Ron Paul: Trump's Tweets End The Myth Of Fed Independence

President Trump's recent Tweets expressing displeasure with the Federal Reserve's (minor) interest rate increases led to accusations that President Trump is undermining the Federal Reserve's independence. But, the critics ignore the fact that Federal Reserve "independence" is one of the great myths of American politics.

When it comes to intimidating the Federal Reserve, President Trump pales in comparison to President Lyndon Johnson. After the Federal Reserve increased interest rates in 1965, President Johnson summoned then-Fed Chairman William McChesney Martin to Johnson's Texas ranch where Johnson shoved him against the wall. Physically assaulting the Fed chairman is probably a greater threat to Federal Reserve independence than questioning the Fed's policies on Twitter.

While Johnson is an extreme example, history is full of cases where presidents pressured the Federal Reserve to adopt policies compatible with the presidents' agendas — and helpful to their reelection campaigns. Presidents have been pressuring the Fed since its creation. President Warren Harding called on the Fed to lower rates. Richard Nixon was caught on tape joking with then-Fed chair Arthur Burns about Fed independence. And Lloyd Bentsen, President Bill Clinton's first Treasury secretary, bragged about a "gentleman's agreement" with then-Fed Chairman Alan Greenspan.

President Trump's call for low interest rates contradicts Trump's earlier correct criticism of the Fed's low interest rate policy as harming middle-class Americans. Low rates can harm the middle class, but they also benefit spend-and-borrow politicians and their favorite special interests by lowering the federal government's borrowing costs.Significant rate increases could make it impossible for the government to service its existing debt, thus making it difficult for President Trump and Congress to continue increasing welfare and warfare spending.

President Trump will have a long-lasting impact on monetary policy. Two of the three sitting members of the Fed's board were appointed by President Trump. Two more of Trump's nominees are pending in the Senate. The nomination of economist Marvin Goodfriend may be in jeopardy because Goodfriend advocates "negative interest rates," which is a Federal Reserve-imposed tax on savings. If Goodfriend is defeated, President Trump can just nominate another candidate. President Trump will also be able to nominate two other board members. Therefore, by the end of his first term, President Trump could appoint six of the Federal Reserve's seven board members.

The specter of a Federal Reserve Board dominated by Trump appointees should cause some to rethink the wisdom of allowing a secretive central bank to exercise near-monopoly control over monetary policy. Fear of the havoc a Trumpian Fed could cause may even lead some to support the Audit the Fed legislation and the growing movement to allow Americans to "exit" the Federal Reserve System by using alternatives to fiat money, such as cryptocurrencies and gold.

Given the Federal Reserve's power to help or hinder a president's economic agenda and reelection prospects, it is no surprise that presidents try to influence Fed policy. But,instead of worrying about protecting the Fed from President Trump, we should all worry about protecting the American people from the Fed. The first step is passing the Audit the Fed bill, which Congress should do before adjourning to hit the campaign trail. This will let the people know the full truth about America's monetary policy. Auditing, then ending, the Fed is key to permanently draining the welfare-warfare swamp.

The Myths Of Stocks For The Long Run

The Problem Of Psychology


During this series so far we have primarily discussed the more mechanical issues surrounding "investing myths" over the duration of an individuals investing "life-span."

Individuals are often told:


"There has never been a 10 or 20-year period in the market with negative returns."

As showed previously, such is not exactly correct once you account for inflation.



While "buying and holding" an index will indeed create a positive return over a long enough holding period, such does not equate to achieving financial success. But even if "investing your way to wealth" worked as advertised, then why are the vast majority of Americans so poorly equipped for retirement?

Every three years, the Federal Reserve conducts a study of American finances which exposes the lack of financial wealth for the bottom 90% of households. (Read: The Bottom 90% & The Failure Of Prosperity)



Other survey's also confirm much of the same. Via Motley Fool:


"Imagine how the 50th percentile of those ages 35 – 44 has a household net worth of just $35,000 – and that figure includes everything they own, any equity in their homes, and their retirement savings to boot.

That's sad considering those ages 35 and older have had probably been out in the workforce for at least ten years at this point.

And even the 50th percentile of those ages 65+ aren't doing much better; they've got a median net worth of around $171,135, and quite possibly decades of retirement ahead of them.

How do you think that is going to work out?"

Another common misconception is that everyone MUST be saving in their 401k plans through automated contributions. According to Vanguard's recent survey, not so much.
The average account balance is $103,866 which is skewed by a small number of large accounts.
The median account balance is $26,331
From 2008 through 2017 the average inflation-adjusted gain was just 28%.

So, what happened?
Why aren't those 401k balances brimming over with wealth?
Why aren't those personal E*Trade and Schwab accounts bursting at the seams?
Why are so many people over the age of 60 still working?

While we previously covered the impact of market cycles, the importance of limiting losses, the role of starting valuations, and the proper way to think about benchmarking your portfolio, the two biggest factors which lead to chronic investor underperformance over time are:
Lack of capital to invest, and;
Psychological behaviors

Psychological factors account for fully 50% of investor shortfalls in the investing process. It is also difficult to"invest" when the majority of Americans have an inability to "save."



These factors, as shown by data from Dalbar, lead to the lag in performance between investors and the markets over all time periods.



While "buy and hold" and "dollar cost averaging" sound great in theory, the actual application is an entirely different matter. The lack of capital is an issue which can only be resolved through financial planning and budgeting, however, the simple answer is:


Live on less than you make and invest the rest.

