Coronavirus May Kill Our Fracking Fever Dream

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 yearmore 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.

Covid-19 has exposed our financial fragility

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.


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Asset Manager positioning in S&P futures hit a new high as of February 11 in both net contracts and value. S&P futures comprises the bulk of equity futures positioning by these funds.

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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.

The Next Coronavirus Financial Crisis: Record Piles of Risky Corporate Debt

A fast-growing market in junk-rated leveraged loans is showing severe strains, a sign of a looming credit crunch that could stifle future economic growth

Serious strains are starting to appear in the $1.2 trillion market for loans to high-risk companies, which have borrowed record sums in recent years as investors chased bigger yields.

The market, which survived the 2008 financial crisis, has become overstretched since then, say regulators and economists, who worry that it is now so big and risky its problems could amplify any economic damage caused by the coronavirus crisis.

“What I’ve always worried about is that the existence of overleveraged corporations will exacerbate a downturn that occurs for any reason,” said former Fed Chairwoman Janet Yellen in an interview.

Years of low interest rates and easy credit have allowed companies across the board to borrow big, building a record $10 trillion mountain of debt. Lenders expect the vast majority of that money to be repaid on time.

The epicenter of risk involves a subset of that total: $1.2 trillion in leveraged loans, junk-rated debt secured by corporate assets much like mortgages are backed by homes. The market has exploded, ballooning by almost 50%—or $400 billion—since the start of 2015, as investors desperate for the high interest payments these loans provided threw cash at borrowers.

Private-equity firms fueled a lot of the growth, borrowing billions at a time to buy brand names including Dell Technologies and Staples Inc. Smaller but relatively stable public companies like car supplier American Axle & Manufacturing Holdings and electrical supply maker Atkore International Group Inc. also took out leveraged loans to fund share buybacks and acquisitions.

The banks that make such loans rarely hold on to them now because of regulations passed after 2008. Instead they sell the debt directly to money managers or repackage it into complex securities that are marketed to investors around the world.


Should the government rescue investors who made leveraged loans to high-risk companies? Join the conversation below.

When prices of the loans drop, or they fall into default, the losses hit pensions, insurers, and scores of mutual funds and hedge funds, some of which react by selling out, exacerbating market swings.

In addition, investors become less willing to buy new loans and the banks that arrange such deals stop making new ones. That can be compounded by sharp losses in the complex securities Wall Street repackaged many of the loans into, causing credit markets to seize up and leave already indebted companies without access to fresh cash. The consequences could cascade: A wave of defaults and bankruptcies, forcing job cuts and amplifying the economic slowdown.

The impact will likely be long and drawn-out. Most loans don’t start coming due until 2022 and the hardest-hit sector—energy—is a small component of the market. Still, loan prices can fall sharply well before companies run out of cash, hurting investors who own the debt. And as business dries up for some companies, they may not be able to stay current on their existing loans.

Leveraged loans suffered their worst run since the financial crisis this month when a widely tracked index lost about 16% of its value. Prices for loans to 24 Hour Fitness Worldwide, which operates a chain of gyms, fell to about 44 cents on the dollar this week from 80 cents in February, according to analytics firm AdvantageData Inc. Prices of loans to airlines such as United Airlines Holdings Inc. and American Airlines Group Inc. declined about 10% in the first two weeks of March, more than any full-month loss since October 2008, according to S&P Dow Jones Indices.

Repackaging loans into bundles called “collateralized loan obligations” became popular in the 2000s, alongside similar techniques employed to market mortgage-backed bonds. Unlike mortgage bonds, very few CLOs defaulted in the 2008 financial crisis. That record and their high yields have made CLOs popular in recent years, but they are susceptible to violent price swings and have been one of the worst-performing debt investments this month.

Loan investors remain hopeful that the virus will subside and that its aftershocks will be brief. But with the amount of loans outstanding about twice as large as in 2008, according to data from S&P Global, a recession will likely trigger a larger wave of defaults and heavier losses on their debt than the dot-com bubble or the financial crisis, analysts say.

Companies that borrow in the junk loan market now are far weaker financially than those in that era. Borrowers with loans Moody’s Investors Service rated at the lowest rungs of the junk-debt ladder—B3 or lower—made up 38% of the market in July compared with 22% in 2008.

“Investors will probably be surprised by the extent of their losses on loans compared with their historical losses,” said Oleg Melentyev, a strategist at Bank of America Corp. He calculates that about 29% of outstanding leveraged loans will likely default cumulatively in the next credit downturn, compared with an average of about 20% by junk-rated companies during the 2007 to 2009 period. Worse yet, investors will likely recover less money: about half of their original investment, compared with 58% back then.

The storm is rocking even well-established leveraged-loan borrowers like hotel chain Hilton Worldwide Holdings Inc. The company took out a $2.6 billion loan in June to refinance debt left over from when Blackstone Group bought it over a decade ago, according to data from LevFin Insights.

Prices for the loan, stable at 100 cents on the dollar in late February, have now fallen to about 83 cents on the dollar, according to data from IHS Markit. The company has borrowed more in recent days on a $1.75 billion revolving loan—basically a line of credit—to build cash as tourism and travel plummet. Prices of the revolver have fallen to around 79 cents.

Other companies won’t have the same access to cash. “The real risk is in those incremental borrowers, the borrowers who need access to capital that could dry up,” said Frank Ossino, senior loan portfolio manager at Newfleet Asset Management, which holds about $2 billion of leveraged loans in the $10 billion of investments it manages.

Cracks appeared in the market last week as businesses sent workers home, travel slowed, sports leagues halted play and predictions about the virus’s economic impact grew increasingly dire.

A terminal of Reagan National Airport in Arlington, Va., on March 17.


Moody’s downgraded Cirque du Soleil Inc. on Wednesday to a credit rating “in, or very near, default” after the company, which employs 4,000 people, suspended its shows in Las Vegas. Prices of about $700 million in loans the circus operator mostly borrowed for its purchase by private-equity firms in 2015 fell to 68 cents on the dollar from around 94 at the start of the month, according to data from IHS Markit. Officials for the company couldn’t immediately be reached for comment.

CLOs are highly susceptible because they use borrowed money to buy leveraged loans, boosting the yield, and the risk, of the investments. CLO managers issue bonds to buy bundles of leveraged loans, then use cash flow from the loans to pay interest and principal on the CLO bonds, pocketing the difference.

When downgrades and defaults mount, CLO managers stop making payments on their most junior bonds, prices plummet and the market for new CLOs shuts down. Lower-quality CLO securities were the worst performers this month out of 29 types of debt measured by Citigroup Inc. analysts, losing 22% through March 13.

“CLO formation has come to a grinding halt,” said Alex Jackson, chief investment officer for Nassau Corporate Credit, which manages six CLOs and had planned to launch more this year. “It does feel like the market accelerated into a panic over the course of the week.”

Pain TradeLeveraged loan prices are plummeting,punishing investors who piled into the debt inrecent yearsS&P Global Leveraged Loan IndexSource: S&P Dow Jones IndicesNote: Data as of March 18
2016’17’18’19’2017501800185019001950200020502100215022002250Aug. 12, 2018×2120.52

Loan markets seized up briefly the last time stocks tumbled in December 2018, but the declines are much sharper now and many fear a more prolonged disruption. During the last financial crisis, issuance of new leveraged loans slowed to a trickle for about a year starting in August 2008, according to data from S&P Global Market Intelligence.

