Black Swan Sighting?

black swan

Today marked the first significant drop in broad market indices in the Trump era.

Since the election, the S&P 500 has climbed more than 11%, the Dow Jones Industrial Average (^DJI) has gained 14% and the Nasdaq Composite Index (^IXIC) has climbed about 13.6% during the same period and the S&P 500 and Dow had now gone 109 days without a 1% decline according to Yahoo Finance, a record not achieved since 1995.

Today, all of the broad market indices dropped by more than 1%:

markets march 2017

Source: Yahoo Finance

 

The real story is what has been happening behind the scenes.  As the markets proceeded on a three-month tear, money managers have been allocating significantly more money to protect their gains.  The price of the CBOE Skew Index, a measure of the price of out of the money put options, has soared while market volatility has decreased – a diverging trend that is not typical and a possible sign of imminent volatility in the near future.  In layman’s terms, professional investors are increasing willing to pay much more to protect against downward stock prices.  You can see the increasing cost of Skew puts (white line) compared to overall market volatility (blue line) in the Bloomberg screenshot below:

tail risk hedging

Some are calling this a precursor to a Black Swan event like the one that heralded the last recession.

What does this mean to you?  Bond prices will likely rise and foreign stock markets will likely take a bigger percentage dive because when America sneezes, Asia often gets a typhoon and the rest of the world catches a cold.  Asia reacts first because their markets are the first to open, followed by Australia, the Middle East then Europe and South America.  (Absent any buying signals of which there are none at present).

What should you do?  As an investor, nothing.  You did an excellent job of creating a well-diversified and down-side protected portfolio with you investment adviser so if we do have a setback in the market, wait it out and look for buying opportunities when the dust settles.

As a business owner, the answers are more complex.  If this is truly a black swan, a repeat of 2008-2012 or worse, there are few safe havens.  If you have kept up with the Vertical Capital Advisors blog posts over the past year, you have been steadily building your cash hoard and your war chest will enable you to secure a dominant position in the markets you serve.

baron rothschild

As we published on August 3, 2016, you can channel Baron Rothschild and “Buy when there’s blood in the streets, even if the blood is your own”.

 

 

 

 

ABOUT VERTICAL

Vertical Capital Advisors is an Atlanta-area business advisory firm built on creating tangible value for our clients, serving clients in just about every industry.  Our clients are both capital growers and capital allocators.  How can Vertical help your firm maximize value?

 

Joe Briner
Managing Director
Vertical Capital Advisors LLC
briner@verticalcapitaladvisors.com
866-912-9543 ext 108

Red Dragon Snowflakes

We found it!  The snowflake that will start the avalanche.  The Red Dragon Snowflake.  Here’s a picture of it falling right outside our window:

red-dragon-snowflake

In fact, the first sign of the avalanche has already happened.  There is a very good chance that it will start in China and that it will start with rapidly falling real estate prices.

Take a look at China’s money printing binge since 2000.  It dwarfs ours here in the U.S.

money-supply

Source: WSJ 11-1-16

At the same time Chinese debt has nearly doubled:

debt-as-gdp

And now, the Chinese, who by and large are incipient investors, preferring the hard asset class of real estate as their preferred investment of choice, started to pull back from real estate this year:

shenzhen

Kind of looks like a snowflake falling.  Certainly resembles a mountain peak.  Definitely represents a bubble bursting.

The Politburo centrally-controlled Chinese economy will likely be patient zero for the next correction/recession.  Look for phrases like “Asian Contagion” to ripple through media reports in the coming weeks.  The decrease in asset values in China will not have much of an impact on the rest of the world because China’s capital account is largely closed, it has enormous reserves and nearly all of its debt is held domestically and all of it is denominated in yuan.  But because markets tend to react psychologically as much as they do to economic data, when the panic starts, because of the sheer size of the Chinese market, there will be panic selling globally.  The Politburo can continue offering cheap credit and forcing Chinese citizens to invest in financial assets for a time but even the Chinese do not like to see their net worth drop, especially when it is heavily leveraged.

All bubbles burst.  We know we are in one now.  China knows it too. what-should-i

What should you do about it?

