How to Blow $12.2 Billion in No Time Flat

Fake Responses 

What kind of stock market purge is this? Over the last 30 days the stock market's offered plenty of fake responses. Yet we're still waiting for a clear answer.

As the party continues, the dance moves of the revelers are becoming ever more ominous. Are they still right in the head? Perhaps a little trepanation is called for to relieve those brain tensions a bit? 

The stock market, like the President, knows the art of ballyhoo. Day after day, stocks behave in shocking and unpredictable ways. They bluster and then recoil with the inconsistent elegance of a President Trump twitter tirade.

Wild multi-hundred-point swings on the Dow Jones Industrial Average (DJIA) have become the norm. Up 300 points one day. Down 300 points the next. Do you hear anything? All we hear from the stock market is a giant racket. There's much noise being made. But there's nothing of substance behind it.

Certainly, after a nine year bull market there's risk of a massive sell off. That much is abundantly clear. Perhaps it could be another 50 percent bloodbath like what happened in 2008-09. But when will the next great panic hit?

Is all this volatility of late coinciding with the actual market top? At this point, the verdict is still out. Remember, market tops are unknown until well after they pass. Market tops are also a process; not a single event. What to make of it?

Just in case you were wondering about the cure proposed above – it has been known for about 5,000 years and reportedly cures almost everything. It drives out demons, fixes chronic migraines, and according to its modern-day practitioners "increases brain blood volume", which "gives you back the energy you had as a child" and provides you with a "permanent high" to boot. We just wanted to make a little joke, but after looking into the issue more closely, we found out that the above depicted Bart Huges actually triggered a kind of mini-mass psychosis after his auto-trepanation and writing a bizarre manuscript entitled Homo Sapiens Correctus while in prison (he avers he was in jail for "experimental reasons"). A bunch of people who otherwise come across as quite normal (if slightly eccentric) decided to mimic him and drilled holes into their heads as well. The depth of their delusion is nothing short of astonishing – buying stocks at a CAPE of 33 is probably quite rational by comparison (here is a video for those who have the stomach for it; at first it is funny, but on second thought it is sad). [PT]

Two Short-Term Data Points

Any old halfwit can venture an endless supply of guesses as to why the market is doomed for a massive panic attack. What follows is a running list:

Rising interest rates. Diminishing liquidity. A new Fed Chairman. Quantitative tightening. Rate hikes. Trump trade tariffs and a new trade war. A new fighting war. The 115th U.S. Congress. Kim Kardashian. Extreme valuations. A market that is overripe for rot. An economy that may be weaker than advertised. Inflation. Deflation. And much, much more!

Here is one of the problems: short term rates are going up sharply. LIBOR in particular reflects that European banks are scrambling to obtain dollar funding – as a result, their US subsidiaries are not expanding credit, which has a sizable effect on the overall creation of inflationary credit and deposit money in the US. There is a certain irony in the fact that this time, European banks may actually trigger the bursting of the bubble by reining in the creation of fiduciary media. [PT]

You name it. Any one of these prospects sound like a valid reason for an imminent market crash. Make of them what you will. Here at the Economic Prism we like to keep things real simple. Hence, we'll offer two other short-term data points to be on the lookout for…

The DJIA hit an all-time high on January 26 of 26,616. Then, after an explosive decline, the DJIA hit an interim bottom of 23,360 on February 9. Since then, the DJIA has bounced around within this range, fluctuating wildly on a day-to-day basis.

What is important to watch for is if the DJIA first breaks out above the January 26 high or if it first drops below the February 9 interim low. Should the market first drop below the February 9 interim low, it could continue down for another step or two lower. Moreover, it increases the likelihood that the bull market's days are numbered.

The Dow Jones Industrial Average, the S&P 500 and the Nasdaq are getting all the press – but broad-based indexes like the NYA are probably a better reflection of how the average domestically focused portfolio of equities is performing. Since the rebound has in the meantime begun to take an a-b-c shape, one would be inclined to expect a push above the last interim high – mainly because such chart formations very often develop strong symmetry/ self-similarity between their individual legs; there is no "rational" explanation for this tendency, it is merely an empirical observation. The question is though: does this look bullish? Not really, at this juncture. Admittedly that could easily change, since the all time high is not very far away. Volume is declining as the rebounds continues, and the strong initial sell-off has all the hallmarks of a "kick-off" move. 