Also worrying, it became increasingly difficult last week to trade existing loans of large companies normally viewed as comparatively safe bets. The gap between what sellers were asking and what buyers wanted to pay for Dell loans widened to 2 percentage points last week from about a half-point normally. On March 9, too few banks were making markets in the $5.3 billion loan of fast-food chain Restaurant Brands International, which owns Burger King, to accurately price the debt, according to IHS Markit.

If trading dries up, investors and analysts hope the Fed can intervene to avoid a credit crunch. The central bank on Sunday slashed interest rates to near zero and said it would buy $700 billion in Treasurys and mortgage-backed securities to help ease stress in the financial markets.

On Tuesday, the Fed announced plans to start making loans to American companies in a bid to unclog the $1.1 trillion market for short-term IOUs called commercial paper, which companies use to finance day-to-day business operations such as payroll expense.

Eric Rosengren, president of the Federal Reserve Bank of Boston, said earlier this month that without a stronger response from Congress and the White House to combat any downturn, the Fed would need Congress to authorize new tools to spur growth, such as allowing the central bank to purchase corporate bonds and other private-sector assets.

A high level of corporate debt “is one of the negative outcomes of having low interest rates for a long time,” he said. “We’ll see how much of a problem that is for unemployment.”

Worries over the risk in the leveraged loan market have been overstated, said Lee Shaiman, head of the Loan Syndications and Trading Association trade group. The biggest industries in the market, like business services and technology, are less affected by the virus than others, he said. And lower interest rates have cut debt expenses for most borrowers significantly in the past month. Energy companies, among the worst hit in the March turmoil, comprise only 3% of the loan market, according to data from S&P Dow Jones Indices.

But low-rated companies also borrowed more against their assets than ever before, while granting fewer lender protections, or covenants. And there are signs of weakness in some technology firms, which make up about 15% of the loan market. Loans of Coral Gables, Fla.-based data center operator Cyxtera Technologies fell about 14% this month to 72 cents on the dollar, according to IHS Markit.

Cirque du Soleil Inc., which employs 4,000 people, suspended its shows in Las Vegas, leading to a credit downgrade.


Some losses will hit investors in mutual funds, which now own about 10% of outstanding leveraged loans, down from around 17% in 2018 at the recent peak of the market’s popularity, according to research by Barclays PLC. About 65% of the loans are now owned by CLOs.

CLOs have become popular with institutional investors like Canada’s government pension plan and began to show signs of weakness in November when prices of some of their securities swung wildly. The recent selloff has been far worse and newly forming CLOs, which are still purchasing loans from banks, could also get caught in the market freeze.

Some CLO managers who are struggling to sell bonds to investors have begun liquidating the loans they had been accumulating in warehouses, fund managers said. Loans in such warehouses amounted to $10 to $12 billion in early March, according to research by Wells Fargo Securities.

Raoul Pal’s Thesis: The “Doom Loop”

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.

Source: Deloitte

(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:

Source: Milliman

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.

The Risk That Interest Rates Stay Low.. And We Can’t Afford an Increase (Crisis)

