The next financial crisis will likely be  induced by a cyber attack

The next financial crisis will likely be  induced by a cyber attack

According to JP Morgan, one of its models that “calculates outcomes based on the length of the economic expansion, the potential duration of the next recession, the degree of leverage, asset-price valuations and the level of deregulation and financial innovation before the crisis” sees the next financial crisis occurring in 2020.  We recognize this current economic expansion is long in the tooth, but to us what is more worrisome is how the next financial crisis might start. Several new reports point to cyber threats as the likely culprit. Perhaps companies will take heed of these findings and perspectives, which would serve as the latest catalyst for our Safety & Security investing theme.

On Wednesday, the Depository Trust & Clearing Corp., which provides clearing and settlement for the financial markets in the U.S., released a report, entitled “The Next Crisis will be Different: Opportunities to Continue Enhancing Financial Stability 10 Years After Lehman’s Insolvency.” It discusses several macroeconomic and market-related risks to the financial system but specifically said that cybersecurity threats “have grown to a point where they may have become the most important near-term threat to financial stability.”

Cyberthreats have consistently been ranked as the number one concern by respondents to Depository Trust’s Systemic Risk Barometer since the survey began in 2013: “The motivation of cyber-attackers is shifting from purely achieving financial gains to disrupting critical infrastructures, such as through nation-state attacks, which threatens the basis for confidence in the financial system and even national or international stability.”

They aren’t the only ones worried. After the financial crisis, the Dodd-Frank Act established the Financial Stability Oversight Council to identify and monitor excessive risks to the U.S. financial system. The chairman is the secretary of the Treasury.

The Office of Financial Research provide financial data and research to the council and each year publishes a Financial Stability Report on risks to the financial system.

The most recent report, published in December, came to the same conclusion as the Depository Trust: “A large-scale cyberattack or other cybersecurity incident could disrupt the operations of one or more financial companies and markets and spread through financial networks and operational connections to the entire system, threatening financial stability and the broader economy.”


Source: A cyberattack could trigger the next financial crisis

Obama Claims Country Better Off Today?

Obama Claims Country Better Off Today?

Obama claims the country is better off?  Uh, what? Last week President Obama told a small group of wealthy donors that by almost every metric, the U.S. is significantly better off under his leadership than under Bush’s. Oh dear God this is just getting embarrassing! Can we please have a little reality check here?



The most basic metric for how well the country is doing is median household income – are families making more today than in years past?  Errrr, not so fast there Mr. President. As the chart below shows (the red line) we are still well below we were when you took office… and that is despite the massive amount of government spending and monetary policy stimulus! Or perhaps, this is in fact because of all that insanity? In fact, median household income, after taking inflation into account, is where it was back in 1989, twenty-six years ago!

2015-07 Median Household Income


One of the reason household income is so low is that despite the often touted “unemployment rate” the more important number, the percentage of people in the country actually working is down to levels not seen since the early 80s and well below the ratio during George W Bush’s Presidency.

2015-07 Employment Population Ratio

On top of that, 2.2 million Americans are in part-time jobs who want to work full time, still far above the level at the start of the recession and during George W’s entire Presidency.

2015-07 Part-time for economic reasons


So people are making less and fewer people are working… what about the debt burden on those who do have jobs?  When Obama took office, the total Federal Debt was 10.7 trillion. Today it is over 18 trillion and expected to be well over 19 trillion by the time he leaves office.  That’s more than an 80% increase in the debt burden shouldered by the American people in just 8 years, nearly doubling!

2015-07 US Total Public Debt

This has also been the weakest economic recovery in the nation’s history. For the first time ever, U.S. GDP has contracted twice since the recovery and on an annual basis remains well below historical norms. Normally after a recession, we experience a period of above average growth which helps repair the damage experienced during the recession.  Not only did we never get that above average growth, but the economy continues to stumble along at very weak levels.

Just exactly what is it that you are looking at Mr. President?  As the “most transparent Administration in history,” (snort, chuckle, eye roll) how about if you show us?


Germany and Greece: An Impossible Relationship?

Germany and Greece: An Impossible Relationship?

This morning the markets in Europe rose giddily on the belief that the problems with Greece were resolved, despite the bureaucrats insistence that they were in fact, not at all. By late afternoon in Europe, it had become clear that there was no resolution, but the talks continued. I swear I’ve had breakups that seemed an awful lot like this!

