Archive for Most Recent Stories – Page 2

Recession Or Expansion – How Much Does It Really Matter To Equity Investors?

By GaveKal Capital

Is the US economy about to lift-off out out of the recovery phase and enter into a self-sustaining expansion? Or is the US economy cratering towards a debt constricting, deflationary recession? Few questions in economics or finance garner as much emotion and flamboyant diction as to where is the economy “heading”. Instead of prognosticating on the difficult question of where the economy is heading, today we want to ask how much does it really matter to equity investors where the economy is?

For our data needs today, we are going to use the Dow Jones Industrial Average going back until 1900. Of course we are aware of the limitations of using the DJIA, however, it does have the important advantage of 114 years of history. This extended history allows us to analyze the Pre-WWII era against the Post-WWII era which one will soon see plays an important role in determining how much the economic environment plays into stock returns. We will also be using the NBER official business cycle dates to determining whether or not the US economy was in a recession or an expansion.

Regardless of whether or not the US was in a recession or an expansion, the average market return during any economic phase is a healthy 24% (figure 1). The median is quite a bit lower at 9% indicating positive skew in the data set. The average max drawdown during any phase is -15%, with median max drawdown of -9% during any phase.

Figure 1 – Total DJIA Series


When we begin our data slicing and break out the returns based on the type of economic phase the US was in, the performance data skews heavily in favor of expansions relative to recessions. In Figure 2, we show the average and median returns when the US is in an expansionary phase. And in figure 3, we show the returns when the US in a recessionary phase.

Looking at these two figures, without a doubt it has been much to be an equity investor during an expansion that during a recession. The average market performance in 60% higher and the median market performance is 37% higher. Just as important, the max drawdown is significantly less in an expansion relative to a recession.

Figure 2 – Expansionary Phase


Figure 3 - Recessionary Phase


We tipped our hand to this earlier, but now let’s analysis pre-WWII and post-WWII returns based on economic phase. Doing so we find a couple of interesting characteristics:

  • Market performance during different expansions pre-WWII were more similar and had less skewness as indicated by their much closer average and mean returns (Figure 4) compared to the market returns post-WW2 (Figure 6). The max return is higher after WWII and the median return is slightly lower.
  • Recessions were harsher to investors prior to WWII (Figure 5). The median market return during a recession was -9% before 1946 while the median market return since is actually positive (3%) (Figure 7). Max drawdown highlights this as well as the median max drawdown was 11% deeper before WWII (26% vs 15%).

Figure 4 – Pre-WWII Expansion Phase


Figure 5 – Pre-WWII Recession Phase


Figure 6 – Post-WWII Expansion Phase


Figure 7 – Post-WWII Recession Phase


So yes, the economic phase matters to equity investors. However, it has mattered less since WWII. Why is this case? There may be myriad of explanations such as companies leveraging technology to ride out the business cycle more profitability or globalization of sales and profits. Or perhaps it has more to do with the monetary policy backdrop, such as going off the gold standard, than it has to do with other factors. Most likely, it is a combination of many reasons working together. Regardless, it is clear the economic phase is still important to equity investors but as we are reminded nearly every quarter by “professional” forecasters, it is anyone’s guess as to which phase we are headed.

(source for all data above is from Dow Jones, Gavekal Capital, NBER)

How to jumpstart the Eurozone economy

By Francesco Giavazzi and Guido Tabellini (via VOXeu)

Some More Q&A…

Here’s some more on the Q&A from last week:

Q: The return on these option indexes created by the CBOE look way to good to be true. Basically they are indexes of writing covered puts and calls on the S&P 500, and the way outperform it. Wondering if you might be able to point out what I am missing. Seems like if these returns were true everyone would be doing this.

CR:  1)  I don’t see the word “fee” in that PDF at all.  I’d be interested in seeing the real, real returns there….2)  Many of those benchmarks are available ETFs.  They haven’t performed nearly as well as that fact sheet says.  See PBP the SP500 buy/write for instance….

Q: Cullen, I was wondering where you think a 30 year mortgage might be in 2017?

CR:  If I had a gun to my head I’d probably bet that they will be marginally higher than today….

Q: I wanted to get your thoughs on the Fed’s recent push, by some members, to push up rates sooner rather than later. It seems like bank lending is just still too slow and new bank Capital requirements restrict them from lending out as heavily as before: hence less inside money in the system and therefore lack of inflation. Wage growth also seems too low to make much of a difference. Am I wrong in thinking this way?

CR:  You’re dead right.  Any fears of inflation are likely overblown.  The Fed is at risk of looking like the ECB in 2011.  There is way too much slack in the economy today to warrant a rate increase any time soon.

Q: How come I suck at investing?

And if you had one question you could ask Yellen what would it be.

CR:  1)  Investing is hard and you probably don’t have a very good process that you can stick to.  2)  I’d ask her what her largest personal asset holding is.

Q: I’m wondering what about the current US fiat system that makes inflation good in comparision to a gold standard where inflation is always bad?