Bolster cash reserves.  Very soon, you may be able to buy good, income-generating assets like you could have at the bottom of the crash in 2008-2009.  Maybe at late 80’s prices.

 

________________________________

ABOUT VERTICAL

Vertical Capital Advisors is an Atlanta-area business advisory firm built on creating tangible value for our clients, serving clients in just about every industry.  Our clients are both capital growers and capital allocators.  How can Vertical help your firm maximize value?

Joe Briner
Managing Director
Vertical Capital Advisors LLC
briner@verticalcapitaladvisors.com
866-912-9543 ext 108

 

 

 

Reference: http://www.wsj.com/articles/asset-bubbles-from-stocks-to-bonds-to-iron-ore-threaten-china-1477952654

 

 

Watch Out for the Twin Capital Destroyers

Paraphrasing, a friend wrote to me last night and asked, “Hey Joe, is it time to invest?”  I polished me crystal ball, gazed inside and saw the charts below magically appeared:

m2-money-stock velocity-of-m2-money-stock

Pay attention to the shaded areas.  The shaded areas are recessions, destroyers of capital.  Do you see how the velocity line decreases in the shaded areas in the top chart?  What this shows is that a decrease in velocity predicts a recession.  PREDICTS a recession.  That’s an important verb, predicts.  It is not often in the life of a practitioner in the financial markets (or business manager or investor…) that you can see with clarity what is going to happen next.  And the exact timing of an event is always the most difficult part of the game.

In the top chart we have an exception to the rule.  The line bends straight down since 2011 yet no recession because of what is happening in the bottom chart.  The bottom chart shows that we printed $4.4 trillion since 2011 to prevent a recession.  PREVENT a recession.  That’s a mighty hard thing to do.  Prevent a recession.  But money supply is the only input the government controls.  So it is the only tool they have to “fix” the
economy.  And it is a binary tool – either it is on and they are pumping money into the economy or it is off and they are drawing liquidity out of the market.  This month we learned that the Fed is actually drawing money oupricet of the system.  This will accelerate the next recession.  That is government interference in the markets in action and the price we will pay is pain – material pain in the financial markets.  Great Depression-magnitude pain?  Possibly.

We should have been in a recession since 2011 based on the declining velocity of money.  If you remember the pain of the 2008-2010 recession and you can see the magnitude of the downward trajectory in the velocity of money since 2011 in the top chart, you can see that the next recession will be every bit as painful as the last recession, and, I predict, actually much worse.

As we have blogged a couple of times, the slowing velocity of money indicates that capital is being trapped or logjammed inside the financial system.  So I wrote to my friend:

When money slows, it indicates it is not being invested in productive, growing enterprises.  And if money is not being invested in productive assets, it is being invested in idle assets (read: financial engineering or speculation).  And this is a predictor of a recession (or more precisely, a bubble before a recession).  I think the drop could be 70% across the board – investment real estate included.

Today we have twin destroyers of capital working in collusion: The Fed mainlining money directly into the markets (Increasing Money Supply) and the markets plowing it into non-productive assets (Slowing Velocity of Money).  This dual action is driving prices of financial assets higher while generating no (or very little) new production of goods and services.  The twin destroyers of capital.

Be patient.  Soon you should be able to buy assets at 2008 prices.  The NASDAQ today is over 5,300.  In November 2008 it dropped below 1,500.  That would be a decline of over 70% from today’s figure!  It could get close to that number in the next downturn and while that would wipe out trillions of dollars of net worth, it will only send us back to 2008.  And somehow we all survived that setback.

Have some cash in hand but don’t rush in.  You may have an opportunity to create dynastic wealth that will transform the lives of several future generations if you can be disciplined in your approach to the market.

Business owners and capital allocators, you would do well to dust off the worst case scenario plan and focus on cash generation.  And if the storm hits as it looks like it will, give us a call.  We are experts at navigating such waters.  We can help stabilize the ship, pare back to the key drivers and help you maximize the value of your assets.  That’s how we create tangible value.