MIKE GREEN: Mike Green, I’m here for Real Vision at the Real Vision Studios in New York
Today, we’re going to sit down with another individual who is known for his work in the
past of space, in particular, his work on ETFs.
Steven Bregman has a been on Real Vision before with an extended series called, “The Dark
Side of ETFs,” where he sat down with Grant several years ago.
We’re going to revisit that, particularly in the context of some of the stuff I’ve talked
I’m really interested in how Steven thinks about the endgame of the passive strategies
and how to think about the influence in the market.
Let’s sit down and see how this goes.
Steven, you and I have not had the chance to talk for a couple of years, you’ve been
one of the other voices in the wilderness shouting about the risks associated with passive
I’d love to pick into your brain and understand the approach that you’re taking to some of
these challenges and some of the opportunities that are created by the growth of passive
One of the places to start is one of the areas of difference.
I focused primarily around the indexing component and you’ve spent a lot of time talking about
STEVEN BREGMAN: Well, essentially, they’re one of the same.
Sometimes people use the terms interchangeably because they don’t know the difference, and
they’re being casual about it, and I do the same actually, ideal primarily with direct
individual clients.
They’re not institutions.
They don’t have an institutional mindset.
They’re unaware of real differences.
They’re unaware of the fact that asset management companies, Wall Street is not really about
It’s about asset gathering.
They would be unaware, for instance, that how does an index come to be.
An index comes to be because a certain asset management specialize in this might be under
pressure from ever declining fees and you can’t charge a premium fee for a commodity
Once upon a time, I think the fees on S&P; 500 index are like 50 basis points 60 basis
points, now, they’re down to zero.
What do you need to do to justify a higher fee?
Create something that seems to have, at least has the fig leaf of differentiation.
You can charge more for that, at least for a while.
You invent a new index, you do some back testing, you find some bucket of 20 or 30 or 40 companies
that fit some theme that back test well for the last five years.
By definition in this industry in modern portfolio theory, as applied nowadays, that means, some
positive rate of return with some relatively low comparative volatility, beta correlation,
what have you, and then you can float a new index, and they’re from offering ETF against
You can’t even get it off the ground unless it back test well.
That’s how that works.
Indexes don’t just come about because they’re good investments, they come about because
it’s an opportunity for a management company to gather assets through a new ETF for which
at least initially, they can charge 45 or 55 or 65 basis points.
They can keep that fee, except if they’re lucky enough to gather enough assets, not
10 or 20, 30, or 40, 50 million, not even enough to break even, but if I gather some
hundreds of millions of dollars, well, then somebody else would come and knock them off,
like Vanguard and drag the fees down again.
People don’t even get these basic concepts and because my natural audience are individuals,
who really are the victims of this asset gathering business that parades as an investment business,
we study that.
MIKE GREEN: Well, you and I originally started in the same space.
You come up from the classic stock picker, single stock focus, run a highly concentrated
portfolio and by some measures, you found a few names that you think are truly extraordinary.
We can talk about a few of them if you’d like, but your insight into ETFs that I know you
from the Grants Conference discussions is largely around the dynamic of many different
ETFs buying the same underlying products, and this tendency to overlap.
You’ll see very high representation of Exxon Mobil, you’ll see very high reputation representation
of other stuff.
The dynamic that you’re talking about now, where effectively you offer a good back test
to try to offer something that you can actually charge fees for and the potential for if that
gets to scale, either you to lower your costs so that new entrants can’t come in and replicate
it or to be disintermediated by one of the giants in the industry.
STEVEN BREGMAN: They’re very disinclined to do that, they need every penny.
How do you think about this dynamic of the difference between a Vanguard model and a
BlackRock type model where they are charging rock bottom fees and the need within the industry
for innovation in order to push forward how thought process is going?
STEVEN BREGMAN: The whole thing doesn’t even make a difference.
There’s no differentiation.
The whole thing, I’m going to say something, it sounds incendiary, I don’t mean to be incendiary,
but well, I shouldn’t say it’s a lie, but it’s false.
The whole thing is a false premise.
Now, we actually have the evidence.
The evidence is in.
We now have a couple things I’ll mention.
First of all, the great indexation passive investing ETF experiment, which took off for
real, more or less yearend 1999.
Slowly at first, but it was given a real boost in the wake of the 2007-2008 financial crisis
and people got really scared.
Now, they did everything that people do, which is act reflexively, which is not necessarily
helpful, which is first of all, sell your securities and memorialize a perhaps temporary
Then when they get back in after there’s confirmation that things are going up, which means they’ve
lost much of the recovery.
That’s normal.
What they did is they defaulted immediately to ETFs.
They were there.
They had time to become better known.
They’re a better mousetrap than a mutual fund and people had been really traumatized.
Traumatized, by the way, not just individual investors, but their brokers, financial advisors,
trustees of pension funds, [indiscernible] they all work.
They were scared of risk, all kinds of risk; manager risk, security specific risk, everything.
The proposition of an index made a lot of sense.
People had the experience, I could buy my favorite REIT.
Maybe that’s the one that goes to zero or I could buy an REIT sector index fund, and
it might not do well but it’s not going to zero.
That started taking off.
ETFs is supposed to be better, and indexations are better.
People like me could talk about it and analyze it and start coming up with a very amusing
and hopefully illuminating examples of how distorted it was becoming.
It was still subject to a lot of argumentation that passive investing, which is supposed
to benefit from the free rider principle, we just want to participate in the wave of
what active managers do when they contest in the open market and the set clearing prices
and just participate without changing anything.
We could argue that they’re beginning to actually alter clearing prices but those are arguable.
We could argue that the only reasons they were outperforming active management then
that came to be there are any innumerable articles about it, that active management
has just been proven to underperform indexes.
We could argue that simply because they were pushing up their own very limited number of
securities in which they traffic people and understand that you have to elucidate that
also why that is, but that was all arguable.
Now, we’ve got some proof because now, we’ve got a 20-year track record for ETF -based
index investing and history has spoken, and they all found one thing.
The S&P; 500 for the last 20 years has got roughly a 4.5% annualized return.
If you go to the MSCI All Country World Index, less than that, maybe 3.5% or 4%.
If you bought a 20-year Treasury note, and you’re in 1999, you could have bought about
a 6.3% or 4% yield.
MIKE GREEN: Remember it well, yes.
STEVEN BREGMAN: You could have done just fine.
They didn’t even perform as well as called a risk free Treasury but 20 years is a long
Then if you take another look at what we think is the primary risk to investors, and the
primary responsibility of an investment advisor is not comparable returns to some other manager
or to some set of managers or some abstract index or an index with some abstract purpose
or importance, but at the very least, to maintain someone’s purchasing power over time, and
hopefully to increase it.
Well, the measure of monetary debasement over these last 20 years, M2 money supply expansion,
has been more than 6% a year.
In that sense, if you owned the iShares S&P; 500 index over the last 20 years, you actually
lose in purchasing power.
MIKE GREEN: How do you disaggregate that, though, between the outcome versus the process?
Because if I were to point to active manager performance, almost by definition has to be
worse, because we’ve seen in aggregate, active managers underperform the benchmarks.
STEVEN BREGMAN: What are the benchmarks?
What if the benchmarks are rigged?
What are we going to be talking about here?
MIKE GREEN: Yes, exactly.
STEVEN BREGMAN: By the way, I should preface this by saying I’m willing to try to defend
it and I feel comfortable with that.
I think this is the– not just the United States but globally, we’re in the biggest
financial bubble ever that includes stock, include bonds.
Basically, it’s the entire set of financial assets worldwide.
It doesn’t happen in a vacuum.
It happens because it’s unprecedented, but it follows on the heels of something whose
causality here, something else is unprecedented is there’s never before been a coordinated
global coordination by the world central banks to drive interest rates down to these artificially
low 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 people
feel good, but it’s actually very pernicious, because it transfers the risk and returns
between savers and borrowers.
If you’ve done everything you’re supposed to as an individual, you’re a retired accountant
or you’re an attorney or you’re a doctor, and you pay for your house and you’ve got
a million dollars, $2 million saved up.
What’s $2 million times if you put it all into a 10-year US Treasury note in less than
2% and it’s taxable, but even if it’s not taxable, what do you get?
You can hardly live on that.
If you don’t expect to spend your principal, you don’t know when you’ll die.
MIKE GREEN: Yeah, it’s a pretty extraordinary statistic.
STEVEN BREGMAN: It’s a crisis.
I like to differentiate, there’s a term statistic and then there’s a place for interpreting
for people, because it’s really a crisis, it’s a yield crisis, and people can’t get
What does that do?
There’s a dynamic to bubbles, they build over time and people owned a series of bonds, municipal
bonds or corporate bonds, or within a bond fund and little by little, their maturities
calls and the yield goes down because the coupon goes down, or the average coupon goes
down, because they replace it with lower coupon bonds and happens slowly.
Little by little, people realize I’ve got a problem.
Wall Street is a unique industry.
Among other respects, that is the only industry I know of, in which, if there’s sufficient
