Why Nassim Taleb Thinks Leaders Make Poor Decisions

Why do experts, CEOs, politicians, and other apparently highly capable people make such terrible decisions so often? Is because they're ill-intentioned? Or because, despite appearances, they're actually stupid? Nassim Nicholas Taleb, philosopher, businessman, perpetual troublemaker, and author of, among other works, the groundbreaking Fooled by Randomness, says it's neither.

It's because these authorities face the wrong incentives.

They are rewarded according to whether they look good to their superiors, not according to whether they are effective. They have no skin in the game.

Seasoned readers of Taleb will be pleased to see the so-called "experts problem" pop up in living color in Skin in the Game: Hidden Asymmetries in Daily Life, Taleb's latest collection of essays on risk, rationality, and randomness. According to Taleb, dentists, pilots, plumbers, structural engineers, and "scholars of Portuguese irregular verbs" are real experts; sociologists, policy analysts, "management theorist[s], publishing executive[s], and macroeconomist[s]" are not.

The difference is that, when people from the first list are wrong about something, it's obvious from the results and they suffer; they have skin in the game. Bad teeth, crashed planes, and leaky pipes are bad for business. People from the second list rationalize by substituting a different theory. They were not really wrong but just early, and, if they're lucky, which is to say skillful at apple-polishing, earn promotion after promotion by not failing utterly. (Financial advisors can argue that the fiduciary standard is the most powerful tool for putting them in the first list.) Skin in the Game is full of insights like this, some recycled from his earlier work but many of them new. It is well worth the relatively quick read.

Despite the many good qualities of Skin in the Game, Taleb's work, including the present volume, is often infuriating. He is too sure of himself, too unkind to his enemies, too full of bluster and obscure humor. Acting on his belief that some kinds of experts are worthless, he has populated the book's dust jacket with anonymous tweets instead of celebrity testimonials. Here's the first tweet: "The problem with Taleb is not that he's an ass— (spelled out in full on the jacket). He is an ass—. The problem with Taleb is that he is right." I agree.

Asymmetry, or why we are ruled by the most easily offended

In chapter two of Skin in the Game, entitled "The Most Intolerant Wins," Taleb asks why we seem to be governed by the most easily offended. You have to refrain from smoking in the non-smoking section, but you don't have to smoke (that is, refrain from not smoking) in the smoking section, which, by the way, is much smaller. Few people really care whether you say Merry Christmas or Happy Holidays, but the latter has become de rigueur in some circles. Almost all soft drinks are kosher.

The reason, Taleb explains, is that, for any given issue, there are a few people who care deeply about it and a great many people who do not. Those who care are spurred to action, even violent action in the case of religious or political passions. The rest of us, wishing to be left alone, rarely fight back with equal vigor. The results of this process include the increasing domination of Taleb's beloved, multi-religious Lebanon by Muslims, for whom conversion to Islam is irreversible. Conversion away from Islam is at least theoretically punishable by death; Christians and Jews don't much care if you leave the faith.

In ancient Roman times, Taleb explains, Christians were the intolerant minority that pushed their views on the Roman majority. That's how Christianity eventually became the official religion of the empire in 323 A.D. Times and players change but the principles of human nature remain the same.

Almost all soft drinks are kosher because it's relatively easy to make a drink kosher. So manufacturers put forth this small effort rather than have two kinds of each drink, one for observant Jews – a fraction of a percent of the total population – and one for everybody else.

If this argument sounds familiar, it's recycled in much more general form from Frédéric Bastiat, the great 19th century French economist. Bastiat wrote that, for any given government action, such as a tax levied to subsidize some activity, there are a few people who will benefit greatly by it and they will work day and night to see it enacted. The great many who stand to lose will typically only lose a few pennies and will put forth little or no effort to prevent it. Thus the number of rules, regulations, taxes, handouts, and special favors granted by government grows exponentially with very little acting to restrain the growth.

These are just a few of the asymmetries of daily life to which Taleb's subtitle refers. Once you understand the principle, you'll see it in everything.

Waiter, there's a fly in my soup

The New York deli called Lindy's is famous for its clientele of Broadway actors and comedians, and for having food so bad that it has inspired a bevy of jokes including the one that starts with, "Waiter, there's a fly in my soup." But, Taleb tells us, it is also well-known among mathematicians and other scholars as the place where the Lindy effect was first observed. This is the idea that the age of an inanimate object is a good indicator of its future longevity:

Broadway shows that lasted for, say, one hundred days, had a future life expectancy of a hundred more. For those that lasted two hundred days, two hundred more. The heuristic became known as the Lindy effect.

Likewise, Judaism, 3,500 years old, will probably last another 3,500; Scientology will be lucky to get another 60. Shakespeare will last longer than Stephen King. Even living things that do not age on a particular schedule, like trees, tend to follow this rule. It could be because the old ones, having survived, are anti-fragile, a concept from Taleb's earlier book by that title; they are not just robust, but gain further robustness from exposure to stresses. Or maybe, like Shakespeare, they're just better.

This principle is very powerful and Taleb applies it to many topics, with the Lindy theme running through the whole book. Academia, for example, sometimes resembles an athletic contest in which the hardest-working or most aggressive participants appear to win. It should not. "The winner is the one who finishes last," said the philosopher Ludwig Wittgenstein; that is, the academic whose theories are least easily overturned, most enduring, had the best theories.

Investors would do well to understand the application of the Lindy principle to their enterprise. Indexing as a concept is about 75 years old; value investing is even older. These great ideas are unlikely to be overturned any time soon. Instead, improvements around the edges are the best we can expect. The latest idea for earning alpha, whatever it is at the moment, will almost certainly turn out to be a flash in the pan, easily arbitraged away by the time it can be widely implemented.

Why are there so many employees?

To illustrate how the principle of skin in the game applies to labor contracting, Taleb compares the behavior of two private jet pilots. Bob is a freelance contract pilot who is sometimes useful to your little airline but is at other times too busy hauling Saudi princes to fancy resorts to do the work you need done. The result, an occasional stranded planeload of people, is disastrous for your business.

