there were some way that we as individuals could of respond to the Kunming train station massacre but what is among the most awful aspects of this kind of insane event is the feeling of helplessness it creates. As individuals there seems to be so little we can do either to prevent this kind of behavior or to console the victims.

And it is not just in Kunming that things seem unsettled. Recent events in the Ukraine have capped several years of social unrest, revolution, and war around the world, and these seem to have intensified since the beginning of the global crisis of 2007-08. This should not have surprised us, and we should probably brace ourselves for several more years of political uncertainty. In late 2001 I published an article with Foreign Policy discussing what I expected the world to look like following the global crisis that I, perhaps a little prematurely, was expecting imminently.

In the article I pointed out that in the past 200 years we had experienced a number of globalization cycles, driven largely by deep changes in monetary conditions, that followed a pattern regular enough to allow us to make some fairly confident predictions. We were, I argued, living towards the end of one such cycle, and when underlying liquidity conditions changed, we were likely to see the same sort of things that we had seen in previous cycles. Among these, I wrote:

Following most such market crashes, the public comes to see prevalent financial market practices as more sinister, and criticism of the excesses of bankers becomes a popular sport among politicians and the press in the advanced economies. Once capital stops flowing into the less developed, capital-hungry countries, the domestic consensus in favor of economic reform and international integration begins to disintegrate. When capital inflows no longer suffice to cover the short-term costs to the local elites and middle classes of increased international integration – including psychic costs such as feelings of wounded national pride – support for globalization quickly wanes. Populist movements, never completely dormant, become reinvigorated. Countries turn inward. Arguments in favor of protectionism suddenly start to sound appealing. Investment flows quickly become capital flight.

These predictions about what the world was going to look like in the next several years were easy to make, I argued, because they occurred so regularly. One of the predictions that I should have made, but didn’t, was that after the globalization process had been reversed we were likely to see an upsurge in war, revolution, conflict and social unrest. These, after all, were events we usually associated with the end of previous globalization cycles, but at the time I wrote the article (published less than two weeks before the 9/11 terrorist attack) it really seemed that the world had changed in some subtle but profound way and that we had become too sophisticated to engage in such disruptive behavior.

I should have known better. I have spend much of the past two decades trying to show how persistently historical patterns reemerge, and why the claim that “this time is different” is almost always wrong, and yet I believed that when it came to revolution and war perhaps this time really was a little different. International institutions were strong enough, I believed, to manage the kinds of pressures that normally emerged from a reversal of many years of globalization.

This turns out perhaps not to be the case. Watching the news on television, especially events unfolding in the Ukraine, leaves me with a sense that we haven’t figured out how to manage these pressures. The recent rout in emerging markets has left a lot of people very confused about the direction in which the global economy, and developing countries more specifically, are going, but it turns out that once again we should not have found recent events at all surprising. They are part of the globalization cycle.

There was no “decoupling”

But once again we wanted to argue that this time was different. For several years we had been hearing that the global crisis of 2007-08 marked some kind of inflection point that signaled the decoupling of developing countries from the advanced countries of North America and Europe. The argument, as I understand it, was that the developed countries of Europe and North America had got themselves caught up in a debt-fueled consumption boom, of which the crisis was the culmination and the beginning of the process of reversal.

The developing world had, according to this argument, managed to untie itself from developed-country demand and its growth was now more likely to be driven by domestic demand arising at least in part from the more favorable demographics of the developing world. The growing middle classes, especially in China and India, were emerging to become a major focus of demand, and not only were other developed countries benefiting from this new source of demand, but eventually all countries would benefit from demand generated in the developing world.

I never found this thesis very convincing and completely rejected the “decoupling” argument. As I see, it the decade before the crisis was characterized by a series of unsustainable processes driven largely by structural changes in the global economy that tended to force up savings rates globally. In my view, the 2007-08 crisis was just the first stage of the rebalancing process, in which overconsumption in the developed world was forced by rising debt to reverse itself. But of course this couldn’t happen without equivalent adjustments elsewhere. The crisis now affecting developing countries is, as I see it, simply the second stage of the global rebalancing, or the third if you think of the sub-prime crisis in the US as the first stage and the euro crisis in Europe as the second stage.

To understand the link, we need to go back to the pre-crisis period. Ever since the 2007-08 global crisis, the world has suffered from weak global demand. Demand had been strong before the crisis, but this largely reflected the credit-fueled consumption binge, combined with a huge amount of what proved to be wasteful real estate development, unleashed as a consequence of soaring stock and real estate markets that were themselves the consequences of speculative capital pouring into countries like the United States and peripheral Europe.

