Edge and Odds

The enemy of knowledge is not ignorance, it’s the illusion of knowledge (Stephen Hawking)

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so (Mark Twain)

Edge and Odds

Invest with smart knowledge and objective odds

BEARNOBULL’S WEEKENDER

Stanley Druckenmiller Admonishes Short Term Thinking, Warns On Debt (By Mark Melin)

Like Blackrock’s Larry Fink, Duquesne Capital’s Stanley Druckenmiller thinks society is borrowing from its future and “is in a short term bubble.” (…)

“Everyone is managing for the short term, and that is the problem with the Fed,” Druckenmiller said. While some are succeeding by ignoring short term, quarter-to-quarter fiscal results, it is the exception rather than the rule, as epitomized by U.S. central bankers. It was the Fed, Druckenmiller says, that “was late in recognizing the situation” that led up to the 2008 financial crisis, and then acted to right the ship. “What they did in 2009 was unbelievable creative, forceful and terrific.” While the best path forward is often best viewed from hindsight, the big question remains that “who knows what would have happened without (the Fed action)?” (…)

After six years of artificial market stimulation “you would have thought we would have gotten out of emergency measures,” he said. “At some point over six years when you have zero rates and quantitative easing, you cause investors to move out the risk curve” and emerging markets are allowed to act irresponsibly and engage in borrowing that “would never be allowed” in a history. (…)

Druckenmiller thinks an excessively accommodative stance by the central bank is “unnecessary” and “causing irrational behavior by governments, investors, corporations.” This behavior “is rampant in our whole society” and is “pulling demand forward today… borrowing from the future. There is a misallocation of resources. We are going to pay the piper at some point.”

When Druckenmiller mentions “the chickens will come home to roost,” he addressed the seldom publicly discussed issue of actual government debt obligations being obfuscated. He pegs real government debt liabilities at $205 trillion, a number that has been echoed by academics and economists. As first publically identified by Boston University’s Larry Kotlikoff and actively discussed in private meetings among quantitatively focused hedge fund managers, the government does not categorize as accounting liabilities money due retiring seniors for social security and medical benefits, as well as certain national defense obligations. Although it received scant press attention, Kotlikoff along with over 5,000 top academics and economists, called on the government to engage in accounting that properly accounts for its full liabilities.

“Sometime between now and 2030 this is going to be a problem, a big problem,” he said, quoting the outer edge of the range.  The problem is in part demographic, as between now and 2050 the over 65, non-working population will grow at 117 percent while the working age population, from 18 to 64, grows at only 17 percent. While those taking retirement benefits from the system will grow dramatically, this spending growth comes off an already high level of entitlement spending on seniors.

Druckenmiller pointed out that the government currently spends $8,000 per child in the U.S. and over $44,000 on each senior. This spending gap is only going to grow on an aggregate basis as 11,000 new retirees are pulling benefits from a “lock-box” social security system that is bereft of assets.

Druckenmiller earlier said he was “worried about the eventual consequences and who is going to pay for it, which is not going to be me.” The answer, according to academics such as Kotlikoff, is to start addressing the situation by at least properly accounting for the situation, the first step. 9…)

Druckenmiller said he is anticipating chaos, a market condition under which he has thrived and generated his biggest absolute returns. He is currently “working on assumption we may have started a primary bear market in July” and “can see myself getting very bearish, but can’t see myself getting very bullish.” He is currently shorting euro on assumption that central bank quantitative easing is going to remain strong in Europe as it is reduced or eliminated in the US amid “heavy breathing” regarding potentially raising rates. It is that “heavy breathing” that could turn into decisive action in December or might just turn out to be bad breath.

Yogi Berra: “When you come to a fork in the road, take it!”

From Gavekal’s Charles gave via John Mauldin:

(…) So, what is the fork now in front of us? To the right, we have what I would call the return to a normal cycle. The great disturbance of 2008-2009 has finally been absorbed. The US economy continues to grow, albeit more slowly than before. The US dollar has made its high, and long yields their lows, together with US inflation. If the world follows this road, it is now time to underweight America and move capital out of the US.