Most people have at some point in their lives been in a relationship, be it romantic or platonic, with another person who has a different view  of “The Way Things Ought to Be.” This can be over something as mundane as how frequently one ought to exercise to how much and how loudly one ought to laugh or perhaps just how much fun is appropriate in one’s life or the really volatile one, just how wild one ought to get into the wee hours!  Having a material discrepancy over “The Way Things Ought to Be” can be highly destructive to the relationship, leaving both parties fuming at each other in an indignant, self-righteous huff.

Germany and Greece: An Impossible Relationship?

A giant banner protesting Greece's austerity measures hangs near the Parthenon on Acropolis hill in Athens early May 4, 2010. A group of demonstrators from Greece's communist party, KKE, staged the protest atop the Acropolis as Athens braced for a 48-hour nationwide strike by civil servants which would also include the shutdown of travel services.    REUTERS/Pascal Rossignol  (GREECE - Tags: EMPLOYMENT BUSINESS POLITICS CIVIL UNREST)








These two are the sovereign equivalent of that couple that seems rather fascinated by each other, perhaps some seriously passionate sparks on occasion, but are eventually at each other’s throats, utterly baffled as to how the other cannot see just how clearly WRONG they are! Each is convinced that if they just lay down the law and point out precisely what the other ought to be doing instead of what they are doing followed by an ultimatum, the indisputable “rightness” of their position will become clear and they’ll get their way… because that’s so often how human nature works!

Deep in German culture is a profound belief, darn near religious, that inflation can never be used to manage debt.  For Greece, that’s a bit like arguing ouzo is best used as a floor cleaner! The nation has been wracking up debt then discarding it in a variety of ways, often via inflation for over two centuries. Carmen Reinhard and Kenneth Rogoff, in their book “This Time Is Different,” determined that between 1800 and 2008, Greece spent 50.6% of the time in default or restructuring!

Germany on the other hand derives great joy and satisfaction from strictly following the rules – tell that to a nation so tied up in bureaucratic red tape that trying to resolve the proper way to handle something there goes a bit like this.

A Greek entrepreneur goes to a public agency and asks, “What do I need to be able to do this thing X?” 
Answer: “A, b, c, d, maybe e, probably f, not sure though about g.”

Hmmm, OK… so our entrepreneur goes to another agency and asks the same question.
Answer: “E, f, not sure about a, definitely not c but definitely g and we’ve never heard of b.”

Exasperated our entrepreneur seeks the advice of a prominent attorney, thinking they’ll be able to properly chart the course, only to discover that they’ve got no idea either.  There are so many laws sitting on top of contradictory laws and regulation upon regulation that there is no clear answer.  Ta da!  Welcome to graft.  If there is no one clear answer on the books, you just have to buy a temporary one from whomever is in charge that day.

In the end our entrepreneur gives up, forgets trying to build a business and gets a job as a public employee!

So here’s the  problem now.  Germany thinks that if it strong arms Greece out of the eurozone, the rest of the eurozone trouble-makers will get scared straight, fall back in line and Germany can relax that everyone will from now on start playing by the rules. So far what Germany is pushing will not allow Greece’s economy the room it needs, culturally and financially, to change – “Dear Eurozone: I love you but you are just no good for me.”

What if Greece gets the boot, defaults, starts all over again and after a while its economy is more robust than Italy’s or Spain’s?  That’d be a bit like having one’s ex show up to a friend’s party with their gorgeous and very successful new significant other; more than just a little bit awkward.

Can’t you just see the love?

Shove It! A Greek Tragedy?

Shove It! A Greek Tragedy?

The headlines are once again dominated by the living Greek economic tragedy, vacillating between dire predictions of a Greek collapse and ensuing global financial calamity to ebullient, (and frankly rather ludicrous) stock market jumps of joy on hopes of a pseudo happily-ever-after. Conventional wisdom has been to lambast the Greeks with the usual damning triumvirate of a nation whose citizens are either lazy, stupid or evil… or all three. The nation is currently in a technical default, having failed to make payments already due on loans to the International Monetary Fund (IMF), but has claimed that it will make a single lump sum payment later in the month for all monies due in June. The size of the Greek debt relative to GDP is second only to Japan, which given its ability to control its own currency is a very different animal.



To put the level of Greek debt in context, at a total of $352.7 billion, it is about half of the $700 billion that was approved by Congress for the Troubled Asset Relief Program in 2008.   So in the context of global debt, it isn’t that big of a deal, what is a big deal however is the precedent the situation will set for the Eurozone, the second largest economy in the world. I can’t imagine just how much coffee and antacids have been consumed this week in Luxembourg, as all sides find themselves stuck between a rock and a hard place, with no clear common ground.

