BNN Full Interview for January 19th, 2018

BNN Jan 19

 

Market Call Interview

https://www.bnn.ca/video/full-episode-market-call-for-friday-january-19-2018~1301270

 

Past Picks:

https://www.bnn.ca/video/ross-healy-s-past-picks~1307955

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Black Hole Economics: Why The Rich are Getting Richer and You are Getting Poorer

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It wasn’t supposed to be like this, you know. Back in 1979, that glib snake oil salesman, Arthur Laffer, promised that with tax cuts for the corporations and the rich, everyone would benefit as the increase in economic growth that would result would trickle down to everyone’s benefit. 39 years later, the rich have certainly benefited but somehow the rest of us have largely become poorer as wealth has become massively concentrated in the hands of the top 1%. Today, so entrenched has the Laffer Curve “theory” become that finally one of those 1 percenters has reached the top office in the USA, on a platform of – yes – cutting taxes for the rich! And, heaven help us, many Americans – and, apparently, most of the Republican members of Congress – still believe the story. The last two exercises in tax cutting (and the resultant debt growth) has now led the US to the point where GDP growth has largely slowed to a crawl and the total indebtedness of the US economy has reached unprecedented highs. So what went wrong with ‘trickle-down’ economics that has brought us to the current state of affairs? And now that Congress has written ‘chapter three’ in the tax reduction tale, the Corporate Welfare Act of 2017 (a.k.a. “tax reform”), the question is where are we going from here?

Let’s start with the “what went wrong” question. Politicians love cutting taxes. For Ronald Reagan way back in 1980, that was easy and very popular. But if your income gets cut back, then your expenditures had better be cut back as well – or you will have to borrow to cover your household ‘deficit’. Reagan’s ‘household’ (so to speak) was the US government, but cutting government spending would not have been popular – and he felt, unnecessary – when all the growth that Laffer promised would be coming soon. Tax collections would increase, and the government would then cover off any immediate spending deficits with the growth that would result from tax cutting.

Only that part never happened. US government deficits began to grow relentlessly and the total indebtedness of not only the federal government of the US but also the US states have soared more or less since then, with but one all too brief respite.

And so it was that the debt load on the US economy actually grew and grew, and the US economy grew increasingly more sluggish as deficits mounted. Following the election of 1992, new president, Bill Clinton, was so alarmed that he instituted a regime of raising taxes, slashing expenditures, and paying down the US government debt. His policies – which were the complete antithesis to the tax reducing ‘Laffer strategy’ – worked like a charm. As the previously growing debt burden was lifted from America’s back, the economy soared, the stock market soared, consumer confidence soared, and the US dollar rose to new highs. To this day, thanks to the memory of his spectacular economic success, Bill Clinton remains one of the most popular and respected (ex) politicians in America. Parenthetically, by the year 2000, people in the investment industry actually began to be concerned that low risk US government bonds would vanish!

They need not have worried. Hanging chads killed Al Gore’s chance to be elected president following in Clinton’s footsteps, and George W. Bush Jr. was elected on a platform of slashing taxes in order to out-Reagan Reagan. By 2008 not only had that explosion of government debt triggered a massive real estate boom and bust, but it also led the US (and as it turned out, much of the Western economic world) to, and actually briefly into, the economic Black Hole.

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At the same time as Laffer was propounding his “theory” of taxation and economic growth, the founder of Strategic Analysis Corporation, Dr. Verne Atrill, made some remarkable calculations based on a set of mathematical theorems that he had spent his life developing. He discovered that there is a precise point at which an economic entity (corporation, household, or entire country) stops expanding and begins to contract instead. This is a mathematical singularity, and, for the economy as a whole, can be measured by using the ratio of GDP/ Total Debt, This point is akin to the event horizon of a celestial ‘black hole’ and it acts in a similar manner. A celestial black hole draws energy (light and matter) into its vortex, and an economic black hole draws economic energy – GDP – into its ‘vortex’ due to the dead weight of massive debt. Below that point, if central banks continue to use so-called Quantitative Easing in all its forms, debt will continue to expand (and historically has done so with increasingly speed), but more and more GDP will be sucked in, eventually causing a collapse of the economy along with the value of the currency. Today, parts of the Euro Zone notably Greece and Spain, have already slid into that vortex, and Japan and the US are dancing on the rim!

For those who are curious, the complete mathematics are freely available online by visiting my blogsite, The Occasional Contrarian. In the appendix to this article, I show the full mathematical development of the theorem of solvency from first principles, including the associated table of values, and the graphic relationship which results (shown below). This relationship is termed the Marginal Productivity of Debt Curve , or MPD Curve. In the chart, a GDP/Debt ratio of .289[1] ($3.50 of debt per $1.00 of GDP) is the financial equivalent of the “event horizon” of a celestial black hole. Like the celestial sort, economic ‘black holes’ keep increasing as the mass of debt increases, but in doing so, sucks in more and more GDP to support that debt (that is, stultifies and then starts to reverse the growth of GDP). Below that ratio value, the growth of real GDP turns negative while total indebtedness keeps expanding at a and faster and faster rate. Essentially, it becomes activity for the sake of activity, but that only serves to crush GDP itself and increase the dead weight of debt on an economy. For those who like hard numbers, the current total debt of the US stands at $68.6 trillion and current GDP is $19.7 trillion, a ratio of debt/GDP, or almost precisely 3.5:1.

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In the 20th Century, a considerable number of paper money-issuing governments and their central banks, faced with the problem of trying to stimulate growth at that .289 (and lower) level, have done so by trying to issue more and more paper (debt, both short and long term) to attempt to counter the failure of the real economy to catch fire. According to a study by the Cato Institute, in the 20th century, 55 governments had executed this ‘strategy’, all with devastatingly similar consequences for their economies and currencies. Thus far in the 21st Century, we have watched Greece, Spain, Venezuela and Argentina fail (among others). Initially, stock market values in those countries usually soar, so that the “stimulus” policies seem to “work”! However, looking at it another way, as the debt aneurism expands and the money has to go somewhere, it heads into the “safety” of the ownership of hard assets.  However, if history is a reliable guide, this eventually leads into a shrinkage of the GDP, then to price hyper-inflation. The US is currently dancing on the edge of its own “event horizon”, and may only be still standing because it is the global key currency. While GDP growth has not proven to be self-sustaining without continuing stimulus, it is, however, ‘self-delusioning’.

At and then below a GDP/Debt ratio of .289, the growth of GDP (due to the weight of added debt) falls to and then below zero. We term this a scientific bankruptcy because the effects of bankruptcy hold. Debt compounds while value (GDP activity) recedes. Parenthetically, such a point must exist, because otherwise, Zimbabwe (for one) would be one of the richest countries in Africa, and Greece and Spain would be sitting atop all of Europe.

 

I’ll Build a Stairway to…

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Looking at the chart of US national solvency, we find a tale of careless accounting, hubris, and political sloth if not outright venality. Reagan cut taxes but not spending, and by the time his successor, Bush Sr. had left office, the US solvency condition had slipped into chronic deficit. Clinton cleaned up the Federal balance sheet by raising taxes and cutting expenditures, but Bush Jr. quickly went back to tax cutting – again without matching spending reductions. This took the US down to the Black Hole horizon condition (.289), which is where, over the last 41 quarters and counting (as of May 2018), the US has been ever since then. Trump and the Republicans (some reluctantly!) have now cut taxes a third time, again with no spending cuts. Unfortunately, the next step down promises to be a lulu.

You will observe that once the US crossed that second-order insolvency (“Black Hole”) condition in 2007-8, the US economy went into an ugly plunge, most horribly in the banking, housing, and auto sectors. Fortunately, the US Fed reacted and adjusted very quickly and pulled the economy back up and out, and a larger collapse was aborted. The impact on the Fed’s balance sheet, however, has been massive, and – while I suspect it is not repeatable – has placed a very heavy onus on it.

The IMF Wades In

Even the IMF had managed to get into the picture. The IMF forecasts that the US is the only economy to expect an increase in the Debt/GDP Ratio, or to put it the other way, the US is the only economy which should expect a decline in the GDP/Debt Ratio, which would – unfortunately mean that the .289 line in the sand will be breached.

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Implications of Economic ‘Black Holes’

As the Stability Ratio of the US approaches .289 and growth falls very close to zero – and since 2008-9, US growth has been extremely sub-par –several things happen as a consequence.

  1. First and foremost, since growth grinds almost to a halt, there are few price pressures due to a lack of shortages – of almost everything. And without the pressure of rising demand on goods and services, we don’t experience price inflation. And without that demand pressure, wages and prices will either be steady or even decline. Everyone has been waiting for the “usual” increase in inflation that comes late in a business cycle – particularly late in an expansion that has been going on for almost 10 years – but thus far, there is no evidence of anything of the sort, GDP growth being so very slow.
  2. Without growth, there is very little demand for money. Businesses notably had been paying down their debt, not increasing it as usually has happened following recoveries from past cyclical contractions. In recent years, Corporate America is paying out through share buybacks as much as or more than it is earning, which explains why loan growth hasn’t caught fire in this cycle, even with near zero interest rates. From Economics 101, if there is almost a zero or even negative demand for money, why would anyone expect anything but a low or even negative return on money?
  3. While our central bankers may not be happy about the economic growth trajectory, at least they can say that all that ‘pump priming’ that they have indulged in to keep the economy moving has not led to the kind of inflation that the economists of olden days warned us about. Interest rates have remained low and encouraging. ‘Monetarism’ and the ‘Philips Curve’ seem to be out the window (“thanks to ‘wise’ central bank guidance”)! The bottom line for central bankers is that long term quantitative easing is nothing to be feared.
  4. The failure of wages, prices, and interest rates to react to massive monetary stimulus has lulled our central bankers into a sense that the real risks to the economy lie in deflation with falling prices, when in fact, we are indeed already facing rampant inflation, the problem being one of measurement.
  5. The critical item that Government and economists do not choose to identify or measure is the cost of a dollar of GDP. For most of the 20th century, it used to take (‘cost’) the US about $1.45-.50 of additional debt to generate $1.00 of additional GDP (the peak of the Atrill Curve). Since 1984-5, the marginal “cost” of an additional $1.00 of GDP has steadily escalated to $3.50. Yet central banks and main stream economists are completely mute on this issue. They certainly do not refer to this as “inflation”! However, referring to the 55 examples of insolvent countries since 1900, all pursued massive monetary easing of some sort, and all of them ended with an inflationary collapse of both their economies and associated currencies.

For those are interested in the current US numbers, the .289 ratio has held virtually dead steady for the past 27 quarters, with a brief dip prior to that in the recession/depression of 2008-9!

Of course, there has been some real economic growth in the US economy, for which the US can thank net immigration of ¾ of 1% per year (and the quantitative easing programme). Since the US economy first achieved the GDP/Debt ratio of 0.289 in the third quarter of 2007, the US economy has expanded at an average rate of 1.4%, despite all efforts to grow at a faster rate, far short of the “usual” 3%+ annual rate in earlier decades.

Some Consequences that flow from the Atrill Curve

  • Money On Strike: Velocity Declines Endemically

Velocity of Money – US (Source: FRED)

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One of the truly striking features of the US, Japan, and Europe is that the velocity of money is not only declining but has been in a steady decline for a long time, in one case going back three decades (“money zero maturity”, or MZM in the US). This is a central characteristic of all increasingly insolvent economies that we have examined – Europe, Japan and the US. Money does less and less “work’, in essence ‘trying’ to counteract the increasing financial inefficiencies brought on by excess debt.

Note that the velocity of MZM – the loosest definition of ‘money’ – peaked out in 1980 at the peak of the balance sheet strength of the US, M2 peaked out at the end of Clinton’s presidency when Bush began to weaken the balance sheet (again), and finally M1, so-called high-powered money – only peaked when the solvency of the US finally fell to .289, the start of the scientific bankruptcy condition of the US.

  • When Money Goes On Strike, The Printing Presses Go To Work

The challenge to monetary authorities is that of trying to overcome what is effectively falling money availability caused by falling velocity. Historically, they have done this by issuing more and more money through programmes equivalent to very aggressive ‘quantitative easing’. Unfortunately, the MPD Curve shows all too clearly that this makes the problem worse.

In all those 55 countries referred to above, I suspect that research will find that there is a tipping point when price and wage inflation suddenly start to accelerate, as currency values and GDP implodes. Price and wage inflation then reverses their moribund course and velocity re-accelerates massively as well (as Weimar Germany, for one, shows. By the way, Germany has left an excellent documentation of that period for anyone to see, and we recommend the records of the Bundesbank to all students of national insolvencies.). At that point, holders of those currencies in question try to exchange their money for things – anything – which can hold their value as the purchasing power of those currencies collapses. Seen in this light, we should all hope that the current quest by central banks to stimulate an uptick in inflation (as measured by wages and prices) fails, as they are likely to waken a sleeping tiger. Germany, alone among advanced Western economies, has already been there but can’t seem to convince the unfortunate Greeks (and the rest of us) that far worse things may lie ahead!

In very modern times, when both Greece and Spain fell to that .289 condition, and then pushed (hard) to stimulate further, their respective economies virtually immediately collapsed to the tune of about -25%. At that point, lenders stop allowing their governments to borrow anything more, and both governments have been brought (more or less) kicking and whining to heel. While lenders do recognize what is essentially a bankrupt, there is nothing in current economic theory that shows that any limit has been surpassed. Worse, to confront the problem head-on is to threaten the solvency of many European banks which hold Greek and Spanish debt. And, naturally, those bankrupt governments are unwilling to stop borrowing, as borrowing is so much easier and more popular than instituting the austerity needed to reverse their sad condition.

One may well ask, if a decline through the .289 breakpoint has triggered hyper-inflation in those 55 countries in the Cato study, why has modern Spain and Greece avoided a similar hyper-inflationary fate? The answer is very simple. Being monetarily constrained by being in the Euro-zone, neither country controls the money printing-press the way that the other 55 failures did. So their economies collapsed as the MPD Curve predicted, but exploding prices could not occur. Modern day Venezuela is, of course, a similar story and is suffering both outcomes.

  • The Disappearance of Public Companies

Roughly one third of all US public companies have disappeared since 2008, in a sort of fit of corporate cannibalism. When a company cannot expand in the usual way because of a lack of demand growth, but enjoys a high valuation and has shareholder pressures to achieve greater growth, then growth by acquisition makes sense. But growth by acquisition is inevitably followed by reducing expenses in the combined firm through achieving efficiencies and eliminating what may now be overlapping jobs, that is, increasing unemployment.

