Monday, January 7, 2013

Breaking The Taboo - The War On Drugs

For the preview click here.

2013 Outlook Part 5: Global Debt Binge & Policy Response

2013 Outlook Part 1: Introduction
2013 Outlook Part 2: What Is A Bond?
2013 Outlook Part 3: How Did We Get Here?
2013 Outlook Part 4: Can You Lose Money In Bonds?
2013 Outlook Part 5: Global Debt Binge & Policy Response
2013 Outlook Part 6: United States Bubble Bond Prices
2013 Outlook Part 7: Residential Home Prices Have Not Bottomed
2013 Outlook Part 8: Commercial Real Estate Cap & Interest Rates
2013 Outlook Part 9: Chapter 2 Of The Sovereign Debt Crisis Begins
2013 Outlook Part 10: Japan's Government Debt Bomb Goes Off
2013 Outlook Part 11: Should I Buy US Stocks Today?
2013 Outlook Part 12: How To Invest

The debt super cycle is a global phenomenon. The current global debt to GDP ratio is 350%. That is $200 trillion in debt vs. $62 trillion in GDP. GDP refers to Gross Domestic Product or the total size of the global economy.

Debts begin to become unsustainable when they cross the 60% debt to GDP ratio. Beyond that point the initial boost to the economy that additional debt provides begins to diminish significantly. In the long term, debt always reduces growth because you are borrowing from the future when debt is taking on. The additional boost to spending in the short term must be met with sacrifice in the future to pay back the debt - plus interest.

This is where we find the world today. It has borrowed $200 trillion from the future and now the bill is here to pay. What are the consequences of this? Significantly lower growth from the highest debtor countries, corporations, and individuals around the world.

In order to overcome this mountain without a slow down would take a massive increase in growth for the total economy and incomes. Remember that the government borrows from both the people and the companies that exist within the states borders. Not only do individuals and corporations have debts of their own to deal with, but they must pay back the wild spending of the governments through current and future taxation. 

The problem with cutting spending and raising taxes is that it slows down growth in the short term. For some nations a slow down in growth means reducing the total GDP and total tax intake. By doing the right thing it actual adds to the deficit problem. This is what is occurring in countries like Spain today as any austerity is being met with revolt in both the bond market and from the people.

They are boxed in a corner, and they have reached what John Mauldin calls in his excellent book "The Endgame." We will see moving through this outlook that many of the developed countries around the world are already at this Endgame, only the bond markets have not recognized it yet. Countries like Japan and the United States have no possible way of avoiding their predicament without a crisis. Slashing spending and raising taxes will bring on a deflationary depression. Raising spending and cutting taxes in order to try and outgrow the problem raises the risk of a bond market revolt. 

Up until late last summer we saw the first option being tested in Europe. Germany, still remembering their devastating hyperinflation during the early 1920's put a leash on the European Central Bank's ability to print money to purchase debt. That ended over the summer when the ECB promised to back stop a significant portion of the market.


Economists and financial analysts looked at what took place in Europe over the last two years and concluded that it was the wrong policy response. Cutting spending and not allowing your central bank to provide unlimited printing will slow the economy in the short term. It is the equivalent of putting a drug addict into rehab. They will experience pain and withdrawals during the initial stages.

With Europe now ready to unleash the printing press, they will join other developed powers like the United States, Japan, and the UK that have provided relentless government spending alongside unlimited central bank firepower. This brings us to where we are today. With all governments around the running full blast we will see if they will be able to outgrow the debt.


It is my belief that they will not be able to do it. The burden this time has finally become too large. This will bring about the "change" to the financial system discussed during the introduction. Every individual and corporation around the world has put their full faith into their governments and central banks. If they fail, which they will, it will create a completely new paradigm shift, or awakening.

This paradigm shift will create a dislocation in the market the size of which has never been witnessed in history. There will be chaos, collapse, and revolution. Most likely we will experience war during some portion of this process, which will be an unfortunate event to witness for those that understood the crisis and how it could be avoided. Battles will be fought over mistakes made the last few decades and paid for with unnecessary deaths of many people around the world.

I will briefly discuss how the worst possible scenario could be avoided (war and collapse), but it is a futile exercise as I believe with 100% certainty that the wrong course of action will be followed.

