To Have and Have Not; Corporate Inequality is Soaring with Colossal Bond Sales – Where’s the Best Risk-Reward?

“Our indicators tell us, we’re very close to a Lehman-like drawdown,” argues Larry McDonald, a former strategist at Société Générale who now runs The Bear Traps report.

Financial Times, February 20, 2020

*Our institutional client flatform includes; financial advisors, family offices, RIAs, CTAs, hedge funds, mutual funds, and pension funds.

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One of Ernest Hemingway’s classics, “To Have and Have Not” was published during the depression in 1937. The scene is set after a wealthy man sneaks off without paying his bill to the fishing boat captain after a three-week fishing trip, leaving the captain destitute, forcing him to a life of crime. The 1930s connectivity to 2020 is ominous-looking out to 2021-2023. At what point does capitalism break on the back of social unrest? Let us explore.

% of Total Profits Coming from the Largest 100 Companies*

2020: 90%
2017: 84%
1997: 52%
1977: 48%

*U.S. publicly traded corporations, Wall St. Journal data and the Bear Traps Report. We are capitalist, with a profound love for capitalism, but is this trend sustainable? It’s clear, events like Lehman’s failure in 2008 and COVID19 2020, only exacerbate a Hayek’s Road to Serfdom. We MUST be prepared for what’s coming.

The Haves and Have Nots

In financial markets today, we also face a case of the “Haves” and the “Have Nots”. The Fed is not a solvency provider for the benefit of the “Have Nots”, but a liquidity provider for the benefit of the “Haves”. It’s survival of the fittest, complete with steroid injections. Sure, liquidity can help some companies that are hurt but not destroyed by the pandemic. But it is a fantastic boon to the real “Haves” that are not in distress at all. All but free money allows cheap financing to garner a still greater percentage of the economy. Classic Marxian concentration of capital. Meanwhile, the “Have Nots” who are heavily impacted by the pandemic, still can’t raise new debt capital, even in today’s awash-in-capital funding world. They are left helpless and forced to not only file for bankruptcy but downsize their operations by firing employees, rendering them destitute, like the hero of Hemingway’s novel.

Horrible Long Term Breadth
As you can see above, the S&P 500 equal-weighted index relative performance against the Nasdaq 100 is unsightly. Remember, an equal-weighted index treats all 500 stocks equally, unlike the S&P 500 SPY ETF where a few stocks are holding up the index. Over the last 5 years, the Nasdaq 100 is 116% higher vs. 31% for the S&P 500 equal-weighted index.

US Treasury Debt Issuance

2021: $4.10T
2020: $5.20T
2019: $1.10T
2018: $1.20T
2017: $0.60T
2016: $0.60T
2015: $0.65T
2014: $0.70T
2013: $0.80T
2012: $1.10T
2011: $1.1T
2010: $1.6T
2009: $1.5T

*Net Marketable Treasury Issuance, Guggenheim. One MUST ask, with the US government coming to borrow at this pace, how much will be left for the have nots of corporate America? 

Extreme Inequality – One Uneven Playing Field
Everyone knows the Federal Reserve has expanded their balance sheet by nearly $3T in recent months, but few realize the colossal distortions that are forming in markets. Our friends at Artemis Capital Management have a unique lens on market distortions – while the mad mob was playing “don’t fight the Fed” roulette in February, they were getting long volatility at very attractive prices. See their powerful chart above.  The strange thing is, the same crowd that was telling us “don’t fight the Fed” in February – is piling back into the Nasdaq again. They’ll NEVER learn, but why should they when the Fed bails them out each time? Year-to-date the Nasdaq 100 QQQs are +2.6%, while the Russell 2000 is -24.1%. Remember, 44% of the Qs are in just six stocks (Facebook, Apple, Amazon, Netflix, Google, and Microsoft). Where’s the trade? There is one sector we believe which will dramatically outperform the Nasdaq over the next 24 months, email for our special report.

Recent debt issuance has been phenomenal, well outstripping former years.

Weekly US Investment Grade New Bond Issue Supply

2020: $81B
2019: $42B
2018: $37B
2017: $34B
2016: $42B
2015: $41B
2014: $35B
2013: $27B
2012: $26B

*Nearly $800B YTD, four-week moving average above marking each year’s highest level. Bloomberg data. Last year, US investment-grade bond issuance was near $1.05T, at the current (unsustainable) pace – 2020 will end up close to $2.4T, fueling corporate inequality.

Bonds for Sale
Companies are raising a COLOSSAL amount of cash, preparing for a long period of uncertainty. After extremely tight financial conditions, many U.S. corporations were shutout from borrowing in March. Today, they’re running to the open arms of investment banks -trying to get their hands on fresh capital. Many claim we’re entering a period of debt deflation, which begs the question. With capital markets this – wide-open – (see above) is it inflationary or deflationary? BY DEFINITION, debt deflation comes with extremely tight credit conditions leading to deflation. As you can see, the Fed is seeking to AVOID deflation while creating an environment where capital is easily accessible. The bottom line, the HAVE NOTs are forging deflation risk, at the same time the HAVEs are bringing on inflation risk in our view. 

Two-Tiered Access to Capital

So, who are these “Haves” with unfettered access debt markets at almost free interest rate levels, rates well below what U.S. Treasuries yielded only a few months ago? Most are NASDAQ 100 companies and multi-nationals.

And, who are the “Have Nots”? The Russell 2000 and other small caps, who, by the way, employ a lot of people.

Nasdaq QQQ Extreme Richness to Russell 2000 IWM
Is the Fed picking winners and sowing the seeds of losers? As central banks suppress interest rates with trillions of dollars of asset purchases (much of the buying U.S. Treasuries), bond prices are NOT the only thing moving higher. Why? It all comes down to the net present value of cash flows, a premium builds in Nasdaq equities during QE periods. A 1.25% 30 year U.S. Treasury yield makes corporate cash flows more valuable, it’s that simple. Large companies can borrow at far cheaper levels than small companies and it’s becoming exponentially unfair. The relationship between the Nasdaq QQQs and small-cap equities is reaching blood-curdling extremes. Since Q4 2018, the 2000 stocks in the Russell are flat and the Qs are up nearly 60%. One group has had easy access to capital powering stock buybacks, the other has not. It’s corporate inequality at its worst. Where’s the trade? There is one sector we believe which will dramatically outperform the Nasdaq over the next 24 months, email for our special report.

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The Power of Hot Air – Inside the Secondary Market Corporate Credit Facility (SMCCF) 

“Boeing just raised $25 billion on a deal that was met with $70 billion in orders, making it the sixth-largest corporate bond placement on record. In fact, investment-grade corporate bond issuance this year has broken the previous monthly record twice, with March volume of $262 billion breaking the previous record in May 2016 of $168 billion, and April volume of $285 billion breaking March’s record. Year-to-date investment-grade bond issuance through April totals $765 billion, putting 2020 on track to easily surpass last year’s total of $1.1 trillion. Many companies, including Boeing, Southwest, and Hyatt Hotels, have likely gained access to financing simply on the strength of the government’s intentions to intervene in credit markets. Successful debt offerings have also been completed by recent fallen angels like Ford and Kraft Heinz, both of which had corporate bonds trading at or near distressed levels only weeks ago. This was a real success for corporate bond issuers, but it was also a success for the Fed. The Fed has yet to buy a single bond in the SMCCF, but the mere announcement of the program has managed to tighten credit spreads dramatically and greatly ease liquidity issues.)”

Our friend Scott Minerd, CIO Guggenheim

Solvency vs. Liquidity

In our global, New York Times best-seller, we break down the difference between a solvency and liquidity crisis. In the case of the latter, sometimes healthy firms collapse because they can’t access the credit window, the Fed can address this risk. The former focuses on companies that can’t survive no matter how much they can borrow – they need a large cash flow boost. The Fed is helpless here, fiscal policy can provide some relief.