CR:  Well, the idea of inflation has to be put in the right context.  Inflation can rise and have no meaningful negative impact on your life if your wages also rise.  If inflation doubles, but your wages also double then you aren’t worse off.  And for the most part, we’ve seen wages handily outpace inflation over the last 100 years.

Q: Rocky’s? The Tap Room? or Cass Street Bar?

CR:  A local.  I love it.  I lived in PB for 8 years and am moving to north county now.  I’ll miss it, but I’ve hit my expiration date.  Rocky’s – best burger in San Diego.  Cass – best local bar in PB.  Don’t love Tap Room.   I pretty much live at Fish Shop….

Q: You may address this in your book, but why did the world (generally) decide to outsource the creation of money to private banking? What’s the history involved there?

CR:  Good question.  I think that most free economies developed with a high degree of skepticism about the govt controlling the money supply too much.  The private banking system created a buffer of sorts and allowed the money supply to be only loosely controlled by governments.

Q: Farmers that have a bad year might expect a higher price for their milk/wheat/vegetable. Less supply should equal higher price. But they are then told that the markets are global and just because one country have bad crops one year, prices don’t rise unless global supply is down.
Now Russia cut food imports from Europe. Suddenly the price crashes. European diplomats urge other countries not to step in and take the market.
I don’t get it. If the market is global. Supply is the same. Demand is the same (Russia can import from other countries). Why does the price of food crash in Europe? Is the market so inefficient?

CR:  The real effects here are probably too micro for my pay grade, but my guess is that yes, the markets are a lot less efficient than people generally think.  Just look at the volatility in the global price of oil.  I mean, every little shock causes a huge ripple through prices.  But time and time again we see that these big geopolitical events don’t have nearly the impact that people assume.  But the end producers still have to hedge their bets and ensure that the risk of less supply is not borne entirely by them.  So yes, I think the market is inefficient in part because the people setting prices have to be rather imprecise in how they manage their risks (which is efficient for them, but looks very inefficient to everyone else)….

Q: Given the constraints of a finite resources and the law of diminishing returns, do you think it is probable that over the long term that productivity growth can/will outpace that of credit growth?

CR:  I don’t think productivity has to decline because of the lack of available resources. The global economy is becoming more diverse than ever.  More and more of what we “produce” are services that don’t necessarily translate from real resources.  This is actually a big part of the increase in productivity.  It’s a lot easier to build a webpage than it is to build a factory.  It can be as efficient also depending on your business….


You think Ms. Yellen is reading your website?

CR: God save us all if the Fed Chief takes me input into serious consideration.  And no, I don’t think she reads my website.

Q: Do you believe that America is sustainable as a whole(unemployment, bubbles, banks, wars, energy, entitlements, population growth, government ect.)? When you look at the macro picture that you seem to put in a lot of effort to understand, do you honestly think the U.S. is progressing, or regressing? Do you think Americans will see a lowering standard of living in general(for larger portions of the population) as future progresses?

CR:  My general view is that we’re sort of like Micrsoft.  The USA is this big developed entity that has likely seen its best days, is now losing market share, but continues to do a lot of really great things.  So we’re making progress, but at a slower rate.  I am not a permabull, but I am an optimist.  But there are places in the world where I am much more optimistic than the USA over the long-term because I think the USA is bound to lose global market share….

Q: What are your thoughts on expanding the EITC vs. increasing the minimum wage? Perhaps it should be an “either/or” question.

Lot’s of discussion about inequality, Piketty, a $15 minimum wage, etc. these days.

Perhaps a better question for you is what do you think the federal government should do to help low income workers?

CR: The minimum wage debate is a moral debate.  I mean, increasing wages doesn’t necessarily make the economy better off because it doesn’t mean that households will necessarily save more of their income.  So raising wages is just a redistribution of sorts.  Which means that it’s really a moral discussion that centers around making sure that corporations don’t mistreat their employees.  I am not against an increase in the minimum wage.  But that has nothing to do with me thinking it’s good for the economy.  It’s because I think corporations can and will take advantage of their employees if given the opportunity and I think someone should stand up for the workers of the world who can’t stand up for themselves.

Q: are you going to launch an ETF based on the Global Financial Asset Portfolio? i suppose the Vanguard 40/60 LifeStrategy would perform similarly and i might switch to it soon – my main 80/20 is far too risky now i think about it.

CR:  No, I have no ETF plans in the future.  But I am getting back in the asset management game this year.  :-)

What do you think we will see first, 1% or 4% on the 10 year Treasury?

CR:  That’s a hard one.  It would take a real shit show for the world’s safest asset to hit 1%.  I’m not bearish right now, but I can’t see that in the coming years.  I also can’t see 4% any time soon….Can I guess neither and update you later?  :-)

Q: “If the output of a society declines or is viewed as less valuable to its users then the money which is used as a medium of exchange will also be viewed as less valuable.”