One Fight Too Many

Over the last nine years those who followed the mantra 'buy the dip' were rewarded for their mindless optimism. However, at some point one of these dips will not be the dip to buy. Rather, the subsequent bounce will be the bounce to sell.

The stock market has a way of humbling even the most successful investors. A body of work built up over decades can be rapidly wrecked by a bear market. Sometimes there's no coming back.

Boxing champions always seem to hang around for one fight too many. Time has a way of sneaking up on even the greatest fighters without them knowing it – or being willing to recognize it. Money and glory often cloud their decisions.

Some champion boxers lose their desire. Some lose their physical edge. Some lose both at the precise moment they're in the ring, functioning as a human punching bag. Muhammad Ali should have passed on his 1980 fight with Larry Holmes.

Larry Holmes (left) pummels his much older rival Muhammad Ali. Watching this sorry excuse for a fight in hindsight, one suspects Ali was already suffering from Parkinson's disease. If it wasn't that, he was seriously damaged from his previous fights (by the time this fight took place, he had allegedly taken a total of 200,000 hits in the course of his career). Sylvester Stallone watched the fight and remarked that "it was like watching an autopsy on a man who is still alive". It was the first time Ali lost in a fight that was stopped by the referee, also known as a "technical knock-out". The last round is pitiful to watch.

Photo credit: John Iacono

He was near 40-years-old. He'd taken a lot of punches. He'd lost his edge. But he fought anyway. He needed the money. Boxing writer Richie Giachetti called it "…the worst sports event I ever had to cover."

Ali should have quit while he was ahead. Now may be a good time for investors to quit while they're ahead too. Otherwise, they could be setting themselves up for something ugly…

Achieving the Impossible

Bill Miller knew he was smarter than the stock market. He knew this not because he believed it was so. He knew he was smarter than the stock market because he had the track record – data – to prove it.

As fund manager of the Legg Mason Value Trust fund, Miller outsmarted the stock market for 15 consecutive years. From 1991 to 2005, Miller beat the stock market every year. No other fund manager we know of matched this near impossible achievement. Was it innate intelligence? Was it luck? Did he guess the correct coin flip 15 times in a row?

Most likely it was a combination of hard work, shrewd acumen, an attuned gut, and dumb luck. Indeed, Miller could do no wrong.

On New Year's Day 2006, Miller should've hung it up. He had nothing to prove. He should have quit while he was ahead, and taken to wood whittling or restoring old cars. Like an aging boxing champ, Miller had lost his edge. He just didn't know it yet. The market had changed. He hadn't. In short, he had become a disaster waiting to happen.

How to Blow $12.2 Billion in No Time Flat

When the stock market peaked out in mid-2007, in the early days leading up to the 2008-09 crash, Miller knew exactly what to do. Like now, it was unclear in the fall of 2007 if the moderate decline that had occurred was merely the market coiling for the next spring upward or if it was rolling over for a more advanced decline.

A real-life test of the Martingale strategy. In Casinos users of this strategy usually either fail because their bankroll is eventually exceeded, or because they reach the Casino's betting limit (n.b.: the strategy would have a long term expected value of zero if 50/50 bets were actually available; alas, the presence of one or two zeroes on the roulette wheel guarantees that the expected long term value of the strategy is negative). Systematic roulette players reportedly broke the bank at the Monte Carlo Casino several times in its early years (in the 19th century), despite the undeniable long-term mathematical advantage enjoyed by the house. According to lore, the strategies employed by these players were essentially the opposite of the Martingale. While the details are not known, they were apparently increasing their bets when they were on winning streaks and focused on lengthy uninterrupted runs in single chances. One reported case involved a sharp observer spotting and exploiting imbalances in roulette wheels. Note that all these reports are unconfirmed to this day; while it is true that the bank was broken a few times, the precise circumstances and identities of the people involved are a matter of dispute. [PT]

Miller held his licked finger up to the air and felt an amiable warm breeze blowing across the land. So, like what he'd always done, he seized the moment, and began Martingale betting the market. What we mean is he was buying the dip with ever increasing bets.