Equity Returns Sorted by Credit Ratings
We are entering a period that will be extremely difficult for passive asset management. The days of blindly placing capital in index funds (S&P 500 SPY) and outperforming are over. Looking forward, if you cannot pick the winners from the losers – you will underperform. We believe long/short active asset managers are coming into a bull market in terms of incoming assets under management. As you can see above, credit leads equities. If you don’t understand the credit risk, you shouldn’t be in the stock.

Political Risk Surging Across Fixed Income and Equity Markets

Populist movements and political risk is SURGING across equity and fixed income markets. FAANG equities, for example, will have a significant target on their back moving forward as Washington moves to either break up these companies or find new, creative ways to tax them. Another example is found in the  Fed’s Primary Market Corporate Credit Facility. This tool is designed to have the central bank buy debt directly from issuers – WITH strings attached.  As a reminder, Treasury provided $75B of collateral to these programs, that the Fed leverages 10:1, to buy $250B in the secondary market and $500B in primary market debt. We hear some issuers will NOT sign up for it. Why? Some are thinking only ~20 companies (Ford, GM etc) because the government’s terms require CEO and CFO sign-off and potentially leave them exposed to some sort of congressional/government probes in the future, which many issuers may want to avoid. Translation, companies don’t want to become the next Fannie and Freddie. The GSEs went into Federal assistance (conservatorship) a decade ago and have NEVER come out of Uncle Sam’s grip with hundreds of BILLIONs of dollars in profits swept to the U.S. Treasury.


However, there is a flaw to being one of the “Haves” if the number of “Have Nots” increases exponentially. Even the “Haves” need customers, and those customers may be fast disappearing as the “Have Nots” experience rolling bankruptcies and downsizings.

The savings rate recently vaulted (nearly doubled) to 25%, and for good reason, given the times in which we live. After a decade long buying binge, Americans have enough stuff. And as the super-charged unemployment compensation from the stimulus bill expires July 31st, the excess income it offered will evaporate, and fees for Netflix will decline. Companies can create all the content they want for people who have no money or who are desperately saving what little they have. Multi-hundred dollar smartphones? Forget it. Pay to play apps? Not a chance. Pay for movies? They’re free on Pluto. Keep your old phone and use the free apps you already have.

So the “Haves” become the “Have Nots” down the road. Look at it this way. Say a yacht was worth $30 million six months ago. What is it worth now that there are no buyers? Zero. What happens to private golf courses when half the members quit? They fold. Luxury cars? A bid here. A bid there. But the aspirational shopper is gone. Some asset prices can and will crash. High-end contemporary art is already offered at a 30% discount.

And what happens to that portion of spending attributable to keeping up with the Joneses when the Joneses run out of luck? Kaput. So much for multiple once in a lifetime vacations every year.

As the core of the economy is hollowed out, the number of “Haves” joining the ranks of the “Have Nots” will only increase.

This is part and parcel of “The Fourth Turning”. Over the next 6-8 weeks, correlation will rise across equity market sectors.

Money Supply Surge

Beware – broad money supply year-over-year percent growth is now at a record 18.5%, this is sowing the seeds of inflation 6-12 months out. We say this with HIGH conviction. More than QE1, QE2 or QE3 combined, the Fed’s nearly $1T of asset purchases in April is at an unsustainable pace. In the inflation recipe, there are three primary ingredients and we have them all; a) large printing to fund government spending, MMT, b) a large budget deficit, c) a significant supply shock.

Total Returns YTD

Nasdaq 100: +0.14%
Berkshire: -19.35%

1 Year

Nasdaq 100: +14.09%
Berkshire: -15.5%

3 Year

Nasdaq 100: +60.02%
Berkshire: +10.02%

Since 2000

Nasdaq 100: +181.08%
Berkshire: +412.02%***

Bloomberg data

Buffett is NOT Interested

Over the weekend we learned Berkshire Hathaway has been a net seller of stocks this year. Even with a $137B war chest of cash – Buffett has no interest in making a large purchase. Keep in mind, his pile of greenbacks is up from $53B in 2016! This is fascinating, clearly, Buffett doesn’t want to play the “don’t fight the fed” roulette – he’s waiting for real value. Clearly, low rates put FAANMG like equities in high demand. Buffett doesn’t want to chase, play musical chairs in these stocks, thus he continues to get swamped on a relative performance basis. What could stop this seemingly endless trend? Just the slightest hint of INFLATION will crush the Nasdaq 100, unimaginable destruction. Join us below for our special report:

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Fed’s Tool Kit and the Power of Forward Guidance

“Our indicators tell us, we’re very close to a Lehman-like drawdown,” argues Larry McDonald, a former strategist at Société Générale who now runs The Bear Traps report.

Financial Times, February 20, 2020

*Our institutional client flatform includes; financial advisors, family offices, RIAs, CTAs, hedge funds, mutual funds, and pension funds.

Don’t miss our next trade idea. Get on the Bear Traps Report Today, click here

In our New York Times bestseller, we take a deep dive into a wounded global economy and the weapons central banks have in their back pocket. Looking over the last 15 years,  two primary exogenous shocks brought the U.S. economic ecosystem to its knees; Lehman Brothers failure and COVID19. Nearly every time the Fed raised the inflation bar needed to get off the accommodation gravy train – certain asset prices responded forcefully, some FAR more than others. Let’s explore…

What is Forward Guidance and How do Asset Classes Perform During Weeks when it has been Aggressively Used?

On Wednesday, April 29th the Federal Reserve meets for the first time since mid-March, that’s close to 27 million jobless claims ago. Unimaginable heartbreak and destruction will very likely result in an even more creative tool kit from central banks.

It’s all about the Fed conveying more certainty of the economic data allowing them to stay lower for longer. The whole point is new language – in the statement – allowing for an overshoot on inflation. Acceptance of a level – well above – their well stated 2% PCE target.

This Week: The Ultimate Message from the Fed

a) If things get better, they’ll stay HIGHLY accommodative.
b) If economic conditions deteriorate further, they’ll offer markets even more creative accommodation.

The only path forward is massive accommodation or more accommodation.

The Fed has Five Primary Weapons, BUT really JUST ONE; 

1) Rate cuts are out of gas (the Fed has cut its upper-bound target rate from 2.50% in July, to 0.25% in March).
2) Unconventional balance sheet creativity (is out of gas for now, the political backlash coming at high yield buying promises is growing. We believe the Fed wants to keep this powder dry. They have yet to buy a high yield bond).
3) Forward guidance (lots of bullets in the chamber)
4. YCC (yield curve control, NOT there yet).
5. Negative interest rates (NOT there yet).*

***‘Unprecedented situations require unprecedented actions. That’s why the U.S. Federal Reserve should fight a rapidly deepening recession by taking interest rates below zero for the first time ever’

Narayana Kocherlakota, Federal Reserve Bank of Minneapolis

***So far this has been the most aggressive discussion on the Fed going negative yield, but how much influence does an ex-Fed President have? We say NOT much. The real tell – trial balloon – would be coming out of a Lael Brainard speech, that’s not happening, as of yet. 

Have Gold Bugs figured out Gold is a Rates Trade?

Precious metals are NOT inflation driven for now. Weak inflation data and higher gold prices go hand in hand, this is the opposite of what “gold bugs” have been preaching for the last 30 years. Many don’t realize precious metals respond to heightened deflation risk as much as they do to inflation risk.

Over the last 40 yrs, we’ve been lectured on the relationship between gold / silver and inflation, but it’s really about price stability. Markets have been pricing in deflationary risks for much of this year. The bottom line, all you need to know is when central banks lose control of prices – it triggers meaningful tailwinds for precious metals.

How do Asset Classes Perform?
Forward Guidance – What’s fascinating is, the first 4 times they used it in the post-Lehman era – the market believed them (2008-2012). Gold and Silver responded forcefully early on, each of the 4 times. Then, the weapon (forward guidance) became the “boy that cried wolf” in 2012. The markets smelled out the coming 2013 taper and gold and silver collapsed.

How do Asset Prices Respond?