The crisis put an end to this. After stock and real estate markets in the United States and Europe collapsed, and once financial distress worries constrained the ability of households to borrow for additional consumption, the great consumption and real estate boom in many parts of the world also ended.

Normally slowing consumption growth should also cause slowing investment. The purpose of productive investment today, after all, is to serve consumption tomorrow, but at first this didn’t happen. Instead we saw an intensification in 2009-10 of the credit-fueled investment binge in China, as well as in developing countries that produced the hard commodities China needed. This increase in investment was supposed to offset the impact of declining consumption in the west, and it certainly had that effect. The collapse in China’s current account surplus, for example, had almost no impact on domestic employment because it was offset by an astonishing surge in domestic investment.

This is what set off talk of “decoupling”. As weaker consumption and real estate investment in Europe and the US forced down growth in global demand, it was counterbalanced by greater demand in the developing world, driven in large part by China. Not surprisingly this meant that a larger share of total demand accrued to poor countries at the expense of rich countries.

Decoupling in the 1970s

But the process was not sustainable. In China well before the crisis we were already experiencing the problem of excess investment in manufacturing capacity, real estate and infrastructure. In developing countries like Brazil this was matched by investment in hard-commodity production based on unrealistic growth assumptions in China. Weaker demand in the rich countries, especially weaker consumption, should have reduced whatever the optimal amount of global investment might have been, especially as we already suffered from excess capacity. To put it schematically:

  1. Before the crisis the world had already over-invested in real estate and manufacturing capacity based on unrealistic expectations of consumption growth.
  2. The global crisis forced consumption growth to drop. This should have meant that if investment levels were too high before the crisis, they were even more so after the crisis.
  3. Instead of cutting back on investment, however, the developing world reacted to the drop in rich-country demand by significantly increasing investment, driven at least in part by worries that the consumption adjustment in Europe and the US would cause a collapse in export growth which would itself force unemployment up to dangerous levels. 

Clearly this wasn’t sustainable, and not surprisingly soaring debt is now forcing this investment surge to end. As a result, we are now going to experience the full impact of slower consumption growth in the rich countries, but instead of this being mitigated by higher investment growth in the developing countries, it will now be reinforced by slower investment growth in the developing world. Over the next few years demand will revive slowly in the US, not at all in Europe, and it will weaken in the developing world.

We’ve seen this movie before. In the mid-1970s the US and Europe were mired in recession as loose monetary policy in the 1960s, soaring oil prices, and many years of US spending on both the Great Society and the Vietnam War forced the US into an ugly adjustment. Instead of succumbing to reduced global demand, however, developing countries, flush with cheap capital driven by international banks eager to recycle burgeoning petrodollar deposits, intensified a developing-country investment binge that had already driven a decade of high growth for many countries. While the West suffered, they continued to grow, and for perhaps the first time in modern history excited bankers and businessmen spoke ecstatically about the decoupling of the developing world from growth problems in the US and Europe.

But the end result should have been predictable. Developing-country debt levels soared throughout the late 1970s, and once the Fed, concerned with US inflation, turned off the liquidity tap, excessive debt forced much of the developing world, and all of Latin America, into a “lost decade” of low growth, high unemployment, political turmoil and financial distress. In the 1970s of course the big capital push behind the surge in investment was driven by soaring savings in the Middle East, as oil revenues rose much faster than the ability of Middle-Easterners to increase consumption. Today the big capital push is driven by soaring savings in China, as structural constraints cause China’s production of goods and services to rise much faster than China’s ability to consume them.

The result is that over the next few years global demand will be even weaker than it has been since the crisis. Consumers in North America, peripheral Europe, and the newly rich middle classes around the world are still cutting back on consumption to pay down debt. Investors in China, Latin America and Asia are finally responding to overcapacity and soaring debt by themselves cutting back on investment. But if we all cut back our spending to service our debts, paradoxically, our debt burdens will only rise, and the great danger is that rising debt burdens will force us to cut back even more, thus making the debt burden worse (and, by the way, forcing at least some countries, in both the developing world and in Europe, to default).

Nothing fundamental has changed. Demand is weak because the global economy suffers from excessively strong structural tendencies to force up global savings, or, which is the same thing, to force down global consumption. Lower future consumption makes investment today less profitable, so that consumption and investment, which together comprise total demand, are likely to stagnate for many more years.