demand for a product, they can create effectively infinite supply almost instantaneously.
If someone likes a certain GM truck, they have to retool, there’s certain amount of
capital you got to put in, but they’ll sell you whatever you want.
What happens?
Some firms see, oh, there’s a need for yield.
Why don’t we create– it also helps the fee aspect.
Let’s create a dividend aristocrats ETF index.
You’ve got various kinds of companies like they collect the higher dividend yield and
so people, they go with their lead there.
You get less than 2% in the Treasury, if it’s looking good, 3.5% in this REIT index or this
dividend aristocrats index.
They put more money into bonds than they really should, been into equities than they should.
They’re doing what they can.
Then you have the dividend aristocrats fund and so forth and so on, but it’s important
to understand the magnitude of asset flows into index funds.
We’re talking about several hundred billion dollars every single year for a decade, it’s
actually been climbing until this past year, and what happens is when you have trillion
dollar asset managers, and they create a new fund, and it could be a $200 million fund,
a $400 million fund, a $500 million fund and there’s going to be a knockoff of one of the
competitors, as a pure business proposition, you’ve got some really bright people in the
back office, working up different packages of stocks, new indexes, and they tried to
make it work.
Let’s just say that they create a list that back test really well, that’s got a nice theme
to it and then they bring it to their managers, they managed it well, there’s a problem here,
is that you’ve got these hundred stocks, except in the nether regions of that list by market
weight, the ones at the bottom, they just don’t have the trading liquidity.
They’ve got so many shares per day of trading.
They’re an X percent, let’s say it’s equal weighted, and it’s X percent of your list
and we can’t go above certain liquidity limits that we set in place, we can only raise 100
million dollars for this.
It’s not even worth the time, barely pays for your salaries.
They go back to the drawing board and they fiddle with the rule set.
It’s a very simple rule set, and they simply drop out.
They find a way to drop those companies out.
It’s legitimate.
We’re only– we have this list, but only companies with above this much creativity or whatever.
Now, you drop those out and suddenly, you can raise $500 million.
That’s an example of why real practical purposes, the ETFs or their bond ETFs or stock ETFs
have trafficked substantially completely in large cap and mega cap stocks.
They really need basically industrial strength trading liquidity, which is why you find Exxon
Mobil everywhere they can put it and why you find technology stocks in funds where they
don’t belong, because Facebook’s really liquid, or Microsoft’s really liquid, to find a way
you can find individual stocks, like an Exxon Mobil or Microsoft or something else, and
you’ll find they’re in growth ETFs, they’re in value ETFs, they’re in momentum ETFs, they’re
in fundamental tilted ETFs, they’re in dividend ETFs, they’re everywhere.
If you actually look at it, it defies logic other than they need the trading liquidity.
There’s so many systemic risks in the market now.
What will happen is when something gets over done enough, when you get like a deep bear
market, you get a bubble, aside for the fact that they can go higher than you ever imagined,
more overvalued then you ever imagined, or lower, they become a variety of systemic risks.
One of them nowadays, systemic risk, set systemic risk meaning it’s going to affect substantially
most of the securities in the universe you’re talking about, a single variable and one of
those variables now– I know you’ve observed it and are concerned particularly, you study
it closely, is the concentration risk.
People are unaware of what the concentration risk now is.
They think they’re getting diversified.
Diversification semantically only just a name, because all the same stocks are being owned
by these ETFs.
The fund flows come in, the ETFs are– the indexes are price agnostic, there is no–
in their short list that makes up the rule set for inclusion or exclusion of ETF, market
cap, industry sector, PE, whatever it might be, those descriptive attributes, there is
no place for valuation.
It’s not on that list.
There are different ways to talk about the concentration risk.
Not too long ago, only a matter of weeks ago, I accounted up in the S&P; 500, the top 100
names, 20% of the names accounted, just happens that the numbers of this even 67% of the market
value of the index.
That’s real concentration.
Although we’ve never had concentration like that before.
They drive the market.
The asset allocation’s idea of shifting from one sector to another in terms of market capitalization,
it can’t happen anymore.
I think the figures for the Russell 2000, is it $2 billion and below?
MIKE GREEN: I think it’s a little higher than that actually now, but yeah, something like
STEVEN BREGMAN: The sum, the complete market capitalization of all the Russell 2000 stocks,
it may only be several percent the value of the Russell 1000, S&P; 500.
Even if for the sake of argument, it were undervalued, let’s say it were undervalued
and people just wanted to shift some money there, they can’t.
You can’t have a thimble that’s a 5% or 6% size to accommodate that.
In one sense, people– they don’t know it, but they’re stuck.
They’re stuck in the dark, there’s nowhere to go.
They’re going to go to treasuries and earn a basically return that will [indiscernible].
I want to talk about that too, because the lie or the complete let’s say misapprehension
of indexation, talk about active managers you asked me before.
This is a long winded way of getting around to this response, which is that the indexes
have been buying automatic bid.
Every time money comes in, they’re required probably to buy and hold all the stocks they
own in precise proportions.
They’ve been buying their own book.
It’s arguable, pushing them up.
Therefore, this is not passive, if you’re not participating in whatever the clearing
price mechanism established by active managers.
In fact, one of the reasons why active managers have done more poorly is they have been the
bank of funds and you could– there are places to look and you can see on a given year, a
given quarter, so much money comes out of active managers, and pretty closely, that’s
the amount that goes into indexes.
They’ve been the bank providing that, therefore, like [indiscernible].
You might like what he does, you might not like what he does, but give him this.
He sticks to his knitting.
He hasn’t bent.
He’s not going to do what he doesn’t want to do in terms of his, let’s say the integrity
he has over the investment process.
He loses money every quarter, but he’s got to sell and you get redemptions.
He’s got to sell things that aren’t in the indexes, there really is no buying interest.
He owns undervalued securities, and he’s selling them, make them even less, more undervalued.
The system is gamed, I don’t think the conclusion on that basis that indexes have proven active
managers to not be able to perform as well as index is false.
There’s another anecdotal bit of information I like.
I made a list a year or so ago, of like a half a dozen really well respected value managers,
value managers who had 20, 30 years of ongoing investment performance over obviously, over
multiple cycles, superb performance, like really stellar, well respected, not anymore.
Because in the last five or 10 years, they’ve underperformed plus five years, the underperformance
year by year, and back to back.
We’re talking about not just five percentage points, 10 percentage points, 15 percentage
points a year.
If you take people like [indiscernible] and Chuck Royce and Sequoia Fund and so forth
and so on, even Carl Icahn, first of all, there’s information content in that.
How can you take, let’s say, half a dozen or 10 people like that, with proven serial
success, and suddenly in the last five years– and by the way, they all have different approaches.
They have an affinity or skill set for a different type portion of the markets, or style of investing
or method of doing it.
There’s very little overlap in their portfolios.
Suddenly, altogether, they got stupid or incompetent at the same time.
It just is quite improbable.
Therefore, there’s information content in that which is maybe something else is going
on, and I can talk about why the S&P; 500 underperform for 20 years the All Country World Index has
and get into that.
Before I give you this more specific, another more overarching observation, have you heard
of the or read the Bessembinder Study?
STEVEN BREGMAN: You’re going to like this.
I know if you’re going to read some point in the next week or month.
My business partner, [indiscernible], came across this and he wrote about it.
Let’s call it the academic invalidation of indexation as practiced.
This is a guy, Hendrik Bessembinder.
It sounds like someone from the 19th century, but– MIKE GREEN: This were in Germany but
STEVEN BREGMAN: He’s a professor at Arizona State University.
Two years ago, he published a study.
It’s a 90-year study of equity returns 1926 to 2016 but it’s entirely different than what
we’re used to.
It was called little insouciantly, do stocks outperform treasury bills?
I tell you, this is a seminal piece of scholarship.
It’s like a significant contribution to the field of study of finance, and essentially
it invalidates indexation.
What he did is the differences that– I used to wonder about this, the reliance as a standard,
this is the way it’s supposed to be when you measure performance returns for people.
It’s all based on this time weighted percentage rate of return.
That’s because it’s designed for institutions, how to compare managers, but individuals,
they need to measure their performance in dollars.
That’s not how it’s done.
All the studies are done that way.
The difference is that his study was based on dollars of wealth creation.
How much did each company over that period of time contributed in terms of dollars of
value increase as opposed to just percentage return?
Because that only– I say “only” advisedly, only compounds at 12% a year for 20 years,
which is actually really good and creates a lot more dollars of wealth for some small
company, in a percentage basis, it’s a rocket ship for 10 years but doesn’t really have
that much impact on the total index.
This study encompasses over 25,000 different stocks.
Of those 25,000 call it 700 stocks, only 1092 by 4% of the total were responsible for all
of the $34.8 trillion of wealth generated from the equity market between July 1926 and
December 2016.
96%, the other portion of all equity studied performed no better than treasury bills.
He can draw some very quick conclusions from that or propositions.
Indexation as practiced is purports to be a representation of market reality, but it
really doesn’t mirror market reality.
That’s not how the market works.
If 96% of the securities don’t provide a higher return in treasury bills, then when you trade