______________________________________

ABOUT VERTICAL CAPITAL ADVISORS

Based in Atlanta, GA and created to help businesses survive the devastation of the Great Recession, Vertical Capital Advisors is a firm built on creating tangible value for our clients.  We work with clients in just about every industry and we work with both capital growers and capital allocators..

Joe Briner
Managing Director
Vertical Capital Advisors LLC
briner@verticalcapitaladvisors.com
866-912-9543 ext 108

Sources: https://fred.stlouisfed.org/series/M2, https://fred.stlouisfed.org/series/M2V

 

Would you be willing to risk a 60% loss in order to get 2.85% interest from your bank?

Would you be willing to risk a 60% loss in order to get 2.85% interest from your bank?

Italy’s 50-Year 2.85% Bonds are 300% Oversubscribed – So what?

This week Italy began selling 50-year bonds paying 2.85% and they had three times more orders than they had bonds to sell[1].

“So what?” you ask.  “That means nothing to me”.

Or does it?

Bond buyers are generally a very bright lot.  They are probably the sharpest people in the business world.  They analyze every scrap of economic data continuously, day and night.  These hyper-analytical people are willing to commit money to an investment that has a very low yield for a very long time and whose host is in dangerous financial territory.  The Italian banking system is technically bankrupt as we wrote about in earlier posts and unemployment is over 20%.  We pegged Italy as one of the likely triggers for the next recession.

The country risks are readily apparent.  The interest rate risk is even greater. interest-rate-risk

You probably know that the price of bonds is inversely related to the rate.  As rates go down, prices generally go up.  As rates go up, prices fall.  The relative price to rate movement is determined by a bond’s duration which is a function of the rate and the time to maturity.  With a low rate, there is not much room to fall but a lot of room to rise.  And 50 years is an eternity in the world of bonds.  So if rates rise just 1%, these bonds are expected to lose 22% of their value.  Now the average rate for 10-year Italian bonds since 1991[2] has been a shade under 6%, let’s call it 3% higher than the 2.85% rate on the 50-year bonds.  Investors are willing to risk losing over 60% of the value of their bond investment in order to get a paltry 2.85% return and are in fact betting that interest rates do not return to normal, because if they do, and if they need liquidity, they will lose over 60% as sure as the sun will rise tomorrow.

italy-govt-bond

Forget Brexit.  It will be conditions like this that set off the next round of creative destruction.

So, would you be willing to risk a 60+% loss in order to get 2.85% interest from your bank?  Of course not.  Why are billions of dollars flowing into these bonds, then?  Because there is no alternative.  Investors are starved for yield.  They would rather risk the devil they know over the devil they don’t.

Fortunately, we have found a few brave capital allocators who are willing to seek higher returns from unknown enterprises like yours because they have the intellectual capital to analyze your business plan and make a rational determination that the expected return is higher and the risk is lower than Italy’s 50-year 2.85% bonds.

 

________________________________

ABOUT VERTICAL CAPITAL ADVISORS

Based in Atlanta, GA and created to help businesses survive the devastation of the Great Recession, Vertical Capital Advisors is a firm built on creating tangible value for our clients.  We work with clients in just about every industry and we work with capital consumers and capital providers.

 

Joe Briner
Managing Director
Vertical Capital Advisors LLC
briner@verticalcapitaladvisors.com
866-912-9543 ext 108

[1] Reference: http://www.wsj.com/articles/italian-treasury-sounding-out-investors-on-50-year-bond-1473260474

[2] Reference: http://www.tradingeconomics.com/italy/government-bond-yield

The Great $550 Trillion Bet of 2016 – And how it will impact YOU within a year

falling off cliffA college student asked me today, “a group just did a presentation on the last crisis and they just didn’t seem to think it would happen again or at least to that level because of the regulations in place – what do you think?”

Wow.  Loaded question.  How to answer and not sound like a cantankerous old WASP?  (52 is ancient to millennials).

We can start by taking a look at how we are creating the next recession before it has even officially started.  We are not getting into this recession the way we get into most recessions.  Most recessions represent a cooling off period after the economy overheats – – inflation caused by expansionary monetary policy is followed by a period of higher interest rates and contraction, a.k.a. a recession.