Squeezing out median households

Two processes bear most of the blame for weak demand. First, because the rich consume less of their income than do the poor, rising income inequality in countries like the US – and indeed in much of the world – automatically force up savings rates. Second, policies that forced down the household income share of GDP, most noticeably in countries like China and Germany, had the unintended consequence of also forcing down the household consumption share of GDP. This income imbalance automatically forced up savings rates in these countries to unprecedented levels.

For many years the excess savings of the rich and of countries with income imbalances, in the form of capital exports in the latter case, funded a consumption binge among the global middle classes, especially in the US and peripheral Europe, letting us pretend that there was not a problem of excess savings. The 2007-08 crisis, however, put an end to what was anyway an unsustainable process.

It is worth remembering that a structural tendency to force up the savings rate can be temporarily sidestepped by a credit-fueled consumption binge or by a surge in non-productive investment, both of which happened around the world in the past decade and more, but ultimately neither is sustainable. As I will show in my next blog entry in two weeks, in a closed economy, and the world is a closed economy, there are only two sustainable consequences of forcing up the savings rate. Either there must be a commensurate increase in productive investment, or there must be a rise in global unemployment.

These are the two paths the world faces today. As the developing world cuts back on wasted investment spending, the world’s excess manufacturing capacity and weak consumption growth means that the only way to increase productive investment is for countries that are seriously underinvested in infrastructure – most obviously the US but also India and other countries that have neglected domestic investment – to embark on a global New Deal.

Otherwise the world has no choice but to accept high unemployment for many more years until countries like the US redistribute income downwards and countries like China increase the household share of GDP, neither of which is likely to be politically easy. But until ordinary households around the world regain the share of global GDP that they lost in the past two decades, the world will continue to face the same choices: an unsustainable increase in debt, an increase in productive investment, or higher global unemployment, that latter of which will be distributed through trade conflict.

Emerging markets may well rebound strongly in the coming months, but any rebound will face the same ugly arithmetic. Ordinary households in too many countries have seen their share of total GDP plunge. Until it rebounds, the global imbalances will only remain in place, and without a global New Deal, the only alternative to weak demand will be soaring debt. Add to this continued political uncertainty, not just in the developing world but also in peripheral Europe, and it is clear that we should expect developing country woes only to get worse over the next two to three years.


This is an abbreviated version of the newsletter that went out three weeks ago.  Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at, stating your affiliation, please.  Investors who want to buy a subscription should write to me, also at that address.

Investors Most Bullish in Nearly 27 Years

Sentiment is not a timing indicator, but it is an indicator of problems. And bullish sentiment is greater today than at any time in the past 27 years according to Asbury Research.

Please consider When Being Bullish Can Become Problematic.
Investor sentiment is an important component of financial market analysis because it tells us what investors are collectively thinking.  More specifically, when a certain type of investor gets either too bullish or too bearish on an asset, it usually means something important — that investors have become “off-sides” — and typically precedes a  important trend reversal in the price of that asset.

One of the dozen or so data series that we track, the Investors Intelligence data, was particularly interesting this past week because the Bulls minus Bears subset of this series (blue line, lower panel of chart below) rose to an historic most bullish extreme that hasn’t been seen since February 1987.

More simply stated, the stock market newsletter writers that have comprised this series since 1963 have not been this bullish in almost 27 years.

The red highlights on the show that, at 46, this series as at an historic high extreme, and that similar or lesser extremes have coincided with or led some of the most important peaks in the S&P 500 (black bars, upper panel) in recent history including October 2007, April 2010, and 2011.
Sentiment can always get more extreme, and indeed that is how it reached higher levels than the stock market peaks in 2000 and 2007. Thus my caution "sentiment is not a timing indicator."

Nonetheless, history suggests those plowing into the market today are going to regret it.

Mike "Mish" Shedlock

A new secular bull? Don’t count on it!

As the chart below shows, the Dow Jones Industrial Average, along with other the major US averages, have decisively made new all-time highs and broken out of its trading range, can we expect the launch of a new secular bull market for stocks?

Dow Jones Industrials Average from 1910

Zooming in, here is the 10-year monthly chart of the Dow. The upside breakout is clear on that chart as well.

Despite the technical evidence, I believe that the odds that this is the start of a secular bull market is low for three reasons. All of the are signals that valuations are elevated, which is what matters in the long-term.