Many will argue that productivity, not growth, will save us. They conclude that there is some sort of new industrial revolution waiting around the corner that will take care of unemployment and income growth. The problem with this thought is that the actual productivity growth, which is still growing, is occuring at a lower rate every year.

The reason is that the creation of hot water plumbing, electricity, and cars during the first half of the 1900's caused an exponential rise in growth per capita in the developed world. This growth reached a peak in the 1950's and has been falling since. The creation of an iPad over its predecessor, the laptop, provides a far less incremental growth in productivity than the creation of the car had over horses.

The following chart shows this exponential rise and exponential fall first in the UK then in the US when they become the world's economic super power. 


We understand now that the problem exists and that the final reckoning day, is upon us. Let's now look at the individual participants of this grand debt supercycle finale followed by the best estimate on how it will all play out.

Sunday, January 6, 2013

2013 Outlook Part 1: Introduction

2013 Outlook Part 1: Introduction
2013 Outlook Part 2: What Is A Bond?
2013 Outlook Part 3: How Did We Get Here?
2013 Outlook Part 4: Can You Lose Money In Bonds?
2013 Outlook Part 5: Global Debt Binge & Policy Response
2013 Outlook Part 6: United States Bubble Bond Prices
2013 Outlook Part 7: Residential Home Prices Have Not Bottomed
2013 Outlook Part 8: Commercial Real Estate Cap & Interest Rates
2013 Outlook Part 9: Chapter 2 Of The Sovereign Debt Crisis Begins
2013 Outlook Part 10: Japan's Government Debt Bomb Goes Off
2013 Outlook Part 11: Should I Buy US Stocks Today?
2013 Outlook Part 12: How To Invest

We live in a world on the precipice of the greatest change in financial history. This simultaneously comes at a time when almost everyone in the world believes that moving forward, things will be the same.

This means that the relative pricing of financial assets, the relative structure of business and economic models, and the relative structure of how people in general live their lives is about to face the greatest (non-war) dislocation in history.
If you can understand just those first two paragraphs, then the rest of the story, charts, and data presented over the following pages are far less important. You will already be ahead of the vast majority of people.

This change will create the greatest wealth transfer in history for those that are prepared and understand it is coming, and it will decimate the lives of the majority of people who have based their finances and their lives on a model of the future extrapolating forward on its current path.


How did we get to this major change in history and why is it that no one knows changes are coming?

Our entire quadrillion dollar plus financial system is built on a foundation of debt. To see this, you only need to go back to the very beginning of the chain and you find that money, when first created, is lent into existence. This debt today is known as a bond. If this concept is new to you, I highly recommend watching the following videos to provide yourself with a basic understanding of the modern monetary system.


These bonds are now layered across every part of the financial system - beginning with the balance sheet of the average citizen. They probably own a home (mortgage bond) have a CD (bond) at the bank and invest a large portion of their 401k directly into a Prime Income Fund (bonds).

Corporations around the world are financing a large part of their growth through debt issuance (corporate bond) and even the countries those corporations are located in finance their operations through debt issuance (government bond).

My goal with this outlook is to take you further in depth on how we got to the world we live in today and provide you with my lens on how I see the world unfolding in the years ahead. I will use simple models/examples and move at a pace that should be readable for a novice entrant into the financial markets but still provide enough data to to challenge someone who has already spent a significant amount of time in this field.

My goal is not to provide a “hot trade of the week,” but to reshape a portion of the way you look at everything around you.  Imagine that you could go back to 2007 and you had just a fraction of an understanding that something didn’t feel right. The business and financial world were valued around home prices rising forever. If you thought home prices might just move sideways (instead of collapsing by 40%), how would it have changed your thinking about the world?

What if you had worked for a mortgage broker or home building company? What if you were a real estate agent or someone involved in the home upgrade business (financed by home equity)? What if you worked at Home Depot in a bubble market? What if you owned a home in a bubble market or your business would be dramatically impacted should real estate prices fall?

What I want to do with this outlook is to show you the next subprime mortgage crisis before it arrives.