By contrast, to the left we have the risk of something unexpected: a massive rise in the value of the US dollar, similar to the one which followed the last great Keynesian experiment initiated in the 1970s by Federal Reserve chairman Arthur Burns. Most of the time, people analyze currencies on a flow basis, looking at differences in interest rates, current accounts, capital flows, purchasing parities, and so on. For 90% of the time this approach works. However, once in a while, a problem of stock arises.

By 1981 the short position on the US dollar—the dollars borrowed internationally—was greater than the US money supply. Technically the market had been cornered, and the dollar went ballistic. In 1985, in what amounted to the first great quantitative easing in history, the Fed extended massive swaps to the world’s major central banks to allow them to break out of the corner. Something similar happened in 2008.

My concern is that we could be in a similar situation again today (just see the latest BIS Quarterly Review). If we are, then the US dollar will go through the roof, US interest rates will fall by at least half, and US inflation will turn negative. I am not saying that the world economy definitely will take this left hand fork; I am saying that it could.

So, for investors, the solution is not to bet on one or other outcome, but to build a portfolio which will deliver acceptable performance whichever happens. This is difficult, because the two scenarios are clearly not compatible with each other. The only hedge against the second scenario, which would devastate countries and companies with US dollar debts and negative cash flows, is for investors to hold a sizable proportion of their assets in US zero coupon bonds, with a preference for constant durations of seven years or more, which would rally even as equity markets tanked. In parallel, investors should buy far out of the money US dollar calls to
protect their portfolios against a six sigma event, praying that these calls never move into the money.

On the equity front, if we are moving into deflation, investors should own only the shares of companies selling goods and services elastic to prices. These are easily identified, because today they are the ones with rising sales. Investors should eliminate companies which have falling sales from their portfolios, as these companies are obviously selling goods and services which are inelastic to price. In the second scenario, they would get killed. During the latest earnings season fewer than half US companies reported rising sales, so equity portfolios investing only in companies selling goods and services elastic to prices will have massive tracking errors against the indexes. This is the price you will have to pay if you want to survive.

This 3-D Map Shows the Cities Where Most Economic Activity Happens in the USA
Martini glass How Millennials Are Changing Wine

“SO MANY MILLENNIALS ARE interested more in the narrative of the wine rather than the wine,” said Jason Jacobeit, the 29-year-old head sommelier of Bâtard restaurant in New York. “A lot of mediocre wine is being sold on the basis of a story.”

Mr. Jacobeit lamented the fact that few of his generational peers took the time to understand why certain wines are greater than others. The rustic sparkling wine Pét-Nat (short for pétillant-naturel), for example, may be hip and fun, but it will never be as great as Champagne. Mr. Jacobeit said that his peers need to learn to distinguish the difference between “being excited about wine and wine that is genuinely exciting.”

Taylor Parsons, the 35-year-old wine director of République in Los Angeles attributes these “gaps” in millennials’ wine knowledge to their incessant search for the next cool thing, be it orange wine or Slovenian Chardonnay. “We get tons of requests for Slovenian Chardonnay,” he said.

Which might just mean you’ll soon be seeing many more Slovenian Chardonnays on restaurant wine lists. After all, millennials have been heralded as the generation capable of changing everything. The largest generation to date at 75 million strong, they certainly have clout. This group of 18- to 34-year-olds is technologically savvy, environmentally engaged and eager for stories about the things they love. They’ve helped transform the way we connect with one another, but will they also (re)shape the way we drink? I’d say “perhaps,” although a millennial might answer “Yaaaasssss!” (…)

So how and where are millennials getting their wine education? “Millennials don’t like ratings, but they like some kind of review,” said Adam Teeter, the 32-year-old editor and co-founder of VinePair, a New York-based online wine magazine for millennials. “They have a great thirst for knowledge.” (…)

Yet with conventional wisdom holding that millennials don’t care about luxury and aren’t loyal to brands, it’s little wonder that wine producers all over the world—like every other business—are scrambling to figure out what they want.