one stock for another, you only have a 4% chance, about 25 chance that the new position
will outperform cash.
That’s the best argument I’ve heard so far for buy and hold investing.
As that 4%, that’s why indexes ultimately undiversified themselves.
We wrote exercises about this a long, long time ago, that you just buy a list of stocks.
This has to be large enough to encompass a normal distribution.
However, that’s 20 stocks or 10, or whatever it is, 30.
Most people say 35, statistically is a good number.
You just don’t touch it.
Then the two smart ones, now you don’t know which one is smarter then, they will outperform
over time.
Over time, the performance of the account will converge upon the performance of those
two stocks.
The account will get more and more volatile but it’ll also outperform.
The thing about indexation, though, is for a variety of reasons, it will never permit–
it can’t permit that to happen.
Number one, they’ve placed caps or limits on what a position size can be.
Number two, there are constantly new entrants, Uber comes along, IPO, they have to make shelf
space for it, they have to reduce so they get diluted over time just in a natural way.
Anyway, as practice, one can see why ultimately the indexes can do as well as for variety
of reasons, the historical returns suggest.
MIKE GREEN: Yeah, I think there’s definitely some truth to that.
I think the underlying dynamic of survivorship bias, the inability to fully participate,
the other component, of course, is that the participation of the individual is not reflective
of the performance of the index.
Particularly if you’re buying in an ETF where you’re paying bid versus ask, which can be
quite narrow, but accumulates over time.
To me, the most interesting thing that’s happened with the index space, though, is actually
almost the exact opposite.
Because we have functionally locked in a group of stocks that money gets continually piled
The most popular mutual fund is the Vanguard total market index, where functionally every
stock, there are some that are excluded for sampling and liquidity purposes exactly as
you’re describing, which get excluded and then continue to underperform which naturally
draws the eye of astute value investors such as yourself, which locks in potentially underperformance
even as you’re accumulating a greater ownership of an undervalued asset relative to an index
that’s playing off of momentum.
That type of dynamic perversely actually ends up really damaging the capitalist system.
Because companies participate, regardless of their underlying fundamentals.
Now, I’ve changed the way I talk to clients about the market and the bubble and so forth.
What I do find people can readily assess our bonds.
Bonds have many fewer variables.
You’ve got a coupon, you got a maturity date, and if it’s money good, you’re getting 100
cents on the dollar at the end period.
If you’re not sure it’s money good, that’s usually pretty determinable.
That’s not such a mystery usually.
I now can use this to talk about the falsity of the way modern portfolio theory and efficient
markets and blah, blah, blah, the way that portfolio management is practiced in an institutional
basis, which filters into these asset allocation models, which induces people or their investment
counselors to put them into certain asset classes and certain indexes and so forth,
the basic false premise of it.
You mentioned the most popular ETF by size, which is the Vanguard total market.
Well, in the bond realm, the fifth largest ETF is the iShares 20-year plus Treasury ETF,
TLT is the ticker.
Last year, actually through November, it got $7 billion of new assets which increases assets
by 65%.
The problem is that the average investor who owns TLT probably thinks they did pretty well
last year, and they’re very pleased with it.
They think it’s a high return low risk investment.
Well, first of all, it’s up 14% last year, what they don’t look at necessarily and know
to look at is that the average coupon is not even 3%, 2.99%, which means that 80% of their
term came from appreciation and that that appreciation only happened because the government
lowered interest rates or interest rates were lowered, got lowered.
Well, what if they say, what if it keeps getting repeated?
Well, there’s obviously a limit to that.
Even so, the majority is still only 2.29%.
You hold that for 20 years, the same more or less, you can expect that’s what you’re
going to get and that is below the rate of inflation.
The government is telling you that you are guaranteed for 20 years to this purchasing
power every single year.
If M2 money supply, which in the last 20 years has been 6.2% or so, last year, it was more
like 7%, the last six months, it’s more like 9% on an annualized basis.
That’s monetary debasement.
If you’re going to lose 4% in terms of purchasing power every year, that means in 10 years,
the hundred thousand dollars, the million dollars you put in those 10-year treasuries,
those 10-year treasuries will be worth half as much in terms of purchasing power, you
could be in real trouble.
If the amount of income you’re able to get off, it was just enough for you in year one.
That’s an existential crisis for people and they sense it, but they don’t know how to
evaluate in terms of what they’re buying.
The other problem is how Wall Street describes risk to them.
If you go to the TLT website, right on the main page, I’ll tell you, it’s got this duration,
it’s got this convexity.
I don’t know what that is.
MIKE GREEN: You can know what it is, but yeah.
STEVEN BREGMAN: Investors aren’t conversant with that.
What they don’t know, in terms of risk is that if 20-year interest rates, just for the
sake of argument, next year, go from 2.29% which is what is about the [indiscernible]
and that is, to five, that they’re going to lose 30% of their investment.
They don’t know that.
MIKE GREEN: Perversely, though, if that happens because of the higher coupon, they’ll actually
end up with a higher total return over that 10-year period.
While the immediate impact would be negative, and I spent a bunch of time digging into exactly
this topic, post the global financial crisis because I was trying to understand what are
the real risks in bonds.
The real risks and bonds are exactly as you’re describing that the rates go low and stay
low 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 behavioral
finance, is that interest rates will stay very low if the government can help it for
a very, very long time.
If it can help it, simply because it can’t afford for them to go up.
MIKE GREEN: I agree with that.
STEVEN BREGMAN: They’ll do whatever they have to.
Eventually, they create a real crisis of one sort or another.
MIKE GREEN: I think the interesting challenge is thinking about it from the standpoint not
of a valuation system which most people tend to focus on the idea that low interest rates
translates 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.
What do you see as the alternatives?
STEVEN BREGMAN: In today’s world, we have basically a bifurcated market in terms of
clearing prices, and how those clearing prices are developed.
That is either you’re in the indexation.
Above the ETF divide, you’re in the indexation sphere of activity as a security or you’re
not, and even excluded by the relatively simple rule sets of the ETF universe because you
don’t have the– you might be a large cap company, I’ll name a company, I’m not recommending
it or not.
AP Moller Maersk.
I forget the market cap, could be 30 billion.
It’s the largest shipping container company in the world.
Aside from the fact that it’s not a US based company, but even if they were, the thing
is the Moller family, I don’t remember, but they owned 45%, 55% of shares.
Therefore, the effective market cap is way, way lower, it doesn’t suit.
It also doesn’t have the volatility return characteristics you might want because the
shipping industry has been in depression for years.
That’s not going to be in an index.
What will happen is, if you’re below what I call below the ETF divide, there is no institutional–
for the original purposes, virtually no institutional interest in you.
There aren’t any analysts covering you because they can’t get paid to cover you.
Therefore, for the first time in my career, which only goes back to 1982, you can have
companies, you can get a free lunch– now, there is no free lunch, you have to figure
out like why it seems free, otherwise, you’re on thin ice.
You can get a free lunch in all sorts of ways because the excesses in the indexation centric
securities market has created deficits, in clearing prices and valuations in below the
ETF divide.
What will happen is that there are companies now that are undervalued not for any fundamental
reason, meaning fundamental adding to their balance sheet or their income statement or
competition or technological displacement or regulatory problems or management issues.
How can you find a decent company trading at a low enough price that you think you’re
getting some discount or margin safety?
Very, very difficult.
You really couldn’t.
What you needed to do traditionally is find some company with a blemish, the CEO absconded,
they lost a big contract, whatever it might be, stock drops.
Then our job is to try to evaluate that and find out whether that insult is transitory
or permanent.
Whether it’s structural or it’s superficial.
I say you know what, in two years or three years or four years, somewhere beyond the
standard institutional investment time horizon, I can’t take the time risk, I’m willing to
take the time risk.
That’s what I think my advantages is, is it’ll be fine.
In which case, what’s the normalized earnings on this and what’s some a normalized perfectly
average valuation?
Oh, I’ll do pretty well.
I’ll buy it and wait.
That’s what you have to do.
Now for the first time, you can buy companies that are deeply undervalued relative to some
objective measure, their assets and their assets are profitable, or their earnings or
their free cashflow, whatever it might be, good balance sheets, there’s no blemish on
The only reason they’re cheap is that they’ve been excluded from the indexes, probably either
one of two reasons.
They don’t have sufficient trading liquidity.
Large companies, small or they don’t fit the shape parameters, meaning it might be a trust,
or it might be some odd– it might be a multi-industry company.
It’s not exactly– it might even be a real estate company, but it’s not a REIT, they
want REITs, they don’t lend to development companies.
What’s happening now is that if you’re willing to look– if you have the license as an investment
advisor, to look below the ETF divide, you can find everything you want.
It’s possible.
It’s really possible.
You can create for somebody, you can create a portfolio with bonds and other income securities
or equity series that’s got, let’s say, I’ll give an example, let’s say a 4% gross yield,
dividend and interest, some of which is tax exempt, that has strategic, important strategic
flexibility, let’s say 20% in cash reserves, that also has both bonds and equities in there
that have plenty of optionality of a high order continued to force or modest but steady