First, private equity firms like Fortress and Blackstone are seeking to sell their equity positions, according to this Bloomberg report:
Private-equity managers from Fortress Investment Group LLC (FIG) to Blackstone Group LP (BX), which made billions by buying low and selling high, say now is the time to exit investments as stocks rally and interest rates start to rise...

“It’s almost biblical: there is a time to reap and there’s a time to sow,” Apollo’s Black said at a conference in April. “We think it’s a fabulous environment to be selling. We’re selling everything that’s not nailed down in our portfolio.” 
Black’s New York-based firm, which oversees assets worth $114 billion, generated $14 billion in proceeds from the sale of holdings between the first quarter of 2012 and the first quarter this year.
Where they can't exit their positions, private equity firms appear to be intent on extracting as much value as they can from issuing debt, according to this WSJ report. It seems that this class of investors just can't find good values in the market [emphasis added]:
The industry’s focus on exits has reduced volumes of leveraged buyouts this year, with the number of private-equity deals announced declining 20 percent to 3,047 worldwide from the same period last year, according to data compiled by Bloomberg. 
It’s a difficult environment to find really attractive things when the markets are robust as they are,” Fortress’s Edens said yesterday.
That seems to be the position taken by patient value fund managers, according to this other Bloomberg report [emphasis added]:
The $1.1 billion Weitz Value and $980 million Weitz Partners Value funds each have cash stakes that are close to 30 percent. At the $10.6 billion Yacktman Focused fund, cash has crept up from 14 percent a year ago to 19 percent. The $1.3 billion Westwood Income Opportunity has about 16 percent in cash, more than double what it had at the start of the year. Cash makes up about 28 percent of assets in the $8.9 billion IVA Worldwide Fund, up from 10 percent a year ago, and is 33 percent of the $508 million GoodHaven fund, up from 19 percent a year ago.

Those are some seriously contrarian positions. The average diversified U.S. stock fund has less than 5 percent in cash, according to Morningstar. For funds such as IVA Worldwide that fall into the "world allocation" fund category and invest globally across a wide range of asset classes, the average cash stake is below 15 percent. 
There’s no big macroeconomic prediction fueling the move of these value managers into cash. Just some simple investing discipline as managers pare positions in stocks they bought at deeply depressed prices. The Leuthold Group reports that the median price-earnings ratio for large-cap value stocks is 13 percent to 25 percent above its long-term historic norm; large-cap growth stocks trade at an 8 percent to 10 percent discount to their historic norm. 
After taking profits on stocks that have risen close to what we believe is their value, we aren’t finding enough mispriced securities to redeploy that cash into,” says IVA Worldwide co-manager Charles de Vaulx. He'd rather know with certainty that he'll lose a little by holding cash “than stay invested in stocks I don’t think offer enough value and lose a lot.”
In addition, the median appreciation potential of stocks tracked by Value Line is flashing a danger signal:
While not intended to be a market-prediction tool, it has worked nicely as one, especially for investors with a time horizon of a few years. Academic studies have ratified its value in this regard. The market-newsletter tracker Hulbert Financial Digest has ranked it first among market-timing services in forecasting four-year market performance. 
Since 1970, the VLMAP, as it is known, has flagged the tremendous buying opportunities at the bear-market lows in 1974, 1982 and 2009, each time suggesting the median return potential was an annualized 25% or more over the next five years. That’s almost exactly how the Standard and Poor’s 500 index has performed in the four-plus years since the March 2009 market low. 
Conversely, every time the number has fallen to its current 7% level – which is in the lowest 10% of all readings since 1970 – the broad market has been flat or down over the subsequent half-decade.

The combination of VLMAP, private-equity and value managers represent long-term patient money and modeling techniques. Private equity and value managers are not day-traders or swing traders, but their ticks are in months or quarters. So when patient money tells me that stocks are expensive, I have to sit up and take notice.

To be sure, short and medium term fundamental and technical indicators are still supportive of fresh highs in the major US equity indices. Market breadth remains positive and Street consensus forward earnings continue to grow, according to Ed Yardeni, and this is bullish for equities.

Regardless, long-term investors who put money to work in the stock market today are likely to be disappointed if they were to come back and examine their positions in three to five years.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Can It Get Any Better Than This?