The other, a pilot-employee – I'll call him Bill – does more or less what you want, including working overtime in a pinch. Why the difference? Taleb writes,

People you find in employment love the regularity of the payroll, with that special envelope on their desk the last day of the month, and without which they would act as a baby deprived of mother's milk… [H]ad Bob been an employee rather than something that appeared to be cheaper, that contractor thing, then you wouldn't be having so much trouble.

Economics dictates that employment is just one of many ways to contract for labor, and a particularly inflexible one that requires you to pay the employee whether you can keep them busy or not. You've probably considered replacing employees with contractors in whatever business you operate or work. Yet there are a lot of employees! Taleb's tale provides a clue to why: "Every organization wants a certain number of people associated with it to be deprived of a certain share of their freedom." Employment is the only legal way to achieve that sort of dependent relationship.

What's the connection to skin in the game? We tend to think of freelancers and entrepreneurs, such as Bob the pilot-contractor, as risk takers, skin-in-the-game players. And they are. But, as Taleb reminds us, "skin in the game is not [about] incentives, but disincentives." You don't want the employee to do what is best for himself in the short run – that's what contractors do – so you set up an alignment of interest between his long-run welfare and yours. As an employee with a family and a mortgage, and considerable costs if he has to get another job and relocate, he has skin in your game.

That's why we have so many employees.

 

Two very different kinds of risk

Since investing is applied philosophy, Taleb's whole book is relevant to investors, but the most directly applicable part is Chapter 19, "The Logic of Risk Taking." He draws the distinction, fundamental but rarely fully understood, between ensemble probability andtime probability. (Like double-entry bookkeeping, this is one of those wonderful ideas that's obvious once you've heard it; less so in advance.) Ensemble probability involves a risk faced by a population at a given point in time, such as that of a hundred people visiting a casino once, where each person can make a one-time, double-or-nothing bet involving his or her entire fortune. In that single visit, about half of them will be ruined. The other half, having doubled their money, will be perfectly fine.

Time probability, in contrast, involves an ongoing risk faced by an individual over time. Consider someone visiting a casino 100 times in succession, also making a double-or-nothing bet involving his entire fortune. In 100 visits, that person will be ruined; usually ruin will occur after just a few visits. No one who behaves this way will ever be fine.

With ensemble probability, then, as Taleb explains, "the ruin of one does not affect the ruin of others." With time probability it's the opposite: once you get a sufficiently bad outcome, the game is over and you cannot become un-ruined.

This distinction is relevant to investing because the risks investors face involve time probability, not ensemble probability. In most aspects of life, we are accustomed to thinking about risk in the ensemble sense: a football team has a 2-in-3 chance of winning a game, a disease has a 10% mortality rate. So we are familiar with that kind of risk, and comfortable extending the concept to other aspects of life.

But, in investing, the state of a person's wealth at any point in time is contingent on her wealth at the previous point in time; returns are cumulative; investing exposes us to time risk, cumulative risk. We are not typically able to do the mental approximations needed to think about that – if the risk of getting in a car accident on the way to work is one in 10,000, what is the risk of driving to work 10,000 times? (It's not 100%, nor is it insignificant; it's 64%. You should go to work anyway.)

Thus, we need to be very careful when relying on intuition to tell us about investment risk. Investing involves more risk than you think. We also need to be wary of extrapolating from the past (and avoid the temptation that comes from the fact that it's so readily accessible). Paul Samuelson famously said that "we have only one sample of the past," meaning that far more things could have happened than did happen; there's only so much you can learn from studying history. But it's just as important that we will get only one sample of the future! The return pattern that we will experience is just one of the infinitely many possible ones, and it will not be the one that we "expect" statistically; it will be something different, possibly very different.

Are you an IYI? I hope not

Consistent with his famously combative persona, Taleb takes pot shots – frequent and vigorous ones – at intellectuals, or, in his acronym, IYI. An intellectual yet idiot (IYI) is someone who is beloved by the public for his or her knowledgeable airs but who is actually full of baloney, having no practical sense. Taleb considers Steven Pinker, author ofEnlightenment Now and a current darling, to be an example, and calls him a "journalistic professor," not the psychologist and linguist that he obviously is. (I'm reviewing Pinker's book, favorably, in an upcoming Advisor Perspectives.)

When one gets past the gratuitous insult, however – Taleb doesn't think much of journalists or professors – he has a point. When a real expert strays from his own field, he is susceptible to making the foolish mistakes of an amateur, except that an amateur is likely to be humbler.

 

Taleb has not convinced me that Pinker is a wandering amateur; maybe it's Taleb, not Pinker, who is wandering too far from the core of his knowledge. Intellectuals, whether or not IYI, must, when turning against their kind, be on guard against becoming AIYA: anti-intellectual yet ass­­­­—. (Pardon my French; Taleb inspires it.) At 16, I fit the description; I do not think Pinker does.

Dedicated to the one I love?

Book dedications are rarely interesting; they usually feature one's parent, spouse, or teacher. But, in an odd twist that allows us to see (a little) into Nassim Taleb's mind, he dedicates Skin in the Game to two well-known people whom I would have praised less lavishly. First, Ron Paul, "a Roman among Greeks"; second, Ralph Nader, "a Greco-Phoenician saint."

In a self-referential joke, Taleb's comment about Ron Paul reverses the dedication of his earlier book, The Black Swan, to the great mathematician Benoit Mandelbrot, "a Greek among Romans." It took me a bit of effort to find out, by searching through Taleb's tweets, that he admires the Romans' practicality:

As I came to realize...[,] the Romans were no-B.S. Fat Tonys; they resented grand theories and favored prudent and progressive tinkering. Much of what they built, from constitution, to Roman law, to bridges, to low income housing, to their literature, to their imperial administration (still around in the structure of the Catholic church), has survived 2000 years.

Paul, a doctor and former congressman from Texas, is an honorable man who often stands alone in objecting to his colleagues' expedient political follies. I'm not sure (and Taleb doesn't say) why that makes him a Roman, but maybe an encomium is deserved; I would not have singled him out.