As a sidebar to this, predatory hedge funds have actively sought out companies with strong balance sheets and therefore ‘spare’ investment resources, with the intent of forcing them to divest (pay out) their ‘surplus’ investment resources to shareholders. This may have prevented some companies from making unfortunate acquisitions but it puts pressure on corporations to divest themselves of the surplus liquidity which otherwise might have been used for expansion purposes when and if opportunity knocks. It has become a sort of mantra in the US that returning money to shareholders is a ‘good thing’ and the stock market often rewards companies that do this with high – and sometimes extreme – market valuations. But a high market valuation without a concomitant business expansion doesn’t do anything for the economy, even though it does enrich shareholders (“the 1%”), albeit, I suspect, temporarily.

  • The Disappearance of Jobs

The ‘Participation Rate’ of the US – the ratio of persons who are working against those who are eligible to work – has fallen steadily for some years now. To gloss over this reality, with in a clear attempt to throw sand in the eyes of its citizens, the so-called Unemployment Rate has been steadily falling (thereby coming under the heading of ‘good policy’), not by increasing the number of persons working but by redefining “unemployment” to mean those who have only been looking for work within the past year, and eliminating from being counted as ‘unemployed’ everyone else.

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John Williams, in his excellent service, Shadow Government Statistics, shows the participation rate as well as his own determination of the US Unemployment Rate, which suggests that the actual US unemployment rate is close to 22% when measured on the scale last used in the early 1960s. That may be on the high side, but it is close to matching the potential for the increase in GDP that we have calculated would occur assuming that the US returned to a degree of optimum solvency. That big jump in Williams’ alternate unemployment rate occurred, as one would expect, once the US hit its ‘Black Hole’ event horizon at .289 – and it has not changed materially ever since (the blue line on the chart).

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  • Infrastructure Spending Dies a-Borning

In 2016, the election of Donald Trump came with a platform of a strong increase in spending on new and very much needed infrastructure. However, with no ability to expand the public balance sheet (government debt) and no incentives for private monies to fund such projects due to the lack of visible demand growth, it is no surprise that infrastructure spending has pretty much died on the vine, at least so far. The Corporate Welfare Act of 2017 should pretty much seal the coffin shut on any such initiatives as there will simply be no public money available at all going forward. Worse, the Trump requirement that the states match the federal spending, when conjoined with the effect on state tax collections due to the Trump tax ‘initiative’, should close off any state and local spending here as well.

  • Austerity Does Work

In 1992, Bill Clinton took the reins of office the US and set out to clean up the insolvent US government balance sheet by raising taxes and cutting costs. When he left office in 2000, the US was on top of the world, its currency was at an all-time high, consumer confidence was at an all-time high, the stock market was booming, and the economy was on fire. Small wonder that he is still revered today. Revisiting the MPD Curve, it is, or should be, apparent that the impact of an increasingly solvent government, from an insolvency state, spills directly and immediately over into the real economy. From 1992 to 2000, the decline in federal government leverage pushed the US economy up the MPD Curve.

 

The Pathology of Insolvency

Armed with the suggestions below, I expect that economic historians like Kenneth Rogoff will find that there are some general characteristics of overall economies which are heading into (a mathematical or ‘scientific’) bankruptcy. These seem to mark the lull before the storm, and have probably been present in all those 55 countries where the currency ended up collapsing under the eventual pressure of national bankruptcy and hyper-inflation:

  1. Velocity of money falls endemically
  2. Private sector borrowing (and corporate investing) dries up
  3. Interest rates fall towards zero initially as there is no demand for money, thereby hurting the middle-class in the economy (in particular) by – effectively – looting their savings
  4. Although the real economy slows, hurting the economically weak man in the street, the financial economy (the stock and bond markets) soars, helping the wealthy to become even more wealthy
  5. Inflation, as measured by prices, initially falls due the lack of demand growth
  6. The government balance sheet gets steadily worse
  7. Internal political harmony turns to intense dissonance (‘its not my greed, its yours’)
  8. Central banks are, in effect, left holding the bag in the absence of any political will or agreement to find policy solutions for weakening economies
  9. In the absence of a mathematics to the contrary, to central banks, every ‘weak economy’ problem can best be resolved by printing more money in one form or another

Our expectation (based on the Weimar reported experience) is that when a country crosses the .289 threshold and their currency really begins to fall and internal prices (i.e.: inflation) really start to rise, their central banks do not react by slowing their money printing, because to curtail that monetary growth would be to “kill any possible expansion just as it got underway”. These same fears stopped Greenspan from acting responsibly (as he openly admitted in his book) and were probably always there among those 55 countries noted above, as they were in the US. The actual linkage would be fascinating to discover – but for students of the subject, now we know where (and why) to look.

 

Outcomes and Issues

  • The Lifeboat Economy

When overall growth ends or slows drastically, there are two possible outcomes, either share what is there or grab everything that one can. I call this a Lifeboat Economy because growth can no longer skate our overall desire for more onside. In the US, the expansion of government entitlement rights has grown from a modest percentage of total government revenues to more than 100% of annual tax revenues as the more powerful groups seek to protect what they now have against others looking to enhance their own interests. Cooperation between political parties has fallen below zero because to share what we already have is to take away from what we now have. The US political scene has bifurcated into two parts, those who are at least trying to expand the sharing process, although they have nothing to share that doesn’t belong to someone else in the absence of real growth, and the Republican Party which is determined to keep even more of what they have at the expense of the rest of the populace (i.e., through cutting taxes). Internationally, Greece is a caricature of the lifeboat phenomenon. Having eaten themselves out of house and home, they came demanding that others support them. Germany (alone) is on the right track about fixing, not pandering to, their debt problem.

In the US, a major global issue has arisen, and that is the effort by President Trump to use pre-emptive trade wars as a means of ‘balancing’ the negative global trade books back in favour of the US. Not since Smoot-Hawley has the US attempted such an unfortunate measure to overcome this issue (and then spent the next 80 years undoing that damage!). While as of the time of writing, there is no firm evidence as to the direction that this latest endeavour will ultimately take, the move to grab more for the US at the risk of escalating a global trade war is further support for the lifeboat nature of the current economic situation.

  • Reducing Debt Will Lead to Strong Growth

If, at the peak of the Atrill Solvency Curve, it takes $1.50 of debt to generate $1.00 of GDP in a normal, healthy, and solvent economy, then there is an astonishing amount of excessive debt outstanding today in Europe, Japan, and the US, all of which is weighing down on their economic potential. Harvard economist Ken Rogoff identified the value $3.50 of debt per $1.00 of GDP (.289) as quite possibly having considerable economic significance for countries. Without the Atrill solvency mathematics to back his findings up, Rogoff could not defend his findings and therefore he was and is, essentially, simply ignored. The assertion of possible importance without a rigorous mathematical proof could not stand up to his critics with their neo-Keynesian, pro-debt-issuance axes to grind.

The resolution of the current debt problem is (axiomatically) simple. How would a bankruptcy lawyer or accountant deal with bankruptcy? He would direct the bankrupt to sell assets and pay down debt, write off any and all debt which the bankrupt is unable to pay down, and then live within one’s means (no credit cards!). Arthur Laffer once asserted that no country ever improved its growth outlook by raising taxes (and paying down debt), yet from the MPD curve, that outcome for the US would bring a large increase in GDP as a result of the government debt burden being lifted. However, governments do not like, nor want to abide by, what is essentially the banking discipline and Greece is proving to be, perhaps, merely the first example of a 21st Century insolvent government to outright reject Germany’s ‘sell assets’ suggestion and solution!

As Bill Clinton’s presidency clearly showed, if that excessive debt load can be lifted, then two things occur. The GDPs of those bankrupts will lift to a considerable degree. Elsewhere, using the numerical data from the MPD curve, one can readily calculate that the GDP of the US could be in the order of 40+% higher than it is today without that excess debt. Indeed, we have calculated that the average US household income could rise by something in the order of $15-20,000 if the US were solvent.

  • The “Chinese Miracle” Explained…and a Myth Exploded

Can we use the Atrill MPD Curve to explain the “Chinese Growth Miracle” (and for that matter, the ‘Japanese Miracle’ after WWII)?  By referring to the complete curve below, you can see that on the right hand side of the peak of the curve that there is an area in which additional debt adds significantly to the generation of value (GDP).

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Using the MPD Curve, we can readily understand that the emergence of China as a global economic power has not been due to some superior insight into the economic growth process as they like to claim, but simply due to the growing use of debt after about 1970. The advantage of debt is that you can get lots of money for expansion with the wave of the hand and growth will follow almost magically! The disadvantage comes when an economy roars up and over the peak and heads down the slippery slope towards the Black Hole condition. Suddenly, debt has a cost and the economy will slow dramatically at the .289 point.

China has not discovered a ‘new way’ of managing the economy. It just followed the exact same roadmap left behind by post-war Japan, “the Japanese miracle” which followed a similar solvency trajectory. However, when more than 20 years ago, Japan crossed the .289 boundary condition, their growth came to an abrupt halt as that country reached the event horizon of its own ‘Black Hole’. It should be noted that the Debt/GDP Ratio of China (as reported) has risen from a very low level to more than 3 times (a GDP/Debt /ratio of .33). With China falling so rapidly towards their own Black Hole condition, my guess is that China will soon experience the same lesson that Japan has to this day still not learned, and it should not be long before the Chinese Miracle grinds to a halt.

It is no surprise that global GDP growth has been so slow with US, Japan and much of Europe in a very weak solvency condition (as defined) along with a few other major countries including Argentina and Venezuela. Give China another two or four years, and global growth should be a thing of the history books. We will then all have fallen under the spell of modern central bank solutions for slow-growth economies.

  • Does an Economic and Currency Collapse Necessarily Occur?

Japan is a story about the failure of Quantitative Easing. It has been over 20 years since Japan became a second-order insolvent with a GDP/Debt ratio of .289. Curiously, however, Japan has hung right there and hasn’t got any worse (or any better). However, Government Debt as a percentage of GDP rose from 100% in 1995 to more than 200% today. GDP has essentially flat-lined. In the meantime, household and corporate debt fell to keep the overall national solvency ratio constant. Ben Bernanke is widely considered to be the cause of the current militant QE in Japan by chiding Prime Minister Abe that the problem with Japanese stimulus was that it was not enough. Well, Japan tried harder. The results? Japanese GDP growth remains extremely tepid, and their central bank is increasingly ending up owning a growing percentage of the country’s debt and equity market wealth. So far, however, Japan has remained right at the .289 level.

For what it is worth, the US has been emulating Japan with very slow GDP growth, rising government debt but flat or falling private sector borrowing, notably in the productive corporate sector, and a central bank that has (had??) been steadily acquiring financial assets. The past years have been very interesting as corporate America has basically used virtually all of its reported net earnings for dividends and share buy-backs. With essentially no investment in future growth, the US GDP outlook would have to be characterized as questionable. Even with the most recent corporate tax cut, the game has not changed for the better, as what is appears to have done is to accelerate mergers and acquisitions, now running at a record pace, rather than capital spending.

  • Let’s Retire the Miller/Modigliani Hypothesis

Anyone with an ounce of common sense “knows” instinctively that debt does count in the valuation process that the market carries out. However, having proved that debt does not seem to particularly matter in the valuation process (using the debt/equity ratio), Messrs. Miller and Modigliani did inspire at least one ‘client’, government, to cheerfully ignore the impact of too much debt…on everything.

Leverage does count. Using the Atrill Solvency Ratio as defined above (and in the appendix attached), below .5 on the MPD curve, GDP growth really slows and at .289, real economic growth starts to go into reverse. One of our board members did his Ph.D. thesis on forecasting currency and interest rate movements using the Atrill Solvency mathematics, with excellent success. In our common stock valuation work, it is a maxim that price follows solvency (leverage). In short, it is time to expunge the M/M ‘Theorem’ from the books of both government and academia.

Where Do We Go From Here?

I can see three possible outcomes for the US stemming from the current situation:

  1. In the next recession, increase debt and a push the US below the .289 ratio. The Corporate Welfare Act and the incipient trade wars would seem to more or less guarantee this outcome.
  2. Decrease the debt and follow the Clinton solution, but this is very unlikely under President Trump
  3. Do nothing much either way, and continue to follow the Japanese path.

One thing that flows from the MPD Curve is that the process does not heal itself. As Japan and now the US have shown, the .289 breakpoint is remarkably stable – a sort of stasis point of balance. From real time observation of Greece and Zimbabwe (for two), it takes a concerted effort to push the economy below the .289 level as there is a powerful pushback from the players in the economy, and certainly from the banking system, as shown by the falling velocity measure. But improving the Solvency Ratio is also very difficult because the austerity that is initially entailed from cutting spending is politically difficult to swallow – as Greece has clearly shown.

An economic historian with time on his/her hands should be able to examine other economies that have gone through this phase to find parallels – as there must be. The private sector also systematically responds by reducing its own indebtedness to balance the expanding balance sheet of government. I have to conclude (from a limited sample) that the entire system does not go into the Black Hole willingly and without a strong effort by the private sector participants to resist that move. Stasis is therefore a very real and continuing possibility going forward – in which case, the rich will continue to get richer as share buybacks and M&A activity increasingly concentrate ownership of productive assets in fewer and fewer hands!

Because the US GDP/Debt ratio has remained virtually steadfast at 0.289 since the third quarter of 2007, no increase in the basic economic growth rate can occur no matter how many economists and pundits attempt to forecast a return to the faster historical rates of growth. Every year since the recession following the 2008 market collapse, a growth rate of 3%+ for the coming year has been the standard forecast. And every year, the final number comes in around that 1.4-2.0% rate. Heading into 2018, economists were again looking for accelerating global growth of 3%+, and this against a background of slower economic readings from a number of international sources, including Japan, China and Canada. I would not be holding my breath in the expectation of anything like the forecast number!

What About The Corporate Welfare Act?

The Corporate Welfare Act of 2017 (a.k.a “tax reform”) is the crowning glory of 30 out of the last 38 years in the history of US fiscal mismanagement. Referring to the newly-passed “tax reform” bill (and based on the experience of previous US tax cutting exercises), the main outcome will be a rise in government indebtedness, with a very tiny proportion (maybe 6-8% at the most) of the corporate “savings” flowing into actual expansion. The stock market has done well and may continue to do so! However, this late in the business cycle and with this level of slow growth and a potential trade war underway, I cannot see that US corporations are going to be undertaking much new capital spending expansion, while the impact on the weakening US government balance sheet should become increasingly clear and fairly severe.

