Wednesday, July 1, 2015

Puerto Rico Is A Bigger Risk Than Greece

Austerity Or Bankruptcy?

When you borrow from the future to live better in the present, the day comes when you must pay for those indulgences. It has arrived for Greece, and it will soon be arriving for countries around the world that went on a debt binge to fuel economic growth. The ability to print money and purchase debt does not solve the problem, it only temporarily pushes the day of reckoning back and creates a larger crisis in the future. 


Tuesday, June 30, 2015

Greece Is Only A Preview Of The Real Crisis

My thoughts on the Greece situation and the market turmoil:

A few years ago if Greece defaulted it would have had a major impact on the financial system because banks held most of the Greek debt (think Lehman). Over the past four years the decision makers in Europe have moved that debt off the bank balance sheets to the government balance sheets by creating bailout funds (EFSF, etc.).


A big chunk of the debt has also been taken on by the IMF, which is essentially the global central bank for individual country central banks.


There is no longer systemic risk with a default. If you are a hedge fund that owns Greek debt, or you are an individual that lives in Greece and has money in a bank, you may lose some money if a bank fails. It's hard to feel sorry for the people standing in lines at the ATMs when they knew this was coming every day for the last four years (more on that in a moment).

Greece itself should have little impact on whether stocks go up or down at this point. Stocks fell hard yesterday around the world, and the media is blaming it on the Greek drama. Stocks should fall around the world, not because of Greek banks, but because many markets are obscenely expensive relative to the underlying fundamental growth potential in the global economy. 

What will happen with Greece? I have no idea. I can discuss their options briefly and my thoughts on what they should do. When you borrow more than you can pay back and your creditors have cut you off there are no good options. Your life tomorrow is going to be worse than it is today; it is just a question of how you want to take the pain.

1. Accept a bailout with the new terms. This means Greece can borrow more debt to pay back the current debt. The austerity programs will make it more difficult to pay back the new larger pile of debt, and they will be back in a few months for another bailout to pay the new debt. This option is a very slow and painful death that drags on over many years. The economy will remain in depression for decades.


2. Default and exit the Eurozone. Without access to bailout money Greece would need to print their new currency (most likely go back to the Drachma) in order to stem the panic. This would cause massive inflation and potentially hyperinflation in the short term. Eventually they would hit bottom, debt free, and begin to rebuild the country from a solid foundation. There would be civil unrest and it would be a nightmare within the country for at least 2 years.


3. Default and exit the Eurozone, but reach out to Russia for help (they have contacted Greece with a proposal for financial assistance). This option is not discussed in the mainstream news. Greece would do everything it did in number 2 but they would have the full backing and financial support from Russia, which would provide the funds needed to protect their bank deposits and even create a layer of liquidity ready to provide new loans to businesses. The drastically reduced value of their currency would create an export boom, and it would incentivize tourists to come visit the country. Russia would receive strategic geo-political benefits from essentially becoming godfather to Greece. While I could write a lengthy discussion on this option (and I may in the future) I believe this is by far the best option for Greece.


What is the most likely scenario? Number 1, but we'll wait and see.

The real scare for the markets is that a Greece default and/or exit from the euro would cause the markets to look toward the next weakest link in the chain of PIGS (Portugal, Italy, Greece and Spain). If one of those countries were to be in the situation we have today with Greece it would be a very big deal and a Lehman type event.

We'll get there eventually with all those PIGS, and we'll get there with Japan and the United States as well. In the meantime, we'll see if they can push back the next round of the global sovereign debt crisis and keep the thin layer of confidence intact for a little longer.


A quick side on the people standing in lines in Greece at ATMs unable to get their money. Wouldn't it have been prudent as a Greek citizen to already have taken your money out, but also to have converted a portion of that money into physical precious metals? This would cover you in two ways;

1. If Greece stays within the Eurozone and continues using euros, but your individual bank fails, you still have your money.

2. If Greece stays within the Eurozone and begins using the drachma, you have protected your purchasing power by holding precious metals. The value of gold and silver will surge in price, when priced in drachmas.

Most governments around the world are facing the exact same situation as Greece, only their ability to print money has temporarily pushed back the day of reckoning (if the Greek central bank could print euros we would not be discussing them right now). When and where will the real crisis begin? My guess is Japan, but we'll have to wait and see.

Fore more see: Tranquility Creates Fragility: The Coming Collapse Of Financial Markets



Friday, June 26, 2015

How The Home Bias Phenomenon Impacts Investors: Domestic Purchases

In the past I have discussed the psychological phenomenon known as "home bias," which in simple terms means investors are more likely to purchase stocks from their own country. See How The Home Bias Phenomenon Impacts Investors.

 Investopedia defines it as:

"The tendency for investors to invest in a large amount of domestic equities, despite the purported benefits of diversifying into foreign equities. This bias is believed to have arisen as a result of the extra difficulties associated with investing in foreign equities, such as legal restrictions and additional transaction costs."


I am reading a book this week called "Misbehavior: The Making Of Behavioral Economics," which is the best book I have ready this year by far. It reviews the journey of the author, Richard Thaler, from the early days of his behavioral economic research through present day. Throughout the book he provides steady examples of the irrational behavior humans engage in due to the way we are made up psychologically.