With this understanding I hope you will be able to make choices in your life beyond just a “hot trade” in your account. If you are young, this coming change to the financial world and global economy will impact your life for the next 20 years. Decisions someone makes in their 20’s or 30’s are magnified exponentially due to the law of compounding interest when you look back from the future.

Let’s begin.

2013 Outlook Part 2: What Is A Bond?

2013 Outlook Part 1: Introduction
2013 Outlook Part 2: What Is A Bond?
2013 Outlook Part 3: How Did We Get Here?
2013 Outlook Part 4: Can You Lose Money In Bonds?
2013 Outlook Part 5: Global Debt Binge & Policy Response
2013 Outlook Part 6: United States Bubble Bond Prices
2013 Outlook Part 7: Residential Home Prices Have Not Bottomed
2013 Outlook Part 8: Commercial Real Estate Cap & Interest Rates
2013 Outlook Part 9: Chapter 2 Of The Sovereign Debt Crisis Begins
2013 Outlook Part 10: Japan's Government Debt Bomb Goes Off
2013 Outlook Part 11: Should I Buy US Stocks Today?
2013 Outlook Part 12: How To Invest

Imagine that Ted wants to raise some money to start a home business. He goes over to his friend Jim’s house for a few beers and he tells him about his idea. The only problem Ted tells Jim, is that he is a little short of start up capital.

"No problem," says Jim. "I will lend you $10,000 at 10% interest per year for a period of 10 years." That means that Ted owes Jim $1,000 per year over those ten years and then he must pay back the entire $10,000 (principal).  

This is a called a bond.

It is the prime tool that banks, corporations, local governments and national governments use to raise money.  Another option to raise money for corporations would be the sale of stock (going public), but we’ll discuss stocks in a later section.

While the interest rate on a bond is fixed when you buy it, the underlying principal (the amount of debt you purchased) has the ability to change in value in the open market – just as a stock has the ability to change in value. Many average hard working people, most of which are loading their retirement accounts with bonds as I type this, have no idea how bond prices work.

We’re going to come back to this story with Jim and Ted in just a moment to see how it ends, but first let’s take a brief look at how we arrived at this point in the bond market cycle.

2013 Outlook Part 3: How Did We Get Here?

2013 Outlook Part 1: Introduction
2013 Outlook Part 2: What Is A Bond?
2013 Outlook Part 3: How Did We Get Here?
2013 Outlook Part 4: Can You Lose Money In Bonds?
2013 Outlook Part 5: Global Debt Binge & Policy Response
2013 Outlook Part 6: United States Bubble Bond Prices
2013 Outlook Part 7: Residential Home Prices Have Not Bottomed
2013 Outlook Part 8: Commercial Real Estate Cap & Interest Rates
2013 Outlook Part 9: Chapter 2 Of The Sovereign Debt Crisis Begins
2013 Outlook Part 10: Japan's Government Debt Bomb Goes Off
2013 Outlook Part 11: Should I Buy US Stocks Today?
2013 Outlook Part 12: How To Invest

The current debt cycle has been coined by many as "the debt super cycle." It is a 70 year event in the making that is now at its final stages. Bonds today are at the highest price in history at a time when they are extremely dangerous based on fundamentals.

How did we get here?

The starting point for the debt super cycle began on April 29, 1945 when Germany surrendered to conclude World War II. Post war periods saw the debts accumulated paid down from the victors from the countries on the losing side. Usually these countries paid as much as they could and then had to default on the rest (following WWI, Germany decided to “print” the debts it owed creating one of the most notorious hyperinflations in history – that process will soon repeat itself again).

The conclusion of the second World War was the last time the debts of world were “balanced” in any major way. Imbalances begin to build soon after and continued for the next few decades with the United States owing the rest of the world a large portion of gold in order to make good on their IOU’s. In order to keep the gold within the borders of the US, President Nixon took the world off the gold standard in August 1971 (a move that will be looked back on as wise for the US and disastrous for the rest of the world when we reach the final endgame to this story). This allowed the US to pay its debts with paper IOU’s and it allowed every government around the world to run debt and print new currency with absolutely no limit.