Over the years, the FOMC used forward guidance to support economic activity and a return of inflation to its 2 percent target.  Gold and Silver responded to these events meaningfully: (see the attached chart above).

December 16, 2008: The FOMC lowered its target for the federal funds rate to a range of 0 to 1/4 percent, which the FOMC considered an effective lower bound. In addition, the Committee stated that “weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.” Back in 2008, from December 15 to February 20 of the following year; Silver was 42% higher with Gold 26% to the upside.

March 18, 2009: The FOMC replaced “for some time” with “for an extended period” in its postmeeting statement. Back in 2009, from March 17 to December 1st, silver was 54% higher while gold surged 34%.

August 9, 2011: The FOMC announced it will likely keep the federal funds rate at exceptionally low levels “at least through mid-2013.” Back in 2011, from August 8 to September 6, Gold was 16% higher with silver up 14%. 

January 25, 2012: The FOMC replaces “at least through mid-2013” with “at least through late 2014.” Back in 2012, from early January to March 1st, gold was 14% higher with silver up close to 35%. Precious metals investors were front-running the Fed for much of 2011-2012.

September 13, 2012: In conjunction with the announcement of its third large-scale asset purchase program (henceforth “LSAP3”), the FOMC states that it “expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.” In addition, it indicates that exceptionally low levels for the federal funds rate are likely to be warranted “at least through mid-2015.” Back in 2012, from August to October, Silver was 30% higher with gold up 12%.

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The Week Ahead

Rate cuts get vaporized in a swift economic downturn. This week, the Fed will tell us if they use forward guidance now – with force – while the US economy’s struggles are in deep/early stage, we’ll actually have a chance at fighting off deflation and the negative rate trap in Europe and Japan. The bottom line, they will back up the truck on forward guidance. 

A Lot is at Stake

As our friend Chris Cole points out, some people think private equity is a “defensive asset.” It’s NOT. In a global recession, state pensions with over 71% exposure to equity-like assets, will face a $3-10T solvency problem if Japan-like deflation occurs without greater allocation to true diversifiers like gold, silver, and long equity volatility strategies. We are coming to a point where real interest rate returns are pushed so low that investors holding the debt won’t want to hold it and will start to move to something they think is better. In our view, investors desperately want a deflation or inflation hedge.

Our Tweet from June 2019, Gold $1378
We love technical analysts, some of our closest associates are in this profession, BUT let us be VERY clear. Looking at charts without a macro overlay lens only shows you half the picture. As you can see above, back in June 2019, the technical picture was bright for gold. Even more attractive – budget deficits in Washington were surging and a trade war was punishing the global economy. Both factors were forcing the Fed into a far more accommodative policy stance, gold’s ultimate fuel.

An Ugly Budget Coming out of Washington

U.S. budget deficit increased by $140 billion during the first nine months of last year to $747.1 billion as government revenues and spending both hit records. BEFORE covid19 arrived – the Treasury Department’s deficit was up 23.1% over the same period a year before with tax receipts rising by just 2.7%. The Trump administration forecasted a deficit for the full budget year, which ended on Sept. 30, topping $1 trillion, up from a deficit of $779 billion the year before. This number is NOW close to $4T. The US’s budget deficit will end the fiscal year at almost 18% of GDP, its highest level since the year after World War II ended and up from 4.6% in 2019: CBO data. Congressional Budget Office says coronavirus aid, likely recession to cause the deficit to reach $3.7 trillion this year.

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Funding Colossal Liabilities

The world is facing a colossal need to fund liabilities – this will fule the mad rush into alternatives, Next, there simply is not enough capital to meet the needs for it – large deficits that are being monetized. We are about to come into a world with thousands of Yanis Varoufakis like leftists – private property rights are fleeting.

Bond BUYERS BEWARE – the Left wants your Capital

“I shall wear the creditors’ loathing with pride.”

Yanis Varoufakis

*”Yanis” Varoufakis is a Greek economist, academic, philosopher and politician. He has been Secretary-General of MeRA25, a left-wing political party, since he founded it in 2018. A former member of Syriza, he served as Minister of Finance from January to July 2015 under Prime Minister Alexis Tsipras.

Down the Road Ahead

Central bank asset purchases, currency depreciation, and large tax increases have increased the conflicts between the capitalist haves and the socialist have-nots. Holders of debt will receive very low or negative nominal and real returns in currencies that are weakening, which will de facto be a wealth tax.

Federal Reserve’s Balance Sheet

2020: $6.6T
2019: $3.7T
2018: $4.2T
2017: $4.5T
2016: $4.5T
2015: $4.5T
2014: $4.5T
2013: $3.7T
2012: $2.8T
2011: $2.8T
2010: $2.3T
2009: $1.8T
2008: $0.8T

*Gold $1050 to $1750 since Q4 2015.

What is Forward Guidance, and how is it used in the Federal Reserve’s Monetary Policy?
Per the Fed’s own claims, forward guidance is a tool that central banks use to provide communication to the public about the likely future course of monetary policy. When central banks provide forward guidance, individuals and businesses will use this information in making decisions about spending and investments. Thus, forward guidance about future policy can influence financial and economic conditions today.  The Federal Open Market Committee (FOMC) began using forward guidance in its postmeeting statements in the early 2000s. Before increasing its target for the federal funds rate in June 2004, the FOMC used a sequence of changes in its statement language to signal that it was approaching the time at which a tightening of monetary policy was warranted (for a review of that experience, see Feds Note “The Effects of FOMC Communications Before Policy Tightening in 1994 and 2004”).  In the aftermath of the global financial crisis, the FOMC reduced its federal funds rate target nearly to zero and then used forward guidance to provide information about likely future monetary policy. For example, the postmeeting statement issued in December 2008 noted that the Committee anticipated that weak economic conditions were “likely to warrant exceptionally low levels of the federal funds rate for some time.” The FOMC’s forward guidance has evolved over time; eventually, the Committee’s guidance indicated that the future path of the federal funds rate would depend upon how future economic conditions changed. In addition, the FOMC used forward guidance language about the flow-based asset purchase program that it undertook in September 2012.

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 Investors Beware

“Bonds are a claim on money and governments are likely to continue printing money to pay their debts with devalued money. That’s the easiest and least controversial way to reduce the debt burdens and without raising taxes. My guess is that bonds will provide bad real and nominal returns for those who hold them, but not lead to significant price declines and higher interest rates because I think that it is most likely that central banks will buy more of them to hold interest rates down and keep prices up. In other words, I suspect that the new paradigm will be characterized by large debt monetizations that will be most similar to those that occurred in the 1940s war years. So, the big question worth pondering at this time is which investments will perform well in a reflationary environment? A world with large liabilities coming due and with significant internal conflict between capitalists and socialists, as well as external conflicts. Most people now believe the best “risky investments” will continue to be equity and equity-like investments, such as leveraged private equity, leveraged real estate, and venture capital, and this is especially true when central banks are reflating. As a result, the world is leveraged long, holding assets that have low real and nominal expected returns that are also providing historically low returns relative to cash returns (because of the enormous amount of money that has been pumped into the hands of investors by central banks and because of other economic forces that are making companies flush with cash).  I think these are unlikely to be good real returning investments and that those that will most likely do best will be those that do well when the value of money is being depreciated and domestic and international conflicts are significant, such as gold. Additionally, for reasons I will explain in the near future, most investors are underweighted in such assets, meaning that if they just wanted to have a better-balanced portfolio to reduce risk, they would have more of this sort of asset. For this reason, I believe that it would be both risk-reducing and return-enhancing to consider adding gold to one’s portfolio.”

Ray Dalio, July 2019

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Trading and Portfolio Management, 10 Lessons of a Lifetime

“Our indicators tell us, we’re very close to a Lehman-like drawdown,” argues Larry McDonald, a former strategist at Société Générale who now runs The Bear Traps report.

Financial Times, February 20, 2020

*Our institutional client flatform includes; financial advisors, family offices, RIAs, CTAs, hedge funds, mutual funds, and pension funds.

