Juggling Dynamite

In understanding the origins and nature of the present financial crisis, we should appreciate that subprime debt and its ‘securitization'(selling junk as investments to indiscriminate and duped buyers) were deployed to revive animal spirits after the 2000-03 tech wreck, and enabled the largest consumer credit boom ever in human history.  This swept from the US (the world’s largest economy) to the rest of the globe in a tsunami of record, unsustainable consumption between 2003-07. When that first wave of the bubble broke in 2007, it halved lofty asset values for a second time, and pummeled spending, revenue and economic output everywhere.  It also left a mountain of excess capacity and goods worldwide. No more so, than in the world’s second largest economy–China.

The second wave of the crisis came in 2008-10 when many governments increased spending to try and counteract economic contraction. No more so than in China, where excess reserves (built during the west’s spending bubble) were recycled into even more superfluous infrastructure and supply at home as a stop gap hope until western consumers could bounce back.

The third wave of the crisis began in 2011, when spending and revenues were weakening once more, industrial production turned down, asset markets slumped and central banks jumped on the slippery slope of increasingly desperate monetary measures: QE- asset buying, zero and now negative rates.

The fourth wave of the crisis is the present revelation that global consumer demand has not revived, savings levels have not rebuilt and debt levels are many trillion dollars higher now than they were when the bubble first burst in 2007. No more so, than in China, which is now stumbling under the weight of the largest debt bubble ever in history. As pointed out by Vitaliy N. Katsenel this week:

From 2007 to 2014, its debt quadrupled from $7 to $28 trillion (according to McKinsey). Over the same time period its economy tripled, growing from $3.5 to $10.5 trillion. These numbers are staggering, and they point to one indisputable fact: all Chinese growth since 2007 came from borrowing. There was no miracle in it.

To reform and finally recover from our generation’s financial demise: facts must be faced.  All of the price gains in risky assets since at least 2010 have been unwarranted, irrational and unsustainable.  And just as China is finding today, running full speed off a cliff in hopes that the ground will miraculously rise up to catch you, is a self-destructive plan.

My partner Cory Venable‘s long term chart of the S&P 500 shows the precarious level at which stocks now hover, blindly hoping (as they did in 2000 and 2008) that the ground –falling consumer demand and economic growth–will reverse course and rise up to prevent their fall.
So entranced and desperate are participants today, that they have strapped on record amounts of margin/debt to accelerate their speed off this cliff–the very opposite of parachutes.

The next phase of this crisis is the monetary-faith-bubble bursting, and asset prices succumbing to laws of math and the business cycle once more.  The secular bear lives and has been incited to maul for the third time since 2000.  Reckless policies have earned its wrath.

We recently watched the amazing Netflix documentary about jazz legend Nina Simone, What happened, Miss Simone?

Using never-before-heard recordings, rare archival footage and her best-known songs, this is the story of legendary singer and activist Nina Simone. Here is a direct video link.

The story of how Simone trained to be a classical pianist and then was reluctantly forced into jazz music and singing reminded me of the story Billy Joel tells of how he too trained as a classical pianist and had to transition to a career in pop music and singing only by default. He explains in this 2012 podcast with Alec Baldwin which is well worth the listen.

Listening to Billy Joel
from Here’s The Thing with Alec Baldwin. https://t.co/jtwWGGgcO1

— Danielle Park (@kdaniellepark) August 12, 2016

The trouble with most money managers, advisors and investment products is that they are structured to collect the highest fees when assets are allocated to the riskiest assets. Equity and corporate debt allocations routinely exact higher fees than those held in cash and the lowest risk fixed income holdings. After all, how can you convince people to pay you out-sized management fees each year if you don’t tell them you will make them ‘rich’ with big gains no matter what the market cycle or valuations look like? This is the inherent and rarely mentioned bias of the industry. The fact that this glaring conflict of interest is not brought to the attention of investors, is a failure of fiduciary duty that litigation lawyers, suing to recover client losses, should not overlook.

For all the marketing hype about ‘smart money’, the truth is that captive money–that’s paid most to remain in risky assets even at irrational prices–is not smart at all, it’s indiscriminate and dumb. And thanks to years of QE-goosing, liquidity swamped markets have continued to float dumb and reckless participants a few years longer than usual this cycle. Nevertheless, it is likely a grave error to think mean reversion or bear markets have been abolished, or that confident, long-always gurus actually are the geniuses they pretend.

This article from David Rosenberg in the Financial Post yesterday summarizes the remarkable chaos presently dominating the high-risk-highest-fee asset management world.  See:  If you think this market is confusing, wait until you see what the ‘smart money’ is doing?

Of course, Rosenberg works for Gluskin Sheff who also collects a higher fee percentage on the client capital it advises to riskier asset classes.  After founders floated a $133 million initial public offering of their shares in May 2006, prices plunged 79% to $3.61 in December 2008 before rebounding on QE with overall markets to top at $29.57 in April 2014.   Today at $17.63 Gluskin shares are below their IPO a decade ago, and have fallen 40% from the most recent 2014 peak as the founders sue the company for post-retirement entitlements of $185 million.

You need a lot of client fees to sustain this kind of compensation for executives and board members (remember media personality and Senator Pamela Wallin was pulling down 450k as an annual stipend just for sitting in as one of the members on quarterly Gluskin board meetings until she resigned in 2013).  Wallin wasn’t there to offer her non-existent financial expertise on how to best manage risk and keep fees low for the company’s clients.  She was there for profile to help impress and attract new believers to the company’s investment products.

As in 2008 with all risk-selling financial gurus,  the next bear market is likely to try client faith further still.  Warren Buffett has famously said, you only know who is swimming naked when the tide goes out.  If you really want to know how adept a financial guru is at managing risk for their clients, you have to look– not at how they do in rising markets– but at how their accounts performed during negative years like 2007-09.  For Buffett, ironicially, the answer for his Berkshire shares was a stark naked  -50%–nearly lock step with declines on the S&P 500.  What management genius?

The majority of investment capital today is held captive in risk exposed funds and products.  The managers are not ‘smart’ so much as self-interested in growing their management fees above all else.  Investors need to be aware of this before they buy in.