state internally generated growth in shareholders equity overtime and therefore income production.
You can get a yield that’s twice the 10-year Treasury rate.
You can have a purchasing power protection.
You can get everything you’re supposed to have.
Now, is it going to track what’s happening in the marketplace?
No, but that’s not my goal.
I have a different objective.
You can do that, but you can’t find it in the– same with bonds, I heard you discussing
this is that you find a bond that’s sure valuation, perfectly good.
It’s money good for the next four or five years till it matures but it’s not an index.
It might not be a large enough issue, you can buy a 7% yield and it’s not a junk bond.
MIKE GREEN: Interesting.
Well, I think that’s going to be the interesting question.
A lot of the dynamics that you’re discussing, we both experienced in ’99 to 2000.
Similar components I’ve talked about, homebuilders right before the big housing bubble being
priced at half bulk value.
The challenge in my mind, and we referenced it a little bit before in the discussion,
it says that we have actually created such a fundamental flaw in the structure of how
assets are collected and how money comes into the system.
It’s not clear to me that we’re going to be able to capture those means reverting characteristics
that you’re highlighting.
If 95% of the money that comes in, if millennials who are going to be the millennials, and those
who come after them are fundamentally forced into passive investing styles because of regulatory
systems, and gain no experience whatsoever, are we setting up the conditions in which
we destroy those mean reverting characteristics?
I would highlight is a good example, the travails of FedEx relative to Amazon.
Amazon functionally has a zero cost of capital because of the dynamics of inclusion that
you’re highlighting.
They’re able to make investments that would be uneconomic for almost any company to make
certainly a large scale logistics company like a FedEx, they’ve been able to build a
second FedEx, something we would have thought of was having a giant significant moat for
an extended period of time.
They’ve been able to replicate it in the period of roughly three years.
The real fear that I have is that we’ve broken that characteristic and I think it’s going
to be fascinating to see if it reverses itself.
STEVEN BREGMAN: You bring up two points which I think spark some responses.
One is you’re pointing to something that people forget generationally.
Every generation, there are some companies that for 20 years, 30 years, grow and grow
and grow and they become recognized.
In the course of someone’s life, their personal experience, they’ve been there forever.
They’re stable.
That’s not how business works.
They’re not stable.
What’ll happen is that’s another reason why indexes have trouble doing well, which is
that one of the reasons why– another reason why they get this 4.5% annualized return since
’99 in the S&P; 500, is because if you look at the largest 10 companies in the S&P; 500
at the end of 1999, most of them have suffered displacement by competitors.
IBM was displaced by cloud computing.
Dell was displaced by the emergence of the iPad, and so forth and so on.
That’s natural, because the largest companies represent the easiest largest targets for
a national competitor to secure customers and revenues, and people think that an Amazon
or a Facebook or a Google are somehow impervious to technological displacement.
If you take a look, there are a whole variety of companies and technologies or just plain
old competition that is beginning to make inroads.
We don’t know which will work or not, but to give you a nontechnological form of what
can happen, the margins, the returns on equity of the modern Information Technology slash
technology companies like Facebook, Google, Twitter, are simply enormous.
The stated ROEs might be 30%, or something like that, depending on, but really, it takes
all the cash and marketable securities and the market securities in the balance sheet,
which are nonproductive, they don’t need them to do the business.
You take that away, the returns in equity could be 50%, 60%, 100%.
It’s simply like unheard of.
It’s not really sustainable.
Someone’s going to come after that.
Now, how can they come after it?
Well, Dell, which displaced all sorts of other companies in manufacturing PCs by doing a
direct to consumer approach, and they were willing to sustain a lower profit margin to
get there.
Dell is now getting into cloud computing.
What does that mean?
It sets you off up a warehouse, and you buy all the equipment and you do it.
Now they’re going to compete.
By the way, there’s a food fight going on now.
Amazon and IBM, IBM needs to succeed in cloud computing to protect itself now.
Dell’s getting involved.
Amazon at some point, there’s going to be margin compression.
One of those players is going to be willing to take a lower margin just like in ETFs.
Here’s why I don’t think it can keep going on.
We talked earlier, the bank of funds for suctioning out of active management into the passive
management, that’s finite.
As of a year ago, I think there’s a Fortune magazine article, they did a study.
They thought that we passed the 50% dividing line, very significant one, of all passive
assets as a percentage of all investment assets in public markets.
That has all sorts of implications.
You’ve looked into them yourself.
There’s a law of large numbers.
Now, there’s 50% float available to them.
Now, it’s less, now it’s 49.
If that was a correct number, 48.
Every year, in order to maintain the same constant pressure on the automatic bid on
all the stocks owned by old ETFs and bonds, they need larger inflows each year, like it
was $350 billion last year, whatever the number was, now it’s going to be more but the pool
from which they’re drawing is getting smaller.
That can start to accelerate real fast.
When the flow of funds into indexation slows, or stops, or turns negative, there’s no more
automatic bid and the marginal trade which is effectively indexation has been for the
last 10 years and increasingly in recent years.
The marginal trade, like the baton is handed over to the active manager and the active
manager, I just referred [indiscernible] because it occurs to me.
He’s not buying a blue chip.
He’s not into technology, but he’s not buying a day now mature trending into cyclical blue
chip, like Coca Cola, or McDonald’s or Procter and Gamble, which actually had sales declines
in recent years, at 25 times earnings, just not doing it.
Where’s the bid going to be?
This is before we get to other dynamics.
MIKE GREEN: The pushback that I would make to that is that the old people, for lack of
a more descriptive term, are the ones who own active managers.
The young people who continue to have inflows are those who own passive vehicles.
There’s nothing that actually says that active manager ever gets to bid again, there’s no
rule of the universe, there’s no law that says that has to happen.
It’s unfortunately catastrophic, but there is no law that requires that.
That I think is going to be the really interesting question is, if the system can’t find itself
STEVEN BREGMAN: The rules again, when you get extremes, you get other possibilities.
Since it’s fully disclosed, the precise percentage positions in every single ETF, you know exactly
what they own, you know how many total dollars of assets are every in single ETF.
At a certain point, if the inflows get small enough, even with a lower age demographic
making contributions, it’s going to start to peter out.
We don’t know, I’ve never worked with these kinds of numbers the way you have but at a
certain point, if it looks like it’s tipping, you can have short sellers who know if there
are going to be any redemptions, net redemptions.
They’ll know exactly how much is being sold of every single security.
They have almost unlimited quantities of assets that they can front run.
That’s a different scenario.
I worked through the numbers, and I think it’s going to be interesting to see how it
plays out.
I don’t think– STEVEN BREGMAN: It’s more dynamic than that.
MIKE GREEN: It’s more dynamic than that.
I think the real risk is that we’ve seen short sellers already eviscerated by the inflation
that I think is caused by the passive investment process.
STEVEN BREGMAN: But the passive investment process has still– that’s why those short
sellers are missing an important element.
Money’s flowing in, to the tune of hundreds of billions of dollars a year.
You can’t get in front of that.
MIKE GREEN: Well, to your point, though, that money is coming out of the active managers,
are flowing into the passive, ironically, if you have that inflation, the supply of
assets that’s available to the active managers goes on much longer.
We’ve probably seen this, there’s very few stocks, you highlight it yourself, unless
they’re outside of the indices, which Vanguard total market index had very few stocks that
actually are outside of that unless they fail to meet float dynamics or ownership dynamics.
STEVEN BREGMAN: Yeah, but if they’re, 100th of 1%, they’re in de facto in a de facto sense,
but it’s meaningless, statistically meaningless.
No, I think that’s right, but that’s exactly the point that I’m making, which is the assets
that are owned by the active managers who by and large, buy stuff with similar characteristics
to the passive indices, you being one of the notable exceptions, they can experience that
same inflation and so one of the big push backs I have is the idea that value stocks
are cheap as they were ’99.
I don’t see that at all.
I think there’s elements exactly as you’re describing.
I think we’re going to run out of time, but one of the things that I think is going to
be so interesting, and I’d love to come back and sit down with you in another year is this
underlying 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 social
MIKE GREEN: I agree.
STEVEN BREGMAN: When you see serious tumult in nations, social tumult, it really often
follows when there’s been currency debasement, loss of purchasing power, inability to live
on 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 hear
whether they are willing to let me work with them on it or not, is the ultimate hedge against
currency debasement.
It might never work, it might never be necessary, but it can save your financial future and
it can be done in such a small amount that will never harm you if it doesn’t work, which
is a fixed issuance meaning nondebasable cryptocurrency.
If the time ever comes that people in various parts of the world feel they need a non-debasable
currency, the returns can be on the order of hundreds of times your money.
MIKE GREEN: I share those sentiments.
Historically, it would be gold.
We don’t know if going forward, it’s going to be a crypto asset but I agree with you
that those types of nonlinear properties will become an important part of any asset allocation
I really look forward to sitting down with you again and sharing these thoughts.
STEVEN BREGMAN: I actually enjoyed listening to you more than talk with you.
Thank you.