Behavioral biases, however, are an issue which is little understood and accounted for when managing money. Dalbar defined (9) nine of the irrational investment behavioral biases specifically:
Loss Aversion – The fear of loss leads to a withdrawal of capital at the worst possible time. Also known as "panic selling."
Narrow Framing – Making decisions about on part of the portfolio without considering the effects on the total.
Anchoring – The process of remaining focused on what happened previously and not adapting to a changing market.
Mental Accounting – Separating performance of investments mentally to justify success and failure.
Lack of Diversification – Believing a portfolio is diversified when in fact it is a highly correlated pool of assets.
Herding– Following what everyone else is doing. Leads to "buy high/sell low."
Regret – Not performing a necessary action due to the regret of a previous failure.
Media Response – The media has a bias to optimism to sell products from advertisers and attract view/readership.
Optimism – Overly optimistic assumptions tend to lead to rather dramatic reversions when met with reality.

George Dvorsky once wrote that:


"The human brain is capable of 1016 processes per second, which makes it far more powerful than any computer currently in existence. But that doesn't mean our brains don't have major limitations. The lowly calculator can do math thousands of times better than we can, and our memories are often less than useless — plus, we're subject to cognitive biases, those annoying glitches in our thinking that cause us to make questionable decisions and reach erroneous conclusions."

Cognitive biases are an anathema to portfolio management as it impairs our ability to remain emotionally disconnected from our money. As history all too clearly shows, investors always do the "opposite" of what they should when it comes to investing their own money. They "buy high" as the emotion of "greed" overtakes logic and "sell low" as "fear" impairs the decision-making process.

Let's dig into the top-5 of the most insidious biases which keep us from achieving our long-term investment goals.
1) Confirmation Bias

As individuals, we tend to seek out information that conforms to our current beliefs. For instance if one believes that the stock market is going to rise, they tend to heavily rely on news and information from sources that support that position. Confirmation bias is a primary driver of the psychological investing cycle.

To confront this bias, investors must seek data and research that they may not agree with. Confirming your bias may be comforting, but challenging your bias with different points of view will potentially have two valuable outcomes.

First, it may get you to rethink some key aspects of your bias, which in turn may result in modification, or even a complete change, of your view. Or, it may actually increase the confidence level in your view.

The issue of "confirmation bias" is well known by the media. Since the media profits from "paid advertisers," viewer or readership is paramount to obtaining those clients. The largest advertisers on many financial sites are primarily Wall Street related firms promoting products or services. These entities profit from selling product they create to individuals, therefore it should be no surprise they advertise on websites that tend to reflect supportive opinions. Given the massive advertising dollars that firms such as Fidelity, J.P. Morgan (JPM), and Goldman Sachs (GS) spend, it leaves little doubt why the more successful websites refrain from presenting views which deter investors from buying related products or services.


As individuals, we want "affirmation" our current thought processes are correct. As human beings, we hate being told we are wrong, so we tend to seek out sources that tell us we are "right."

This is why it is always important to consider both sides of every debate equally, analyze the data accordingly, and form a balanced conclusion. Being right and making money are not mutually exclusive.
2) Gambler's Fallacy

The "Gambler's Fallacy" is one of the biggest issues faced by individuals when investing. As emotionally driven human beings, we tend to put a tremendous amount of weight on previous events believing that future outcomes will somehow be the same.

The bias is clearly addressed at the bottom of every piece of financial literature.


"Past performance is no guarantee of future results."

However, despite that statement being plastered everywhere in the financial universe, individuals consistently dismiss the warning and focus on past returns expecting similar results in the future.

Performance chasing has a high propensity to fail continually causing investors to jump from one late cycle strategy to the next. This is shown in the periodic table of returns below. "Hot hands" only tend to last on average 2-3 years before going "cold."



We traced out the returns of the S&P 500 and the Barclay's Aggregate Bond Index for illustrative purposes. Importantly, you should notice that whatever is at the top of the list in some years tends to fall to the bottom of the list in subsequent years. "Performance chasing" is a major detraction from an investor's long-term investment returns.

Of course, it also suggests that analyzing last year's losers, which would make you a contrarian, has often yielded higher returns in the near future.
3) Probability Neglect

When it comes to "risk taking" there are two ways to assess the potential outcome. There are "possibilities" and "probabilities." As individuals, we tend to lean toward what is possible such as playing the "lottery." The statistical probabilities of winning the lottery are astronomical, in fact, you are more likely to die on the way to purchase the ticket than actually winning it. However, it is this infinitesimal "possibility" of being fabulously wealthy that makes the lottery so successful. Las Vegas exists for one reason; amateur gamblers favor possibility over probability.


As investors, we tend to neglect the "probabilities," or specifically the statistical measure of "risk" undertaken, with any given investment. Our bias is to "chase" stocks that have already shown the biggest increase in price as it is "possible" they could move even higher. However, the "probability" is by the time the masses have come to discover the opportunity, most of the gains have likely already been garnered.

"Probability Neglect" is the very essence of the "buy high, sell low" syndrome.

Robert Rubin, former Secretary of the Treasury, once stated;


"As I think back over the years, I have been guided by four principles for decision making. First, the only certainty is that there is no certainty. Second, every decision, as a consequence, is a matter of weighing probabilities. Third, despite uncertainty, we must decide and we must act. And lastly, we need to judge decisions not only on the results, but on how they were made.

Most people are in denial about uncertainty. They assume they're lucky, and that the unpredictable can be reliably forecasted. This keeps business brisk for palm readers, psychics, and stockbrokers, but it's a terrible way to deal with uncertainty. If there are no absolutes, then all decisions become matters of judging the probability of different outcomes, and the costs and benefits of each. Then, on that basis, you can make a good decision."
4) Herd Bias


Maybe the best way to show how susceptible we are to follow the crowd is by watching this video from Candid Camera.



Though we are often unconscious of the action, humans tend to "go with the crowd." Much of this behavior relates back to "confirmation" of our decisions but also the need for acceptance. The thought process is rooted in the belief that if "everyone else" is doing something, and if I want to be accepted, then I need to do it also.