Don’t miss our next trade idea. Get on the Bear Traps Report Today, click here

“Without owning something over an extended period time, where one has a chance to take responsibility for one’s recommendations; where one has to see one’s recommendations through all action stages and accumulate scar tissue along the way for the mistakes. Where one has to pick one’s self up off the ground, feel the pain and dust one’s self off. Without that process, there is very little real learning.”

Steve Jobs on Research vs. Trading, on “Consultants”

A Weekend in Omaha

An icy cold breeze rolled in through an open window, early morning was coming out of deep sleep. I reached for the covers and tried to get some rest, but just couldn’t, the adrenaline was pumping. There were just two thoughts in mind; the Munger meeting and waking up in Omaha, Nebraska. It was our 3rd year in a row, but this journey was special. Charlie Munger invited us for a 1-1, private meeting. To many, Buffett’s right-hand man is the behind the scenes “gem” of
Berkshire. On this Saturday, we walked into the Quest Center, close to 20,000 were waiting for Buffett and Munger to sit down in two chairs positioned on center stage. There were another 10,000 investors in town for events and weekend activities that make up Berkshire Hathaway’s Annual Meeting. After a 45-minute kickoff presentation, Buffett and Munger opened up the gathering for Q&A. It was a sight to behold. There were over 70 different spots selected around the arena for shareholder questions, each with a microphone and an attendant. Over the next hour, inquiries poured in – it’s the ultimate live display of corporate transparency on earth. After two full hours, I could see my wife was a bit agitated. She leaned over, tapped a woman on the shoulder and said, “how long do these questions go on for?” It was her first time in Omaha and I had made the tragic mistake of not informing my better half of this vital piece of information. “Another 3 hours,” the lady in the next row said with a broad, Midwest smile. Then, I was on the receiving end of the “death stare” from the Mrs.

“Larry, always remember, human nature is your great enemy near market lows. At your absolute climax of fear, you must do the exact opposite of what you want to do.”

Charlie Munger

The next day we walked into the Marriott hotel in Omaha. Glancing across the foyer, in one room there was Bill Gates with pension fund investors. Around the next corner, there was Mr. Buffett himself with the sovereign wealth funds. We were escorted to a small private room. The first thing we could see was a sparsely accommodated conference table, complete with just pencils and paper – vintage Berkshire. The most memorable part of the conversation came down to how Charlie Munger looks at convexity, searching for the best upside, relative to the downside relationship in an investment. He spoke of “crowd folly” – a large collection of highly intelligent people, the “lemmings” acting like idiots. “Emotions have to be under control, you need patience and discipline and an ability to take losses, adding to positions where the real value is found. We find the best opportunities where emotional liquidity is driving price action. We look for the best risk-reward, asymmetric payoff driven returns. We buy businesses with sustainable competitive advantages at a low or even a fair price.” The bottom line, “across the investing playing field, nothing is guaranteed. There will be losses as well as profits, but “insisting upon proper compensation for the risk assumed is the only way to win in the long- term investing game.”

Lehman Lessons

As a trader at Lehman, I remember Mike Gelband coming by the desk and asking traders an important question, one I will never forget; “Are you long because you like it – Or do you like it because you’re long?” Being wrong doesn’t get you stuck. Not admitting that you are wrong gets you stuck in a bad position. Mike is one of the best risk managers on Wall St., one of the good guys, trying to stop the madness as the ill-fated bank was heading for that giant iceberg in 2008.

Which brings to mind the ultimate focus of this blog post.

What makes a great risk trader?

There are 10 qualities and key ingredients. To start, a very creative nature, a high sense of urgency, very aggressive, highly skeptical, and not accommodative. And now, the rest of the best:

1) You need to think about forward price fluctuation differently than everyone else. Great traders aren’t copycats.

2) You have to move immediately before the opportunity is lost. You aren’t the only creative one out there. Paralysis by analysis is the state of over-analyzing (or over-thinking) a situation so that a decision or action is never taken, in effect paralyzing the outcome. NFL legend Tom Brady always reminds us, you must have your homework done BEFORE the game begins. Having enough experience to ride an opportunity when it shows up at your door is the key.

3) In traditional high yield bond trading, you have to go to the mat to get the trade done. No one and nothing can stand in your way. Ever. If that involves yelling at people, so be it.

4) You can’t be sucked in by everyone else’s bullshit or you are doomed. Doubt everything all the time. Take nothing for granted, especially your favorite trades. Every line item in your account is sitting there, waiting to destroy you. You must have HIGH conviction if the trade is still on your pad (in your books), if NOT exit and move on.

“Higher prices bring out buyers. Lower prices bring out sellers – size opens eyes. Time kills ALL trades. When they’re cryin’ you should be buyin’. When they’re yellin’ you should be sellin’. It takes years for people to learn those basics – if they ever learn them at all.”

Larry McCarthy, Former Head of Distressed Fixed Income trading at Lehman Brothers

5) Risk decisions aren’t compromises. They are definitive. They don’t reconcile different people’s opinions. The trade is put on one way or the other. This whole hold-your-hands-together-to-build-consensus-and-team-cohesion thing is simply ridiculous when you have 20 seconds to launch $50 million of risk one way or another. This ain’t day camp to get in touch with people’s feelings. If people on your team have emotional problems with how a trade went down, they can always become social workers.

6) There’s nothing more dangerous on Wall St. than a bored trader with an unused capital line. As the great Seth Klarman says, “buying right, NEVER feels good.” Complacency is a capital killer. Over the years, one of our most important lessons is; trade LESS and make each trade count. On waiting and waiting to pounce (buy), Charlie Munger said; “the toughest thing to do is stare at a screen all day and do nothing.” The 2nd hardest thing for a trader to understand is that you don’t always have to make the bet. Sometimes the best position is no position. Not long. Not short. Just out.

7) Our friend Eric Peters used to say, “there are only a few times in a year to make a lot of money. When those times occur, you need to be involved, aggressive, big. The rest of the year it’s best to do as little as possible.” This is one of my all-time favorite quotes when it comes to trading.

8) The market is always wrong at the open, and always right at the close. Only buy on the open if you have the HIGHEST conviction that stocks will rip all-day long. Lessons learned, you’re much better off waiting and putting long or short positions on later in the day.

9) Made a mistake once? That is ignorance. Made the same mistake twice? That is stupidity. Made the same mistake a third time? That is neurosis. Made that same mistake a fourth time? Congratulations! You are an analyst, economist or strategist. The trend is your friend, when improving and with moves lower here and there, you are far more likely to notice the dips than the overall improvement.

10) High self-awareness is key. Great traders are very aware of their own feelings. Measuring your fear is key, the more you feel, the closer you are to a good entry point on the long side. Self-awareness allows for the understanding of others. Why? Because that understanding is a misnomer. It is really ascription to others what one feels oneself. Why does that work? Because we are all more or less the same. One self-consciousness is like another. As Kant puts it in the Paralogisms of Pure Reason in his Critique of Pure Reason: “Now I cannot have the least representation of thinking being through an external experience, but only through self-consciousness. Thus such objects are nothing further than the transference of this consciousness of mine to other things, which can be represented as thinking beings only in this way.”

Sound tough? It is.

Larry McDonald ran a highly successful distressed bond trading business at Lehman Brothers, was considered one of the firm’s most profitable traders.



Elliot Wave Meets Populist Rebellion

“Our indicators tell us, we’re very close to a Lehman-like drawdown,” argues Larry McDonald, a former strategist at Société Générale who now runs The Bear Traps report.

Financial Times, February 20, 2020

*Our institutional client flatform includes; financial advisors, family offices, RIAs, CTAs, hedge funds, mutual funds, and pension funds.