Can It Get Any Better Than This?
By John Mauldin
August 3, 2013


Can It Get Any Better Than This?
A Korean Black Swan?
Maine, Montana, San Antonio, and Bismarck

What in the world is going on?! As I write this letter from the Maine woods, the S&P 500 has just cleared 1,700 for the first time. The German DAX continues to set all-time highs above 8,400. The United Kingdom’s FTSE 100 is quickly approaching its 1999 record high of 6,930, and its mid-cap cousin, the FTSE 250, just broke through to its all-time level above 15,000. And last but not least, Japan’s Nikkei 225 is extending its gains once more, toward 14,500. This weekend I am sitting around with some of the smartest economic and trading minds in the country. At Leen’s Lodge, where we’re fishing and eating where our phones don’t work, the question on our minds is, how long can this run go on? The debates can get intense in a room full of strong opinions.

So, with a little help, I did some research on what our forward-looking prospects are for the markets. Let me take this opportunity to introduce a new name to readers, one that will become familiar over the next few years. I have gotten to know Worth Wray, a young economist (though I should say that, as I stare 64 in the face, a lot of people are looking young these days) who has really impressed me with the breadth of his knowledge and insights. He was the former portfolio strategist for my good friends at Salient down in Houston, and they were kind enough to let me entice him to come to Dallas to work with me. This is a big move for both of us, and I am finding that it’s one I should have undertaken a long time ago. Worth is really going to help me expand my abilities to do research and present my thoughts to you. I asked him a few questions, and he helped me tee up this week’s letter. Plus, we’ll look across the Pacific, and I’ll share some thoughts I’ve had about an interesting black swan that could be developing in the Korean Peninsula. Let’s get started!

Can It Get Any Better Than This?

To many investors, developed markets appear healthier and stronger than they have in years. Major equity markets are rallying to record highs; corporate credit spreads are tight versus US Treasuries and getting tighter; and broad measures of volatility continue to fall to their lowest levels since 2007.

This kind of news would normally point to prosperity across the real economy and call for a celebration – but prices do not always reflect reality. Moreover, the combination of high and rising valuations, low volatility, and a weakening trend in real earnings growth is a proven recipe for poor long-term returns and market instability.

Let’s take the S&P 500 as an example. It returned roughly 42% from September 1, 2011, through August 1, 2013, as the VIX Index fell to its lowest levels since the global financial crisis. Over that time frame, real earnings declined slightly (down about 2% through Q1 2013 earnings season), while the trailing 12-month price-to-earnings (P/E) ratio jumped 44%, from 13.5x to 19.5x. That means the majority of the recent gains in US equity markets were driven by multiple expansion in spite of negative real earnings growth. This is a clear sign that sentiment, rather than fundamentals, is driving the markets higher.

Of course, the simple trailing 12-month P/E ratio can be misleading at critical turning points if you are trying to handicap the potential for long-term returns. For example, the collapse in real earnings during the global financial crisis sent the S&P 500’s trailing P/E multiple through the roof by March 2009. So, while trailing P/E is a useful tool for understanding what has already happened in the market, the “Shiller P/E” is far more useful for calculating a reasonable range of expected returns going forward. This approach won’t help you much with short-term market timing, but current valuations have historically proven extremely useful in forecasting long-term returns. In his book Irrational Exuberance (2005), Robert Shiller of Yale University shows how this approach “confirms that long-term investors – investors who commit their money to an investment for ten full years – did do well when prices were low relative to earnings at the beginning of the ten years. Long-term investors would be well-advised, individually, to lower their exposure to the stock market when it is high … and to get into the market when it is low.”

As you can see in Figure 6, compared to the more common trailing 12-month P/E ratio in Figure 5, the Shiller P/E metric essentially smooths out the series and helps us avoid false signals by dividing the market’s current price by the average inflation-adjusted earnings of the past ten years. Historically, this range has peaked and given way to major market declines at around 29x on average (or 26x excluding the dot-com bubble), and it has bottomed in the mid-single digits. Not only does today’s Shiller P/E of 24x suggest a seriously overvalued market, but the rapid multiple expansion of the last two years in the absence of earnings growth suggests that this market is also seriously overbought.

John Hussman helps us keep current valuations in historical perspective:

The Shiller P/E is now 24.4, about the same level as August 1929, higher than December 1972, higher than August 1987, but less extreme than the level of 43 that was reached in March 2000 (a level that has been followed by more than 13 years of market returns within a fraction of a percent of the return on Treasury bills – and even then only by revisiting significantly overvalued levels today). The Shiller P/E is presently moderately below the level of 27 at the October 2007 market peak. It’s worth noting that the 2000-2001 recession is already out of the Shiller calculation. Moreover, looking closely at the data, the implied profit margin embedded in today’s Shiller P/E is 6.3%, compared with a historical average of only about 5.3%. At normal profit margins, the current Shiller P/E would be 29.