But Ralph Nader a saint? He certainly sacrificed personal income, and subjected himself to harassment, when making the case that U.S. auto companies were making dangerous cars; he had skin in that game. But Nader has a dark side. Despite having taken a poverty vow and very publicly living like a monk, he revealed a personal fortune of $3.8 million in his 2000 presidential election filing – not a large fortune but not monkish either. He has also founded nonprofit organizations that do research of dubious quality, and his latest crusade is a meaningless fight against share buybacks (an important mechanism for enabling investors to get cash flow out of their portfolios). Nader is an odd choice for sainthood.

Skin in the game everywhere

Like many authors who've discovered a principle that they believe applies in many aspects of life, Taleb isn't shy about discussing every aspect he can identify. They include the role of looks in choosing a surgeon: don't choose a dignified, handsome one – one who looks more like a butcher "had to have much to overcome in terms of perception." Military interventionism? He's against it, arguing that policy analysts who make war from comfortable offices don't know what it's really like on the ground and have no personal stake in the consequences. Religions, at least at first, demand extreme sacrifices from their adherents because their leaders know they can only hold the tribe together if its members can see that fellow members have sacrificed too: "The strength of a creed," Taleb writes, "did not rest on 'evidence' of the powers of its gods, but evidence of the skin in the game on the part of its worshippers."

This campfire-style storytelling makes the book seem, in places, more like a collection of loosely related essays, as I referred to it at the outset, than a coherent book. This approach has an upside and a downside. It's easy to read parts of the book without losing the train of thought, since many of the parts were written as magazine articles and stand well on their own. The downside is that, if you try to read the book as a coherent whole, you'll find it too full of interruptions and asides.

Conclusion

Taleb's writing is nothing if not lively. What other philosopher, let alone investment writer, creates characters like Fat Tony, a worldly-wise trader who cares little for book learning; Yevgenia Nikolayevna Krasnova, a neuroscientist with three philosopher ex-husbands who writes a runaway best-seller called A Story of Recursion; and Nero Tulip, a thinly disguised version of Taleb himself? Taleb entertains, educates, and infuriates all at once, a heady combination for readers who score high on curiosity but frustrating for those who are just in a hurry to gather information and get on with it. This is Sunday afternoon, not Monday morning, reading.

Mercifully, Skin in the Game is also relatively short, unlike Taleb's previous book,Antifragile. It can be consumed effectively by a casual reader and does not require sustained attention.

Skin in the Game is not Taleb's best book – that's Fooled by Randomness – but it's his most accessible. I highly recommend it.

“Dark Money” Runs the World

Few people know financial markets' biggest secret…

For the last 40 years, most people believed the stock market always goes up. Simply buy and hold long enough, the theory went, and you could sit back and watch the money accumulate in your account. No thought or hard work needed.

It was a nifty strategy — until the idea burned most investors in 2008. Almost a decade later, the scar tissue is still fresh for many investors.

Even today, after the U.S. stock market has rallied by 271% since the bottom on March 6, 2009 — nearly tripling investors' money — only about half of Americans are invested in the stock market, according to NPR. That's down from two-thirds compared to a decade ago.

The rest are in cash on the sidelines. Maybe that's been you.

And who can blame you? "Fool me once, shame on you," the saying goes. "Fool me twice, shame on me."

Last June, Fortune surveyed readers. 71% of respondents said "the economic system in the U.S. is rigged in favor of certain groups."

A few years earlier, the Los Angeles Times reported "Poll finds 64% of voters believe stock market is rigged against them…"

They're not wrong.

Somebody's made gains from all of those sectors in the stock market. It just hasn't been Main Street.

Since I've left the world of big banking, I've made it my mission to change that. That leads me to the catalyst for my new project…

Dark money.

Dark money is the #1 secret life force of today's rigged financial markets. It drives whole markets up and down. It's the reason for today's financial bubbles.

On Wall Street, knowledge of and access to dark money means trillions of dollars per year flowing in and around global stock, bond and derivatives markets.

I learned this firsthand from my career on Wall Street. My first full year working on Wall Street was in 1987.

I wasn't talking about "dark money" or central bank collusion back then. I was just starting out.

Eventually, I would uncover how the dark money system works… how it has corrupted our financial system… and encouraged greed to the point of crisis like in 2008.

When I moved abroad to create and run the analytics department at Bear Stearns London as senior managing director, I got my first look at how dark money flows and its effects cross borders.

The "dark money" comes from central banks. In essence, central banks "print" money or electronically fabricate money by buying bonds or stocks. They use other tools like adjusting interest rate policy and currency agreements with other central banks to pump liquidity into the financial system.

That dark money goes to the biggest private banks and financial institutions first. From there, it spreads out in seemingly infinite directions affecting different financial assets in different ways.

Yet these dark money flows stretch around the world according to a pattern of power, influence and, of course, wealth for select groups. To be a part of the dark money elite means to have control over many. How elite is a matter of degree.

These is not built upon conspiracy theories. To the contrary, alliances make perfect sense and operate publicly. Even better, their exclusive dealings and the consequences that follow are foreseeable — but only if you understand how the system works and follow the dark money flows.

It's easy to see how this dark money affects the stock market at a high level, because we can monitor its constant movement.

Here's the smoking gun:

 

The black line shows you how much "dark money" the Federal Reserve has printed since 2008.The gray line shows  you the S&P 500. They move together — more dark money drives the market higher. Much higher.There are dark money charts from around the world, just like the one I showed you for the Federal Reserve and U.S. stock market. Look at this "dark money" chart from Japan, for example:

The blue line shows the dark money created by their central bank, The Bank of Japan. The red line shows Japan's major stock index, the Nikkei 225, going up as well. The dark money drove the market much higher over the past eight years.

Or, look at this "dark money" chart from the U.K.:

Again, the blue line shows the "dark money" created since 2009 by the U.K.'s central bank, The Bank of England. The black line shows how the FTSE 100, their stock index, has followed higher in lock-step.

To invest profitably in financial markets, you need to understand the hidden power relationships that drive financial and political events. Ideologies and personal associations among elites are oblivious to political party lines and international boundaries. So is dark money.

But even when the data is as clear as these charts, it's hard to know how to trade around it.

For an individual investor like you, looking to manage your individual portfolio positions, this dark money is invisible. Without help, it's hard to identify and execute trades based on dark money.

