Saturday, May 24, 2014

The Farmer and the Viper

The story of the Farmer and the Viper is one of Aesop's fables and goes something like this,

A farmer finds a viper freezing in the snow. Taking pity on the snake, the farmer picks it up and places it inside his coat. The farmer's body heat revives the viper who then immediately bites its would be rescuer.

While there are various endings (and therefore morals) to the story, the one I thought I'd focus on for this post comes from Odo of Cheriton. In this version the dying farmer asks for a simple explanation why the snake would deliver a mortal bite given the farmer's compassion. The snake answers,

 "Did you not know there is enmity and natural antipathy between your kind and mine? Did you not know that a serpent in the bosom, a mouse in a bag and a fire in a barn give their hosts an ill reward?"

As you probably noted in my previous post about the US economy, I have some pretty cynical and sharp views about the financial industry. Ironic I know as I've worked in the industry for over 20 years. To my defense, I wasn't always this skeptical. I started in the business with the same wonderment and awe as every other rookie who was hired on to work at a brokerage firm. No, my cynicism was accumulated over the years, as the shiny veneer peeled away and I got a better understanding of the darker workings industry. Now, let me stop right there and say there are obviously a TON of amazingly brilliant, honest and wonderful people who work in this business. But, there are also a lot of vipers as well and they are threatening our economy (again).


Dr. Robert Hare from the University of British Columbia wrote a book with industrial psychologist Paul Babiak called "Snakes in Suits: When Psychopaths go to Work". The book discusses how psychopaths work (and excel) in the corporate world. An article on MSN referenced Hare and Babiak's work and highlighted that in a very small study of 203 corporate executives, 4% met the criteria to be deemed a 'psychopath' - an interesting number given the average for the general population is about 1%. Moreover, Hare made a very interesting comment in the article specifically about the financial industry  -

"it may even be higher than 10%, on the assumption that psychopathic entrepreneurs and risk-takers tend to gravitate toward financial watering-holes, particularly those that are enormously lucrative and poorly regulated".
Ding Ding Ding.
Okay, not convinced yet?

How about this story from 2011 - "Going Rogue" - that discussed the case against UBS trader Kweku Adoboli who made unauthorized trades that led to losses of about $2.3 billion?

this was the part of the article that stood out to me:  

"According to a new study at the University of St. Gallen seen by SPIEGEL, one contributing factor may be that the stockbrokers' behavior is more reckless and manipulative than that of psychopaths. Researchers at the Swiss reseearch University measured the readiness to cooperate and the egotism of 28 professional traders who took part in computer simulations and intelligence tests. The results, compared with the behavior of psychopaths, exceeded the expectations of the study's co-authors, forensive expert Pascal Sherrer, and Thomas Noll, a lead administrator at the Poschwies prison north of Zurich. "Naturally one can't characterize the traders as deranged," Noll told SPIEGEL, "But for example, they behaved more egotistically and were more willing to take risks than a group of psychopaths who took the same test".Particularly shocking for Noll was the fact that the bankers weren't aiming for higher winnings than their comparison group. Instead they were more interested in achieving a competitive advantage."

This makes a lot of sense when you consider that a psychopath's brain is wired to seek reward at any cost

But are guys like Kweku Adoboli, Jerome Kerviel, Yasuo Hamanaka and Nick Leeson just a few bad apples? Is there really only one or two cockroaches here?

Well maybe, but it could be that they were hired exactly because they were psychopaths. Consider this:

"Functional psychopaths make the best investors"

From the article:

"Functional psychopaths make the best investment decisions because they can't experience emotions such as fear, a study by researchers at Standford Graduate School of Business showed. Fear stops people from taking even logical risks, meaning those who have suffered damage to areas of the brain affecting emotions, and can supress feeling, make better decisions, the report showed. The ability to control emotion helps performance in business and financial markets, the researchers found".

So what am I trying to say here? What is the point of this particular blog entry?

Well, let me lay out my thesis.

1. The financial industry attracts a higher proportion of psychopaths than would be found in the general population.

2. Psychopaths display characteristics that allow them to excel in the industry but they are also tend to pursue reward at any cost, or risk.

