America’s energy independence was an illusion created by cheap debt. All that’s left to tally is the damage.
Ever since the oil shocks of the 1970s, the idea of energy independence, which in its grandest incarnation meant freedom from the world’s oil-rich trouble spots, has been a dream for Democrats and Republicans alike. It once seemed utterly unattainable — until the advent of fracking, which unleashed a torrent of oil. By early 2019, America was the world’s largest producer of crude oil, surpassing both Saudi Arabia and Russia. And President Trump reveled in the rhetoric: We hadn’t merely achieved independence, his administration said, but rather “energy dominance.”
Then came Covid-19, and, on March 8, the sudden and vicious end to the truce between Saudi Arabia and Russia, under which both countries limited production to prop up prices. On March 9, the price of oil plunged by almost a third, its steepest one-day drop in almost 30 years.
As a result, the stocks that make up the S.&P. 500 energy sector fell 20 percent, marking the sector’s largest drop on record. There were rumblings that shale companies would seek a federal lifeline. Whiting Petroleum, whose stock once traded for $150 a share, filed for bankruptcy. Tens of thousands of Texans are being laid off in the Permian Basin and other parts of the state, and the whole industry is bracing for worse.
On the surface, it appears that two unforeseeable and random shocks are threatening our dream.
In reality, the dream was always an illusion, and its collapse was already underway. That’s because oil fracking has never been financially viable. America’s energy independence was built on an industry that is the very definition of dependent — dependent on investors to keeping pouring billions upon billions in capital into money-losing companies to fund their drilling. Investors were willing to do this only as long as oil prices, which are not under America’s control, were high — and when they believed that one day, profits would materialize.
Even before the coronavirus crisis, the spigot was drying up. Now, it has been shut off.
The industry’s lack of profits wasn’t exactly a secret. In early 2015, the hedge fund manager David Einhorn announced at an investment conference that he had looked at the financial statements of 16 publicly traded shale producers and found that from 2006 to 2014, they spent $80 billion more than they received from selling oil. The basic reason is that the amount of oil coming out of a fracked well declines steeply after the first year — more than 50 percent in year two. To keep growing, companies have to keep plowing billions back into the ground.
The industry’s boosters argue that technological gains, such as drilling ever bigger wells, and clustering wells more tightly together to reduce the cost of moving equipment, eventually would lead to a gusher of profits. Fracking, they said, was just manufacturing, in which process and human intelligence could reduce costs and conquer geology.
Actually, no. The key issue is the “parent child problem.” When wells are clustered tightly together, with so-called child wells drilled around the parent, the wells interfere with one another, resulting in less oil, not more. (This may not surprise anyone who is attempting to be productive while working in close quarters with their children.)
The promised profits haven’t materialized. In the first half of 2019, when oil was around $55 a barrel, only a few top-tier companies were profitable. “By now, it should be abundantly clear that the current shale oil business model does not work — even for the very best companies in the industry,” the investment firm SailingStone Capital Partners explained in a recent note.
Policymakers who wanted to tout energy independence disregarded all this, even as investors were starting to lose patience. As early as 2018, some investors had begun to tell companies that they wanted to see free cash flow, and that they were tired of compensation models that rewarded executives with rich paydays for increasing production, but failed to take profits into account. As a result, fracking stocks badly underperformed the market.
But with super-low interest rates, investors in search of yield were still willing to buy debt. Over the past 10 years, the entire energy industry has issued over $400 billion in high-yield debt. “They subprimed the American energy ecosystem,” says a longtime energy market observer.
Even as the public equity and debt markets grew cautious, drilling continued. That’s because one big source of funding didn’t dry up: private equity. And why not? Private equity financiers typically get a 2 percent management fee on funds they can raise, so they are incentivized to take all the money that pension funds, desperate for returns to shore up their promises to retirees, have been willing to give them.
In the Haynesville and the Utica Shales, two major natural gas plays, over half of the drilling is being done by private equity-backed companies; in the oil-rich Permian Basin, it’s about a quarter of the drilling. From 2015 through 2019, private equity firms raised almost $80 billion in funds focused mostly on shale production, according to Barclays.
Until the capital markets began to get suspicious, private equity investors could flip companies they had funded to larger, public companies, making a profitable exit regardless of whether or not the underlying business was making money.
That, too, is ending, as investors in such funds have become disillusioned.
You can see how all of this is playing out by looking at Occidental Petroleum. In 2019, Oxy, as it’s known, topped a competing bid from Chevron and paid $38 billion to take over Anadarko Petroleum, which is one of the major shale companies. Since that time, Oxy’s stock has plummeted almost 80 percent in part due to fears that the Anadarko acquisition is going to prove so wildly unprofitable that it sinks the company.
On March 10, the company announced that it would slash its dividend for the first time since the early 1990s, when Saddam Hussein’s invasion of Kuwait sent oil prices plummeting.
Occidental is just one piece of the puzzle. In April, the Energy Information Administration cut its forecast for U.S. oil production, estimating that it will fall both this year and next — suggesting that the days of huge growth in production from shale are over.
On March 10, Scott Sheffield, the chief executive of Pioneer Natural Resources, a major driller in the Permian Basin, told Bloomberg that U.S. oil output could fall by more than two million barrels per day by next year if prices remain where they are today.
“This is late ’80s bad,” a close observer of the industry says.
After the United States engaged in a high-stakes negotiation with Russia and Saudi Arabia to curtail production, a tentative deal was struck on Thursday. Certainly, President Trump, who has staked so much on the American shale industry, wants to save it. “We really need Trump to do something or he’s going to lose all the energy states in this election,” Mr. Sheffield told CNBC in late March.
A deal, and higher oil prices, might help the industry. But they won’t fix its fundamental problem with profitability. Energy independence was a fever dream, fed by cheap debt and frothy capital markets.
All that’s left to tally is the environmental and financial damage. In the five years ending in April, there were 215 bankruptcies for oil and gas companies, involving $130 billion in debt, according to the law firm Haynes and Boone. Moody’s, the rating agency, said that in the third quarter of 2019, 91 percent of defaulted U.S. corporate debt was due to oil and gas companies. And North American oil and gas drillers have almost $100 billion of debt that is set to mature in the next four years.
It’s still unclear where most of this debt is held. Some of it has been packaged into so-called collateralized loan obligations, pieces of which are held by hedge funds. Some of it may be on bank balance sheets. Investors in the equity of these companies have already seen the value of their holdings decimated. Pension funds that have poured money into private equity firms may take a hit soon, too. All we know for sure is that fracking company executives and private equity financiers have made a fortune by touting the myth of energy independence — and they won’t be the ones who have to pick up the pieces.
An orgy of borrowing, speculation and euphoria has left the markets on the verge of catastrophe
Financial markets have experienced the fastest ever crash over the past few weeks. Even during the dotcom bust and the Lehman crisis, stocks did not fall this quickly. In less than a month, we have seen major indices fall almost 30%, and stocks in sectors such as oil and travel down by 80%. We are experiencing terrifying daily declines not seen since the 1929 stock market crash that preceded the Great Depression.
We are at a watershed moment: the coronavirus Covid-19 is a catalyst fast bringing many long simmering problems to the boil. It is exposing the creaking financial systems around us and it will change the way economies function. Economic and financial pundits, however, have been focusing almost exclusively on the short-term effects of coronavirus and so are missing the much bigger themes at play.
Epidemiologists tell us that when it comes to the virus, we are looking at a once in a century event. It is highly contagious and highly lethal. Experts are not comparing Covid-19 to SARS or Swine Flu, but to the Spanish influenza of 1918 that killed between 50 and 100 million people worldwide.
We do not have good data on what the stock market did during the 1918 flu, but we do know that it led to a severe recession. The connection between influenza and recessions is well documented. Going as far back as the Russian flu in 1889-90, the Spanish flu in 1918, the Asian flu in 1957-58 and the Hong Kong flu of 1968-69 — they all led to recessions. This one will be no different.
But this recession will not only be driven by the economic loss of able-bodied workers, it will be helped along too by the steps political leaders take to avoid the spread of the coronavirus. In medicine, the immune system’s response can often be worse than the disease. When the body goes into septic shock, the immune system overreacts, releasing what doctors refer to as a cytokine flood, which can reduce blood to vital organs and lead to death. Sepsis is common and kills more than 10 million people a year. Today, the political reaction to Covid-19 is causing something akin to a septic shock to the global economy.
The recession is likely to be very sharp and but brief. Recessions are self-regulating. De-stocking of shelves and warehouses leads to re-stocking. Collapsing low interest rates and oil prices eventually spur spending and borrowing. Government spending and central bank easing eventually feed through to the real economy. While there will be massive panic and bankruptcies today, there is little doubt that markets will be better in a year, and certainly will be in two to three years,
But the structural changes to how our economy operates, however, will be felt for decades to come. And this is in large part because we didn’t learn the lessons of the last crash.
Over the years since the 2008 crisis, central banks have been trying to stamp out every single small fire that flares up (the European crisis in 2011-12, the Chinese slowdown in 2015-16, the slowdown last year); but suppressing volatility and risk only creates bigger fires. Risk is like energy and cannot be destroyed. It can only be transformed.
Forest fires are a useful analogy. California has infrequent, devastating forest fires; the Mexican state of Baja California has many small frequent fires and almost no major catastrophic fires. Both states have a similar climate and vegetation, yet they have vastly different outcomes. That’s because when there are very few small fires, underbrush grows, vegetation increases and creates greater kindling for the next fire. Suppressing small risks only makes them emerge eventually as very big ones.