The timing of this round of tax cutting for corporations and the wealthy is very unfortunate. When Reagan undertook his tax cutting exercise, the solvency condition of the US placed it well up towards the peak of the Atrill Curve. In other words, the US was in great shape, and could withstand the stunning load of debt that Reagan and Bush thrust on to it. By 1992, the solvency ratio had declined to .5, leading Bill Clinton to clean up the deficit mess that they left behind. When George Bush Jr. sponsored The Homeland Investment Act, or what we would classify as Round 2 of tax cutting in 2004, he was following on the hard work and success that Clinton left behind in getting the US out of its chronic deficit by strengthening the US balance sheet. In other words, the US was in an improving fiscal condition in 2000. By the election of 2008, however, the Solvency Ratio of the US had actually fallen below .289, or what we term the ‘brink of scientific bankruptcy’, and the US suffered its worst recession in decades before the Fed managed to pull the US (barely) back onside. Obama did nothing at all to repair the damage that Bush Jr. left behind him. And so President Trump is starting his tax cutting exercise with the US in the worst fiscal condition that it has ever been in, save the near depression in 2008-9. The US balance sheet plunged dismally during the tax-cutting tenures of Reagan/Bush and Bush /Obama but there is simply no room for another such decline in the US solvency measure, without crossing the Black Hole event horizon. As a result, we are entering a totally new era with potentially very unfortunate consequences on the horizon.

Critics and economists everywhere, not to mention President Trump, are free to ignore the mathematics, the analysis, and the conclusions herein. A sort of grand experiment is afoot, and therefore this is an ‘interesting time’ in the economic life of the US. Mr. Trump himself has seen his own enterprises go bankrupt three times before and so this could he his fourth one – although on a much grander scale than his previous failures. The question at this moment is, does Trump and the political and economic community wish to play Russian Roulette with the welfare of 322.4 million Americans? (That’s the US population of 325.7 Americans less the One Percent.)

Sorry to say, it is not ‘paradise’ that this stairway leads to.

One can, of course, adopt a completely clinical attitude towards this event and simply wait and see. Indeed, given the unwillingness of the president and the Republican-controlled Congress to mitigate – or even understand – the potential outcome of such an event, that is probably all that any person of any political/economic persuasion can do. However, it couldn’t hurt if readers passed on this information to others.

I certainly do not detect any political willingness in the US, Europe or Japan to embrace a modern Clinton-style solution to the debt problem. Right now, most central banks are at least paying lip service to the concept of ending Quantitative Easing and moving towards some level of Quantitative Tightening, as – believe it or not – all central banks are acutely aware of the Weimar experience. However, it would be my guess that as the current “expansion” phase of the US and global economy slows and heads into something that looks like a recession, especially if this is accompanied by prolonged stock market weakness, the political pressure on central banks to reverse course and stimulate again will be tremendous. Unfortunately, with no tools left to them and certainly no political support for a Clinton-style solution, then for the central banks, monetary (debt) expansion is likely to be the solution of choice with all that that entails for the GDP/Debt Ratio for the US.

What would be a real concern would be a significant recession coupled with a stock market meltdown – or perhaps we should put that the other way around given the extreme valuation of the US stock market – a significant bear market in common stocks which triggers a strong slowdown in the economy as it did in 2001-2 and 2008-9. A decline in the US GDP accompanied by a large increase in stimulus (debt issuance) could push the US through the .289 mark with unknown and unforeseen consequences. The offset to public debt increases could, of course, be the rapid paydown of private sector debt in this circumstance, with the ending balance being more or less still at that point of stasis, as Japan experienced for two decades. What we cannot know as yet, is, is whether there is a point of central bank frustration coupled with the lack of response of the private sector which pushes one or more central banks to pile on stimulus much more urgently, á la Germany in the 1920s and Zimbabwe (among others) in later years?

A strong leader of the US Federal Reserve Board could emerge with good political support from Congress, with a mandate to actually resolve the US debt problem (and, of course, by definition, the rest of the insolvent world which will take their cue from the Americans). We are cynical enough to doubt that this will occur, but cautious enough not to bet the farm that it won’t. However, Jerome Powell, the new Fed chairman, has been labelled the GOP version of Janet Yellen (the outgoing chair person), and so I would expect nothing imaginative or innovative during his tenure.

Despite the general consensus that interest rates will rise, we would not look for much of an increase in overall interest rates, save for the Fed-controlled short end, unless one of two things happen. First, if the US debt/GDP ratio does plunge much below .289, then interest rates are very likely to soar. Second, if, on the other hand, structural change occurs which resolves the current malaise and the debt/GDP ratio returns to the average of most of the 20th century of roughly 0.70, interest rates will return (that is rise) to normalcy as well. But until there really is a true debt resolution movement underway, then things cannot change much from the conditions which we have outlined above. Demand for money will continue to be very weak, the US economy will continue to sputter along, and the rich will continue to get richer as the centrifugal forces of debt expansion continue, driving the poor and middle classes further into debt or at least genteel poverty. As depressing as this may seem, it is actually not a bad outcome, given the alternative of a plunge into the Atrill Black Hole.

What Should be Your Principal Take-aways?

First, I want to leave any readers who have managed to hang on to the bitter end with a very clear message. The Marginal Productivity of Debt Curve visually and clearly shows that if the US (and Japan and Europe) were closer to the peak of the curve, the additional GDP which would result would be enormous – I calculate from the table of values, somewhere in the order of +18-20% greater than today. We should observe that while this calculation follows from our math, Bill Clinton has already ‘proved’ that the math is essentially correct when it suggests a strong and favourable outcome. The MPD Curve does not portend merely a modest improvement, but a game-altering change in the growth outlook resulting in a powerful improvement in the US economy and its annual growth rate – at least until their respective economies get to their usual peak level, if not for some time afterwards.

Second, I came across this unfortunate and seriously misguided bon mot recently: “A monetarily sovereign government has the unlimited ability to create its sovereign currency”. After reading this article, I trust that the reader understands that for the US, it is not longer the case that it has an unlimited ability to create currency (debt) any longer. It is extremely close to its own limits of debt issuance before there is a profound and negative impact on its economy.

The Symbology of Change

picture 8The Laffer Curve, shown as originally propounded by Laffer himself, suggests a trade-off between tax rates and tax revenues with a “prohibitive range” thrown in. Intuitively, the curve “makes sense” in that something like what is shown here seems to be the likely out-come of any taxation policy. The problem is that the proffered outcome is entirely intuitive, has not a shred of any statistical evidence behind it, certainly has no mathematics to back

 

it up, nor an equation for its construction. However, for those, including Ronald Reagan, who were looking for an easy-to-digest symbol to back up and market their assertion that cutting taxes came under the heading of a “good thing”, the Laffer Curve was superb.

Unfortunately, as we have all discovered in the years since he first put this notion forward, the Laffer Curve and the real world have little to do with each other. Application of the curve to American tax policies since 1980, with one brief interlude, have been proven lead to disaster – and if the current tax cuts are allowed to continue, may well lead to a second massive setback to the US economy. Using this symbol as a guide to an overall evaluation of its success, we would suggest that the D– as shown, is very probably the appropriate letter grade for both Laffer and his curve.

picture 9Turning to the Atrill Marginal Productivity of Debt Curve, here I have shown this curve in a slightly different way. Rather than using an arithmetic scale along the X Axis, I have used a logarithmic scale instead. In doing so, I actually more closely reference the mathematics which Atrill used. The curve shown here not only has excellent mathematical and theoretical underpinnings, but better, can be used as a forecasting tool for economists and those who set tax and spending policies for government. As for the symbolic and emotional content of the Laffer Curve, the Atrill Curve clearly points the way to a massive recovery and growth in the US economy, leading to genuine full employment rather than the current manipulated version of full employment (arrived at by eliminating every soul who has been unable to find a job ‘in the past year’). What we get with this version of the Atrill Curve is a fairly close representation of an ‘A’.

As Bill Clinton has already pointed the way to, raising taxes and cutting spending, when the economy is in the terrible solvency condition that it is, is an economic and political formula for huge economic and electoral success once the evidence starts to flow that the Atrill Curve ‘works’ – as it will. The courage to flout the Laffer Curve nonsense, however, will be significant, as the Laffer Curve has become almost a sacred tenet in American political life.

Afterthoughts

The Divine Right of Kings has long ago been supplanted by the Divine Right of Government. It is this problem in the past 100 years or so, and up until now, that allows and has allowed money-printing governments to spend and borrow, and run economically amok, to the massive detriment of employment, resource allocation and utilization, and the general well-being of their citizens. This “divine right” needs to be supplanted by a constitutional requirement for the government of every country to be solvent as measured, and be as close to peak efficiency as possible, reporting to their citizens on a regular and timely basis.

Finally, I do not think for a moment that the solvency problems that we are faced with today are the result of political malfeasance, ill will, greed, or even stupidity.  In general, politicians and financial leaders act in what they consider to be the best interests of the greatest number of people. Their intentions are good.  Unfortunately, as Michael Bloomberg has observed, you cannot manage what you don’t measure, to which I must add, you cannot manage if you don’t know what to measure.  My (late) colleague, Dr. Atrill has shown us what to measure and why: it is now up to us to do something about it.

  1. Ross Healy, MBA, CFA
  • Chairman, Strategic Analysis Corporation
  • Associate Portfolio Manager, MacNicol and Associates Asset Management

In the appendix that follows, I have set out the mathematics behind Dr. Atrill’s Theorem of Solvency from first principles.  Note that this is not based on statistical analysis.  The casual reader may not require this depth of analysis, but if I am to assert – as I do – that at .289, the GDP of an economy will start to actually shrink, then there had better be solid and conclusive mathematical evidence for that conclusion.

 

Appendix:

The Economics of Solvency

 

I shall start by visiting Dr. Atrill’s “Stability Ratio”, a simple but key leverage ratio derived from balance sheet accounts that is an excellent predictor of balance sheet stress. By this, I measure how sensitive a company’s internal financial system is to external financial stresses. I will show why this ratio is better than other, ‘standard’ leverage ratios, and I will do so by determining the limit at which leverage ceases to generate economic activity and becomes a drag instead.

When the traditional accountant looks at a balance sheet to see what is available to take care of the total debt, he likes to take into account all of those things which can be liquidated to meet the debts, and the easiest things to seize are the property, plant and equipment. But we are measuring something different: we are providing a measure for what the accountant terms the ‘Ongoing Concern Principle’. A company that must sell off all or part of its plant, equipment and inventories to meet its debts will violate that principle because, whatever happens after that, the potential to generate business will have shrunk. In other words, tomorrow will not look like today. The Stability Ratio is designed to measure the solvency of an entity and its ability to continue on in business (do equivalent economic work) for the foreseeable future.

The Stability Ratio is the ratio of ‘dynamic receivables’ (that which is in or coming into the company which is readily available to meet its obligations), which we symbolize as ‘R’, to dynamic payables (its debts), which we symbolize as ‘P’. Looking at a typical balance sheet, R is the total assets of the company (or whatever) minus the Net Plant, Equipment and Inventories, plus the Accumulated Depreciation. ‘P’ is the total debt of the organization, short and long term. Accumulated depreciation is a non-cash deduction from the plant and equipment which permits a recovery of taxes which otherwise would be a payable (a debt). Hence, it is added back into the R in the ratio.

The Stability Ratio is the net result of all of the routine transactions that go on in the life of a company/entity, and are periodically sampled and summed up in the balance sheet. We find that for most entities, the Stability Ratio tends not to change a great deal from quarter to quarter or even from year to year. It is the result of the money Entry and Exit events that occur, and their relative stability suggests that organizations tend towards a modality in their operations that remains fairly constant. How the Entry and Exit events are tied together and related is the key to understanding how all economies actually work.

Defining The Exchange Conditions

(Entry and Exit Events)

I must begin by observing that every economic Entity has a process within it that ties together its Entry and Exit Events. The easiest way to think of this is the case of a company which seeks to turn service inputs (labor, raw materials etc.) into a product. At the same time as this is happening there is another process within the company that is related to the first process, but is entirely distinct from it. It is the process of turning its receivables into payments. These two processes within the company run opposite to each other as shown in Figure 1.

In Figure 1, Process 1 shows service inputs being turned into product. As just stated, we are not concerned with the technical details of how this is done. However, we realize that Product cannot appear or Exit from the Entity if there are no service inputs (labour, materials and so on). Likewise, Payment cannot occur without Receipt Events. The tie between Entry and Exit Events is therefore a fundamental economic reality that all entities must respect in order to remain functional.

The complete process for an established entity can be described as turning inputs into product (Product Transformation – Fig. 1), exchanging (‘selling’) this product for a receipt, and processing those receipts into payment (Money Transformation – Process 2 in Fig. 1). The process then begins anew as that money is then exchanged for new inputs, in an endless cycle.

From the point of view of the Entity Process, Exit and Entry Events therefore happen at both “ends” of the Entity through the process of Exchange. At one end of the Entity, we have payments (Exit Events) exchanged for Service Inputs (Entry Events). At the other end we have product (Exit Events) exchanged for Receipts (Entry Events).

The goal of the theory of Accounting Dynamics is to determine how much financial stress can be put upon the relationship between Entry and Exit Events and to measure this stress in an objective manner. Through this, we bring an engineering approach to the management of balance sheets.

The first step is to determine how this process can be represented. One’s first reaction may be to construct a technical relationship such as a ‘production function’ that turns input into output or receipts into payment. These types of technical relations however, are specific to each Entity and degenerate into trying to “estimate”, if possible, the proper form of the function. Rather than pursuing this route, we search for a general relationship that applies to all companies and is based upon what we observe as a fundamental characteristic of Entity Activity.

In order to determine the fundamental relationship between Entry and Exit Events, we can ask the question, “If the Entry Events of an Entity were cut off right today [that is, if no more materials came to the plant and all the labour ceased to work], what would happen to its Exit Events [the product going out the shipping doors and the sales receipts which flow from that]?”. Would all Exit Events stop abruptly because Entry Events have ceased? Well, certainly not immediately! When Entities experience a “cash crunch” they try to conserve cash, typically by reducing or extending their payables, paying only those bills that must be paid and putting off the rest. In other words, what we observe is that the Exit Events, sales and the receipts there from, start to diminish. Similarly, if Exit Events (sales and receipts) were to cease, Entry Events would start to diminish, as inventories cannot accumulate indefinitely.[i]

In order to formalize this relationship between Entry and Exit Events we begin by abbreviating:

a = Exit Events

 

b = Entry Events.

