Excerpts from James Grants' 

Talk at Google

I Tweeted about James Grant's Google talk here.

The following are some excerpts. 

Material in blue font is Jim's. Material in black font is mine.

In the old days, when a bank needed additional capital, its shareholders would provide it. This was a legal requirement. Nowadays, it's the government that provides it from taxpayer money.

We need to restore individual responsibility on Wall St. Those who benefit from the upside are not bearing any of the costs on the downside. Interpretation: This is testimony to the power of Wall St. Note the array of public officials who have worked on Wall St. before assuming public office.

The only banking institution that didn't receive or require any government bailout during the 2008/2009 Great Financial Crisis was a New York bank named Brown Brothers Hariman. Why? Because they are a partnership where the partners are personally liable for the bank's liabilities. The partners are individually responsible for the risks taken on by the bank.

The 1920/1921 depression self-corrected in 18 months. The 2008/2009 Great Financial Crisis hasn't been set right after 7-8 years of Fed intervention.

The US no longer believes in Adam Smith's invisible hand. Instead it believes in command and control. It's like Poland in the 1950s.  But it's not working!

The Fed employs 700 PhD economists. They are well-intentioned and well-trained, but lack in common sense. Why? Because they missed the subprime mortgage crisis not by 5 miles but by 5,000 miles.

The Swiss national bank creates Swiss francs with the click of a mouse. It then buys shares in American companies. Thus, it gets "something from nothing." How does this make any sense? Money needs to be tied to some kind of material object that has value. Grant is a self-declared gold bug.

Prices, in this case the interest rate (which is the price of credit), need to be "discovered" through the market mechanism, not "administered". The Fed has been doing the latter! Yet the Fed continues to believe that it is better for society that interest rates be administered rather than discovered. This isn't a market economy, but this is the US that we're talking about! 

On US defaulting on its debt. It has already defaulted twice: 1933 and 1975. When inflation exceeds the Treasury bond yield, that's also a form of default.

The present value of US public unfunded liabilities is $120 trillion. Source: Cato Institute, Jeffrey Miron. The US is bound to default in some nuanced form, but it won't necessarily be perceived as outright default.

The US Fed is a monopoly and we all know that monopolies aren't good for society. So why not create competition for it and see what happens? The competition would be to allow, for example, for gold and silver to act as money.

In 1979/1980 when long-term Treasuries were yielding 15%, investors were scared to buy them because previously, they had yielded 9% or less. This meant that bond holders looking backward in time had suffered capital losses due to the fall in bond prices; bond prices fall when yields rise. However, that would have been a great buy because the investor would be locking in a 15% annual yield for 25-30 years. Incredible returns by today's standards.

Today, Treasuries are yielding around 2% and investors still scramble to buy them because since 1980, bond yields have been dropping and so bond holders have experienced capital gains due to a rise in the bond price level; bond prices rise when yields fall.  Interpretation: humans aren't good at detecting turning points in the market. They think that the future will be a continuation of the past. 

Today, there's over $10 trillion worth of government bonds around the globe that have a negative yield. (See the evidence here.) This means that holders of these bonds are paying the issuer for lending it their money! Why is this happening? Because many institutions (insurance companies, pension funds) are mandated to invest in nothing but "safe" securities. There's nothing safe about a negative yielding bond! Central banks are another buyer.

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James Grant gave the above talk in May 2016. In the prior month, he wrote an article that appeared in Time Magazine which I wrote about. See my Tweet and blog post about that article.

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Added on June 7, 2016.

The British author Trevor-Roper has said that the history of thought has not been a straight path from darkness to lightness. Grant seems to be suggesting that monetary policy today may be in the dark and that the US economy in 1920/1921 was in some ways operating better than today.

Description of 1920/1921 Depression

The following description is interesting because it shows how market forces when left unrestricted can lead to self-correcting adjustments that lead to economic recovery and coming out of a depression.

Industrial production fell by 30% between 1920 and 1921 from peak to trough. There was severe unemployment, certainly in the double digits. The stock market was down by half. Commodity prices were down by 40 odd percent. Corporate profits were down by 90%.