As for that excruciating austerity we keep hearing about, meaning the cuts governments were wailing about having been forced to endure. Errrr, hmmmmm, not so sure where that is coming from when we look at data from the IMF on the next chart….


Spending cuts? Where? All three countries have increased their debt to GDP ratios since the crisis began. So here’s the real scoop.


Greece has a massive government full of rules and regulations on darn near everything that makes it very difficult to start or run a business and a tax code that makes War and Peace look like a summer beach read. Now all these rules, regulations and taxes were put in place for ostensibly good reasons, like most bureaucratic shenanigans, “We need to protect hotel employees, cab drivers, restaurants, nurses, fishing boats, gardeners etc. etc. etc.” The problem is that when you add up all this “protection” for existing businesses, employees, consumers, tradespeople… it becomes increasingly tough to run a business.


To make up for just how tough it is, the government has made it a practice to promise people lots of safety in the form of pension systems, welfare aid, etc. The math here isn’t too tough to figure out. If on the one hand you make it really hard on people to get things done and on the other hand you provide ample support for a decent living for those who aren’t working for whatever reason, well you’ll have less people working their tails off, which means less money available to tax and spread around to those who aren’t working. But that’s ok, because hey, we are part of the Eurozone and can get debt cheap, so we’ll just borrow whatever we can’t get through taxation and spend that. No worries.


That worked for a while… until the market started looking at the math a bit more in depth and realized that Greece had reached the point where it really cannot sustain its debt any longer.

Greece is like the family with a single income earner holding down two jobs that pay slightly over minimum wage who needs to support a spouse, some kids, manage a $525,000 adjustable rate mortgage whose rate keeps rising, has two cars in the driveway in desperate need of rather costly repairs, a cousin who just moved in and has some serious health problems and found out today that the roof has a major leak. Now the bank keeps calling and telling you that you need to work harder and cut back on the spouse’s spending habit as your mortgage rate continues to rise and you are already late on a few months’ worth of payments and your credit cards are maxed out. Your boss is telling you that your skills are seriously lacking and your cousin says she can’t possibly live in that room you gave her unless she gets to redecorate it on your dime. At some point, you throw your hands up in the air and tell everyone to shove it!


Earlier this week, according to a report by the Financial Times, Greek prime minister Alexis Tsipras argued that,


“The pensions of the elderly are often the last refuge for entire families that have only one or no member working in a country with 25 per cent unemployment in the general population, and 50 per cent among young people.” That’s Greek for shove it.


How does a politician manage this type of pressure from back home? Ms. Merkel and Mario Draghi just aren’t that scary or persuasive!


So that’s where we are. The majority of Greeks have decided to go the “shove it” route and sent Yanis Varoufakis to deliver the message, in a rather debonair manner we might add, (that’s Yanis on the left in the picture below.) This has left Germany’s Angela Merkel, the European Central Bank’s Mario Draghi and France’s François Hollande in a tizzy as they try to figure out how to work with a Greek envoy that appears to be quite confident their game theory skills will eventually get them whatever they want. Italy’s Renzi, by the way, is mostly back home dealing with his nation’s struggling economy and the seemingly eternal roll of sitting between the U.S. and Russia – poor man has enough on his plate!



So here we stand with Greece still wanting to be part of the Eurozone club, having never, even upon admission to the club, been able to satisfy the requirements for membership. To be fair, many nations who were let into the Eurozone club never have been able to meet them either.


Bottom Line: What does a Grexit mean for the rest of the world? First, it likely means a stronger dollar relative to the euro, at least in the near-term, as there will be a flurry of uncertainty given that (1) the Maastricht Treaty didn’t provide any way for a nation to exit the Eurozone and (2) there will be fears that other member nations may try to find wiggle room around their heavy sovereign debt loads, which will give some cause for concern about the future of the Eurozone. Eventually, all that flurry will likely pass as frankly a Eurozone without Greece is stronger than one with it. Holders of Greek debt will be hit hard, which means a lot of European banks, (primary holders of all that debt) are getting even more complicated. However, the Eurozone economy is still struggling, thus the ECB will continue on with its euro-style quantitative easing, which means that over the longer run, the U.S. dollar is likely to continue it bull run.

Greece in Hotel California

Greece in Hotel California

Greece was all over the headlines again last week as the deadline for debt talks neared. The           Maastricht Treaty, which created the European Union, is starting to sound an awful like the Eagles “Hotel California,” with many in Greece left rethinking, “This could be Heaven or this could be Hell.” The treaty provided a lengthy list of requirements to enter the Eurozone “hotel,” but provides no way to exit, making all members, “…just prisoners here, of our own device.” Greece, among quite a few others, didn’t exactly meet the economic fitness requirements to obtain membership in the Eurozone. The current members were well aware that Greece was essentially doping to get the level of performance required and were all too willing to look the other way. After all, “We are programmed to receive. You can check-out any time you like, but you can never leave!”