The next step is to represent mathematically how these two Events diminish in relation to each other. To do this we use the following logarithmic expressions:

logab = diminishing level of Entry Events due to arrested Exit Events

logba = diminishing level of Exit Events due to arrested Entry Events

Let us consider the first logarithmic expression. The effect of reducing Entry Events is equivalent to an Exit Event. For example, the payment of bills has the same effect on bank balances as postponing the collection of money from receivables. We represent this relation mathematically in terms of the logarithmic expression logab, which means that the decrease of Entry Events b is related to the arresting of Exit Events a by a power law. Recall the definition of the logarithm: If logab = x, then b = ax (x is the diminished level of Entry Events due to ceased Exit Events). In words, Entry Events are diminished in proportion to diminished Exit Events raised to a power.

Likewise, the collection of receivables (i.e. Entry Events b) has the same effect on the bank balance as the postponement of payments, which is represented by our second logarithmic expression, the diminished level of Exit Events, logba. Mathematically, as above, if logba = y, then a = by (y is the diminished level of Exit Events due to ceased Entry Events).

The question we now have to answer is what determines the powers x and y which represent the diminished levels of Entry or Exit Events due to arrested Exit or Entry Events, respectively.

Let us examine the first expression, logab = x, or, as stated above, equivalently from the definition of the logarithm, b = ax. Entry Events b are diminished proportionally if Exit Events a cease. This reduction of Entry Events in turn (cf. Figure 1) leads to a further reduction or arresting of Exit Events and so forth. If a company stops paying its bills (Exit Events), its suppliers will reduce their shipment of raw materials (Entry Events). This in turn leads to the reduction of production (Exit Events), which results in a reduction of sales (Entry Events). We therefore postulate that Exit Events a are related to logab, which is the reduction of Entry Events b due to ceased Exit Events. In turn b is related to logba. More precisely[ii],

a is proportional to logab

b is proportional to logba

This means that there exists a “feedback loop” between Entry and Exit Events. Our task is now to determine the precise relation of the feedback, or mathematically speaking, the proportionality factor.

We cannot simply equate b to logba and a to logab, since this would imply that all companies’ Entry and Exit Activities are related in precisely the same way. What is implied, however, is that the nature of the relationship between these Activities is the same for all companies. The precise form of the relationship between the decrease of Exit Events due to the arrest of Entry Events (or vice versa) will differ among Entities. Clearly, the financial condition or “solvency” of each Entity will affect this relationship. That is, solvent companies have the ability to pay their creditors quickly and less solvent or insolvent companies will pay at slower and slower rates.

 

We must therefore create a measure to capture the financial condition of the company that is relevant to the Entity Process described in Figure 1. However, we cannot measure every transaction of a company since it would make the analysis burdensome and of no practical use. Rather than studying individual transactions, we create surrogate measures that capture these Events. The obvious database for our measures is the Entity’s balance sheet since it captures the net effects of all the Entity’s transactions.

Referring to Figure 1, there are service inputs being turned into product, along with the mirror image of turning receipts into payment. We therefore want to capture in our measures the Entry and Exit activities that are associated with the creation of product and the payment of service inputs.

When constructing our surrogate money measure of Entry Events we realize that not all Entry Events are turned into product. In particular, some go into inventories and supplies, while some go into plant and equipment. At the same time, however, we also realize that some of the plant and equipment is ‘consumed’ as depreciation during the production of the product. Our surrogate measure, “R”, noted below, is constructed to capture these observations. (Money) Entry Events are: Total Assets plus Accumulated Depreciation, minus Net Plant, Equipment, Inventory and Supplies.

To capture the effects of Exit Events we turn to the “other side” of the balance sheet. We remove the net worth of the company from this side of the balance sheet, since it reflects what the company has retained from its operations. What is left therefore is the Total Liabilities of the company which become the surrogate measure of Exit Events and which we symbolize by the letter “P”.

The two surrogate measures, R and P, represent the accumulated effects of Entry and Exit Events over the company’s lifetime as of the balance sheet date. The Stability Ratio is the ratio R/P and captures the company’s condition with respect to what it has built up in terms of Entry Events relative to Exit Events.

By linking balance sheets together over time, we can see the evolution of the company in terms of how it operates (the modality of the Stability Ratio) and the options that that modality presents. In doing so, we elevate the balance sheet from being a “snapshot” of a company’s financial condition (the standard interpretation) to a dynamic document that “tracks” a company’s financial and operational footpaths.

We can now return to the postulate that a is proportional to logab, and b is proportional to logba. The Stability Ratio is the proportionality factor that we seek:

 

(1)

(2)

Equation (1) means that Exit Events a decrease further after Entry Events have decreased due to ceased Exit Events b (mathematically given by logba), where the strength of the reduction depends on the company’s Stability, and similarly for equation (2) with the roles of Entry and Exit Events exchanged. A company with a strong Stability Ratio can withstand temporary stresses due to arrested Entry and Exit Events better, because it has more Operational Assets than Operational Liabilities.

At this point one may inquire why we would use the Stability Ratio in both cases and not the inverse, P/R, for one of the relationships, as the two appear to be of opposite direction. The reason we use the Stability Ratio in both cases is that the structure of the Entity in both cases remains the same, whether we are looking at Exit Events in terms of the diminished level of Entry Events due to (other) arrested Exit Events (encoded in the logarithm), or Entry Events in terms of the diminished level of Exit Events due to arrested Entry Events. Therefore, the Stability Ratio is used in both cases. Embodied in this assertion is the notion that there is no unique direction to production. In this sense we do not distinguish between service inputs and output or product, since each can be viewed as playing either role. It is just as correct to say that an Entity is in the business of paying labor, buying supplies, etc., as it is to say it is in the business of selling cell phones and collecting payments. When unions and governments talk of “job creation”, for example, they are in fact looking at a company in this way.

In Figure 2, we reproduce the Entity Process of Figure 1 along with the mathematical relationships between Entity activities and their associated diminished levels that we have derived above.

To graph equations (1) and (2) we must re-write them such that all as or bs occur only on one side of the equalities instead of on both sides. We abbreviate R/P to be equal to ω, that is, (1) becomes a = ω logba. We then divide by ω and obtain a/ω = logba. We transform (2) in a similar manner. Using the definition of the logarithm (on page 2), we can now rewrite equations (1) and (2) in a power-law or exponential form,

In words, as already stated above, Entry and Exit Events are related to each other by a power law, and we have established that the power is determined by the Stability Ratio, R/P = ω, which is the ratio of Total Assets R to Total Liabilities P.

Equations (1) and (2) (or their rearranged, exponential forms (3) and (4)) are referred to as the E-Conditions in Accounting Dynamics. They are the structural equations that represent the fundamental nature of Entity activity with respect to Entry and Exit Events.

Figure 3 graphs the E-Conditions for values of the Stability of 1.7, 1, and 0.5. Note that as the Stability Ratio falls in value, the arc lengths become longer.

The horizontal branches of the E-Conditions in Figure 3 represent the process associated with Entry Events (b = a(a/ω)), while the vertical branches represent the process associated with Exit Events (a = (a = b(b/ω)). From Figure 1, we know that Entry and Exit Events happen at both ends of the Entity where exchange takes place. Whether we are referring to service inputs being exchanged for payment or product being exchanged for receipts, both exchanges are represented identically by the E-Conditions. The graph of the E-Conditions therefore applies equally to both exchanges.

In describing the events for the remainder of this paper, we will do so in terms of product being exchanged for receipts.

From Figure 3 we can read off a number of properties of the E-Conditions.

  1. The points where the horizontal and vertical branches intersect are the points where both equations are simultaneously true, that is, where Exit and Entry Events are equal and the equations (3) and (4) are mutually consistent.
  2. The arc lengths of the branches become longer, approaching 3.0 as the Stability approaches zero. The arc lengths become shorter and approach 1.0 as the Stability tends towards infinity.
  3. All branches, irrespective of the value of the Stability Ratio, pass through and intersect at the point where a = b = 1.

The fact that the point a = b = 1 is special, in a sense that we will define below, can also be seen mathematically by examining equations (3) and (4). If we place the values a = b = 1 into equation (3) or (4), we obtain 1 = 1(1/ω). This equality is true for any value of the Stability ω, because 1 raised to any power always remains 1. So the point where a = b = 1 represents a special circumstance in Accounting Dynamics because regardless of the value of the Stability, the E-Condition arcs always pass through that point.

We interpret this in our economics as the production process (the Entity Process as represented by the E-Conditions) being associated with something that rises to a “unit”, but does not go beyond it. In other words, the point a = b = 1 signifies the end of the production process. The end of the production process is marked by another occurrence, however, and that is the appearance of product. The coordinate a = b = 1 is therefore the point where the production process ends and product itself appears.

Remember, however, that there are two processes within the Entity, production and exchange. The point a = b = 1 is also the end of the second process that is within the Entity. That process is the collection of receipts for payments. At a = b = 1 therefore, we are at the end of our collection process. At the end of our collection process is, of course, payment.

Therefore at a = b = 1 three things occur: (1) Exit Events equal Entry Events (a = b), (2) the production and collection processes are complete, (3) product and payment appear. Given these three occurrences that take place, the point a = b = 1 defines for us the point of exchange (sale).

The production and collection processes, as stated by the E-Conditions, and the product and payment that appear at the end of these processes at a = b = 1, is, of course, an abstract representation of the Entity. This means that Entry and Exit Events are not measured in terms of some actual currency (e.g. dollars, Euros, or Yen), but in abstract units. The abstract product obtained from the production process is defined as a unit delivery of output which is exchanged for the abstract payment defined as a unit collection of receipts. These abstract units of product and payment which define for us exchange, act as our numeraire, that is, as a measure of the worth of different goods and services relative to one another. Instead of specifying the value of our abstract product and payment in some definite currency, they always appear in units, that is, a and b assume a value of 1 at the end of the production process. Given this built-in numeraire, we do not have to depend on a subjective theory of value. We simply have product and payment appearing in units, the unit itself being a measure of activity.

Defining The Market Conditions

(Market-Exchange Events, between balance sheets)

The E-Conditions derived above describe Entry and Exit Events as seen from the perspective of the Entity. Let us now look at these events and the associated E-Conditions from a different perspective, namely those who are outside the Entity, that is to say “the market” for the entity’s goods or services.

The E-Conditions represent the productive processes that occur within each Entity. In their logarithmic forms, equations (1) and (2), these processes are interpreted as the arresting of one type of Event that causes the other type of Event to diminish. In other words, one type of Event restrains the other. In their rearranged, exponential forms given by Equations (3) and (4) however, no such restraint exists. Just as the logarithmic form of the E-Conditions has economic meaning, so, too, does the exponential form.

To properly interpret the exponential forms of the E-Conditions, we must consider them in the way they were derived. Since the exponential forms arise from rewriting the logarithms in terms of powers, which is the inverse operation of taking logarithms, we have a sense that equations (3) and (4) must represent something that is opposite to what the logarithmic forms (1) and (2) represent. Since the logarithmic forms represent a process that is restrained, the exponential forms must represent something that is not restrained.

All transactions of the Entity with its buyers and suppliers (the “market”) are recorded in one set of accounting records, that of the Entity itself. All of these Events, as we have seen above, restrain each other within that single set of accounts. The Events of the Entity’s buyers and suppliers, however, are contained in many sets of books. The buyers’ account with the Entity does not restrain the suppliers’ accounts just as the account of one supplier to the Entity does not restrain the accounts of other suppliers to the Entity and so on. Therefore, if we examine the purchase and sales Events for an Entity from the perspectives of all other companies involved, these companies do not encounter the same set of restraints as the Entity under consideration. The accounts of the buyers and sellers, are “opposite” in character to those of the Entity since what is entered on the debit side of the Entity’s account is entered on the credit side of its suppliers or buyers and vice versa.

However, all of the various accounts that are involved in exchanges with the Entity, and which are held by all its buyers and suppliers, can be imagined as defining a single Trading Entity. That Trading Entity is characterized by the fact that buying and selling Events do not restrain each other as in the case of the Entity itself. Given this concept of a Trading Entity, aa (for the sake of simplicity, from now on we set the Stability Ratio, ω, as equal to 1.0 unless stated otherwise) refers to the Entry Events of the Trading Entity that are the Exit Events a of the Entity. In other words, the mathematical expression aa summarizes the Entry Events of all the companies that do business with the Entity, which is given by all the net Exit Events of the Entity. Likewise, bb refers to the Exit Events of the Trading Entity that correspond to the Entry Events b of the Entity. That is, the exponential forms aa and bb refer to the Events a and b of the Entity as seen from the perspective of the Trading Entity.

The following table summarizes the relations between Exit and Entry accounts for the Entity and its Trading Entity:

Entry Events   Exit Events

Entity                        b                    a

Trading Entity          aa                   bb

The exponential forms of the E-Conditions therefore represent how “exchange” manifests itself in the Trading Entity. This exchange is, however, given by the final record in the books. Striking a “Bargain” or making a “market” are not recorded, but simply the Entry or Exit Events for the Entity on one side of the books and for the Trading Entity on the other side of the books.

When exchange takes place, it can be described as “something” that disappears from one side of the exchange and appears on the other. In the same way, “something that equals it” also disappears from the second side of the exchange and appears on the first side. This description of exchange gives us our exchange relation. That is, when Exit Events a disappear from the Entity, they appear as aa in its Trading Entity. The disappearance of a is represented by a approaching zero, and through exchange it appears in the Trading Entity as aa, which approaches 1. This is consistent with the notion that product and payment appear in units, as noted before in the E-Conditions. Similarly, as Entry Events b of the Entity disappear, and Exit Events bb of the Trading Entity approach 1, that is, the Entry Events are backed up into the Trading Entity. The exchange relations can therefore be expressed as:

In words, equation (5) means that the Entity makes a payment or delivers product to another company, encoded by the term (-a), where the minus sign signifies the outflow of payment or product. This payment or product is recorded as an Entry Event by another company, as aa. The fact that this exchange always appears in units (a company does not deliver half a product) means that on the right hand side we have the unit 1.

Equations (5) and (6) tell us that exchange drains the Entity of the unit Exit and Entry Event, that is a and b are reduced from 1.00 to zero as they appear in the Trading Entity as aa and bb. Given that a and b for the Entity have been reduced to zero, does this mean that Entity Activity comes to an end? That would be the case only if the Entity itself then disappeared. As stated earlier, there is a feedback loop within the Entity Activity which manifests itself by the resumption of Activities. We must go one step further and recognize therefore that as Exit and Entry Events tend to fall towards zero, they start up again since economic activity in general does not cease when one particular aspect of economic activity is finished (for example, the completed production and sale of one car does not mean the end of the whole car manufacturing process). The aforementioned feedback loop as seen from the perspective of the entire Trading Entity can now be described as a feedback between Entry and Exit Events of the Entity b and a and the Entry and Exit Events of the Entity’s surroundings aa and bb, the Trading Entity. The question that remains to be answered is thus what the nature of this type of feedback is.

