Juggling Dynamite

Senator Carl Levin, (D-MI), a co-author of the Volcker rule, discusses the renewed warning on systemic risks with JP Morgan’s $2 billion trading loss and the loop-holes bankers like Dimon are pushing for, in order to work around regulation. Here is the direct link.

I will be in New York on Sunday to Wednesday next week for some meetings and media and to speak at the Hard Assets New York investment conference at the Marriott Marquis in the heart of Times Square.  Things kick off bright and early at this show.  My presentation is Tues morning 7:40 to 8:20 am.  You can see more about the agenda and speakers here.

Here is a point typically missed in the hours of breathless banter on bankers’ “hedging strategies”. Leverage magnifies risk: it increases profits on the way up and predictably vaporizes capital when asset prices reverse course. On the opposite end of the spectrum– a true hedge neutralizes risk. A hedge is designed to make the risk free rate-today nil–with no gains and no losses.

For several years now, Investment bankers have been trading with leverage for profit, and calling it hedging. This would be their own suicide mission if they were doing it on their own risk. But they have not. They have kept the gains, and given tax payers all the losses, because they are now improperly under the protection of Central Bankers and governments who are mandated to backstop the banking system. The solution is simple. Separate banks from risk traders. Let the “traders” live and die by their own sword. How much pain must the world endure before this simple rule is reinstated?

Neil Barofsky, former special inspector for the U.S. Treasury’s Troubled Asset Relief Program and a Bloomberg Television contributing editor, talks about JPMorgan Chase & Co.’s $2 billion trading loss. Here is the direct link.

Danielle was a guest today with Phil Mackesy on Talk Digital Network discussing recent developments in the global economy and markets.  You can listen to the audio clip here.

James Montier is a member of the asset allocation team at GMO UK Ltd. Previously, he was co-head of global strategy at Société Générale S.A. and a global equity strategist at Dresdner Kleinwort. Mr. Montier is the author of several books, including Behavioural Investing, Value Investing, and Behavioural Finance. He is a visiting fellow at Durham University and a fellow of the Royal Society of Arts. Mr. Montier holds a BA in economics from the University of Portsmouth and an MSc in economics from the University of Warwick.

He gave a useful presentation at the CFA Institute’s Annual Conference this week where he systematically reveals the dangerous nonsense underpinning modern portfolio theory so widely followed in finance today.

Here is a direct link to the clip. You will need to advance the play bar to 18:40 to where Montier is introduced.

There are many gems in his talk–such a refreshing relief to hear someone call bullshit rubbish on conventional wisdom in this area.  (I gave a similar talk at the CFA Institute Conference in Atlanta in 2008.  It was well received, and completely unheeded by the industry, of course.)  Existing business models in the money industry are so flawed, endemic and misguided that it is very slow to evolve changes needed.  And so the firms, advisors and clients will apparently keep learning hard lessons the hard way for a few more years to come.

Yesterday I did my bi-weekly spot with Kerry Lutz out of Greenwich. You can listen to the audio here.

Lakshman Acuthan, Economic Cycle Research Institute, says a recession could begin by the middle of 2012. “It takes six months after a recession begins for people even to recognize [it],” he tells “Squawk Box.”  Here is a direct link.

This clip is a wonderful study (albeit embarrassing to watch) of how infantile the mainstream CNBC-esque understanding is of market cycles. Joe Kernan and company are representative of almost all business commentator/hosts today. They understand next to nothing and yet they are looked to as “experts” in this field. They rail against the idea that we are entering the next recession because they think of recessions as unfortunate anomalies–like a 100-year flood. In fact recessions are a normal part of a full business cycle and during secular bear periods, recessions come on average every 3 years. We are now due for the next one.

The truth is that the seeds of the incoming cyclical recession were sown in the reckless excess of the stock boom period of the 90′s, and the credit orgy to 2006 (to 2011 in Canada). The economy is not about to blow up. It already did. We are now just moving through the rationalization, deflation and clean up phase. Central banks may continue to intervene, but the weight of the downturn has a gravity born of the dizzying heights of the bubbles before it. No governments or central banks can stop the process of mean reversion. And that is a good thing. The next organic secular boom period can only start after asset prices have been fully wrung out and capital can be efficiently redeployed in productive business ventures rather than extractive financial shell games. Wise investors will get out of harm’s way and let this process unfold in its due course.