I could not understand that. I certainly would agree that the two would be highly correlated in a statistical way, but I couldn’t understand why it was (absolutely) necessary.

CR:  Well, it’s about understanding how the outstanding balance of assets relates to price/value.  If there is a fixed quantity of money in the economy and the quality of output is declined then the value of the money MUST, by definition, decrease in value because its value relative to the reduced quality of assets makes it less valuable, all else being equal.

Q: How would you interpret this chart?

CR:  Well, there’s a blue line and a red line and the red line appears to be winning the race to the upper right hand corner which is pretty great for the red line because that means it’s winning and winning is good, right?  Oh wait, that’s not a sports scoring sheet.  Sorry.

That’s just a representation of QE.  There has been weak loan demand in recent years so loans are stagnating, but QE has resulted in deposit creation so QE has resulted in a continued expansion of M2 by reducing the pvt sector’s quantity of T-bonds.  Some people make this out to be very scary, but it’s just a representation the basic asset swap accounting behind QE.

Q:  the left sees the economy as a fixed pie, with some people taking more than their fair share. the right says that the pie grows enabling everyone opportunity to benefit. how do you see it, and where are they wrong?

CR:  They’re both right to some degree.  The economy does expand the pie for all of us by creating goods and services that enhance our lives.  But it can also become very uneven in terms of who benefits most from producing these goods and services.  I think the living standards of Americans are expanding at a faster rate than economic growth would imply.  But I also think the disparity between how people benefit from this is expanding more rapidly.  So they’re both right to some degree.

 Q:  I would be interested in your comments on this article in Foreign Affairs entitled “Print Less but Transfer More: Why Central Banks Should Give Money Directly to the People” (by Mark Blyth and Eric Lonergan).

Basically, they propose a helicopter drop equal to 2% of GDP (which works out to around $1000 per person), along with using interest rates as a control valve for inflation.

CR:  If the Fed were to print dollars and shoot them out the front door then that would clearly have a big impact on the economy.  It would be similar to deficit spending in that it adds to the private sector’s financial net worth dollar for dollar.  In an economy where so many people are debt burdened I think that would be a net positive.  I think firing dollars out the front door is a bad way to do it.  I’d prefer a tax cut or some government investment in infrastructure or something like that….

Q:  What do you think will cause the next recession?

CR:  Corporate America will stop investing.

Q:  Federal debt takes two forms. Debts to individuals, institutions, and other governments. The other form is where it owes itself for the money it has created.

If we maintain the obligation to the individuals, institutions, and other governments but erase the balance sheet obligations for the second kind of debt, what would be the consequences? Why recognize any type of obligation for debt we have purchased with created money?

CR:  Well, most of the debt the government owes to itself is actually owned by citizens.  It’s military pension funds, Social Security and things like that.  So I don’t think it would make sense to wipe it off the books.  The government’s liabilities are generally the non-government’s assets.




Is the Global Financial Asset Portfolio the Perfect Indexing Strategy? – Part 2

Last week I presented the Global Financial Asset Portfolio (GFAP).  In case you missed it here’s a brief summary:

    • The GFAP represents the current allocation of the world’s financial assets.
    • The GFAP is the only pure “passive” index as this is the index that gives you “what the market gives you”.
    • The GFAP is approximately a 55% bonds, 40% stocks, 5% REITs index at present.
    • The GFAP has performed extremely well in the last 30 years on both a risk adjusted and nominal basis.

While I think this portfolio could be fine for many people I also believe this analysis has exposed several flaws in the traditional view of “forecast free” and “passive” investing.  Instead, this analysis requires us all to take a much more nuanced perspective. It’s very likely that the people selling the idea of a purely “passive” or “forecast free” approach do not understand the underlying dynamics at work.  Let me explain.

First, as I explained previously, the true global asset portfolio (as depicted in this paper), is impossible to replicate perfectly.  So there is really no such thing as buying exactly what the “market gives you”.  You have to alter the index using various subjective assumptions.  In the case of my GFAP I removed commodities for instance because I wanted to remove non-financial assets based on the understanding that commodities don’t perform well in real terms over the long-term.  Clearly, that’s been somewhat wrong over the last 15 years as some commodities have performed extremely well.  But the point is that there’s a degree of subjectivity here that makes this a much more nuanced and active endeavor than we might think.

Second, the GFAP is an ex-post snapshot of what the financial asset world looks like today.   Historically, the GFAP should change over time as the underlying balance of assets will inevitably change over time.  So the GFAP has to be reactively dynamic to some degree.  Therefore, the portfolio requires its own degree of reallocation just to remain consistent with the actual underlying allocation of outstanding financial assets.

