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Survival of the Biggest

December 17, 2020

Survival of the Biggest

Small Business Slaughter
Triumph of Bigness
Zombie Companies
Small Business Startups Are Increasing
Final Thoughts and Valuations

The essential point to grasp is that in dealing with capitalism we are dealing with an evolutionary process… At the heart of capitalism is creative destruction.

…Situations emerge in the process of creative destruction in which many firms may have to perish that nevertheless would be able to live on vigorously and usefully if they could weather a particular storm.

—Joseph A. Schumpeter

The most important feature of an information economy, in which information is defined as surprise, is the overthrow, not the attainment, of equilibrium. The science that we have come to know as information theory establishes the supremacy of the entrepreneur because it appreciates the powerful connection between destruction and what Schumpeter described as “creative destruction,” between chaos and creativity.

—George Gilder

In its purest form, capitalism is an evolutionary process. Businesses that best adapt to changing conditions survive and grow. Typically, that means offering a product or service superior to current ones, or giving consumers more choices. Weaker or poorly managed businesses that don’t adapt to the new situation wither and eventually die. That’s not always pleasant but it’s how nature works. Joseph Schumpeter coined the term “creative destruction” to describe the process. It is not pleasant when you are on the destruction end, but the creative side can bring innumerable joys and sometimes even wealth.

The difference, however, is we don’t have capitalism in its purest form, or anywhere close. It has been tweaked, modified, corrupted and/or regulated into something else, the particulars of which vary. The common thread is that survival depends not only on impersonal nature, but on other non-random forces that can be manipulated. Governments can and often do create barriers to entry, protecting favored constituencies and groups from competition.

…click on the above link to read the rest of the article…

This Was All Predicted 10 Years Ago

December 3, 2020

This Was All Predicted 10 Years Ago

In 2010, the scientific journal Nature published a collection of opinions looking ahead 10 years, i.e., where we are right now.

Nature then published a short response from zoologist Peter Turchin in its February 2010 issue.

Quantitative historical analysis reveals that complex human societies are affected by recurrent — and predictable — waves of political instability (P. Turchin and S. A. Nefedov Secular Cycles Princeton Univ. Press; 2009). In the United States, we have stagnating or declining real wages, a growing gap between rich and poor, overproduction of young graduates with advanced degrees, and exploding public debt. These seemingly disparate social indicators are actually related to each other dynamically. They all experienced turning points during the 1970s. Historically, such developments have served as leading indicators of looming political instability.

Very long “secular cycles” interact with shorter-term processes. In the United States, 50-year instability spikes occurred around 1870, 1920 and 1970, so another could be due around 2020.

We are also entering a dip in the so-called Kondratiev wave, which traces 40- to 60-year economic-growth cycles. This could mean that future recessions will be severe.

In addition, the next decade will see a rapid growth in the number of people in their 20s, like the youth bulge that accompanied the turbulence of the 1960s and 1970s.

All these cycles look set to peak in the years around 2020.

Again, that was from 2010. Right on schedule, we are experiencing the “instability spike” Turchin says tends to come along every 50 years.

Why 50 years? It relates to the human lifespan.

Consider who was “in charge” during the period around 1970. Baby Boomers were all 25 or younger at the time. Managing the chaos fell on older generations, who remembered it well and spent the rest of their lives trying to prevent more of it.

But after 50 years or so, they are mostly gone. We who remain must learn the lesson again.

…click on the above link to read the rest of the article…

Prelude to Crisis

January 2, 2020

Prelude to Crisis

Simple Conceit
Radical Actions
Ballooning Balance Sheet
Merry Christmas and the Happiest New Year

Ignoring problems rarely solves them. You need to deal with them—not just the effects, but the underlying causes, or else they usually get worse. The older you get, the more you know that is true in almost every area of life.

In the developed world and especially the US, and even in China, our economic challenges are rapidly approaching that point. Things that would have been easily fixed a decade ago, or even five years ago, will soon be unsolvable by conventional means.