This was the first major event that “pushed back” the day of reckoning on the debt super cycle. In the decades since that August of 1971, we have witnessed a combination of both fiscal and monetary policy working in tandem to push back the day of reckoning as far as possible. A walk through of how the United States handled the "push back" (other countries have followed a similar path) goes as follows:

While the Fed was fighting inflation in the early 1980’s, it was the government that ran massive deficit spending stimulus programs to keep the economy churning. When inflation had been cleansed it was time for the Fed to take over in the 1990’s and they stepped in every step of the way to stimulate the markets. During this period, it allowed the government to take a break, balance its budget, and even run a surplus in the late 1990’s/early 2000’s.

In 2000, we reached the point where both the Fed and the government had to work simultaneously to keep the day of reckoning from arriving. Beginning in 2001, the Fed slashed interest rates to 1%, flooding the economy with cheap money. The government came in and announced massive tax cuts and stimulus programs that would be financed with deficit spending. The crisis was pushed back.

From 2008 to present day we have seen the same program enacted, only this time on steroids. The Fed not only has brought interest rates to 0%, but they have promised an additional $1 trillion plus QE program “forever.” The government now runs $1 trillion plus annual deficits and the consensus is that any slow down in the economy should be met with additional printing and additional deficit spending.

The Secular Bond Market Cycle:

In the late 1970’s as the previous secular bond bear market was winding down its 30 year cycle, bonds were known as "certificates of confiscation." They were the most hated investment on the planet. This was at a time when many safer longer dated bonds paid close to 20%.

Investors assumed that inflation would keep rising forever and bonds would never provide the protection needed to cover the rising cost of living. They also assumed that interest rates would rise on bonds forever meaning prices would just continue to go down. Pessimism toward the bond market was at its highest point in history. Investors at the time, which most people cannot remember, wanted to own something called gold which was entering its mania stage of the 1970's bull run. There were lines around precious metals shops filled with buyers, just as investors are lined up electronically today to put 401k money as quickly as possible into a bond fund.

Back in the late 1970’s, financial analysts used to review the US money supply on a weekly basis. If the monetary base rose, bond prices would sell-off. Why? Because an increase in the money supply dilutes the value of the underlying currency. This means you will be paid out your principle with devalued dollars in the future if the money supply is rising.

Today, a new QE program (massive printed money injection) is greeted with a surge in bond prices. This paradox is striking for those that have studied history or those that were fortunate enough to have lived through and remember the past. Fundamentally, bond prices should plunge at the announcement of every QE program but the exact opposite occurs (or has so far). Why? Because investors believe that they can front run the Fed’s purchases and sell quickly enough to be the first one out of the burning theater when it catches fire. The market today consists of hot money from professional investors with their trigger on the sell button combined with the cattle herd of middle class investors sitting in the large slow funds waiting for slaughter.

How was the middle-class average investor once again duped?

A large percentage of stock market investors lost faith in the market after the 2000 crash. Some of them crept back into stocks leading up to 2008 only to find themselves crushed again. Many people in this generation will not ever be returning to the stock market. Why? Psychologically the fear of loss is always greater than the desire for gain. In addition, events that occur more recently, known as “recency,” have a much greater impact on people’s decision making.

Some of those that ventured out of the stock market in 2000 decided to test the waters elsewhere. Their capital found a home in real estate. This market, just as they were told with stocks, "would continue to rise forever." In 2007, they were slaughtered.

Now money has moved from real estate and stocks to bonds. The TIC flows show how 401k money is being allocated - a steady selling of stock funds since 2008 and a steady buying of bond funds.

The fear of loss is amplified to an even greater degree the closer one gets to retirement. Someone in their 20’s cares much less about their small amount of capital being hurt in the short term by another stock market crash. But what about someone that is in their early 60’s looking to retire in the next few years? If they were to put their money back into stocks only to find another crash waiting for them, it would devastate their retirement portfolio.

These people have now put their money into the one investment they know and have been told "never goes down in price", bonds. They may be getting a small return on their money, but they know that at least their money will be there waiting for them. As the debt super cycle begins the process of unwinding and this mania moves back in line with reality, investors will once again learn their lesson the hardest way possible.