Although many fight the progress and change needed in the world, I see a lot of very exciting things happening in science and innovation which I know can help to solve the major hurdles presently facing humanity. As much as I am defensive of capital during the present credit crisis, I also can’t help but be longer-term optimistic about opportunities ahead. A couple of examples of important new thinking are below.

Last night on Piers Morgan Tonight, Suzanne Somers explained that she was recently able to grow her breast back after a mastectomy with an innovative new process that injects one’s own stem cells into the chest. The ramifications of what this can mean for the future of stem cells to heal and rejuvenate the human body is mind-boggling. She explains the remarkable process here.

Separately in the field of alternative energy, the evolution of ideas is also exciting. My 12 year old son wants to be an engineer so he can help develop efficient new technologies for the future. This is the type of thinking that inspires him (and me). Here is the direct link.

Paul Krugman is a controversial economist to say the least. In recent years he has become famous for anti-austerity pleas, insisting that governments need to keep up deficit spending to ward off an intensifying of the global recession. I would agree that governments can ideally help ease downturns where possible through stimulative spending in things like infrastructure. My point would be, not all government spending is equal in this. It matters what governments direct taxpayer dollars into, if they are to be helpful in moderating the extreme highs and lows of the business cycle.

The trouble is that governments have been notoriously bad at moderating the upswing in risk and credit. Indeed politicians tend to follow not lead, jumping onto status quo bandwagons accelerating risk to the upside. And as we have seen in the past few years, when the inevitable downside hits, where governments could have had a moderating effect on pain in the real economy, they have foolishly squandered finite, precious resources by trying to resist needed changes and bail out undeserving institutions and their leaders in sectors like banks and car companies. So much revenue and deficit spending was misdirected to wrong headed moves at the start of the financial crisis, that there is much less available now to help moderate the next phase of contraction.

In this interview, Krugman makes some very insightful points on money, cognitive dissonance in wealth and power, and the general human desire to be liked and respected. Here is the direct link.

“The presidential election is well under way but as President Barack Obama tries to position himself as the defender of the middle-class who will protect the 99% against corporate malfeasance and too big to fail banks, he may find himself in a precarious position. His record does not necessarily reflect his rhetoric and at the same time Wall Street donors have padded his campaign coffers.”

Peter Schweizer author of “Throw them All Out” and president of the Government Accountability Institute, a non-profit think tank, joined The Daily Ticker to talk about the connection between Washington and Wall Street and how Obama’s benign response to the financial crisis could hurt his bid for re-election. Here is the direct link.

The good news about the push back against austerity in Europe now, is that it forces a desperately needed new phase of thinking.

Over the past 3 years, banks have managed to hold governments hostage by threatening that if they weren’t bailed out by taxpayers and saved harmless from losses on their bond and swap holdings, the economy would collapse.  This has been a self-serving lie and is a large reason why austerity has failed to balance budgets to date.  The truth is that the economy has already collapsed.  Only through further irresponsible debt issuance have governments and bankers together, been able to create the illusion of some economic recovery.

The truth is that there is only so much cash flow to go around, and if bondholders continue to be paid their pounds of flesh in full, there is not enough tax revenue left over to pay for other basic needs of the real economy.  The economic pain of the past few years makes it clear that no matter how much governments cut spending–budgets cannot balance while still paying back debts in full to bankers.

The truth is that debt reorganization and write-downs along with austerity are necessary in order to close budget deficits.  This a recurring fact of human life and the very reason we have bankruptcy procedures as a key reset mechanism in capitalism.   Too much debt eventually leads to default. We have seen this through centuries.  In order to transform debt-paralyzed people and countries back into engines of growth and tax revenue, they have to get first become cash flow positive again.  This requires paying out less than one brings in and building up surplus savings.

Banks have tried to hold themselves harmless at the expense of real economies and workers everywhere.  But in doing so they have smothered growth and recovery prospects.  The workers are down to their tee-shirt and shorts while bankers continue to collect bonuses and doll out dividends.  This let-them-eat-cake approach has always been doomed to fail.

Cleaning up after the financial crisis requires the shared sacrifice of all stake holders.  Those who were purely bank depositors must be held harmless– they did not sign up for capital risk.  Those who agreed to participate in a reckless scheme as ‘investors’ and bond holders will lose.  That is the very nature of investing after all– one agrees to accept capital risk from the outset.  Governments will have to be downsized.  Citizens will have to make do with less.. Yes many banks and individuals will go bankrupt– such is the capitalist way after all!