3. Given these competitive advantages and successes (see #2) - we can assume that psychopaths would tend to climb the corporate ladder faster than others, and therefore would tend to cluster at the top of an organization.

4. Given the clustering of like minded individuals with common goals (ie pursuing rewards at any cost) the psychopathology would lead to less ethical behavior and heightened risk taking for that company or industry. William Black describes this as "Control Fraud"

5. A Gresham's dynamic compels other competitors to adopt similar tactics until the entire industry is affected.

This I believe played a large part in the lead up to (and fall out of) the Great Financial Crisis of 2008.

But here's the problem. Who did we turn to to help get us OUT of the Financial Crisis?

Wall Street.

Wall Street convinced everyone (just ask Tim Geithner) that it was critical to save them. So we did.

But therein lies the problem - and why I referenced the Farmer and the Viper story above.

Yes - we saved Wall Street, but failed to clear out or even control the activities of the 'psychopaths'. So, it is absolutely naive and unreasonable for us to assume that today they have "seen the light" and are going to change their behavior going forward.

How many times have we, the Farmers - saved Wall Street only to be lethally bitten once they recovered from the cold?

In the last 40 years we've had a Latin American Debt Crisis  in the early 80s, an economic collapse from a credit bubble in Japan in the late 80s, then we had the Savings and Loans situation in the US, LTCM, in 1998 and of course the bubble and 2008/09 global crisis.

Again, I am not saying that 'everyone' in the industry is bad - clearly they aren't. But I can't help but notice some of the excesses of old are starting to creep back into the marketplace..

sub prime is making a comeback

as are PIK-Toggles.. 

I am also seeing a lot of commentary lately given the fine imposed on Credit Suisse - and how it will not end up being a deterrent for future abuses. Credit Suisse got off lightly

It's happening again - and I will say I am worried.

Change will only come when we, the people, demand it. It is our duty to facilitate sweeping changes in the financial industry to once again realign our objectives with our clients.

And we need to do this soon, lest we find ourselves mortally bitten once again and asking "why".

Thursday, May 15, 2014

It's a whole new paradigm...

I have a confession to make: I've never met a piece of paper that I didn't like. To the left is a scanned copy of a research report that I've carried with me through a firm change, two office changes and over 14 years of work. I kept the report because as soon as I saw it, I knew it contained the kind of important lesson that one would want to remember for the rest of their career. Now, to be fair it doesn't matter what firm it was, nor who the analyst at the time was. That part is neither here nor there because as most of us who worked during the days know, this report was more the rule and not the exception. EVERYONE was bullish on technology in December of 1999. Well, not 'everyone' - as you probably can imagine, I was decidedly NOT bullish on tech. Not because I didn't understand the technology because I did, and used it a fair bit. I had my own website in 1993, wrote my own html, and had figured out a way to hook up my cell phone to my laptop to access my dial-up account so I could show clients stock quotes during meetings at their homes. What I didn't understand about tech were the astronomical valuations.

It's funny - when you talk about the bubble now, people nod their heads and go "yeah yeah, it was a crazy time..", as if by rote. And when you ask them where they worked at the time, you find out they were in grade 11 and weren't actually working through it. For those of you who did work during that time, then you know damned well the 'bubble' tag only came after it popped. Prior to it popping, there was a TON of debating going on about the validity of the run. I know I tried my best to warn people, but in return was told how it was a 'new paradigm' and how I needed to 'think outside the box' - whatever the hell that meant.

I had been in the business for six years - was still pretty small (hell, still am) - but was a keen student of the market. Always reading, always trying to learn, always trying to understand.

To me, the research piece above shows you the dangers in complacency - the dangers in style creep - the dangers of changing a narrative to justify why a stock price is going up.

With the benefit of 20/20 hindsight we now know that adopting a "Price to sales" model was NOT a better indication of Nortel's value. We also know that a red flag should have been waving when Nortel's management stopped disclosing details about their product line revenues in '98. We should have realized that putting a $180 two year target on a stock with a 92x multiple (and 20% earnings growth) was maybe paying a bit too much.

The point I'm trying to make is this - when the stock market starts really rolling, it's critical to stick to your discipline. If a stock looks expensive based on the models you use, then guess what - it's expensive. Sure, maybe it gets "more" expensive - but if you stick to your discipline, then that becomes someone else's problem.