Which begs the question: What are you supposed to do with this information?

If you know where this dark money is coming from… where it's going… and how it will be used… you can position yourself defensively and securely for the future.

I'm not suggesting anyone become a cheerleader for the bubble dynamics in today's financial markets. I'm not suggesting anyone "fight the Fed," either.

I'm suggesting it's possible to find the opportunities to trade around the dark money flows that Wall Street thrives on.

I believe that — equipped with the right approach, tools and systems — you can make protect your money.

A key part of the process involves understanding how governments and markets function.

Another part involves knowing how both are intertwined. Yet another part requires interpreting central bankers talk.

There is one thing I have learned over my career. People matter just as much as data. Relationships matter.

Central Bank Money Rules the World

Central bank credit that supports markets — is not just creation of the Fed, but by central banks and institutions around the world colluding together. Global markets are too deeply connected these days to consider the Fed in isolation.

Since last month's correction, the world has been watching the Fed because its policies have global implications. And worldwide sell-offs sent a clear sign to Fed Chair Powell to relax with the rate hikes.

When fears arise that central bank QE will recede on one side of the world, we see more volatility and rumors of hawkishness. To counter those fears, there will be a move toward dovish policy on the other side of the world.

Central banks operate in collusion. When the Fed signals it is raising rates, or markets over-react negatively to the threat, another central bank steps in. By colluding, other central banks offer even more dark money-QE to keep the party going.

The net result is a propensity toward the status quo in global monetary policy: a bullish, asset bubble-inflating bias in the stock markets and caution in the bond markets.

Here's what's going on with some of the most powerful central bankers right now, starting with Japan…

While U.S. markets were correcting earlier this month, Japan's financial benchmark, the Nikkei 225 index fell more than 1,200 points. At the same time, the rumors of Japan's central bank curbing its dark money-QE programs are just that.

While investors have speculated that the BoJ could be moving towards an exit from dark money policy (despite the BOJ denying this), we know that central banks are too scared of the outcomes.

In an economic pinch, the Bank of Japan (BoJ), will keep dark money flowing.

Confirming my premise, when Japanese Government Bond prices were dipping too fast, the BoJ announced "unlimited" buying of long-term Japanese government bonds. This is simply the continuation of the policy the BoJ already has in place.

It was also, as CNBC reported, "the first time in more than six months that the BOJ has conducted special operations to buy bonds to achieve the yields it wants to see…"

That's a clear sign of more manipulation of the bond market. And now we have confirmation that Japan likely has more dark money coming…

For the past year, there have been media rumblings that Japanese Prime Minister Shinzō Abe would relieve current Bank of Japan (BoJ) head, Haruhiko Kuroda. The dark money maven was set to end his term on April 8.

Seeing through the media craze, I have repeatedly detailed that it would not be the case. Abe and Kuroda go together like peanut butter and jelly. Abe specifically chose Kuroda to implement a massive dark money strategy in what has been referred to as a monetary "bazooka."

A piece in Japan Today confirms this view. It concludes that 73-year-old Kuroda will stick around for a second five-year term, through 2023. So as the article notes, "He would be the first BoJ governor to serve two terms in half a century."

Kuroda has implemented the most aggressive dark money manufacturing on the planet since taking the helm of the BOJ in 2013. Prime Minister Abe has become the longest-standing Japanese prime minister in years with the success of the snap elections he called for last fall.

Logically, why would he seek to end a partnership that is lifting the Japanese markets and making its economy appear rosy? (Though as in the U.S., wage growth and consumption remain tepid.)

With core inflation rising just 0.5% last year, well below Kuroda's 2% target, you should expect that he'll be pumping even more dark money into Japanese markets. For investors that means more opportunities in Japanese stocks. Currently, I'm focused on sectors related to the 2020 Olympics and the infrastructure projects that come with it.

Japan offers us a clear roadmap. Financial markets in Japan are clearly addicted to dark money.

Chinese Economic Implosion And Asian Contagion On The Horizon

current debt levels make the fragility of the Chinese economy even more sensitive to property market and/or equity market disruptions…"

Our previous three segments of this research report detailed not only the history of the Chinese economic activity but also detailed some of the capital flow issues that have been active in presenting this unique instance in time as it relates to a potential implosion of economic activity in China and most of Asia.  We, the research team at Technical Traders Ltd., have attempted to clearly illustrate all of the components and facets that have existed to make up a very unique scenario where traders may be able to experience a once or twice in a lifetime trade that could result in massive returns.

Within our previous posts, we attempted to disclose what we believe to be one of the most critical and potentially damaging economic events in our future.  We urge all readers to review (Part I, Part II, Part III) of this multi-part research report to bring everyone up to speed with our thinking.  Please take a moment to our earlier posts before continuing.

In this section, we are going to explore the ongoing relationship between debt levels, shadow economic functions, global equity price levels and global economic activity all coincide at this very unique time to present a potentially massive and unprecedented event in human history – a massive economic collapse across dozens of nations and resulting in a potentially cataclysmic economic outcome.  We are certain you might be asking, "how could this happen again?".  Well, in some ways the recovery process in the US, Europe and other areas could have prompted a very unique and dangerous setup in China, India and the general Asian region.  Why are these areas uniquely at risk?  The reason is because China has become a major economic driving force in the region and has become responsible for much of the areas economic advancement.  This has been the case since the late 1990s.

In the previous section, we hinted that a downturn in the Chinese property market between 2015 till 2016 in combination with an equity price decline in excess of -15% to -20% and an outflow of capital from the Chinese economy resulting in a massive, $1 trillion, decrease in the Chinese capital reserves.  How could something like this result in a total of $1 trillion in reserves to be depleted?  The answer is that pressures on the economy at that time resulted in a number of general and corporate debt failures that, if left alone, would have pressured the entire Chinese financial/banking system into a possible crisis.  Therefore, the Chinese had to make the problem go away and they did this by diving into their reserves to wash away the debt issues while continuing to prop up their economies and banking institutes.  This $1 trillion reserve decrease was the "patch" that was needed to make sure the economic collapse was averted.