New ideas will bring us into a more stable future where we waste less and save more.  Here are a couple of articles on trends that are key parts of the solution:

• Renting Prosperity:  “Across the board—for goods ranging from cars to books to clothes—Americans are increasingly acclimatizing to the idea of giving up the stability of being an owner for the flexibility of being a renter. This may sound like a decline in living standards. But the new realities of our increasingly mobile economy make it more likely that this transition from an Ownership Society to what might be called a Rentership Society, far from being a drag, will unleash a wave of economic efficiency that could fuel the next boom.”. Now this is part of the solution back to solvency…getting smarter and more efficient with capital, sharing and renting more, buying less stuff, living leaner and keeping expenses lower…all good for individuals and their families.

• Eat Vegan & Run:  “FOR NEARLY TWO DECADES, SCOTT JUREK has been a dominant force in the rarefied sport of ultrarunning. And perhaps just as impressive as his many victories, including seven consecutive wins at the Western States 100-Mile Endurance Run, is that he achieved these feats on an entirely plant-based diet. In this excerpt from his new memoir, Eat & Run: My Unlikely Journey to Ultramarathon Greatness, Jurek shares how turning vegan transformed his life…” This is part of the solution too.  If people learn to eat less and better and add time for exercise– countries, states and households can find billions (if not trillions) in savings in health and drug costs while making huge gains in population productivity and contentment.

Getting the crushing weight of extractors like bloated banks and drug cos off individuals will help tax payers everywhere afford more.  Money available for productive parts of the economy will then rise significantly:  education, conservation, environmental protection, smarter energy, better infrastructure, arts and scientific research will all be affordable once more.  But first we will have to earn that recovery in the good old-fashioned ways, like sacrifice, discipline, hard work and tough love.

Edward Luce of The Financial Times talked to Charlie Rose about his book “Time to Start Thinking: America in the Age of Descent”.

Bold new ideas and ethical leadership across all walks of society are needed to reignite innovation and strength in America and elsewhere. We have tried the quick-bucks-approach and that has been devastating. Time to stop paying financial wizards for magic tricks and get back to hard work, critical thought and individual responsibility. Fiat lux. You will need to go here to the site to find the clip.

Vice-chairman of Berkshire Hathaway Corporation Charlie Munger talks to CNBC about the need for creative destruction in business, value that can be found in failure, and the reckless trends in today’s capital markets and government. I appreciate most of what Munger says and I have always liked his candor.

I think it is important to note however, that when he and Buffett speak about how well Berkshire has done in terms of book value gains on their business portfolio, it must be acknowledged that Berkshire is a publicly traded company. The way that Berkshire investors have fared is reflected in the price action of its shares, including since this secular bear began in 2000. And on that count, Buffett and company have been struggling through a secular bear with the other long-always equity managers. The chart below is of Berkshire A shares, but it could easily be mistaken for a chart of the S&P (or the TSX).

After peaking with the credit bubble and the risk trade in 2007, Berkshire shares fell more than 50% to March 2009, before recovering and losing with the overall stock markets over the past 3 years. The bottom line is that investors in Berkshire are flat now for 5 years, and if they happened to join near the peaks in 2007, 2008 or 2011, they have lost money.

During the next bear market  (historically due any day now)  those who hold Berkshire shares, like those who hold other stocks, are likely to lose heavily once more.  Perhaps this is no trouble for Berkshire’s billionaire founders, but for the rest of the regular population, years of market loses and especially in one’s 50′s and older can be a life-altering event–not in a good way.

Which leads one to the elephant in the room that long-always advocates dare not address: what is the point of huge capital risk and volatility in order to earn flat to negative returns over years of holding? Who’s interests are passive asset allocations serving?

Danielle was a guest today with Phil Mackesy on Talk Digital Network discussing recent trends in global markets and the economy.  You can find the audio clip here.

Two chart updates today worth considering. This first one shows 10 Treasury yields continuing to fall as money flows to strategic ‘risk-off’ mode parking in the relative liquidity of US Treasuries.

Source: Cory Venable, CMT, Venable Park Investment Counsel Inc.

Another big picture snapshot of the Canadian stock market confirms this trend, with capital continuing to flow out of the ‘risk on’ global-growth bet.

Source: Cory Venable, CMT, Venable Park Investment Counsel Inc.