October 2017

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The world and employment within that world is changing quickly. Apart from government based jobs, which are really non-productive, the nature of productive employment is rapidly evolving.

In the next 20 years, we will see more change and improvement than we’ve seen in the last hundred. Think where we were 100 years ago and how much has changed since then. That much and more is going to happen in the next two decades.

Global society really is going to transform that fast.

Let’s Start with Some Good News

In 1820, about 94% of the world’s population lived in extreme poverty. By 1990, the figure was 35%, and in 2015, it was just 9.6%.

Research shows that, on a global basis, the poor are getting richer faster than any other group. However, if you look around the US or Europe, that is not the conclusion you come to. But Africa or Asia? Absolutely.

Let’s be clear: The Industrial Age and free-market capitalism, for all of its bumps and warts, has lifted more people out of poverty and extended more lives than has any other single development.

Because of where the emerging-market economies are in the development cycle, they have the potential for vast, rapid improvement in the lives of their people.

But most of you do not live in the emerging markets. We live in the developed markets, and here, some of the outcomes of the coming transformation will not be so comfortable.

I’ll give you three examples that show the vast implications of the looming paradigm shift.

The Oilfield Industry Retransformed in Two Years

The rig count in US oilfields is rising rapidly—no surprise there. But distressingly, the number of oilfield workers is continuing to fall. How can this be?

The answer is a new robotic machine called an Iron Roughneck that reduces the human labor required to connect pipe from a crew of 20 down to a crew of five. And those jobs were quite high-paying.

Now look back at the chart. The amazing thing is that this transformation happened in two years; it didn’t take a generation or even half a generation. You were an oilfield worker with what you thought was potentially a lifetime of steady, well-paying— if dangerous, nasty, and dirty—work. And then BOOM!

The jobs just simply disappeared. Your on-the-job experience doesn’t translate to any other industries very easily, and now you and your family are on the skids.

The Automation of Driving

RethinkX, in a 77-page report, concludes that 90% of all driving in the US will be TaaS (transportation as a service) by 2030, although that will utilize only 60% of the cars.

The report projects that the adoption of TaaS will come about in typical technological adoption fashion: slowly and then seemingly all at once. The authors talk about the end of individual car ownership.

And it is not just the six million taxi and truck driver jobs that are threatened. Automated driving will save some 30,000 lives per year just in the US, which is something to be applauded. But it will also dramatically decrease the number of people going to emergency rooms from automobile wrecks, reducing the need for healthcare workers.

Since cars won’t be in wrecks, the number of people required to repair them will be radically reduced. There are 228,000 auto repair shops in the country, employing some 647,000 workers (at a minimum – data from BLS).

If driving is TaaS, then automobile dealerships are in trouble, as are most car salesmen and the 66,000 people who work in automotive parts and accessories stores. What about auto insurance salesmen? And all the gas stations that will not be needed? (When an automated car gets low on electricity, it will simply pull into a spot and replug – automatically, of course, aided by robotics.)

The US auto industry employs 1.25 million people directly and another 7.25 million indirectly. Not all driving jobs will be lost, but the authors estimate that around 5 million will be, with a reduction in national income of $200 billion.

And if we need fewer cars? That shift would put a lot of automotive manufacturing companies and their workers under severe strain.

The End of Cancer and Many Careers

I was talking with my friend Dr. Ray Takigiku, chief executive and chief scientist of Bexion Pharmaceuticals. The company is now 15 months into a phase I trial to determine the safety of a drug called BXQ-350, which is basically a full-on silver bullet for mass-tumor cancers.

It has so far been a small trial in four medical research universities, with a limited but growing number of patients who have pancreatic cancer and brain tumors. The results have been very promising.

Full disclosure: I was a first-round investor in Bexion, and so I have a strong home-field bias in wanting BXQ-350 to succeed, but the reality is that its success will be extraordinarily good for humanity.

But let’s think for a minute about the impact of the success of a drug of this type beyond the many lives that will be saved and the significant reduction of pain and suffering. I couldn’t determine the number of healthcare workers specifically associated with the treatment of cancer, but it has to be in the hundreds of thousands, and they have relatively high-paying jobs.

Then there are all the hospital beds filled by cancer patients – easily many tens of thousands. Plus all the ancillary workers that are associated with the care and welfare of cancer patients.

Kyle Bass gave me the estimate that at least $500 billion of market cap in big Pharma will be destroyed by a cure for cancer.