The government met this situation with a balanced budget, and with higher not lower interest rates. The latter was perhaps a mistake. 

What proceeded to happen was that markets adjusted.  Prices fell. Wages fell. Because wages fell, profit margins were restored at lower levels of selling prices. So, prices came down. Wages came down too. Equilibrium was restored at lower levels of activity. Because things were cheap, profit seeking individuals sought opportunities. Foreigners sent money to the US for that very purpose.

The gold price was fixed. But the cost of mining it fell. And because the cost of mining it fell, profit margins for the miners increased, and they proceeded to produce more of what in a depression the world needs more, which is money. So automatic forces, or quasi-automatic forces in the marketplace proceeded to do what government actions in this particular long-running cycle -- i.e. 2008 to 2016 -- have so far simply failed to do.

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My Personal Reaction

to Stanley Druckenmiller's Presentation

at Sohn Conference

So, if Druckenmiller sees the world this way (see full article at ZeroHedge or my excerpts of it), why doesn't the mainstream media see it his way? By reading the mainstream media, you would think that everything was normal ...

Maybe that's not their job ....

Or maybe they aren't independent ....

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So, what is an investor to do? Maybe, borrow cheap capital and invest in private projects. Maybe, invest in income-producing hard assets.

Or, short the equity market(s)?

Or, buy gold? Which is what Druckenmiller claims to have done.

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Easy questions to ask. Answers, not that easy. 

Which reminds me: 

When they asked Soros in an interview what he has learnt when he looks back at history and his own investing experience, he answered, "I learnt to expect the unexpected." It's a hard lesson to digest because our natural tendency as humans is to think/believe that tomorrow will be the same as today.

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Excerpts from Stanley Druckenmiller's

Talk at the Sohn Conference,

May 4, 2016

Stanley Druckenmiller spoke at the Sohn Conference recently. ZeroHedge printed an article on it which I Tweeted. See link to that article here.

Below, I present excerpts from that article which I have prefaced with my own questions. So, it's as though Druckenmiller was answering my set of questions. I think this makes for a more interesting read.

Anything in bold or underlined is from the original article except, of course, the questions themselves which are mine.

What has been the goal of most policymakers since the 2008/09 Great Financial Crisis? Has it been to leverage or deleverage?

Druckenmiller: The policy response to the global crisis was, and more importantly, remains so forceful that it has prevented any real deleveraging from happening. Leverage has actually increased globally. Ironically from where I stand, that has been the intended goal of most policymakers today.

Is the Fed being as "data dependent" as they claim to be?

Druckenmiller: If the Fed was using an average of Volcker and Greenspan’s response to data as implied by standard Taylor rules, Fed Funds would be close to 3% today. In other words, and quite ironically, this is the least “data dependent” Fed we have had in history. 

How does today's investment environment compare to the early 1980's? Which one promises superior returns to investors?

Druckenmiller: When I started Duquesne in February of 1981, the risk free rate of return, 5 year treasuries, was 15%. Real rates were close to 5%. We were setting up for one of the greatest bull markets in financial history as assets were priced incredibly cheaply to compete with risk free rates and Volcker’s brutal monetary squeeze forced much needed restructuring at the macro and micro level. It is not a coincidence that strange bedfellows Tip O’Neill and Ronald Reagan produced the last major reforms in social security and taxes shortly thereafter. Moreover, the 15% hurdle rate forced corporations to invest their capital wisely and engage in their own structural reform. If this led to one of the greatest investment environments ever, how can the mirror of it, which is where we are today, also be a great investment environment? 

What seems to be the vision of today's central bankers?

Druckenmiller: The obsession with short-term stimuli contrasts with the structural reform mindset back in the early 80s. Volcker was willing to sacrifice near term pain to rid the economy of inflation and drive reform. The turbulence he engineered led to a productivity boom, a surge in real growth, and a 25 year bull market. The myopia of today’s central bankers is leading to the opposite, reckless behavior at the government and corporate level. Five years ago, one could have argued it was in search of “escape velocity.” But the sub-par economic growth we are experiencing in the 8th year of a radical monetary experiment and in Japan after more than 20 years has blown that theory out of the water.