There is almost no willingness to face our top problems, specifically our rising debt. The economic challenges we face can’t continue, which is why I expect the Great Reset, a kind of worldwide do-over. It’s not the best choice but we are slowly ruling out all others.

Last week I talked about the political side of this. Our embrace of either crony capitalism or welfare statism is going to end very badly. Ideological positions have hardened to the point that compromise seems impossible.

Central bankers are politicians, in a sense, and in some ways far more powerful and dangerous than the elected ones. Some recent events provide a glimpse of where they’re taking us.

Hint: It’s nowhere good. And when you combine it with the fiscal shenanigans, it’s far worse.

Simple Conceit

Central banks weren’t always as responsibly irresponsible, as my friend Paul McCulley would say, as they are today. Walter Bagehot, one of the early editors of The Economist, wrote what came to be called Bagehot’s Dictum for central banks: As the lender of last resort, during a financial or liquidity crisis, the central bank should lend freely, at a high interest rate, on good securities.

…click on the above link to read the rest of the article…

Corporate Debt Is At Risk Of A Flash Crash

August 24, 2019

Corporate Debt Is At Risk Of A Flash Crash

The world is awash in debt.

While some countries are more indebted than others, very few are in good shape.

The entire world is roughly 225% leveraged to its economic output. Emerging markets are a bit less and advanced economies a little more.

But regardless, everyone’s “real” debt is likely much bigger, since the official totals miss a lot of unfunded liabilities and other obligations.

Debt is an asset owned by the lender. It has a price, which—like anything else—can go up or down. The main variable is the lender’s confidence in repayment, which is always uncertain.

But there are degrees of uncertainty. That’s why (perceived) riskier debt has higher interest rates than (perceived) safer debt. The way to win is to have better insight into the borrower’s ability to repay those loans.

If a lender owns debt in which his confidence is low, but you believe has value, you can probably buy it cheaply. If you’re right, you’ll make a profit—possibly a big one.

That is exactly what happens in a recession.

Investment-Grade Zombies

While it’s easy to point fingers at profligate consumers, households largely spent the last decade reducing their debt.

The bigger expansion has been in government and business. Let’s zoom in on corporate debt.

The US investment-grade bond universe is considerably more leveraged than it was ahead of the last recession:

Compared to earnings, US bond issuers are about 50% more leveraged now than in 2007. In other words, they’ve grown debt faster than profits.

Many borrowed cash not to grow the business, but to buy back shares. It’s been, as my friend David Rosenberg calls it, a giant debt-for-equity swap.

…click on the above link to read the rest of the article…

Japanified World Ahead

April 17, 2019

Japanified World Ahead

Losing Decades
Too Much, Too Fast
A $10 Trillion Federal Reserve Balance Sheet
Mastering Private Markets
Living on Puerto Rico Time

Regular readers may have noticed me slowly losing confidence in the economy. Your impression is correct and there’s a good reason for it, as I will explain today. The facts have changed so my conclusions are changing, too.

I still think the economy is okay for now. I still see recession odds rising considerably in 2020. Maybe it will get pushed back another year or two, but at some point this growth phase will end, either in recession or an extended flat period (even flatter than the last decade, which says a lot). And I still think we are headed toward a global credit crisis I’ve dubbed The Great Reset.

What’s evolved is my judgment on the coming slowdown’s severity and duration. I think the rest of the world will enter a period something like Japan endured following 1990, and is still grappling with today. It won’t be the end of the world; Japan is still there, but the little growth it’s had was due mainly to exports. That won’t work when every major economy is in the same position.

Describing this decline as “Japanification” may be unfair to Japan but it’s the best paradigm we have. The good news is it will spread slowly. The bad news is it will end slowly, too.

I believe we will avoid literal blood in the streets but it will be a challenging time. We’ll be discussing how to get through it more specifically at the Strategic Investment Conference next month. It is now sold out but you can still buy a Virtual Pass that includes audio and video of almost the whole event. Click here for information.