2013 Outlook Part 4: Can You Lose Money In Bonds?

2013 Outlook Part 1: Introduction
2013 Outlook Part 2: What Is A Bond?
2013 Outlook Part 3: How Did We Get Here?
2013 Outlook Part 4: Can You Lose Money In Bonds?
2013 Outlook Part 5: Global Debt Binge & Policy Response
2013 Outlook Part 6: United States Bubble Bond Prices
2013 Outlook Part 7: Residential Home Prices Have Not Bottomed
2013 Outlook Part 8: Commercial Real Estate Cap & Interest Rates
2013 Outlook Part 9: Chapter 2 Of The Sovereign Debt Crisis Begins
2013 Outlook Part 10: Japan's Government Debt Bomb Goes Off
2013 Outlook Part 11: Should I Buy US Stocks Today?
2013 Outlook Part 12: How To Invest

Let's return back to our two friends Jim and Ted from Part 2.

Jim gave Ted $10,000 to both help a friend and hopefully make some money at the same time. Jim is in his early 60’s and ready to retire so he needs to know what to do with the rest of his money. He knows for sure that he wants nothing to do with either stocks or real estate after the recent crashes.

Not wanting to take any risks, he decides to put his $1,000,000 retirement savings into the safety of a bond fund. He wants as much yield as possible, but he does not want anything too risky, so he invests in a fund that returns about 2.5% per year. This is a mixture of local government, federal government, mortgage, and corporate bonds. Most of the bonds within the fund are longer dated – meaning they are 20 – 30 year bonds which allow him to get the highest possible return.

What would happen if interest rates for these longer dated bonds were to rise to just 5%?

The value of his retirement fund would be cut in half, from $1,000,000 to just $500,000. 

Why?

Bonds underlying value are based on interest rates. Imagine there are 10 people living on an island thinking about investing in the only 2 boat making companies. They are looking for the best return on their money. The first company sells the first $1,000,000 debt offering to Michael at 2.5% interest. That means Michael collects $25,000 per year.

The second boat company announced a $1,000,000 bond offering at a 5% interest rate. The next investor, Robert, now steps up and gives the company $1,000,000 in exchange for a return of $50,000 per year. This 5% rate is now the market rate for boat company bonds on the island.

Here is the important part: If one of the remaining 8 members of the island wants to receive the $25,000 (the same annual return as Michael) how much would they need to buy in boat bonds? 

Only $500,000 with today's new 5% interest rate. ($500,000 x .05 = $25,000)

Michael's portfolio value has been cut in half as it now only takes $500,000 in boat bonds to receive $25,000 in annual interest. For a further discussion on bonds and how they are valued please see:


This is exactly the same situation that Jim has now put himself in. However, what if interest rates instead move from 2.5% to just 1.25%? The exact opposite happens – his investment doubles in value

This is what investors believe will occur that are purchasing bonds today. It is the exact same psychology seen during the 1999 – 2000 years of the stock market mania and the 2005 – 2006 years of the real estate mania. Investors have no care about the prices paid for the investment because they know they will always be able to sell it at a higher price.

We are now about to extrapolate this concept out much further to show how the bursting of the global bond bubble will impact every part of the world around us. Before we did that it was important to explain what a bond was and how we reached the mania stage of this debt cycle. A mania occurs through the fear of loss, followed by the herd mentality creating the desire for gain, compounded by the emphasis on recency, global demographics, and the limited value of financial understanding the average investor has around the world.

This discussion goes well beyond why the average investor will be hurt. Corporations have now created models moving out into the future based on a low interest environment forever. Professionals that manage money have done the same. Most now consider toxic government debt as “cash good” collateral just as they did with subprime mortgages back in 2006. When interest rates rise it will not only completely change this paradigm, it will most likely lead to a completely new financial system and potentially the next global war.

2013 Outlook Addendum: Relationship Between Bond Prices & Interest Rates

From the Khan Academy. Online learning is the future of education.

Introduction To Bonds:



Relationship Between Bond Prices & Interest Rates:

2013 Outlook Addendum: Modern Money Mechanics

The following will hopefully help you understand how money is loaned into existence and backed by nothing.

Modern Money Mechanics:



Michael Maloney Discusses The Current Monetary System:



If this peaks your interest and you want more on the monetary system, I suggest reading The Creature From Jekyll Island. It takes you back to the origins of the Federal Reserve, bringing you current through present day.