What is the Fed's end game?

Druckenmiller: The Fed has no end game. The Fed’s objective seems to be getting by another 6 months without a 20% decline in the S&P and avoiding a recession over the near term.

What is the major divergence between EBITDA and corporate debt today?

Druckenmiller: As you can see, the growth in operating cash flow peaked 5 years ago and turned negative year over year recently even as net debt continues to grow at an incredibly high pace. Never in the post-World War II period has this happened. 

How would you summarize the American corporate sector today?

Druckenmiller: The corporate sector today is stuck in a vicious cycle of earnings management, questionable allocation of capital, low productivity, declining margins, and growing indebtedness. And we are paying 18X for the asset class.

How would you summarize the Chinese debt situation today?

Druckenmiller: China: As a result, unlike the pre-stimulus period, when it took $1.50 to generate a $1.00 of GDP, it now takes $7. This is extremely rare and dangerous. The most recent historical analogue was the U.S. in the mid- 2000’s when the debt needed to generate a $ of GDP increased from  $1.50 to $6 during the subprime mania. 

Do you perceive the US stock market as overvalued or undervalued today?

Druckenmiller: If we have borrowed more from our future than any time in history and markets value the future, we should be selling at a discount, not a premium to historic valuations. It is hard to avoid the comparison with 1982 when the market sold for 7x depressed earnings with dozens of rate cuts and productivity rising going forward vs. 18x inflated earnings, productivity declining and no further ammo on interest rates.

What are your recent observations on global equity markets?

Druckenmiller: The lack of progress and volatility in global equity markets the past year, which often precedes a major trend change, suggests that their risk/reward is negative without substantially lower prices and/or structural reform. Don’t hold your breath for the latter. While policymakers have no end game, markets do.

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US stock market: How much can it drop?

The Historical Context

The following is an excerpt from John Hussman's weekly commentary dated April 18, 2016 (link). It lists the relative drop in the US stock market when previous bubbles burst.

Based on valuation measures having the strongest correlation with actual subsequent market returns across history, equity valuations have approached present levels in only a handful of instances: 1901 (followed by a -46% market retreat over the following 3-year period), 1906 (followed by a -45% retreat over the following year), 1929 (followed by a -89% collapse over the following 3 years), 1937 (followed by a -48% loss over the following year), 2000 (followed by a -49% market loss over the following 2 years), and 2007 (followed by a -57% market loss over the following 2 years). A few lesser extremes occurred in the 1960’s and 1970’s, followed by market losses in the -35% to -48% range.

Note added on Aug. 14, 2016: I Tweeted a relevant chart. Click here.

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Market Topping Process

US Equities

The following is an excerpt from John Hussman's weekly commentary dated April 25, 2016 (link). The excerpt appears in blue font and my comments appear in black font.

Still, even if the major indices were to register fresh highs, my impression would remain that the market is in the process of tracing out the arc of an extended top formation.

2000 Top Formation

It’s largely forgotten that during the 2000 top formation, the S&P 500 lost 12% from July-October 1999, recovered to fresh highs, retreated by nearly 10% from December 1999 to February 2000, recovered to fresh highs, experienced another 10% correction into May, recovered to a new high in total return (though not in price) on September 1, 2000, retreated 17% by December, and by January 2001 had recovered within 10% from its all-time high, and was unchanged from its level of June 1999.

Total time taken = June 1999 to January 2001; 20 months

2007 Top Formation

Likewise, during the 2007 top formation, the S&P 500 corrected nearly 10% from July to August, recovered to a fresh high in October, corrected over 10% into November, recovered nearly all of it by December, followed with a 16% loss, and by May 2008 had recovered within 9% of its all-time high, and was unchanged from its level of October 2006.

Total time taken = October 2006 to May 2008; 20 months, again!

Prediction. The current cycle: peak was May 2015. Add 20 months. Result is Dec. 2016.