After Greece made it onto the Eurozone team, things went quite well for a while. The global economy appeared to be performing in tip-top shape and “dealers” for Greece’s performance-enhancing creative debt securitizations were ubiquitous. Now before anyone gives into the desire to finger wag, first recall that parts of the US economy also indulged in such performance-enhancing financial supplements, (housing and now the auto sector). Frankly, pre-financial crisis the proliferation of creative debt securitization on the global stage was a lot like an excerpt from a Lance Armstrong post-2012 doping deposition, “Everyone was doing it. You had to if you didn’t want to be left in the dust.” Pssst, a version of this is still going on today, just ask any company that is juicing its EPS by using newly issued debt to fund stock buybacks such as Apple (AAPL), IBM (IBM), Monsanto (MON), CBS (CBS) and many more.


Today, global economic conditions are such that the hills have gotten a hell of a lot steeper, the pavement is full of cracks, there are powerful headwinds, rain flurries and Greece’s pre-crisis performance-enhancing suppliers are no where to be seen. Debt-doping allowed the nation to get away with all kinds of economic sins, gorging itself on regulations and labor laws akin to years of multiple-pint nightly threesomes with my two favorite partners-in-crime, Ben and Jerry, followed by many a lazy day-after spent series-binging on “Ex-wives of Rock” while sprawled on the couch munching on peanut butter Cap’n Crunch out of the box. Now with no “supplements” available, an overweight, out-of-shape and endocrine-exhausted Greece is being told to get pedaling faster and faster on a bike with bald tires, a broken gearbox and gyrating handlebars.


You would think that Germany, of all countries, would remember that driving a nation into the economic ground is never a good idea. Most economists and politicians refer to Germany’s understandable fear of hyperinflation but that overlooks the much more relevant and painful lesson from the impossible demands placed on the country post WWI, which destroyed not only its relationship with its neighbors, but also its democracy and ultimately led to WWII. How ironic that the Maastricht Treaty, which was conceived in part to prevent another war between European neighbors, is now the cause of so much inter-European strife!


Greece simply cannot pay its debt, which is pretty much its standard operating procedure. According to Kenneth Rogoff and Carmen Reinhart, “from 1800 to 2008, Greece was in default 50.6% of the time,” so angry bondholders, how about a reality check? Last week we mentioned that the nation’s economy had contracted by 26% from 2008-2013, yet it is still managing to remain current on its debt payments while running a primary surplus of about 1.5%. That would be a seriously crowd-pleasing performance on NBC’s The Biggest Loser!  The problem is its creditors want Greece to increase that surplus, meaning ride even faster up that blasted hill! Even Jillian Michaels wouldn’t push that hard.


Last Thursday Greece formally requested a 6 month extension after four weeks of brinkmanship, which was quickly returned with an “I don’t think so,” from Germany.  On Friday night a four month interim pact was reached that will once again kick the can down the road, albeit a much shorter road than after previous kerfuffles, conditional on Greece submitting a list of reforms by Monday 23rd.  Greece submitted such a list close to midnight on Monday, which the eurozone commission officials claim contains significant changes from “a more vague outline originally discussed at the weekend.”  One official reportedly said, “We are notably encouraged by the strong commitment to combat tax evasion and corruption.”


The Eurozone finance ministers will hold a conference call on Tuesday to determine the acceptability of Greece’s proposed reform plans.  Most likely an agreement will be reached.  The bailout money will continue to come and the European Central bank will continue to stand behind the nation’s banking system.  However, all the finger pointing and accusatory language has greatly damaged relationships and backed both parties into difficult corners.  The next round of talks in four months could be even more contentious.

State of the Economy

State of the Economy

The flattening of the yield curve as interest rates fall is bad news for banks that make money by borrowing short-term and lending long, yet another sector that under current conditions is a headwind for the economy. Frustratingly, the yield curve isn’t the only headwind to banks as last week, Morgan Stanley (MS) was the last of the major Wall Street firm’s to report disappointing fourth quarter earnings citing, like many others, weak trading volumes. So far J.P. Morgan Chase (JPM), Bank of America Corp. (BAC), and Citigroup Inc. (C) all failed to meet expectations while Wells Fargo (WFC) met them and only Goldman Sachs Group Inc., (GS) was able to beat.

So just how is the economy doing?