Losing Decades

…click on the above link to read the rest of the article…

The Debt Train Will Crash

July 16, 2018

The Debt Train Will Crash

Off the Tracks
Woes to Come
Growing Leverage
Pension Problems

We are approaching the end of the debt Train Wreck series. I’ve spent several weeks explaining why I think excessive debt is dragging the world economy toward an epic crash. The tracks ahead are clear for now but will not remain so. The end probably won’t be pretty. But there’s good news, too: we have time to get our portfolios, our businesses, and our families prepared.

Today, we’ll look at some new numbers on just how big the problem is, then I’ll recap the various angles we’ve discussed. This problem is so big that we easily overlook key points. I hope that listing them all in one place will help you grasp their enormity. Next week, and possibly a few after that, I’ll describe some possible strategies to protect your assets and family.

Before we go on, let me give a quick plug for Over My Shoulder. We rejuvenated this service a few months ago and it’s working even better than expected. Having Patrick Watson co-edit with me has been a big help. We’ve worked together, on and off, for 30 years now so he knows how I think. Between us, we have sent subscribers tons of fascinating economic analysis from my best sources—most of which you would never see otherwise. You get both the original item and our quick-read summary.

At just $9.95/month, Over My Shoulder may be the best financial research bargain out there, if I do say so myself. Click here to learn how you can join us.

Now on with the end of the train.

Off the Tracks

Talking about global debt requires that we consider almost incomprehensibly large numbers. Our minds can’t process their enormity. How much is a trillion dollars, really? But understanding this peril forces us to try.

…click on the above link to read the rest of the article…

Unfunded Promises

July 2, 2018

Unfunded Promises

In describing the global debt train wreck these last few weeks, I’ve discovered a common problem. Many of us define “debt” way too narrowly.

A debt occurs when you receive something now in exchange for a promise to give something back later. It doesn’t have to be cash. If you borrow your neighbor’s lawn mower and promise to return it next Tuesday, that’s a kind of debt. You receive something (use of the lawn mower) and agree to repayment terms – in this case, your promise to return it on time and in working order.

One reason you try to get that lawnmower back on time and in the proper condition is that you might want to borrow it again in the future. In the same way that not paying your bank debt will make it difficult to get a bank loan in the future, not returning that lawnmower may make your neighbor a tad bit reluctant to lend it again.

Debt can be less specific, too. Maybe, while taking your family on a beach vacation, you notice a wedding taking place. Your 12-year-old daughter goes crazy about how romantic it is. In a moment of whimsy, you tell her you will pay for her tropical island beach wedding when she finds the right guy. That “debt,” made as a loving father to delight your daughter, gets seared into her brain. A decade later, she does find Mr. Right, and reminds you of your offer. Is it a legally enforceable debt? Probably not, but it’s at least a (now) moral obligation. You’ll either pay up or face unpleasant consequences. What is that, if not a debt?

These are small examples of “unfunded liabilities.” They’re non-specific and the other party may never demand payment… but they might.

…click on the above link to read the rest of the article…

The EMP Threat: How It Works and What It Means for the Korean Crisis

February 19, 2018

The EMP Threat: How It Works and What It Means for the Korean Crisis

Before we begin with this week’s installment of This Week in Geopolitics, I want to draw your attention to the 2018 Strategic Investment Conference. Last year at the SIC, I said the United States would likely launch a pre-emptive attack on North Korea. I failed to anticipate the level of opposition from South Korea, which would bear the brunt of the casualties in such an attack. Without South Korea’s support, the US reconsidered its position. No attack came.

Obviously, I would like it if GPF were right about everything. Our track record is pretty good, but in this case, we were wrong. Still, I view this as the reason the SIC is such a valuable conference. The SIC’s greatest asset is how it brings together thinkers with profoundly different viewpoints to discuss the most important issues in the world today—people who aren’t afraid to tell you what they think, or to admit when they were wrong. I’m honored to be speaking once more at the SIC, where the theme for the year ahead is “Crossroads.”