In politics and economics, massive change events tend to happen not in orderly sequences, but in sudden spasms, like the Arab Spring, or the collapse of the Eastern Bloc. Watching events unfold is often like watching sand grains pile slowly on top of one another until a final, random grain causes the entire pile to collapse. People knew the Arab countries were fragile and that the Eastern Bloc might eventually fall, but predicting which grain of sand would do it precipitate either was impossible.
Physicists call these transitions critical thresholds. Critical thresholds are everywhere in nature. Water at moderate temperatures is disorganised and free-flowing, yet at a given critical value, it has an abrupt transition to a solid. It’s the same with the sandpile: one grain too many can trigger collapse — but which one?
In 1987 Per Bak, Chao Tang, and Kurt Wiesenfeld found that while sandpiles may be individually unpredictable, they all behave the same way. The critical finding of their experiments was that the distribution of sand avalanches obeys a mathematical power law: The frequency of avalanches is inversely proportional to their size. Much like forest fires, the less frequent they are, the more catastrophic they are.
It’s the same with financial markets and the economy. We will experience years of quiet, interrupted by sudden avalanche. Years of slowly adding grains of sand can end abruptly — to our great surprise. Today in financial markets, many unsustainable trends have been building, and the coronavirus is merely the grain of sand that has tipped the sandpile.
It would be controversial to say that the stock market reaction to the coronavirus would not have been very big had we not been in the middle of an orgy of borrowing, speculation and euphoria. Of course, stocks would have fallen with coronavirus headlines, but it is unlikely they would have crashed the way they did without those exacerbating factors. Furthermore, without enormous underlying imbalances of high corporate debt, the prospect of poor sales would not have driven so many stocks to the verge of collapse.
This aspect of the current crisis has so far gone unreported. But not unmentioned. A few weeks before the crash, Charlie Munger, vice chairman of Berkshire Hathaway and Warren Buffett’s longtime business partner, issued a dire warning, “I think there are lots of troubles coming,” he said at the Los Angeles-based Daily Journal annual shareholders meeting. “There’s too much wretched excess.”
Speculative euphoria was at record highs. As Sir John Templeton once said, “Bull markets are born in pessimism, grow on skepticism, mature on optimism and die on euphoria.” Investors were all on the same side of the boat, and it capsized, as happens in market crashes.
- Investors were buying a record amount of call options, or bets on stock prices rising further. According to SentimenTrader, by early February, “We’ve never seen this level of speculation before. Not even close.”
- Asset managers were betting in record quantities on stock futures, which are instruments to bet on underlying indices. Positioning in S&P futures hit a new high as of February 11.
- Hedge fund borrowing to buy stocks was at a 24-month high. They were highly confident markets would keep rising.
It was not a coincidence that there was such euphoria. Retail brokerages had announced over the past few months that they were eliminating all commissions on trading activity. Buying and selling stocks was suddenly “free”. It was like pouring truckloads of kerosene on a blaze. At Charles Schwab, daily average trading revenue exploded 74% after the change.
In scenes reminiscent of the dotcom boom, stocks were doubling overnight. Virgin Galactic Holdings, with no revenue, was worth over $6 billion dollars. Tesla, which has never made money selling cars, had a market capitalisation greater than any other car manufacturer. Its stock price quadrupled in less than three months. The market was so stretched that it would have crashed due to its own absurdity — with or without coronavirus.
The source of this “free” trading came from high frequency trading firms that are supposed to act as market makers, executing buys and sells for clients. Except that they are not really disinterested middlemen; they are running their own trading strategies to make money off retail investors. They execute the order flow of so called mom and pop investors and profit from these “dumb money” retail traders, in the words of Reuters.
The brokerages which sell retail orders receive hundreds of millions of dollars in return from the market makers. This means that, essentially the market makers are bribing the brokerages to profit from retail traders. For example, E*Trade received $188 million for selling its customer order flow last year, while TD Ameritrade made $135 million in the fourth quarter alone. The market makers are willing to pay so much because they almost never lose money — they trade fast and know where the market is going.
As Warren Buffet once said, “As they say in poker, ‘If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.’” Retail is the patsy.
Ken Griffin is the owner of Citadel Securities the biggest market-making firm, and his business is so profitable that he has gone on one of the greatest property buying sprees of all time. In 2015 Griffin paid $60 million for multiple condo units in Miami. He paid a U.S.-record $239.96 million penthouse in New York City, a $122 million mansion in London, and over $250 million in Palm Beach properties. Market making against “dumb money” is a fabulous business.
As the mania deflated in late February, though, mom and pop were abandoned. As the crash started, market makers pulled back and provided less liquidity. Retail investors were left high and dry. It is no wonder prices fell so quickly.
The high frequency market makers have since been pleading for more capital, and rumors swirl that many are experiencing financial difficulties. The illusion of benign market makers looking after retail investors has vanished.
There are echoes here of the old problems from the Lehman crisis; but they have mutated into different forms. During the Lehman crisis, mortgage bonds were pooled together, and insurance companies and pension funds bought them. Today, retail investors have been buying popular funds known as Exchange Traded Funds (ETFs). These are easy to trade and cheap, but they have a fundamental problem. While ETFs have simple tickers like HYG, JNK, LQD that the average retail broker can trade on their screen, they are really holding hundreds of individual bonds inside of them that the investor is unaware of. These bonds are not easy to trade at a moment’s notice and are highly illiquid. But while the ETFs rose slowly and steadily, and investors poured more money in, lulled by a false sense of security.
While the ETF shares trade daily by the second, the underlying bonds are not easy to trade on their own. In the old days, insurers and pension funds bought these bonds, put them away in a drawer and never traded them. Today, though, investors expect instant liquidity from an illiquid investment. Liquidity mismatches are as old as banking itself (deposits and cash are highly liquid, while mortgages and loans are often completely illiquid); the problems of ETFs have been known all along, and the outcome has been inevitable.
As the coronavirus panic spread, the ETFs started trading at big discounts to the underlying value of the baskets of bonds. Markets are broken, and the gap is a sign of how illiquid the underlying holdings really are.
But these ETFs should never have been allowed in the first place. In the words of Christopher Wood, an investment strategist at Jefferies, “they commoditise equity and bond investing in an insidious way which ultimately creates a dangerous illusion of liquidity. True, ETFs are cheap. But so is fast food.”
While ETFs may appear technical and unrelated to the broader problems in markets, they share the same underlying problem. We have had the illusion of safety and liquidity for some time, and it is the coronavirus that has exposed the gaping holes in financial markets.
The coronavirus won’t kill companies. But it will expose their bloated, overleveraged balance sheets. Corporate debt in companies has never been higher and has now reached a record 47% of GDP.
Rather than encouraging moderation, central bankers and policy makers have been reloading the all you can eat buffet and persuading everyone to come back for third and fourth plates. The European Central Bank and the Bank of Japan have been buying corporate bonds, and central banks have kept funding at zero rates, which has encouraged a massive increase in indebtedness over the past decade.
Central bankers have long promoted high corporate leverage because they see it as a way to stimulate demand. Even now, many economists see no problems on the horizon. In the New York Times, Nicolas Veron, a senior fellow at the Peterson Institute for International Economics in Washington, was openly mocking anyone advocating prudence, “The prophets of doom who thought that more debt was more risk have generally been wrong for the last 12 years.” Like most central bankers for the past decade, he argued, “More debt has enabled more growth, and even if you have a bit more volatility, it’s still net positive for the economy.”
But while debt has encouraged growth, it has also introduced much greater financial fragility, and so the growth is fundamentally unsound. We are now finding out that less debt, rather than lower rates is better for financial stability.
The global economy has gone mad
According to FactSet, 17% of the world’s 45,000 public companies haven’t generated enough cash to cover interest costs for at least the past three years. Debt has been used to finance more debt in a Ponzi fashion. The Bank for International Settlements looked at similar economic measures globally and found that the proportion of zombie companies — companies that earn too little even to make interest payments on their debt, and survive only by issuing new debt — is now higher than 12%, up from 4% in the mid 1990s.
Entire industries are zombies. The most indebted and bankruptcy prone industry has been the shale oil industry. In the last five years, over 200 oil producers filed for bankruptcy. We will see dozens if not hundreds more bankruptcies in the coming year. They were all moribund with oil at $50 dollars; they’re now guaranteed to go bust with oil at $30.
Only now, belatedly, are groups like the IMF waking up to the scale of the problem. In a recent report they warned that central banks have encouraged companies to pursue “financial risk-taking” and gorging on debt. “Corporate leverage can also amplify shocks, as corporate deleveraging could lead to depressed investment and higher unemployment, and corporate defaults could trigger losses and curb lending by banks,” the IMF wrote.
According to the IMF, a downturn only half as bad as 2008 would put $19 trillion of debt—nearly 40% of the corporate borrowing in major countries—at risk of default. The economic consequences would be horrific.
Corporate debt has doubled in the decade since the financial crisis, non-financial companies now owe a record $9.6 trillion in the United States. Globally, companies have issued $13 trillion in bonds. Much of the debt is Chinese, and their companies will struggle to repay any of it given the lockdown and the breakdown in supply chains.