We know that the Entity’s Exit Events a act as the Trading Entity’s Entry Events aa. Therefore, if a increases, so does aa. From this we postulate that the replenishment of aa as a result of the replenishment of a as seen from the perspective of the entire Trading Entity has the mathematical form and similarly, that the replenishment of bb as a result of the replenishment of b has the mathematical form . Furthermore, by extending our exchange relation in equations (5) and (6) and applying it to  and  and the exponential forms aa and bb in precisely the same way that the exponential forms aa and bb relate to a and b in equations (5) and (6), we obtain:

Equations (5) and (6) gave us the exchange relation as exchange takes place and reduces the Events to zero. Given that the Events start up again, that is we assume that the company does not disappear right after selling its product but goes right back to doing the same thing over and over again, equations (7) and (8) describe a more complete exchange relation where the production and exchange Events are continually replenished.

Again, in order to be able to graph and study the equations (7) and (8) we must rewrite them such that a and b appear only on one side of the equality, just like the E-Conditions (1) and (2) were rewritten as (3) and (4). We start this rearrangement with (3) and (4), b = a(a/ω) and a = b(b/ω), then raise these two equation to the power ω, which gives us bω = a(a/ω)ω or bω = aa, and likewise aω = bb. Using these equalities for aa and bb by substituting bω for aa and aω for bb in (7) and (8), we find:

Now, let us look at the first expression. We bring bω to the right-hand-side, obtaining = 1 + bω. Raising both sides by the power 1/bω, using  and performing an analogous rearrangement for the second expression, we arrive at the final forms:

Expressions (9) and (10) are called the M-Conditions and represent the exchange relation in the market with Activity replenishment from the point of view of the entire Trading Entity. The M-Conditions thus summarize the feedback between Entry and Exit Events of the Entity and the Entry and Exit Events of its surrounding Trading Entity, with the strength of the feedback again encoded by the Stability Ratio, ω. Figure 4 graphs the M-Conditions for Stability values of 0.5, 1, and 1.7.

As before, we can read off a number of properties of the M-Conditions from Figure 4. The most relevant for our purposes here is that the horizontal and the vertical branches intersect along the diagonal between the points a = b = 1 and a = b = 2. The precise intersection point depends on the value of the Stability Ratio of the entity and approaches a = b = 2 as ω falls to zero and approaches a = b = 1 as ω tends towards infinity.

 

 

The Value of the Process of Production

The E-Conditions describe for us the process of production and product appears at the point a = b = 1. We have noted above that this is an “abstract product” in abstract units, which are defined by the fact that the abstract product appears simultaneously with the abstract unit of payment. Thus the end of product and payment production processes define for us a measure (or numeraire) by which we can value the processes themselves instead of using any specific currency.

The process of production for Entry Events, represented by the horizontal branches in Figure 3, begins at a = 0, b = 1 and ends at a = b = 1. Conversely, for Exit Events, which are represented by the vertical branches, the production process begins at a = 1, b = 0 and ends at a = b = 1.

The arc length of a vertical branch in Figure 3 between the points a = 1, b = 0 and a = b = 1 represents the value of the process needed to produce one unit of product (that is, one unit of Exit Event b), using the aforementioned intrinsic measure of value.

Likewise, the value of the process needed to collect payment is the arc length of a horizontal branch between the points a = 0, b = 1 and a = b = 1. It is measured per unit of payment.

The fact that the length of the two arcs are equal for a given value of the Stability ω indicates that the value of the processes are equal at the point of exchange a = b = 1. The value of the process of production, whether it be for Entry or Exit Events, is therefore the length of the arc.

Going back to the E-Conditions, the arc length depends on the value of the Stability Ratio (see Figure 3). As the Stability Ratio falls, the arcs bow out more and more, and the arc length increases, which means that the value of the production process increases. This is because a decrease in the Stability Ratio is equivalent to a deepening of capital, that is, plant equipment and inventories and other liabilities increase relative to total assets. This increase in liabilities and decrease of assets leads to a higher effective cost of the production process, graphically represented by an increase in the arc lengths in Figure 3.

 

 

Exchange Value: The Value of the Product

The M-Conditions, on the other hand, describe for us the exchange between the Entity and its Trading Entity. The solution to the M-Conditions which are given by the points where the two branches of the M-Conditions in Figure 4 intersect, always occur on the diagonal between the points a = b = 1 and a = b = 2. As mentioned above, the precise intersection point depends on the value of the Stability Ratio and approaches a = b = 2 as ω (the Stability Ratio) falls to zero and approaches a = b = 1 as ω tends towards infinity. A Stability Ratio of infinity means that total liabilities P are 0.

The precise location of this intersection point, as it depends on the Stability Ratio, is central to our valuation objective. The length of a straight line from one of the coordinate axes to the intersection point defines another important measure of value. (Since the intersection points lie on the diagonal, the lengths from either axis to the intersection point are equal). Just as in the previous section, where the arc length in Figure 3 represented the value of the production process, here the length of the straight line from the coordinate axis to the point where the M-Conditions intersect in Figure 4 measures the value of the product as viewed from the entire exchange process. This measure is again given in units of product.

To help convince ourselves that these lengths are reasonable measures for the valuation of production and exchange, let us consider an extreme case. When the Stability Ratio goes towards infinity, the intersection point of the M-Conditions in Figure 4 is a = b = 1. This means that the exchange value as measured by the straight line from one of the axes to the intersection point is equal to 1.0. The production value as measured by the arc length in Figure 3 also becomes 1.0 when the Stability Ratio approaches infinity. Given that a low Stability Ratio is tantamount to a deepening of capital for the Entity, a Stability Ratio of infinity implies that the Entity has no capital. An Entity with no capital cannot have a process of production, and the process of production disappears, effectively becoming a non-process of production, mathematically signified by a production value of 1.0. In Figure 3 graphically, as the Stability goes towards infinity, the arcs curve out less and less, and are deformed into straight lines lying directly on the coordinate axes when the Stability is infinity.

The Exchange Value also collapses when the Stability Ratio tends to infinity. With no process of production, there is no value added from the non-production process. This means that at the limit when the Stability becomes infinity, Entry Activities are exactly equal to Exit Activities as they enter and exit unchanged, and the exchange value is 1.0.

Both exchange and production values are equal to each other and to 1.0, as measured by the above defined geometric lengths, when the Stability tends to infinity. This fact demonstrates that these geometric lengths are reasonable measures for production value and exchange value.

Figure 6 combines Figures 3 and 4 and graphs both E- and M-Conditions for values of the Stability of 0.5, 1, and 1.7.

What Is ‘Insolvency’?

As the Stability Ratio falls from infinity and capital formation begins, the Entity develops a process of production. This is reflected in the E-Conditions as they begin to bow out to form arcs (showing that an actual ‘business’ forms, with entry and exit events) and their length increases from 1.0. At the same time, the point where the M-Conditions intersect moves up along the diagonal towards the point a = b = 2. As this happens, the exchange value becomes greater than 1.0 as well (value could be said to be added to the economy). Subtracting the Production Value from the Exchange Value, we will find that the exchange value will be greater than the production value for all Stability Ratios greater than 0.289… Graphically (Figure 5), the length of the line from the M-Condition intersection point to the axis is greater than the arc length of the horizontal and vertical E-Condition branches. However, at Stability Ratios lower than 0.289… when capital deepens, the value of the production process is greater than the value of the product in exchange. [Note that at a Stability Ratio of .289, the inverse way of looking at this ratio is that there is $3.50 of debt outstanding, ‘P’, per dollar of ‘R’.]

In other words, at a Stability Ratio greater than 0.289 the company could be said to “make a profit”, and at a Stability Ratio of less than 0.289 the company “loses money”. Thus there is a critical breakpoint at a Stability Ratio of 0.289 indicating a change in the company’s solvency state. In order to increase its ‘profitable’ business activities at this point, the company has to increase its Stability Ratio again. One way that businesses which become insolvent, as defined, do this is by selling assets and paying down its liabilities (debt) to the level, that is, its Stability Ratio, where the company can meet the servicing requirements of its liabilities once again.

Below we plot the difference between the exchange value and the production value for Stability Ratios between 0 and 3. Note that if we extend the curve into the hyper-solvent end of the spectrum, the curve becomes asymptotic to the X-axis at the zero mark. Since we are measuring the productivity of debt, when there is no debt at all, there is a zero productivity associated with debt. On the other hand, since the curve rises from a ‘pure-equity’ condition, the curve also shows that to achieve maximum productivity of total capital employed, debt is absolutely necessary, but is

Stability Ratio

certainly not a necessary evil[iii].

Implications

The Stability Ratio is a deceptively simple ratio derived from balance sheet accounts. It is calculated by taking Total Assets plus Accumulated Depreciation, minus Net Plant, Equipment and Inventories and dividing this by Total Liabilities. The strength of the Stability Ratio comes from the underlying theory from which it is constructed. This theory focuses on the activity of a company (entity) in terms of Entry and Exit Events. This framework is extended to include the company’s surrounding Trading Entity, which is the amalgam of all the individual companies (entities) which do business with that company itself. There is a feedback between these Entry and Exit processes, both from the perspective of the company and the Trading Entity. The Stability Ratio encodes and embodies the strength of this feedback.

While the theory in its totality identifies several breakpoints which identify different solvency states for a company, in this paper. I have only highlighted one breakpoint, 0.289, because it is the start of the condition where the value in production has become greater than the value in exchange. It is as if the entity was attaching dollar bills to its product going out the door. Dr. Atrill termed this condition a “scientific bankruptcy” because, whether it is acknowledged or not, the economic consequences of bankruptcy hold, namely that value is being destroyed by permitting the entity as structured to continue. In other words, the company is better off selling its assets than using them for whatever business it is in. This is the “must sell assets” condition.

The other breakpoints that are identified by the theory are as useful as 0.289, but are beyond the intent and scope of the particular analysis. I should add, however, that these Stability breakpoints allow us to make incisive observations of a company’s financial state. As occurs most starkly at .289, the analysis becomes even more powerful when the Stability Ratio is in the process of violating one of the breakpoints. These transitions mark clear changes in the company’s solvency state and these changes in state tend to result in a change in a company’s behaviour, as well as the behaviour of its Trading Connections, in logical and predictable ways. As any given entity approaches one of the breakpoints, the change in behaviour will always tend to have the same general characteristics. The forecasting ability of Accounting Dynamics is therefore a quantum leap forward for the world of economics.

Measuring an Entire Economy

For an economy in the aggregate, the R or ‘incoming activity” is equal to the GDP, and P, the debt both short and long term, is (of course) the total debt of the economy. I ascertained this for several reasons. First and foremost, when I analyzed the Debt/GDP Ratio of the US many years ago for the 20th Century, I found that it peaked out at roughly .689. This is the peak at the reciprocal of the Marginal Efficiency of Debt Curve, and is what we call the Atrill Solvency Curve, and is the calculated point where R+P (total economic activity) is maximized, as opposed to R (GDP) per unit of P (debt) which is the MPD Curve measure where the R itself is maximized. I theorized that if the US economy adhered to what we think of as the ‘efficiency discipline’ at the top, then it should adhere to the insolvency parameters at the bottom.

Following from that, and much more practically, as I was following the solvency course of Greece and Spain, I observed that the GDP of both countries plunged virtually immediately once they had crossed the .289 boundary condition. You will also observe above that once the US crossed that second-order insolvency condition in 2007-8, the US economy went into an ugly plunge, most horribly in the banking, housing and auto sectors, all three of which were themselves in a condition of bankruptcy and had to be bailed out.

I was not alone in this observation. The Harvard Economist, Kenneth Rogoff, had also observed that of the economies that he had studied which became insolvent (their GDP and currencies collapsed), it seemed as if that event came at the point where those economies were carrying $3½ (or whatever currency units) per $dollar of GDP. In other words, in practice, according to his observations, at the ratio of .289, those economies moved into a condition of extreme stress (not his term, as far as I know, but it is the term that we use when measuring the solvency condition of weak companies and now, weak economies).

Fortunately, in 2009, the US Fed reacted and adjusted very quickly and pulled the economy back up and out, and a larger collapse was averted. In this effort, the Fed’s balance sheet became heavily laden with the debt that it had purchased to stabilize the US economy. The big question – with a very much unknown answer – is if the US enters another balance sheet recession, can it do the same thing a second time? And, more to the point, do we want to find out?

[1].289 is the numerical value of Wein’s Constant in physics. It is one of 11 constants from the realm of physics that show up in the book How ALL Economies Work, by my late guru, friend, and partner, Dr. V.H. Atrill.

[i] Equally, we could assume a speeding up of the processes of exchange because that kind of event often places other kinds of stresses on a balance sheet. For present purposes, however, it is the slowing down kinds of stresses that I wish to pursue.

[ii] The linear proportionality between a and b and their logs with the proportionality factor being the Stability Ratio is a postulate. One might observe that there could be other mathematical ways of measuring the ‘slowing down’ (or ‘speeding up’) effect other than the use of logarithms. While Dr. Atrill left it to others to determine whether or not there is a better surrogate measure of this process which could be employed instead, the forecasting value of the results that Dr. Atrill obtained are so powerful that they speak for themselves.

[iii] One could expand the limits of the curve to cover the extremely solvent end of the spectrum. The curve gradually becomes asymptotic to the ‘0’ plane, which is due to the fact that there can only be “no debt”, not negative debt; so at a Stability Ratio of nearing infinity, no stress is caused by (no) debt. However, at high Stability Ratios, entities which are equity heavy also produce a drag on the economy (although unlike debt pressures, it can never be negative). Economies that operate at these kinds of levels are very close to operating on a barter basis and tend to be very low energy kinds of economies. This, for instance, is more or less where China was before it began its great migration to a much more ‘capitalist’ approach. Clearly, rising up the Debt Productivity Curve by starting to employ leverage produces very rapid growth as the mathematics of the curve promises.

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Could This Market “Die of Old Age”?