Unprecedented Weak Growth: The long-run average growth rate for the United States is 3%. Typically the economy experiences several years of above average growth rates, which helps households and businesses recover from the recession. No such V-shaped rebound has occurred and we have yet to achieve even the long-term normal rate of growth on an annual basis. Although, the U.S. economy did grow at a 4.6% rate in the second quarter and an impressive 5% rate in the third quarter of 2014, which was the highest in 11 years.

Consumer is still suffering: The income of the median U.S. household was $51,900 in 2013, according to the U.S. Census Bureau. That’s nearly unchanged from 2012, after adjusting for inflation, is 8% lower than in 2007, before the recession began and 9% below the all-time high from 1999!   A decade and a half later and household income is still down 9%.

Fewer and fewer working: As of December 2014, the labor force participation rate was 62.7%. This rate peaked in early 2000 at 67.3%, but is now at levels not seen since the late 1970s. This is harmful to the economy because it means there is a smaller portion of the population working to support their families, pay taxes that fund government spending, and support programs such as Medicare and Social Security.

2015-01-30 Gallup Biz Death BirthWeak Business Environment: For the first time in 35 years, American business deaths now outnumber business births. The U.S. now ranks 12th among developed nations in terms of business startup activity.  Yes, you read that right. According to the US Census Bureau, Countries such as Hungary, Denmark, Finland, New Zealand, Sweden, Israel and even Italy all have higher startup rates than America does. Keep that bit about Italy in mind as you read later on just how benevolent the business environment is in Italy relative to say… Rwanda. This is a very, very big deal and explains a lot of income and employment. The key driver for employment in any economy is the growth of new businesses, and without it a significant level of new jobs and material income growth is darn near impossible.

Banks & the Fed – Bail 'em Out then Beat 'em Up

While shoppers were watching their pennies this holiday season, I was grinching over the relationship between the Fed and the big banks as reminiscent of the abusive relationship between Ike and Tina Turner – bail them out then beat them up with an onslaught of massive fines.  According to a global banking study by the Boston Consulting Group, legal claims against the world’s leading banks have reached $178 billion since the financial crisis, with heavy fines now seen as a cost of doing business, a cost ultimately born by shareholders with no banking employees or executives facing charges for wrong-doing.

All these fines do little to deter wrong-doing in the future while taking money out of the hands of those saving for retirement and give it to the government to spend with zero accountability.


Real vs Financial Economy:  Thoughts from Monte Carlo

Real vs Financial Economy: Thoughts from Monte Carlo

Last week I had the great honor of being invited to speak at the XIIth Annual International CIFA Forum, (the Convention of Independent Financial Advisors which is in special consultative status with the United Nations) in Monte Carlo. Who knows how I got invited back after speaking there last year, but when someone asks me speak in front of such an impressive audience, I don’t question. The conference is truly first rate with phenomenal guests as well as speakers, excluding of course the statistical anomaly of yours truly. If you find yourself in Monaco, I recommend staying at either the Hotel Hermitage or l’Hôtel Métropole and you cannot miss dining at Joël Robuchon at Métropole. If you want to see more of the famed nuttiness that is Monte Carlo after dark, make your way to Buddha Bar and I guarantee you’ll come away with stories to entertain for hours.

I highly recommend driving into Monaco from the Italian side on the Autostrada dei Fiori, (A10) which essentially means the highway of flowers. The road is high on the side of sheer mountains, winding along the coast of the Mediterranean, with countless bridges followed by tunnels and as you wander through the beauty of the land where the Maritime Alps meet the sea. Greenhouses, full of brightly colored flowers, dot the mountainside with unexpected flashes of color amongst the lush shades of green. As you look south, the Mediterranean’s beauty changes throughout the day as her moods softly sway, ranging from bright aquamarine, to the more subtle tones of oxidized copper to a moody ashen navy. Looking back towards the mountains, you may even catch sight of snow covered peaks. Surely some of the heavens’ best work is to be found in Italy. The drive however, is not well suited for those who have a significant fear of heights as the picture at left illustrates!

At the conference I spoke about the real vs financial economy, which is a topic that I’ve alluded to often in these monthly pages. This month let’s go a bit deeper. When we think of the economy, it can be broken into two distinct aspects: the real and the financial.

The real economy is what we primarily think of when referring to the economy. It is essentially composed of four types of capital:

  • Natural capital provides the basis for all human activity. It consists of raw natural resources such as minerals, timber, water etc. From this platform, human capital combines with social capital to general built capital and intermediate goods.
  • Human capital refers to individual productive capacity
  • Social capital refers to the networks and connections between individuals that facilitate the production of, and exchange of, goods and services.
  • Built capital refers to the man-made materials and productive devices utilized by human capital to produce desired goods and services.