We have not even begun to see the full extent of the corporate bond market meltdown. One little discussed problem is that a large proportion of the debt is “junk”, i.e. lowly rated. An astonishing $3.6 trillion in bonds are rated “BBB”, which is only one rating above junk. These borderline bonds account for 54% of investment-grade corporate bonds, up from 30% in 2008. When recessions happen, these will be downgraded and fall into junk category. Many funds that cannot own junk bonds will become forced sellers. We will see an absolute carnage of forced selling when the downgrades happen. Again, the illusion of safety and liquidity will be exposed by the coronavirus.
The average family is encouraged to save money for a rainy day, in case they are fired, or they face hardship. Saving some money is considered prudent. It’s quite different for business. Companies pocket the profits in the good years and ask Uncle Sam to bail them out in the bad years. Heads shareholders win, tails the taxpayer loses.
Industry can’t be blamed for not expecting an act of God or force majeure, but in the past 30 years we have seen two Gulf Wars, 9/11, SARS, MERS, Swine Flu, the Great Financial Crisis, etc. Saving for a rainy day should only be expected in cyclically sensitive industries.
But rather than do that, companies have been engaging in a rather more reckless strategy: borrowing to buyback shares. This may boost their Return on Equity (ROE), but it is not remotely prudent and makes their companies highly vulnerable. Borrowing to prop up their own shares means they have less on hand when hard times come.
According to Barons, “Stock buybacks within the S&P 500 index totaled an estimated $729 billion in 2019, down from a record $806 billion in 2018.”
And then along came coronavirus.
Of those industries that are now seeking a bailout, none has saved for a rainy day. Boeing, the poster boy of financial engineering and little real engineering, bought back over $100 billion worth of stock over the past few years. Today it is asking the government for a backstop to its borrowing.
According to Bloomberg, since 2010, the big US airlines have spent 96% of their free cash flow on stock buybacks. Today, they’re asking US taxpayers for $25 billion.
Airline CEOs have been handsomely paid while not saving for a rainy day. Delta Airline’s CEO Ed Bastian made the most, earning nearly $15 million in total compensation. American CEO Doug Parker $12 million, while United CEO Oscar Munoz earned total compensation last year of $10.5 million.
Corporate buyback culture is financial engineering not value creation
The cruise liners were little different. Over the past decade, Carnival Cruises paid $9.2 billion dollars in dividends to its billionaire owners and bought back $6.7 billion of shares. Royal Caribbean, which is a smaller company, paid out $2.7 billion in dividends and $1.6 billion in buybacks. And the smallest cruise liner Norwegian Cruise Line spent $1.3 billion on share buybacks.
For years, the cruise lines have triumphally proclaimed massive dividends and buybacks. For example, Carnival proudly announced in 2018. “In just three years, we have doubled our quarterly dividend and invested $3.5 billion in Carnival stock.”
Cruise lines have no real claim to any bailout. They pay no taxes due to a legal loophole, and all their vessels fly the flags of Liberia, Panama and the Marshall Islands. Furthermore, their owners tend to be billionaires with more than enough financial wherewithal to recapitalise their own businesses. Their shareholders are not among the 1%. They’re among the 0.01% of richest people in the world. In the worst-case scenario, the US has a highly efficient bankruptcy process. Bondholders of today become shareholders of tomorrow, and the companies can have a fresh start. Bondholders would only be more than happy to own the equity of these companies.
Banks, too, will inevitably be asking for bailouts before this is over. Banks have among the most aggressive stock buyback programs of any industry, with some repurchasing a staggering 10% of their outstanding shares annually. The eight biggest banks have announced they will suspend their share buybacks for the next two quarters due to the COVID-19 pandemic on the global economy. In 2019, the top eight banks bought back $108 billion of their own stock.
If any good can come of the current crisis, perhaps it is exposing the irresponsibility of share buybacks and lack of prudence of most companies.
Monetary policy was one of the mechanisms employed in response to the last crisis, in the hope its effects would trickle down to the unwashed masses. Central banks bought vast amounts of treasuries and mortgage bonds to tighten financial spreads for banks and borrowers, but none of it went directly to households. It was all intermediated by the financial system and those who had access to capital.
The absurdity of the policy was perfectly illustrated recently in Europe. The European Central Bank has been busy buying bonds, and recently it bought bonds from LVMH, the luxury conglomerate owned by the world’s richest man Bernard Jean Étienne Arnault. The bonds had a negative yield, meaning that the ECB was paying LVMH to borrow. LVMH used the ECBs money to buy Tiffany.
If rates are now so low that billionaires are being paid to borrow, monetary policy has reached the limits of its usefulness.
Investors own stocks because their bond portfolios have acted like a hedge. Whenever stocks have fallen, bonds have gone up. In every downturn since the 1980s, central banks have cut rates, but most government bonds now have close to zero yields.
Extremely low interest rates and high valuations mean that any small change in interest rates will make portfolios much more volatile. If interest rates were to rise even slightly, they would vaporise many bond and stock portfolios. The margin of safety in bonds and stocks has diminished rapidly as rates have approached zero.
The world is now upside down. Many investors now buy stocks for current income and buy bonds to trade given how volatile they have become. Things cannot hold.
What do high frequency market making, share buybacks and high corporate debt have in common? They are supposedly tools to make trading, growth and returns on capital more efficient and cheaper, yet they have made the system more fragile and less resilient. Perhaps returns on capital and cheapness of market orders and ETFs are less important than stability and anti-fragility, i.e. designing systems that are robust in the face of stress.
We have seen the fragility in supply chains in the recent crisis.When the coronavirus struck in China, suddenly companies everywhere found out that outsourcing all their manufacturing and even medicines and face masks to China might be a problem.
Manufacturing has become less robust, more fragile, even if the returns on capital are better for those companies that outsource everything to China in pursuit of share buybacks.
The lessons of history are instructive. Although planting a single, genetically uniform crop might be more efficient and increase yields in the short run, low genetic diversity increases the risk of losing it all if a new pest is introduced or rainfall levels drop.
Have we been played by China?
The Irish Potato Famine is one such cautionary tale of the danger of monocultures, or only growing one crop. The potato first arrived in Ireland in 1588, and by the 1800s, the Irish had used it to solve the problem of feeding a growing population. They planted the “lumper” potato variety. All of these potatoes were genetically identical to one another, and it was vulnerable to the pathogen Phytophthora infestans. Because Ireland was so dependent on the potato, one in eight Irish people died of starvation in three years during the Irish potato famine of the 1840s.
The lessons from nature are dire. In the 1920s, the Gros Michel banana was almost wiped out by a fungus known as Fusarium cubense, and banana shortages became a growing problem. The widespread planting of a single corn variety contributed to the loss of over a billion dollars worth of corn in 1970, when a fungus hit the US crop. In the 1980s, dependence upon a single type of grapevine root forced California grape growers to replant approximately two million acres of vines when the pest phylloxera attacked.
Today, China is manufacturing’s monoculture.
Against this dangerous backdrop of volatility and uncertainty, the coronavirus will now achieve the impossible. For the past few years, two ideas have floated around on the political fringes of the Left, but they have been dead on arrival. No one has seriously thought they might become government policy. Today, the Left and Right in the United States and Europe are embracing them.
Andrew Yang, a former tech executive from New York, ran a quixotic, obscure presidential campaign in the United States based on the idea that every citizen should receive a Universal Basic Income (UBI). He advocated a “Freedom Dividend”. This would be a form of universal basic income that would provide a monthly stipend of $1,000 for all Americans between the ages of 18 and 64.
Today, Trump, Pelosi, Romney and others are fully backing Yang’s idea. Respected think tanks such Brookings and Chatham House have advocated UBI. But once it is implemented, there will be no going back. Handouts will start small and grow.
The other big idea has come from Stephanie Kelton, who advised Bernie Sanders and advocates for Modern Monetary Theory (MMT). Kelton argues that in any country with its own currency, budget deficits don’t matter unless they cause inflation. The government can pay for what it needs by simply printing more money — no reason to borrow by issuing bonds. Helicopter money.
Could free cash fix the economy?
Her ideas were widely criticised across the Left and Right, ranging from Paul Krugman to Warren Buffett to Federal Reserve Chairman Jay Powell.
Yet today, the two ideas have come together. There are no atheists in foxholes. Even libertarians on Twitter are now calling for government intervention. Investors and politicians of all stripes are calling for UBI financed by MMT money issuing.
This is an epochal turning point, a great reset. The coronavirus is the grain of sand that will cause the avalanche.
For once the taboo of printing money to pay citizens is broken, we can never go back. Governments will spend money with few constraints, aided by central banks. It’s a strategy that has not worked well in emerging markets, and it did not work well in the 1970s — which has conveniently been forgotten.
Undoubtedly, the government must compensate citizens from mandatory curfews and quarantines. The short-term impacts of the lockdowns must be mitigated, but temporary policies must not become permanent political expedients.
That’s why the danger is not today or even a year from now, it’s five to ten years away, when the crisis has past, along with the reason for UBI and monetary easing. What politican will be disciplined enough to stop spending? What central banker will raise rates when it is unpopular to do so?
Today we are reaping the whirlwind of the last financial crisis. Rather than pursue lower leverage, less debt and more robust institutions and more responsible corporate behaviour, investors and companies instead learned that they would be bailed out in a crisis.
Central banks became enamored of their own success as fire fighters, and they have busily been trying to put out fires by
- encouraging reckless behaviour,
- prizing low volatility above a robust financial system,
- viewing “risk management” as preferring no financial corrections ever.
They should accept that sometimes putting out every single fire creates greater conflagrations. They should be humbler about the extent and limits of their power.
It looks like they’re about to learn the hard way.