Business Insider, in a December 10, 2008 article titled, The Fall of Bill Miller , offered the gory particulars:

"Mr. Miller was in his element a year ago when troubles in the housing market began infecting financial markets. Working from his well-worn playbook, he snapped up American International Group Inc., Wachovia Corp., Bear Stearns Cos. and Freddie Mac. As the shares continued to fall, he argued that investors were overreacting. He kept buying. What he saw as an opportunity turned into the biggest market crash since the Great Depression. Many Value Trust holdings were more or less wiped out. After 15 years of placing savvy bets against the herd, Mr. Miller had been trampled by it…"

Between late-2007 and late-2008 the Legg Mason Value Trust fund collapsed nearly 60 percent, wiping out the gains that had been accrued in the funds lengthy streak of beating the market. The fund's assets under management collapsed from $16.5 billion to $4.3 billion.

There are many fun and interesting ways to blow $12.2 billion in no time flat. Some people buy professional sports teams. Others buy expensive hotels and private tropical islands with outdoor air conditioning. Some build indoor ski resorts in the desert. Others start businesses that consume massive amounts of capital producing electric cars. Some even get mixed up with questionable women with names like Stormy Daniels.

Miller, no doubt, was lacking in creativity. For Miller did none of these things. He merely flushed $12.2 billion – which represented the hard work, hopes and dreams of countless fund investors – down the toilet. What a waste.

Could it be that Bill Miller was the inspiration for this guy? Probably not – consider that burning billions in standard money is actually outright deflationary, as the money de facto disappears from the face of the earth. This is not what happened with the money Miller lost – he gave it to those who gladly sold their shares in failing financial companies to his fund. The money as such didn't disappear – it merely changed hands. Obviously this was no consolation to investors in his fund (as an aside: he got to keep his yacht, the $100 million "Utopia" – see further below). [PT]

"Every decision to buy anything has been wrong," said Miller following his disastrous performance. There are dips to buy and dips not to buy. The stock market dip that occurred between mid-2007 and mid-2008 was a dip not to buy.

Most likely the next stock market dip will be dip not to buy too.

Miller's luxury yacht "Utopia", a $100 million extravaganza (reportedly he has sold it in the meantime, and instead bought a "large mansion north of Baltimore"). Insert: Fred Schwed's classic on an age-old and evidently still quite pertinent question…

James Howard Kunstler: The Coming Economy Of "Less"

In a wide-raging discussion ranging from the pervasiveness of propaganda in today's media to the risk of nuclear war, Kunstler also re-news his warnings of a current secular economic slowdown.

After too many years of market interventions, magical thinking, racketeering, and bleeding the 99% dry, he warns that our culture and economic system will soon reach a snapping point:

The important story is what happens in the financial sector and how it effects the economy in the next twelve to eighteen months.As we know, the financial system is the most abstract and fragile of all the systems that we depend on because the other systems can't run without it. The trucks won't make the food deliveries to the supermarkets unless the finance system works. The gasoline won't get to the pumps at the stations.

Nothing's going to move if the financial system cracks up. People no longer trust each other to transact, to get paid. And so they stop transacting.

We're talking about a falling standard of living and getting used to an economy of "less". It sounds kind of Ebenezer Scrooge-ish to suggest that people may have to do with less rather than more, because more has always been the expectation in our lifetime. But that's probably a fact. And as I've said more than once, reality has mandates of its own. Circumstances are going to inform us about how this economy is emerging and where we need to go with it. And we can either pay attention or just sit there with our fingers in our ears. 

What we're talking about here is the armature of our culture and economy that people hang their lives on. And that armature is crumbling. There are fewer things that people can hang a life on in a meaningful way, or a way that even ensures that they can have a little bit of security looking into even a short-term future.