The financial economy is essentially the world of money, including the various prices for money, namely interest rates and exchange rates. The financial economy overlays and supports the real economy by facilitating transactions and setting market prices for the stock and flow of the four capitals in the real economy.

When the real economy is healthy, market prices reflect the value of the true contribution of the four capital stocks and the real and financial economy align. In this environment debt and equity markets, as a percent of GDP, are small and are principally designed to channel savings into investments.

When the two are misaligned, and the financial economy dominates, the capital market is far larger than GDP and channels savings not only into investments, but also continuously into expanding speculative bubbles. The danger of this arrangement is somewhat intuitive. When there is more money floating around than the underlying real economy calls for, that money is going to race about nervously, seeking ways to generate returns. Since it is not attached to anything real underneath, its flows can be quite volatile, with bubbles able to quickly form and dissipate even more rapidly.

That is not to say that bubbles don’t occur when the real economy dominates, but those bubbles tend to stay small and have little impact on the overall economy. In the real economy, bubbles tend to be contained by the availability of savings and credit, whereas in the financial economy (where capital markets are disproportionately large relative to the real economy), the effectively unlimited availability of credit leads to speculative bubbles, which cause enormous price distortions and excessive flow of capital from the real economy into the bubble. We saw this occur in housing boom that reached its pinnacle in 2007 and has as of yet only recovered, on a national basis, about 1/3 of the cumulative decline during the recession.

When bubbles form in the financial economy, the size of the “white elephant” investments can be so large that the economic benefits that arise from an investment boom are dwarfed by the damage from the inevitable bust. In the most recent housing boom and bust, excessive investments were made in the housing industry on the somewhat Ponzi-style belief that prices would simply continue to go up and up. (Hmmm, I believe we mentioned the dangers of chasing returns in our prior section!) That led to more and more people building skills in construction, mortgage generation and other housing sector-specific skills. At the end of it all there were too many people working in a sector with too much capacity built up, so all those people and the physical capital that goes along with them needed to get shifted around into other parts of the economy; an arguably painful process for those who have to endure it.

So just how big has the financial economy become? According to data from the World Bank, stock market capitalization to GDP for the US has risen remarkably in recent decades. In 1990, it was just under 57.6%.

In 1999 it peaked at 162%, dropping to 115% by 2003, only to once again rise up to a peak of 141% in 2007. After the crisis, it fell to 97% in 2009 and is now back up to about 115%, still about twice where it was in 1990.

If we look at total credit market debt as reported in the Federal Reserve Flow of Funds report, in Q1 1990, total debt to GDP was 120%. In April 2009 that number had more than doubled to 274% and is now about 245%.

Now that’s all very interesting, but how does it pertain to investing and why do you care?

When looking to invest capital, there are essentially two choices:

  • Allocate “entrepreneurially” to the real economy, meaning in the production of goods and services, or
  • Allocate “financially” in legal claims against such activities.

Think of “entrepreneurial” allocation as investing in your cousin’s new restaurant or in the construction of a new corporate office complex that your attorney suggested as opposed to the financial economy which is, for example, about buying shares of Apple, call options on General Electric or Ford bonds.

A study by Philipp Mudt, Niels Forster, Simone Alfarano and Mishael Milakovic looked at just this, by studying over 30,000 publicly traded firms in more than forty countries that represent 70% of the global population and about 90% of the world’s income, comparing both average rates of return and volatility of returns from 1997 to 2011. Unsurprisingly, average returns for investments in either the real economy or the financial economy were roughly equal, but volatility of financial returns was a magnitude higher than that of “real” returns.

When you think about this, it is somewhat intuitive. We know that in the real economy, profits face a negative feedback mechanism which helps establish a rather stable profit level; a fairly well understood process in classical notions of competition. A sector that is experiencing high profit levels will naturally attract more capital, which in turn attracts more labor, thus increases output, which eventually reduces prices as supply increases relative to demand and puts downward pressure on profits over time. As profits decline, capital has incentives to go elsewhere, and the reverse process occurs leading to higher prices and profits for firms that remain in the industry.

In the financial sector, rather than this negative feedback mechanism, we can see a temporary positive feedback mechanism and strong cross-correlations which can lead to an almost Ponzi scheme effect. Prices for a particular security or type of security rise. This rise attracts additional capital, and the momentum generated by speculators chasing the hot sector attracts more and more capital until finally you find yourself getting tips on the hottest sector or stocks from your cab driver and dry cleaner.

