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Bond King Gross Says Ditch the Dollar Before It’s Too Late

Contrarian Profits — Fri, 05 Jun 2009 17:30:52 +0000

We spent the morning musing on the Maginot Line. The French built this elaborate line of fortifications along its border with Germany in the 1930s to thwart an invasion by its Great War enemy. When Germany invaded France in May 1940, Adolf Hitler’s armies simply bypassed the line and invaded France through neighbouring Belgium. The Maginot Line proved to be an elaborate dud.

As Nassim Taleb points out in his book The Black Swan: The Impact of the Highly Improbable:

The story of the Maginot Line shows how we are conditioned to be specific. The French, after the Great War, build a wall along the previous German invasion route to prevent reinvasion – Hitler just (almost) effortlessly went around it. The French had been excellent students of history; they just learned with too much precision. They were too practical and exceedingly focused for their own safety.

What does this have to do with investing? It’s a fair question. To our humble minds, the story of the Maginot Line illustrates that we humans tend to base our vision of the future on past events and have trouble imagining a future radically different from what has happened before. We are, if you like, sitting ducks: we build our defensive walls and then guard them jealously only to be blindsided at the crucial moment.

One of our central aims in Notes is to imagine futures unpalatable to the mainstream – futures that often seem impossible because of their lack of precedent in the past. It’s niche work. Most people don’t have the time or the inclination to wonder about what will come next. But to be a successful investor, you must first peer into distance and imagine the world that’s coming.

Today, we offer up a vision of a diminished America – an America weakened by decades of living beyond its means and almost entirely reliant on its foreign creditors. Some might say this future has already arrived. But here at Notes, we believe the country has further to fall. We’re short, if you like, on US hegemony.

Bond king Bill Gross is also concerned. He calls this diminished America “the new normal.”

Gross is better qualified than most to prognosticate on America’s fate. He runs the world’s biggest bond fund. So it’s his job to know where the US economy is heading. He’s also an honorary underground investor: he puts his money where his mouth is and he doesn’t pander to mainstream opinion.

In his latest monthly missive, Gross argues that the tipping point for the end of US economic dominance is easy to spot and is a matter of simple mathematics.

Private sector deleveraging, reregulation and reduced consumption all argue for a real growth rate in the US that requires a government checkbook for years to come just to keep its head above the 1% required to stabilize unemployment. Five more years of those 10% of GDP deficits will quickly raise America’s debt to GDP level to over 100%, a level that the rating services – and more importantly the markets – recognize as a point of no return. At 100% debt to GDP, the interest on the debt might amount to 5% or 6% of annual output alone, and it quickly compounds as the interest upon interest becomes as heavy as those “sixteen tons” in Tennessee Ernie Ford’s famous song of a West Virginia coal miner. “You load sixteen tons and whattaya get? Another day older and deeper in debt.” Pretty soon you need 17, 18, 19 tons just to stay even and that describes the potential fate of the United States as the deficits string out into the Obama and other future Administrations.

It’s a slow motion car crash, dear reader, and all we can do is sit and gawp. As Gross also points out, the US is already producing less wealth in proportion to the rest of the world. And less of its citizens are getting into the Forbes rich list as a result.

This does not come at a good time. America’s ability to borrow cheaply is dependent on its debt-to-GDP ratio, which at 13% is already at highs not seen since World War II. One way of improving this ratio is to grow GDP. But as Gross points out, this is becoming more and more difficult thanks to “private sector deleveraging, reregulation and reduced consumption.” And all of this does not begin to take into account what Gross describes as the “pig in the python” demographic squeeze on resources on the way.

Private think tanks such as The Blackstone Group and even studies by government agencies, such as the Congressional Budget Office, promise that Federal spending for Social Security, Medicare, and Medicaid will collectively increase by 6% of GDP over the next 20 years, leading to even larger deficits unless taxes are increased proportionately. Collectively these three programs represent an approximate $40 trillion liability that will have to be paid. If not, you can add that present value figure to the current $10 trillion deficit and reach a 300% of GDP figure – a number that resembles Latin American economies such as Argentina and Brazil over the past century.

What Gross understands better than most is that we do not live in a world without consequences. This is the beauty of the bond markets: they provide (welcome) limits to the “something for nothing” culture that has gripped the US for far too long.

The big question, of course, and the one Team Obama would like to dodge for as long as humanly possible, is who is going to buy America’s tsunami of debt?