Raoul Pal is a former hedge fund manager who retired at age 36 but remains actively involved in the world of macroeconomics and finance. In recent years, he started a finance news and content service called Real Vision.
In a video posted on YouTube on August 14th, Pal discusses his case for a recession in the next year or so as well as a very alarming scenario he calls the “doom loop.” It’s a fascinating and frightening thesis, and I find it persuasive. Here’s the line of reasoning:
(1) The Fed lowers interest rates to stimulate the economy through increased lending. How else are lower interest rates supposed to stimulate anything besides through more lending, i.e. more debt?
(2) As a result, all sorts of market and government actors increase their debt loads. Corporations, especially, took advantage of falling rates to refinance and take on more debt.
(3) Some of this debt buildup has been for acquisitions or mega-mergers, but much of it was taken on simply for share buybacks. See, for instance, this chart showing the way in which debt issuance and share buybacks became tightly correlated right around the time that the Fed Funds rate bottomed near zero. (See my article addressing this subject here.)
Source: Hussman Funds
Debt-funded buybacks have served as a convenient way for corporate executives to lift earnings per share, thus meeting guidance more regularly and reaching the targets for their performance bonuses more often. (I wrote about this subject here.) What’s more, an SEC study found that insider selling tended to coincide with the announcements or implementation of buybacks.
(4) Indeed, if you look at the performance of U.S. stocks versus any other country or world region’s stocks, you’ll notice a stark difference. U.S. stocks have soared ahead of the competition. It turns out that this is largely because of buybacks, as corporations themselves have been the biggest net buyers of corporate stock since the Great Recession:
Source: Avondale Partners
Notice that institutions (including pension funds) have been net sellers of U.S. equities since the recession. This likely means that pensions have been forced to sell many of their assets to fund benefit payouts but have sold other assets such as Treasuries at a faster rate than equities.
(5) Who is buying all this debt being issued to fund buybacks? The answer, in large part, is pensions. Mainly corporate pensions:
Writes Mark Johnson: “This uptick in bond buying has caused corporate pension funds to play a more influential role in the bond market, since pension managers tend to hold bonds for the long term. As more and more companies adopt the strategy of buying more bonds, pension demand could total $150 billion a year. It is estimated that corporate pension funds buy more than 50 percent of new long-term bonds, up from an estimated 25 percent a few years ago.”
So corporate pensions are buying more and more bonds. Which bonds? Specifically, corporate bonds: “Pension plans… like to use corporate bonds to hedge liabilities.” Corporate bonds offer the highest yields. Of course, pensions are only allowed to own investment grade corporate debt, but if they opt for longer duration or lower rated bonds they can get a higher yield. In the previous twelve months, BBB-rated corporate bonds have yielded as high as 4.83%, certainly better than the highest yield offered by the 20-year Treasury bill in the last twelve months — 3.27%.
BBB-rated corporate debt has grown to be roughly half of all corporate debt outstanding. That’s one (small, for some companies) step above junk status.
(6) During a recession, much of this investment grade debt (Pal guesstimates 10-20%) will be downgraded. But remember: pensions cannot own junk bonds. If BBB-rated debt on their books gets downgraded, they will be forced to sell it, even at a loss. If multiple downgrades happen quickly in succession, the supply of newly labeled junk bonds will overwhelm demand from other market buyers of those debt instruments. This could lead to a fire sale scenario, in which the prices of junk bonds plunge as pensions dump huge supplies into an unsuspecting market.
(7) Not only would pensions have to accept a fraction of their cost basis for these former investment grade bonds, they would also see their primary revenue stream — tax revenue — slacken during a recession. Tax receipts, after all, are as cyclical as the business cycle. When individuals and businesses aren’t making as much money, there is less available to be taxed. This would diminish demand for corporate bonds, which would cause corporate bond yields to spike.
(8) All of this chaos in the credit markets will make it very difficult for corporations to issue debt at anything other than high rates. This will cause the costs of new debt to soar high enough for buybacks to become prohibitively expensive. Moreover, cash flows will dry up, as they do in every recession, and thus every potential source of funds to use for buybacks will disappear.
(9) If the previous points play out, the biggest net buyer of U.S. equities over the last ten years will no longer be a buyer. “The largest buyer will have left the room,” as Pal says. In fact, publicly traded corporations may actually be net issuers of shares during the next recession as they were in 2008-2009.
In the words of Jesse Colombo, “If the stock market performed as poorly as it did in 2018 with record amounts of buybacks to prop it up, just imagine how much worse it would be if buybacks were to slow down significantly or grind to a halt?”
I don’t see how the preceding chain of events playing out as described would not ultimately result in a very nasty stock market crash. Whether it’s a relatively quick crash like in 2008-2009 or a bit more drawn out like from 2001-2003 is unknown. Either way, I see the above scenario as plausible. Disturbingly so.
Since I’m an income-oriented investor, my preferred method of hedging against this possible crash scenario is to hold ample cash and ultra-short term bond funds. That way, if this scenario does play out, I will be prepared to buy assets at fire sale prices with yields higher than I might ever see again in my lifetime.
Raoul Pal’s thesis is fascinating, but it could be wrong. What I’m much more certain of is that the Fed bears the majority of the blame for the underfunding of pensions and thus for putting us into a situation in which Pal’s thesis would even be possible.
Transcript00:01MIKE GREEN: Mike Green, I’m here for Real Vision at the Real Vision Studios in New York00:05City.00:06Today, we’re going to sit down with another individual who is known for his work in the00:10past of space, in particular, his work on ETFs.00:13Steven Bregman has a been on Real Vision before with an extended series called, “The Dark00:18Side of ETFs,” where he sat down with Grant several years ago.00:21We’re going to revisit that, particularly in the context of some of the stuff I’ve talked00:24about.00:25I’m really interested in how Steven thinks about the endgame of the passive strategies00:29and how to think about the influence in the market.00:32Let’s sit down and see how this goes.00:34Steven, you and I have not had the chance to talk for a couple of years, you’ve been00:40one of the other voices in the wilderness shouting about the risks associated with passive00:44investing.00:45I’d love to pick into your brain and understand the approach that you’re taking to some of00:50these challenges and some of the opportunities that are created by the growth of passive00:55investing.00:56One of the places to start is one of the areas of difference.00:59I focused primarily around the indexing component and you’ve spent a lot of time talking about01:03ETFs.01:04STEVEN BREGMAN: Well, essentially, they’re one of the same.01:07Sometimes people use the terms interchangeably because they don’t know the difference, and01:12they’re being casual about it, and I do the same actually, ideal primarily with direct01:18individual clients.01:19They’re not institutions.01:20They don’t have an institutional mindset.01:25They’re unaware of real differences.01:29They’re unaware of the fact that asset management companies, Wall Street is not really about01:36investing.01:37It’s about asset gathering.01:39They would be unaware, for instance, that how does an index come to be.01:44An index comes to be because a certain asset management specialize in this might be under01:53pressure from ever declining fees and you can’t charge a premium fee for a commodity02:00product.02:01Once upon a time, I think the fees on S&P; 500 index are like 50 basis points 60 basis02:07points, now, they’re down to zero.02:11What do you need to do to justify a higher fee?02:15Create something that seems to have, at least has the fig leaf of differentiation.02:20You can charge more for that, at least for a while.02:24You invent a new index, you do some back testing, you find some bucket of 20 or 30 or 40 companies02:32that fit some theme that back test well for the last five years.02:36By definition in this industry in modern portfolio theory, as applied nowadays, that means, some02:44positive rate of return with some relatively low comparative volatility, beta correlation,02:53what have you, and then you can float a new index, and they’re from offering ETF against03:03it.03:04You can’t even get it off the ground unless it back test well.03:08That’s how that works.03:09Indexes don’t just come about because they’re good investments, they come about because03:13it’s an opportunity for a management company to gather assets through a new ETF for which03:19at least initially, they can charge 45 or 55 or 65 basis points.03:23They can keep that fee, except if they’re lucky enough to gather enough assets, not03:2810 or 20, 30, or 40, 50 million, not even enough to break even, but if I gather some03:35hundreds of millions of dollars, well, then somebody else would come and knock them off,03:39like Vanguard and drag the fees down again.03:41People don’t even get these basic concepts and because my natural audience are individuals,03:46who really are the victims of this asset gathering business that parades as an investment business,03:56we study that.03:57MIKE GREEN: Well, you and I originally started in the same space.04:01You come up from the classic stock picker, single stock focus, run a highly concentrated04:06portfolio and by some measures, you found a few names that you think are truly extraordinary.04:11We can talk about a few of them if you’d like, but your insight into ETFs that I know you04:18from the Grants Conference discussions is largely around the dynamic of many different04:25ETFs buying the same underlying products, and this tendency to overlap.04:30You’ll see very high representation of Exxon Mobil, you’ll see very high reputation representation04:35of other stuff.04:36The dynamic that you’re talking about now, where effectively you offer a good back test04:41to try to offer something that you can actually charge fees for and the potential for if that04:48gets to scale, either you to lower your costs so that new entrants can’t come in and replicate04:52it or to be disintermediated by one of the giants in the industry.04:56STEVEN BREGMAN: They’re very disinclined to do that, they need every penny.05:00MIKE