Why is that relevant now? Well, the S&P is hitting new highs, I'm hearing lots of stories about an economic recovery but haven't seen much in over five years in fact I'd suggest things are starting to slow down again - and.. apparently it is everyone's belief that corporate profit margins are going to stay fat forever.

David Tepper made a great point yesterday - we are getting complacent. It's not a new paradigm, it never is - gravity will apply tomorrow just like it applied 100 years ago.

Outlying statistics ALWAYS mean revert - we don't know when but it's kind of a mathematical law..

just maybe something to kick about in your own head as you enjoy the cool chart I made today with Doc Shiller's great data.

Saturday, May 10, 2014

REVISED The View from 30,000 feet - the US economy was sick before the Great Financial Crisis

As I've stated before, writing anything is a bit of a struggle for me, and I wasn't happy with my original posting of this, so I've gone back in and retweaked a few things. None of the main research is any different, but I've added a bit more of a conclusion to it. Obviously I need to write a LOT more about my view, but this is a start and will provide people with the basics of why I don't feel as though any recovery we see in the US will be sustainable and 'robust'.

Nice to see Thomas Piketty's book getting so much attention given income inequality carries a large weighting in my view as well. I have it but haven't had enough time to read the book but sounds as though his suggested solutions are a bit controversial. From my view, any discussion is a positive thing because it means we are finally becoming aware of the problem and starting to debate solutions.

anyhow - here are my (revised) thoughts - I hope you find them interesting.


The US economy was broken long before the Financial Crisis and “Great Recession” of 2008/09. The crisis and corresponding recession were therefore symptoms of a much larger and far less understood structural problem. Failure by economists, analysts and Central Banks to properly understand these underlying issues is resulting in misguided policy responses which are not only yielding insufficient results, but a growing list of dangerous unintended consequences as well. 

The introduction of workers from China, India and the former Soviet Republic in the early 90s doubled the global labor pool almost overnight. This massive influx of new workers from emerging markets were willing to work for lower wages compared to their North American and European counterparts which created a ‘labor arbitrage’ opportunity for market savvy corporations. By moving their manufacturing bases to these emerging markets, companies paid significantly less on their labor inputs (wages) and therefore enjoyed a dramatic increase in profitability. The benefits of “outsourcing” were so significant that a large majority of companies had to follow suite to ensure that they remained competitive within the global economy.

The positive impacts from outsourcing were enjoyed almost immediately as prices on consumer products declined, and the stock markets soared spurred on by record high corporate profits. The negative consequences of outsourcing (while present) were far less obvious.  Hidden behind the record markets and surge in consumption were job losses, declining relative wages, a hollowing out of the manufacturing base of the economy, a decline middle class through income inequality, and an increasing reliance on debt to maintain a falling standard of living.  

The economic and housing market bubbles that burst in 2008 were simply symptoms of a bigger and more complicated problem that had finally hit a tipping point. Consumers had been spending beyond their means and had accumulated an unhealthy amount of debt in the process. Contrary to the headlines and economic reports we read today, the “The Great Recession” has not ended for most citizens. The policy response of choice by Central Banks has been to focus on increasing the value of the stock and housing market, in the hope that a trickle down ‘wealth effect’ will stimulate a more sustainable economic recovery. Unfortunately there is a volume of research showing that wealth effects on the overall economy are marginal at best. As a result, the focus solely on the level of the stock market has led income inequality between the ‘haves’ and ‘have nots’ to surge to levels not seen since just before the Great Depression of the 1920s.

Failure to properly identify and resolve the true cause of our economic problems has created a massive disconnect between the stock market and the economy, which in turn has greatly increased the implied risk levels faced by investors. While optimistic headlines promise that better times lie just ahead, the reality is that the US consumer (and therefore economy) continues to suffer from an unresolved sickness which makes a full ‘recovery’ impossible.

Main Paper: 

 Having long threatened to write something explaining my longer term view on the investment world, an article by Nobel laureate Joseph Stiglitz on February 6th of this year finally pushed me over the edge. In “Stagnationby Design” Stiglitz suggested that the US economy was sick even before the financial crisis of 2008.