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The Recurring Highly Improbable

Great Panics and S&P 500 Drawdowns

Lehman Subprime 2008: -57%
Dotcom Crash 2000: -49%
Wuhan Pandemic 2020: -36%
Trade War, Rate Hike Panic 2018: -20%
Grexit Panic, Credit Default 2011: -20%
Oil Crash 2016: -16%
China Currency Deval 2015: -15%

That’s right, over twenty years – seven drawdowns from 15 to 57%. Bear Traps Report data, Bloomberg terminal.

“The only problem with losing 50% of your money? You need a 100% return to get it all back.”

Former Lehman Trader, Larry McCarthy

Passive Investing Victims

Why does the “highly improbable” happen with such predictive regularity? Complacency and hubris have cost investors billions of dollars over the last twenty years. Sure, the “buy and hold” crowd says if you stay invested it’s all good, but the facts tell a very different story. The average daily volume of the SPY SPDR S&P 500 ETF Trust reached nearly 300m shares in late March, close to 5x February levels.  In March 2020, “long term” investors in the largest passive index fund on the planet were selling with both hands and two feet. Keep in mind, there are 916 million shares of the SPY ETF outstanding, so 300m shares a day speaks to a lot of fannies running for the hills. Unfortunately, much like the December 2018 swoon – a large swath of market participants, sadly “puked in the hole.”

“Always remember, human nature is your great enemy near market lows. At your absolute climax of fear, you must do the exact opposite of what you want to do.”

Charlie Munger

Since 2010, with conviction, we have stressed this core belief to our clients globally. “Fine, stay invested with 50%-60% of your equity market allocation, but cash MUST be put to work when stocks go on sale.  This is where the best risk-adjusted returns are found.” It all comes down to buying stocks ahead of the policy response coming from central banks and government officials. In March 2020, we issued more trade alert buy recommendations than any other month in the last decade. As our old friend Seth Klarman likes to say, “buying right, NEVER feels good.”

A Policy Response and the Counter-Trend Rally
In our New York Times bestseller, “A Colossal Failure of Common Sense,” (now published in 12 languages) we made this important point. It rings true, year after year since Lehman’s failure. More often than not, the beast inside the market will provide the ultimate incentive for policy-makers to act. Lehman, a Greece default and the COVID19 pandemic; all violently tightening financial conditions, and literally forced the policy response from bureaucrats, politicians,  and central bankers.  Over the last 15 years, Fed governors have gone from firing bazookas to tactical nuclear weapons. See Mr. Powell’s new toolbox, it makes the 2008-2009 variety look like child’s play. At the same time, politicians have tossed aside austerity, running right into the arms of reckless fiscal spending at any cost. After all “with interest rates so low, it’s free money” they tell us over and over and over, again. MMT (modern monetary theory) is the new magic potion, governments don’t have to find buyers for their bond sales when central banks will finance run-away deficits.

Observation from a Friend

“Daily, we get consistent news about the economic devastation that is inflicted on the global economies together with the continuous and innovative efforts that governments and central banks are doing to do to minimize the impact of this devastation on markets and on people. As always, trying to stabilize markets is always easier, but whether that means that the people will be better off as a result is another issue. ”

See our Q2 Trade ideas here:

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A Fourth Turning, the Elliot Wave and Populism’s Rage – All Converge

We must keep a critical observation in mind. In the same way financial market stress brings upon the fiscal and monetary policy response, it also acts as a possible accelerant when it comes to political inertia surrounding populism.

Debt D-Day in Italy

Italy has a $2.4T debt problem, along with a likely 30% GDP contraction coming in Q2 2020 – the country is insolvent in our view, Greece squared. We know COVID19’s grave economic threat was a policy (fiscal and monetary) catalyst/accelerant. But we MUST ask ourselves, how much does COVID19 accelerate populism’s rage? Decisions that politicians would have had to make over the next 2-3 years are NOW brought forward, dramatically accelerating near term risks in our view.

Heavy NPLs

Total non-performing loans (NPLs) across the largest 123 eurozone banks are still near $530B, by the end of last year. But Greek, Cypriot, Portuguese and Italian banks still have NPL ratios above 6-8% – UGLY.

New Term Debt Maturities – OVERLOADED
With $800B in debt maturities coming due between now and 2024 there are some tough decisions to be made. Germany now owns Italy’s $2.4T debt profile, political leaders just don’t know it yet. The $1.6T stated above is the public debt, there’s another trillion behind the scenes.  The Eurogroup has proposed corona-bonds, but there’s serious pushback in northern Europe (Holland could leave the EU in a near-term showdown). In the south, Italy’s populist sensation Matteo Salvini will use any pushback as a reason to threaten to walk (finance our debt or we exit, take it or leave it – all of this is VERY sterling bullish by the way). Fratelli d’Italia, a party that is further right than Matteo Salvini’s Lega, has reached a new high of 14.5% (up from 4.4% six months ago) in Tecnè’s latest poll.

Political Risk is Drawing Forward Bank Credit Risk
Alert: Italian bank credit risk spiked in recent days, see the five-year credit default swaps – the cost of default protection for UniCredit. See the credit divergence away from Morgan Stanley and Goldman. 

Sovereign Credit Risk – Italy vs. Germany
Italy’s ten-year bond yield spread is pulling away from Germany, spiking wider in recent weeks as populists’ demands surge.

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Beware, the Elliot Wave is Starting to Line Up with Political Risk Trends
After the counter-trend rally, the green line represents the future Elliot Wave trend, this chart from Aleksandar Koprivica. The point 5 target is near 1834, close to 1000 handles below this last week’s high near 2800 (S&P 500). Elliot Wave doubters make a lot of solid points. Stand-alone Elliot Wave signals mean little – but when corroborated with cross-asset class (credit markets, forex, etc..) signals and large shifts in political risk, they mean a lot.

Fourth Turning

In their book, The Fourth Turning, published in 1997, Strauss-Howe proposed a generational theory of history in which societal cycles repeat every 80 to 100 years. The cycle is composed of four generations: the first generation builds (think post-WWII), the second generation is one of cultural awakening (think the ‘60s); the next generation exploits and unravels (think yuppies); and then follows crisis leading to a new order for the fourth generation (think now and the immediate future). After giving several centuries of examples, in the third to last chapter they predicted the rise of a blunt, populist-nationalist given prior precedents. And indeed Mr. Trump was elected president – the nailed it. Their description of the hypothesized leader reads almost exactly like the president of today. As per the theory, we should be heading into a crisis from the ashes of which will rise a new vision of what society is and should be, differing markedly, in our case from the 1950s. They further posit a gray-haired old man prophet who would point the way (Bernie Sanders?). Sure, thanks to some help from Elizabeth Warren’s early exit and a creative DNC (Democratic National Committee), Bernie is history, but this is still a remarkably prescient call. Now, this may fit in with Elliott Wave theory.

S&P 500, a 3400 to 2200 Drawdown – and the 50% Retracement
It is obvious to everyone that the recent sell-off in the S&P 500 from the February highs near 3400, has all the characteristics of a primary impulse wave down. In our view, this is clearly Elliott Wave 1, with a powerful countertrend rally, a 50% retracement on the mark.

Great Counter Trend Rallies in Bear Markets
If we look back at all the great U.S. equity market drawdowns; from 1929, 2008 and 1999 – in each there were massive, counter-trend rallies, some lasting quite a while.

April 2020, the 50% Retracement after the Policy Response

In recent weeks, with conviction we felt a wave two rally to the midpoint of the prior decline (50% retracement) would follow the $6T fiscal and monetary policy response coming from Washington.  Last month in our Bear Traps Report,  we emphasized a follow-on standard a-b-c format of two waves up with a pause in between. This occurred and constitutes wave two. The prior “wave one” decline that bottomed this past March 24, was a classic “shock” decline. The ensuing “wave two” move higher is a classic, follow-on, “hope” rally. The shock was the virus and lockdowns. The hope is based on pandemic following bell curves in South Korea, Italy, and Germany which projects a much more manageable crisis by April end. Not over, but a lot less bad.

We are now approaching Elliott Wave 3-lower, which is the “recognition” phase decline, the “gig is up” sell-off when the mad mob realizes “it is all over”. There follows another wave 4 up or sideways. Then, there’s a final decline wave 5 which is the “exhaustion” decline, in one word; despair.