We have been watching the news and related investment research for years attempting to stay on top of these moves and keep our members aware of the potential for a market correction/reversal.  Part of our research is now warning us that we need to begin to prepare for the eventual crumbling of the economic footing of the global markets and we believe China/Asia will play a massive role in the next big move.

Chinese debt to GDP is massive compared to the US or other developed nations.

And China's debt just keeps rising…

By our estimates, the current Chinese debt to GDP levels have increased by nearly 100% (to somewhere above 350% of total annual GDP.  Additionally, current levels are well in excess of 200% to 300% of levels found near 2005 to 2007.  If we consider 2014 levels alone, the time just before the massive $1 trillion reserve decrease, debt levels today are nearly 45% larger than debt levels in 2014.  Therefore, the fragility of the Chinese economy in terms of debt constrictions related to any proposed property market price rotation and/or any capital/equity market price correction, particularly if they happen at the same time (like before), could present a very unique collapse event.  It is our opinion that the current debt levels make the fragility of the Chinese economy even more sensitive to property market and/or equity market disruptions.

China's shadow banking, particularly WMP (Wealth Management Products), Entrusted, Trust and loans by Financial Firms present a huge issue in regards to stability of the Chinese credit markets.  Over 4~5 short years, over $30 Trillion Yuan in these types of loans have been originated – a massive 400% increase on average.  The individual component levels range from a 100% increase to well over 650% increase.

Remember, these financial (credit) instruments are rooted in the projections that borrowers have the ability and capability to repay these loans, or that the projects they back will result in substantial real value at some point.  The loan origination data, below, shows a decent increase just after the US Presidential elections and we are certain this recent rally in the US and global markets has eased some pressure away from the Chinese and other Asian markets.  Yet, the recent price rotation (February and March 2018) could be "just enough" to crush the floor in the Chinese/Asian markets waiting for that last pin drop to start the crumbling process.

It is our belief that any contraction in any single market, Chinese property, Chinese equities or Chinese debt could likely be contained as long as the contraction range is less than 15~25% from the most recent highest valuation points.  Our range of 15~25% is just that, a range that should be considered extremely dangerous for the Chinese and Asian markets.  Should two or more of these market react in a similar manner, decreasing by 15~25% over an extended 12~24 month period, we believe the pressures of this type of move could be catastrophic for China and parts of Asia.  The simple fact that two, or more, capital markets that experience this type of valuation decline would likely put an additional $1 to $2.5 trillion (or more) in reserve pressure on the Chinese and local markets.

Additionally, this type of valuation pressure would likely result in liquidations of foreign assets at near fire-sale prices to move these asset into cash as quickly as possible.  This type of market action is called a "death spiral" for a reason.  As panicked sellers dump assets to get into cash, they are driving the property and equity valuations even lower in the process – causing others to become panicked sellers and perpetuating the cycle.  A death spiral event is one that sparks up overnight, causes runs on banks as people try to get as much cash as possible and causes wildly unreasonable price valuations simply because people are desperate to unload assets that could destroy their balance sheets.  It is better to sell it for X than to hold onto it and watch it destroy any existing capital I may currently have.

Now that we've gone through quite a bit of detail in describing what could happen, allow us to go into just a bit more detail with our next article showing the current equity markets and the current property markets in these regions in addition to more of our predictions.

53 years experience in researching and trading makes analyzing the complex and ever-changing financial markets a natural process. We have a simple and highly effective way to provide our customers with the most convenient, accurate, and timely market forecasts available today.Our stock and ETF trading alerts are readily available through our exclusive membership service via email and SMS text. Our newsletter, Technical Trading Mastery book, and 3 Hour Trading Video Course are designed for both traders and investors. Also, some of our strategies have been fully automated for the ultimate trading experience.

If you like what we offer, please visit to learn more about our trade alert services and research.  We put these types of research posts out to the public because we believe it is our duty to alert and warm traders of opportunities and risks that others may not be talking about.  We try to make it simple, but in this case, the details are more complex and require a bit more effort on our part.  We welcome you to join our valued members and become part of our team of professionals while we navigate these markets and find opportunities.  Please visit www.TheTechnicalTraders.com to learn more.

Chris Vermeulen has been involved in the markets since 1997 and is the founder ofTechnical Traders Ltd. He is an internationally recognized technical analyst, trader, and author of the book: 7 Steps to Win With Logic

Through years of research, trading and helping individual traders around the world. He learned that many traders have great trading ideas, but they lack one thing, they struggle to execute trades in a systematic way for consistent results. Chris helps educate traders with a three-hour video course that can change your trading results for the better.

His mission is to help his clients boost their trading performance while reducing market exposure and portfolio volatility.

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Beware the fragility of the global economy

Quantitative easing (QE) saved us from the 2008 crash and kick-started a recovery, but also encouraged a build-up of one-sided risk in the financial system. Are markets and the economy ready for the fallout?

The sudden rise in volatility last February shows that, despite strong growth, financial markets remain vulnerable. Since 2008, we have experienced seven flash crashes followed by sudden recoveries. Volatility has become binary with markets swinging between periods of shock and calm. While the VIX index, which measures the stock market's expectation of volatility, has traded at a median of 16 since QE, against 18 before, the spikes in volatility have become twice as frequent. This is equivalent to exchanging stable, drizzly rain in the City of London for sunny weather but with more hurricanes.

As central bankers attempt to normalize policy, the risk is a collapse of carry trades in financial markets, where an investor borrows at a low interest rate to invest in something promising a high return, with a negative spillover into the economy. 

Central banks have bought $21 trillion in government debt globally since 2008, pushing investors to search for yields in riskier markets. The result is a pyramid of trades dependent on stable interest rates: $12 trillion of government debt yields less than 1% and the yield from $11 trillion of corporate debt is nearing a record low. As cash-flows and growth rates are discounted at near-zero rates, $8 trillion of high dividend and growth stocks trade at record high valuations. At the top of the pyramid are strategies betting on stable volatility and asset correlations, which total up to $2 trillion, according to our estimates.