"The basic point that I raise a half-decade ago was that, in a fundamental sense, the US economy was sick even before the crisis; it was only an asset-price bubble, created through lax regulation and low interest rates that had made the economy seem robust. Beneath the surface, numerous problems were festering; growing inequality; an unmet need for structural reform (moving from a manufacturing-based economy to services and adapting to changing global comparative advantages); persistent global imbalances; and a financial system more attuned to speculating than making investments that would create jobs, increase productivity, and redeploy surpluses to maximize social returns"

I have been making this same argument for many years and have been frustrated by the lack of available research and commentary that puts all of the pieces of the puzzle together. To date I have seen very little published anywhere that sets out to explain why the US economy was sick before the Financial Crisis hit. It is my hope that this document will add some light to these trends and more importantly, inspire others to expand on this work in greater detail.

The basis of my investment thesis draws largely from the work of Sir James Goldsmith’s 1993 book, “The Trap”. A short summary of Goldsmith’s concerns were discussed in an interview he had with Charlie Rose in 1994 

Goldsmith’s concerns were quite simple: GATT, the General Agreement on Tariffs and Trade model, was based on flawed logic. In the interview Goldsmith worried that if GATT was fully implemented it would,

“Impoverish and destabilize the industrialized world while at the same time cruelly ravaging the third world”

Goldsmith elaborated,

It must surely be a mistake to adopt an economic policy which makes you rich if you eliminate your national workforce and transfer production abroad, and which bankrupts you if you continue to employ your own people”.

Goldsmith’s concerns related to the economic distortions created by the introduction of China, India and the former Soviet Union Bloc (CIFSB) being fully integrated to the global labor & trade market.

“If 2 billion people enter the same world market for labor and offer their work at a fraction of the price paid to people in the developed world, it is obvious that such a massive increase in supply will reduce the value of labor”.

Goldsmith’s book was first published in 1993, and his interview with Charlie Rose was held in 1994. 
Unfortunately Sir James Goldsmith passed away in 1997, so we no longer have his wisdom to draw from. 

But, 21 years have passed since “The Trap” was printed so we do have a lot of data with which to measure the validity of this theory and accuracy of his predictions. The remainder of this paper sets out to do exactly that.

1. The Global Labor Force:

 In 2004, Harvard Economics Professor Richard Freemen wrote an article entitled, “Doubling the GlobalWorkforce: The Challenges of Integrating China, India and the Former SovietBloc into the World Economy”. In his publication, Freeman estimated that in 1980 the Global workforce population was approximately 960 million people. By the year 2000, a further 510 million people were added suggesting the total global labor pool was 1.46 billion workers.

The year 2000 also marked a huge change in the political systems of China, India and the former Soviet Bloc (CIFSB). This change enabled CIFSB laborers to enter the global labor pool en masse for the first time in history. This transition was unprecedented and, as James Goldsmith forecasted 7 years prior, added an additional 1.47 billion people to the Global labor pool.

The laws of supply and demand suggested that this massive influx of new workers to the global labor pool would have a deflationary influence on the level of global wages. Further amplifying this downward pressure on wages was the fact that the CIFSB workers hailed from relatively more impoverished “emerging markets” and were therefore willing to work for far less than the going global wage. As such, a labor arbitrage opportunity now existed whereby corporations with nimble capital could move their centers of production and manufacturing to these lower labor cost emerging markets in an effort to maximize their profitability. This labor arbitrage opportunity became the driving force behind the trend known later on as “outsourcing”.

2. Outsourcing Trends

French voters are trying to preserve a 35-hour work week in a world where Indian engineers are ready to work a 35-hour day. Good luck”  - ThomasFriedman

While outsourcing was already in use prior to the 1990s, the sheer number of new CIFSB entrants into the Global labor pool was unprecedented and therefore became highly disruptive to the global economy. It didn’t take long before many European and North American companies began to outsource many of their operations to take advantage of the lower wages paid in the emerging markets. The impact from outsourcing was felt almost immediately: Corporate profits started to expand at a faster rate while manufacturing (and other) jobs in the United States, Canada and Europe started to be exported.

