Sunday, May 1, 2016

The Coming Global Bond Market Massacre: Japan Prepares For The Opening Act

I am trying to enjoy every moment of the central bank driven global asset mania before it implodes because years from now people will look back and be both astonished and fascinated by everything that was occurring before the implosion. We could walk through the stock market, residential real estate, commercial real estate or even something like fine art, but nothing comes close to the insanity taking place in the bond market.

I expect many equity and real estate markets to be sledgehammered lower in the years ahead, but the greatest losses will eventually come in the one area where investors believe they are the most safe; bonds. People counting on pension funds, 401k's, life insurance policies, and general government debt spending support will be rocked when the artificial world we live in today evaporates.

The chart below shows that the average yield on global bonds has fallen to a record low. Bond values rise when yields fall. This means investors have, in general, made large paper gains on bonds since late 2008.



Things have become so insane there are now $8 trillion in government bonds that have negative yields. Investors now give the government their hard earned money, and they have to write the government a check every month for the "privilege" of letting them hold their money.



You can see in the chart above the largest portion of negative yielding government debt comes from Japan, so we'll focus our attention today on the madness taking place within their borders.

The paradigm of the world we live in shifted from the global central bank put to pre-emptive central banking policy in March of 2009 (for much more on this important topic see: The Grand Finale For Worldwide Asset Bubbles: Pre-Emptive Central Bank Action). No central bank has led this charge with more force than the Bank of Japan. The following chart shows the size of their central bank's balance sheet in relation to the size of their economy (GDP). As they print money to purchase assets the size of their balance sheet grows. It currently stands at 80% of Japan's GDP and that number is growing rapidly by the month.



The graph below shows the expansion of their monthly QE program in the second quarter of 2013. You can see the amount of government bonds they are purchasing every quarter (red bars) is now much larger than the growth in the overall size of the government bond market (green bars). This means they are rapidly gaining a larger and larger ownership stake of the entire market. 



Japan's government debt to GDP is currently hovering close to 250%, the largest in the world by far (Greece imploded when it hit 130% and the United States is currently close to 100%). They are running a deficit every year equivalent to about 8% of their total GDP. As you can see above, the Bank of Japan is monetizing their entire annual deficit and then purchasing even more of the existing bond supply. They have essentially become the bond market, and very few bonds are traded outside of the Bank of Japan's purchases.

This may already sound insane, but I assure you it gets much worse. In addition to government debt, the Bank of Japan is purchasing corporate bonds and stocks. They have been steadily buying such a large quantity of ETFs they are now a top 10 shareholder in about 90% of the companies within the Nikkei 225 index. For those that live in America, this would like the Federal Reserve becoming a top 10 ten shareholder in most of the companies within the S&P 500.



The Bank of Japan now owns about 55% of Japan's entire ETF market! The orange bars below represent their holdings.



Japan's central bank has moved so far beyond the realm of reality that it is impossible to fathom how catastrophic the ending to this story will be. Here's just one question (of about a thousand we could ask); what happens if and when they would like to "exit" this program? They are going to be dumping shares of stocks on the market and rapidly driving down the price of these shares. The same question can be asked about the corporate bonds they are purchasing. Companies will see their cost to borrow surge if the central bank should decide to exit their positions.

Hold that thought and let's move back to the government bond side of the story because that's where the worst of the bloodshed will occur. The cost to service the public debt (pay the interest) in Japan is now their largest annual expense:


The yield on Japan's government bonds are negative out to 10 years and the 40 year bond fell to 0.29% this week (from about 1.40% to start the year). This means investors are paying the government to hold their money for ten years, and it you want them to hold it for 40 years you receive 0.29% annually. As I mentioned in the opening paragraph, please take the time to drink this all in because this insanity will not last forever.



It should be obvious that no one is holding these bonds because of their annual income. They are buying and holding these bonds because they think yields will fall further from here and they will make profits on the underlying principal value of the bond as yields fall. It is a pure speculation play. I should mention that so far this speculation has been paying off huge. Investors holding 40 year bonds (in the chart above) have made significant gains on paper this year.

The problem with this speculative form of investing is it has now become nothing more than a ponzi scheme. Investors were purchasing U.S. real estate back in 2006 with negative yielding cash flow because they were confident that a greater fool would simply come in behind them and purchase the real estate at an even higher price. This process works extremely well until the greater fool is not there waiting behind you as investors in Las Vegas real estate found out in 2006;



At some point we know yields will bottom and begin rising. The massive paper gains will then start to become paper losses. We know investors tend to not "calmly" walk to the exits when they see others running to the doors around them. Pension funds, banks, and even individual investors will realize they are holding an IOU from a bankrupt government that they have to pay to hold every month because they bought it at a negative interest rate. Then the bond market will receive gravity lessons.