The 2008-2010 “Great Recession” was different.  The Fed embarked on a bold new plan of social engineering, increasing home ownership by encouraging creative financing alternatives in the residential mortgage lending market and allowing banks to invest trillions of dollars of Tier 1 capital into mortgage backed bonds, among other systemic changes.  This caused the “housing bubble” which when it burst, rained $4 billion on John Paulson personally, enabling Michael Lewis to write the New York Times bestseller (and later a movie based on the book), The Big Short.  (This is the abbreviated version – call me if you would like to schedule the 4-hour lecture.  Seriously, call me.  I have one).

The next recession will be a totally new breed of economic disaster.  It is a hairy, monstrous beast being fed a steady diet of ever increasing sovereign nation debt and corporate debt, most of which is producing no new output of any kind.  And the debt is being juiced with steroids made of derivatives, over $550 trillion of them worldwide according to the Bank for International Settlements.  Amazingly, U.S. banks have exposure to $247 trillion of them!

As I wrote in a previous blog, the CIA World Factbook indicates that the Global GDP (OK, it’s GNP when talking globally, forgive me professor Tutterow) is only $107.5 trillion.  So why do we need to hedge every economic transaction five times over?   We don’t.  It is all speculation.  And when speculation turns to panic triggering a full-blown collapse, guess what?  We get a singularity!  Everything will go down because nothing will hold its value.  No one wants to buy anything, no matter the price.

What might the first step down the slippery slope be?

How about Japan.  Japan’s national debt has grown 94% in the last 10 years (from USD$1.55 trillion to $3.02 trillion) and now stands at 229% of its GDP despite no real growth in nearly three decades and yet the yen is still one of the strongest currencies in the world.  Why?  Because almost everything else is worse!    Japan’s only solution is debt monetization, a fancy economics term for paying off corporate debt with even more sovereign debt.  And with its low borrowing rates, it has long been a favored source for traders to obtain low-cost funds to place their bets in riskier markets offering higher yields (known as the carry trade).  What happens when traders no longer want to play this game?  That could be the first slippery step.

aug 4 graph

Or how about Italy?  The average Italian bank has 18% non-performing loans and 8% capital.  If they recover 50% of every non-performing loan, the capital base of the entire Italian banking system will be wiped out.  Greece at 34% non-performing loans and Ireland at 19% are even worse.  Portugal at 12% is technically bankrupt as well.

And don’t forget the $247 trillion of derivatives held by US banks.  During the great recession some of these instruments had nearly infinite (at least very difficult to calculate with any accuracy) negative values.

These are only a few potential flashpoints built into the global economic system.  There are myriad others that could be the last snowflake that triggers the avalanche.  I don’t see a soft landing under any scenario.  Having learned nothing from the worst recession in nearly a century, we have levered up in every way imaginable.  We have dialed up the risk to a point that no individual, corporation, government or intergovernmental entity can manage.  The powder keg is busting at the seams.  One spark is all it will take.

As we wrote about earlier, the best way to protect yourself is to have ample cash on hand to weather the storm.  Or as more aptly spoken streets quoteby Baron Rothschild in the panic that followed Napoleon’s defeat at the Battle of Waterloo, “Buy when there’s blood in the streets, even if the blood is your own”.

$550 Trillion Global Derivatives: www.bis.org/cpmi/publ/d135.pdf

Japan External Debt as of 8/3/16: USD$8.978 trillion per www.nationaldebtclocks.org/debtclock/japan

Japan External Debt as of 2006: http://mecometer.com/whats/japan/total-external-debt

Japan Debt as a Percent of GDP: www.tradingeconomics.com/japan/government-debt-to-gdp and www.boj.or.jp/en/statistics/br/bop_06/edp.htm

 

What next? Sell in May and Go Away

Sell in May and go away

That’s the mantra of many traders.  Nothing happens in the summer months because everyone is in the Hamptons.  It’s 5:00 Friday, July 1 and if I needed to reach one of my former bosses right now, my call would likely be returned sometime around Wednesday next week.  I know.  It happened more than once.

But this summer the roads back to NYC and Greenwich from the Hamptons may be clogged soon.