And it’s safe to say that whatever millennials do want, they’ll probably get it; by 2017, they’ll have more buying power than any other demographic group. So though boomers and Gen Xers helped build and sustain the wine business over the years, companies big and small are paying attention to millennial habits and marketing their products accordingly. (…)

E.&J. Gallo Winery’s Carnivor Cabernet is a perfect example. Launched in 2013 and priced at $15, the wine is aimed at young male drinkers. “Millennials are very driven by word-of-mouth, so we engage key influencers in conversation about our product,” Molly Davis,Gallo’s vice president of marketing, wrote in an email about the brand’s strategy. In other words, they send bottles to bloggers and hold tasting events. Carnivor Cabernet’s website is heavy on social media, promoting the hashtag #DevourLife and featuring a feed from its Instagram account. And the company has put together a guide to meat cuts, with recipes, in the hope of furthering its millennial appeal. (…)

The Cour-Cheverny was acceptable, but the back story I told them—an obscure white grape (Romorantin) that almost disappeared—was deemed uncompelling. “Maybe if the story was more interesting I would have liked the wine more,” Confused smile said Steven, a 32-year-old lawyer. In this regard, at least, my focus group supported the research I’d found. (…)

Will millennials in the end “revolutionize” wine—or banking or dining, for that matter? Will they render wine scores obsolete and classic wines like Bordeaux and Burgundy mere runners up to…Slovenian Chardonnay? Perhaps. They’ve certainly done their part to promote small producers creating interesting wines in odd corners of the globe. But to truly claim their position as the most powerful consumers in the world, they’ll need to develop a broader context and a deeper understanding of the entire world of wine—and not just an appreciation of a good story or a few obscure grapes.

NEW$ & VIEW$ (6 NOVEMBER 2015): The “Old Normal”

Surprised smile U.S. Employers Add 271,000 Jobs

U.S. Yields Climb to Highest in Almost Four Months Before Jobs

From Reuters:
THE ‘OLD NORMAL”

Moody’s brings us back to the “old normal:

  • Forward-looking market lifts Treasury yield above model’s prediction

In addition to the high-yield spread, a regression model that predicts the 10-year Treasury yield includes (i) the federal funds rate, (ii) the annual rate of core PCE price index inflation, and (iii) the percent of employees aged at least 55 years among its other explanatory variables. The regression equation’s exceptionally strong adjusted R-square statistic of 0.91 shows that the model performs very well at explaining the 10-year Treasury yield.

The statistical inquiry utilized monthly data beginning with January 1985 and ending in September 2015. According to the model, the recent 10-year Treasury yield eclipsed its predicted value. Some combination of expectations calling for a higher fed funds rate, faster core inflation, and a thinner high-yield spread explain why the predicted 10-year Treasury yield now exceeds the actual yield. (Moody’s)

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  • Core inflation stands out among 10-year Treasury yield’s primary drivers

Among the primary drivers of the 10-year Treasury yield, none is more significant than the annual rate of core PCE price index inflation and that is shown by core inflation’s very high “t-statistic” of 17.0. Holding everything else constant, the model suggests that for each percentage point rise by the annual rate of core PCE price index inflation, the 10-year Treasury yield increases by 90 bp.

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  • 10-year Treasury yield often moves independently of fed funds

When the other explanatory variables of the model are unchanged, a percentage point increase by the fed funds rate is expected to add 23 bp to the 10-year Treasury yield, on average. However, the relatively lower “t-statistic” warns of a wider band around the average response of a change in the 10-year Treasury yield to movement by fed funds. Forces other than the fed funds rate exert considerable influence over the 10-year Treasury yield. As the accompanying chart shows, the benchmark Treasury yield moves independently of fed funds, where the inverted yield curve serves as an extreme example. The latter refers to situations where the fed funds rate exceeds the 10-year Treasury yield. In the past, an inverted yield curve has been a reliable harbinger of an impending recession.