While it may be impossible to accurately predict when this policy-driven market will break, history suggests it would be very reasonable for the secular bear to eventually bottom at a P/E multiple between 5x and 10x, opening up one of the rare wealth-creation opportunities to deploy capital at truly cheap prices. Some of these technical details are rather dry, but I hope you’ll focus on the main idea: We are not talking about the potential for a modest 20% to 30% drawdown in the S&P 500. If history is any indication, we are talking about the potential for a 50%+ peak-to-trough drawdown and ten-year average annual returns as bad as -4.4%, according to the chart above from Cliff Asness at AQR. Such a result would fall in line with somewhat similar deleveraging periods such as the United States experienced in the 1930s and Japan has experienced since 1989. There is no way to sugarcoat it: too much equity risk can be unproductive and even destructive in this kind of economic environment.

But where there is danger, there is also opportunity. This is a terrific time to take some profits and diversify away from the growth-oriented risk factors that dominate most investors’ portfolios. Instead of concentrating risk in one asset class or one country, investors can boost returns and achieve more balance by taking a global view, by broadening the mix of core asset classes, and by weighting those return streams to achieve balance across potential economic outcomes (rather than trying to predict the future). Since equities and credit are essentially a directional bet on positive economic growth and benign inflation, you have a lot to gain from diversifying into other core market risks: commodities, which thrive when inflation, or more specifically expected inflation, is rising; and nominal safe-haven government bonds, which thrive as inflation gives way to deflation and the other assets typically decline. While each group of asset classes responds to economic conditions differently and exhibits low correlations to the others, each of them tends to offer similar risk-adjusted returns over long periods of time, thus warranting constant inclusion in any core portfolio.

It also makes sense to embrace truly diversifying alternative strategies that are either less correlated or negatively correlated. When valuations are expensive across the board, momentum-based strategies like managed futures can be a fantastic addition to a portfolio. Aside from government bonds, momentum is the only easily accessible strategy that tends to become more negatively correlated with broader markets during times of extreme stress and tends to deliver outsized returns when your other investments are losing money.

Of course, combining the asset classes into one portfolio is the hard part, but research going back to the early 1970s suggests that broadening this mix of core assets – so that you have some element of your portfolio that responds positively to every potential economic season – and managing the relative allocations to each economic scenario may be your biggest opportunity to add value in the investing process.

You have a lot to gain from diversifying as broadly as possible, eliminating unrewarded costs, reducing your reliance on equity risk, and reining in the emotional mistakes that often lead investors to dramatically underperform. Remember, in a world characterized by deleveraging, changing demographics in aging populations, financial repression, and increasingly experimental monetary policy, every basis point counts and anything can happen.

With that, let’s end our discussion with a few words of advice from the world’s largest and arguably most successful hedge fund manager, Ray Dalio:

What I’m trying to say is that for the average investor, what I would encourage them to do is to understand that there’s inflation and growth. It can go higher and lower and to have four different portfolios essentially that make up your entire portfolio that gets you balanced.  Because in every generation, there is some period of time, there’s a ruinous asset class, that will destroy wealth and you don’t know which one that will be in your life time. So the best thing you can do is have a portfolio that is immune, that is well diversified.  That is what we call an all-weather portfolio.  That means you don’t have a concentration in that asset class that’s going to annihilate you and you don’t know which one it is.

A Korean Black Swan?

Last week I was in Newport, Rhode Island, at the Naval War College, where I participated in a summer study group focused on possible futures and how they might affect the strategy of the US Defense Department. The discussions were wide-ranging and mind-expanding, at least for me. As readers know, I believe that Japan has begun a long-term process of continually devaluing its currency. For reasons I have written about at length in previous letters, I think the yen could go to 200 to the dollar in the next five years. I don’t see a precipitous move, simply a steady erosion as Japan tries to bring back inflation and export its deflation.

While the yen at its current valuation is not a particular problem for the rest of the world, when it hits 120 we will start to see raised eyebrows and political speeches from the countries most affected. At 140 we could start to see serious reactions.

One of the countries that I think is put into a most difficult situation is South Korea. Their options for responding to a weakening yen are quite limited. If they respond by printing more of their own currency, they are likely to engender a debilitating inflation, which is of course not a good thing. Protectionism will have little real effect vis-à-vis Japan. Remember that the Japanese yen was 357 to the dollar about 40 years ago. The Japanese watched their currency rise by almost 400% in the decades since. The only real response available to them was to simply become more competitive and more productive as their currency got stronger, and to their great credit they did.