The Clock Is Ticking

So there are just three examples of major disruptions to employment that will be caused by near-future technological change. We haven’t even gotten into the brick-and-mortar retail jobs that online sales firms like Amazon are taking away. And warehouse workers?

The list could go on and on of whole job classifications that are endangered species. These changes are going to disrupt our lives and the social cohesion of our country. And of course these shifts are coming not just in the US, but in the entire developed world.

And even technology centers in the developing world are going to find themselves at risk of employment dislocations.

Just so that I don’t appear to be a total Gloomy Gus, let me quickly note that the very technologies that are destroying jobs are also going to result in tens of millions of new and in many cases better jobs. Many of them will be high-paying, more life-fulfilling, and far less dangerous than the occupations they replace.

The glib answer to the question, “Where will the jobs come from?” has always been “I don’t know, but they will.” That is what has always happened in the past. We went from 80% of laborers working on the farm in the 1800s at barely subsistence-level incomes to 2% producing far more food today.

But that transition took place over 200+ years—10 generations. There was time for people to adjust and for markets to adapt. Even when whole industries appeared and then disappeared again, it happened over generations.

The transformations I am talking about are going to happen in one half a generation, or at the most a full generation. That is not much time for adjustment, especially for a country like the United States, where 69% of families have less than $1,000 in savings. (I have seen the figure quoted that 47% have less than $400.)

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The purpose of James Ledbetter’s new book, One Nation Under Gold (2017) is to convince you that anything to do with gold – especially basing your money on it – is folly, superstition, mania, obsession, and madness. We know this because he tells us so, in the introduction:

Fixing our money to gold and amassing great stacks of it is no more a guarantor of sustained economic health than a witch doctor’s potions. And, as with religion, what gold believers do can often resemble, in the eyes of the less devout, madness and destruction. From the earliest days of the American republic, gold blinded men from seeing the financial realties around them. And it brought with it all manner of fraud and false hope, gold by-products that are still with us today. … To avoid gold’s false paths, we need to argue with the past, to test the assumptions that are too often and too casually passed uncritically. This book, I hope, is that argument.

“Witch doctor’s potions”? Really? The dollar was worth $19.39/oz. of gold in 1792; in 1914, it was almost unchanged at $20.67/oz. During this time, the United States was the most successful country in the world, rising from thirteen war-torn colonies along the Atlantic coast to command most of an entire continent, along the way going from crude subsistence agriculture to the world’s leader of industry, the wealthiest and freest people the earth had ever seen. After 125 years of money based on gold, America had achieved greatness; after 46 years of a floating fiat dollar, today we wonder how to make America great again.

It wasn’t just the U.S. During the century before 1914, those countries that firmly embraced the principle of gold-based money – Britain, France and Germany – had the best economic performance, and, between them, ruled the world. The countries that had long bouts of floating currencies – Spain, Greece, Portugal – stagnated along the margins, while greater powers disassembled their once-mighty empires. When a country went from a floating currency to a gold standard – the U.S. in 1879, Russia in 1898, Japan in 1897 – a burst of strong economic progress followed. The lesson learned from this was pretty clear, and had nothing to do with superstition.

This would be a pretty interesting tale to tell, but Ledbetter did not tell it. Instead, he focused on the California gold rush that began in 1848. The mining business (including copper, lead and tin, plus oil, gas and coal) has always been a playground for adventurers, rogues and charlatans, often exploitive of workers and an environmental blight. The gold mining business is no better. But, it turned out that gold mining, and the use of gold as a basis for money, never had much to do with each other. Annual gold production today is the highest it has ever been, and roughly double what it was in 1971, the end of the Bretton Woods gold standard system. Roughly half of all the gold ever mined, in human history, has been mined after 1971.

Ledbetter then focused on a series of crises in 1893 and 1896, intimating that they had “something to do with the gold standard.” Indeed they did – they were caused by various threats, by Democrats and Republicans alike, to devalue the dollar by about 50% and then let it float vs. gold, known at the time as “free coinage of silver.” Wouldn’t you panic if members of both political parties threatened a devaluation of this sort? The election of pro-gold president William McKinley in 1896 put an end to the crisis, ushering in two more decades of powerful economic growth.

Ledbetter followed with sections on the devaluation of 1933, when it was made illegal for U.S. citizens to own gold bullion; the Bretton Woods era; and some interesting details regarding the re-legalization of gold ownership during the 1970s. Much of this is valuable historiography, although, reinforcing Ledbetter’s stated intent to portray anything gold-related as being tinged with madness, it tends toward the clownish and absurd, including the legal adventures of a solid gold statue of a rooster that authorities claimed too-closely resembled a (then-illegal) bullion ingot; and some speculation that bismuth could be turned to gold with an atomic particle collider.