Uncertainty, about to Take on New Meaning

We are about to enter a period where the largest % of U.S. corporations during an earnings season will withdraw forward guidance. Above all, our functional recognition of unemployment is about to change dramatically – a true secular change. Unemployment will be either double or triple (or maybe more) what it used to be. Governments will have to find ways to fund the spending of former service sector employees. Governments have out-lawed casual consumption and will have to replace that former reality. We estimate, 5-10% of service sector employment will transition into entirely new fields like infrastructure. As you can see, this landscape does not paint a picture of high animal spirits.

Headfake After Headfake – Spring into Summer

The most likely cause for a “recognition” wave three – a substantial move lower – will be the realization that re-starting the economy will be more than difficult. See the second wave of infections (above), expected in the mid-November 2020 to Mid-January 2021 time frame. The recovery process won’t be impossible, but a sentiment killer. The U.S. economy’s multiplier effect desperately needs the defibrillator after a violent sudden stop, that’s NOT happening anytime soon.  Not every U.S. state will open economic activity up simultaneously. As lockdowns partially and intermittently relax, not everyone will return to work. Federal and state unemployment insurance plus the stimulus legislation effectively pay people $22 an hour on a forty-hour week. Many will receive $15 an hour on a 30 to 35 hour week. So they won’t return to the workforce until August. Furthermore, crowded venues will be far less in demand. Over 60% of the U.S. economy is service-based, and much of that will come back very slowly – over 36 months. As the populist threat surges, a certain, $1T plus infrastructure bill will create lots of jobs, but if successful it will trigger mass migration out of urban centers. Society won’t be the same for years, NOT months. So the recovery will be halting and fitful. That is the stuff wave three sell-offs are made of, when everyone recognizes “this ain’t gonna be easy.”

Alternative Count

Now, the problem with Elliott Wave Theory is that it purports to be exact. Sometimes it is. But sometimes it’s fuzzy. It is part and parcel to posit an “Alternate Count” which re-characterizes the prior wave formations.

So in the instant case we have lived through, described above, the Alternate Count would label the March low as the end of wave A, the recent rally wave B, and the upcoming smash will constitute wave C. Under standard practice that would be the end of it and a sustainable bull market would ensue, though again, there are caveats, variations and complications even with the Alternate Count too exhausting to detail for present purposes.

But here is the real point of both the Preferred Count and the Alternate Count: get out of the way. Hall of fame tactician Marty Zweig used to say that he didn’t care if it was a correction or a bear market, he didn’t want to be “long” or “own” either one.

From a tactical point of view, it doesn’t matter if the next decline is wave three of a five-wave formation initiating a secular bear market, or wave C of an a-b-c correction that will be over soon enough and will lead to a new secular bull market in a couple of months. Both are devastating declines leading to significant new lows.

That said, there are reasons to favor the Preferred Count for a long term bear market. One is the Fourth Turning. If indeed we are going through a once in a multi-generational socio-economic transformation, it should be gut-wrenching and time-consuming, fraught with career-ending risks, volatility, and surprise. A quick a-b-c selloff a few months in duration doesn’t fit the bill for such vast and permanent multi-generational socioeconomic transformation.
Furthermore, the Fourth Turning and the Preferred Count in Elliott Wave Theory are mutually reinforcing. If there is to be multi-generational socioeconomic transformation, then the bear market should last years, peppered with mind-blowing rallies along the way.
On the other hand, if the Preferred Count in Elliott Wave Theory is correct, then we are in the early stages of a protracted and devastating bear market symptomatic of a painful, fundamental and permanently transformative mutation in the economy and in society.
The Fourth Turning reinforces the Preferred Count and vice versa.
But that is not all. There is a basic rule in trading: parabolic rises are followed by parabolic declines. Think when the Hunt brothers cornered silver. It shot up to $50 an ounce only to collapse to $5. Think when the dotcom bubble burst. The NASDAQ closed the month of March 2000 at 4572 only to decline to 1172 by the close of September 2002.

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Dow Parabola

Now, if you look at a long term chart of the Dow Industrials, you see a clear parabola. The snap-off of a parabolic top is unsubtle and unmistakable. We are in the decline phase of the parabola.

*In mathematics, a parabola is a plane curve which is mirror-symmetrical and is approximately U-shaped. It fits several other superficially different mathematical descriptions, which can all be proved to define exactly the same curves. 

Dow Jones Industrial Average
During the 2008-2009 drawdown, the Dow Jones Industrial Average broke its 200-week moving average, today this number sits down at 15,229.

Gold, MMT, and Central Banks
In recent years, buying gold miners when they’ve gone on sale has led to exceptional profits. As investors put less trust in central bankers to control asset prices (deflation or inflation), gold comes into high demand. The latest  Fed Balance sheet tally printed on Thursday at $6.08 Trillion, that’s up from $3.85 trillion just 6 months ago. The lesson from the 2008 financial crisis comes down to a Fed not taking their foot off the asset purchases accelerator until the economy is well into an expansionary era. In this environment, precious metals remain HIGHLY attractive. We remain long 1/3 gold miner position, with more significant exposure to silver and copper. We have seen massive and coordinated fiscal/monetary response to this crisis, and one who’s footprint will outlast the current issues plaguing the global economy. The other side of this? The capital to be issued (bond sales), MUST be taken up by respective central banks via substantially increased asset purchase programs. The age of MMT* has arrived, and a lot sooner than most had projected. Pretty much every developed country in their response to COVID19 is going to be engaged in some form of MMT, where government deficits are largely financed by
the central bank. We believe the implications of this are enormous, and the beneficiaries should be commodities and cyclicals especially as the Fed and U.S. Treasury seemed determined to keep a cap on the U.S. dollar. Email for our latest report.

*Modern Monetary Theory (debt monetization) is a macroeconomic theory and practice that describes the practical uses of fiat currency in a public monopoly from the issuing authority, normally the government’s central bank. Using a central bank to finance bond sales, in other words, a Ponzischeme.

Lessons from Bretton Woods

What happened? What caused the parabola in the first place? A little history…

The US left the gold standard in 1933 to combat the depression. The dollar’s ties to gold were cut, allowing the government to provide monetary liquidity to the financial system, and assisting the Fed in its effort to lower interest rates. But the dollar was still not completely a fiat currency. The U.S. still allowed foreign governments to exchange dollars for gold. In 1971 the Bretton Woods monetary system arrived, the Nixon adminestration put an end to foreign governments from liquidating their dollar holdings into gold, thereby depleting our own gold reserves. If you think about it, that act shows little faith in the fiat currency. The motive should have been to maintain dollars in circulation to maintain a liquidity preference for the dollar. But in fact – it was the spectre of depleted gold reserves that caused the final and full transformation of the U.S. dollar into a fiat currency.

After the dollar went full fiat in 1971, the Industrials traded in a wide sideways range for over a decade. A month-end high was made December, 1972 at 1020, followed by month-end low of 608 on September 1974, in turn followed by a month-end high of 1004 on December 1976, with a final monthly low set end of June 1982 at 812, albeit an intra-month low followed at 780.

But then the market began to truly rally. That summer seasoned veterans were leaving the floor mid-day their faces literally drenched in tears. Unforgettable. Suddenly the Volker interest rate shock was working. Inflation at long last was moderating. And if high interest rates worked, that meant they wouldn’t need to last. Thus began the great bull market in US treasuries that still endures down to the present day.

The resultant improvement in economic conditions and relaxation in monetary policy fueled a super-trend long term bull market that indeed was interrupted by bear markets but went parabolic with Quantitative Easing from the Great Recession. That super-trend long term bull market started in that summer of 1982. That super-trend bull market ended in February 2020. A thirty-eight year run. Remarkable.

The chart on the Industrials shows the foothills of the parabola. When the Industrials first closed over 1200, everyone knew. “This is it!” It was an amazing moment of renewal of optimism and confidence.