In life, "conforming" to the norm is socially accepted and in many ways expected. However, in the financial markets, the "herding" behavior is what drives markets to extremes.

As Howard Marks once stated:


"Resisting – and thereby achieving success as a contrarian – isn't easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while. (That's why it's essential to remember that 'being too far ahead of your time is indistinguishable from being wrong.'

Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it's challenging to be a lonely contrarian."

Moving against the "herd" is where the most profits are generated by investors in the long term. The difficulty for most individuals, unfortunately, is not necessarily knowing when to "bet" against the stampede but the psychologically debilitating action of being different. As they say, "it is lonely at the top."


5) Anchoring Effect

This is also known as a "relativity trap" which is the tendency to compare our current situation within the scope of our own limited experiences. For example, I would be willing to bet that you could tell me exactly what you paid for your first home and what you eventually sold it for. However, can you tell me what exactly what you paid for your first bar of soap, your first hamburger, or your first pair of shoes? Probably not.

The reason is that the purchase of the home was a major "life" event. Therefore, we attach particular significance to that event and remember it vividly. If there was a gain between the purchase and sale price of the home, it was a positive event and, therefore, we are likely to assume that the next home purchase will have a similar result. When we become mentally "anchored" to an event we tend to base our future decisions around it.

When it comes to investing we do very much the same thing. If we buy a stock and it goes up, we remember that stock and that outcome. Therefore, we become anchored to that stock. Individuals tend to "shun" stocks which lost value even though the individual simply bought and sold at the wrong times. After all, it is not "our" fault an investment lost money; it was just a bad company. Right?

This "anchoring" effect also contributes to performance chasing over time. If you made money with ABC stock but lost money on DEF, then you "anchor" on ABC and keep buying it as it rises. When the stock begins its inevitable "reversion," investors remain "anchored" on past performance until the "pain of ownership" exceeds their emotional threshold. It is then they tend to panic "sell" and now become "anchored" to a negative experience and never buy shares of ABC again. Worse, DEF, despite your past experience owning it, may present great value at reduced prices, but your previous negative experience reduces your inclination to purchase it.
Conclusion

In the end, we are just human. Despite the best of our intentions, it is nearly impossible for an individual to be devoid of the emotional biases that inevitably lead to poor investment decision making over time. This is why all great investors have strict investment disciplines that they follow to reduce the impact of human emotions.

Take a step back from the media, and Wall Street commentary, for a moment and make an honest assessment of the financial markets today. Are valuations at levels that have previously lead to higher rates of future returns? Are interest rates rising or falling? Are individuals currently assessing the "possibilities" or the "probabilities" in the markets?

As individuals, we invest our hard earned "savings" into a "speculative" environment where we are "betting" on a future outcome. The reality is the majority of individuals are ill-prepared for an impact event to occur. This is particularly the case in late-stage bull market cycles where complacency runs high.

The discussion of why "this time is not like the last time" is largely irrelevant. Whatever gains investors garner in the first-half of an investment cycle by chasing the "bullish thesis" will be almost entirely wiped out during the second-half. Of course, this is the sad history of individual investors in the financial markets as they are always "told to buy," but never "when to sell."

Technically Speaking: Valuation Measures & Forward Returns

On Tuesday night, was addressed the issue of price versus fundamentals. In the short-term, a period of one-year or less, political, fundamental, and economic data has very little influence over the market. This is especially the case in a late-stage bull market advance, such as we are currently experiencing, where the momentum chase has exceeded the grasp of the risk being undertaken by unwitting investors.

As shown in the chart below, the longer-term price trend of the market remains clearly bullish. However, despite commentary on valuations, sentiment, economics, or politics, the PRICE of the market suggests a weakening trend in investor confidence at current levels. That weakness has also instigated a short-term "sell signal" which suggests prices may struggle more in the days ahead. One thing we need to pay attention to is a potential break of the bullish trend line running along the 50-day moving average. Such a break would likely coincide with a correction back to 2330 in the short term.



Alternatively, if the market can reverse the current course of weakness and rally above recent highs, it will confirm the bull market is alive and well, and we will continue to look for a push to our next target of 2500.

With portfolios currently fully allocated, we are simply monitoring risk and looking for opportunities to invest "new capital" into markets with a measured risk/reward ratio.

However, this is a very short-term outlook which is why "price is the only thing that matters."


Price measures the current "psychology" of the "herd" and is the clearest representation of the behavioral dynamics of the living organism we call "the market."

But in the long-term, fundamentals are the only thing that matters. I have shown you the following chart many times before. Which is simply a comparison of 20-year forward total real returns from every previous P/E ratio.



I know, I know.


"P/E's don't matter anymore because of Central Bank interventions, accounting gimmicks, share buybacks, etc."

Okay, let's play.

In the following series of charts, I am using forward 10-year returns just for consistency as some of the data sets utilized don't yet have enough history to show 20-years of forward returns.

The purpose here is simple. Based on a variety of measures, is the valuation/return ratio still valid, OR, is this time really different?

Let's see.

Tobin's Q-ratio measures the market value of a company's assets divided by its replacement costs. The higher the ratio, the higher the cost resulting in lower returns going forward.



Just as a comparison, I have added Shiller's CAPE-10. Not surprisingly the two measures not only have an extremely high correlation, but the return outcome remains the same.



One of the arguments has been that higher valuations are okay because interest rates are so low. Okay, let's take the smoothed P/E ratio (CAPE-10 above) and compare it to the 10-year average of interest rates going back to 1900.



The analysis that low rates justify higher valuations clearly does not withstand the test of history.

But earnings can be manipulated, so let's look at "sales" or "revenue" which occurs at the top-line of the income statement. Not surprisingly, the higher the level of price-to-sales, the lower the forward returns have been. You may also want to notice the current price-to-sales is pushing the highest level in history as well.