Harry Browne, the author of the hugely popular 1970 book How You Can Profit From the Coming Devaluation, was the target of more scorn from Ledbetter, who seems to have been blinded from seeing the economic realities of the time. The dollar was indeed devalued in 1971, going from its $35/oz. Bretton Woods peg all the way down to briefly touching $850/oz. in 1980, before stabilizing around $350/oz. in the 1980s and 1990s. Harry Browne’s followers enjoyed tenfold gains (in dollars) on their gold during the 1970s, while stock and bond markets swirled the toilet.

Glenn Beck, who was recommending gold on his TV show in 2009, later appeared for his share of tomato-throwing. The fact that gold was the best-performing asset class of the 2000-2009 decade, beating stocks and bonds worldwide, apparently meant nothing. It meant something to Glenn Beck; and indeed, gold did rise from around $1100/oz. in November 2009 to around $1900/oz. in 2011. There was good reason to think that the decade-plus bull market in gold (which, like the 1970s, was really a bear market in fiat currencies) had a lot further to go – a whole swath of European governments threatened to default in 2012, and the Federal Reserve, which had been quiescent for a while, began a new “quantitative easing” program that was its most aggressive yet. But, Mario Draghi of the ECB told everyone in late 2012 that he would “do what it takes” to make everything better; soon, bond yields went to their lowest in all of human history, the gold market fell like it was being beaten by a club; and stock markets everywhere levitated in a low-volume, low-volatility march to the skies.

I actually liked much of One Nation Under Gold, as it threw light upon certain historical episodes in an entertaining and readable way. But, I know enough already to be largely immune to Ledbetter’s agenda. Why all the gold-bashing? Ledbetter admitted that gold-based money remains popular in the U.S. He cited a 2011 poll among Republicans and Democrats combined that found 57% favored “returning to a Gold Standard if you knew it would reduce the power of bankers and political leaders to steer the economy.” Only 19% opposed. The American people still know the difference between success and failure: the Bretton Woods era, the 1950s and 1960s, when the dollar was fixed (somewhat precariously) at $35/oz. of gold, had the best economic performance, and the biggest gains by the American middle class, of the past century. Since the floating fiat dollar appeared in 1971 median real wages have stagnated, for the first time in American history.

The elites, however, are almost unanimously opposed. Ledbetter is, apparently, their spokesperson.

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Here are three trends that are often discussed in isolation:

  1. The low birth rates of advanced economies

  2. The rise of a xenophobic anti-immigration politics

  3. The fragility of the welfare state

While these subjects might seem to have nothing to do with each other, in fact they crash into each other like dominos. As rich countries have fewer babies, they need immigration to grow their prime-age workforces. But as the foreign-born share of the population rises, xenophobia often festers and threatens egalitarian policymaking.

There is no reason to think that this cause-and-effect is inevitable, but the trend is clear enough that liberal policymakers need to think hard about this doom loop and how to break it. Let’s spell it out in greater detail.

First, babies. American demographers are “freaking out as each year brings a new record low in the number of women giving birth. There are several ways to cut the fertility data—including annual births per population, or total lifetime births per woman. But every statistic tells the same story: Americans are having fewer babies than they were 50 years ago, or even 30 years ago. Japan and many European countries are dealing with their own “perfect demographic storms.”

A baby shortage sounds like an adorable misfortune of middling significance. Actually, it’s a critical problem. To expand their economies, countries need to expand their populations, particularly at a time of low productivity growth. Rich countries also need a larger and richer workforce to pay for government services to the sick, poor, and elderly. In the long term, with automation, these countries may run out of jobs. But in the short term, they are running out of people. In fact, the number of Americans between 25 and 54 years old has not grown in more than a decade.

That brings us to the second story: immigrants. As the birth rate has declined in the U.S., Canada, Western Europe, and Japan, the immigrant share of their populations has increased. This is a perfectly natural and good development. These countries have high median incomes, which are attractive to international migrants, plus their economies need new humans to sustain both GDP growth and government services.

This might sound counterintuitive to some people who’d assume that a large influx of low-skilled immigrants would be a huge drag on federal resources. In the short term, they might be. But as the children of immigrants find jobs and pay taxes, immigrant families wind up being a net contributor to the government over many decades, according to a 2016 report from the National Academy of Sciences. Beyond this economic accounting, there is a strong moral case to allow families from low-income countries move to a richer country, where they can improve their lot by an order of magnitude.