True, there was a large sweeping sideways motion from the burst of the dotcom bubble to the end of the Great Recession. Thus were completed the foothills of the ensuing parabola.

From a monthly closing low of 7698.92 on the Industrials, set at March 2009, to the closing all-time high of 29,551 on 2/12/2020, an astonishing run of 21,942 points!

A parabolic decline should retrace roughly 80% of the parabolic rise. It has happened that 100% has been re-traced. An 80% decline would be 17,554 points off the top, for a target of 11,997 in two to five years.

What could cause such a catastrophe? The death of fiat money. Note that in the entire history of civilization, no fiat currency has lasted even 90 years. Ours started in 1933…

The first record of fiat currency is found in the Travels of Marco Polo. He described paper money as “a kind of magic.” The liquidity it provided the Chinese Empire created the incredible wealth in city after city, as detailed in his chronicle, which was intended as a map for trader merchants. Alas, the prosperity didn’t last – deficit spending paid by the printing press collapsed into a debauched currency and unprecedented economic devastation. What ensued? A return to gold as the medium of exchange.

The USA now has a debt to GDP ratio of over 100% for the first time since WWII, which, say what you will, caused more death than the current pandemic.

How long will the economic collapse following the death of fiat money presaged by the end of the parabolic rise of stock prices fueled by Quantitative Easing? Years, thus requiring the Preferred Count in Elliott Wave Theory, thus fulfilling the prophecy of the Fourth Turning.

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Mortgage Market Meltdown 2.0, Implications are Far and Wide

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“Our indicators tell us, we’re very close to a Lehman-like drawdown,” argues Larry McDonald, a former strategist at Société Générale who now runs The Bear Traps report.

Financial Times, February 20, 2020

Destructive Unintended Consequences 

The Federal Reserve’s response to the Coronavirus crisis is having a significant impact on the mortgage industry. Some industry players believe capital losses within the sector could be on par with the 2008 financial crisis. The epicenter of risk is focused on capital requirements (mortgage lenders need to function) and covenants allowing them to do business. Lets us take a look…

One Loud Backfire
From March 2nd to March 19th, the brain-trusts at the Federal Reserve took the Fed Funds target rate from 1.75% to 0.25%. During the financial crisis, they made a similar move but it was over a 3-month period, NOT 17 days. The unintended consequences of Fed policy are more than significant, the yield on the 30-year mortgage soared. Unintended Consequences:  housing, over 20% of US GDP is at risk as MOST of the entire US mortgage ecosystem is currently dysfunctional.

Three Year Break-Even

Mortgage servicers typically pay 1% of the mortgage loan amount for the privilege of typically earning 0.30% of the loan amount and the responsibility for forwarding the mortgage payments to the loan originator or secondary investor, taking care of insurance, taxes, and records. Thus the break-even for the servicer is a little more than three years.

Black Swan Drawdowns
Countless ETFs in the mortgage sector have crushed investors, large and small alike. Since non-bank financial companies now service most mortgages but don’t have access to the funding window at the Fed like banks do, aren’t these companies in for a massive liquidity shock once people start defaulting on mortgages?

Wipe Out

With the recent overnight collapse in interest rates, these mortgage loans will pre-pay rapidly. Thus the loans the servicers paid for vanish and the servicers see a loss from a wipe-out of their performing loan portfolio. Normally changes in interest rates are gradual enough such that pre-pays are gradually replaced with new mortgages. Not this time!  On the other hand, unemployed mortgagers will default. When that happens, servicers still have to pay the interest to the secondary owner of the mortgage. And most servicers are levered to boot. In sum, the good loans go away, and the bad loans that remain leave no way to pay interest to secondary owners or their lenders. Most banks don’t own the mortgages. They package them up and sell them to ETFs that are bought by retired people. They sell them to pensions and insurance cos. Banks get paid to originate, not to carry them. A holiday would have minimal if any impact on Wall St., but CRUSH servicers.

“The Federal Reserve and its master (Too Big To Fail
Banks) are trying to thin [knock-out] the nonbank servicer
herd through margin calls. As usual Fed economists are too
theoretical to understand markets. Killing one, in crisis
leads to broad failures.” 

Josh Rosner, New York Times Bestselling Author – Reckless Endangerment 

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Be Careful

In recent weeks, there is a meaningful amount of well-intentioned discussion about the suspension of payments (mortgage, car, student loans, etc); keep in mind contract rule of law, protection of private property (creditors) is constitutionally protected – a large reason investors flock to the USA.


Furthermore, the government has granted forbearance of mortgage payments. It is not clear that this is constitutional. Back in the depression, the Frazier-Lemke Act forbade banks from foreclosing on farms. The Supreme Court ruled that law unconstitutional.  The good news is that a Mortgage Services Facility has been created to bridge mortgage servicers through this difficult period. The bad news is that it’s too little, too late.

Many mortgages were already in pre-payment and replacement just as the homeowners became unemployed. The new facility doesn’t contemplate that challenge. Defaults are not deemed collateral and the servicers are left holding the bag.   Additionally, service fees have dropped from 1% to half that. While this means new portfolios may be bought less expensively, the servicers themselves are less creditworthy thus increasing their cost of capital. This loan conduit for the mortgage industry is a shadow of its former self.

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Finally, lenders and servicers alike have hedged their portfolio risk against default by shorting mortgage-backed securities or their derivatives. But the Fed is buying MBS in its new QE program! Thus their portfolios have deteriorated while their hedges have run-up in their faces. The situation is so bad we believe the Fed* is about to reduce the pace of its former announce MBS buying program.  The net result of the above is that the Fed’s actions restrain lending, the exact opposite of what the Fed intended. Whether or not the road to hell is paved with good intentions is a matter for debate. But the road to hell is certainly paved with the corpses of mortgage servicers.


“The Fed bought $21B today and reduced the plan for the week from $40 to $30B, no more short settlement either. There should be a liquidity facility for the originators especially since the regulators caused this problem. They can’t allow the basis to blow back out though.”

Barry Knapp

“NY Fed task force to help servicers being formed and trying to figure out how to support servicers who will have to province timely interest and principal payments to investors from those who cannot pay their mortgages (forbearance).”

“The ramp-up in MBS TBA prices has led to unprecedented levels of margin calls on mortgage originators who use the TBA market to hedge their loan production and eliminate any interest rate risk. The situation became acute Monday leasing the Fed to announce a reduction in their daily MBS purchase: the pace of its MBS buying program. Housing, over 20% of US GDP is at risk as MOST of the entire US mortgage ecosystem is currently dysfunctional.  TBA prices did end the day lower than Friday’s close after being up 1/2 point in the late morning. Independent mbs issuers are over 500 firms, the entire industry with 2 more days of ramped up MBS would have been insolvent. “

Larry McDonald

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A Wounded Federal Reserve, a Lehman Era Tool Box sits on the Shelf

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“Our indicators tell us, we’re very close to a Lehman-like drawdown,” argues Larry McDonald, a former strategist at Société Générale who now runs The Bear Traps report.

Financial Times, February 20, 2020

In September and October of 2008, the Federal Reserve showed the beast inside the market their body armor.  With a newly minted – creative toolbox, they stood tall and stared down a large group of short-sellers in what was the most prolific “bear raid” since 1929.

In a strong bull market a larger and larger group of participants “buy the dip” taking stocks to places oftentimes they shouldn’t go.  In a ferocious bear, short-sellers pound overnight futures in an effort to shake the confidence of investors. As stops (stop losses) are triggered – a larger and larger collection of long term investors get placed on the sidelines, confidence is lost and some investors won’t return to stocks for years to come.

LQD Investment Grade Bond ETF

Some would say,  global central bank’s multi-trillion-dollar asset purchases in recent years sowed the seeds of this financial crisis. In early 2020, nearly every asset class was dramatically mispriced relative to encroaching risks. Now losses are in the trillions and we’re handing over more power to the enablers? Unfortunately yes, they hold all the cards.