By 2007, it was estimated  that the United States alone had exported 3 million full time jobs to the emerging market economies. Further, Princeton economist Alan Blinder, who served as vice chairman of the Federal Reserve during the Clinton administration wrote a paper in 2007 suggesting fully 30-40% of all jobs in the United States could be “offshorable” in the next 10 to 20 years. This would equate to one out of every three service sector jobs in America. (Note: Blinder was referring to services that were “impersonally delivered” as it would be impossible to outsource personally delivered service jobs such as taxi drivers or bartenders). 

Wall Street Journal reporter David Wessel wrote a wonderful article about the jobs lost to outsourcing in 2011 (link to the full story here) that included this very telling graphic:


In the article Wessel stated:

“in 2009, a recession year in which multinationals' sales and capital spending fell, the companies cut 1.2 million, or 5.3%, of their workers in the U.S. and 100,000, or 1.5%, of those abroad.”

From a cost-benefit standpoint it makes sense for a profit maximizing business to cut back on its relatively higher paid workers (from North America and Europe) first during slow economic times in an effort to help improve their bottom lines.

 As one would expect, the trend towards outsourced labor contributed greatly to the rapid decline of the US manufacturing base starting in the early 1990s - best shown in this chart on the number of Manufacturing jobs in the US from the St. Louis Federal Reserve website

  While the job losses tended to accelerate during recessionary periods (as US companies looked to
‘cut the fat’) domestic cutbacks continued during relatively calm economic times as well.

Contrary to the narrative from corporations that outsourcing job losses were only affecting “low skilled” manufacturing sectors, countries such as India & China (where English is taught in schools) maintained an outstanding education system, and started producing technically skilled laborers as well. As a result, these countries were turning out highly qualified job candidates in the fields of engineering, medicine and information technology as well.

Given the population differential and the high cultural focus placed on education, both China and India are now turning out more Honors students than the United States has total students enrolled in college. It follows then that the trend of highly educated and skilled workers from China and India competing for jobs in the US, Canada and Europe continues to this day.

From a corporate profitability standpoint, the lower labor costs achieved via outsourcing were contributing directly to corporate America’s vastly improving bottom line:

The increase in corporate profits helped drive the US markets to all time record highs:

But for all of the positives achieved via the move to outsource labor: consumer access to cheaper goods, increased corporate profits and record high stock markets, there was a growing problem: middle and lower income Americans were losing jobs at a staggering pace and struggling to keep up with everyone else.

Not only were American’s losing jobs at a staggering rate, but most of the employment opportunities that were available paid significantly less than the jobs that had been lost due to outsourcing. So most displaced workers who were lucky enough to find another job were not making a wage comparable to the job that moved to China.

3. Job Loss, Standard of Living Trends and the Utilization of Debt

“The losers will, of course, be those who become unemployed as a result of production being moved to low-cost areas. There will also be those who lose their jobs because their employers do not move offshore and are not able to compete with cheap imported products. Finally, there will be those whose earning capacity is reduced following the shift in the sharing of value-added away from labor”.
                                                                                                          Sir James Goldsmith, “The Trap”

As discussed above, the corporate shift towards outsourcing had a significant impact on the jobs market in the United States. Millions of jobs were exported to the emerging markets of China, India and the former Soviet Bloc (as well as other non-Japanese countries such as Vietnam, Thailand and Cambodia) as companies sought to maximize profits via wage arbitrage.

Due to the doubling of the Global Labor pool and the corresponding excess supply of willing workers, there was also pressure on wages to fall in advanced economies as well. As such, a growing number of Americans who lost their jobs to outsourcing were unable to find new jobs at the same pay scale.

Outsourcing had a significant impact on standard of living trends both in the United States and the emerging markets as well. While the direct benefactors of outsourcing (China for example) saw their standard of living improve (as measured by real GDP growth), the relative standard of living in the United States stayed mostly flat.