For example, I had a day yesterday that felt like national Murphy's Law Day. I got a screw in a tire. The screw was in a place where, under New York State law, they're not allowed to fix the tire if the screw is near the outside of tread. So I had to buy a brand-new tire. And then I was going to take the trash to the dump in my old pickup truck, which I keep around for that purpose. But the battery was dead. So I had to go down to the auto parts store and buy a new battery, and bring it home and put it in.

Now, I'm among the lucky people in this land who can actually buy a new tire and buy a car battery. But probably some enormous percentage of the population, like 78% or 84% -- I'm not quite sure what it is -- they don't have enough money to buy a new car battery if their car dies on some god forsaken freeway shoulder 38 miles from home. Imagine how crazy-making that is. I can easily, because I was a truly starving bohemia until well into my 40s, struggling just to pay the light bill while writing book after book. So I know what it's like to live day after day in that kind of financial anxiety.

I imagine that the financial anxiety out there right now is just so extreme that there's a whole mass of people who are being pushed to the limits of their sanity.

J. Grant: "Uncomfortable Shocks" Lie Ahead As The Great Bond Bear Market Begins

J. Grant is one of a handful of credit-market luminaries who have declared the end of the 30-plus-year bond bull market that began in 1981. Interest rates, Grant argues, probably touched their cycle lows during the summer of 2016. And as the secular bear market begins, investors who have uncritically accepted obvious aberrations like Italian junk bonds trading with a zero-handle will face a painful reckoning.

"...and since interest rates are critical in the pricing of financial instruments, these distortions preceded the uplift in all asset values.. and the manifestation of this manipulation is in many ways responsible for what we are now seeing in the markets."

So Grant explains in an interview with Erik Townsend, host of the MacroVoices podcast, where he shares his views on topics ranging from his opinion of the Fed Chairman Jerome Powell to inflation to the flawed logic of risk parity.

Grant begins the interview by praising Powell, whom he prefers to former Fed Chairwoman Janet Yellen because Powell lacks a PhD and is able to communicate with lawmakers and the public in plain English - not tortured Fedspeak.

Well, Jay Powell has one commanding credential. And that credential is the absence of a PhD in economics on his resume. I say this because we have been under the thumb of the Doctors of Economics who have been conducting a policy of academic improv. They have set rates according to models which have been all too fallible. They lack of historical knowledge and, indeed,  they lack the humility that comes from having been in markets and having been knocked around by Mr. Market (who you know is a very tough hombre).

Jay Powell at least has worked in private equity. He knows a little bit about the business of buying low and selling high. Also he's a native English speaker. If you listen to him, he speaks in everyday colloquial American English, unlike some of his predecessors. So I'm hopeful. But not so hopeful as to expect a radical departure from the policies we have seen.

Moving on to market conditions, Townsend poses the question that credit-market analysts are probably sick of hearing from their clients: What, exactly, is driving this market? Is it Trump? Is it inflation? Is it the global reining in of intrusive central-bank stimulus?

Believing that one man - even the most powerful man in the world - could have a unilateral impact on markets is almost an expression of arrogance. Instead, Grant believes credit markets turn on multidecade cosmic cycles - and that the bull cycle that began in 1981 has just about run its course...

I'm a little bit more fatalistic. You know, we have come to accept that financial markets are driven by people and by policies and by personalities. And, what is Chairman Powell going to do? What will President Trump tweet next? As if they were in charge.

Well perhaps sometimes they are not in charge. I have observed over the years that the bond markets have tended to move in generation-length cycles. Anywhere from 20 years to 35 years. This is not an ironclad law of physics, but it is an observation from the middle of the 19th century forward.

So we have concluded (perhaps) the bull market in bonds that began in 1981 and that maybe ended in the early days of July 2016 (I think). So it might just be that interest rates are going up because they are going up. It sounds a little bit mysterious and indeed fatalistic, but I'm a little bit less inclined than others to assign causation to people and policies.