I was struck the other day by an article by Byron Wien, vice chairman of Blackstone Advisory Partners. He recently wrote that in his view, the market could keep going for some time – perhaps into 2019 – because the usual factors that warn of impending bear markets are simply not in evidence at this time, and that markets do not die of old age. There is no inverted yield curve, he observes that retail investors are not euphoric about equities as they were in 2000 and 2007 for instance, hedge fund net exposure shows a mood of caution, the leading indicator index has been climbing steadily since 2016, corporate earnings have been increasing, and he asserts that strong business activity exists in the US, Europe, Japan, China and India. There is a lot of investor complacency, as evidenced by the very low VIX index readings, but as long as the economy continues to grow, he thinks that maybe that is not all that negative. Under those circumstances, a major crash-and-burn kind of stock market outcome seems to be unlikely in the near or even intermediate future. Since I myself have been cautious about the markets, and continue to be so, it struck me that I am either too pessimistic or Wein is too optimistic – and which is the more likely outcome? I do agree with Wein that the usual indications of a bull market peak are not present. That does not mean that strong bear market indications are absent, however, nor that this market is not very long in the tooth.

At the top of that list of bear market indicators is the lack of intrinsic value as we at my company, Strategic Analysis Corporation, measure it, notably in the S&P 500 and the NASDAQ 100. I recall that early in the year 2000, the S&P reached a valuation in which our Fair Market Value (FMV – our intrinsic value upside/downside determination) fell to zero. It actually bumped against that zero value level three times early in that year before the market finally slipped into the bear market mode that prevailed for the next 2 years into mid-2002. While the clear signs of rampant speculation in the dot-coms may be what most investors and commentators remember about 2000, for me it was the zero FMV potential which is what I recalled most vividly, and which – in my view – was what caused the market to run out of gas. Speculative excess, yes! But I said then and I would say again, I do not think that markets can run on negative energy – which is what they are trying to do now. Wein, of course, has no measure that matches our FMV and is therefore entitled to ignore it (at his peril, perhaps).

A second enormous issue is the massive and continuous efforts by the central banks to prop up markets through Quantitative Easing (QE) which they have been hard at work in executing since the horrific lows of 2008-9. Investors now expect that the central banks will maintain their programmes of stimulation – even if, for a moment or two in time, they falter at this task, or decide to end their current QE programme and replace it with some Quantitative Tightening (“Tapering” or QT) in order to wean the markets and the economy off all of that stimulus. That is thought to be a ‘temporary measure’ at worst, to be repealed at the first sign of serious market weakness. QE, in all of known market history, has never been tried before, and the comforting notion that the Fed will always be protecting the backs of investors is certainly a driving force behind steadily rising market values. I do not know what will happen when the Fed actually tries QT instead, and, as reassuring as their words may be that QT carries ‘no adverse consequences’, “tapering” definitely can not have the same positive effects as “easing” has had (although this proposition has yet to be tested).

Chief among those who claim that they cannot see any market tops in sight are those who observe that there does not seem to be any visibly obvious valuation excesses such as the Nifty-Fifty stocks of the early 1970s, the dot-com stocks in 2000, and the housing bubble which peaked in 2007-8. In some ways, this is the easiest claim to refute because the valuations (in price/book terms) of today of some of the very largest of stock market capitalizations easily match the extremes of the dot-com stocks in 2000. The measured downside risk of most of the FANGS are enough – if they were experienced (again!) – to cause massive losses of investment capital, and the investor pain that goes with it. Facebook carries a forward PE Ratio of a mere 28, while Invidia has a 50x PE Ratio for 2018, Netflix has a 106x PE Ratio, with Amazon being the champion at 138. Amazon, Invidia, and Netflix have all had histories of stunning percentage price declines in weak markets. Apple, another market favourite, is also not immune to huge price declines. The problem with such massively capitalized stocks suffering price declines in line with their own historical magnitude is that they drag down more stocks with them the further that they fall.

picture 1
Observing the popular crypto-currency movement as well as the willingness of investors to blindly put their money into vehicles that they don’t understand and can’t measure in any case is to harken back to the Mississippi Bubble era of three centuries ago. As well, with more than 1000 bitcoin issues public right now (and rising steadily), it is looking almost worse than the dot.com market of 2000. Does the world really need all those cryptos and what – if anything – is their intrinsic value in any case? My guess – based on long and sometimes bitter experience – is that most will die in the coming period, the survivors will be seriously tarnished, and the speculators who own them will be severely mauled.

In the meantime, investor expectations appear to be very powerfully optimistic. Merrill Lynch finds that their clients are holding the lowest allocation to cash in the last 13 years. The Market Vane poll show that 71% are bullish and 65% of respondents expect stock market prices to be higher in the next 12 months. There are also a record number of speculator futures contracts which are short the VIX. Technically, at any rate, those numbers are concerning. It is really difficult to assert that investors are anything but rampantly bullish!

Further, I are intrigued by the extremely low VIX levels averaging about 0.3% a day (the measure of volatility of the markets which historically has served to measure the comfort of investors with the valuations in evidence). I vividly recall, for instance, the one-day market crash of 1987 which was preceded by a long period in which the daily fluctuations of the market averaged close to 2%. One day, that 2% change just kept on going – down 28% before finding a bottom (in price/book terms, from about 2 times down to about 1.5 times book in a single day). In other words, that crash was clearly signalled – or perhaps “clearly in retrospect” would be a much more accurate way to put it. Our advice to our clients at the time was “the market is levitating”, although we hardly expected a one-day termination of that condition. Today, there is no obvious parallel between October 1987 and October 2017 in VIX terms, save to observe that an extremely low VIX may be a sign of extreme investor comfort and complacency – for all the reasons that I noted above, especially the promise of Fed intervention should anything untoward occur. Do keep in mind that in 1987 Fed intervention also occurred – vigorously – but not until the day after that market crash. Curiously, the same set of conditions applied then as do now, namely all of those market algorithms that kicked in to sell out investors as the market plunged are alive and well today as trading robots (“bots”), resetting stock allocations on the go, as it were. I am hoping that the automatic stabilizer mechanisms remain in place that were put in place after 1987 – but I doubt it as none have been tested in a real-life meltdown. Simulations, maybe, but reality? Recent one-day “mini-crashes” do not give me confidence that a serious setback will not be exacerbated by all of those bots. And how is one to know when the next “mini-crash” occurs that it is merely an error in someone’s programme or the start of something much more serious? Not that I am expecting anything like another 1987, but current valuations are a sleeping tiger best left unmolested. I do note, however: the market is levitating again.

Evidence that the economy is actually slowing is abundant (although the IMF just raised its 2018 outlook!). Auto sales are long in the tooth and home sales plus auto sales are starting to run in negative territory (below). Like others, I am also wondering if the householder is running out of discretionary spending ability after a 9-year Fed-encouraged spree. However, consumer confidence remains quite positive, thank you very much. The ECRI’s US Weekly Leading Index growth has fallen to a 79 week low, indicating thqt economic growth is as good as it is going to get. (Is this a precursor to much slower conditions – or is this move into negative ground merely a temporary condition?)

picture 2

What about tax reform in the US, however? Surely with corporate taxes coming down, earnings per share would move strongly upwards in 2018-19. That assumes, however, that tax reform is even remotely possible and in the cards. The huge issue with tax reform is how to pay for it – that is to say, what is the offset to slashing taxes for corporations (and the wealthy by inference)? Reforming Obamacare (that is, slashing spending on Obamacare) died aborning, and other alternatives do not seem to appeal much either. Cutting corporate taxes when US corporations are buying back their stock does not really seem to make much sense, and capital spending in the US is quite tepid in any case. I have made the case, complete with the detailed mathematics, in The Limits of Debt (see my blogsite, The Occasional Contrarian) that US GDP cannot grow rapidly because of the very issue that the congressional leaders are concerned about – the size and sheer weight of the US debt on the economy. This would be exacerbated if taxes were to be cut without a balance elsewhere. And in a “lifeboat economy” (my Limits of Debt term) “I” am not prepared to reduce “my” share of the economy only to see “you” get “more”. I fully expect that tax reform will fail to get off the ground.

 

An Elderly Market, With Clear Signs of Aging

And so I come back to my question – how will this market finally reach its end and does it need the kinds of signals and indicators that in the past have been clear precursors of bear markets? I would observe that to a considerable extent, all of the usual precursors are already here. Complacency, mass speculation, and ultra high valuations are already part of the current investment condition. With the Fed trying to pull off Quantitative Tapering, at least one more rug will be removed from under the feet of investors. In medical terms, the patient has a very weak pulse (the VIX), it has no energy to keep going (zero overall intrinsic upside value potential in evidence), and the doctors are actively planning on pulling the life support plug (QT is coming). Personally, I really don’t want to bet too heavily that this sclerotic market is facing a long and healthy life ahead!
But – one last question – how would we “know” when the end finally does come? Does the stock market just lie down and refuse to get up one morning? Like General MacArthur’s ‘old soldiers’, does it just fade away? Or does it suddenly fall by 20% (or whatever)? What about a 10-20 day cascade of prices? I strongly suspect that when the VIX awakens this time, things will not be pretty. Byron Wein can’t see it and the investing public is acting as if there is no end in sight. I would be less than candid if I were to say that I am able to, either. However, the market got here by unusual measures, and its demise should be unusual, too.

What I am doing is what I have done in the past, that is to rely on our valuation measures to tell me when a break is coming. As we did at the break in the market is 1987, 2000, and 2008, I will rely on our technical signals to sound the alarm. Already, the intrinsic potential of the S&P and the NASDAQ are sounding a warning that the market is out of gas. I have not yet seen the technical break that I saw in 2008, but it is close by in percentage terms. A break below the 2400 level (2.5 times adjusted book value, and the ceiling valuation for the S&P for the 2002-8 market period) for the S&P will signal the end of the bull market for me.

For the time being, I have to say that no break has been signalled and that a bull market therefore remains in force, however poorly supported that it may be. I am, however, happy to be defensively positioned with a good cash holding.

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BNN Appearance October 5th, 2017

BNN October 5

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The “Rules” of Prediction

The “Rules” of Prediction

As Benjamin Graham, the father of modern common stock analysis, once wrote, “In the short run, the market is a voting machine, and it’s quite clear that the votes are not always cast in favor of value. Still, in the long run, it is a weighing machine.”

For those looking for some excellent reading, we recommend that you obtain a copy of Michaels Lewis’ (of MoneyBall etc. fame) new book, The Undoing Project. It is, in its essence, the background history of behavioural economics. The two fathers of the modern psychology of predictions, Amos Tversky and Daniel Kahneman, took away the “rules” that used to underlie the assumption of the ‘rational man’, so beloved by people like B.F. Skinner, and gave us a whole new way of thinking about how decisions are actually made. The book is written in Lewis’ usual breezy style with lots of personal stuff to remind us that they are/were human, too, but leading to some fascinating insights into the way that we actually think.

At SAC, we do, of course, attempt to predict the future of stock prices and even overall market movements, even though we are very aware that prediction is often more an art form than a strict science. As cited above, however, we do know that in the long run, the market is, as Benjamin Graham pointed out many years ago, a weighing machine. It is the short term that is often the devil in the details when the market becomes a popularity contest, a voting machine. In chapter 7 of Lewis’ book, we found this excellent summary of the prediction process – which would seem to go some way to explain why markets are the way that they are today.

Consider their outline of the “science” of prediction:

  •         People predict by making up stories
  •         People actually predict very little, but stories ‘explain’ everything
  •         People live under uncertainty whether they like it or not
  •         People believe that they can tell the future if they work at it hard enough
  •         People will accept any explanation as long as it appears to fit the facts
  •         The handwriting may be on the wall. It was just that the ink that is used tends to be invisible
  •         People often work hard to obtain information that they already have, and avoid new knowledge
  • People mistake the delay of consequences with the absence of consequences.

This argument is quite popular with investors who haven’t spent much time getting their hands dirty with historical data, satisfied to repeat verbal arguments they’ve heard elsewhere as a substitute for analysis.

  •         Man is a deterministic being thrown into a probabilistic universe
  •         In this match-up, surprises are (or should be) expected
  •         Since the explanations that are invoked following events “fit the facts”, everything that has already happened must therefore have been inevitable. And if that is so, why is it that we can’t see what is inevitable in the future which lies immediately ahead of us?

A Self-Perpetuating Do-Loop

What seems to have happened recently is a sort of self-perpetuating do-loop between market strength and economic expectations. As John Hussman recently observed, “In recent months, the consensus of survey-based economic measures has turned higher, including a variety of surveys of purchasing managers, as well as indices compiled by regional Federal Reserve banks. At the same time, economic measures based on actual activity such real GDP, real sales, consumption, and employment haven’t been nearly as robust, and in some cases have turned lower. This disparity between “hard” activity-based and “soft” survey-based measures has been particularly wide relative to historical norms.

Soft survey-based measures tend to be most informative when they uniformly surge coming out of recessions. In contrast, during late-stage economic expansions, positive disparities in soft measures tend to be false signals that are resolved in favor of harder measures. Sharp downturns in “soft data” can contribute to recession warnings, but they should be confirmed by measures such as slowing growth in employment, real personal income, and consumption. That has been particularly true in recent years, when historically reliable survey-based signals were regularly distorted by swings in expectations about quantitative easing.

The current positive divergence is particularly likely to be misleading. The charts of survey-based measures demonstrate this. What’s striking about survey-based economic measures is that their 5-year rolling correlation with actual subsequent economic outcomes has plunged to zero in recent years (and periodically less than zero), meaning that these measures have been nearly useless or even contrary indicators of subsequent economic outcomes.

What Hussman is saying is that the (soft) survey data that things are getting better and better are reinforcing the bullishness reaction of the stock market. And the bullish stock market reinforces the soft survey data because it is ‘obvious’ that a strong market is indicative of a strong economy. So this is the ‘story’ that supports the observed outcome, a rising market in the face of increasingly poor actual fundamentals.

Now to finish the story, the higher that the market goes and the weaker the fundamentals that support it, the less investors are able to rely on solid fundamental data to build portfolios upon, and the more that they must rely on momentum. That means that “value managers” tend to underperform the market, and, indeed, almost any form of active management tends to underperform as stock selection implies using sound judgement based on hard data, but it is not that kind of judgement that is driving the market today.

Take that a step further, and we have the powerful move to ETF investing (exchange traded funds which mimic some underlying index of stocks, either the overall market or specific groups however defined). ETF investors simply buy the index and everything in it without regard to value, because they have “discovered” that value investing doesn’t work [anymore]. As the self-perpetuating market/survey-based data do-loop continues to weave its magic, we get another self-perpetuation do-loop, namely that investment selection based on “value” is a mugs game: all you have to do is to buy the index, warts and all, no matter what is inside it as it doesn’t really matter.

As investors pour money into Index ETFs, which by definition have to buy everything in an Index, capitalization-weighted of course, the highly priced and highly cap-weighted get more highly priced and cap-weighted regardless of their intrinsic value. It is a virtuous circle if you happen to manage ETFs and a vicious circle if you do not. As a money manager, you cannot avoid buying the ridiculously priced stocks because to fail to do so is to underperform the

ETFs to which you are being compared.