Corporate return on equity (ROE) sends the same message.



Even Warren Buffett's favorite indicator, market cap to GDP, clearly suggests that investments made today, will have a rather lackluster return over the next decade.



If we invert the P/E ratio, and look at earnings/price, or more commonly known as the "earnings yield," the message remains the same.



No matter, how many valuation measures I use, the message remains the same. From current valuation levels, the expected rate of return for investors over the next decade will be low.

There is a large community of individuals which suggest differently as they make a case as to why this "bull market" can continue for years longer. Unfortunately, any measure of valuation simply does not support that claim.

But let me be clear, I am not suggesting the next "financial crisis" is upon us either. I am simply suggesting that based on a variety of measures, forward returns will be relatively low as compared to what has been witnessed over the last eight years. This is particularly the case as the Fed, and Central Banks globally, begin to extract themselves from the cycle of interventions.

This does not mean that markets will just produce single-digit rates of return each year for the next decade. The reality is there will be some great years to be invested over that period, unfortunately, like in the past, the bulk of those years will be spent making up the losses from the coming recession and market correction.

That is the nature of investing in the markets. There will be fantastic bull market runs as we have witnessed over the last 8-years, but in order for you to experience the up, you will have to deal with the eventual down. It is just part of the full-market cycles that make up every economic and business cycle.

Despite the hopes of many, the cycles of the market, and the economy, have not been repealed. They can surely be delayed and extended by artificial interventions, but they can not be stalled indefinitely.

No. "This time is not different," and in the end, many investors will once again be reminded of this simple fact:


"The price you pay today for any investment determines the value you will receive tomorrow."

Unfortunately, those reminders tend to come in the most brutal of manners.

"What We've Seen Is Unprecedented": "Mysterious" New Whale Emerges In The Market | Zero Hedge

A reader who works for a market-making group in the Eurodollar options writes in to describe a new ED market entrant and notes that "what we have seen over the past 3 months is unprecedented."

WHAT: A mysterious customer has been trading downside put-spread ratios, where they are selling the extra put units. They have done this to the point where they are short MILLIONS of put units in long-dated options. Goldman Sachs has even started taking the other side of the trade for size, but they continue to push it their way (how much capital can they possibly have). Is this why rate vol has collapsed to near record levels?

Consensus estimate among local Chicago trading groups is that this customer is short approx 3 million puts, amounting to 1 million straddles in volatility risk. The capital requirement for this position is estimated to be $1 billion. They continue to add every trading day.

EFFECTS: "It has pushed skew and put volatility well beyond all time lows (see below for recent analysis by a Eurodollar broker)."

POSSIBILITIES: "The trader must have access to huge amounts of capital to sustain such a large position. If interest rates were to rise in any volatility-inducing manner (rise quickly - aka futures breaking), this player could be on the hook for HUGE money. We believe if 2-3 year interest rates rose 1.5-2%, this player would have losses in the billions, and capital requirements would skyrocket."

Some have ventured a guess that PIMCO is the mysterious customer?

* * *

And here is a detailed trade analysis courtesy of x-fa's John Hayden.

This is the PnL Heatmap of the EDZ0 55/60 PS1x4 (+4Leg) at a purchase price of 0 Ticks. The time step is set at 30 Days and you will see the Fut Price on the vertical. Additionally the Volatility is set to Roll Forward so as we move forward in time the Vol Surface is reduced along the same path as the current Atm Vol Term Structure. For comparison, the following is the same heatmap with Vol set to Static (Fixed)

This trade really boils down to where 5-10 Delta long dated Put Skew is priced. And friends it is CHEAP. It is so cheap that it gives me great pause as to why someone would buy 1/sell 4 at these levels in this size. I have no idea. The following shows how cheap this vol is. Here are 5 year charts of the 5% Put, 10% Put, and ATM Vols.

Not only is the Put side on its all time lows – but the Risk Reversal is on it all time lows as well (Puts cheap).

The heat map says it all. The owner of 4 legs at Even literally has no risk … unless vol comes in. Here is the Static
Heatmap with Atm Vol run at the low (52%) (Which puts the Put area well below levels we have ever seen.)

As you can see there is very little change to the worst case scenario a year out. In other words its hard to lose when you own something for nothing.

You can imagine how ugly this trade could get for the seller of 4 legs if Vols peak and the Risk Reversal flips back to Puts.

In closing this trade is good for many reasons. It also gives the owner of 4 Legs a nice back stop to trade against if vols gravitate higher – and at very little risk.

I have saved the best for last … Here is the 5Y LookALike lookback on the 1by4 (+4Leg). It is hard to believe…

Here's How Systems (And Nations) Fail

These embedded processes strip away autonomy, equating compliance with effectiveness even as the processes become increasingly counter-productive and wasteful.

Would any sane person choose America's broken healthcare system over a cheaper, more effective alternative? Let's see: the current system costs twice as much per person as the healthcare systems of our developed-world competitors, a medication to treat infantile spasms costs $8 per vial in Europe and $38,892 in the U.S., and by any broad measure, the health of the U.S. populace is declining.

This is how systems and nations fail: nobody chose the current broken system, but now it can't be changed because the incentive structure locks in embedded processes that enrich self-serving insiders at the expense of the system, nation and its populace.

Nobody chose America's insane healthcare system--it arose from a set of initial conditions that generated perverse incentives to do more of what's failing and protect the processes that benefit insiders at the expense of everyone else.

In other words, the system that was intended to benefit all ends up benefitting the few at the expense of the many.

The same question can be asked of America's broken higher education system:would any sane person choose a system that enriches insiders by indenturing students via massive student loans (i.e. forcing them to become debt serfs)?