GREEN: Yeah.05:02How do you think about this dynamic of the difference between a Vanguard model and a05:08BlackRock type model where they are charging rock bottom fees and the need within the industry05:15for innovation in order to push forward how thought process is going?05:19STEVEN BREGMAN: The whole thing doesn’t even make a difference.05:22There’s no differentiation.05:24The whole thing, I’m going to say something, it sounds incendiary, I don’t mean to be incendiary,05:28but well, I shouldn’t say it’s a lie, but it’s false.05:33The whole thing is a false premise.05:34Now, we actually have the evidence.05:37The evidence is in.05:40We now have a couple things I’ll mention.05:43First of all, the great indexation passive investing ETF experiment, which took off for05:50real, more or less yearend 1999.05:53Slowly at first, but it was given a real boost in the wake of the 2007-2008 financial crisis06:00and people got really scared.06:02Now, they did everything that people do, which is act reflexively, which is not necessarily06:07helpful, which is first of all, sell your securities and memorialize a perhaps temporary06:14loss.06:15Then when they get back in after there’s confirmation that things are going up, which means they’ve06:19lost much of the recovery.06:23That’s normal.06:26What they did is they defaulted immediately to ETFs.06:29They were there.06:31They had time to become better known.06:35They’re a better mousetrap than a mutual fund and people had been really traumatized.06:43Traumatized, by the way, not just individual investors, but their brokers, financial advisors,06:49trustees of pension funds, [indiscernible] they all work.06:53They were scared of risk, all kinds of risk; manager risk, security specific risk, everything.07:02The proposition of an index made a lot of sense.07:06People had the experience, I could buy my favorite REIT.07:10Maybe that’s the one that goes to zero or I could buy an REIT sector index fund, and07:17it might not do well but it’s not going to zero.07:21That started taking off.07:22ETFs is supposed to be better, and indexations are better.07:29People like me could talk about it and analyze it and start coming up with a very amusing07:34and hopefully illuminating examples of how distorted it was becoming.07:38It was still subject to a lot of argumentation that passive investing, which is supposed07:42to benefit from the free rider principle, we just want to participate in the wave of07:48what active managers do when they contest in the open market and the set clearing prices07:53and just participate without changing anything.07:55We could argue that they’re beginning to actually alter clearing prices but those are arguable.08:02We could argue that the only reasons they were outperforming active management then08:10that came to be there are any innumerable articles about it, that active management08:14has just been proven to underperform indexes.08:19We could argue that simply because they were pushing up their own very limited number of08:25securities in which they traffic people and understand that you have to elucidate that08:29also why that is, but that was all arguable.08:33Now, we’ve got some proof because now, we’ve got a 20-year track record for ETF -based08:42index investing and history has spoken, and they all found one thing.08:48The S&P; 500 for the last 20 years has got roughly a 4.5% annualized return.08:59If you go to the MSCI All Country World Index, less than that, maybe 3.5% or 4%.09:06If you bought a 20-year Treasury note, and you’re in 1999, you could have bought about09:10a 6.3% or 4% yield.09:12MIKE GREEN: Remember it well, yes.09:13STEVEN BREGMAN: You could have done just fine.09:15They didn’t even perform as well as called a risk free Treasury but 20 years is a long09:22time.09:23Then if you take another look at what we think is the primary risk to investors, and the09:31primary responsibility of an investment advisor is not comparable returns to some other manager09:38or to some set of managers or some abstract index or an index with some abstract purpose09:46or importance, but at the very least, to maintain someone’s purchasing power over time, and09:52hopefully to increase it.09:54Well, the measure of monetary debasement over these last 20 years, M2 money supply expansion,09:59has been more than 6% a year.10:01In that sense, if you owned the iShares S&P; 500 index over the last 20 years, you actually10:09lose in purchasing power.10:10MIKE GREEN: How do you disaggregate that, though, between the outcome versus the process?10:14Because if I were to point to active manager performance, almost by definition has to be10:20worse, because we’ve seen in aggregate, active managers underperform the benchmarks.10:24STEVEN BREGMAN: What are the benchmarks?10:28What if the benchmarks are rigged?10:29What are we going to be talking about here?10:31MIKE GREEN: Yes, exactly.10:33STEVEN BREGMAN: By the way, I should preface this by saying I’m willing to try to defend10:38it and I feel comfortable with that.10:41I think this is the– not just the United States but globally, we’re in the biggest10:45financial bubble ever that includes stock, include bonds.10:50Basically, it’s the entire set of financial assets worldwide.10:54It doesn’t happen in a vacuum.It happens because it’s unprecedented, but it follows on the heels of something whosecausality here, something else is unprecedented is there’s never before been a coordinatedglobal coordination by the world central banks to drive interest rates down to these artificiallylow rates.Now, people have caught on to this.I have books at home that have the evidence, the lowest interest rates in 5000 years.One of the things that’s happened is that it raises financial asset prices, makes peoplefeel good, but it’s actually very pernicious, because it transfers the risk and returnsbetween savers and borrowers.If you’ve done everything you’re supposed to as an individual, you’re a retired accountantor you’re an attorney or you’re a doctor, and you pay for your house and you’ve gota million dollars, $2 million saved up.11:52What’s $2 million times if you put it all into a 10-year US Treasury note in less than11:572% and it’s taxable, but even if it’s not taxable, what do you get?12:01You can hardly live on that.12:03If you don’t expect to spend your principal, you don’t know when you’ll die.12:07MIKE GREEN: Yeah, it’s a pretty extraordinary statistic.12:09STEVEN BREGMAN: It’s a crisis.12:11I like to differentiate, there’s a term statistic and then there’s a place for interpreting12:15for people, because it’s really a crisis, it’s a yield crisis, and people can’t get12:23yield.12:24What does that do?12:25There’s a dynamic to bubbles, they build over time and people owned a series of bonds, municipal12:36bonds or corporate bonds, or within a bond fund and little by little, their maturities12:41calls and the yield goes down because the coupon goes down, or the average coupon goes12:46down, because they replace it with lower coupon bonds and happens slowly.12:52Little by little, people realize I’ve got a problem.12:55Wall Street is a unique industry.13:00Among other respects, that is the only industry I know of, in which, if there’s sufficient13:08demand for a product, they can create effectively infinite supply almost instantaneously.13:16If someone likes a certain GM truck, they have to retool, there’s certain amount of13:22capital you got to put in, but they’ll sell you whatever you want.13:28What happens?13:30Some firms see, oh, there’s a need for yield.13:31Why don’t we create– it also helps the fee aspect.13:35Let’s create a dividend aristocrats ETF index.13:40You’ve got various kinds of companies like they collect the higher dividend yield and13:45so people, they go with their lead there.13:51You get less than 2% in the Treasury, if it’s looking good, 3.5% in this REIT index or this13:57dividend aristocrats index.13:59They put more money into bonds than they really should, been into equities than they should.14:07They’re doing what they can.14:09Then you have the dividend aristocrats fund and so forth and so on, but it’s important14:13to understand the magnitude of asset flows into index funds.14:21We’re talking about several hundred billion dollars every single year for a decade, it’s14:27actually been climbing until this past year, and what happens is when you have trillion14:33dollar asset managers, and they create a new fund, and it could be a $200 million fund,14:39a $400 million fund, a $500 million fund and there’s going to be a knockoff of one of the14:45competitors, as a pure business proposition, you’ve got some really bright people in the14:51back office, working up different packages of stocks, new indexes, and they tried to15:00make it work.15:02Let’s just say that they create a list that back test really well, that’s got a nice theme15:07to it and then they bring it to their managers, they managed it well, there’s a problem here,15:15is that you’ve got these hundred stocks, except in the nether regions of that list by market15:21weight, the ones at the bottom, they just don’t have the trading liquidity.15:25They’ve got so many shares per day of trading.15:28They’re an X percent, let’s say it’s equal weighted, and it’s X percent of your list15:34and we can’t go above certain liquidity limits that we set in place, we can only raise 10015:40million dollars for this.15:41It’s not even worth the time, barely pays for your salaries.15:46They go back to the drawing board and they fiddle with the rule set.15:49It’s a very simple rule set, and they simply drop out.15:51They find a way to drop those companies out.15:53It’s legitimate.15:55We’re only– we have this list, but only companies with above this much creativity or whatever.16:00Now, you drop those out and suddenly, you can raise $500 million.16:04That’s an example of why real practical purposes, the ETFs or their bond ETFs or stock ETFs16:13have trafficked substantially completely in large cap and mega cap stocks.16:20They really need basically industrial strength trading liquidity, which is why you find Exxon16:26Mobil everywhere they can put it and why you find technology stocks in funds where they16:35don’t belong, because Facebook’s really liquid, or Microsoft’s really liquid, to find a way16:40you can find individual stocks, like an Exxon Mobil or Microsoft or something else, and16:46you’ll find they’re in growth ETFs, they’re in value ETFs, they’re in momentum ETFs, they’re16:50in fundamental tilted ETFs, they’re in dividend ETFs, they’re everywhere.16:53If you actually look at it, it defies logic other than they need the trading liquidity.17:01There’s so many systemic risks in the market now.17:03What will happen is when something gets over done enough, when you get like a deep bear17:09market, you get a bubble, aside for the fact that they can go higher than you ever imagined,17:13more overvalued then you ever imagined, or lower, they become a variety of systemic risks.17:20One of them nowadays, systemic risk, set systemic risk meaning it’s going to affect substantially17:26most of the securities in the universe you’re talking about, a single variable and one of17:32those variables now– I know you’ve observed it and are concerned particularly, you