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GDPNow

The Atlanta Fed GDPNow model forecast for real GDP growth (seasonally adjusted annual rate) in the fourth quarter of 2015 rose to 2.3% on November 4, up from 1.9% on November 2. Following the Non-Manufacturing ISM Report On Business, the forecast for fourth-quarter real consumer spending growth increased from 2.4% to 2.7% while the forecast for real fixed investment growth increased from 3.0% to 4.3%.

Evolution of Atlanta Fed GDPNow real GDP forecast

Number of First-Time Home Buyers Falls to Lowest Levels in Three Decades Figure represents third straight annual decline and lowest percentage since 1987

First-time buyers fell to 32% of all purchasers in 2015 from 33% last year, the third straight annual decline and the lowest percentage since 1987, according to a report released Thursday by the National Association of Realtors, a trade group.

The historical average is 40%, according to the group, which has been recording such data since 1981. (…)

Without them, current owners have difficulty trading up or selling their homes when they retire. (…)

The median price of previously built homes sold in September was $221,900, up 6.1% from a year earlier, according to the NAR. The median price for a newly built home rose to $296,900 in September from $261,500 a year ago, according to the Commerce Department. (…)

A quarter of first-time buyers said their biggest challenge was saving for a down payment. Of those, a majority said student loans were the main obstacle. (…)

The typical first-time-buyer household earned $69,400, up from $68,300 in last year’s survey. They purchased a 1,620-square-foot home costing $170,000. The median repeat buyer purchased a 2,020-square-foot home costing $246,000. (…)

EARNINGS WATCH
  • 437 companies (90.1% of the S&P 500’s market cap) have reported. Earnings are beating by 4.8% (4.7% yesterday) while revenues have missed by -0.2%.
  • Expectations are for a decline in revenue, earnings, and EPS of -4.0%, -1.8%, and -0.9%. EPS growth is on pace for -0.4% (-0.3%), assuming the current beat rate for the remainder of the season. This would be 6.4% excluding Energy (6.6%). (RBC Capital)
Low oil lifts credit risk at US banks Joint report from regulators finds value of weak loans rises 9.4%

In a joint report US banking watchdogs said the value of weak loans nationwide had risen by 9.4 per cent from last year, while the value of loans that were heading towards trouble was up 18.5 per cent. (…)

The total value of loans to oil producers and service companies is $276.5bn, or 7.1 per cent of the universe of big loans assessed jointly by three federal regulators in an annual review.

Outside the oil and gas sector, the regulators said leveraged lending and loose underwriting were also increasing credit risk. (…)

“REINVESTORS” VS “RETURNERS”

[U.S. large corporations’] profitability, as measured by the Credit Suisse Holt group in a new white paper, shows a 13.5 per cent return on investment once excess cash is excluded. That excess pool of cash is enormous — $2.1tn, or 15 per cent of total assets.

That cash can be deployed in mergers and acquisitions, or reinvested in the business, or distributed to shareholders via dividends or by purchasing stock so as to shrink the outstanding float of shares.

Historically, according to the Holt white paper, companies have deployed an average of 60 per cent of their cash flows in capital investment (whether organically or through M&A) and have returned 26 per cent to shareholders (12 per cent dividends and 14 per cent share buybacks). More recently, the capital invested has dropped to 53 per cent while cash returned to shareholders has increased to 36 per cent, with an increasing share going to buybacks.

For the past seven quarters, according to S&P, at least 20 per cent of S&P 500 companies have reduced their share count by 4 per cent or more. That has risen to 23 per cent in the latest quarter. (…)

The Holt paper follows the fortunes of “reinvestors” and cash “returners” and finds that the latter increase their sales by only 5 per cent per year over the ensuing five years on average. Reinvestors managed to grow sales at 19 per cent per year. So the critics’ picture of tired ex-growth companies, out of ideas for growth, and deciding to reward their shareholders to the detriment of the chance for economic growth, has at least something to recommend it. (…)

But it is still hard to read the pattern of cash flows optimistically, even if financial engineering has brought the US stock market close to its all-time highs for now. Companies are getting less cash than they used to, they are not optimistic that they can invest it productively and so they are choosing to deploy it in a way that weakens the chances of sales growth in the future. Not encouraging. (FT)

High five Are share buybacks jeopardizing future growth? Fears that US companies underinvest by paying too much back to shareholders are unfounded. Rather, the rise in buybacks reflects changes in the economy.

