August 2015


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An essay on debt that I disagree with.

Through history public debts have gone up and down, often expanding in periods of war or large changes in basic infrastructure and technologies, and then going down in periods when things have settled down.

The pros and cons of public debt have been put forward for as long as the phenomenon itself has existed, but it has, notwithstanding that, not been possible to reach anything close to consensus on the issue — at least not in a long time-horizon perspective. One has as a rule not even been able to agree on whether public debt is a problem, and if — when it is or how to best tackle it. Some of the more prominent reasons for this non-consensus are the complexity of the issue, the mingling of vested interests, ideology, psychological fears, the uncertainty of calculating ad estimating inter-generational effects, etc., etc.

In classical economics — following in the footsteps of David Hume – especially Adam Smith, David Ricardo, and Jean-Baptiste Say put forward views on public debt that was as a rule negative. The good budget was a balanced budget. If government borrowed money to finance its activities, it would only give birth to “crowding out” private enterprise and investments. The state was generally considered incapable if paying its debts, and the real burden would therefor essentially fall on the taxpayers that ultimately had to pay for the irresponsibility of government. The moral character of the argumentation was a salient feature — according to Hume, “either the nation must destroy public credit, or the public credit will destroy the nation.”

Later on in the 20th century economists like John Maynard Keynes, Abba Lerner and Alvin Hansen would hold a more positive view on public debt. Public debt was normally nothing to fear, especially if it was financed within the country itself (but even foreign loans could be beneficient for the economy if invested in the right way). Some members of society would hold bonds and earn interest on them, while others would have to pay the taxes that ultimately paid the interest on the debt. But the debt was not considered a net burden for society as a whole, since the debt cancelled itself out between the two groups. If the state could issue bonds at a low interest rate, unemployment could be reduced without necessarily resulting in strong inflationary pressure. And the inter-generational burden was no real burden according to this group of economists, since — if used in a suitable way — the debt would, through its effects on investments and employment, actually be net winners. There could, of course, be unwanted negative distributional side effects, for the future generation, but that was mostly considered a minor problem since, as  Lerner put it,“if our children or grandchildren repay some of the national debt these payments will be made to our children and grandchildren and to nobody else.”

Central to the Keynesian influenced view is the fundamental difference between private and public debt. Conflating the one with the other is an example of the atomistic fallacy, which is basically a variation on Keynes’ savings paradox. If an individual tries to save and cut down on debts, that may be fine and rational, but if everyone tries to do it, the result would be lower aggregate demand and increasing unemployment for the economy as a whole.

An individual always have to pay his debts. But a government can always pay back old debts with new, through the issue of new bonds. The state is not like an individual. Public debt is not like private debt. Government debt is essentially a debt to itself, its citizens. Interest paid on the debt is paid by the taxpayers on the one hand, but on the other hand, interest on the bonds that finance the debts goes to those who lend out the money.

To both Keynes and Lerner it was evident that the state had the ability to promote full employment and a stable price level – and that it should use its powers to do so. If that meant that it had to take on a debt and (more or less temporarily) underbalance its budget – so let it be! Public debt is neither good nor bad. It is a means to achieving two over-arching macroeconomic goals – full employment and price stability. What is sacred is not to have a balanced budget or running down public debt per se, regardless of the effects on the macroeconomic goals. If “sound finance”, austerity and a balanced budgets means increased unemployment and destabilizing prices, they have to be abandoned.

Now against this reasoning, exponents of the thesis of Ricardian equivalence, have maintained that whether the public sector finances its expenditures through taxes or by issuing bonds is inconsequential, since bonds must sooner or later be repaid by raising taxes in the future.

In the 1970s Robert Barro attempted to give the proposition a firm theoretical foundation, arguing that the substitution of a budget deficit for current taxes has no impact on aggregate demand and so budget deficits and taxation have equivalent effects on the economy.

The Ricardo-Barro hypothesis, with its view of public debt incurring a burden for future generations, is the dominant view among mainstream economists and politicians today. The rational people making up the actors in the model are assumed to know that today’s debts are tomorrow’s taxes. But — one of the main problems with this standard neoclassical theory is, however, that it doesn’t fit the facts.

From a more theoretical point of view, one may also strongly criticize the Ricardo-Barro model and its concomitant crowding out assumption, since perfect capital markets do not exist and repayments of public debt can take place far into the future and it’s dubious if we really care for generations 300 years from now.

Today there seems to be a rather widespread consensus of public debt being acceptable as long as it doesn’t increase too much and too fast. If the public debt-GDP ratio becomes higher than X % the likelihood of debt crisis and/or lower growth increases.

But in discussing within which margins public debt is feasible, the focus, however, is solely on the upper limit of indebtedness, and very few asks the question if maybe there is also a problem if public debt becomes too low.