I call this a sort of market-directed Ponzi scheme simply because in the long run companies cannot afford to pay more to financial stakeholders than they earn from their real activities, thus financial returns are eventually tied to real returns… unless of course one seriously mucks with the financial economy, as is the case today. Under today’s conditions, the long run rule still holds, but “long” is much longer.

As all Ponzi schemes eventually fail when no new buyers can be found, the stock prices start to fall when new buyers cease to come in and existing owners struggle to find someone to take their shares when they need to cash out. We have all seen this accelerating decline in various forms. Here’s the latest example. A lot of air has already come out of the euphoria for social media stocks in 2014. Most of the leading stocks in the social media sector are down substantially for the year to date through April 28th, including Linked In (-32%), Twitter (-34%), Yelp (-19%), Groupon (-40%), Youku (-25%), SINA (-43%) and Yandex (-44%). Speculators who chased last year’s bubbly returns in social media shares have been stung by substantial losses in the first several months of 2014.

One of the most striking aspects of the panel in Monte Carlo was unanimous concern regarding the significant potential risks in the global economy today as a result of the size magnitude of the financial economy relative to the real, the actions of central bankers during and after the crisis and the lack of any meaningful reform post-crisis. Gretchen Morgenson of the New York Times noted that financial crises seem to have become much more impactful on the overall economy and more severe in recent decades. She expressed concern that we have the makings for a much more severe correction in the future as she believes that few if, any of the causes of the last crises have been accurately and adequately addressed.

Roger Nightingale had a more distressing outlook than Ms. Morgenson’s, stating that he believes the world is in for one whopper of a depression when central banks find they have no choice but to cut back on the liquidity they’ve been injecting into the economy since the start of the crisis. He believes the cut back to be inevitable as he attributes the high levels of fraud we’ve seen in the financial sector to be a direct result of the excess levels of liquidity. He claimed that a sharp pull-back will be necessary, else society as a whole will cease to have any faith in our institutions if the fraud is able to continue at its current levels.

Louise Bennetts stirred the crowd with her assessment that Dodd-Frank has done very little to address the problems of the financial crisis and has in fact made the situation far more volatile as much of the legislation gives regulators considerable discretion concerning how to deal with bank problems. Throughout history, discretion translates into inconsistent treatment and typically to considerable levels of graft. These combine to inject significant uncertainty into the markets, which as we’ve already seen, increases instability in a sector that has not yet recovered. I highly recommend her work, along with Arthur Long on the impact of proposed bank regulations on global growth.

The group also engaged in a stimulating debate concerning why the media continues to present such a simple “all is well and let’s be on our merry way” version of the economy. Explanations ranged from lack of true understanding of the deeper data, to political positioning and the possibility that with the media cycle reality of today, there is no real interest in discussing risks that are more than a year or so out into the future. Whatever the cause, we could all agree that it certainly provides us with plenty of work with which to earn our keep!

Bottom Line: The size of the financial economy relative to the real economy has grown substantially in recent decades, making comparisons to historical norms difficult at best and misleading at worst. Additionally, sovereign debt levels are at perilously high levels relative to GDP for many of the world’s largest economies at a time when interest rates are at exceptionally low levels, (debt is likely to become increasingly more expensive over time) and aging demographics make future growth more challenging. While the current recovery looks to be thankfully gaining ground, longer-term significant problems loom large on the horizon; a reality to keep in mind when assessing portfolio risks. On the bright side, the market has done some correcting of the bubbly valuations in the most euphoric sector of 2013, social media, as expectations for what these companies can achieve in the real economy have come down.

Signs That Housing is Cooling

Signs That Housing is Cooling

First the good news, data through November 2013, released January 28th by S&P Dow Jones Indices for its S&P/Case-Shiller Home Price Indices, the leading measure of U.S. home prices, showed that the 10-City and 20-City Composites increased 13.8% and 13.7% year-over-year. Dallas posted its highest annual return of 9.9% since its inception in 2000. Chicago also stood out with an annual rate of 11.0%; its highest since December 1988. The three cities tracked by the indices in California also enjoyed strong year-over-year returns as of November, with San Francisco up 23.2%, Los Angeles up 21.6% and San Diego up 18.7%.