Students and their parents certainly wouldn't choose the current broken system, but the lenders reaping billions of dollars in profits would choose to keep it, and so would the under-assistant deans earning a cool $200K+ for "administering" some embedded process that has effectively nothing to do with actual learning.

The academic ronin a.k.a. adjuncts earning $35,000 a year (with little in the way of benefits or security) for doing much of the actual teaching wouldn't choose the current broken system, either.

Now that the embedded processes are generating profits and wages, everyone benefitting from these processes will fight to the death to retain and expand them, even if they threaten the system with financial collapse and harm the people who the system was intended to serve.

How many student loan lenders and assistant deans resign in disgust at the parasitic system that higher education has become? The number of insiders who refuse to participate any longer is signal noise, while the number who plod along, either denying their complicity in a parasitic system of debt servitude and largely worthless diplomas (i.e. the system is failing the students it is supposedly educating at enormous expense) or rationalizing it is legion.

If I was raking in $200,000 annually from a system I knew was parasitic and counter-productive, I would find reasons to keep my head down and just "do my job," too.

At some point, the embedded processes become so odious and burdensome that those actually providing the services start bailing out of the broken system. We're seeing this in the number of doctors and nurses who retire early or simply quit to do something less stressful and more rewarding.

These embedded processes strip away autonomy, equating compliance with effectiveness even as the processes become increasingly counter-productive and wasteful. The typical mortgage documents package is now a half-inch thick, a stack of legal disclaimers and stipulations that no home buyer actually understands (unless they happen to be a real estate attorney).

How much value is actually added by these ever-expanding embedded processes?

By the time the teacher, professor or doctor complies with the curriculum / "standards of care", there's little room left for actually doing their job. But behind the scenes, armies of well-paid administrators will fight to the death to keep the processes as they are, no matter how destructive to the system as a whole.

This is how systems and the nations that depend on them fail. 

Meds skyrocket in price...

...student loans top $1 trillion...

F-35 fighter aircraft are double the initial cost estimates and so on, and the insider solutions are always the same: just borrow another trillion to keep the broken system afloat for another year.

All The Makings Of A Major Economic Fiasco

Mud Wrestling: Trump vs. Xi

About 6,940 miles west of Washington DC, and at roughly the same latitude, sits Beijing.  Within China's massive capital city, sits the country's paramount leader, Xi Jinping.  According to Forbes, Xi is currently the most powerful and influential person in the world.

Papa Xi, the new emperor of China. [PT]

Xi, no doubt, is one savvy fellow.  He always knows the right things to say.  He offers the citizens of his nation the "Chinese Dream."  They consume it like boysenberry funnel cakes at the county fair.

So, too, Xi always knows the right things to do.  He elaborates his vision for securing world dominance through something called the Belt and Road Initiative.  His people get behind it without question. But all is not bliss for Xi…

After decades of hard work, dedication, and loyalty to the Communist Party of China, Xi finally rose to the top of the trash heap in 2016.  That's when the party gave him the elite title of core leader.  What a disappointment it must have been to first look out across the geopolitical landscape and see a boorish New York blowhard like President Trump snarling back at him.

Upper left: explaining the Chinese Dream; lower left and middle: one belt, one road; right: hitting the snooze button on China's 2023 leadership change.

What could be a more ignoble fate for an anointed leader from a culture with a zealous emphasis on the abstract concept of "saving face," than having to get twisted up with Trump?

Trump, without question, is a guy that likes to tuck in his shirt, fluff up his hair, and put on a coat and tie, before stepping out to the back alley with his opponent to roll around in the mud.  Xi, on the other hand, is more of a "let's settle it at the poker table" type of guy.

Naturally, it is Trump's bad manners, and the popular delusion of MAGA, that provokes the unwavering support of Trumpians.  However, Xi, in order to save face, must get muddy with Trump. And the trade war provides the perfect opportunity to do so.

Get ready for some mud-wrestling, ye purveyor of waving pussies. [PT]

We'll have more on this in just a moment.  But first a brief diversion – and a scratch for instruction..

How Government Benevolence Works

In 1850, French economist Frédéric Bastiat penned the clear, concise, essay titled, "That Which is Seen, and That Which is Not Seen."  Therein, Bastiat, through the parable of the broken window, traces the effects and unintended consequences that result from government intervention in the economy.  Bastiat shows how certain effects of a new law or policy are immediate and easily observable, and how other effects unfold in succession—they are not immediately seen.

Famous French economist Frédéric Bastiat, who among other things acquainted the world with the concept of the broken window fallacy, explained the blessings of free trade and warned of the depredations of government. It seems the lessons he taught – as appealing as they are to common sense and logic – have to be relearned every few generations, usually the hard way. [PT]

The misplaced belief in government benevolence, via forced philanthropy, and the failure to recognize the true magnitude of its consequences is alive and well in today's world.  Rent controls, for instance, often cause a shortage of new development.  This shortage, in turn, aggravates the need for low income housing… which was the purpose of rent control in the first place.

Local governments then offer the boneheaded solution of mandating low income units in new developments.  However, this discourages developers from investing in new projects, which further exacerbates the need for low income housing.  After years of these solutions, affordable housing is scarce and the streets are crawling with homeless people.

Have you been to Santa Monica or San Francisco lately?  The consequences of the many solutions to the affordable housing problem have resulted in sidewalks covered in human waste. San Francisco's solution to their human waste problem includes the addition of 18 staffed public restrooms, known as pit stops, since 2014.  From what we gather, there are plans to add five more.

One enterprising software engineer even plotted the precise locations of human turds on a San Francisco city map.  This, indeed, is a handy tool for city residents and visitors.  It's also a poignant illustration of the literal mess that government solutions make of things. Can you appreciate the insanity?