This suggests two key trends: 1) The workers in China (and other countries that were benefitting directly from the outsourcing trend) were enjoying a newfound sense of wealth which was enabling consumers to make purchases that they had never had access to before. People were moving out of the villages and into the cities as demand for manufacturing jobs boomed and relative wages & net wealth increased versus their Global counterparts. 
2) The people of the United States (also applies to Canada and Europe) were seeing their standard of living falling off in comparison. This suggests that people were having a difficult time doing and buying the same things that they had in previous years. Unfortunately rather than reduce their expenditures to reflect these trends, Americans, Canadians and Europeans supplemented their declining relative earnings by accumulating personal debt (via the use of credit cards, lines of credit and home equity loans). As you can see in the graph below, personal savings rates had been falling for many years, but the assumption of debt (and erosion of savings) accelerated significantly during the late 90s.


Part of the rise in debt levels came from the well meaning but misguided economic policies adopted by US Presidents Bill Clinton and George W. Bush. Both Presidents wanted to support policies that would serve to maximize the number of Americans who owned their own homes. President Bush spoke about transitioning America towards an “Ownership Society”.

The housing boom turned toxic thanks to a confluence of unsustainable factors. These included the relaxing of mortgage standards, consumer friendly mortgage products (such as Sub Prime, “Ninja Loans” and AltA Mortgages) and an excessively promoted “pro-house ownership” narrative pushed by the US government and main stream media.

 All of these factors helped motivate scores of people to pursue buying a home even though they couldn’t afford to buy one via traditional standards (that is putting 20% down and assuming a mortgage with a 25 year amortizations, etc). Unfortunately, the housing bubble burst in 2007 as housing valuations (based on flimsy and false income declarations) were not sustainable and prices fell substantially, leaving millions of Americans owing more on their mortgage than their house was actually worth.

The bursting of the Housing Bubble had a devastating impact on the Global markets. Unfortunately, mortgage debt wasn’t the only problem. Many Americans (and Canadians) were also using various forms of debt to finance day to day living expenses as well.

In addition to mortgages, many consumers were accumulating ‘non-productive’ debt (debt that by its nature does not offer an underlying capacity for wealth creation). This ‘non-productive debt’ became a burden that had to be serviced (through interest payments) but did not contribute to a consumer’s financial well-being.
So, as more and more Americans used debt to finance their day to day living, the precarious burden of debt servicing grew as well. The wealthiest Americans however, did not have the same problem. The accumulation of debt leads us to issue #4.

4. Income Inequality Gaps:

From 1983 to 2004, middle income households saw their gross incomes increase by an average of one percent per year. Meanwhile, the top 1% of income earners enjoyed a significantly higher rate of growth on their income. The gap between the two incomes can be seen diverging widely in the early 90’s, just as outsourcing started to become more widely used by US multinational companies. There has been a tremendous amount of valuable work on the subject of income inequality by Levy/Temin, Emmanuel Saez, & Saez/Piketty.

The graph below is taken from a Congressional Budget Office report, and shows the growth in US income inequality that started in the early 90s. The CBO was created by the US government in 1974 to help them provide independent analysis of budgetary and economic issues. 


Obviously the wealthy not only have higher incomes (earned via their positions as owners or executives of companies), but they also tend to hold a larger proportion of financial assets (stocks & bonds) relative to their middle and lower income earning counterparts as well.

5. CEO and Executive Pay, Bonuses and Equity Based Incentives:

As discussed above, corporate profits as a percentage of GDP soared due to the profit margin improvements enjoyed by companies who took advantage of the wage differentials in CIFSB (and Asia ex Japan) via outsourcing. This enhanced profitability enabled CEOs, executives and board members to enjoy significant increases in their pay, as compensation is closely linked to corporate profitability. 

While base salaries remained relatively flat, total CEO & executive compensation reflected a growing trend towards rewarding stock options and bonuses linked to corporate profitability.

 “From 1978 to 2011, CEO compensation increased more than 725 percent, a rise substantially greater than stock market growth and the painfully slow 5.7 percent growth in worker compensation over the same period.”

6. The Struggling Middle Class:
As discussed in note 3 above, it is my theory that in an effort to offset their declining standard of living, middle class Americans started to utilize credit facilities to supplement their lifestyles. Consumers started saving less and borrowing more, optimistically thinking that things would get better once ``the economy picked up again”.