Honing their competitive edge may also be the only real option for South Korea. But it is not an easy one, of course, and you will hear lots of complaints from Korean politicians and businessmen. Not an easy environment, to be sure.

Now let’s shift our focus to North Korea. Everyone (including your humble analyst) is worried about the isolationist regime in North Korea having access to nuclear weapons and the ability to deliver them on missiles. But a few conversations I had this past week led me to think there is another scenario we should consider.

A side conversation at the study group began with an observation by a senior officer about the ability of the North Korean military to actually project power. As this information is nothing more than what you can find in the newspapers, I feel comfortable discussing it here. Everyone knows that North Koreans have been malnourished for multiple decades. Studies suggest that North Koreans may be up to three inches shorter than South Koreans and have diminished IQs because of malnourishment as children. The latter is a known effect on human beings anywhere who are subjected to a starvation diet. The North Korean population has suffered from severe diet restriction for decades.

How capable is the North Korean military of actually mounting an offensive when their soldiers are simply not physically able to withstand the pressures of combat? I was also able last week to visit with one of the great geopolitical strategists of our time, Professor Ian Bremmer of Columbia, who is the president and founder of Eurasia Group, with some 100 geopolitical analysts working for him. I shared with him my concerns about the Korean peninsula. He immediately said that he was more worried about the Korean peninsula than any other part of the world, including the Middle East. One of the interesting things that he shared is that an increasing number of cell phones are being smuggled into North Korea from China and that the North Koreans are beginning to get the real story about the world rather than just the propaganda fed to them by their government.

While there is little ability for the North Korean population to actually stage a revolution, as they do not have the weapons and hungry people really have difficulty mounting military operations, there is the possibility of the country becoming increasingly difficult to manage. Combine that with the potential for a disastrous food-production year, and the potential for the collapse of the government is not all that far-fetched.

There were not many people forecasting the collapse of the USSR in 1987. Yet as we look back, the confluence of causes that resulted in its collapse seems rather obvious. Probably, the current dictatorship will maintain its stranglehold on North Korea. That is the tendency with repression and tyranny – witness Cuba and any number of other countries. But one cannot dismiss the possibility of a collapse of the North Korean state.

If that were to happen it would be a humanitarian disaster. In the long run it might be better for the North Korean people, but in the short run it would be catastrophic. It is not unreasonable to expect that South Korea would have to do the bulk of the heavy lifting, especially after the first year or so. And should the world no longer have to focus on the ability of North Korea to create mischief with nuclear weapons, North Korea could soon become page 16 news.

No matter how positively you would want to view Korean unification, the process would be enormously expensive for South Korea. Assimilating a population long challenged by hardship into a new reality, not to mention incorporating it into a modern economic model, is a daunting challenge. I think the task would be more difficult and more expensive on a per-capita basis than the unification of Germany.

And this could happen while the attention of South Korea is focused on dealing with the devaluation of the yen and the need to become progressively more competitive to maintain its export and business model. There is also the possibility of massive refugee movements into China. That is a significantly different issue than worrying about a million-man army crossing the DMZ into South Korea.

I’m not saying this will happen, but it is a possibility we need to keep an eye on.

Maine, Montana, San Antonio, and Bismarck

I’m at Leen’s Lodge in Grand Lake Stream, Maine, at “Camp Kotok,” with about 50 people from all areas of the financial sector: money managers, traders, writers, real economists (as opposed to your humble analyst), financial media, Federal Reserve economists, and other guests. Old friends whose names are familiar to my readers have become regulars here – people like Paul McCulley, Barry Ritholtz, Jim Bianco, David Rosenberg, Mike McKee of Bloomberg, Bill Dunkelberg (chief economist of the National Federation of Independent Businesses), Phillipa Dunne of the Liscio Report, and others too numerous to mention. David Kotok of Cumberland Advisors organizes the event and masterfully crafts the mix of guests and the agenda for the long weekend. Some people have referred to this group as the Shadow Fed, but that is far too serious a moniker for what really happens here. This is one of the more fascinating discussion groups I ever get to participate in, and I always learn a great deal. I should note that at least ten of our group are women, which makes it somewhat unusual for a financial-industry gathering, but it’s a trend I would like to see more of.