While carry trades have flourished, the architecture of financial markets has become increasingly fragile. In 1976, the economist Hyman Minsky wrote that a crisis can develop when financial structures amplify rather than dampen an initial shock. Today, we can identify a number of negative feedback loops in strategies which use leverage, buy illiquid assets or own a large percentage of their asset class. A bank-loan, exchange-traded fund (ETF) issues listed shares but takes between 30 and 60 days to settle a loan sale in the secondary market. There is also a systemic impact. ETFs own 3.9% of US high-yield bonds – more than the inventory of all broker-dealers put together. Passive strategies and quantitative trading together represent 60% of equity assets, according to JP Morgan research. With tighter banking regulation limiting the room for trading desks to absorb risk, markets can be caught in violent crosswinds when passive strategies unravel.

In the February sell-off, junk bond ETFs lost around 13% of their shares outstanding. Like instantaneous redemptions, these force the ETFs to sell bonds in the secondary market to redeem shares, expediting a sell-off. Because investors know this, they may be encouraged to sell, as the Bank for International Settlements wrote in a report last Sunday: 

"[T]he unique structures of ETFs might allow, or even encourage, less stable investment behaviour by owners of these products". Short volatility strategies act similarly: by selling volatility and put options in good times, they buy the dip, keeping stocks and credit within a narrow range. Lower volatility, in turn, generates profit for such trades and encourages more investors to pile into the same strategies. In a sell-off, however, the mechanism works the other way around and exacerbates the sell-off.

The result is increased fragility: if a flash crash can cripple markets during a global expansion, what will happen in a recession? And can financial market fragility translate into economic volatility?

While the Federal Reserve is normalizing policy rates, the European Central Bank and Bank of Japan remain the fulcrum for central bank balance sheets making up half of global QE assets. This means it will be more difficult for them to exit without shocks. In turn, financial shocks can hurt growth, potentially through three contagion channels.

Firstly, if QE worked through a wealth effect on asset prices and consumption, falling markets could reverse it. In the US, the top 10% of income earners account for a quarter of national consumer spending, according to the Bureau of Labor Statistics. This is also the group of people who saw their net wealth grow 24% from 2010-2016, thanks to rising asset prices, while the bottom 40% of earners experienced a decline in net wealth in the same period. In other words, income and wealth distribution has become increasingly polarized, which makes domestic consumption vulnerable to a financial market slump. 

Have you read?

What impact can QE have on inflation and growth? 

Ten years after the Credit Crunch, here's how to stop the next financial crisis 

The payback date for today's economic recovery is getting closer 

Secondly, easy monetary policy has reduced funding costs for corporates but has also kept "zombie companies" alive, instead of having them restructured. This weak tail of corporates are susceptible to a sharp rise in bond yields: default risks would increase materially if the five-year Treasury yield is near 3% and high-yield spreads are above 500bp, according to UBS research.

Thirdly, tighter and more volatile financial conditions tend to discourage investments and dampen sales, which, in turn, hurts growth. As research by the St Louis Fed suggests, corporate investment in 1990-2015 on average dropped by more than 10% when financial conditions were bad, while sales growth also stagnated. The deterioration in investment and sales is especially pronounced for companies with high dependence on external financing. 

Since the crisis, regulators have focused on bank capital to prevent a reoccurrence, while macro-prudential measures have overlooked market risks.

To build an anti-fragile market, regulators should encourage diversity and long-term incentives among investors, preventing negative feedback loops and promoting instruments that act as circuit-breakers in a crisis, such as convertible bank capital for banks and growth-linked debt for sovereigns. Without these measures, the risk of tail-events will remain high, and the likelihood of a full-policy normalization is low. Investors should prepare for hurricanes while the sun is still out.

BofA: This Is "The Last QE Trade"

Last week we reported that shortly after the biggest equity fund inflows on record at $43BN, retail investors were whipsawed and amid the latest spike in market vol which sent the VIX back over 20, yanked a "huge" $19.9BN in cash from equity investments, of which the $18.6BN in equity ETF outflows was the second highest on record.

And while last week may have been shortened by one day thanks to Easter, the volatility remained with US equities subject to increasingly greater swings in both price and sentiment.

As a result, according to BofA, equities closed off the quarter with another "huge" week of outflows, led by $13.1BN pulled from equities ($10.6BN from ETFs and $2.5BN from mutual funds), as well as $2.0Bn in bond redemptions. It is worth noting that already some 22% of the record YTD inflows into equities have now been unwound.

With the sharp recent reversal in sentiment, it is hardly surprising that Q1 saw the first quarterly loss in the S&P 500 since 2015 and the first quarterly decline in the FTSE All World index since the start of 2016.

And while the US was once again the focus of selling, it was not all doom and gloom. In fact, in what BofA's Chief Investment Strategist, Michael Hartnett, has dubbed "the last QE trade", Japan registered the second biggest inflows on record of $5.8bn & annualizing record $149.3bn inflows for 2018 as investors scrambled into the safety of the only central bank which has not given any indication it will be tapering any time soon.

According to the FT, it is likely that local Japanese investors took profits on overseas holdings, bringing the money home ahead of the end of the fiscal year on March 31. EPFR Global said most of the cash into Japanese equity funds was yen-denominated, while recent strength in the yen would also have made such a move attractive.

What is bizarre is that this flood into Japan counter-intuitively also coincided with testimony in a cronyism scandal involving Abe's government: Nobuhisa Sagawa, an ex-finance ministry official, said the decision to alter documents about a sale of public land was made by his staff alone and there were no orders from Abe, his wife Akie Abe, finance minister Taro Aso, or any of the prime minister's aides (some have said Sagawa was clearly lying to protect his former bosses, potentially under duress but so far there is no proof of that).

"It is a respite," said Max Gokhman, head of asset allocation at Pacific Life Fund Advisors, adding that the scandal was "an ongoing issue".

Perhaps the explanation is far simpler: the BOJ simply stepped in, guns blazing, and bought everything it could... just as the ECB did last week with European bonds. Sure enough, on Tuesday, the day of Sagawa's testimony, the Topix index added 2.7%.

In contrast Europe inflows rolling over with biggest outflows since July 2016.

In spite of big losses for big tech companies such as Facebook and Google's Alphabet in March, tech funds saw net inflows of $500m each in the past two weeks. Concerns ranging from online privacy and Donald Trump's opinion on Amazon have halted a rally in the shares of large tech companies that has been a pillar of the US bull market in equities.