And indeed, the world is at a crossroads. The post-2008 financial crisis “recovery” has not curbed speculation or reduced inequality. It has not halted the rise of political instability in the world’s most important countries. As Europe celebrates what 10 years ago would have been meager growth rates—and as the US celebrates sky-high stock prices one day only to watch them fall the next—the world stands on a precipice where the choices seem to be imminent chaos or delayed crisis.

…click on the above link to read the rest of the article…

Data-Dependent … on Imaginary Data

February 18, 2018

Data-Dependent … on Imaginary Data

Invisible Derivatives
Giant Mystery
Zero Confidence
Sonoma and the SIC in San Diego

Federal Reserve officials like to say their policy course is “data-dependent.” That sounds very cautious and intelligent, but what does it actually mean? Which data and who’s interpreting it? Let’s ask a few questions.

Photo: Federal Reserve Board of Governors

First, how could their policy choices not be data-dependent? The only alternatives would be that they made decisions randomly or that there was an a priori path already determined by previous Fed policymakers that they were forced to comply with. A predetermined path would, of course, eventually be leaked, and then everybody would know the future of Fed policy. Until they changed it.

Of course, they do depend on data, and lots of it, but are they looking at the right data? If it is the right data, theoretically speaking, is it accurate? As we will see, more often than not they are basing their decisions on data created by models that rely on potentially biased assumptions derived from past performance, etc. Often the data they look at is actually a sort of metadata, a kind of second-derivative model, with all sorts of built-in assumptions, quite removed from the actual data.

That approach is actually reasonable when you realize that the amount of data that must be managed is simply too large for any human being to process in a coherent manner. The data has to be massaged, and that means making assumptions that create the models in the programs. Those are assumptions are not made by computers, they are made by human beings who are doing the best they can – using models based on assumptions they build in to guide them as to what assumptions they should make about the data. Convoluted? Yes.

…click on the above link to read the rest of the article…

A Fly in the Economic Ointment?

January 25, 2018

A Fly in the Economic Ointment?

Global Growth Cap
Repeating History
Flying Blind at 20X
China Chills
Sonoma and San Diego

The holidays are fading from memory, and 2018 is off to a good start, economically speaking. Most of the forecasts I’ve read expect a good year – not a blockbuster year or a horrendous one, but a mild pickup that ought to satisfy investors. Even the bears seem less confident than usual.

The stock market is off to a rip-roaring start. For the first time ever, the Dow Jones Industrial Average has spent an entire quarter above its upper Bollinger band. That is, it’s more than two standard deviations above its 21-day moving average. You can click on the link for more detail. This might be a little technical for some of you, but it does demonstrate that there’s a great deal of exuberance in the market.

Tony Sagami

Further, Howard Silverblatt at S&P just came out with his forecasted earnings for 2018 (hat tip Ed Easterling for sending this to me). He revised 2017 earnings down by a few dollars to $110 as S&P analysts realized that companies are going to have to take write-downs for their deferred tax losses. But oh my is Howard positive about 2018. Look at this table straight from the S&P site. Focus on the reported earnings highlighted in yellow. Howard is expecting earnings to grow from $110 to $138 in 2018. That $28 jump in earnings represents about 25% earnings growth. If it actually materializes, the S&P 500 is going to be on a royal tear upwards.

Standard & Poors

The contrarian part of me wants to scream, “Aha! No one expects catastrophe, so that’s exactly what we’ll get.” While I don’t completely rule out anything, I’ve lived through several recessions and bear markets. This just doesn’t feel like another one.

…click on the above link to read the rest of the article…

The Next Crisis Will Reveal How Little Liquidity There Is

November 7, 2017

The Next Crisis Will Reveal How Little Liquidity There Is

This is something I’ve been pondering for some time. I think the next crisis will reveal how little liquidity there is in the credit markets, especially in the high-yield, lower-rated space.