Broadly speaking, the problem is twofold. On the supply side, the US Treasury is set to issue roughly four times last year’s amount of bonds – an estimated gross issuance of $3 trillion. On the demand side, America can no longer rely on the current account/trade deficit to fund borrowings. As Gross points out, with this figure down to about $500 billion this year, China and other surplus nations simply won’t have the spare cash to fund Washington’s spending requirements.

There are only two possible outcomes to this supply-demand dislocation. The first is that the yield curve steepens. As we argued in yesterday’s Notes, there is enormous pressure right now on long-dated US Treasury yields. Yields are rising fast. And if this trend continues unabated, any “green shoots” will be choked off by the weeds of rising mortgage rates and corporate rates.

The second possible outcome is that the Fed steps into the breach and continues to buy back US Treasurys. This is horribly inflationary, as the money the Fed uses to pay for US debt is of the freshly printed variety. The Chinese are already getting nervous at the swelling of the Fed’s balance sheet. Should this trend continue private and sovereign holders of dollar-denominated debt will increasingly look to diversify out of their dollar assets, selling US Treasurys in the process.

The picture is a grim one. But the illusion of something for nothing is strong, and Team Obama shows no signs of quailing in front of this precipitous debt pile.

We read with horror in USA Today that one in six dollars of Americans’ income comes in the form of a federal or state check or voucher. This is the highest level of state-funded personal income since records began in 1929.

“In all,” reports the paper, “government spending on benefits will top $2 trillion in 2009 — an average of $17,000 provided to each US household, federal data show. Benefits rose at a 19% annual rate in the first quarter compared to the last three months of 2008.”

We don’t expect a return to balanced budgets anytime soon.

What other ways are there to hold on to your wealth in this “new normal”? It’s another fair question, and one that has been preoccupying us here at Notes for some time.

According to Gross, “staying rich in this future world will require strategies that reflect this altered vision of global economic growth and delevered financial markets.” Here’s what he advises:

Bond investors should therefore confine maturities to the front end of yield curves where continuing low yields and downside price protection is more probable. Holders of dollars should diversify their own baskets before central banks and sovereign wealth funds ultimately do the same. All investors should expect considerably lower rates of return than what they grew accustomed to only a few years ago.

Why the Dark Side of the Moon Is Harder to See

Contrarian Profits — Wed, 15 Oct 2008 01:09:17 +0000

What if things weren’t as they seem?

Investors rely on predicting the outcome of events. Causation. If this happens, then that will.

But what if randomness and uncertainty were the real movers and shakers of future events? It’s a scary thought. But it’s one that could make you a wiser investor.

It’s all in the Ludic fallacy theory of controversial polymath Nassim Taleb.

We deeply need to be assured it will all end up one way or another. Depression or bounce? Recession or depression. Up or down. The problem is we ignore the random because it is abstract, not logical, and therefore takes more effort to uncover.

Taleb’s exposition of the Ludic fallacy [from Wikipedia]:

We love the tangible, the confirmation, the palpable, the real, the visible, the concrete, the known, the seen, the vivid, the visual, the social, the embedded, the emotional laden, the salient, the stereotypical, the moving, the theatrical, the romanced, the cosmetic, the official, the scholarly-sounding verbiage (b******t), the pompous Gaussian economist, the mathematicized crap, the pomp, the Academie Francaise, Harvard Business School, the Nobel Prize, dark business suits with white shirts and Ferragamo ties, the moving discourse, and the lurid. Most of all we favor the narrated.

Alas, we are not manufactured, in our current edition of the human race, to understand abstract matters — we need context. Randomness and uncertainty are abstractions. We respect what has happened, ignoring what could have happened. In other words, we are naturally shallow and superficial — and we do not know it. This is not a psychological problem; it comes from the main property of information. The dark side of the moon is harder to see; beaming light on it costs energy. In the same way, beaming light on the unseen is costly in both computational and mental effort.

Or take Taleb’s “black swan” events. This from the first chapter of his book The Black Swan: The Impact of the Highly Improbable.

Before the discovery of Australia, people in the old world were convinced that all swans were white, an unassailable belief as it seemed completely confirmed by empirical evidence. The sighting of the first black swan might have been an interesting surprise for a few ornithologists (and others extremely concerned with the coloring of birds), but that is not where the significance of the story lies. It illustrates a severe limitation to our learning from observations or experience and the fragility of our knowledge. One single observation can invalidate a general statement derived from millennia of confirmatory sightings of millions of white swans. All you need is one single (and, I am told, quite ugly) black bird. [...]

Think of the terrorist attack of September 11, 2001: had the risk been reasonably conceivable on September 10, it would not have happened. If such a possibility were deemed worthy of attention, fighter planes would have circled the sky above the twin towers, airplanes would have had locked bulletproof doors, and the attack would not have taken place, period. Something else might have taken place. What? I don’t know.