The home bias phenomenon is a perfect example of this irrationality. As a United States citizen I see it every day. The majority of finance articles published by U.S. media outlets are about U.S. stocks. Why would that be in today's borderless financial world?

Numerous studies have shown investors in the United States have an irrationally large percentage of their portfolio composed of U.S. stocks. This comes at a time when U.S. companies in general are far more expensive than foreign markets, due in large part to the explosive move higher in price over the past 4 years.

Over this period the rational investor would allocate a larger percentage of his or her portfolio to less expensive global stocks as prices in the U.S. move higher, but usually the exact opposite occurs.

Barry Ritholtz put some charts up on his site today showing how home bias even exists within the borders of countries. The visual below shows investors favor technology out west, energy in the south, financials in the northeast and industrials in the midwest.



Why? Investors are surrounded by these companies so they are familiar with the names. This makes them more likely to purchase these stocks over a company they are less familiar with (even though another company or sector may be far less expensive or have greater earnings growth potential in the future).

Digging even deeper you often see employees have an over sized weighting of shares of companies they work for in their portfolio. This again shows home bias and investor irrationality at work.

Thursday, June 25, 2015

Carl Icahn On The Extreme Danger He Sees In U.S. Stocks & Bonds

Billionaire Carl Icahn provides an incredibly honest assessment of the danger he sees ahead for the average investor in U.S. stocks and bonds. While he thinks stocks will fall, he believes the bond market is even more dangerous.

"I think the public is walking into a trap again as they did in 2007. I think it's almost the duty of well-respected investors, like myself I hope, to warn people, to tell people, that really you are making errors."

Part One:



Part Two:



Part Three:

Wednesday, June 24, 2015

Agriculture Beaten Down & Hated: Buying Opportunity?

The chart below from Short Side Of Long shows the dreadful price performance for agriculture since early 2011. The commitment of traders report has investors net short on agriculture for the first time in over a decade. Not only have investors sold out of positions, but they are betting heavily on further price declines.



The fundamentals look rough for the market in the short term. The U.S. dollar is currently strong, supplies are already plentiful for many different types of food and it has been a great few years of weather for farming. This has caused many farmers to either cut back or redirect their crop production.

I believe it's likely the perfect farming weather will not remain uninterrupted for another 10 years. I also believe the rapidly growing population around the world is going to continue to need food over the next decade, while new supply to feed that population is not being put into place today. A common term in the commodities market is "the cure for low prices is low prices." The exceptionally low prices seen today combined with horrific sentiment should be a welcome opportunity for long term investors.

I have been buying corn (CORN), sugar (CANE) and wheat (WEAT) steadily for the past year, and I began purchasing the broader agriculture ETF (DBA) when it fell below 23 in March. I plan on continuing to buy each of these unless they move higher or positive sentiment returns to the market. My hope, as with the other commodity sectors I am accumulating in today (precious metals, uranium, oil) is that prices stay low and sentiment stays miserable for a long time.

Monday, June 22, 2015

CEO Pay Back Above 300 Times The Average Worker

In an article on Quartz this week they provided a chart showing how much the CEOs at the top 350 companies in America make relative to the average worker (currently 300 times the average worker's salary).



This massive gap in pay has been common knowledge for some time, but I found it interesting how directly this ratio correlates to the performance of the S&P 500. You can see in the chart above the booms and busts in CEO pay track in line with the performance of the general U.S. market (below).



There are a few thoughts I have looking at these charts.

1. The wealthy receive the bulk of the benefit when financial markets are booming, and they are hurt the most when markets crash (the middle class and poor have relatively low savings so a 50% decline in the stock market may only be a loss of $7,000 to their net worth). Market booms create a greater divide between the haves and the have nots, while market crashes bring the rich closer in line with "the rest."

2. CEOs are paid based on stock performance. When their stock price booms, even if that boom is mostly due to a general asset market mania (see the last three stock market booms starting in 1995), they are rewarded heavily. When stocks fall, even if it is due to market conditions outside of their own control, they are punished. This provides CEOs an incentive to "cash in" during the booms and explains why corporations today are spending an enormous amount of money (and even borrowing when possible) to purchase their own shares and drive prices artificially higher. 

How El Nino Impacts The Price You Pay At Starbucks

Friday, June 19, 2015

Tranquility Creates Fragility: The Coming Collapse Of Financial Markets

I used to love watching the Back To The Future movies in the late 1980's. In the second movie Doc drew up the alternate timeline on the chalkboard to explain to Marty how they had entered a parallel universe. You can watch the scene here.


Thinking about the financial markets today I feel as if we live within an alternate reality. This new parallel world began in early 2009 with the response to the financial crisis in 2008. Governments and central banks unleashed the greatest fiscal and monetary response to a crisis we will most likely ever see in our lifetime (I don't think the markets will allow them to repeat their actions during the next crisis and much as they will want to).

Their response essentially created a world wide panacea that moved the world from concerns over the amount of debt in the financial system and central bank's ultra loose monetary policy (which people understood caused the 2008 crisis) to a new world that ranges from mild optimism to complete euphoria.