1928 Top Formation

In 1954, John Kenneth Galbraith offered a similar narrative of the top-formation leading up to the 1929 crash: “The temporary breaks in the market which preceded the crash were a serious trial for those who had declined fantasy. Early in 1928, in June, in December, and in February and March of 1929 it seemed that the end had come. On various of these occasions the Times happily reported the return to reality. And then the market took flight again. Only a durable sense of doom could survive such discouragement. The time was coming when the optimists would reap a rich harvest of discredit. But it has long since been forgotten that for many months those who resisted reassurance were similarly, if less permanently, discredited.”

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Excerpts from James Grant's 

Time Magazine Article

The Time article in question was Tweeted here.

The following are some excerpts:

• The very language of government debt is calculated to tranquilize the critical mind. 
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• Today’s miniature interest rates constitute another form of public sedation. You’d suppose the doubling of the debt would jack up the cost of servicing the debt. Nothing of the kind. As the debt has doubled, the rate of interest has halved.
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• In 2007, we owed $5 trillion and paid an average interest rate of 4.8%. Net interest expense: $237 billion. In 2016 we’ll owe $14.1 trillion and pay the average interest rate I already mentioned: 1.8%. Net interest expense: $240 billion. 
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• The public debt will fall due someday. (Some of it falls due just about every day.) It will have to be repaid or refinanced. If repaid, where would the money come from? It would come from you, naturally. The debt is ultimately a deferred tax. You can calculate your pro rata obligation on your smartphone. Just visit the Treasury website, which posts the debt to the penny, then the Census Bureau’s website, which reports the up-to-the-minute size of the population. Divide the latter by the former and you have the scary truth: $42,998.12 for every man, woman and child, as I write this.
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• In the short term, the debt would no doubt be refinanced, but at which interest rate? At 4.8%, the rate prevailing as recently as 2007, the government would pay more in interest expense–$654 billion–than it does for national defense. At a blended rate of 6.7%, the average prevailing in the 1990s, the net federal-interest bill would reach $913 billion, which very nearly equals this year’s projected outlay on Social Security.
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• To understand our financial fix, put yourself in the position of the government. Say you earn the typical American family income, and you spend and borrow as the government does. So assuming, you would earn $54,000 a year, spend $64,000 a year and charge $10,000 to your already slightly overburdened credit card. I [James Grant] say slightly overburdened–your outstanding balance is about $223,000.
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• According to the Government Accountability Office, unpaid taxes add up to more than $450 billion a year. Even so, according to the Tax Foundation, Americans spend 6.1 billion hours and $233.8 billion each tax season complying with a federal tax code that runs to 10 million words. 
• We owe more than we can easily repay. We spend too much and borrow too much. Worse, we promise too much. We conjure dollar bills by the trillions–pull them right out of thin air. I [James Grant] won’t insist that this can’t go on, because it has. I only say that it will eventually stop.
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• I [James Grant] don’t know the date, but I believe that I know the reason. It will stop when the world loses confidence in the dollars we owe. Come that moment of truth, the nation will resemble Chicago, a once prosperous polity now trying to persuade its once trusting creditors that it is actually solvent.

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Richest 1 per cent and the Gilded Age redux

Sir, Alan Rohrbach (Letters, March 5) says that there is no obvious bubble. I disagree. In 1979 the richest 1 per cent of Americans took home 9 per cent of gross domestic product. Today they earn one in four of all dollars earned in the US. In 1979 the bottom 99 per cent of Americans earned 60 per cent of GDP. Today they earn 50 per cent of GDP. For the weaker sections of society the fall in income has been even worse.

The bubble is visible politically. Donald Trump draws his support from generally uneducated white southerners. Their standard of living has been decimated for the benefit of the Trump class. Fed chair Janet Yellen can’t generate 2 per cent inflation since her dynamic stochastic general equilibrium model with its Phillips curve assumption is misfiring due to the hold the 1 per cent have on the US economy.

It also appears as though corporate America has given up on investment to drive growth. Last year C-suites took $1tn out of the national corporate balance sheet in the form of buybacks. This is how the 1 per cent works.

It is all very Gilded Age redux. As Scott Fitzgerald wrote in The Great Gatsby: “So we beat on, boats against the current, borne back ceaselessly into the past.”

Cathal Rabbitte Villars sur Ollon, Switzerland

Financial Times, March 12, 2016