But there is a growing body of evidence that as rich majority-white countries admit more foreign-born people, far-right parties thrive by politicizing the perceived threat of the foreign-born to national culture. That concept will sound familiar to anybody who watched the 2016 U.S. presidential race, but it’s a truly global trend. A 2015 study of immigration and far-right attitudes in Austria found that the proximity of low and medium-skilled immigrants “causes Austrian voters to turn to the far right.” The effect was strongest in areas with higher unemployment, suggesting that culture and economics might reinforce each other in this equation. Last week, the far-right Austrian party triumphed in the nation’s election.

This is where the story finally connects with welfare and the future of liberalism. Rich countries tend to redistribute wealth from the rich few to the less-rich multitude. But when that multitude suddenly includes minorities who are seen as outsiders, the white majority can turn resentful and take back their egalitarian promises. Take, for example, the Twin Cities of Minnesota. They were once revered for their liberal local policies—like corporate-tax redistribution from rich areas to poor neighborhoods and low-income housing construction near business districts. But since the 1980s, as the metro area attracted more nonwhite immigrants, the metro has become deeply segregated by income and race and affordable-housing construction has backtracked. Or take Finland, that renowned “Santa Claus State” of cradle-to-grave social services, where the welfare state is being “systematically dismantled.” The far right has emerged in the last few decades, just as foreign-born population has suddenly grown.

The modern liberal vision of the U.S. is a pluralistic social democracy—the dream of a nation that uniquely promotes both diversity and equality. The marriage of those twin virtues is, perhaps, the singular American experiment—even if, outside of California, Canada seems to be doing a much better job with the execution. But an unavoidable lesson of the last few years, from both inside and outside the U.S., is that cultural heterogeneity and egalitarianism often cut against each other. Pluralist social democracy is stuck in a finger trap of math and bigotry, where to pull on one end (support for diversity) seems to naturally strain the other (support for equality).

The future of the U.S. economy depends on population growth. The future of U.S. population growth depends on immigration. But, as in so much of the world, immigration can trigger bigotry and backlash. The liberal cause requires  Americans learning to break the catch-22 of diversity and equality. If multicultural egalitarianism is the future of liberal politics, the road to the future will be bumpy.

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Just one more post about yield curves – I promise! With Friday’s release of the CFTC commitment of traders report, I couldn’t resist.

In the coming years, I believe the yield curve steepener has the potential to be one of the all-time great trades. Eventually, I think the Fed, along with all the other developed countries’ Central Banks, will lose control of the long end, and yield curves throughout the world will explode to record wides.

As I discussed previously, I am not sure about the long-term timing. Will the Fed invert the curve? Or does the new post-GFC environment throw all those old playbooks out the window?

I am still trying to decide about my long-term positioning, but I am increasingly confident, from a short-term trading perspective, the 5-30 steepener trade is a screaming buy.

Why do I feel so strongly?

Let’s start with the speculative positioning within the US Treasury futures complex.

Speculators are now record short five-year treasury note futures!

But the really interesting part?

They are long 30-year bond futures.

And they are even long the 10-year note futures.

So it’s obvious the spec community has the 5-30 year flattener (or 5-10) on in size.

Easy to see why. It’s been a one-way ticket.

I don’t know if this is the ultimate bottom in the 5-30 year spread, but at least for a trade, it’s a great bet down here.

Anytime the hedge fund crowd of wise guys become this sure of any trade, it’s time to write a ticket fading them. Remember, the new reality is that the market is nothing more than a Series of Rolling Mini-Bubbles. Flattener trades are by no means immune to this phenomenon.

And the real kicker? The steepener is a positive carry trade. The always enlightening hedge fund manager Mark Dow recently had a great exchange on twitter about the carry on the 5-30 steepener trade (click here if you want to be taken to the twitter thread).

Now there is some debate about measuring the carry on a steepener trade. Basically, it comes down to the fact that to get the position balanced so that one basis point change in 5-year yield equals the same as one basis point change in the 30-year yield, you need to be long many more 5-year futures.

Here is the hedging ratio to get the position balanced.

So you need 4 times as many 5-year note futures. Even though the 5-year note cheapest-to-deliver (the “CTD” that Mark referenced) yields 1.95%, which is less than the 2.577% equivalent for the 30-year future, the fact that you are long so many more five-year futures (which are yielding more than the short-term overnight rate), means you pick up more carry than you pay out.