When interest rates begin to rise the cost to service the government debt (the annual interest payments) will quickly consume all annual tax receipts. The Bank of Japan will quickly begin printing money just to pay interest on the debt. The value of the yen will likely begin to drop violently while the Bank of Japan tries desperately to defend rates by purchasing even more bonds.


While the world watches Japan melting down, many investors will likely begin to connect the dots and realize The European Central Bank (ECB) and the Federal Reserve are essentially playing the same confidence game. What happens from there is, of course, unknown. My guess is the IMF will need to step in and help with the Japanese crisis. This will create a blueprint for how developed markets are bailed out moving forward. How quickly the United States and parts of Europe follow Japan into chaos will depend on how quickly the public realizes their governments are also bankrupt and the power of their central banks is nothing more than an illusion based on false confidence.

For more see:

The Grand Finale For Worldwide Asset Bubbles; Pre-Emptive Central Bank Action


Wednesday, April 27, 2016

Jim Rickards On Gold

I just read Jim's new book titled "The New Case For Gold." Some of it is repetitive for those that have previously studied the gold market, but some of the chapters are fascinating; specifically the discussion on the Fed's insolvency and complexity theory. It is a quick and easy read.


Tuesday, April 19, 2016

Thinking Of Money As Time

The following is an excellent piece from Eric Peters' weekend notes. It provides another way to look at how government and central bank policies have benefited those that own financial assets (the wealthy) since 2009, while the poor and middle class have broadly seen their quality of life stagnate or decline. It also provides another way to demonstrate that financial assets (stocks, bonds, real estate) are currently expensive across the board, a topic I have discussed here continuously for the past few years.

“People work in order to convert their time into a unit of account,” he said. “We call that money, and it’s an invention that allows us to store time.” Most people have stored little or none. So when they receive money, they quickly purchase necessities; food, shelter, health care. “People who are able to save money inevitably purchase real estate, stocks, bonds – all of which are alternative vehicles for storing time.” One share of Google stores 30 hours of work for the average American, or 30 minutes of copying-and-pasting formation documents for the average hedge fund attorney. “Bill Gates has stored enough time to fund a 1bln person army for 20 years.”
As the gulf between people’s income has grown, the amount of stored time has accumulated in fewer hands. “Wealthy people convert their hours into financial assets so that they can accumulate excess hours relative to their fellow man. But the average worker is simply thinking how to exchange hours for dollars and then exchange those for food.” Central banks face a different problem altogether. They need to get people who’ve saved time to exchange it for something other than clever inventions that store it. They’ve largely failed. So now, everything that stores time is extremely expensive and offers little or negative return, while the pace of economic activity slows. “The problem that we face now is that there is simply too much time that’s been saved. Another way of saying it is that there’s too much capital in the world, in too few hands.”
To restart the system, capital needs to exchange hands or be destroyed, spurring people to rebuild their store of time, rather than just save it. “It is an elemental truth that at some point, through inflation, war, or confiscation and redistribution, this imbalance will correct, and the system will then restart.”

Sunday, April 17, 2016

Kyle Bass On Negative Rates, China, Politics & Gold



Part Two on his experience with Bear Stears before their collapse. Maria asks him if there is anywhere in the world he would currently be buying stocks as a long term investor. His response; "No."

Thursday, April 14, 2016

Peter Thiel: Everything Is Overvalued

The founder of Paypal and the first outside investor in Facebook spoke with Bloomberg this week and said he feels like just about everything is overvalued. Here was the key line;

"If there is a bubble it is probably centered on the zero percent interest rates, the quantitative easing, the money printing and that's a very strange one because it permeates everything


Amazon's Jeff Bezos On Failure & Being Bold

My wife told me yesterday Amazon is now offering same day shipping for online orders in our city. Same day means if you order in the morning it will be there that afternoon. The disruptions Amazon continues to create in the retail world are staggering.

I also came across this great piece from Amazon's letter to shareholders this week on failure and swinging for the fences (emphasis mine).

"One area where I think we are especially distinctive is failure. I believe we are the best place in the world to fail (we have plenty of practice!), and failure and invention are inseparable twins. To invent you have to experiment, and if you know in advance that it’s going to work, it’s not an experiment. Most large organizations embrace the idea of invention, but are not willing to suffer the string of failed experiments necessary to get there. Outsized returns often come from betting against conventional wisdom, and conventional wisdom is usually right. 