Is this why crashes blindside investors? We buy into the narrative of Wall Street… and then the inconceivable comes along and knocks it down.

At Contrarian Profits, we like to think we at least question that narrative. Poke fun at it. Turn it on its head.

Not just for the fun of it.

But because it might, now and again, beam a light into the darkness.

Bradford and Bingley’s White Swan Event

Theo Casey — Mon, 02 Jun 2008 20:23:19 +0000

When is a Black Swan not a Black Swan? When the “perfect storm of highly improbable events” happens all the time.

Nicholas Nassim Taleb coined the term Black Swan to explain how massive unforeseen events have the greatest impact on markets. But only the most naïve and optimistic of investors was not expecting further fallout from the abominable banking sector.

Bradford & Bingley (B&B), like Northern Rock, RBS, Alliance & Leicester, Barclays and HBOS before it, is in the spotlight and in a lot of trouble.

The company has launched a £258m rights issue at an offer price of 55p a share. They are set to issue a profit warning. Steven Crawshaw has stepped down as CEO. And they have agreed to sell 23% of their shares to Texas Pacific Group (TPG) Capital, a US private equity firm for £179 million.

This “perfect storm” hit the firm so hard that the FSA were forced to come in and suspend trading in the shares.

The downturn in the buy-to-let housing market means the UK’s eighth largest bank, from £3 billion in 2006, now is worth a mere £404m — less than Dignity funeral care. Which is shocking, viewed in isolation.

But, I’m pretty blasé about all of these rights issues and share plunges. Anything happening in the banking sector is a write-off (pun intended). Regular readers know that I’ve no interest in bottom-fishing for ‘bargain’ banks.

Despite my antipathy, I have been constantly advised to pile into banking shares. In the past 3 months I’ve been told:

To buy Barclays at 510p; the shares are now 363p;
To buy RBS at 330p; now 222p;
And to buy HBOS at 497p; now 368p.

All three tips were made, among other things, on the basis of big dividend yields, which seem to cover a multitude of sins.

Except they don’t. All three tips have incurred a greater capital loss than their total annual dividend payout would compensate for. And, none of these three firms is paying a dividend in cash. They’re paying them in shares instead.

This only serves to hurt the per share profitability, which lowers the already low share price… not what the dividend hunters signed up for.

The world’s worst stock tipper

I will no doubt receive another tip for Bradford & Bingley. Why do the tippers persevere with banks?

Because the culprit ultimately responsible for all of these tips is still at large, pushing bank stocks like never before.

Let me now reveal to you who that culprit is. This is today’s the print-out from my Bloomberg terminal, objectively ranking stocks by their value credentials:

Bradford & Bingley, Score: 99:89
Alliance & Leicester, Score: 83.96
HBOS, Score: 80:86
Barclays, Score: 78.68
RBS, Score: 76.42

Blame the machines.

Across the entire UK stock market, banks are the five best value investments around today. And it’s not just Bloomberg… running any value ‘stock screen’ from Reuters, to Digital Look, to Zacks, to ADVFN produces the same result. This is what every investor and fund manager has been seeing on their screens since late-October.

In objective terms, these are the shares to buy. But anyone who’s been following this advice over the last 12 months has lost, and lost big.

There are two ways to look at investments, bottom-up and top-down.

Bottom-up investing uses stock-screens — systems that zero-in on company fundamentals. Think of it as tunnel-vision investing. In a bull-run, it is a great way to buy stocks. I used to build stock screens for a critically-acclaimed investment service, so I can personally testify to how effective they can be.

Top-down investing is quite different. This method is far more big picture. The first question is not ‘What company should I look at?’ It’s ‘What assets should I look at?’

Top-down investors are not only looking at numbers, but at sentiment and market opportunities outside of a machine’s scope.

While neither method is perfect, in a market downturn it is essential to think big.

Bottom-up investing can lag reality — in the 2000 bear market, stock screeners were picking out the companies that had fallen hard and were more value trap than value opportunity. The same thing is happening here. A system is not a substitute for common sense.

If the market falls by 20%, you have to sit up, take notice and, depending on the portfolio, take action.

The fallout was an opportunity to re-evaluate and find safe-havens for your money. Those who did this have profited in the last six months. Those who had well diversified portfolios in a variety of sectors have probably broken even.

Those who held the ‘good value’ banks, house-builders and retail stocks must now take drastic action to pull things back.

Theo Casey

Source: Bradford And Bingley’s White Swan Event