This Time is Different?

Now that the financial and the popular press has seized on this obvious fact, the resultant upwelling flood of money into ETFs essentially does nothing except to distort the values in the market even further. Professional judgement is not needed any longer. The market therefore concludes that the ETF is here to stay, and investors now have an easy, one-decision judgement to make.

One decision investing! How simple can life get? However, before we embrace the concept whole-heartedly, it might be well to inquire, ‘have we ever been there before?’ and what was the outcome? For those of us who have been around this block before, we remember Charlie Ellis’ great landmark book, Institutional Investing, which appeared in 1971. In his book, Ellis noted that if you bought the then-called Nifty Fifty growth stocks, they had (note the tense) outperformed the market for decades, and that therefore all a money manager had to do to outperform the market was to buy those stocks as the core of any and all portfolios. After that, money poured into those stocks. But can anyone guess what happened next? By the bottom of the bear market of 1973-4, the average Nifty Fifty stock was down by some 80%. Many never came back to their previous highs and those that did often took decades to do so.

Of course, we don’t have to go back that far. Just recall 1999-2000 when the internet was going to revolutionize the world and the dot-com stocks went wild. When we criticized the valuation levels of some of these stocks on BNN (then ROB-Tv), we were accused of “not understanding the 21st Century”. But it turned out that it was not the 21st Century that needed to be understood: it was market valuations and balance sheets that one needed to grasp, and after a 2-year bear market which saw the utter collapse of those stocks, suddenly value was back in vogue. Warren Buffett was not dead (as one earnest advisor assured us in the Spring of 2000) after all!

As Tversky and Kahneman discovered in their research, fear of remorse over lost opportunity gains often drives decisions. If the market goes up 10%, and you are in too much cash or too cautious, how annoyed, concerned, and bothered would you be, even though you know that the values that you would have had to be invested in were stupidly extreme – if you only make 3-4-5% instead? Being “left out” is tough to swallow. And it helps to have a willingness to suspend belief in support of the ‘the story’. We observed, for instance, that CP Rail recently had a flat quarter, and the stock is close to an all-time valuation high with no fair market value potential left? Of course, the stock jumped 4% because management assured us that ‘things will get better’. There’s a lot of story-telling without supporting evidence going around these days. It’s all bullish (no ‘T’ in the spelling!).

Plus Ça Change, Plus C’est La Même Chose?:

What Now for the Market?

Valuation extremes require investors to argue “this time is different” – and dismiss the entire history of the financial markets – because valuation extremes have always ended badly. As the saying goes, when everyone thinks alike, no one thinks. Dry powder has considerable value here, not because of the poor return it currently generates, but because of the opportunity it may afford to establish constructive and even aggressive market exposure over the completion of this cycle, at much higher prospective returns than are currently available.

In our North American Value Portfolio, ex the gold stocks which we hold for insurance purposes, the median price/book ratio for the majority of stocks is fairly close to 1.1 times, and the average forward Price/Earnings Ratio about 12 times. This is a far cry from the average price/book of the S&P 500 of more than 2½ times and an average PE of 21.3x. For the SPTSX, the numbers are 1.5 times for the price/book and 18.6x for the average PE Ratio. And we hold some cash because we suspect that sometime in the not so distant future, cash may well be king again.

We continue to hold about 10% of the fund in gold shares. We do suspect that if, as, and when markets are weak (bearish), the Fed will mount another charge to the rescue – as it has since the sudden market collapse in 1987 – and flood the land with money again. The Donald would not have it any other way!  

Will the gold stocks hold up if markets go south? Not entirely, but they will come back earlier and faster than the rest of the market because the Fed is highly likely to have a catfit if markets head south, and they will “do something” (stupid but helpful to gold investors) to head off anything too serious in the way of a decline. Are there any better hedges than golds? Not likely, except cash. The reality of markets is that in weak markets (i.e. bear markets) investors sell their garbage first (the stocks that are plunging) and then the good stocks a bit later (the ones that haven’t plunged so far) because “they didn’t go down, so I took some profits to offset my losses”. Even banks take it on the chin, albeit often not so badly, even if sometimes it feels as if they are as bad as anything else. Investors lose all perspective in bear markets and this one may be quite interesting because all those innocent folks who are investing in ETFs will find out that ETFs don’t mean a thing from a safety point of view in a bear market. Most people don’t have a clue as to what’s inside them, but as they are designed to act like the market so they will get pasted like the market and provide you with no cushion of safety at all.

Hussman concludes that, put simply, investors are in an echo chamber now, where their optimism about economic outcomes drives optimism about the stock market, and optimism about the stock market drives optimism about economic outcomes. Given the deterioration in correlations between “soft” survey-based economic measures and subsequent economic and financial outcomes, investors should be placing a premium on measures that are reliably informative. On that front, hard economic data, labor force constraints, factors influencing productivity (particularly gross domestic investment and the position of the current account balance in the economic cycle), reliable valuation measures, and market internals should be high on that list. The hard economic data tell a much different story than soft survey-based measures, and there is a risk that investors may be setting themselves up for considerable disappointment. The GDPNow projection from the Atlanta Fed for first-quarter 2017 GDP growth has dropped to a projected annualized growth rate of just 0.6%. That is a far cry from what the man on the street expects for 2017, but a number that was confirmed in the last week in April when the US GDP actually grew at a 0.7% rate, missing the +1.1% estimate handily.

 

What Now?

 

The market is expensive and risky – but what else is new in 2017? Still, the more comfortable investors become with trusting in ETFs to take all the risks out of stock selection, the more dangerous the markets become. We “know” that if markets were to weaken to any significant degree that the Fed would not be far behind in cutting what rates are left to cut and pumping money into the system. Unfortunately, that is not what the economy needs now, but it is all that t is going to get.

It would be our suspicion and expectation based on the history of the S&P 500 that a setback to its Growth Price (2 times adjusted book value) which would suggest roughly a 23% downside risk from current levels.

For an economy that’s built on the market that’s built on an economy that’s built on the market, the unwinding of this mare’s nest should be something to behold. In the meantime, whether or not “value” is the metric of the day or not – and right now, it is not – we will stick with value stocks in the expectation, no matter how forlorn at present, that good value will prove to be a better investment bed to lie on than hopes and dreams. We feel that a decent amount of cash is a sound strategy, and that given the final outcome, gold stocks will prove their worth.

Posted in Uncategorized | 1 Comment

The “Rules of Prediction

The “Rules” of Prediction

As Benjamin Graham, the father of modern common stock analysis, once wrote, “In the short run, the market is a voting machine, and it’s quite clear that the votes are not always cast in favor of value. Still, in the long run, it is a weighing machine.”

For those looking for some excellent reading, we recommend that you obtain a copy of Michaels Lewis’ (of MoneyBall etc. fame) new book, The Undoing Project. It is, in its essence, the background history of behavioural economics. The two fathers of the modern psychology of predictions, Amos Tversky and Daniel Kahneman, took away the “rules” that used to underlie the assumption of the ‘rational man’, so beloved by people like B.F. Skinner, and gave us a whole new way of thinking about how decisions are actually made. The book is written in Lewis’ usual breezy style with lots of personal stuff to remind us that they are/were human, too, but leading to some fascinating insights into the way that we actually think.

At SAC, we do, of course, attempt to predict the future of stock prices and even overall market movements, even though we are very aware that prediction is often more an art form than a strict science. As cited above, however, we do know that in the long run, the market is, as Benjamin Graham pointed out many years ago, a weighing machine. It is the short term that is often the devil in the details when the market becomes a popularity contest, a voting machine. In chapter 7 of Lewis’ book, we found this excellent summary of the prediction process – which would seem to go some way to explain why markets are the way that they are today.

Consider their outline of the “science” of prediction:

  •         People predict by making up stories
  •         People actually predict very little, but stories ‘explain’ everything
  •         People live under uncertainty whether they like it or not
  •         People believe that they can tell the future if they work at it hard enough
  •         People will accept any explanation as long as it appears to fit the facts
  •         The handwriting may be on the wall. It was just that the ink that is used tends to be invisible
  •         People often work hard to obtain information that they already have, and avoid new knowledge
  • People mistake the delay of consequences with the absence of consequences.

This argument is quite popular with investors who haven’t spent much time getting their hands dirty with historical data, satisfied to repeat verbal arguments they’ve heard elsewhere as a substitute for analysis.

  •         Man is a deterministic being thrown into a probabilistic universe
  •         In this match-up, surprises are (or should be) expected
  •         Since the explanations that are invoked following events “fit the facts”, everything that has already happened must therefore have been inevitable. And if that is so, why is it that we can’t see what is inevitable in the future which lies immediately ahead of us?

A Self-Perpetuating Do-Loop

What seems to have happened recently is a sort of self-perpetuating do-loop between market strength and economic expectations. As John Hussman recently observed, “In recent months, the consensus of survey-based economic measures has turned higher, including a variety of surveys of purchasing managers, as well as indices compiled by regional Federal Reserve banks. At the same time, economic measures based on actual activity such real GDP, real sales, consumption, and employment haven’t been nearly as robust, and in some cases have turned lower. This disparity between “hard” activity-based and “soft” survey-based measures has been particularly wide relative to historical norms.

Soft survey-based measures tend to be most informative when they uniformly surge coming out of recessions. In contrast, during late-stage economic expansions, positive disparities in soft measures tend to be false signals that are resolved in favor of harder measures. Sharp downturns in “soft data” can contribute to recession warnings, but they should be confirmed by measures such as slowing growth in employment, real personal income, and consumption. That has been particularly true in recent years, when historically reliable survey-based signals were regularly distorted by swings in expectations about quantitative easing.

The current positive divergence is particularly likely to be misleading. The charts of survey-based measures demonstrate this. What’s striking about survey-based economic measures is that their 5-year rolling correlation with actual subsequent economic outcomes has plunged to zero in recent years (and periodically less than zero), meaning that these measures have been nearly useless or even contrary indicators of subsequent economic outcomes.

What Hussman is saying is that the (soft) survey data that things are getting better and better are reinforcing the bullishness reaction of the stock market. And the bullish stock market reinforces the soft survey data because it is ‘obvious’ that a strong market is indicative of a strong economy. So this is the ‘story’ that supports the observed outcome, a rising market in the face of increasingly poor actual fundamentals.

Now to finish the story, the higher that the market goes and the weaker the fundamentals that support it, the less investors are able to rely on solid fundamental data to build portfolios upon, and the more that they must rely on momentum. That means that “value managers” tend to underperform the market, and, indeed, almost any form of active management tends to underperform as stock selection implies using sound judgement based on hard data, but it is not that kind of judgement that is driving the market today.

Take that a step further, and we have the powerful move to ETF investing (exchange traded funds which mimic some underlying index of stocks, either the overall market or specific groups however defined). ETF investors simply buy the index and everything in it without regard to value, because they have “discovered” that value investing doesn’t work [anymore]. As the self-perpetuating market/survey-based data do-loop continues to weave its magic, we get another self-perpetuation do-loop, namely that investment selection based on “value” is a mugs game: all you have to do is to buy the index, warts and all, no matter what is inside it as it doesn’t really matter.

As investors pour money into Index ETFs, which by definition have to buy everything in an Index, capitalization-weighted of course, the highly priced and highly cap-weighted get more highly priced and cap-weighted regardless of their intrinsic value. It is a virtuous circle if you happen to manage ETFs and a vicious circle if you do not. As a money manager, you cannot avoid buying the ridiculously priced stocks because to fail to do so is to underperform the

ETFs to which you are being compared.

This Time is Different?

Now that the financial and the popular press has seized on this obvious fact, the resultant upwelling flood of money into ETFs essentially does nothing except to distort the values in the market even further. Professional judgement is not needed any longer. The market therefore concludes that the ETF is here to stay, and investors now have an easy, one-decision judgement to make.

One decision investing! How simple can life get? However, before we embrace the concept whole-heartedly, it might be well to inquire, ‘have we ever been there before?’ and what was the outcome? For those of us who have been around this block before, we remember Charlie Ellis’ great landmark book, Institutional Investing, which appeared in 1971. In his book, Ellis noted that if you bought the then-called Nifty Fifty growth stocks, they had (note the tense) outperformed the market for decades, and that therefore all a money manager had to do to outperform the market was to buy those stocks as the core of any and all portfolios. After that, money poured into those stocks. But can anyone guess what happened next? By the bottom of the bear market of 1973-4, the average Nifty Fifty stock was down by some 80%. Many never came back to their previous highs and those that did often took decades to do so.

Of course, we don’t have to go back that far. Just recall 1999-2000 when the internet was going to revolutionize the world and the dot-com stocks went wild. When we criticized the valuation levels of some of these stocks on BNN (then ROB-Tv), we were accused of “not understanding the 21st Century”. But it turned out that it was not the 21st Century that needed to be understood: it was market valuations and balance sheets that one needed to grasp, and after a 2-year bear market which saw the utter collapse of those stocks, suddenly value was back in vogue. Warren Buffett was not dead (as one earnest advisor assured us in the Spring of 2000) after all!

As Tversky and Kahneman discovered in their research, fear of remorse over lost opportunity gains often drives decisions. If the market goes up 10%, and you are in too much cash or too cautious, how annoyed, concerned, and bothered would you be, even though you know that the values that you would have had to be invested in were stupidly extreme – if you only make 3-4-5% instead? Being “left out” is tough to swallow. And it helps to have a willingness to suspend belief in support of the ‘the story’. We observed, for instance, that CP Rail recently had a flat quarter, and the stock is close to an all-time valuation high with no fair market value potential left? Of course, the stock jumped 4% because management assured us that ‘things will get better’. There’s a lot of story-telling without supporting evidence going around these days. It’s all bullish (no ‘T’ in the spelling!).

Plus Ça Change, Plus C’est La Même Chose?:

What Now for the Market?

Valuation extremes require investors to argue “this time is different” – and dismiss the entire history of the financial markets – because valuation extremes have always ended badly. As the saying goes, when everyone thinks alike, no one thinks. Dry powder has considerable value here, not because of the poor return it currently generates, but because of the opportunity it may afford to establish constructive and even aggressive market exposure over the completion of this cycle, at much higher prospective returns than are currently available.

In our North American Value Portfolio, ex the gold stocks which we hold for insurance purposes, the median price/book ratio for the majority of stocks is fairly close to 1.1 times, and the average forward Price/Earnings Ratio about 12 times. This is a far cry from the average price/book of the S&P 500 of more than 2½ times and an average PE of 21.3x. For the SPTSX, the numbers are 1.5 times for the price/book and 18.6x for the average PE Ratio. And we hold some cash because we suspect that sometime in the not so distant future, cash may well be king again.