Given a ten percent chance of a 100 times payoff, you should take that bet every time. But you’re still going to be wrong nine times out of ten. We all know that if you swing for the fences, you’re going to strike out a lot, but you’re also going to hit some home runs. The difference between baseball and business, however, is that baseball has a truncated outcome distribution. When you swing, no matter how well you connect with the ball, the most runs you can get is four. In business, every once in a while, when you step up to the plate, you can score 1,000 runs. This long-tailed distribution of returns is why it’s important to be bold. Big winners pay for so many experiments."

Selling Too Soon


Monday, April 4, 2016

The World's Cheapest & Most Expensive Stock Markets

The following is an updated info-graphic from The Telegraph showing the world's cheapest and most expensive stock markets. They use an average of the current price to earnings ratio, cyclically adjusted price to earnings ratio (CAPE) and the price to book ratio. This ties in well with my discussion this morning:

What Is The Best Country To Buy Stocks?

Click for a larger visual...


What Is The Best Country To Buy Stocks?

A topic we often review here is how expensive or inexpensive different stock markets are around the world. History has shown buying into markets that are expensive has led to below average returns over the next five to ten years, and buying markets that are less expensive has provided investment returns that yield more positive results. 

I live in the United States and most of the historical data on this subject tends to focus on just the U.S. market. Investors in the U.S. tend to massively overweight their holdings to American companies. There are two main reasons for this:

1. Home Bias: Investors tend to buy stocks in locations and industries they are familiar with. For more on this I would highly recommend reviewing:



2. Recency Bias: Investors tend to make investing decisions based on what has recently happened. For example, they tend to buy stocks after the market has risen for years assuming the recent trend will continue, and they tend to sell stocks or stay out of a market after a major crash. American stocks have been one of the best performing markets since the 2008 crash, and they have been one of the best performing markets over the last 115 years. For more on the recency bias see:


I posted the following list a few weeks ago which shows where every market in the world ranks from the least to most expensive based on the average of a few valuation benchmarks. Brazil and Russia are the least expensive markets in the world while the U.S. and Denmark are the most expensive. 


Based on this chart alone an investor would re-weight their portfolio heavily into Russian and Brazilian stocks and own almost no U.S. stocks. However, let's take a moment to review other factors that should impact an investment decision beyond just valuation. We'll also review why the U.S. market has performed better than many other markets over the past 116 years.

Lawrence Hamtil at Fortune Financial wrote two excellent articles on this topic titled; Not All Stock Markets Are The Same. Mark noted Anglo-Saxon countries (UK, US, Canada, New Zealand, Australia, and Ireland) have seen their markets perform better since 1900 based on multiple reasons beyond just economic growth. The seven major reasons are;

1. It is the fiduciary duty to act in the best interest of shareholders. If the economy is weak companies will lay off workers and return corporate cash to shareholders via buybacks and dividends to make up for weakness in Earnings Per Share growth. The opposite occurs in countries such as Germany and Japan where employees are considered "stakeholders" of the company and are treated with far more care (mass layoffs are rare). 

2. Many of the best opportunities in non Anglo-Saxon countries are closed to public investors. In other words, some of the best companies in many countries tend to stay private and do not rely on public ownership (selling stocks) for financing and growth. Imagine if Coca-Cola, IBM, Microsoft, and others decided to stay private instead of going public. It would completely reshape the performance and perspective on U.S. stocks. 

3. Dedication to stable government. 
4. Stable currency
5. Limited inflation
6. Open trade
7. Property rights

Three through seven on this list should be self-explanatory but they are critically important for investment decisions. Investors in Germany were wiped out in the early 1920's when the country experienced hyperinflation. Argentina was one of the ten richest countries in the world entering the 1900's (ahead of France, Germany and Italy) and it was widely considered a better investment region than the United States. We only know now, with hindsight, that U.S. investors experienced an incredible run throughout the entire 1900's while investments in Argentina languished. 



During the 116 period in the charts above Brazil averaged 4.9% real growth while the United States averaged 3.5%. However, the U.S. grew its global market share from 15% to 52%. Just as with valuation, economic growth should not be considered the only factor when making investment decisions. The graph below shows there is no consistent correlation between GDP growth and equity returns. 



So what does this all mean?

It means investors have to do their homework before investing in a country and not make a purchase based on one single factor (stocks are cheap, economic growth will be strong, ect.) Those are important factors, but they are not the only factors. 

Investors must also consider the seven reasons reviewed above, as well as the macroeconomic and global financial forces that can impact both the currency and the financial markets. I will continue to focus heavily on the last two as we move forward this year.