 Middle and lower income earners in the US saw their savings collapse

And their utilization of consumer debt explode

Since the increase in home values was having a very large (positive) impact on US net worth. Many middle income earners “felt” wealthier and in turn were using the equity in their homes as a quick source of cash. Consumers were tapping into these reserves via “Home equity based Lines of Credit” (HELOCs) to further finance their consumption, even though the rates of consumption were significantly higher than their incomes would support. Some in the financial industry referred to the trend as “using your house as an ATM Machine”.

 As discussed previously, in an effort to offset the invisible impact of a declining standard of living created by the doubling of the Global labor pool, Americans whose savings were already depleted, were desperate to gain access to credit products to drive their consumption desires. The voracious demand for access to credit by consumers created an opportunity that led to my 7th category:

7. Wall Street Incentives to create debt instruments and profit over clients:

Wall Street has always been quick to fulfill demand for a product: be it an internet company, an initial public offering, or some kind of securitized synthetic debt product. Over the years, the issuance of various forms of consumer credit products has grown to become became a very profitable business for the banks. But, as the market of qualified people became saturated with ‘product’, it became necessary for the banks to loosen lending standards, thereby expanding its offerings to a larger cohort within the market: ‘the financially constrained’ individual.

Fulfilling the credit needs of the ‘financially constrained’ was the inspiration behind a long list of now infamous products such as Sub Prime Mortgages, AltA mortgages, No Money Down mortgages, “Ninja” Loans, credit cards (with teaser rates) and Home equity based lines of credit (HELOCs). These are all prime examples of credit products created by the financial industry specifically designed for consumers who had less than stellar credit scores. By expanding these credit facilities and making these products available to the general public, Wall Street enabled consumers to borrow money beyond their means so they could keep spending and consuming. This access to additional credit drove consumption higher, which in turn propelled the economy forward.  

In addition to creating exotic consumer credit products, Wall Street had also developed a very large securitization business. Here, Wall Street purchased pools of loans from the banks (mortgages, auto loans, etc) in order to create pooled funds. These funds would be rated via a debt rating agency such as Standard and Poors or Moodys and then resold to investors as a kind of ‘bond/debt fund’. The appetite for this ‘riskless’ investment (as some of these pools were rated AAA) by institutional investors was voracious, and in turn created a positive feedback loop whereby more exotic (and risky) loans were needed in order to create more pools to sell.

Wall Street was more than happy to oblige, even though privately they were already starting to see problems arising. The Financial Crisis of 2008 started when the flaws in these highly rated investment pools finally started to appear and the true nature of their high risk profiles became more apparent.

Unfortunately, at the peak of the market in 2007, the pursuit of profits by financial firms became so frenzied that some financial companies started to take the unusual step of investing ‘against’ their clients.

At this point in the housing & market bubble Wall Street abandoned its fiduciary duty to the client in favor of profits and bonuses. Conflicts of interest became the norm, and the system finally collapsed on itself and became a crisis. The result: the Financial Crisis of 2008, served as a catalyst for my final investment component for this discussion paper: “Peak Debt”.

8. Peak Debt and the start of the Great Deleveraging:

Debt is future consumption denied
Eugen Bohm von Bawerk

“Peak Debt” was a term coined in 2006 by Jaswant Jain, PhD in 2006. Jain concluded that debt taken on by a consumer will rise until it hits an exhaustion point. Once this point is reached, current income flows can no longer support debt servicing costs. As such, consumption must be reduced so that the consumer can begin paying down his or her debts. This process of reducing debt loads is called “deleveraging”. While this action makes sense for an individual to follow, if too many people stop consuming at the same time the economy would be negatively impacted and a recession would follow (or a recession would expand into a larger, more significant “depression”). Economists refer to this unique situation as

“The paradox states that if everyone tries to save more money during times of economic recession, then aggregate demand will fall and will in turn lower total savings in the population because of the decrease in consumption and economic growth. The paradox is, narrowly speaking, that total savings may fall even when individual savings attempt to rise, and, broadly speaking, that increase in savings may be harmful to an economy.[4] Both the narrow and broad claims are paradoxical within the assumption underlying the fallacy of composition, namely that what is true of the parts must be true of the whole. The narrow claim transparently contradicts this assumption, and the broad one does so by implication, because while individual thrift is generally averred to be good for the economy, the paradox of thrift holds that collective thrift may be bad for the economy.”
So, when the housing bubble finally burst in 2007, in addition to all of the damage done to the Bank’s balance sheets (due excessive leverage and impaired investments) consumers were no longer able
to utilize their home equity to finance additional consumption. Instead, consumers now had to reverse course and withhold new purchases in favor of paying down their debts. In some cases, people had to take the ultimate step and declare bankruptcy, thereby writing off the debt completely. The combination of the collapse on Wall Street along with the decline in consumer expenditures resulted in a very large recession in the United States.