I know – boring bond stuff. I get it.

The important part to realize is that if you slap this position on and nothing happens, not only do you not lose, but in fact, you pick up the carry that Mark references.

During Mark’s twitter discussion, one of the more astute readers, Joseph S. Mauro, noted that “you’re a Taylor heading away from losing a year of carry in 15 minutes…”

And that’s the worry. A hawkish Federal Reserve Chairman appointment will flatten the curve quicker than the VIX’s recent collapse.

But isn’t that why the curve is so flat? This hawkish Fed Chair risk is at least partly baked in, and provides us with the opportunity.

Yet, more importantly, I am a seller that Trump puts a hawk in charge of the Federal Reserve. Say what you want about the guy, but if Trump has an area of expertise, it’s cheap credit. To think he will follow through with his campaign promise to return the Federal Reserve to an era of discipline is naive. He is tweeting everyday about the record high stock market. Do you think he wants that to end with prudent monetary policy? Not a bloody chance.

Enthusiasm about the stock market is running red hot. It’s due to roll over, and when it does, the curve will steepen. Not only that, but specs are leaning way too short the curve (they have flatteners on), and if there is one thing I have learned from these past few years, the one remaining trade that still works, is fading extremes in speculative positioning. Combine all this with a positive carry trade, well, ‘nuff said. Sign me up. I am buying the steepener for a trade.


PS: And just to throw this out there, many believe Janet Yellen to be a dove. Yet during her tenure, she has presided over the curve consistently flattening. What if the announcement of the end of her term marks the bottom in the trend?


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The new coalition government of Labour & NZ First have put forward a policy that will prevent the purchase of existing NZ houses by overseas [foreign] buyers. Residents [permanent] will still be able to do so.

This is in response to the high rise in NZ house prices that has priced many out of the housing market, particularly in Auckland, where prices are quite frankly ridiculous. For example, a two bedroom unit had an asking price of $880,000. I’m not sure whether it sold, but just that the vendor thought he could get that price, or close to it, is an indication of just how far prices have risen.

The commuter belt to Auckland is extending further and further out. Areas that when we first came to NZ were lovely quiet rural villages are now massively expanded with residential housing everywhere.

We were just up north in Whangarei and the population growth, development, etc was really noticeable since we’d moved to Auckland six years ago.

Is there a problem and will this new policy help solve it?

Why do house prices rise?

Obviously there are a number of variables that contribute to rising prices, however they all fall into one of the following: lack or constrained supply and an increased demand.

I haven’t followed world events too closely for a while as I have been busy with other things, but, Europe is a mess and the US under Trump is probably becoming an issue. Both contribute to immigration in NZ. Both however are dwarfed by the immigration from India and most noticeably from China. So relative to the housing stock, immigration is really high.

Building consents, certainly in Auckland, are difficult and slow to get. The new district plan is improving that to an extent, with an increase in high density living, lots of new flats, but opening new land is still quite controlled. So there is still a shortage of housing stock.

Salary and wages have been pretty stagnant for at least 10 years. This though is an argument on economic growth and productivity in NZ.

Interest rates are still very low all around the world. Low interest rates equal high capitalisation rates. It is simple. We have a high deposit requirement ranging from 20% to 40% [depending on the use of the property, investment as against residential occupation] which has made it very difficult for first time buyers. This was supposed to deter investors, rather, it has enabled investors over the first time buyer.

The flip side of interest rates is that, recent purchasers are highly at risk if interest rates rise, so that capital values fall. A rise fro 5% to 6% is a 20% rise in cashflow required on a monthly basis. Most people have little to zero disposable income each month after paying housing costs, especially those that have bought recently and paid high prices. A significant rise in interest rates has the potential of creating a housing collapse and defaults across the country. This is due of course to government monetary policy.

Therefore, controlling foreign speculation may help somewhat, but I doubt it will accomplish what the politicians hope that it will.