There is no concern anywhere in the world today the massive accumulation of debt since 2009 and the worldwide 0% interest QE policies will have any long-term negative impacts on either the financial system or the economy.


The current period of stability, held together with duct tape, smoke and mirrors, has set the stage for a much larger period of instability. Nassim Taleb explained in his book Antifragile that some things benefit from shocks, particularly the financial system. If there is no concern your debt accumulation or speculation can go wrong the invisible hand is removed from the markets and replaced with the visible hand of central banks.

This new alternate reality we have entered looks like a strong well built economy on the surface but it is really a Potemkin village. It is a massive snowbank waiting for a snowflake to trigger an avalanche.


The problems around the world today are the same as they were when we entered the 2008 crisis, but the size and magnitude of the problems have grown exponentially since early 2009. There has been no deleveraging. No government or central bank decided it would be best to take short term pain in order to build a foundation for stable long term economic growth.

There is not a concentrated market or region of the world in danger today that you can focus on to prepare yourself. The danger is everywhere. This danger exists for two reasons:

1. The price of assets (stocks, real estate and bonds) are at levels that do not properly account for the true economic reality of the world. Assets are priced for explosive, long term growth globally moving forward.

2. The explosive, long term global economic growth market participants have priced in is based on the assumption individuals, corporations and governments will be able to continue to borrow excessively at ultra low interest rates moving forward.


If credit growth stops (or even slows) in any part of the world today we will face a credit crisis due to the interconnected nature of the financial system, a world-wide economic slowdown, or both. Here are just some of the places a debt crisis could erupt:

- China has accumulated enough debt since 2008 to recreate the entire U.S. financial system. A large part of this debt is being created in the shadow banking system and used for speculative real estate projects. Over the last 9 months the stock market has entered a full blown mania, fueled in large part through margin (debt). There is no long term solution that will fix China. It needs a crisis and restructuring.




- Europe is a complete basket case. The banks have spent the last three years purchasing toxic government debt with the hope they will be able to offload it to the ECB. Most of the countries are completely bankrupt with insolvent banks that have not deleveraged following the 2008 crisis. There is no long term solution that will fix Europe. It needs a crisis and restructuring.




- The BRICS (Brazil, Russia, India, China, South Africa) have grown their dollar denominated debts from $6 trillion in 2009 to over $9 trillion today. If the dollar continues to strengthen against their currencies it makes the debt burden unmanageable for borrowers. This can trigger a currency crisis from anyone of these countries if the markets get nervous. This occurred with Russia last year, India in 2013, and it's happening in Turkey right now. There is no long term solution that will fix the debt problem in the emerging markets. They need a crisis and restructuring.



- Canada, Australia and Hong Kong are on the precipice of major real estate disasters. Low interest rates combined with the confidence prices will always continue to rise has pushed prices into the stratosphere. As with the U.S. entering 2007, their private debt to GDP ratios have surged, and if prices stop rising and begin moving into reverse there will be a rush for the exits; particularly in the larger cities. The impact on their banking systems and economies (which have become largely dependent on real estate for growth) will be enormous. There is no long term solution that will fix the real estate bubbles. They need a crisis and restructuring.



- The U.K.'s total debt burden in relation to their GDP is the worst in the world. This is due in large part to the enormous size of their banks. If their bank's balance sheets get in trouble (there is currently a massive real estate bubble in London), the government will be unable to nationalize the entire banking system. It will be like standing on the beach with a bucket hoping to catch a tsunami approaching the coast line. When you factor in the off balance sheet derivatives, well, it's impossible to even create an analogy to explain the size of the problem. There is no long term solution that will fix the London real estate bubble or massive bank debt problem. They need a crisis and restructuring.


- Japan is facing a debt crisis and a currency crisis. Their government debt has surpassed 250% of GDP and the yields on the debt are at ridiculously low levels (the 10 year yield recently crossed below 0.20%). Either the Japanese yen will continue to fall, yields on their government debt will begin to rise, or both. When yields rise it will overwhelm the government's ability to manage the interest payments. Look for the yen to reach unimaginable lows before their central bank lets rates rise. There is no long term solution that will fix their debt problem. They need a crisis and restructuring.


The United States currently has the most expensive stock market in the world. Prices have been fueled by record margin (debt) and stock buybacks from corporations, many of which have used debt (because of artificially ultra low interest rates) to purchase their own stocks. Real estate prices have returned back to or have crossed above pre-bubble highs. Prices have been been fueled by speculative euphoria, foreign/institutional buying and artificially low interest rates. Municipals like Illinois are on the precipice of bankruptcy. U.S. banks are larger today than they were before the 2008 crisis. There is no long term solution that will fix the U.S. debt problem. They need a crisis and restructuring.



When confidence is finally removed from the aura surrounding central banks and governments there will be a dislocation in the financial markets that will feel like a big bang meteor struck the earth.


As markets continue to become more frothy and filled with euphoria as an investor you should become more nervous. The tranquility washing over debt and equity markets around the world is creating a fragility under the surface that will be impossible to contain when it begins to crack.