Third, because the GFAP is an ex-post snapshot of the underlying financial assets it is inherently reactive.  Therefore, it could be positioned in such a manner that it will not provide optimal future returns.  For instance, today’s balance of financial assets reflects the falling interest rate environment of the last 30 years.  So the GFAP reflects this balance.  As a result, the portfolio is bond heavy relative to equities because it has become significantly less expensive to issue debt relative to equity over the last 30 years.  As a result we’ve seen a huge decline in equity issuance relative to debt.  So the GFAP has shifted from what was a stock heavy portfolio 30 years ago to a bond heavy portfolio today.  But this is a reactive shift in the landscape.  Any smart asset allocator would look at this environment and argue that there are some unsustainable trends in place here.*

For instance, the Aggregate Bond Index has generated 8%+ annualized returns since 1980.  With overnight interest rates at 0% there is about a 0% chance that bonds will generate the same returns in the next 30 years as they have in the past 30 years.  So this bond heavy portfolio has an overweight to fixed income thanks to the ex-post nature of this index.  But there’s also a strong argument to be made that stocks are expensive in relative terms and likely to be more volatile going forward than they have been in the past.  This means that anyone actively choosing to deviate from the GFAP bond heavy allocation is potentially exposing themselves to a high degree of equity market risk which creates a whole other risk for investors in a low interest rate environment.

Lastly, we should note that there are many factors that play into an asset allocation decision outside of trying to replicate a “pure” index like the GFAP (there is a degree of indexing overkill in some discussions these days).  Clearly, this allocation isn’t appropriate for all investors and you need to be very precise about understanding risk and how it relates to your personal decision before you can allocate your assets appropriately.  So generalizations about the GFAP should be taken with a grain of salt as they do not apply to everyone.

All of this presents an interesting conundrum for asset allocators.  Using an ex-post snapshot of the financial world is clearly not always an optimal approach for everyone.  Most importantly, there’s an obvious contradiction in the idea that we should just accept “what the market gives us” since this implies that the forecasts of the asset issuing entities comprising the current underlying asset allocation, is optimal, and we should therefore just accept the return that their asset issuance generates.

A reliance on a “pure” indexing approach like the GFAP is not necessarily a bad idea for some people, but it has obvious flaws as well.  Asset allocation requires a certain degree of active forecasting and “asset picking” based on how we think the future performance of specific asset classes will translate to our risk profile and financial goals.  There’s a certain degree of forecasting and guesswork involved in any of this.  A reliance on a pure ex-post approach is reactive and static relative to what must be a proactive and dynamic endeavor (asset allocation).  Finding the perfect balance will be difficult for all of us to achieve.  Hopefully this series helps you put things in the right perspective so you can come a little closer to optimizing your own approach.

*  To highlight this point consider the fact that a 40/60 bond/stock portfolio has substantially outperformed a 60/40 bond/stock portfolio over the last 30 years on a risk adjusted basis and only slightly underperformed in nominal terms.  In other words, buying the GFAP from 30 years ago when it told us to be stock heavy, was precisely backwards!


What Stage of the Bull Market Are We In?

By Ben Carlson, A Wealth of Common Sense

“A bull market is like sex. It feels best just before it ends.” – Barton Biggs

Here’s how legendary investor John Templeton once described bull markets:

Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.

And this is how Howard Marks defines the three stages of a bull market:

Fortunately, one of the most valuable lessons of my career came in the early 1970s, when I learned about the three stages of a bull market: the first, when a few forward-looking people begin to believe things will get better, the second when most investors realize improvement is actually underway, and the third, when everyone’s sure things will get better forever.

You should notice that both of these definitions are completely subjective. They don’t say that bull markets are done once we hit defined valuation targets. Nor do they say that once a market sentiment survey reaches a certain level that a bull market will end.

The most intelligent investors are the ones that are willing to admit that there is no certainty with market cycles. The pundits, portfolio managers and financial advisors with the most certainty are usually the ones you should listen to the least. It’s impossible to know exactly when a market cycle will end because the pendulum can swing too far in either direction.

For every data point on stock ownership or investor sentiment that shows stocks are overvalued someone can find the counterargument that shows the market is fairly actually fairly valued and vice versa. Anytime you see a data set trying to define the entire stock market you can take it with a huge grain of salt.

This is because markets are emotionally-driven. There are so many moving parts involved that it’s impossible to simply use a single variable or even a handful of variables to tell you exactly when the good times will end.

We’ve been inundated with crash calls for the past 3-4 years. Much of this is because of the recency bias since we’ve witnessed two huge market crashes in the past decade and a half alone. Some are fear-mongering and ill-conceived but many have come across as intelligent arguments about why the bull market should have ended. It hasn’t mattered just yet.

Investors probably spend too much time trying to determine which year the current market set-up resembles. Is this 1999 all over again? Is it just like 2007? How about 1987? The fact is that investor actions are shaped by past experiences so 2014 is just like 2014. The only constant is that investor emotions shape market dynamics, especially over shorter time frames. This is why Templeton and Marks used market psychology to describe bull markets and not CAPE ratios or free cash flow multiples.

These things are impossible to call with any precision. The best you can do is use the process of elimination to see where we aren’t.

We’re well past pessimism and skepticism (save for those that have been wrong the entire way up).

Everyone realizes the improvement is underway.