study17:39it closely, is the concentration risk.17:43People are unaware of what the concentration risk now is.17:46They think they’re getting diversified.17:49Diversification semantically only just a name, because all the same stocks are being owned17:54by these ETFs.17:56The fund flows come in, the ETFs are– the indexes are price agnostic, there is no–18:04in their short list that makes up the rule set for inclusion or exclusion of ETF, market18:12cap, industry sector, PE, whatever it might be, those descriptive attributes, there is18:17no place for valuation.18:20It’s not on that list.18:21There are different ways to talk about the concentration risk.18:25Not too long ago, only a matter of weeks ago, I accounted up in the S&P; 500, the top 10018:33names, 20% of the names accounted, just happens that the numbers of this even 67% of the market18:40value of the index.18:43That’s real concentration.18:44Although we’ve never had concentration like that before.18:47They drive the market.18:49The asset allocation’s idea of shifting from one sector to another in terms of market capitalization,18:55it can’t happen anymore.18:57I think the figures for the Russell 2000, is it $2 billion and below?19:02MIKE GREEN: I think it’s a little higher than that actually now, but yeah, something like19:06that.19:07STEVEN BREGMAN: The sum, the complete market capitalization of all the Russell 2000 stocks,19:12it may only be several percent the value of the Russell 1000, S&P; 500.19:19Even if for the sake of argument, it were undervalued, let’s say it were undervalued19:24and people just wanted to shift some money there, they can’t.19:27You can’t have a thimble that’s a 5% or 6% size to accommodate that.19:35In one sense, people– they don’t know it, but they’re stuck.19:37They’re stuck in the dark, there’s nowhere to go.19:40They’re going to go to treasuries and earn a basically return that will [indiscernible].19:46I want to talk about that too, because the lie or the complete let’s say misapprehension19:53of indexation, talk about active managers you asked me before.19:57This is a long winded way of getting around to this response, which is that the indexes20:03have been buying automatic bid.20:07Every time money comes in, they’re required probably to buy and hold all the stocks they20:12own in precise proportions.20:14They’ve been buying their own book.20:18It’s arguable, pushing them up.20:23Therefore, this is not passive, if you’re not participating in whatever the clearing20:30price mechanism established by active managers.20:33In fact, one of the reasons why active managers have done more poorly is they have been the20:39bank of funds and you could– there are places to look and you can see on a given year, a20:45given quarter, so much money comes out of active managers, and pretty closely, that’s20:50the amount that goes into indexes.20:52They’ve been the bank providing that, therefore, like [indiscernible].20:55You might like what he does, you might not like what he does, but give him this.21:00He sticks to his knitting.21:01He hasn’t bent.21:03He’s not going to do what he doesn’t want to do in terms of his, let’s say the integrity21:07he has over the investment process.21:09He loses money every quarter, but he’s got to sell and you get redemptions.21:13He’s got to sell things that aren’t in the indexes, there really is no buying interest.21:19He owns undervalued securities, and he’s selling them, make them even less, more undervalued.21:24The system is gamed, I don’t think the conclusion on that basis that indexes have proven active21:33managers to not be able to perform as well as index is false.21:38There’s another anecdotal bit of information I like.21:43I made a list a year or so ago, of like a half a dozen really well respected value managers,21:50value managers who had 20, 30 years of ongoing investment performance over obviously, over21:56multiple cycles, superb performance, like really stellar, well respected, not anymore.22:03Why?22:04Because in the last five or 10 years, they’ve underperformed plus five years, the underperformance22:10year by year, and back to back.22:13Astounding.22:14We’re talking about not just five percentage points, 10 percentage points, 15 percentage22:18points a year.22:20If you take people like [indiscernible] and Chuck Royce and Sequoia Fund and so forth22:25and so on, even Carl Icahn, first of all, there’s information content in that.22:33How can you take, let’s say, half a dozen or 10 people like that, with proven serial22:41success, and suddenly in the last five years– and by the way, they all have different approaches.22:49They have an affinity or skill set for a different type portion of the markets, or style of investing22:56or method of doing it.22:58There’s very little overlap in their portfolios.23:01Suddenly, altogether, they got stupid or incompetent at the same time.23:07It just is quite improbable.23:09Therefore, there’s information content in that which is maybe something else is going23:12on, and I can talk about why the S&P; 500 underperform for 20 years the All Country World Index has23:21and get into that.23:22Before I give you this more specific, another more overarching observation, have you heard23:27of the or read the Bessembinder Study?23:29MIKE GREEN: No.23:30STEVEN BREGMAN: You’re going to like this.23:32I know if you’re going to read some point in the next week or month.23:35My business partner, [indiscernible], came across this and he wrote about it.23:41Let’s call it the academic invalidation of indexation as practiced.23:46This is a guy, Hendrik Bessembinder.23:48It sounds like someone from the 19th century, but– MIKE GREEN: This were in Germany but23:53yes.23:54STEVEN BREGMAN: He’s a professor at Arizona State University.23:56Two years ago, he published a study.23:59It’s a 90-year study of equity returns 1926 to 2016 but it’s entirely different than what24:07we’re used to.24:08It was called little insouciantly, do stocks outperform treasury bills?24:13I tell you, this is a seminal piece of scholarship.24:16It’s like a significant contribution to the field of study of finance, and essentially24:23it invalidates indexation.24:26What he did is the differences that– I used to wonder about this, the reliance as a standard,24:35this is the way it’s supposed to be when you measure performance returns for people.24:40It’s all based on this time weighted percentage rate of return.24:45That’s because it’s designed for institutions, how to compare managers, but individuals,24:52they need to measure their performance in dollars.24:55That’s not how it’s done.24:56All the studies are done that way.25:01The difference is that his study was based on dollars of wealth creation.25:07How much did each company over that period of time contributed in terms of dollars of25:13value increase as opposed to just percentage return?25:17Because that only– I say “only” advisedly, only compounds at 12% a year for 20 years,25:23which is actually really good and creates a lot more dollars of wealth for some small25:28company, in a percentage basis, it’s a rocket ship for 10 years but doesn’t really have25:34that much impact on the total index.25:37This study encompasses over 25,000 different stocks.25:42Of those 25,000 call it 700 stocks, only 1092 by 4% of the total were responsible for all25:53of the $34.8 trillion of wealth generated from the equity market between July 1926 and26:00December 2016.26:0296%, the other portion of all equity studied performed no better than treasury bills.26:09He can draw some very quick conclusions from that or propositions.26:14Indexation as practiced is purports to be a representation of market reality, but it26:24really doesn’t mirror market reality.26:26That’s not how the market works.26:28If 96% of the securities don’t provide a higher return in treasury bills, then when you trade26:34one stock for another, you only have a 4% chance, about 25 chance that the new position26:42will outperform cash.26:44That’s the best argument I’ve heard so far for buy and hold investing.26:48As that 4%, that’s why indexes ultimately undiversified themselves.26:54We wrote exercises about this a long, long time ago, that you just buy a list of stocks.27:03This has to be large enough to encompass a normal distribution.27:06However, that’s 20 stocks or 10, or whatever it is, 30.27:09Most people say 35, statistically is a good number.27:12You just don’t touch it.27:15Then the two smart ones, now you don’t know which one is smarter then, they will outperform27:22over time.27:24Over time, the performance of the account will converge upon the performance of those27:27two stocks.27:30The account will get more and more volatile but it’ll also outperform.27:35The thing about indexation, though, is for a variety of reasons, it will never permit–27:42it can’t permit that to happen.27:43Number one, they’ve placed caps or limits on what a position size can be.27:48Number two, there are constantly new entrants, Uber comes along, IPO, they have to make shelf27:54space for it, they have to reduce so they get diluted over time just in a natural way.28:00Anyway, as practice, one can see why ultimately the indexes can do as well as for variety28:10of reasons, the historical returns suggest.28:11MIKE GREEN: Yeah, I think there’s definitely some truth to that.28:15I think the underlying dynamic of survivorship bias, the inability to fully participate,28:22the other component, of course, is that the participation of the individual is not reflective28:27of the performance of the index.28:29Particularly if you’re buying in an ETF where you’re paying bid versus ask, which can be28:33quite narrow, but accumulates over time.28:35To me, the most interesting thing that’s happened with the index space, though, is actually28:41almost the exact opposite.28:44Because we have functionally locked in a group of stocks that money gets continually piled28:52into.28:53The most popular mutual fund is the Vanguard total market index, where functionally every28:59stock, there are some that are excluded for sampling and liquidity purposes exactly as29:02you’re describing, which get excluded and then continue to underperform which naturally29:07draws the eye of astute value investors such as yourself, which locks in potentially underperformance29:13even as you’re accumulating a greater ownership of an undervalued asset relative to an index29:18that’s playing off of momentum.29:22That type of dynamic perversely actually ends up really damaging the capitalist system.29:30Because companies participate, regardless of their underlying fundamentals.29:34STEVEN BREGMAN: Yes.29:37Now, I’ve changed the way I talk to clients about the market and the bubble and so forth.29:44What I do find people can readily assess our bonds.29:50Bonds have many fewer variables.29:52You’ve got a coupon, you got a maturity date, and if it’s money good, you’re getting 10029:58cents on the dollar at the end period.30:01If you’re not sure it’s money good, that’s usually pretty determinable.30:04That’s not such a mystery usually.30:06I now can use this to talk about the falsity of the way modern portfolio theory and efficient30:18markets and blah, blah, blah, the way that portfolio management is practiced in an institutional30:25basis, which