The government’s ability to conduct an “optimal” public debt policy may be negatively affected if public debt becomes too small. To guarantee a well-functioning secondary market in bonds it is essential that the government has access to a functioning market. If turnover and liquidity in the secondary market becomes too small, increased volatility and uncertainty will in the long run lead to an increase in borrowing costs. Ultimately there’s even a risk that market makers would disappear, leaving bond market trading to be operated solely through brokered deals. As a kind of precautionary measure against this eventuality it may be argued – especially in times of financial turmoil and crises — that it is necessary to increase government borrowing and debt to ensure – in a longer run – good borrowing preparedness and a sustained (government) bond market.

The question if public debt is good and that we may actually have to little of it is one of our time’s biggest questions. Giving the wrong answer to it — as Krugman notices — will be costly:

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So somewhere around the $400/oz mark is where the next great bull market in gold will likely start. This probably makes sense as interest rates really have only one direction to move [higher] which means lower for gold.

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So right around the time I opened this strategy [also on the QQQ’s] the market collapsed. However, here is how the strategy has traded through the current market:

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So far so good.

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In the fall of 2009, Jim Chanos began to ask questions about the Chinese economy. What sparked his curiosity was the realization that commodity producers had been largely unaffected by the financial crisis; indeed, they had recorded big profits even as other sectors found themselves reeling in the aftermath of the crisis.

When he looked into why, he discovered that the critical factor was China’s voracious appetite for commodities: The Chinese, who had largely sidestepped the financial crisis themselves, were buying 40 percent of all copper exports; 50 percent of the available iron ore; and eye-popping quantities of just about everything else. That insight soon led Chanos to make an audacious call: China was in the midst of an unsustainable credit bubble.

Perhaps you remember Jim Chanos. The founder of Kynikos Associates, a $3 billion hedge fund that specializes in short-selling, Chanos was the first person to figure out, some 15 years ago, that Enron was a house of cards.

He shorted Enron stock — meaning that he would profit if the stock fell, rather than rose — and shared his suspicions with others, including my friend Bethany McLean, who wrote a story for Fortune that marked the beginning of the end for Enron. That call not only made Chanos a small fortune; it also made him famous.

Chanos and his crew at Kynikos don’t make big “macro” bets on economies; their style is more “micro”: looking at the fundamentals of individual companies or sectors. And so it was with China. “I’ll never forget the day in 2009 when my real estate guy was giving me a presentation and he said that China had 5.6 billion square meters of real estate under development, half residential and half commercial,” Chanos told me the other day.

“I said, ‘You must mean 5.6 billion square feet.’ ”

The man replied that he hadn’t misspoken; it really was 5.6 billion square meters, which amounted to over 60 billion square feet.

For Chanos, that is when the light bulb went on. The fast-growing Chinese economy was being sustained not just by its export prowess, but by a property bubble propelled by mountains of debt, and encouraged by the government as part of an infrastructure spending strategy designed to keep the economy humming. (According to the McKinsey Global Institute, China’s debt load today is an unfathomable $28 trillion.)

Chanos soon went public with his thesis, giving interviews to CNBC andCharlie Rose, and making a speech at Oxford University. He told Rose that property speculation in China was rampant, and that because so much of the economy depended on construction — in most cases building properties that had no chance of generating enough income to pay down the debt — China was on “the treadmill to hell.”

He also pointed out that much of the construction was for high-end condos that cost over $100,000, yet the average Chinese household made less than $10,000 a year.

Can you guess how the financial establishment, convinced that the Chinese juggernaut was unstoppable, reacted to Chanos’s contrarian thesis? It scoffed.

“I find it interesting that people who couldn’t spell China 10 years ago are now experts on China,” the well-known investor Jim Rogers told The New York Times. He added, “China is not in a bubble.”

The conventional view was that the Chinese economy would continue to grow at a rapid pace, and that Chinese officials, unencumbered by the messiness of democracy, could make quick adjustments if the economy started to slip.

Chanos was undeterred. “It reminded me of 1989, when everybody said that we should emulate the Japanese model,” he told me. “They used to say, ‘They can get stuff done and we can’t’ ” — just as the supposed experts were now saying about China.

As it turns out, China’s economy began to slow right around the time Chanos first made his call. No matter: Most China experts remained bullish. Chanos, meanwhile, was shorting the stocks of a number of companies that depended on the Chinese market. And he was regularly sending out emails when he came upon articles that seemed to confirm his thesis: stories about newly constructed ghost cities and troubled banks and debt-laden state-owned enterprises.