By McKinsey’s calculations, share buybacks alone have increased to about 47 percent of the market’s income since 2011, from about 23 percent in the early 1990s and less than 10 percent in the early 1980s.1 Some investors and legislators have wondered whether that increase is tantamount to underinvestment in assets and projects that represent future growth.

It isn’t. Distributions to shareholders overall, including both buybacks and dividends, are currently around 85 percent of income, about the same as in the early 1990s. Instead, the trend in shareholder distributions reflects a decades-long evolution in the way companies think strategically about dividends and buybacks—and, more broadly, mirrors the growing dominance of sectors that generate high returns with relatively little capital investment. (…)

Regardless of the proportion of buybacks to dividends, there’s little evidence that distributions to shareholders are what’s holding back the economy. In fact, on an absolute basis, US-based companies have increased their global capital investments by an inflation-adjusted average of 3.4 percent annually for the past 25 years5 —and their US investments by 2.7 percent.6 That exceeds the average 2.4 percent growth of the US GDP. Furthermore, replacement rates have remained similar. Capital spending was 1.7 times depreciation from 2012 to 2014, compared with 1.6 times from 1989 to 1999.7 The only apparent decline is in the level of capital expenditures relative to the cash flows that companies generate, which fell to 57 percent over the past three years, from about 75 percent in the 1990s.

That’s not surprising, given how much the makeup of the US economy has shifted toward intellectual property–based businesses. Medical-device, pharmaceutical, and technology companies increased their share of corporate profits to 32 percent in 2014, from 13 percent in 1989. Since a company’s rate of growth and returns on capital determine how much it needs to invest, these and other high-return enterprises can invest less capital and still achieve the same profit growth as companies with lower returns. Consider two companies growing at 5 percent a year. One earns a 20 percent return on capital, and the other earns 10 percent. The company earning a 20 percent return would need to invest only 25 percent of its profits each year to grow at 5 percent, while the company earning a 10 percent return would need to invest 50 percent of its profits. So a higher return on capital leads to higher cash flows available to disburse to share-holders at the same level of growth.

That is what’s happened among US businesses as their aggregate return on capital has increased. Intellectual property–based businesses now account for 32 percent of corporate profits but only 11 percent of capital expenditures—around 15 to 30 percent of their cash flows. At the same time, businesses with low returns on capital, including automobiles, chemicals, mining, oil and gas, paper, telecommunications, and utilities, have seen their share of corporate profits decline to 26 percent in 2014, from 52 percent in 1989 (Exhibit 2). While accounting for only 26 percent of profits, these capital-intensive industries account for 62 percent of capital expenditures—amounting to 50 to 100 percent or more of their cash flows.

Here’s another way to look at this: while capital spending has outpaced GDP growth by a small amount, investments in intellectual property—research and development—have increased much faster. In inflation-adjusted terms, investments in intellectual property have grown at more than double the rate of GDP growth, 5.4 percent a year versus 2.4 percent. In 2014, these investments amounted to $690 billion.

Certainly, some individual companies are probably spending too little on growth—just as others spend too much. But in aggregate, it’s hard to make a broad case for underinvestment or to blame companies returning cash to shareholders for jeopardizing future growth.

Money Goldman Tries Quicker Promotions to Keep Junior Bankers Happy

Hopefully, GS et al will also teach them ethics, that is if they have any…

    But what the heck!

    Will this be better?

    BofA is building a robot to provide investment advice.

    Winking smile Have a good weekend!