Dodd–Frank has greatly limited the ability of banks to provide market-making opportunities and credit markets, a function that has been in their wheelhouse for well over a century.

However, when the prices of massive amounts of high-yield bonds that have been stuffed into mutual funds and ETFs begin to fall, and the ETFs want to sell the underlying assets to generate liquidity, there will be no buyers except at extreme prices.

My friend Steve Blumenthal says we are coming up on one of the greatest buying opportunities in high-yield credit that he has ever seen. And he has 25 years of experience as a high-yield trader.

There have been three times when you had to shut your eyes, hold your breath, and buy because the high-yield prices had fallen to such extreme levels. That is going to happen again.

But it is going to unleash a great deal of volatility in every other market. As the saying goes, when you need money in a crisis, you sell what you can, not what you want to. And if you can’t sell your high-yield, you end up selling other assets (like equities), which puts strain on them.

But that is not just my view. Dr. Marko Kolanovic, a J.P. Morgan global quantitative and derivative strategy analyst, has written a short essay called “What Will the Next Crisis Look Like?” and it’s this week’s Outside the Box (subscribe to this free weekly publication here). He sees additional sources of weakness coming from other areas, too.

…click on the above link to read the rest of the article…

The Pension Storm Is Coming To Europe—It May Be The End Of Europe As We Know It

October 7, 2017

The Pension Storm Is Coming To Europe—It May Be The End Of Europe As We Know It

I’ve written a lot about US public pension funds lately. Many of them are underfunded and will never be able to pay workers the promised benefits—at least without dumping a huge and unwelcome bill on taxpayers.

And since taxpayers are generally voters, it’s not at all clear they will pay that bill.

Readers outside the US might have felt safe reading those stories. There go those Americans again… However, if you live outside the US, your country may be more like ours than you think.

This week the spotlight will be on Europe.

The UK Is Headed to a Retirement Implosion

The UK now has a $4 trillion retirement savings shortfall, which is projected to rise 4% a year and reach $33 trillion by 2050.

This in a country whose total GDP is $3 trillion. That means the shortfall is already bigger than the entire economy, and even if inflation is modest, the situation is going to get worse.

Plus, these figures are based mostly on calculations made before the UK left the European Union. Brexit is a major economic shift that could certainly change the retirement outlook. Whether it would change it for better or worse, we don’t yet know.

A 2015 OECD study found workers in the developed world could expect governmental programs to replace on average 63% of their working-age incomes. Not so bad. But in the UK that figure is only 38%, the lowest in all OECD countries.

This means UK workers must either build larger personal savings or severely tighten their belts when they retire. Working past retirement age is another choice, but it could put younger workers out of the job market.

UK retirees have had a kind of safety valve: the ability to retire in EU countries with lower living costs. Depending how Brexit negotiations go, that option could disappear.

…click on the above link to read the rest of the article…

Global Retirement Reality

October 1, 2017

Global Retirement Reality

Global Shortfall
UK Time Bomb
Swiss Cheese Retirement
Pay-As-You-Go Woes
Lisbon, Denver, Lugano, and Hong Kong

Today we’ll continue to size up the bull market in governmental promises. As we do so, keep an old trader’s slogan in mind: “That which cannot go on forever, won’t.” Or we could say it differently: An unsustainable trend must eventually stop.

Lately I have focused on the trend in US public pension funds, many of which are woefully underfunded and will never be able to pay workers the promised benefits, at least without dumping a huge and unwelcome bill on taxpayers. And since taxpayers are generally voters, it’s not at all clear they will pay that bill.

Readers outside the US might have felt smug and safe reading those stories. There go those Americans again, spending wildly beyond their means. You are correct that, generally speaking, we are not exactly the thriftiest people on Earth. However, if you live outside the US, your country may be more like ours than you think. Today we’ll look at some data that will show you what I mean. This week the spotlight will be on Europe.