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From Grant’s Interest Rate Observer

Everybody out of the pool!  Investors in Whirlpool Corp. (WHR on the NYSE) are throwing in the towel today after the Benton Harbor, Mich., home appliance behemoth once again fell short of consensus expectations. Weaker than expected earnings and revenues marked a fourth consecutive quarterly shortfall, while the company also trimmed its 2017 earnings per share guidance for a third straight time.  Margin compression was a chief negative catalyst:  On the conference call, management cited “significant raw material inflation and freight mix weakness,” along with “related promotion intensity” for the unwelcome shrinkage.
As might be expected amidst this run of futility, no shortage of bad news accompanied the release.  For instance, the company announced the termination of a 101-year-old business relationship with Sears Holdings Corp. amidst a pricing dispute. Sears released a memo accusing its ex-partner of “[seeking] to use its dominant position in the marketplace to make demands that would have prohibited us from offering Whirlpool products to our members at a reasonable price.” Whirlpool CEO Marc Bitzer countered by noting that “the entire Sears business declined over time.” Bitzer pegged Sears business at 3% of the company’s global revenues on today’s call. It was 8% in 2011.
Industry data also pose a concern.  In particular, the most recent reading of the Association of Home Appliance Manufacturers Factory Shipment Report (AHAM-6) showed a sharp deceleration in growth.  September home appliance sales grew by just 1.3% from 2016, far below the 3.5% advance seen year-to-date and the 6.6% compound annual growth rate in the four years ended 2016.  Major categories such as dishwashers, washing machines and both electric and gas cooking appliance sales shrank from their 2016 levels in September.  The destructive hurricanes may have played a role, but then again, new home sales in September rose by 6.1% year-over-year on a seasonally adjusted annual rate.  Year to date, the new home sales SAAR has gained by 3.1% over the first nine months of 2016.  Those divergent fortunes are reflected in recent share price outperformance of the SPDR S&P Homebuilders ETF (XHB on NYSE ARCA) against Whirlpool:
In a Feb. 10 analysis of Whirlpool it was postulated that the accelerating housing market may bestow less favorable winds on the white-goods industry than might be expected, while the post-housing bubble replacement cycle that underpinned the industry’s strong sales growth through 2016 might be set to wane.
[Replacement purchases] account for no less than 50% of overall appliance sales (purchases related to new homes deliver just 20%). So you can expect that a boom would be followed by a kind of echo-boom. And so it has proved recently. The average major appliance lives for eight to 12 years. So the big spending years of 2001 through 2005 have whistled up a second bulge in appliance purchases.
That bulge may have come and gone.
Whirlpool’s industry-leading margins likewise caught the attention of Grant’s, both as a mark of its operational success and as a potential bearish catalyst in the future:
[North American operating margins] reached 11.5% last year, roughly double the average margins of the global competition and 38% greater than the 20-year average margin earned by Whirlpool itself in Canada, Mexico and the United States.
We’re not the only ones who notice this yawning, golden disparity. Foreign white-goods makers, too, observe what riches the top American appliance maker plucks from North America. On form, they will try to move in, fat profits being the red carpet to determined competition.
For its part, Whirlpool management is drawing a line in the sand.  Questioned by analysts over the company’s 2020 earnings targets in light of the trio of cuts to this year’s guidance, Bitzer responded unequivocally:
We’re fully standing behind this. We’ve been part of developing these targets and we’re not going to back off. I know given that it’s my CEO call for an earnings call, probably we’ll be needing one to put some question marks behind this one, but we don’t. We’re fully behind it. We’re committed, which also means for next year without giving any 2018 guidance, our entire focus will be on margin expansion and we need to catch up what we lost this year.
No pressure!

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If I said to you, create your own money, what would that be worth? Who would want to exchange goods and services against that? The whole ‘point’ of money is that you can avoid the whole issue of I have bread and I need shoes but you need apples. Money is a universal mode of exchange.

If you possessed the programming skills required, you could make your own crypto-currency. There are a number of them out there, and their numbers are increasing. The first and probably still the most popular, Bitcoin, says that it has [or will have] a cap. Only a certain number of Bitcoins will ever be ‘mined’. Whatever.

The other cryptos have no such pledge. They will continue to expand indefinitely. We potentially end up with hundreds, or thousands of crypto-currencies that essentially mimic the fiat currencies that we currently have. Like we trust government, we would need to trust the programmers. Well we know where trusting government has got the world as far as ‘money’ is concerned…an endless inflation.

Predicting the future is not easy. In fact, it is pretty much a futile undertaking. Every now and then someone gets lucky and makes a big call. However, with a few caveats, looking at and thinking about history is a far easier proposition.

Gold and silver have been with us for thousands of years and served admirably as money during that time. It is reasonable to suppose that they could do so again. If I was selling something, anything, and a buyer came to me and said I’ll pay you your asking price in gold or silver, would I accept them as ‘money’? Yes I would. I have no qualms about holding money wealth as gold or silver, even up to 100%. Would I accept Bitcoin? In a very small amount and it would because I’d be willing to take a gamble that it might rise in value so that I could sell it or trade out of it at some point. How much would I hold, a small % of my weekly income. That’s it. I have confidence that gold or silver will continue for ever. Bitcoin, who knows, as for the rest, forget it.