These days, with the markets in free-fall, it certainly looks like Chanos has been vindicated. China’s not the only reason the stock market has been so volatile, but it’s the most important one. China’s economy is faltering, its stock market is collapsing, and the ham-handed efforts by government officials to prop up both have mainly had the effect of disabusing anyone who still thinks the government can revive the economy with the snap of its fingers. This loss of confidence in China and its leaders has spooked stock markets around the world.

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INDEX INVESTOR CORNER

Swedroe: Debunking Gold Mythology

August 19, 2015
In mid-July 2012, Merrill Lynch added its voice to the many that were predicting gold would hit $2,000 an ounce by the end of that year. Francisco Blanch, head of global commodities research at the investment bank, said: “We think that $2,000 an ounce is sort of the right number.” Gold was then trading at about $1,577.

At about the same time, in an interview with ETF.com, money manager Peter Schiff, who has attracted much media attention with his doomsday forecasts, offered up this prediction: “I’m looking for another leg up … it’s going a lot higher. It’s hard to tell where the next move is going to take it. But it’s going thousands of dollars higher than it is now.” When asked how high, he responded: “I think a minimum of $5,000. But it could go a lot higher than that.”

These kinds of predictions almost certainly helped drive investor interest in gold. In fact, a 2011 Gallup poll found that 34 percent of Americans said gold was the best long-term investment, far more than those who chose real estate, stocks or bonds.

The question is: Were, and are, individuals investing in gold for the right reasons? Well, one reason for investor interest in gold is the belief that it’s a great inflation hedge. Another is that it provides a hedge against currency risk. And a third is that gold can act as a haven of safety in bad times. Are these valid reasons?

The Evidence

In their June 2012 study, “The Golden Dilemma,” Claude Erb and Campbell Harvey examined these issues. In terms of being a currency hedge, they found that the change in the real price of gold seems to be largely independent of the change in currency values. In other words, gold is not a good hedge of currency risk.

As for gold serving as a safe haven, meaning that it’s stable during bear markets in stocks, Erb and Harvey found gold wasn’t quite the excellent hedge some might think. It turns out that 17 percent of monthly stock returns fall into the category in which gold is dropping at the same time stocks have negative returns. If gold acted as a true safe haven, then we would expect very few, if any, such observations. Still, 83 percent of the time on the right side isn’t a bad record.

In terms of gold’s value as an inflation hedge, the following example should help provide an answer. On Jan. 21, 1980, the price of gold hit a then-record high of $850. On March 19, 2002, gold was trading at $293, below where it was 20 years earlier.

Note that the inflation rate for the period from 1980 through 2001 was 3.9 percent. Thus, its loss in real purchasing power was about 85 percent. How can gold be an inflation hedge when, over the course of 22 years, it loses 85 percent in real terms?

As further evidence of gold’s inflation hedging abilities, Goldman Sach’s “2013 Outlook” contained the following finding: In the post-World War II era, in 60 percent of the episodes when inflation surprised to the upside, gold underperformed inflation. That said, gold has been a good hedge of inflation over the very long run (such as a century). Unfortunately, that’s a much longer investment horizon than that of most investors.

Updated Findings
In August 2015, Erb and Harvey updated their paper. They begin by examining the argument that gold is an inflation hedge, or what they call a “golden constant.”

The authors explain: “One way to think about the golden constant perspective is as a collection of statements that assert that: 1) over a very long period of time the purchasing power of gold remains largely the same; 2) in the long run, inflation is a fundamental driver of the price of gold; 3) deviations in the price of gold relative to inflation will be corrected; and 4) in the long run, the real return from owning gold is zero.”

The study covered the period beginning in January 1975. The authors found that, over the period, the average real price of gold is 3.46 times the U.S. Consumer Price Index (CPI). In June 2015, the CPI level was 237.8. Multiplying gold’s average real price by the current CPI (3.46 x 237.8) delivers a price of approximately $825. This represents what the nominal price of gold should be today—if we assume the real price of gold is constant.

Of course, over time, prices have strayed far from the golden constant. And, as Erb and Harvey note, the golden constant isn’t a fact, just a hypothesis.

But if your reason for buying gold is that it’s an inflation hedge, your expectation should be that gold will revert to its golden constant over time. And despite haven fallen from its peak of almost $1,900 in September 2011 to stand at about $1,100 as I write this, it’s still about 20 percent above the golden constant.

When Gold Deviates From Its Constant
Erb and Harvey then asked: If the golden constant provides a guide to the value of gold, what typically happens when the price of gold is above or below its golden constant value? They found that the high real price of gold has been about 8.73, the low real price of gold has been about 1.47, and that the current real price of gold is about 4.63.