Triple-A Ratings Are So Yesterday

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.

The Era of Fed Power is Over. Prepare for a More Perilous Road Ahead.

Central banks have long exercised influence over booms and busts, but their ability is shrinking.

The Federal Reserve and other central banks have long been the unchallenged drivers of financial markets and the business cycle. “Don’t fight the Fed,” goes one Wall Street adage.

That era is drawing to a close. In many countries, interest rates are so low, even negative, that central banks can’t lower them further. Tepid economic growth and low inflation mean they can’t raise rates, either.

Since World War II, every recovery was ushered in with lower rates as the Fed moved to stimulate growth. Every recession was preceded by higher interest rates as the Fed sought to contain inflation.

But with interest rates now stuck around zero, central banks are left without their principal lever over the business cycle. The Eurozone economy is stalling, but the European Central Bank, having cut rates below zero, can’t or won’t do more. Since 2008, Japan has had three recessions with the Bank of Japan, having set rates around zero, largely confined to the sidelines.

The U.S. may not be far behind. “We are one recession away from joining Europe and Japan in the monetary black hole of zero rates and no prospect of escape,” said Harvard University economist Larry Summers. The Fed typically cuts short-term interest rates by 5 percentage points in a recession, he said, yet that is impossible now with rates below 2%.

Workers, companies, investors and politicians may need to prepare for a world where the business cycle rises and falls largely without the influence of central banks.


The business cycle we’re used to is a bad guide to business cycles going forward,” said Ray Dalio, founder of Bridgewater Associates LP, the world’s biggest hedge fund.

In November, Fed chairman Jerome Powell warned Congress that “the new normal now is lower interest rates, lower inflation, probably lower growth…all over the world.” As a result, he said, the Fed is studying ways to alter its strategy and develop tools that can work when interest rates approach zero.

Fed chairman Jerome Powell on Capitol Hill in November. PHOTO: SAM CORUM/EPA/SHUTTERSTOCK

Central banks are calling on elected officials to employ taxes, spending and deficits to combat recessions. “It’s high time I think for fiscal policy to take charge,” Mario Draghi said in September, shortly before stepping down as ECB president.

There are considerable doubts that any new tools can restore the influence of central banks, or that countries can overcome obstacles to more robust fiscal policy, particularly political opposition and steep debt.

Business cycles in the future may resemble those of the 19th century, when monetary policy didn’t exist. From 1854 to 1913, the U.S. had 15 recessions, according to the National Bureau of Economic Research, the academic research group that dates business cycles. Many were severe. One slump lasted from 1873 to 1879, and some historians argue it lingered until 1896.

Fed’s Fading Influence

U.S. recessions were more frequent before the Federal Reserve took control over interest rates, using them as a lever to slow inflation or boost the economy. Low rates have weakened the central bank by giving it little room to reduce rates further.

The Fed’s sway over the economy has also been weakened by a decline in durable manufacturing and construction, which are sensitive to rates, and the growth in services, which aren’t.

Sources: National Bureau of Economic Research (recessions); Sidney Homer and Richard Sylla (interest rates 1854-1933); Federal Reserve (interest rates 1934-present); U.S. Commerce Department (value-added shares of GDP)

The causes of business cycles were diverse, Wesley Claire Mitchell, an NBER founder, wrote in 1927. They included “the weather, the uncertainty which beclouds all plans that stretch into the future, the emotional aberrations to which business decisions are subject, the innovations characteristic of modern society, the ‘progressive’ character of our age, the magnitude of savings, the construction of industrial equipment, ‘generalized overproduction,’ the operations of banks, the flow of money incomes, and the conduct of business for profits.”

He didn’t mention monetary or fiscal policy because, for all practical purposes, they didn’t exist. Until 1913, the U.S. hadn’t had a central bank, except for two brief periods. As for fiscal policy, U.S. federal spending and taxation were too small to matter.

When central banks were established, they didn’t engage in monetary policy, which means adjusting interest rates to counter recession or rein in inflation. Many countries were on the gold standard which, by tying the supply of currency to the stock of gold, prevented sustained inflation.

The Fed was established in 1913 to act as lender of last resort, supplying funds to commercial banks that were short of cash, not to manage inflation or unemployment. Not until the Great Depression did that change.

In 1933, Franklin D. Roosevelt took the U.S. off the gold standard, giving the Fed much more discretion over interest rates and the money supply. Two years later, Congress centralized Fed decision-making in Washington, better equipping it to manage the broader economy.

Modern times

Macroeconomics, the study of the economy as a whole instead of individuals and firms, was born from the work of British economist John Maynard Keynes. He showed how individuals and firms, acting rationally, could together spend too little to keep everyone employed.

In those circumstances, monetary or fiscal policy could generate more demand for a nation’s goods and services, Mr. Keynes argued. Just as a dam regulates the flow of a river to counter flooding and drought, monetary and fiscal-policy makers must try to regulate the flow of aggregate demand to counter inflation and recession.

The Employment Act of 1946 committed the U.S. to the idea of using fiscal and monetary policy to maintain full employment and low rates of inflation.