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“I don’t know.” That was the only answer I had to each of my dad’s questions. It was very dark as we wandered the streets near my Upper East Side apartment in the early hours of October 20th, 1987, discussing the events of the prior day, Black Monday.

I was 25 years old and had been on John Meriwether’s Arb Desk for just over a year, following two years working in Salomon’s Bond Portfolio Analysis Group. My memories from the day the US stock market dropped 22% didn’t seem very noteworthy when my friend Rich Dewey asked to interview me for an article, Black Monday Revisited, he was writing for Bloomberg to mark its 30th anniversary. After all, compared to the other people Rich was interviewing—Paul Tudor Jones, Howard Marks, Stanley Druckenmiller, Ed Thorp and my former Salomon colleagues Eric Rosenfeld and Michael Lewis— what could I add?

I’ve been thinking that my recollection of some things that didn’t happen might be interesting. First of all, Salomon’s Arb Group didn’t do a single trade on October 19th, or pretty much for that whole week. It wasn’t that we didn’t see great opportunities, but rather that it was clear to everyone that this was a crisis and a time to preserve capital. Salomon was first and foremost a financial intermediary. Our capital was limited, and it would be sorely needed for providing liquidity to clients and projecting financial strength to all our counterparties. Salomon had about $3.5 billion of capital supporting a balance sheet of $100 billion.

We borrowed money to finance our long positions in bonds primarily through the repo market, but we also had to borrow securities to support our short positions. When we shorted a bond, such as the 9.25% of 2/15/2016 that we were running a big position in at the time, we needed to borrow that specific bond from someone who held it in order to make good on the sale. We could borrow money from anyone– a client, a bank or as a last resort even the Fed. But the only party who could lend you a security was someone who owned it free and clear, and hadn’t lent it already. And the lending market was mostly overnight, so we had to roll every day.1

Our biggest fear was that clients who were lending us the securities we were short might ask for them back, forcing us to cover our shorts and unwind our trades. It’s almost axiomatic that when you’re forced to unwind a trade, you lose money on it. With these concerns in mind, John holed us up in a room off the desk, and we put our efforts into methodically triaging our portfolio. We kept the trades we’d be most able to hold to convergence, and cut the ones that were least defensible. We had been having a solidly profitable year up until October, but gave back most of our gains in the few days around Black Monday. The firm’s decision to let us keep our best positions was rewarded with a very profitable 1988.

The defensive orientation on our desk was echoed across the whole firm, and it was probably the same at Goldman, Bankers Trust and all the other trading houses on the Street. As a highly levered financial firm, dependent on short-term funding of our balance sheet, our crisis mentality was about surviving the storm, not trying to profit from it. While the most popular 1987 crash stories celebrate the trading acumen of the likes of Tudor Jones, Druckenmiller or Taleb, the less publicized story of how so much capital was constrained or frozen—an essential ingredient in all market panics– might be the more important takeaway.

Another thing that I don’t remember happening was an economic depression following the stock market crash. Well, I guess that’s because it didn’t! It was supposed to though, just as the Great Depression followed the Black Tuesday of October 1929. In fact, in December 1987, 33 prominent economists (5 with Nobel prizes) issued a statement predicting that “the next few years could be the most troubled since the 1930s.”2 The fact that we moved forward with barely a blip to the real economy makes us feel that October’s stock market crash was bogus, a market move that had nothing to do with fundamentals. But it didn’t have to turn out that way. It’s important to remember what didn’t happen: an alternative future in which the Fed didn’t act as it did (would Volcker have reacted as Greenspan did?), the stock markets fell even further, financial firms started failing, and we got a long and deep recession.3

Could it happen again? Of course it could. And it has. Extreme market moves of the magnitude of Black Monday’s 20-times normal daily move have occurred periodically since then, just not in the US equity market or on the one-day time scale. For example, two years ago, the Swiss Franc put in a 40 times daily upward move against the Euro when the Swiss National Bank suddenly abandoned the policy of capping its value.4 If we look at more arcane, but still important, markets, we find further examples, such as changes in swap spreads or long-dated equity volatility in October 1998 (what is it with October anyway?), or diversified equity momentum trading strategies that lost close to 90% in 2009, or the melt-down of equity quant strategies the week of August 6th, 2007.