There’s no blood in the streets.

There are no babies being thrown out with the bathwater.

It’s not time to get greedy.

Does that mean it’s time to sell all of your stocks because we’ve seen huge gains over the past five years?

That all depends on your time horizon and what kind of investor you are. For some historical perspective see this chart of 30 year real returns from Jesse Livermore at Philosophical Economics:


Here’s Livermore’s observation about investing right before the onset of the Great Depression:

Surprisingly, a long-term investor that bought the market in November 1929, immediately after the first drop, did better than a long-term investor that bought the market in September 1980.

Patience can be a great equalizer of cycles in the financial markets. As Barry Ritholtz reminded his readers in the Washington Post this weekend – time, not timing is key to investment success.

The bull market will end at some point. Stocks will go down and we will eventually see a bear market. These things happen. When it happens is up to Mr. Market.

Who’s afraid of 1929 (Philosophical Economics)

Three Things I Think I Think

Since I am still working through the Q&A from last week I figured I’d take some of the questions for a segment of three things:

Question # 1 – “How can one invest, as opposed to speculate, without knowing value?”

There are many factors that drive price outside of perceived “value”.  In fact, as I’ve made clear in recent weeks, I don’t think value is a very clear factor driving price because “value” is a rather nebulous concept.  No one really knows what the “value” of the stock market is the concept of value has to be dynamic.  Therefore, I don’t even see how this can be the most influential factor in price.

I could be wrong there of course, but the point is that there are lots of different factors that drive price.  Things like momentum, quality, yield, volatility, market cap are some of the more popular ones aside from value, but I’d argue that even that is too micro.  If you give me the macro direction of the economy, a general idea of what type of environment we’re in (high inflation, deflation, de-leveraging, etc) and the health of corporate profits (using Kalecki equation, etc) I’ll tell you which direction stocks are headed 75%+ of the time.  Combine that with general sentiment and I think you can put together a potent mix for making high probability directional bets on the market.  In other words, give me the direction of the current and I’ll tell you, with a high degree of confidence, which way the boats will move.  I could care less what “value” and all those other factors say so long as I know the direction of the current….

Macro modeling is complex and forecasting is difficult, but so is defining any factor that moves price.  In my view, a macro perspective gives you a much clearer perspective and results in a much higher probability of being right about the big trends.  And if you can get the big trends right then the details tend to fall into place much more easily.

Question #2 - Well done on publishing your book recently. Any tips for others writing and publishing/promoting a book?

Thanks.  I’m no guru in promotion of writing.  After all, Pragmatic Capitalism was my first book.  But I do have some advice.  First, go into the process knowing that books don’t make people rich these days (except for a very small percentage of them).  So you have to realize that this huge project is going to have a relatively small monetary payout in all likelihood.  The benefits of writing the book are intangible – maybe someone learns something from you.  Maybe it helps build credibility for you.  Maybe it’s just something you’ve always wanted to do.  I just think you have to go into it with your eyes wide open knowing that it will be a huge amount of work with little monteary payout, but a potentially large intangible payout.  That’s how I viewed it anyhow.  And I can tell you from the feedback I am getting that it’s helping a lot of people better understand investing and money and that’s hugely rewarding for me.

Question # 3  - Hi Cullen. Recently read and loved your book. Your analysis if central banking was very easy to understand. I particularly liked your point about how the US government has tremendous assets, which more than balance the debt. Can you comment on Japan in this regard? Are they tipping the boat over there at all? I do continue to feel like interventionist central banking will find its Waterloo in Japan, and fear this will lead global markets to ultimately lose faith in the other CBs. Any thoughts on this that you might have would be appreciated! Keep up the good work.

I am by no means an expert in Japanese monetary policy, but my understanding is that the MOF and BOJ essentially modeled their system after the Fed system.  So most of what I say about QE and deficit spending in the USA applies to Japan.  Also, Japan is what I describe in the book as a country that is high in terms of being an autonomous currency issuer.  This gives them a degree of flexibility that a country like Vietnam doesn’t have.

I have expressed my skepticism about how much the BOJ can really positively impact the Japanese economy in recent years, but the currency devaluing is certainly working better than I expected.  Not sure how long that can last though.  And I have a feeling that once that’s run its course that the BOJ will continue to run into the disinflation monster again.  It’s not the BOJ that worries me in Japan.  It’s the structural demographic issues that worry me more so.  And this is deflationary in nature and not likely to be inflationary or result in currency collapse.

How To Respond to Someone Screaming About “Money Printing”

Here’s a response to the first question from last week’s Q&A.  I feel like it’s worthy of its own post because it’s important.  The question was:

‘How do you respond to someone who is constantly claiming that inflation and therefore interest rates are bound to shoot up with “all of the money the government is printing?”‘

That’s easy.  Here is how that conversation will usually go:

Inflationist: “Can you believe how reckless our government is printing all this money every year?”