The growing problem of homelessness in San Francisco – incidentally the city with the highest home prices in the US. Here is your opportunity to marvel at a government boondoggle of truly epic proportions. [PT]

All the Makings of a Major Economic Fiasco

At the national and international level, governments also propose solutions to address the consequences of previous solutions.  Government solutions, in other words, compel more government solutions – and more problems.  This week, for example, President Trump unveiled a novel solution to a consequence of his trade tariff policies.  Zero Hedge offers the particulars:

"Facing the brunt of President Trump's trade war with China, which threatens some $34 billion of US products and agriculture with duties, the White House has announced a $12 billion 'short-term' stimulus plan to help US farmers hurt by China's 'illegal' retaliatory tariffs. The package, as expected, will consist of direct payments, food purchases and trade development – under a program already authorized under the Commodity Credit Corp act, which means Congressional approval is not required.  Further details on the program will come by Labor Day, according to USDA Secretary Sonny Perdue and top officials."

Yet many farmers don't want Trump's solution.  They don't want to be put on welfare.  They know that nothing saps a man's industry and ingenuity like getting things for free at the expense of others.

Left: good question; middle: easy wins; right: Trump-farm detected. [PT]

Remember, these trade tariff policies are a solution to the perceived trade deficit problem.  Of course, the massive trade deficit is a consequence of fiat money, and the unlimited issuance of debt that fiat money allows. Fiat money is the government's solution to the rigor and discipline of a gold standard.  With each iteration of solutions to solutions, the effects, which are not immediately seen, become greater.

Economic stimulus explained: it is a bit like pumping water from the deep to the shallow end of the pool, using an extremely leaky hose. [PT]

Here in the USA, Trump pushes trade tariffs and then combats their ill-effects with farm subsidies.  Over in Beijing, Xi has a trick or two up his sleeve too. While China will run out of U.S. imports to impose tariffs on long before the U.S. runs out of Chinese imports to put tariffs on, Xi has a soft spot for the solution of all enterprising statists: currency devaluation

Since April, the yuan has fallen by almost 8 percent against the dollar.  Is this merely a coincidence?  Or is it Xi's solution to Trump's trade war?

USD-CNY, daily: say hello to Xi's solution to US tariffs. [PT]

Certainly, the answers will be revealed in good time.  Regardless, Trump's and Xi's solutions, which include mud wrestling between friends, promise to deliver all the makings of a major economic fiasco.

JPMorgan: QE Might Have Devastating Consequences After All | Zero Hedge

As I have been tolding  for a long time:

QE Might Have Devastating Consequences After All

Approximately 9 years after various "tin-foil" wearing blogs first warned that the long-run negative consequences of QE will drown out and vastly outnumber any positive ones (which have mostly been confined to make the rich richer and create the illusion of economic stability built on the cracking foundations of trillions in newly created dollars), none other than JPMorgan today admits that QE may, indeed, have some devastating financial, economic and political consequences. And by some, we mean a lot.

What prompted this exciting moment of monetary introspection?

According to JPM's Nick Panigirtzoglou, it was last week's report that the BoJ has expressed concerns over negative side effects of its QE current policies (especially keeping the 10Y yield fixed around 0%), and which resulted in a sharp, if brief, global bond steepening which demonstrated once  again just how dominant central bank monetization policies are in determining the long-end of the curve.

And, as the market demonstrated, a hawkish policy shift and a subsequent reduction in duration absorption by the BoJ would intensify the quantitative tightening already in place by the Fed and the ECB, and according to JPM represents "a significant tail risk that has generated intense debate among our clients."

So what are these possible 'devastating' side-side effects from unorthodox BoJ - and other central bank - policies?

Here is a list of the key negative consequences arising from QE, from JPMorgan:

1. Results in Asset Bubbles and a Collapse in CapEx: Even as QE has likely exerted downward pressure on bond yields, the significant increase in central banks' balance sheets makes an exit potentially more difficult, and raises the risk of a policy error or of an increase in perceptions about debt monetization. It potentially creates asset bubbles by lowering asset yields relative to historical norms, that an eventual return to normality could be accompanied by sharp price declines. Perceptions about asset bubbles can thus also increase long term uncertainty. In turn higher uncertainty might prevent economic agents such as businesses from spending, i.e. the collapse in CapEx observed over the past decade as company used cheap debt to purchase their own, making management teams richer.

2. Creates Zombie Companies and Crushes Productivity. Low credit spreads and corporate bond yields are an intended consequence of QE but not without distortions. By allowing unproductive and inefficient companies to survive, helped by low debt servicing costs, QE could potentially hinder the creative destruction taking place during a normal economic cycle. In principle, QE could thus make economies less efficient or productive over time. Which should answer the long-running debate over the chronic lack of economic productivity in the new normal. The debate about so called "zombie" companies has been particularly intense in Japan given the low business turnover rate. According to OECD, Japan's business startup and closure rate is about 5%, roughly a third of that in other advanced economies with several commentators blaming the BoJ's ultra-accommodative policies for this problem.

3. Low Rates crush savers, make the rich richer. One of the most visible impacts of QE has been the decline in discount rates, which in turn has created wealth effects via supporting asset prices. However, an argument could be made that these wealth effects are not evenly distributed, and that low discount rates mean savers suffer from an erosion of income.

4. Exacerbates currency wars. QE could exacerbate so called "currency wars". The value of the Japanese yen collapsed after Abenomics started in November 2012 and has stayed at historical lows since then helped by BoJ's ultra accommodative monetary policy. This is shown in Figure 5 by the real trade weighted index of the Japanese yen. Japan's main competitors across EM and DM have been feeling the pressure from this depreciation, though it is not clear that the depreciation necessarily means the yen is undervalued.