filters into these asset allocation models, which induces people or their investment30:30counselors to put them into certain asset classes and certain indexes and so forth,30:37the basic false premise of it.30:41You mentioned the most popular ETF by size, which is the Vanguard total market.30:46Well, in the bond realm, the fifth largest ETF is the iShares 20-year plus Treasury ETF,31:02TLT is the ticker.31:07Last year, actually through November, it got $7 billion of new assets which increases assets31:13by 65%.31:15Spectacular.31:16The problem is that the average investor who owns TLT probably thinks they did pretty well31:23last year, and they’re very pleased with it.31:25They think it’s a high return low risk investment.31:28Why?31:29Well, first of all, it’s up 14% last year, what they don’t look at necessarily and know31:33to look at is that the average coupon is not even 3%, 2.99%, which means that 80% of their31:41term came from appreciation and that that appreciation only happened because the government31:45lowered interest rates or interest rates were lowered, got lowered.31:49Well, what if they say, what if it keeps getting repeated?31:54Well, there’s obviously a limit to that.31:56Even so, the majority is still only 2.29%.32:00You hold that for 20 years, the same more or less, you can expect that’s what you’re32:03going to get and that is below the rate of inflation.32:10The government is telling you that you are guaranteed for 20 years to this purchasing32:15power every single year.32:17If M2 money supply, which in the last 20 years has been 6.2% or so, last year, it was more32:27like 7%, the last six months, it’s more like 9% on an annualized basis.32:35That’s monetary debasement.32:36If you’re going to lose 4% in terms of purchasing power every year, that means in 10 years,32:46the hundred thousand dollars, the million dollars you put in those 10-year treasuries,32:51those 10-year treasuries will be worth half as much in terms of purchasing power, you32:55could be in real trouble.32:56If the amount of income you’re able to get off, it was just enough for you in year one.33:00That’s an existential crisis for people and they sense it, but they don’t know how to33:05evaluate in terms of what they’re buying.33:07The other problem is how Wall Street describes risk to them.33:12If you go to the TLT website, right on the main page, I’ll tell you, it’s got this duration,33:18it’s got this convexity.33:20I don’t know what that is.33:21MIKE GREEN: You can know what it is, but yeah.33:25STEVEN BREGMAN: Investors aren’t conversant with that.33:29What they don’t know, in terms of risk is that if 20-year interest rates, just for the33:37sake of argument, next year, go from 2.29% which is what is about the [indiscernible]33:43and that is, to five, that they’re going to lose 30% of their investment.33:49They don’t know that.33:50MIKE GREEN: Perversely, though, if that happens because of the higher coupon, they’ll actually33:54end up with a higher total return over that 10-year period.33:58While the immediate impact would be negative, and I spent a bunch of time digging into exactly34:04this topic, post the global financial crisis because I was trying to understand what are34:10the real risks in bonds.34:11The real risks and bonds are exactly as you’re describing that the rates go low and staylow forever.STEVEN BREGMAN: They could stay low.Well, I’m convinced, and this is completely unscientific, this is completely non-technical.I’m a big believer in incentive systems, and basically, behavioral psychology and behavioralfinance, is that interest rates will stay very low if the government can help it fora very, very long time.If it can help it, simply because it can’t afford for them to go up.34:46MIKE GREEN: I agree with that.34:47STEVEN BREGMAN: They’ll do whatever they have to.34:49Eventually, they create a real crisis of one sort or another.34:54MIKE GREEN: I think the interesting challenge is thinking about it from the standpoint not34:57of a valuation system which most people tend to focus on the idea that low interest rates35:02translates to higher valuation, but you’ve referenced them to a couple of times in this.We live in a collateral based credit system.What happens when the government cuts interest rates?The price of the bond goes up.What does that do?It provides you with additional collateral to then go and buy stuff.It’s theoretically worth more even though it’s going to depreciate towards par.I think that is actually one of the key underlying dynamics.We’ve effectively built a system predicated on collateral.It’s not that the interest rate is really what’s driving it, it’s the bond price.35:38What do you see as the alternatives?35:39STEVEN BREGMAN: In today’s world, we have basically a bifurcated market in terms of35:45clearing prices, and how those clearing prices are developed.35:50That is either you’re in the indexation.35:52Above the ETF divide, you’re in the indexation sphere of activity as a security or you’re35:57not, and even excluded by the relatively simple rule sets of the ETF universe because you36:06don’t have the– you might be a large cap company, I’ll name a company, I’m not recommending36:12it or not.36:13AP Moller Maersk.36:14I forget the market cap, could be 30 billion.36:17It’s the largest shipping container company in the world.36:19Aside from the fact that it’s not a US based company, but even if they were, the thing36:25is the Moller family, I don’t remember, but they owned 45%, 55% of shares.36:32Therefore, the effective market cap is way, way lower, it doesn’t suit.36:37It also doesn’t have the volatility return characteristics you might want because the36:44shipping industry has been in depression for years.36:47That’s not going to be in an index.36:48What will happen is, if you’re below what I call below the ETF divide, there is no institutional–36:56for the original purposes, virtually no institutional interest in you.37:01There aren’t any analysts covering you because they can’t get paid to cover you.37:05Therefore, for the first time in my career, which only goes back to 1982, you can have37:13companies, you can get a free lunch– now, there is no free lunch, you have to figure37:17out like why it seems free, otherwise, you’re on thin ice.37:23You can get a free lunch in all sorts of ways because the excesses in the indexation centric37:30securities market has created deficits, in clearing prices and valuations in below the37:38ETF divide.37:39What will happen is that there are companies now that are undervalued not for any fundamental37:45reason, meaning fundamental adding to their balance sheet or their income statement or37:50competition or technological displacement or regulatory problems or management issues.38:00How can you find a decent company trading at a low enough price that you think you’re38:06getting some discount or margin safety?38:08Very, very difficult.38:10You really couldn’t.38:11What you needed to do traditionally is find some company with a blemish, the CEO absconded,38:17they lost a big contract, whatever it might be, stock drops.38:21Then our job is to try to evaluate that and find out whether that insult is transitory38:27or permanent.38:29Whether it’s structural or it’s superficial.38:32I say you know what, in two years or three years or four years, somewhere beyond the38:38standard institutional investment time horizon, I can’t take the time risk, I’m willing to38:41take the time risk.38:42That’s what I think my advantages is, is it’ll be fine.38:48In which case, what’s the normalized earnings on this and what’s some a normalized perfectly38:52average valuation?38:53Oh, I’ll do pretty well.38:54I’ll buy it and wait.38:56That’s what you have to do.38:58Now for the first time, you can buy companies that are deeply undervalued relative to some39:03objective measure, their assets and their assets are profitable, or their earnings or39:09their free cashflow, whatever it might be, good balance sheets, there’s no blemish on39:13them.39:14The only reason they’re cheap is that they’ve been excluded from the indexes, probably either39:22one of two reasons.39:23They don’t have sufficient trading liquidity.39:25Large companies, small or they don’t fit the shape parameters, meaning it might be a trust,39:36or it might be some odd– it might be a multi-industry company.39:42It’s not exactly– it might even be a real estate company, but it’s not a REIT, they39:47want REITs, they don’t lend to development companies.39:50What’s happening now is that if you’re willing to look– if you have the license as an investment39:57advisor, to look below the ETF divide, you can find everything you want.40:02It’s possible.40:03It’s really possible.40:05You can create for somebody, you can create a portfolio with bonds and other income securities40:11or equity series that’s got, let’s say, I’ll give an example, let’s say a 4% gross yield,40:19dividend and interest, some of which is tax exempt, that has strategic, important strategic40:27flexibility, let’s say 20% in cash reserves, that also has both bonds and equities in there40:34that have plenty of optionality of a high order continued to force or modest but steady40:45state internally generated growth in shareholders equity overtime and therefore income production.40:56You can get a yield that’s twice the 10-year Treasury rate.40:59You can have a purchasing power protection.41:04You can get everything you’re supposed to have.41:07Now, is it going to track what’s happening in the marketplace?41:10No, but that’s not my goal.41:11I have a different objective.41:13You can do that, but you can’t find it in the– same with bonds, I heard you discussing41:21this is that you find a bond that’s sure valuation, perfectly good.41:28It’s money good for the next four or five years till it matures but it’s not an index.41:33It might not be a large enough issue, you can buy a 7% yield and it’s not a junk bond.41:40MIKE GREEN: Interesting.41:42Well, I think that’s going to be the interesting question.41:46A lot of the dynamics that you’re discussing, we both experienced in ’99 to 2000.41:51Similar components I’ve talked about, homebuilders right before the big housing bubble being41:55priced at half bulk value.41:57The challenge in my mind, and we referenced it a little bit before in the discussion,42:02it says that we have actually created such a fundamental flaw in the structure of how42:07assets are collected and how money comes into the system.42:10It’s not clear to me that we’re going to be able to capture those means reverting characteristics42:15that you’re highlighting.42:17If 95% of the money that comes in, if millennials who are going to be the millennials, and those42:22who come after them are fundamentally forced into passive investing styles because of regulatory42:30systems, and gain no experience whatsoever, are we setting up the conditions in which42:37we destroy those mean reverting characteristics?42:39I would highlight is a good example, the travails of FedEx relative to Amazon.42:44Amazon functionally has a zero cost of capital because of the dynamics of inclusion that42:52you’re highlighting.42:54They’re able to make investments that would be uneconomic for almost any company to make42:59certainly a large