Now the bad news, in November, the non-seasonally adjusted version of the 20-City Composite, which as the report’s authors acknowledge is the accurate one, posted its first monthly decline, dropping modestly from 165.9 to 165.8, or down 0.06%, since November of 2012. In December, the 20-City Composite showed its second consecutive monthly decline of 0.1%. The concern here is how much of the recovery in housing has been driven by investors, foreign, domestic and institutional, buying in all-cash sales on a speculative basis. According to RealtyTrac, sales of foreclosed and distressed homes made up 16.2% of all home sales last year, up from 14.5% in 2012. All-cash deals accounted for 29.1% of all home purchases, again up from 19.4% the year before. Institutional investors, including hedge funds and private equity groups, were buying up homes of all types last year including foreclosures. During the year, 7.3% of all home sales were to investors, up from 5.1% the year before. Major markets where investors claimed the largest percentage of sales in December included Jacksonville, Fla., (38.7%), Knoxville, Tenn., (31.9%), Atlanta (25.2%), Cape Coral, Fla. (24.9%), Cincinnati (19.3%), and Las Vegas (18.2%).

In January existing home sales fell by 5.1% from December to the slowest pace in over a year. While this is concerning, much of that could be attributed to the horrendous weather. Only the coming months will tell if this is a new directional trend, or a function of an exceptionally difficult winter.

On January 30th, we received more cautious news. Pending home sales fell 8.7% month-over-month, the worst since May 2010, missing estimates by the most in over 3 years. This is a 6.1% drop year-over-year. According to Larry Yun, the Chief Economist for the National Association of Realtors explained:

“Unusually disruptive weather across large stretches of the country in December forced people indoors and prevented some buyers from looking at homes or making offers,” he said. “Home prices rising faster than income is also giving pause to some potential buyers, while at the same time a lack of inventory means insufficient choice. Although it could take several months for us to get a clearer read on market momentum, job growth and pent-up demand are positive factors.”

On Feb 26th, there was a glimmer of silver lining for the housing market, in that new home sales jumped a bigger-than-expected 9.6% to a seasonally adjusted total of 486,000 despite poor weather which hurt foot traffic. Economists were expecting sales to dip 3.4%. The report shows the housing market remains resilient despite bad weather and higher borrowing costs. We don’t want to get too excited about the Feb 26th report, because new home sales figures can be volatile. January’s numbers could be revised down in coming months, as October’s and November’s previously-reported figures were this month. It’s also important to note that new home sales are a small portion of the overall housing market and they remain weak for a late stage economic recovery.

On February 28th that hope dimmed as we learned that contracts to purchase previously owned U.S. homes rose less than forecast in July, climbing only 0.1% versus expectations of 1.8% (according to Bloomberg) and following a 5.8% drop the prior month.

Flipping homes, (when a home is purchased and subsequently sold again within six months) has become quite the money making adventure for some. In 2013, 156,862 single-family homes were flipped, up 16% from 2012 and up 114% from 2011. Homes flipped in 2013 accounted for 4.6% of all U.S. single family home sales during the year, up from 4.2% in 2012 and up from 2.6% in 2011. The chart below at right shows how the magnitude of flipping has grown over the years.

However, the flipping trend appears to be slowing. Flips accounted for 3.8% of all sales in 4Q, down slightly from 3.9% of all sales in 3Q and down from 7.1% of all sales in 4Q 2012, the highest percentage of sales represented by flips in a single quarter since RealtyTrac began tracking flipping data in the first quarter of 2011.

Bottom Line:  The factors driving home prices up may not be sustainable. For housing to enjoy a sustainable recovery over the long run, employment and household income levels need further improvement.


Unemployment Problems Persist

Unemployment Problems Persist

Perhaps the reason so few are saving is because the job situation isn’t exactly rosy, nor are income levels. According to the most recent report from the Bureau of Labor Statistic, the unemployment rate has dropped to 6.7% which looks on the surface to be good news. However, if you look a bit deeper, the source of that improvement is troubling. The labor force participation rate, meaning the proportion of the population either employed or looking for employment has continued to drop, see chart at right, and is now at mid-1970s levels. Without the drop in the participation rate, the unemployment rate would be around 13%, rather than just under 7%. Additionally, according to data from the Minneapolis Federal Reserve (see chart at right), the American economy is experiencing the worst performance for labor markets since the Great Depression.


Some argue that the decline in the labor force participation rate is primarily driven by the inevitable retirement waves of the baby boomers. However, the chart below illustrates that baby boomers are in fact participating in the work force at a higher rate than in decades.















Along with the grim jobs recovery, household income levels continue to struggle, with income levels close to those 20 years ago, see chart above. Bottom Line: The fiscal and monetary stimulus has been unable to get employment or income levels back to anywhere near the levels enjoyed during the start of the 21st century. So far the impact appears to be more visible in rising prices in the stock markets and more recently rising home prices.