Still, as Michael Hartnett adds the tech inflows may be ending: the e-commerce bubble, i.e., the "belly of tech bull market"...

... is now off 11% from March peak "as Occupy Silicon Valley policy drumbeat gets louder" still, Hartnett notes that the $18bn inflows in past 6 months dwarf $5bn prior 15 years.

Tech also represents another key danger to the market as the vulnerability of leadership in the equity sector remains: there are just 5 "sells" out of 250 FAAMG recommendations, and "at March peak market cap Facebook ($541bn) > India ($462bn)" (see:"Hedge Fund CIO: "The Market Generals Are Dead"). Furthermore, at 24%, the tech share of US EPS has rarely been exceeded.

Meanwhile, the pillar that has been carrying equities for years (courtesy of cheap debt-funded buybacks) appears to be cracking as bond funds took a $1.9bn hit in the latest week.  In fact, as BofA points out highlighting the "crack in credit", we just saw a "rare week of outflows across IG, HY & EM debt; in contrast 10th straight week inflows to Treasuries."

This is a classic risk-off move, or as Max Gokhman said, commenting on the interest in short-term government debt, "I would look at that as straight-up de-risking. People may see short duration [assets] as a safe haven given all the recent volatility."

In Unprecedented Move, China Plans To Pay For Oil Imports With Yuan Instead Of Dollars

Just days after Beijing officially launched  Yuan-denominated crude oil futures (with a bang, as shown in the chart below, surpassing Brent trading volume) which are expected to quickly become the third global price benchmark along Brent and WTI, China took the next major step in the challenging the Dollar's supremacy as global reserve currency (and internationalizing the Yuan) when on Thursday Reuters reported that China took the first steps to paying for crude oil imports in its own currency instead of the US Dollars.

A pilot program for yuan payment could be launched as soon as the second half of the year and regulators have already asked some financial institutions to "prepare for pricing crude imports in the yuan", Reuters sources reveal.

According to the proposed plan, Beijing would start with purchases from Russia and Angola, two nations which, like China, are keen to break the dollar's global dominance. They are also two of the top suppliers of crude oil to China, along with Saudi Arabia.

A change in the default crude oil transactional currency - which for decades has been the "Petrodollar", blessing the US with global reserve currency status - would have monumental consequences for capital allocations and trade flows, not to mention geopolitics: as Reuters notes, a shift in just a small part of global oil trade into the yuan is potentially huge. "Oil is the world's most traded commodity, with an annual trade value of around $14 trillion, roughly equivalent to China's gross domestic product last year." Currently, virtually all global crude oil trading is in dollars, barring an estimated 1 per cent in other currencies. This is the basis of US dominance in the world economy.

However, as shown in the chart below which follows the first few days of Chinese oil futures trading, this status quo may be changing fast.

Superficially, for China it would be a matter of nationalistic pride to see oil trade transact in Yuan: "Being the biggest buyer of oil, it's only natural for China to push for the usage of yuan for payment settlement. This will also improve the yuan liquidity in the global market," said one of the people briefed on the matter by Chinese authorities.

There are other considerations behind the launch of the Yuan-denominated oil contract as Goldman explains:

• A commercial benchmark and hedging tool. Until now, Chinese oil imports were based on FOB benchmarks, with long-term procurement contracts settling off Platts Oman/Dubai or Dated Brent. The INE contract has therefore the potential to become the pricing reference for CIF China crude oil, enabling corporate financial hedging. Its warehouse structure is however likely to limit its use for physical crude delivery and may in fact at times reduce its hedge efficiency.
• A new investment vehicle for onshore investors. The majority of China commodity futures trading volumes are from retail investors, yet these had until now little ability to trade oil futures. China's capital control was the main bottleneck  to trading contracts like Brent as authorities only allow $50,000 outflow a year per person. While several petrochemical and bitumen contracts already trade in China, INE will be the first contract for crude oil, likely drawing significant interest.
• Direct access to China's commodity markets for offshore investors. China offers deep and liquid commodity markets to its onshore investors. Due to China's tight capital controls, however, foreign investors have so far only been able to trade these through qualified onshore subsidiaries. The INE contract opens up the first channel for offshore investors to trade in its onshore commodity market, with both the USD deposit and capital gains transferable back to offshore accounts. The government further announced last week that it would waive income taxes for foreign investors trading these new contracts for the first three years. The obligation to trade in Yuan will also add a currency risk exposure to offshore investors. We illustrate in Exhibit 6 a likely template (amongst others) of how overseas investors will be able to access INE liquidity.

The danger, of course, is that such a shift would also boost the value of the Yuan, hardly what China needs considering it was just two a half years ago that Beijing launched a controversial Yuan devaluation to boost its exports and economy.

Still, in light of the relative global economic stability, Beijing may be willing to take the gamble on a stronger Yuan if it means greater geopolitical clout and further acceptance of the renminbi.

Which is why restructuring oil fund flows may be the best first step: as of this moment, China is the world's second-largest oil consumer and in 2017 overtook the United States as the biggest importer of crude oil; its demand is a key determinant of global oil prices.

If China's plan to push the Petroyuan's acceptance proves successful, it will result in greater momentum across all commodities, and could trigger the shift of other product payments to the yuan, including metals and mining raw materials.

Besides the potential of giving China more power over global oil prices, "this will help the Chinese government in its efforts to internationalize yuan," said Sushant Gupta, research director at energy consultancy Wood Mackenzie. In a Wednesday note, Goldman Sachs said that the success of Shanghai's crude futures was "indirectly promoting the use of the Chinese currency (which, however as noted above, has negative trade offs as it would also result in a stronger Yuan, something the PBOC may not be too excited about).

Meanwhile, China is wasting no time, and Unipec, the trading arm of Asia's largest refiner Sinopec already signed a deal to import Middle East crude priced against the newly-launched Shanghai crude futures contract, which incidentally is traded in Yuan.

The bottom line here is whether Beijing is indeed prepared and ready to challenge the US Dollar for the title of global currency hegemon. As Rueters notes, China's plan to use yuan to pay for oil comes amid a more than year-long gradual strengthening of the currency, which looks set to post a fifth straight quarterly gain, its longest winning streak since 2013.