5. NIRP hurts the economy, and chokes off credit supply. Beyond a certain threshold, negative interest rates can have unintended consequences such as lower bank profitability, higher bank lending rates, reduced credit creation to the real economy, impaired functioning of money markets and reduced liquidity in bond markets. And there is a good reason to believe that the threshold below which negative rates start having unintended consequences is higher in Japan than in Europe, not least because of the lower interest margins Japanese banks operate with... Deeply negative policy rates had taken their toll on Danish and Swiss banks' net interest income (Figure 6). Net interest income as % of assets declined in 2015 for both Danish and Swiss banks following the introduction of very negative policy rates in these countries in January 2015.

6. Chokes Repo markets due to collateral shortages. It is not only commercial banks that are hurt as a result of QE. Reduced liquidity in money and repo markets is another side effect. UST collateral shortages have hampered US repo markets. The BoJ and the ECB inflicted similar damage to European and Japanese repo markets as government collateral was withdrawn at an even stronger pace. An argument could be made that the damage to trading turnover and liquidity is likely to have been even bigger with the BoJ's and ECB's QE relative to the Fed's QE, because the BoJ and the ECB went even further than the Fed by lowering its policy rate to negative territory. Negative yields can hamper trading volumes and liquidity as money market participants are less willing to trade at negative yields.

7. Cripples pension funds by increasing funding deficits. Lower bond yields increase pension fund and insurance company deficits putting pressure on pension funds to match assets and liabilities. This pressure to move further away from equities and other high risk assets into fixed income is even stronger in countries like Japan where demographic pressures are more intense. For example, old age dependency ratios, i.e. the proportion of the population aged 65 years and over as a percentage of the population aged 15-64 years, have been rising steadily, with Japan aging more rapidly than the US or Europe (Figure 1). Generally, an aging population means that allocations are likely to shift towards relatively safer instruments as the ability to withstand larger drawdowns on capital diminishes as individuals age.

What is striking in Japan is that in contrast to GPIF, which shifted towards equities post Abenomics most likely under political pressure, private Japanese pension funds did the opposite shifting even more towards bonds (Figure 3).

8. QE Forces consumers to save even more. The yield-to-worst on the Bloomberg Global Agg Yen denominated bond index currently stands at close to 0.15%, around one-sixth of its average in the expansion preceding the financial crisis. In addition to the effect of deleveraging after the financial crisis and the Euro area sovereign crisis, QE has played a role in pushing down on long-term yields. Particularly the QE programs of the BoJ and ECB which have seen net issuance of government bonds outside of the public sector balance sheet turn negative, not just in their domestic economies but for the G4 on aggregate (Figure 4).

These low yields in turn depress the income that investors receive from bonds, inducing them to save even more, in the process making a mockery of the key "widely accepted" economist axiom behind QE.

9. The rise of populism and extreme political frictions. A longer-term tail risk created by QE is the potential for political frictions, which could escalate in the future especially once QE becomes a negative carry trade for
central banks, i.e. when the interest on excess reserves starts rising above the yield they receive on their bond
holdings.

JPMorgan's punchline:

These political issues could become a big problem in Japan if in the future Abenomics, including BoJ's ultra-accommodative policies, are perceived as a failed experiment that brought limited benefits to the Japanese economy and society.

Now if readers expand what JPM said about the failure of QE in Japan, they may be reminded of the piece "An Orgy of Blood" by the UK's Clarmond Wealth, whose conclusion we repost below because with every passing day, the world it previews gets closer:

When historians look back and see the cavalier balance sheets of the central banks they would rightly assume there was a world war going on as every central bank balance sheet is now approaching or exceeding levels not seen since 1945. However, the worrying truth is that there are no external enemies to overcome; the central bankers are only maintaining the growth trajectory that we demand.   

The age of sloganeers

The current social contract is mired in the quicksand of global finance. It is being kept alive by the corpulent balance sheets of central banks, who do their government's bidding so that the politicians do not have to put unpleasant choices in front of their electorates. This cowardly behaviour gives rise to slogans and sloganeers, who provide familiar but false checklists of remedies. "Take bank control"…"America First"…"One Belt, One Road"…"Ein Volk, ein Reich, ein Fuhrer"…"One Man - One Kill". Central banks are currently furnishing the excess credit that, in the past, has been followed by an orgy of blood.

From "Peaceful Indexers" To "Panicked Sellers" - The Problem With 'Passive'

The Problem With Passive

Passive strategies, which are widely popular with individual investors, are often based on Nobel Prize winning portfolio theories about efficient markets and embraced by the banks and brokers that profit from selling the strategies. They are often marketed as "all-weather" strategies to help you meet your financial goals.

To be blunt – there is no such thing as an all-weather passive strategy, no matter the IQ of the person who created it. As we have repeated throughout this series, buy and hold/passive strategies are only as good as your luck. If valuations are cheap when you start passively investing, then you have a decent shot at meeting your financial goals. If, on the other hand, valuations are extreme and rich, you are likely to endure a multi-year period of low to even negative returns which would leave you halfway to retirement without much progress towards that goal.

That is not a hypothetical statement. It is simply a function of math.

Howard Marks, via Oaktree Capital Management, and arguably one of the most insightful thinkers on Wall Street penned a piece discussing the risk to investors.

"Today's financial market conditions are easily summed up:  There's a global glut of liquidity, minimal interest in traditional investments, little apparent concern about risk, and skimpy prospective returns everywhere. Thus, as the price for accessing returns that are potentially adequate (but lower than those promised in the past), investors are readily accepting significant risk in the form of heightened leverage, untested derivatives and weak deal structures.  The current cycle isn't unusual in its form, only its extent. There's little mystery about the ultimate outcome, in my opinion, but at this point in the cycle it's the optimists who look best."