The charts they present show that while there is a tendency to revert to the golden constant, the price of gold can vary greatly from the golden constant, and stay well above or below the constant for a long time. And as they note, there is no way of knowing if the “future high and low real prices of gold may be more or less extreme than in the past.”

The authors add: “The high and low real prices of gold highlight that even if there is on average a golden constant the real price of gold has strayed, and probably will stray, far from this possible central tendency. It is also possible that the future will be unlike the past.”

They thus warn that if the “real price of gold falls, the golden constant level is not a floor—a protective line in the sand that the real price of gold will not cross.” With this caveat, they did go on to examine the outlook for gold returns given where the price is relative to the golden constant.

Expected Returns To Gold

Erb and Harvey examined what happened to the return on gold when prices were above or below the golden constant. As you might expect, they found that “below average real gold prices have been followed by above average 10-year real gold returns and above average real gold prices have been followed by below average 10-year real gold returns.” Because the real price of gold is currently above its historical average, this “suggests that over the next 10 years real gold returns could be below average.”

Erb and Harvey also looked at the downside risk of owning gold. To do so, they asked the question: How low might the price of gold go if the previous low real price of gold is revisited? Given the value of the U.S. CPI for June 2015 and the previous low real price of gold, a possible low price for gold is about $350 an ounce.

This, of course, does not mean that the price of gold will immediately decline to $350 an ounce. Rather, it’s a suggestion that, given the volatile history of real gold prices, because the real price of gold once fell to 1.47, it could fall to that level again.

A Return To Highs
The authors also examined what would happen if gold went back to its previous highest real price. If that occurred, it means the price of gold would again have reached about $2,080.

Erb and Harvey then looked at what would happen to real and nominal returns on gold if we assumed inflation of 2 percent a year for the next 10 years. Why 2 percent? It’s roughly the difference between the yield on 10-year Treasurys and 10-year TIPS, as well as similar to the consensus forecast of economists gathered by the Federal Reserve Bank of Philadelphia.

They found that the golden constant value of gold would increase from $825 an ounce to $1,006 an ounce, and the “overshoot” price would rise from $350 an ounce to $427 an ounce. If, over a 10-year investment horizon, the price of gold fell from $1,096 an ounce to $1,006 an ounce, it would experience a nominal return of ‐0.9 percent per year and a real return of ‐2.8 percent per year.

If the price of gold dropped from $1,096 an ounce to its 10-year “overshoot level,” the nominal and real returns would be ‐9.0 percent per year and ‐10.8 percent per year, respectively. Keep in mind that, regardless of the future inflation rate, the real rate of return is ‐2.8 percent per year if gold falls to its golden constant fair value over the 10-year period.

Erb and Harvey concluded that, even though there is little relation between the nominal price of gold and inflation when measured over 10‐year periods, the evidence suggests that gold does hold its value over the very long run.

For example, in a prior paper, they presented historical evidence that the wage of a Roman centurion (in gold) was approximately the same as the pay earned by a U.S. Army captain today. They also showed that the price of bread (in gold) thousands of years ago is about the same as we would pay today at an upscale bakery.

Summary

The conclusion we can draw is that, while gold might protect against inflation in the very long run, 10 years is not the long run. As Erb and Harvey note: “In the shorter run, gold is a volatile investment which is capable and likely to overshoot or undershoot any notion of fair value.”

I’d add to that another insight that becomes important in the long term. While the laws of economics can be defied in the short term, history demonstrates that investors ignore them at their peril. For instance, a basic economic principle is that, over the long term, prices tend to move toward the marginal cost of production.

In its “2013 Outlook,” Goldman Sachs estimated that the marginal cost of producing gold is less than half the current price (around $750 an ounce). The financial services firm also observed that more than 80 percent of gold production costs less than $1,000 an ounce—or about 10 percent below the current price. Another important point to consider is that, unlike with other commodities, all the gold that’s ever been mined is basically available for sale today.

And, as Dimensional Fund Advisors’ Weston Wellington recently pointed out: “It’s also conceivable that a significant real price increase would encourage development of electrochemical extraction of the estimated 8 million tons of gold contained in the world’s oceans, dwarfing the existing gold supply.” That’s a lot of supply that could potentially hit the market.

The bottom line is that, while my crystal ball always remains cloudy, based on the fundamentals and the historical evidence, there doesn’t really seem to be a case that gold is likely to provide strong investment returns, even though it has already fallen about 40 percent from its peak nominal value (and even more in real terms). Forewarned is forearmed.

If you have been considering an investment in gold—perhaps you see the 40 percent drop from its high as a buying opportunity—hopefully the information in this article will enable you to make a more informed decision.

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Same basic strategy, slightly different structure of the position.

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Just implemented a new [long-term] strategy on the QQQ’s. Once a month, I’ll post a chart to keep track as I reset.

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