In a sign that China's recent Draconian capital control crackdowns have sapped market confidence in a freely-traded Yuan, the currency retained its No.5 ranking as a domestic and global payment currency in January this year, unmoved from a year ago, but its share among other currencies fell to 1.7 percent from 2.5 percent, according to industry tracker SWIFT.

A slew of measures put in place in the last 1-1/2 years to rein in capital flowing out of the country amid a slide in yuan value has taken off some its shine as a global payment currency.

But the yuan has now appreciated 3.4 percent against the dollar so far this year, with solid gains in recent sessions.

"For PBOC and other regulators, internationalization of the yuan is clearly one of the priorities now, and if this plan goes off smoothly then they can start thinking about replicating this model for other commodities purchases," said a Reuters source.

Still, it will be a long and difficult climb before the Yuan can challenge the dollar and for Beijing to shift the bulk of its commodity purchases to the yuan because of the currency's illiquidity in forex markets. According to the latest BIS Triennial Survey, nearly 90% of all transactions in the $5 trillion-a-day FX markets involved the dollar on one side of a trade, while only 4% use the yuan.

* * *

Still, not everyone is convinced that the new Yuan-denominated contract will create a "petro-yuan" as the following take from Goldman highlights:

The launch of the INE contract is not just about oil, as it will also be the first Yuan denominated commodity contract tradable by offshore investors. Such a set-up meets the PBOC's monetary policy committee goal to raise the profile of its currency in the pricing of commodities. It has raised however the question of whether the INE contract is an incremental step in achieving the currency reserve status for the Yuan. We do not believe so.

While the INE launch does represent an additional step in the CNY internationalization, the CNY denomination of the INE contract does not in itself imply CNY investments. The INE contract does not represent an opening of China's capital accounts since foreign deposits operate in a closed circuit, deposited in designated accounts and not to be used to purchase other domestic assets. In practice, the collateral deposit and any capital gains can be transferred back to offshore accounts. The potential for greater foreign ownership of Chinese assets is therefore not impacted by CNY oil invoicing and would require instead oil exporters to recycle their proceeds in local assets, for example. The incentive to do this has not changed with the introduction of the INE contracts. In particular, most Middle East oil producers still have currencies pegged to the dollar and limited ability to hedge CNY exposure.

Whether or not Goldman is right remains to be seen, however it is undeniable that a monumental change is afoot in global capital flows, where the US - whether Beijing wants to or not - will soon be forced to defend its currency status as oil exporters (and investors in this highly financialized market) will now have a choice: go with US hegemony, or start accepting Yuan in exchange for the world's most important commodity.

Deja Vu All Over Again? Subprime MBS Demand "Oversubscribed" And S&P Says Risk Is "Contained"

The stock market is at record highs and people with FICO scores as low as 500 are once again happily obtaining mortgages. Not only that, but these mortgages are once again being securitized and are in demand by yield chasers.

All of the elements that are necessary for the 2008 subprime crisis to repeat itself are starting to fall back into place. Aside from the fact that we have inflated bubbles across basically all asset classes for the most part, not the least of which is evident in the stock market, the Financial Times reported today that not only are subprime mortgage backed securities becoming prominent again, but that the chase for yield was what fueling demand:

Issuance of securities backed by riskier US mortgages roughly doubled in the first quarter from a year earlier, as investors lapped up assets blamed for bringing the global financial system to the brink of collapse a decade ago. Home loans to people with scratches and dents in their credit histories dwindled to almost nothing in the aftermath of the crisis, as litigation-weary lenders retreated to patch up their balance sheets.

But over the past couple of years a group of specialist firms has begun to bring the loans back, navigating a dense web of new rules drawn up to protect borrowers and investors in the $9.3tn US home-loan market. Last year saw issuance of $4.1bn of securities backed by loans that would have been called "subprime" before the last financial crisis, according to figures from Inside Mortgage Finance, with the pace picking up in the latter half of the year. The momentum has continued into 2018, with deals worth $1.3bn in the first quarter — twice the $666m issued in the same period a year earlier.

Our central banks have done such a great job of getting us out of our last crisis that the recovery has prompted a mortgage originators and real estate investors to basically do the same exact thingthat they were doing 2006 to 2007. After all, mortgage levels are already almost back to 2008 levels.

(Source)

If that wasn't disturbing enough, the hedge fund partner that FT quotes in the article says that the subprime market has "a lot of room to grow" as if it were some type of new emerging market generating productivity, and not just a carbon copy repeat of exactly what happen nearly 10 years ago.

"The market is . . . starting from such a small base that it has a lot of room to grow," said Jamshed Engineer, a partner at Axonic Capital, a New York hedge fund with more than $2bn in assets under management.

"[Investors] are definitely chasing yields. Whenever these deals come out, for the most part, they are oversubscribed."

The Financial Times article tries to couch the fact that all hell could be breaking loose yet again at some point soon by citing Dodd Frank reforms that we reported in March are already past the Senate. The key provisions of the rollback are:

• Relaxes a host of reporting requirements for small - medium banks, and to a smaller extent, large banks
• Eliminates a reporting requirement introduced by Dodd-Frank designed to avoid discriminatory lending
• Relaxes stress testing requirements intended to show how banks would survive another financial crisis
• Raises the threshold for banks which are not subject to enhanced liquidity requirements, stress tests, and enhanced risk management, from $50 billion to $250 billion - exempting several institutions which could pose systemic risks down the road.
• Allows megabanks such as Citi to count municipal bonds as "highly liquid assets" that could be used towards the "liquidity coverage ratio," - assets which can be quickly liquidated during a crisis. 
• Calls for a report on the risks and benefits of algorithmic trading within 18 months

Despite the fact that the FT states that 500 FICO scores are getting approved for mortgages, S&P, one of the willfully ignorant and blind rating agencies that missed the subprime crisis thinks that everything is going to be fine:

"The risk is contained, in our view," said Mr Saha.

For the way that our Federal Reserve has addressed the problems of 2007 or 2008, these are the end results that they deserve, but the American people ultimately do not.