Moving on, Townsend turns the discussion to risk parity funds, and what Grant describes as the "flawed" thesis that bonds are inherently less risky than equities…

First, risk parity, as you know, is based on the proposition that bonds are inherently less risk-fraught and less volatile than equities. To someone who was around in the '60s and '70s and '80s,that proposition is somewhat contestable. But that's the idea.

…

Now that may work in a gently trending market. It has not worked at certain times and junctures in which both stocks and bonds decline together. So my sense is that there's a lot of money in risk parity and that a forceful rise in interest rates, a steep decline in bond prices, is going to force liquidation of some part of the risk parity portfolios.

Now, Erik, you wonder how far it can go. People, I think, are arguing that it would be inexpedient if rates went a lot higher. They say impossible. What then actually mean is inconvenient.

I forget now exactly what the size of the interest expense of the public debt is, about $400 billion. The government is paying 2.2 or something on its debt. Doubling of yields to 4-something and doubling of gross interest expense to $800 billion or so would certainly be an inconvenience. It would require very painful political choices. But, no, it is not impossible.

So I think that, yeah, the stock market is going to run into trouble. It's richly valued. But I don't look for Armageddon. I look for higher rates, and I look for appropriately lower price-earnings multiples. And I look for a much higher interest bill on the part of the US Treasury.

Having discussed the historical trajectory of nominal rates, Townsend and Grant move on to the next logical topic: A historical analysis of inflationary trends. As Grant explains, central bankers who are hoping for higher inflation should be careful what they wish for - because,historically, shifts from periods of low inflation to high inflation have been accompanied by uncomfortable shocks.

Well, Erik, I happen to be in the inflation camp. I'm most humbly placed there. There are powerful arguments on both sides of the question. But something to bear in mind is that nobody issues a press release at the start of an inflationary cycle. It kind of creeps in on little cat's feet.

The 1960s are a case in point. In the early '60s there were four consecutive years – 1961 to 1962, '63, early '64 – in those years the measured rate of inflation in the CPI was, if memory serves, less than 2%. In fact in some years it was less than 1%.

...Suddenly, the US was mired in the Vietnam War, and the quiescent interest rates of the 1960s transitioned into 1970s-style stagflation.

This historical example is just another reminder that macroeconomic trends can shift in unexpected and mysterious ways...and that central bankers hoping to catalyze an increase in inflation toward the 2% target should be careful what they wish for…

Scrying these secular shifts in the direction of inflation and real interest rates isn't always helpful, Grant points out.

What is helpful, however, is to perform a simple risk-reward analysis of markets as they are:Think about the volume of debt rattling around the global economy, and the artificially suppressed level of interest rates, and ask yourself: Does this make any sense?

Grant reminds listeners that the 'end of the bond bull market' does not necessarily mean disruptive change...

"it took ten years for the long-dated Treasury to move from its low in 1946 of 2.25% to 3.25% in 1956..." but, as Grant points out, it's different now, "that was before risk parity and the leverage that is now in financial instruments surrounding the bond market."

However, Grant warns that he "suspects the tempo of a bond bear market will indeed be faster now than it was in 1946-56."

Later in the interview, Grant shared his view on the direction of gold, the dollar and the feasibility of long-term debt monetization by the Federal Reserve.

Once again Grant is correct in his diagnosis of the symptoms... and the prognosis - all of which reminds us of his rhetorical question - What will futurity make of the [so-called] Ph.D. standard [that runs our world]?

Likely it will be even more baffled than we are. Imagine trying to explain the present-day arrangements to your 20-something grandchild a couple of decades hence - after the crash of, say, 2019, that wiped out the youngster's inheritance and provoked a central bank response so heavy-handed as to shatter the confidence even of Wall Street in the Federal reserve's methods...

I expect you'll wind up saying something like this:

"My generation gave former tenured economics professors discretionary authority to fabricate money and to fix interest rates.

We put the cart of asset prices before the horse of enterprise.

We entertained the fantasy that high asset prices made for prosperity, rather than the other way around.

We actually worked to foster inflation, which we called 'price stability' (this was on the eve of the hyperinflation of 2017).

We seem to have miscalculated."