The next quarter-century followed a textbook script. In postwar America, rapid economic growth and falling unemployment yielded rising inflation. The Fed responded by raising interest rates, reducing investment in buildings, equipment and houses.

  • The economy would slide into recession, and inflation would fall.
  • The Fed then lowered interest rates, investment would recover, and growth would resume.

The textbook model began to fray at the end of the 1960s. Economists thought low interest rates and budget deficits could permanently reduce unemployment in exchange for only a modest uptick in inflation. Instead, inflation accelerated, and the Fed induced several deep and painful recessions to get it back down.

By the late 1990s, new challenges emerged. One was at first a good thing. Inflation became both low and unusually stable, barely fluctuating in response to economic growth and unemployment.

The second change was less beneficial. Regular prices were more stable, but asset prices became less so. The recessions of 2001 and 2008 weren’t caused by the Fed raising rates. They resulted from a boom and bust in asset prices, first in technology stocks, then in house prices and mortgage debt.

After the last bust, the Fed kept interest rates near zero from 2008 until 2015. The central bank also purchased government bonds with newly created money—a new monetary tool dubbed quantitative easing—to push down long-term interest rates.

Despite such aggressive stimulus, economic growth has been slow. Unemployment has fallen to a 50-year low, but inflation has persistently run below the 2% target the Fed set. A similar situation prevails abroad.

In Japan, Britain and Germany, unemployment is down to historic lows. But despite short-and long-term interest rates near and sometimes below zero, growth has been muted. Since 2009, inflation has averaged 0.3% in Japan and 1.3% in the Eurozone.

The textbook model of monetary policy is barely operating, and economists have spent the last decade puzzling why.

One explanation focuses on investment, the main driver of long-term economic growth. Investment is financed out of saving. When investment is high relative to saving, that pushes interest rates up because more people and businesses want to borrow. If saving is high relative to investment, that pushes rates down. That means structurally low investment coupled with high saving by businesses and aging households can explain both slow growth and low interest rates.

Richard Clarida, the Fed’s vice chairman, cited another reason during a speech in November. Investors in the past, he said, demanded an interest rate premium for the risk that inflation would turn out higher than they expected. Investors are now so confident central banks will keep inflation low that they don’t need that premium. Thus, central banks’ success at eradicating fear of inflation is partly responsible for the low rates that currently limit their power.

While the Fed’s grip on growth and inflation may be slipping, it can still sway markets. Indeed, Mr. Dalio said, the central bank’s principal lever for sustaining demand has been its ability to drive up asset prices as well as the debt to finance assets, called leverage. Since the 2008 crisis, low rates and quantitative easing have elevated prices of stocks, private equity, corporate debt and real estate in many cities. As prices rise, their returns, such a bond or dividend yield, decline.

That dynamic, he said, has reached its limit. Once returns have fallen close to the return on cash or its equivalent, such as Treasury bills, “there is no incentive to lend, or invest in these assets.” At that point, the Fed is no longer able to stimulate spending.

Less than zero

A central bank can always raise rates enough to slow growth in pursuit of lower inflation; but it can’t always lower them enough to ensure faster growth and higher inflation.

The European Central Bank has tried—cutting interest rates to below zero, in effect charging savers. Its key rate went to minus 0.5% from minus 0.4% in September. At that meeting and since, resistance has grown inside the ECB to even more negative rates for fear that would reduce bank lending or have other side effects.

In December, Sweden’s central bank, which implemented negative rates in 2015, ended the experiment and returned its key policy rate to zero. Fed officials have all but ruled out ever implementing negative rates.

In a new research paper, Mr. Summers, who served as President Clinton’s Treasury secretary and President Obama’s top economic adviser, and Anna Stansbury, a Ph.D. student in economics at Harvard, say very low or negative rates are “at best only weakly effective…and at worst counterproductive.”

They cited several reasons why. Some households earn interest from bonds, money-market funds and bank deposits. If rates go negative, that source of purchasing power shrinks. Some people nearing retirement may save more to make up for the erosion of their principal by very low or negative rates.

Moreover, the economy has changed in ways that weaken its response to interest-rate cuts, they wrote. The economy’s two most interest-sensitive sectors, durable goods manufacturing, such as autos, and construction, fell to 10% of national output in 2018 from 20% in 1967, in part because America’s aging population spends less on houses and cars. Over the same period, financial and professional services, education and health care, all far less interest sensitive, grew to 47% from 26%.

They concluded the response of employment to interest rates has fallen by a third, meaning it is harder for the Fed to generate a boom.

The U.S. isn’t likely to plunge into another financial crisis like 2008, Mr. Dalio said, as long as interest rates remain near zero. Such low rates allow households and companies to easily refinance their debts.

More likely, he said, are shallow recessions and sluggish growth, similar to what Japan has experienced—what he called a “big sag.”

Former Fed chairman Ben Bernanke this month estimated that through quantitative easing and “forward guidance,” committing to keep interest rates low until certain conditions are met, the Fed could deliver the equivalent of 3 percentage points of rate cuts, enough, in addition to two to three points of regular rate cuts, to counteract most recessions.

Mr. Clarida warned, however, that quantitative easing may suffer from diminishing returns in the next recession. Moreover, the next recession is likely to be global, he said this month, and if all major countries weaken at the same time, it will push rates everywhere toward zero. That would make it harder for the Fed or any other central bank to support its own economy than if only one country were in trouble.

Fiscal fix

With central banks so constrained, economists say fiscal policy must become the primary remedy to recessions.

History shows that aggressive fiscal policy can raise growth, inflation and interest rates. The U.S. borrowed heavily in World War II. With help from the Fed, which bought some of the debt and kept rates low, the economy vaulted out of the Great Depression. Once wartime controls on prices and interest rates were lifted, both rose.

Today, mainstream academic economists are again recommending higher inflation and deficits to escape the low-growth, low-rate trap.

Advocates of what is called modern monetary theory say the Fed should create unlimited money to finance government deficits until full employment is reached. Some economists call for dialing up “automatic stabilizers,” the boost that federal spending gets during downturns, via payments to individuals and state governments as well as infrastructure investment.

Yet fiscal policy is decided not by economists but by elected officials who are more likely to be motivated by political priorities that conflict with the economy’s needs. In 2011, when unemployment was 9%, a Republican-controlled Congress forced Mr. Obama to agree to deficit cuts. In 2018, when unemployment had fallen to 4%, President Trump and the GOP-controlled Congress slashed taxes and boosted spending, sharply raising the budget deficit. Mr. Trump has pressured Mr. Powell to cut rates more and resume quantitative easing, which the Fed chairman has resisted.

Fiscal policy in the Eurozone is hampered by rules that limit the debt and deficits of its member countries. It is also hamstrung by divergent interests: Germany, the country that can most easily borrow, needs it least. In recent years it has refused to open the taps to help out its neighbors.

Still, Mr. Dalio predicted that a weakened Fed will eventually join hands with the federal government to stimulate demand by directly financing deficits.

Once central banks have agreed to finance whatever deficits politicians wish to run, however, they may have trouble saying no when the need has passed.

The experience abroad and in the U.S.’s past suggests that once politicians are in charge of monetary policy, inflation often follows. In the 1960s and 1970s, presidents Johnson and Nixon pressured the Fed against raising rates, setting the stage for the surge in inflation in the 1970s. Such a scenario seems remote today, but it may not always be.