Unfortunately, that was also a repeat of a passage he wrote in February 2007. In other words, while things may seemingly be different this time around, they are most assuredly the same.

This brings us to the "Rule of 20." The rule is simply inflation plus valuation should be "no more than 20." Interestingly, while the rule is pushing the 3rd highest level in history, only behind 1929 and 2000, such levels suggest the market is more than "fully priced." Regardless of what definition you choose to use, the math suggests forward 10-year returns will be substantially lower than the last.

In a market where momentum is driving an ever smaller group of participants, fundamentals become displaced by emotional biases. As David Einhorn once stated:

"The bulls explain that traditional valuation metrics no longer apply to certain stocks. The longs are confident that everyone else who holds these stocks understands the dynamic and won't sell either. With holders reluctant to sell, the stocks can only go up – seemingly to infinity and beyond. We have seen this before.

There was no catalyst that we know of that burst the dot-com bubble in March 2000, and we don't have a particular catalyst in mind here. That said, the top will be the top, and it's hard to predict when it will happen."

Such is the nature of market cycles.

Missing The Target

The trouble with passive investing is best exemplified by the greatly flawed concept of Target Date Funds (TDF). TDF's are mutual funds that determine asset allocation and particular investments based solely on a target date. These funds are very popular offerings in 401k and other retirement plans as well as in 529 College Savings Plans.

When TDFs are newly formed with plenty of time until the target date, they allocate assets heavily towards the equity markets. As time progresses they gradually reallocate towards government bonds and other highly-rated fixed income products.

The following pie charts below show how Vanguard's TDF allocations shift based on the amount of time remaining until the target date.

The logic backing these funds and others like it are based on two assumptions:

1. You can afford to take more risk when your investment horizon is long and you should reduce risk when it is short.

2. Stocks always provide a higher expected return and more potential risk than bonds.

Let's address each assumption.

With regard to the premise of #1 about age and the propensity to take risks, we agree that an investor looking to withdraw money from their portfolio in the next year or two should be more conservative than one with a longer time horizon. The problem with that statement resides in our thoughts for #2 – there is no such thing as a steady state of expected risk and returns. The truth of the matter is that expected returns for stocks and bonds vary widely over time.

When an asset's valuation is low, ergo asset prices are cheap, the potential downside is cushioned while the upside is greater than average. Conversely, high valuations leave one with limited upside and more risk. This concept is akin to the popular real-estate advice about buying the cheapest house on the block and avoiding the most expensive. Investment risk is not a sophisticated calculation, it is simply the probability of losing money.

To demonstrate, the chart below plots average annualized five-year returns (expected returns), annualized maximum drawdowns (risk potential) and the odds of witnessing a 20% or greater drawdown for various intervals of valuations.

The graph shows, in no uncertain terms, that risks are lower and the potential returns are higher when CAPE is low and vice versa when valuations are high. Based on this historical evidence, we question how an investor can determine asset allocation based on a target date and the assumption that the expected risk and return do not fluctuate.

Currently, CAPE is at 32 which, based on historical data, implies flat to negative expected returns and almost guarantees there will be at least a 20% drawdown over the next five years. Granted, there is not a robust sample size because valuations have rarely been this high. However, given this poor risk/return tradeoff, why should a 2040 TDF invest heavily in stocks? Might bonds, commodities, other assets or even cash, have a higher expected return with less risk? Alternatively, during periods when stock valuations are well below normal and the risks are less onerous, why shouldn't even the most conservative of investors have an increased allocation to stocks?

To point out the flaws of TDF's the article is largely based on stock valuations and their expected risk and return. We do not want to convey the thought that investing is binary (i.e. one can only own stocks or bonds) as there are many ways to gains exposure to a variety of asset classes. Active management takes this into consideration before allocating assets. Active managers may largely avoid stocks and bonds at times, for the comfort of cash or another asset that offers rewarding returns with limited risk.

Simply, the goal of an active portfolio manager is to invest based on probabilities.

Math always wins.

You Aren't Passive

At some point, a reversion process will take hold. It is then investor "psychology" will collide with "leverage" and the problems associated with market liquidity. It will be the equivalent of striking a match, lighting a stick of dynamite and throwing it into a tanker full of gasoline.

When the "herding" into "passive indexing strategies" begins to reverse, it will not be a slow and methodical process but rather a stampede with little regard to price, valuation or fundamental measures.

Importantly, as prices decline it will trigger margin calls which will induce more indiscriminate selling. The forced redemption cycle will cause large spreads between the current bid and ask pricing for passive funds. As investors are forced to dump positions to meet margin calls, the lack of buyers will form a vacuum causing rapid price declines which leave investors helpless on the sidelines watching years of capital appreciation vanish in moments.

Don't believe me? It happened in 2008 as the "Lehman Moment" left investors helpless watching the crash.

Over a 3-week span, investors lost 29% of their capital and 44% over the entire 3-month period. This is what happens during a margin liquidation event. It is fast, furious, and without remorse.

Currently, with investor complacency and equity allocations near record levels, no one sees a severe market retracement as a possibility. But maybe that should be warning enough.

If you are paying an investment advisor to index your portfolio with a "buy and hold" strategy, then "yes" you should absolutely opt for buying a portfolio of low-cost ETF's and improve your performance by the delta of the fees. But you are paying for what you will get, both now, and in the future.

However, the real goal of investing is not to "beat an index" on the way up, but rather to protect capital on the "way down." Regardless of "hope" otherwise, every market has two cycles. It is during the second half of the cycle that capital destruction leads to poor investment decision making, emotionally based financial mistakes, and the destruction of financial goals.

No matter how committed you believe you are to a "buy and hold" investment strategy – there is a point during every decline where "passive indexers" become "panicked sellers."

The only question is how big of a loss will you take before you get there?