First, let me suggest that you read my last letter, “Build Your Economic Storm Shelter Now,” if you missed it. It has some important background for today’s discussiion, as well as a special invitation to attend my Strategic Investment Conference next March 6–9 in San Diego. With so much change occurring so quickly now, next year’s conference is an event you shouldn’t miss.

Global Shortfall

I wrote a letter last June titled “Can You Afford to Reach 100?” Your answer may well be “Yes;” but, if so, you are one of the few. The World Economic Forum study I cited in that letter looked at six developed countries (the US, UK, Netherlands, Japan, Australia, and Canada) and two emerging markets (China and India) and found that by 2050 these countries will face a total savings shortfall of $400 trillion.

…click on the above link to read the rest of the article…

What Could Go Wrong? For Public Pensions, More Than You Know

September 28, 2017

What Could Go Wrong? For Public Pensions, More Than You Know

Here’s a loaded question for you: “What could go wrong?”

In some contexts, it can express mistaken confidence, as in, “Sure I’ll put my hand between that crocodile’s jaws. What could go wrong?”

Investors should ask the same question before entering a position. “What risks am I taking with this trade? What could go wrong if it doesn’t go as planned?”

But here’s the problem: What if you never think to ask the question because you have no idea you’re in that trade?

And guess what—this is your problem if you are a taxpayer anywhere in the US.

Photo: DWS via Flickr

Pension Pain

Part of my job is helping John Mauldin with the research for his Thoughts from the Frontline letters. Regular readers know John isn’t a doom-and-gloom guru. He’s optimistic on most of our big challenges.

Except for a few things—like the brewing state and local pension crisis.

The more John and I dig into it, the worse it looks. We have both spent many hours trying to find any good news or a silver lining, without success.

All over the US, states, cities, school districts, and other governmental entities have promised their workers generous retirement benefits, but haven’t set aside enough cash to pay what they will owe. At some point, perhaps soon, either they will have to cut benefits to retirees or stick taxpayers with a huge bill, or both.

You can read John’s September 16 letter, Pension Storm Warning, to learn more. Then you’ll see why he says to Build Your Economic Storm Shelter Now.

What else could go wrong? Plenty.

…click on the above link to read the rest of the article…

Americans Don’t Grasp The Magnitude Of The Looming Pension Tsunami That May Hit Us Within 10 Years

September 20, 2017

Americans Don’t Grasp The Magnitude Of The Looming Pension Tsunami That May Hit Us Within 10 Years

Total unfunded liabilities in state and local pensions have roughly quintupled in the last decade.

You read that right—not doubled, tripled, or quadrupled—quintupled. That’s nice when it happens on a slot machine, not so nice when it’s money you owe.

You will also notice in the chart that much of that change happened in 2008.

Why was that?

That’s when the Fed took interest rates down to nearly zero, meaning it suddenly took more cash to fund future payments.

According to a 2014 Pew study, only 15 states follow policies that have funded at least 100% of their pension needs. And that estimate is based on the aggressive assumptions of pension funds that they will get their predicted rate of returns (the “discount rate”).

Kentucky, for instance, has unfunded pension liabilities of $40 billion or more. This month the state budget director notified local governments that pension costs could jump 50–60% next year.

That’s due to a proposed reduction in the system’s assumed rate of return from 7.5% to 6.25%—a step in the right direction but not nearly enough.

Think About This as an Investor: How Can You Guarantee 6–7% Returns These Days?

Do you know a way to guarantee yourself even 6.25% average annual returns for the next 10–20 years? Of course you don’t. Yes, some strategies have a good shot at doing it, but there’s no guarantee.

And if you believe Jeremy Grantham’s seven-year forecasts (I do: His 2009 growth forecast was spot on), then those pension funds have very little hope of getting their average 7% predicted rate of return, at least for the next seven years.

…click on the above link to read the rest of the article…

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