Here’s why.

blog 7 1 pic 2

Signaling a massive capital flight to an asset with universal value, gold has skyrocketed $300 or 30% in the last three months:

Source: Monex.com

Large amounts of capital are moving into the asset that has never gone to zero.

Global banks have plummeted over the last five years.  Deutshce Bank lost$7 Trillion in value in the fourth quarter by itself.  That’s Trillion – as in One Thousand Billion, times 7!!

blog 7 1 pic

Source: https://dentresearch.s3.amazonaws.com/EconomyandMarkets/images/2016/070116_ENM.gif

Why?  Because eight years into this “recovery” the global financial system has ingested $550 Trillion in credit default swaps and other derivatives.  Duetsche Bank has ten percent of the total.  One institution has 10% of the global total of what Warren Buffett called “financial weapons of mass destruction”.  “How is that possible, Joe?” you ask.  “I thought it was all about deleveraging after the Great Recession”.

That was what we all read in the financial press.  Financial regulators worldwide were forcing systemically important financial companies to rein it in, to decrease risk, to reduce reliance on borrowed funds.  It appears that was all window dressing.  Even the blog I wrote earlier this week about the eight largest US banks passing the new “stress tests” was evidence of the prevalence of this new story line that on the surface looks great but just below the surface is in reality probably not worth the paper the plans are written on.

To put the risk we are facing in perspective, the Gross World Product was $107.5 trillion in 2014 according to the CIA World Factbook.  Based on the $550 trillion figure above, we have hedged every financial transaction in the world more than four times over.  I just bought a $3 pack of gum at the Atlanta airport.  Global financial traders have already placed bets totaling $12 for and against that transaction.  Why?  Because financial engineering has taken precedence over actual engineering, actual goods and services.

If you don’t follow Harry Dent at DentResearch.com, you should.  Harry has spotted macro trends worldwide for almost 30 years.

Harry identified that many of the world’s largest banks are in deep trouble but regulators, even the vaunted European Supervisory Authorities are apparently ignoring the problem.

How big is the problem?

Italy’s banks have 18% non-performing loans.  That means bad loans are over two times larger than their systemwide collective capital.  I can tell you from personal experience (as the founder of Georgia’s largest community bank – one that failed in the Great Recession, I can say this with no risk of contradiction) that a bank has no hope of survival in this condition.  And this is the entire Italian banking system. Italy is part of the EU.  Losses of this magnitude could wipe out the entire capital base of the EU.

But Italy only takes third place in the deficit Olympics.  Greece has 34% non-performing loans and Ireland has 19%!  No slacker, Portugal has 12%.

If regulatory bodies had the resources to shut these institutions down, they would.  The fact is they are also undercapitalized.  It’s a house of cards that everyone hopes will miraculously remain standing but it simply can’t.  Our own FDIC operated in the red for a couple years but there was nothing anyone could do about it.  The option was to shut it down and start over.  Every bank in the U.S. would have had a run that day.  The next day, all banks would have failed.  Global financial meltdown.  We have been 48 hours away from this scenario a few times.  The first time was in September 2007.  I remember it well.  There was briefly no LIBOR.  Banks would not lend excess reserves to other banks overnight because they were afraid they would not get their money back the next morning.  The Fed and the European Central Bank engaged in coordinated flooding of over $250 billion into the financial markets over one weekend to maintain market liquidity.  I told my bank board that this had never happened before.  That was just a precursor of the tidal wave barreling down on all of us.

The Greater Recession

Enough doom and gloom.  I write about this so that it might give rise to the thought about what to do when the Greater Recession starts.  In the last one, the Great Recession, cash was king.  One client called me and excitedly exclaimed, “I just bought my four million dollar loan from the FDIC for eight cents on the dollar!”  He wasn’t bragging, he was genuinely excited at saving 92%.  He had just saved his company from certain financial ruin.

Be prepared.  Cash gives you optionality.  You can choose to spend it or invest it or you can simply hold it.  If another recession hits, you will have your pick of assets to purchase at very deep discounts if you have cash that you can access.  This is a great time to be building your reserves.  And if we miraculously avoid another recession, you have the option of investing in assets that have a more certain future.