Plus ça change. Humans, with all our behavioral foibles, are still important players in the markets. While the presumed cause of Black Monday, Portfolio Insurance,5 is now defunct, it has been superseded by vast amounts of capital dedicated to algorithmic trading or trend-following, both strategies expressly designed to make money, not to stabilize markets. Risk management systems based on VaR (recent volatility of positions) or a tight stop-loss discipline are inherently destabilizing too. And then we have the Volcker Rule and other post-financial crisis regulatory changes, which have the unintended consequence of dramatically reducing the ability and incentive of the banks to provide liquidity in normal market conditions, let alone in a crisis. What do we have against all this? More circuit-breakers and a tradition of Central Bank intervention to stabilize markets in every crisis since Black Monday.6 Hopefully, they will continue to do so, but we should be prepared for when they don’t.

You may wonder, how did this prepare me for another tumultuous October, eleven years later, when I was a partner at LTCM? Stay tuned, its 20th anniversary is just twelve months away.

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The flow of capital into passive investment strategies has intensified into a veritable deluge. Last week, BlackRock, Inc. reported third quarter net inflows of $96.1 billion, bringing its year-to-date influx to $264.3 billion, and easily surpassing 2016’s take of $202.2 billion. ETF industry assets, under its iShares umbrella, posted 32.1% year-on-year gains in the third quarter.
BlackRock’s primary competitor Vanguard Group is seeing an even more pronounced surge in popularity, attracting a net $291.7 billion in new funds for the first three quarters of 2017 to put John C. Bogle’s not-for-profit enterprise on pace to eclipse last year’s inflows of $323 billion. Count current Vanguard chairman and CEO F. William McNabb among those surprised by the prodigious 2017, in an interview last Tuesday with The Wall Street Journal he noted that “last year was one that I never thought we’d see again.”
The potent force of momentum — shown here in the dual form of the longstanding bull market and growing popularity of indexation strategies — plays a starring role in the cash pile up.  So too does a helpful nudge from regulators.  Both in Europe (in the form of MiFID II regulations set to take effect in 2018) and in the U.S. (with the Department of Labor’s fiduciary rule requiring increased disclosure on commissions), investors are being herded to lower cost products.  On BlackRock’s second quarter conference call in July, chairman and CEO Larry Fink cited the government paradigm: “We’re seeing regulatory changes change the ETF environment. We do believe we’re seeing accelerated flows because of MiFID II, because of the movement toward the fiduciary rule in the United States.”
First you get the assets… BlackRock‘s five year stock price. Source: The Bloomberg
The bourgeoning popularity of indexation isn’t translating into better economics for its architects. To the contrary: Judging by recent moves from smaller industry players such as State Street Global Advisors and Charles Schwab, a full-on price war is underway.  Last week, Barron’s reported that Charles Schwab launched the Schwab 1000 Index ETF, which covers 90% of the entire U.S. equity market according to the company, at an expense ratio of just five basis points (by comparison, institutional cash equity trading commissions used to frequently top 10 basis points). This morning, State Street responded in kind, slashing its own fees on 15 separate ETFs.  For its SPDR Portfolio Total Stock Market ETF, three basis points is the new expense ratio, down from 10 basis points.
The capital gusher into ETFs and other passive instruments corresponds with the almost-robotic upward march in the stock market.  A dispatch in Bloomberg Businessweek detailed the somnolent environment at the midtown prime brokerage desk of Credit Suisse Group AG.  Noting the absence of client reaction to the escalating tensions with North Korea in August, Credit Suisse’s global head of risk advisory Mark Connors marveled that: “Two rockets flew over the land mass of Japan and nothing happened. There were no calls. That’s absolutely crazy.”
Fueled by unprecedented conditions such as negative nominal interest rates in large swaths of Europe and sustained central bank asset purchases despite the absence of recession in any major economy, the bull market continues apace.  The severe dislocations of many ETFs relative to their underlying net asset values seen back on August 24, 2015 (in which one-fifth of all equity ETFs experienced price movements of 20% or more, compared to just 4% of individual stocks, according to Bob Rice of New York-based Tangent Capital) begs the question of what becomes of the passive uprising if and when conditions do shift.
As always, the timing of any such potential sea change remains a mystery. Daniel Wiener, editor of the Independent Adviser for Vanguard Investors, says: “I don’t think there’s much that changes these flows until we have a negative market. I can’t tell you when that happens, but when it does there will be a lot of very surprised investors.”

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I have a number of new cases that I’m working on: there is an employment case, a criminal case, an ACC case and an insurance case. Keeping me busy.

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