Monetary Realist: “Well, technically, the government doesn’t “print” most of the money we use.  Most of the “money” we use is created by banks and is created when banks issue loans which create deposits.  These deposits make up the majority of the “money” we all use to transact”.

Inflationist:  “Yeah, but can you believe the high government deficits were’ running and all that new money that gets printed when the government spends?”

Monetary Realist: “The government isn’t printing new money when they run a budget deficit.  They’re actually “printing” a government bond that is used to raise “money”.  This results in the redistribution of existing money and the issuance of a new government bond.  There actually isn’t any “money printing” going on there.”

Inflationist:  Yeah, but what about all those paper dollars floating around.  Those have to be inflationary at some point, right?

Monetary Realist: “Not necessarily.  Paper money is only accessible to people who have previously had bank accounts.  That is, any cash in the monetary system is placed there by someone who withdrew money from a bank account.  They essentially transformed their deposits into cash notes.  But the “money” still originated with the banks creating deposits even if the US Treasury is the entity that actually prints up the physical notes.  They only do that so you can transact in physical currency more conveniently and this money is distributed THROUGH the banking system.

Inflationist:  “Oh yeah, but Quantitative Easing has been crazy money printing.  Have you seen the size of the Fed’s balance sheet?  Just wait until those dollars all get out of the banking system and cause crazy high inflation!”

Monetary Realist:  “Well, that’s not exactly right.  The Fed has created reserve balances through QE’s asset purchases which resulted in the increase in outstanding reserves in the private sector, but the reduction of another asset in the private sector.  This isn’t asset printing.  It’s asset swapping.

And more importantly, these reserves are used by banks INSIDE the banking system.  That money doesn’t “get out” of the banking system in any meaningful sense.  Remember cash is transformed from deposits so even if customers withdraw cash then this doesn’t mean there is necessarily “more money” in the system.  It just means the type of money has been exchanged.

Inflationist:  “Well, what about when the banks start using all those reserves to multiply the money supply through new loans?  Won’t that cause crazy high inflation?  ”

Monetary Realist: “That textbook story is cute and all, but it’s not really how banks operate.  Banks make loans and find reserves later if they must.  They aren’t reserve constrained.  The money multiplier is a myth.  “

That should help you out.  Good luck.  It’s an uphill argument every time!



Buy Cullen Roche’s New Book Pragmatic Capitalism – What Every Investor Needs to Know about Money and Finance

Learning How to Make Progress From Chris Pratt

By Ben Carlson, A Wealth of Common Sense

“A personal finance crisis is almost inevitable unless you address the truly important tasks in your life before they become urgent.” – Carl Richards

Here’s another one to add to the ever-growing list of scary household saving stats courtesy of Businessweek:

Just 45 percent of upper-middle-class households (income from $75,000 to $99,999) saved anything in 2012, according to the Fed study. That means the other 55 percent didn’t save for a house, retirement, or education. About 16 percent spent more than they earned and went further into debt. The report highlights the consequences of these hand-to-mouth habits: Only half of these households had enough savings to finance three months of living expenses if they lost their job or couldn’t work. A $400 emergency would force about 20 percent of them into months of debt.

Although the financial crisis was tough on many people’s finances, this isn’t necessarily an issue born out of a severe recession. This has been going on for some time now as you can see from this graph:


These aren’t lower income households. This is a large percentage of the upper middle-class that don’t save a dime.

You could point to any number of reasons for the fact that people don’t save any money, but for many it’s simply too difficult to know where to begin. No one teaches you how to manage your personal finances in school. You’re on your own.

The problem for most people is that it’s easy to find reasons to not save any money. There will always be something there to impede financial progress.

It’s almost cliché at this point to compare fitness or losing weight with personal finance principles, but the analogy works. A recent Esquire profile on Chris Pratt (of Parks & Rec and Guardians of the Galaxy fame) reminded me of how difficult it can be for people to just get started when they’re in a rut.

Here’s Pratt talking about the changes he’s seen since he went from being overweight to getting into super hero shape:

When I was way out of shape, the idea of using whitening strips on my teeth seemed terrible. I have to do that every day? I’ll never do it. What you want is instant results when you’re out of shape. You want your teeth whitened in 45 minutes with the use of lasers.

Substitute saving for retirement, paying off credit card debt, creating a budget or any of the personal finance basics for teeth whitening here. When it seems like there are a million different things you need to do to turn your finances around, doing the little things will seem pointless.

But it’s amazing how small successes can build on one another like compound interest once you start to see some progress from putting simple systems in place. Here’s Pratt with how his views have changed now that he’s turned things around:

I like clothes now. I have more energy. I sleep better. My sex drive is up. Blood’s flowing. I’m less susceptible to impulse. I’m in a different mode.

But when you’re in shape, you know it’s the result of doing a little bit every day. Moments aren’t just moments. A moment might be a week or a month. So instead of Boy, I’d love to eat this hamburger right now, I’m considering a little further into the future. I’m thinking, I eat that hamburger and that’s 1,200 calories, and I’mgonna work out tomorrow and lose 800 calories. I may as well eat a salad here, still do that workout, and then I’m actually making progress.