In response to these deflationary economic pressures, the Federal Reserve (FED) implemented a program called “Quantitative Easing” that specifically attempted to reflate asset prices. While the program has been reasonably successful in reflating the stock market back to all time highs, it has not been as successful in sparking a recovery in the underlying US economy. As such, US GDP and job growth continue sputter sporadically at levels that are well below the historical average at this point in a ‘recovery’.  I put quotations around the term “recovery” as I have discussed above, for many people the recession of 2009 never really ended.  References to this can be found here, here and here.

The Dilemma:

Unlike governments, consumers can not consistently spend beyond their means forever. When a consumer purchases a good by assuming a debt, they effectively pull demand forward at the expense of demand they will have in the future (as the debt assumed today needs to be repaid tomorrow). It follows then that when consumption and economic growth rates are higher than wage growth over a prolonged period, the situation is unsustainable and will have to readjust at some future point.

The graph below shows the progress of household incomes, economic growth and consumption in the US from 1990-2013. Clearly consumption and economic growth have outpaced income growth by a wide margin, and therefore it is only natural for us to expect some form of readjustment to a lower and more sustainable level. Alternatively, income levels could increase to better match consumption, but as this paper has shown, this is unlikely to happen.

Optimistic narratives relating to “better times ahead” are focused solely on the metric of a rising stock market and completely ignore the unaddressed economic problems that continue exist under the surface. Consider this statistic: As of March 31st 2014, the median size of a 401(k) (the US equivalent to an RSP account) is $24,400, and for people older than 55, it is $65,300. Plainly put, consumers have spent beyond their means for too long, and are now deleveraging their balance sheets. Wide spread deleveraging of this nature is NOT conducive to economic growth.

By failing to recognize these facts, the Central Banks have arrived at faulty conclusions which have led them to employ ineffective remedies. These remedies are clearly not working and instead could be creating the catalyst for another more damaging crisis in the future.

What to expect going forward:

“I suppose it is tempting, if the only tool you have is a hammer, to treat everything as if it were a nail”
Abraham Maslow

The Federal Reserve has made it clear that they are going to continue to keep monetary policy extremely accommodative until such a time as the economy is firmly back on solid footing. Part of their strategy involves supporting the stock market in the hopes that a trickle down `wealth effect` occurs.  Unfortunately, a closer look at how a ‘wealth effect’ impacts the economy suggests that the contribution is marginal at best.  For those interested, Dr. Lacy Hunt from Hoisington Management wrote a very strong piece discussing the ineffectiveness of wealth effects on the greater economy here:

Given wealth effects don’t work, investors should expect to see a widening gap between stock market valuations and the underlying economy. This is concerning given stock valuations are lofty by almost any metric one cares to use. Robert Shiller, who recently won the Nobel Prize in Economics for his work on identifying asset bubbles has data showing US stocks have only been as expensive as they are today three times in the last century. The previous dates will be very noteworthy to investors:  the late 1920s, early 2000 and the prelude to the 2007 financial crisis. 

Despite calls to the contrary, I believe interest rates will stay low for an extended period of time. Higher interest rates reflect inflationary pressures created via robust economic growth and as I’ve shown in the information above, the US economy mired in severe structural problems that are creating deflationary forces. As such, interest rates will rise only when these structural problems are finally resolved.

It is my sense that the stock market will continue to try and gravitate towards higher levels even as earnings expectations and economic growth forecasts fall short of expectations. With valuations at elevated levels and risk being suppressed by ‘artificial means’ through Fed policy, investors need to be very cautious about their overall investment strategies and asset allocations. It would be wise for all investors to take a very close look at their risk exposures given the issues mentioned above.