We continue to hold about 10% of the fund in gold shares. We do suspect that if, as, and when markets are weak (bearish), the Fed will mount another charge to the rescue – as it has since the sudden market collapse in 1987 – and flood the land with money again. The Donald would not have it any other way!  

Will the gold stocks hold up if markets go south? Not entirely, but they will come back earlier and faster than the rest of the market because the Fed is highly likely to have a catfit if markets head south, and they will “do something” (stupid but helpful to gold investors) to head off anything too serious in the way of a decline. Are there any better hedges than golds? Not likely, except cash. The reality of markets is that in weak markets (i.e. bear markets) investors sell their garbage first (the stocks that are plunging) and then the good stocks a bit later (the ones that haven’t plunged so far) because “they didn’t go down, so I took some profits to offset my losses”. Even banks take it on the chin, albeit often not so badly, even if sometimes it feels as if they are as bad as anything else. Investors lose all perspective in bear markets and this one may be quite interesting because all those innocent folks who are investing in ETFs will find out that ETFs don’t mean a thing from a safety point of view in a bear market. Most people don’t have a clue as to what’s inside them, but as they are designed to act like the market so they will get pasted like the market and provide you with no cushion of safety at all.

Hussman concludes that, put simply, investors are in an echo chamber now, where their optimism about economic outcomes drives optimism about the stock market, and optimism about the stock market drives optimism about economic outcomes. Given the deterioration in correlations between “soft” survey-based economic measures and subsequent economic and financial outcomes, investors should be placing a premium on measures that are reliably informative. On that front, hard economic data, labor force constraints, factors influencing productivity (particularly gross domestic investment and the position of the current account balance in the economic cycle), reliable valuation measures, and market internals should be high on that list. The hard economic data tell a much different story than soft survey-based measures, and there is a risk that investors may be setting themselves up for considerable disappointment. The GDPNow projection from the Atlanta Fed for first-quarter 2017 GDP growth has dropped to a projected annualized growth rate of just 0.6%. That is a far cry from what the man on the street expects for 2017, but a number that was confirmed in the last week in April when the US GDP actually grew at a 0.7% rate, missing the +1.1% estimate handily.

 

What Now?

 

The market is expensive and risky – but what else is new in 2017? Still, the more comfortable investors become with trusting in ETFs to take all the risks out of stock selection, the more dangerous the markets become. We “know” that if markets were to weaken to any significant degree that the Fed would not be far behind in cutting what rates are left to cut and pumping money into the system. Unfortunately, that is not what the economy needs now, but it is all that t is going to get.

It would be our suspicion and expectation based on the history of the S&P 500 that a setback to its Growth Price (2 times adjusted book value) which would suggest roughly a 23% downside risk from current levels.

For an economy that’s built on the market that’s built on an economy that’s built on the market, the unwinding of this mare’s nest should be something to behold. In the meantime, whether or not “value” is the metric of the day or not – and right now, it is not – we will stick with value stocks in the expectation, no matter how forlorn at present, that good value will prove to be a better investment bed to lie on than hopes and dreams. We feel that a decent amount of cash is a sound strategy, and that given the final outcome, gold stocks will prove their worth.

Posted in Uncategorized | Leave a comment

The “Rules” of Prediction

As Benjamin Graham, the father of modern common stock analysis, once wrote, “In the short run, the market is a voting machine, and it’s quite clear that the votes are not always cast in favour of value. Still, in the long run, it is a weighing machine.”

For those looking for some excellent reading, we recommend that you obtain a copy of Michaels Lewis’ (of MoneyBall etc. fame) new book, The Undoing Project. It is, in its essence, the background history of behavioural economics. The two fathers of the modern psychology of predictions, Amos Tversky and Daniel Kahneman, took away the “rules” that used to underlie the assumption of the ‘rational man’, so beloved by people like B.F. Skinner, and gave us a whole new way of thinking about how decisions are actually made. The book is written in Lewis’ usual breezy style with lots of personal stuff to remind us that they are/were human, too, but leading to some fascinating insights into the way that we actually think.

At SAC, we do, of course, attempt to predict the future of stock prices and even overall market movements, even though we are very aware that prediction is often more an art form than a strict science. As cited above, however, we do know that in the long run, the market is, as Benjamin Graham pointed out many years ago, a weighing machine. It is the short term that is often the devil in the details when the market becomes a popularity contest, a voting machine. In chapter 7 of Lewis’ book, we found this excellent summary of the prediction process – which would seem to go some way to explain why markets are the way that they are today.

Consider their outline of the “science” of prediction:

  •         People predict by making up stories
  •         People actually predict very little, but stories ‘explain’ everything
  •         People live under uncertainty whether they like it or not
  •         People believe that they can tell the future if they work at it hard enough
  •         People will accept any explanation as long as it appears to fit the facts
  •         The handwriting may be on the wall. It was just that the ink that is used tends to be invisible
  •         People often work hard to obtain information that they already have, and avoid new knowledge
  • People mistake the delay of consequences with the absence of consequences.

This argument is quite popular with investors who haven’t spent much time getting their hands dirty with historical data, satisfied to repeat verbal arguments they’ve heard elsewhere as a substitute for analysis.

  •         Man is a deterministic being thrown into a probabilistic universe
  •         In this match-up, surprises are (or should be) expected
  •         Since the explanations that are invoked following events “fit the facts”, everything that has already happened must therefore have been inevitable. And if that is so, why is it that we can’t see what is inevitable in the future which lies immediately ahead of us?

A Self-Perpetuating Do-Loop

What seems to have happened recently is a sort of self-perpetuating do-loop between market strength and economic expectations. As John Hussman recently observed, “In recent months, the consensus of survey-based economic measures has turned higher, including a variety of surveys of purchasing managers, as well as indices compiled by regional Federal Reserve banks. At the same time, economic measures based on actual activity such real GDP, real sales, consumption, and employment haven’t been nearly as robust, and in some cases have turned lower. This disparity between “hard” activity-based and “soft” survey-based measures has been particularly wide relative to historical norms.

Soft survey-based measures tend to be most informative when they uniformly surge coming out of recessions. In contrast, during late-stage economic expansions, positive disparities in soft measures tend to be false signals that are resolved in favor of harder measures. Sharp downturns in “soft data” can contribute to recession warnings, but they should be confirmed by measures such as slowing growth in employment, real personal income, and consumption. That has been particularly true in recent years, when historically reliable survey-based signals were regularly distorted by swings in expectations about quantitative easing.

The current positive divergence is particularly likely to be misleading. The charts of survey-based measures demonstrate this. What’s striking about survey-based economic measures is that their 5-year rolling correlation with actual subsequent economic outcomes has plunged to zero in recent years (and periodically less than zero), meaning that these measures have been nearly useless or even contrary indicators of subsequent economic outcomes.

What Hussman is saying is that the (soft) survey data that things are getting better and better are reinforcing the bullishness reaction of the stock market. And the bullish stock market reinforces the soft survey data because it is ‘obvious’ that a strong market is indicative of a strong economy. So this is the ‘story’ that supports the observed outcome, a rising market in the face of increasingly poor actual fundamentals.

Now to finish the story, the higher that the market goes and the weaker the fundamentals that support it, the less investors are able to rely on solid fundamental data to build portfolios upon, and the more that they must rely on momentum. That means that “value managers” tend to underperform the market, and, indeed, almost any form of active management tends to underperform as stock selection implies using sound judgement based on hard data, but it is not that kind of judgement that is driving the market today.

Take that a step further, and we have the powerful move to ETF investing (exchange traded funds which mimic some underlying index of stocks, either the overall market or specific groups however defined). ETF investors simply buy the index and everything in it without regard to value, because they have “discovered” that value investing doesn’t work [anymore]. As the self-perpetuating market/survey-based data do-loop continues to weave its magic, we get another self-perpetuation do-loop, namely that investment selection based on “value” is a mugs game: all you have to do is to buy the index, warts and all, no matter what is inside it as it doesn’t really matter.

As investors pour money into Index ETFs, which by definition have to buy everything in an Index, capitalization-weighted of course, the highly priced and highly cap-weighted get more highly priced and cap-weighted regardless of their intrinsic value. It is a virtuous circle if you happen to manage ETFs and a vicious circle if you do not. As a money manager, you cannot avoid buying the ridiculously priced stocks because to fail to do so is to underperform the

ETFs to which you are being compared.

This Time is Different?

Now that the financial and the popular press has seized on this obvious fact, the resultant upwelling flood of money into ETFs essentially does nothing except to distort the values in the market even further. Professional judgement is not needed any longer. The market therefore concludes that the ETF is here to stay, and investors now have an easy, one-decision judgement to make.

One decision investing! How simple can life get? However, before we embrace the concept whole-heartedly, it might be well to inquire, ‘have we ever been there before?’ and what was the outcome? For those of us who have been around this block before, we remember Charlie Ellis’ great landmark book, Institutional Investing, which appeared in 1971. In his book, Ellis noted that if you bought the then-called Nifty Fifty growth stocks, they had (note the tense) outperformed the market for decades, and that therefore all a money manager had to do to outperform the market was to buy those stocks as the core of any and all portfolios. After that, money poured into those stocks. But can anyone guess what happened next? By the bottom of the bear market of 1973-4, the average Nifty Fifty stock was down by some 80%. Many never came back to their previous highs and those that did often took decades to do so.

Of course, we don’t have to go back that far. Just recall 1999-2000 when the internet was going to revolutionize the world and the dot-com stocks went wild. When we criticized the valuation levels of some of these stocks on BNN (then ROB-Tv), we were accused of “not understanding the 21st Century”. But it turned out that it was not the 21st Century that needed to be understood: it was market valuations and balance sheets that one needed to grasp, and after a 2-year bear market which saw the utter collapse of those stocks, suddenly value was back in vogue. Warren Buffett was not dead (as one earnest advisor assured us in the Spring of 2000) after all!

As Tversky and Kahneman discovered in their research, fear of remorse over lost opportunity gains often drives decisions. If the market goes up 10%, and you are in too much cash or too cautious, how annoyed, concerned, and bothered would you be, even though you know that the values that you would have had to be invested in were stupidly extreme – if you only make 3-4-5% instead? Being “left out” is tough to swallow. And it helps to have a willingness to suspend belief in support of the ‘the story’. We observed, for instance, that CP Rail recently had a flat quarter, and the stock is close to an all-time valuation high with no fair market value potential left? Of course, the stock jumped 4% because management assured us that ‘things will get better’. There’s a lot of story-telling without supporting evidence going around these days. It’s all bullish (no ‘T’ in the spelling!).

Plus Ça Change, Plus C’est La Même Chose?:

What Now for the Market?

Valuation extremes require investors to argue “this time is different” – and dismiss the entire history of the financial markets – because valuation extremes have always ended badly. As the saying goes, when everyone thinks alike, no one thinks. Dry powder has considerable value here, not because of the poor return it currently generates, but because of the opportunity it may afford to establish constructive and even aggressive market exposure over the completion of this cycle, at much higher prospective returns than are currently available.

In our North American Value Portfolio, ex the gold stocks which we hold for insurance purposes, the median price/book ratio for the majority of stocks is fairly close to 1.1 times, and the average forward Price/Earnings Ratio about 12 times. This is a far cry from the average price/book of the S&P 500 of more than 2½ times and an average PE of 21.3x. For the SPTSX, the numbers are 1.5 times for the price/book and 18.6x for the average PE Ratio. And we hold some cash because we suspect that sometime in the not so distant future, cash may well be king again.

We continue to hold about 10% of the fund in gold shares. We do suspect that if, as, and when markets are weak (bearish), the Fed will mount another charge to the rescue – as it has since the sudden market collapse in 1987 – and flood the land with money again. The Donald would not have it any other way!  

Will the gold stocks hold up if markets go south? Not entirely, but they will come back earlier and faster than the rest of the market because the Fed is highly likely to have a catfit if markets head south, and they will “do something” (stupid but helpful to gold investors) to head off anything too serious in the way of a decline. Are there any better hedges than golds? Not likely, except cash. The reality of markets is that in weak markets (i.e. bear markets) investors sell their garbage first (the stocks that are plunging) and then the good stocks a bit later (the ones that haven’t plunged so far) because “they didn’t go down, so I took some profits to offset my losses”. Even banks take it on the chin, albeit often not so badly, even if sometimes it feels as if they are as bad as anything else. Investors lose all perspective in bear markets and this one may be quite interesting because all those innocent folks who are investing in ETFs will find out that ETFs don’t mean a thing from a safety point of view in a bear market. Most people don’t have a clue as to what’s inside them, but as they are designed to act like the market so they will get pasted like the market and provide you with no cushion of safety at all.

Hussman concludes that, put simply, investors are in an echo chamber now, where their optimism about economic outcomes drives optimism about the stock market, and optimism about the stock market drives optimism about economic outcomes. Given the deterioration in correlations between “soft” survey-based economic measures and subsequent economic and financial outcomes, investors should be placing a premium on measures that are reliably informative. On that front, hard economic data, labor force constraints, factors influencing productivity (particularly gross domestic investment and the position of the current account balance in the economic cycle), reliable valuation measures, and market internals should be high on that list. The hard economic data tell a much different story than soft survey-based measures, and there is a risk that investors may be setting themselves up for considerable disappointment. The GDPNow projection from the Atlanta Fed for first-quarter 2017 GDP growth has dropped to a projected annualized growth rate of just 0.6%. That is a far cry from what the man on the street expects for 2017, but a number that was confirmed in the last week in April when the US GDP actually grew at a 0.7% rate, missing the +1.1% estimate handily.

 

What Now?

 

The market is expensive and risky – but what else is new in 2017? Still, the more comfortable investors become with trusting in ETFs to take all the risks out of stock selection, the more dangerous the markets become. We “know” that if markets were to weaken to any significant degree that the Fed would not be far behind in cutting what rates are left to cut and pumping money into the system. Unfortunately, that is not what the economy needs now, but it is all that t is going to get.

It would be our suspicion and expectation based on the history of the S&P 500 that a setback to its Growth Price (2 times adjusted book value) which would suggest roughly a 23% downside risk from current levels.

For an economy that’s built on the market that’s built on an economy that’s built on the market, the unwinding of this mare’s nest should be something to behold. In the meantime, whether or not “value” is the metric of the day or not – and right now, it is not – we will stick with value stocks in the expectation, no matter how forlorn at present, that good value will prove to be a better investment bed to lie on than hopes and dreams. We feel that a decent amount of cash is a sound strategy, and that given the final outcome, gold stocks will prove their worth.

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