Generally this is how financial progress is made as well. Your entire mindset changes and instead of treading water you actively search for ways to continue making progress. And the incremental daily changes that Pratt talks about start to evolve into the correct long-term mindset that gets results.

There are no shortcuts to building a solid personal financial ecosystem. It’s about instituting systems that allow you to build wealth methodically over time. The easiest first step in the process is to automate as many financial decisions as possible. Progress doesn’t have to be impossible but it’s never going to come from a quick fix.

Oh Lord, There Goes That Damn Pratt Boy Again (Esquire)
Even the upper middle class struggles to save money (Business Week)

Housekeeping: You Asked For It….

Okay, I got a TON of complaints after turning the comments off last week so I am going to test an alternative this week.  I am turning Disqus on with the hope that user registration and a more organized commenting system makes the moderation and handling much simpler from my end.  Posts can be voted on so bad content will get pushed down and users can be picked as moderators to help with any negative commentary on the site.

I hope this is a healthy and productive alternative to just shutting things down entirely.  Any feedback during the week would be appreciated.  Thanks.

Europe vs USA: the Unemployment Divergence

Here’s another perspective on the incredible divergence in the US economy and the European economy (via Calculated Risk):


And here’s the chart I posted the other day on industrial production:


Truly amazing.  Truly tragic.


The End of Stock Picking

Jason Zweig has a nice piece in yesterday’s Wall Street Journal on the end of the stock picking asset manager.  He notes:

The debate about whether you should hire an “active” fund manager who tries to beat the market by buying the best stocks and avoiding the worst—or a “passive” index fund that simply matches the market by holding all the stocks—is over.

So says Charles Ellis, widely regarded as the dean of the investment-management industry.

Stock picking “has seen its day,” he told me this past week, as assets at Vanguard Group, the giant manager of market-tracking index funds, approached $3 trillion for the first time. “With rare exceptions, active management is no longer able to earn its keep.”

Jason is totally right.  The myth of Warren Buffett is running its course.  The idea that we can all pick stocks on our way to riches is little more than a myth.  And so the rise of asset allocators is taking hold.  And most importantly, the rise of low fee asset allocators is taking hold.  Stock pickers are getting lost in the dust and being increasingly exposed as closet indexers trying to charge people fees for claiming to be able to “beat the market” by picking stocks inside an index.

The mainstream public is catching on.  And that’s a good thing.  Closet indexers are a waste of money and unfortunately still hold way too many assets.  It’s nice that they’re starting to become extinct.

Buy Cullen Roche’s New Book Pragmatic Capitalism – What Every Investor Needs to Know about Money and Finance

This Commonly Referenced USD Purchasing Power Chart is Useless

You’ve almost certainly seen the chart below over the years – it shows the purchasing power of the US Dollar over time.  It looks terrifying.  And it’s constantly cited by hyperinflationists and other people trying to convince you that the world is quickly coming to an end thanks to the “fiat monetary system” and all the “money printing” that’s going on due to nefarious governments.  Well, the chart is basically a misrepresentation of anything important.


(Figure 1 – Stupid Chart)

The problem is, this chart doesn’t show whether per capita wages are rising or falling.  For instance, if your dollars buy you half as many eggs today as they did in 1913, but your income is twice as high as it was in 1913 then you haven’t gone backwards.  Yes, the USD’s purchasing power has fallen, but your ability to buy the same quantity of eggs has remained exactly the same.  Your living standard hasn’t fallen even if the purchasing power of the dollar has declined.

So, it’s important to put this in the right perspective here.  And when we look at this discussion it’s best to use an inflation adjusted perspective of wages and salary accruals on a per capita basis.  And when we run that figure the chart looks a lot different (reliable data only goes back to 1947):


 (Figure 2 – Smart Chart)

It’s not exactly a thing of glory (especially the last 20 years or so), but it clearly tells a very different story than the chart above which really tells us nothing.  So, next time some hyperinflationist throws the USD purchasing power chart in your face refer him to this post and tell him he isn’t telling the full story.


Buy Cullen Roche’s New Book Pragmatic Capitalism – What Every Investor Needs to Know about Money and Finance

Is Wealth and Income Inequality Inevitable in a Capitalist System?

Good question here from the forum today:

“Is wealth and income inequality inevitable in a capitalist system?”

I discuss this a bit in my new book, which, in my opinion, is a great primer for Thomas Piketty’s book on inequality.  If you want to understand Piketty my book lays the foundation for the entire discussion by helping you understand the macro framework in which he makes his argument.   But here’s my general view:

“Inevitable” is a bit of a generalization. “Highly probable” – yes. The thing is, capitalism runs on profits. And profits are optimized when they’re monopolized. A good capitalist will try to monopolize the means of production therefore maximizing profits.  And when profits are monopolized then you are very likely to get inequality because only a handful of people own the means of production. So capitalism has a natural tendency towards monopolization because capitalists naturally want to maximize profits.