scale logistics company like a FedEx, they’ve been able to build a43:04second FedEx, something we would have thought of was having a giant significant moat for43:09an extended period of time.43:11They’ve been able to replicate it in the period of roughly three years.43:14The real fear that I have is that we’ve broken that characteristic and I think it’s going43:18to be fascinating to see if it reverses itself.43:22STEVEN BREGMAN: You bring up two points which I think spark some responses.43:27One is you’re pointing to something that people forget generationally.43:31Every generation, there are some companies that for 20 years, 30 years, grow and grow43:39and grow and they become recognized.43:42In the course of someone’s life, their personal experience, they’ve been there forever.43:46They’re stable.43:47That’s not how business works.43:50They’re not stable.43:51What’ll happen is that’s another reason why indexes have trouble doing well, which is43:58that one of the reasons why– another reason why they get this 4.5% annualized return since44:03’99 in the S&P; 500, is because if you look at the largest 10 companies in the S&P; 50044:06at the end of 1999, most of them have suffered displacement by competitors.44:14IBM was displaced by cloud computing.44:20Dell was displaced by the emergence of the iPad, and so forth and so on.44:29That’s natural, because the largest companies represent the easiest largest targets for44:36a national competitor to secure customers and revenues, and people think that an Amazon44:46or a Facebook or a Google are somehow impervious to technological displacement.44:54If you take a look, there are a whole variety of companies and technologies or just plain45:01old competition that is beginning to make inroads.45:06We don’t know which will work or not, but to give you a nontechnological form of what45:13can happen, the margins, the returns on equity of the modern Information Technology slash45:21technology companies like Facebook, Google, Twitter, are simply enormous.45:27The stated ROEs might be 30%, or something like that, depending on, but really, it takes45:33all the cash and marketable securities and the market securities in the balance sheet,45:37which are nonproductive, they don’t need them to do the business.45:39You take that away, the returns in equity could be 50%, 60%, 100%.45:44It’s simply like unheard of.45:46It’s not really sustainable.45:48Someone’s going to come after that.45:49Now, how can they come after it?45:51Well, Dell, which displaced all sorts of other companies in manufacturing PCs by doing a46:01direct to consumer approach, and they were willing to sustain a lower profit margin to46:07get there.46:10Dell is now getting into cloud computing.46:16What does that mean?46:18It sets you off up a warehouse, and you buy all the equipment and you do it.46:26Now they’re going to compete.46:28By the way, there’s a food fight going on now.46:32Amazon and IBM, IBM needs to succeed in cloud computing to protect itself now.46:39Dell’s getting involved.46:41Amazon at some point, there’s going to be margin compression.46:47One of those players is going to be willing to take a lower margin just like in ETFs.46:53Here’s why I don’t think it can keep going on.46:58We talked earlier, the bank of funds for suctioning out of active management into the passive47:11management, that’s finite.47:13As of a year ago, I think there’s a Fortune magazine article, they did a study.47:20They thought that we passed the 50% dividing line, very significant one, of all passive47:30assets as a percentage of all investment assets in public markets.47:39That has all sorts of implications.47:40You’ve looked into them yourself.47:42There’s a law of large numbers.47:44Now, there’s 50% float available to them.47:48Now, it’s less, now it’s 49.47:49If that was a correct number, 48.47:52Every year, in order to maintain the same constant pressure on the automatic bid on47:59all the stocks owned by old ETFs and bonds, they need larger inflows each year, like it48:06was $350 billion last year, whatever the number was, now it’s going to be more but the pool48:12from which they’re drawing is getting smaller.48:16That can start to accelerate real fast.48:19When the flow of funds into indexation slows, or stops, or turns negative, there’s no more48:27automatic bid and the marginal trade which is effectively indexation has been for the48:33last 10 years and increasingly in recent years.48:37The marginal trade, like the baton is handed over to the active manager and the active48:43manager, I just referred [indiscernible] because it occurs to me.48:48He’s not buying a blue chip.48:50He’s not into technology, but he’s not buying a day now mature trending into cyclical blue48:57chip, like Coca Cola, or McDonald’s or Procter and Gamble, which actually had sales declines49:04in recent years, at 25 times earnings, just not doing it.49:07Where’s the bid going to be?49:08This is before we get to other dynamics.49:10MIKE GREEN: The pushback that I would make to that is that the old people, for lack of49:16a more descriptive term, are the ones who own active managers.49:20The young people who continue to have inflows are those who own passive vehicles.49:24There’s nothing that actually says that active manager ever gets to bid again, there’s no49:29rule of the universe, there’s no law that says that has to happen.49:32It’s unfortunately catastrophic, but there is no law that requires that.49:38That I think is going to be the really interesting question is, if the system can’t find itself49:43self-regulatory.49:44Sure.49:45STEVEN BREGMAN: The rules again, when you get extremes, you get other possibilities.49:51Since it’s fully disclosed, the precise percentage positions in every single ETF, you know exactly50:01what they own, you know how many total dollars of assets are every in single ETF.50:06At a certain point, if the inflows get small enough, even with a lower age demographic50:18making contributions, it’s going to start to peter out.50:22We don’t know, I’ve never worked with these kinds of numbers the way you have but at a50:27certain point, if it looks like it’s tipping, you can have short sellers who know if there50:33are going to be any redemptions, net redemptions.50:36They’ll know exactly how much is being sold of every single security.50:42They have almost unlimited quantities of assets that they can front run.50:49That’s a different scenario.50:50MIKE GREEN: Yeah.50:51I worked through the numbers, and I think it’s going to be interesting to see how it50:54plays out.50:55I don’t think– STEVEN BREGMAN: It’s more dynamic than that.50:56MIKE GREEN: It’s more dynamic than that.50:58I think the real risk is that we’ve seen short sellers already eviscerated by the inflation51:03that I think is caused by the passive investment process.51:05STEVEN BREGMAN: But the passive investment process has still– that’s why those short51:09sellers are missing an important element.51:15Money’s flowing in, to the tune of hundreds of billions of dollars a year.51:18You can’t get in front of that.51:19MIKE GREEN: Well, to your point, though, that money is coming out of the active managers,51:23are flowing into the passive, ironically, if you have that inflation, the supply of51:28assets that’s available to the active managers goes on much longer.51:32We’ve probably seen this, there’s very few stocks, you highlight it yourself, unless51:36they’re outside of the indices, which Vanguard total market index had very few stocks that51:42actually are outside of that unless they fail to meet float dynamics or ownership dynamics.51:46STEVEN BREGMAN: Yeah, but if they’re, 100th of 1%, they’re in de facto in a de facto sense,51:53but it’s meaningless, statistically meaningless.51:55MIKE GREEN: Yeah.51:56No, I think that’s right, but that’s exactly the point that I’m making, which is the assets52:00that are owned by the active managers who by and large, buy stuff with similar characteristics52:05to the passive indices, you being one of the notable exceptions, they can experience that52:10same inflation and so one of the big push backs I have is the idea that value stocks52:13are cheap as they were ’99.52:15I don’t see that at all.52:16I think there’s elements exactly as you’re describing.52:19I think we’re going to run out of time, but one of the things that I think is going to52:23be so interesting, and I’d love to come back and sit down with you in another year is thisunderlying question of, is there a selflimiting feature?Can this actually wrap back around?STEVEN BREGMAN: I think what’s going to happen is there are going to be some serious socialproblems.MIKE GREEN: I agree.STEVEN BREGMAN: When you see serious tumult in nations, social tumult, it really oftenfollows when there’s been currency debasement, loss of purchasing power, inability to liveon your investments or your income, people get desperate, then things change, desperation,and we’re heading that direction just a lot more slowly than Greece or Venezuela.MIKE GREEN: I share those sentiments exactly.STEVEN BREGMAN: As I mentioned one term, it’s necessary for anybody I talked to, to hearwhether they are willing to let me work with them on it or not, is the ultimate hedge againstcurrency debasement.It might never work, it might never be necessary, but it can save your financial future andit can be done in such a small amount that will never harm you if it doesn’t work, whichis a fixed issuance meaning nondebasable cryptocurrency.If the time ever comes that people in various parts of the world feel they need a non-debasablecurrency, the returns can be on the order of hundreds of times your money.MIKE GREEN: I share those sentiments.54:06Historically, it would be gold.54:08We don’t know if going forward, it’s going to be a crypto asset but I agree with you54:12that those types of nonlinear properties will become an important part of any asset allocation54:17framework.54:18I really look forward to sitting down with you again and sharing these thoughts.54:23STEVEN BREGMAN: I actually enjoyed listening to you more than talk with you.54:27Thank you.
A company’s credit rating is a lot like a person’s credit score. The better the score, the more easily—and cheaply—you can borrow money through the debt markets. The highest score a company can get is AAA. The lowest is D. And for many years, companies strove to get that AAA rating. It wasn’t just the key to low borrowing rates, it was also a sign of solidity and reliability. And it came with serious bragging rights.
Back in the 80s, there were dozens of AAA-rated companies. Today, though, there are just two. Microsoft and Johnson & Johnson. That’s it. Most other companies appear to have given up aiming for that AAA gold standard. They don’t see the point. In fact, many companies seem quite happy to get a BBB-, which is the lowest rating that many investment companies will tolerate, and just one notch above a ‘high-yield’ or ‘junk’ rating.
How can this be? How is it that corporations have gotten okay with letting themselves go like this? We talk with Moody’s Analytics Chief Capital Markets Economist John Lonski and Bloomberg Credit Reporter Claire Boston about what’s changed in the bond market and why companies are content to get a passing grade.