This is the seventh year I’ve attended, and each year I’ve come with my youngest son, Trey. He was 12 the first year we came and is now 19. He has grown up with these men and women. Being with my son each year has made this a very special week in my life. Each year’s event is an emotional and very personal measuring stick as I watch him grow up. The annual competition to see who among us will catch the most fish is a small part of the experience, but Trey does not let me forget that he has won for six years in a row. After our first rain-soaked half-day of fishing, I am ahead by one, but there are two more full days ahead. Watching him grow up here is very special. There is a part of me that hopes he catches at least one more fish than the old man. But I will never tell him that.

Grand Lake Stream is in the middle of Washington County, Maine, which is about the size of Connecticut yet has only 30,000 people. As it turns out, it is also the poorest county east of the Mississippi. Who knew? Local officials assure me that our gathering of economists is one of the biggest financial events for the area each year. In a few weeks they are going to announce what is a fascinating economic experiment. The state of Maine is going to make the entire county an enterprise zone. They are going to eliminate all taxes in the county – every last corporate, personal, and sales tax. As one former state official told me tonight, the state gets such a small amount of taxes from this county that eliminating the taxes won’t affect the state budget whatsoever. And the poverty here is quite real. I will give you an update, down the road, on whether the Washington County experiment makes a difference. My philosophical bet is that it will. In a few years the results will not be just philosophical but something we can all see.

As long as I keep getting an invitation to return, I intend to spend the first weekend of every August in Maine. It is truly a slice of heaven and one of the gatherings I most look forward to every year.

We go back home on Monday, and then the next week I’m off to Montana with Darrell Cain for a week to read, relax, and gather my thoughts. At the end of the month I go to San Antonio for the World Science Fiction Convention (WorldCon), where I get to play groupie for a few days. Then in the middle of the month I will go to Bismarck, North Dakota (details later), and hopefully make a side trip to South Dakota, which will allow me to finally say that I have been in all 50 states.

It is time to hit the send button, as the group is gathering for Lobster Night. Charles Driza, the owner of Leen’s Lodge, and his staff provide fabulous gourmet meals. And the conversation is even better. Have a great week and find a few friends and family to be with. That time is an investment where the valuation is always rising.

Your soaking up the beauty of Maine analyst,

John Mauldin

John Hussman On Profit Margins And Un-„Reasonable Valuations“

Just over a year ago we discussed in great detail the cyclical nature of profit margins, the elegance of the Kalecki (profits) equation (and its Japanese outlier real-world fallacy), and the current desire to 'invest' in dividends and not CapEx creating a vicious cycle of cash-flow-sagging aging assets. The situation has not improved.

As John Hussman notes, the Shiller P/E passed its 24x Maginot Line last week and yet, with revenues stagnant and earnings eking out gains, we are to believe valuations are cheap and margins will save the day. "The impression that stocks are “reasonably valued” relative to earnings is an illusion driven by profit margins that are 70% above their historical norm.


Almost universally, Wall Street analysts are making the mistake of valuing stocks on the basis of a single year of forward operating earnings, as if the present estimate is a sufficient statistic that is representative of the entire future stream of cash flows." It is not...

Excerpted from Hussman Funds - Closing Arguments: Nothing Further, Your Honor,

On profit margins

The facts that savings equal investment and that the deficits of one sector must arise as the surplus of another are not theories. They are identities that must hold true by accounting definition. It does not matter how companies are deriving their profits (domestically or internationally). It does not matter how consumers are obtaining their goods (domestically or internationally). It does not matter how the government is financing its deficits (domestically or internationally). It is true merely and strictly by identity that savings equal investment, and that the deficits of one sector must arise as the surplus of another.


The exact way that this comes about is up for grabs, but the end result is not. It is also true empirically in decades of data since the 1940’s that the following aspect of that relationship holds quite robustly: variations in profit margins are essentially a mirror-image of the combined deficit of households and government. This is true not only of levels, but of point-to-point changes.


Corporate profit margins will contract as the combined deficit of households and government retreats (even moderately) from the record levels of recent years. The impression that stocks are “reasonably valued” relative to earnings is an illusion driven by profit margins that are 70% above their historical norm.


Almost universally, Wall Street analysts are making the mistake of valuing stocks on the basis of a single year of forward operating earnings, as if the present estimate is a sufficient statistic that is representative of the entire future stream of cash flows.



Even profit/GDP levels much less extreme than today’s have always been followed by a contraction of profits over the following 4-year period.

In other words, we had it good but it ain't gonna last...

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