Does it have to happen? No, it’s not certain, but my guess is that if you left a capitalist system entirely to its own devices there would be a handful of capitalists who monopolize everything. In fact, this almost happened in the late 1800′s and early 1900′s before the US government came in and started busting up some of the big companies.  We were well on our way to seeing a handful of people owning everything.

So, why is this potentially problematic?  Well, the economy isn’t like a poker game.  It doesn’t just end at some point where Warren Buffett gets to get up and walk away from the table with all the money.  The other players have to keep playing to keep on generating profits for the big stack players.  And if those big stack players just accumulate more and more chips then the other players have to rely on the incomes from their big stack employer, keep borrowing from the bank, relying on government redistribution to stay in the game OR compete with the big stack.  Of course, they could “pull themselves up by their bootstraps”, but that’s often easier said than done.  Especially when you’re competing against the big stack who has monopolized the means of production.  The endgame is a situation where the people who actually buy the goods and services that the big stack makes, don’t actually have the income or credit necessary to be able to go on participating and so you get a very stagnant economy.

Anyhow, this is a controversial and highly theoretical discussion, but it is my opinion that capitalism, if left entirely to its own devices, would tend towards monopoly which would tend towards inequality as fewer and fewer people own more and more of the means of the production.

It’s Not a Chase For Yield, It’s a Chase For Fees

By Ben Carlson, A Wealth of Common Sense

“One lesson from 2008 is that if it’s very complicated and you don’t understand it, maybe you shouldn’t buy it.” – Harry Markowitz

It appears some people didn’t learn their lesson from the CDO debacle of the last financial crisis. This comes from a story in last week’s Wall Street Journal on a new fixed income derivative product that’s being rolled out by Goldman Sachs (emphasis mine):

Goldman Sachs has been marketing a new structure: a so-called Fixed Income Global Structured Covered Obligation that may come to market in September. It borrows elements of covered bonds, a structure with a long history in Europe. Investors will have a claim on a pool of dedicated assets and against two guarantors, Goldman and Mitsui Sumitomo Insurance.

But in many ways, the deal isn’t a covered bond. Instead of funding mortgages or public-sector loans, it will provide funding for a portfolio of fixed-income securities sourced from Goldman. The deal is structured via a derivative, a total-return swap entered into by Goldman Sachs Mitsui Marine Derivative Products.

And investors won’t know what exactly is in the pool. They will get a breakdown of the kinds of assets included, but not the exact composition. And what is in the structure can change. Crédit Agricole notes the pool could be predominantly residential-mortgage backed securities at one point, sovereign debt at another and corporate bonds at yet another.

From this description, here’s what we know about what this product offers:

1. A complete lack of transparency.
2. The possibility of a higher than average yield.
3. Leverage.
4. Complexity.

Some might call this a chase for yield, but really it’s a chase for fees. This is a way to sell intelligent-sounding products to unwitting investors that are told stretching for extra yield is worth it in this type of structured investment vehicle.

Investors aren’t without fault in these transactions, but sometimes it seems like Wall Street is able to create its own supply and demand for some products because they’re so good at selling.

Many outside of the investment industry could be fooled into believing these types of products must be a great idea because of their complexity. Alas, there are no style points when investing.

There are necessary and unnecessary risks when putting money to work in the markets. Necessary risks include the inherent uncertainty about the future and having to accept volatility to earn returns over time. Unnecessary risks generally come from not knowing what you’re doing. They amplify bad behavior. Investing in products you don’t understand is the epitome of an unnecessary risk.

One of the most overused phrases by financial pundits is ‘this isn’t going to end well’. The truth is I don’t know if this product is going to end well or not. Even if it does “end well” by offering a slightly higher than average yield without blowing up that doesn’t necessarily mean it would be a good decision.

Risk is unavoidable, but one of the questions that investors need to constantly ask themselves when making portfolio decisions is ‘Are these the right risks and are they worth it regardless of the outcome?’

Sure you can get lucky in these types of products on occasion, but over time luck becomes unsustainable.

This doesn’t just concern this one Goldman Sachs fixed income product. Generally, if you don’t understand an investment, you probably shouldn’t invest in it. And just because a product is available doesn’t make it necessary for your portfolio.

Innovation in the investment world isn’t always a bad thing as investors now have access to strategies through ETFs and mutual funds that would have been impossible to replicate in the past at such a low cost. But investors don’t need to feel the need to constantly chase the new and exciting.

Some of the best investment decisions you ever make will be the opportunities you turn down.

Yield Hunters’ New Tune Echoes Financial Engineering’s Past (WSJ)

Here’s what I’ve been reading this week:

Q&A – Ask Me Anything

Since I am trying out the site without comments I figure the least I can do is open things up to a Q&A more often.  Feel free to have at it.  You can rip me a new one for closing comments, ask me something nerdy or whatever you want.  Just don’t be too rude so I go regretting opening up comments….