Leveraged Loans and the New Shadow Banks

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Breaking: *N.Y. FED’S 42-DAY REPO OP. OVERSUBSCRIBED; $42.55B OF BIDS – Bloomberg, December 2, 2019


Q: Who’s the Fed financing here? Leveraged loans??? Global hedge funds???

A: Fed financing lev loans: Why wouldn’t they? Easier to soak the ground now than be trying to put out the fire later (credit fund).

Looking Down the Road Ahead

Our 21 Lehman Systemic Risk Indicator Index (LSRII) was developed in 2007. It focuses on tracking the contagion effect and provides good and bad signals in terms of effectiveness with one important finding. Like a reliable caddie in golf, the longer you’re together – the better he / she is. There was a group of revolutionaries who tried to stop the madness at the ill-fated bank, but one by one they were silenced. We explore the legendary lessons below, enjoy.

The Crow’s Nest
We know elephants leave footprints. Looking over the calm seas across markets, from the crow’s nest if a hedge fund manager David Tepper sees something meaningful risk wise, the first thing he does is takes 0.25% of this year’s p/l and deploys it at the cheapest, relative value protection. If David Einhorn joins him, Seth Klarman’s head trader as well, that’s fairly detectable. Of course, we have no idea what hedge funds are leaving the footprints, just using those three veteran investors as an example.

Our Global Bloomberg Client Chat

In daily interaction with over 300 institutional investors globally, our live Bloomberg client chat helps to provide clues throughout the year. From time to time we’ll hear about a large “print” either in HY CDX, S&P Futures, Forex vol futures, Eurodollar futures, etc. We’re attempting to measure the accumulation of hedges. More size, the more encroaching risk.

At Lehman, our team attempted to hedge the $6B ish of leveraged loans the bank got stuck with, so the origin of the idea comes from that painful experience.

Over the years, we have altered the index weightings relative to parts of the world where risk is most concentrated. In 2011, CDS on Eurozone banks (exposure to Greece debt) were an outstanding leading risk indicator for US equities, much the way US banks were in 2007-8.

Today, the index has been much more Asia focused. Italian bank CDS is still a decent Salvini political risk indicator as well. Above all it’s important to note, we’re starting to shift the focus – back on the US.

US high yield, leveraged loans, and CLOs are near $3.2T, add the $2.6T of BBBs, you get nearly $6T of risk assets. In the QT (quantitative tightening) world, the Fed cluelessly over-cooked the goose. They pulled too many dollars out of the system and tightened FCIs (financial conditions) far faster than they were aware of at the time (Q4 2018). The beast inside the market literally broke the Fed over its knee like kindling being thrown into the fireplace. It was a beautiful capitulation.

We MUST keep in mind – during the 2000-2002 credit cycle flame out, over 45% of the investment-grade universe oozed into “high yield” bond territory. Today that’s the equivalent of $1.2T of “fallen angels” (vs. $195B in 2000-2002)  – a flood of junk near unimaginable proportions. It’s no surprise the Fed caved in such embarrassing fashion, they had a large gun pointing at their legacy (head).

Today, they’ve deployed the QE fire hose (term repo + $60B/m tbills) but when the mark-to-market of say $150B (20 or so idiosyncratic events) of HY, CLOs, loans and junk IGs falls quickly, the ability of banks / hedge funds to hold these assets is highly unknown, untested. It doesn’t matter if $5.5T of the risk pool is just fine, come near year-end everyone has to put some cards on the table.

U.S. Credit Risk Rising

In our view, leveraged loan funds and ETFs are the new shadow banks, outstanding debt in this dark corner of Wall St. has surged to nearly  $1.5 trillion in the US. While Collateralized Loan Obligations are the largest buyers (about 50%), leveraged loan mutual funds and ETFs are the second-largest buyers comprising around 30% of the demand. Over the years we’ve learned, there’s a waterfall effect across credit markets. Stress in one pocket often leads to two and three fairly quickly.  Credit spread contagion MUST be meticulously monitored, especially with an accommodative Federal Reserve. After 3 rate cuts and a $400B balance sheet reversal from contraction to expansion – why are we seeing stress on the rise? Let’s explore.

A Federal Reserve, Juicing Leverage on Leverage on Leverage
As you can see above, debt to EBITDA multiples at issuance > 5x have surged dramatically. It’s clear to us, the longer the Federal Reserve doesn’t allow the business cycle to function – clearing out the bad actors – leverage on leverage continues to pile up. Look at 2019 relative to 2007, it’s screaming moral hazard at Mr. Powell. Debt multiples < 4x make-up just 10% of loan sale volumes vs. close to 30% in 2007.

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The Liquidity Mismatch

Our friend Rod Dubitsky points out, leveraged loan funds offer the promise of daily liquidity, yet the underlying asset is fairly illiquid and the time to sell could be lengthy. Leveraged loans could take up to 21 days to settle, while the funds are required to meet redemption requests within 7 days, but in practice are expected to provide liquidity in one or two days. Innovation in financial products and ETFs has incentivized the unsustainable in our view. How can ETFs and mutual funds offer realistic liquidity on financial instruments inherently illiquid?

Cash Flow Coverage Fleeting in US Loan Market

It’s a clear liquidity mismatch in our view, one that takes us back to the mid-2000s.

A Lehman Visionary

It was a morning in June 2005, one we’ll never forget. Michael Gelband, a Lehman Brothers managing director and the firm’s head of global fixed income, gave a presentation to our team of traders about the dark side of the real estate market. The meeting began just after 6:45 a.m. Each attendee was handed a dossier of about 30 pages.

In our 2009 global bestseller –  A Colossal Failure of Common Sense (now published in 12 different languages), there’s an epic scene where Gelband described the stunning proliferation of “no-doc” mortgages and other toxic loans, sold by commission-driven salesmen and then purchased by Lehman and other Wall Street banks.

Steve Jobs once said of Einstein, “talent hits a target no one else can hit, genius hits a target no one else can see”. A true visionary, Mike could see the train wreck a mile away.

“He cited the shadow banks, the vast complex network of mortgage brokers that were not really banks at all but managed somehow to insert themselves into the lending process, making an enormous number of mortgages possible while having to borrow the money themselves to do so. He cited outfits such as Countrywide, New Century, HBOS, and NovaStar, among others, and he accused them of creating well over $1 trillion in economic activity that was comprehensively false money and would never be converted into genuine economic power.”

Gelband predicted that the house of cards could soon collapse — perhaps in 2007 or 2008 — producing serious consequences for the U.S. economy.  After the meeting, Gelband didn’t stop pressing the issue. He used his position on Lehman’s executive committee to try to persuade the firm to pull back from its massive bets on the real estate market.  But warnings from Gelband and others with similar concerns were largely ignored by senior management at Lehman Brothers.

We MUST NOT ignore the current signals coming from the leveraged loan market – they are screaming loud and clear.

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Are funds set up to meet a severe liquidity challenge in a distressed environment? We agree with Rod, “no way Jose”. While there have been redemption spikes (a surge in the number of people wanting their money back) even within the last year or so, they have been fairly brief, shallow and occurred during relatively robust economic times.

Fed’s Fire Hose
In recent years, the Fed has saved the day numerous times. First on ending rate hikes after promising to march on, then on quickly shifting to rate cuts, and finally a colossal capitulation on their beloved balance sheet reductions plans ($2.5T in reduction promises to recent $400B expansion of their balance sheet). There have been runs on leveraged loan funds, but each time the Fed put out the fire with a reversal toward far more accommodation. Even so, with all the Fed love, stresses are NOT going away!

Even after 3 Rate Cuts, a Downgrade Surge
We believe the market is underestimating this liquidity risk should the market face a true, prolonged downdraft. In 2019, defaults in the U.S. leveraged loan space are approaching $30B. In October and November, defaults are nearly $10B, that’s about 40% of last year’s total in JUST two months.

Fitch Problem Loans of Concern Index

November: $112B / 8% of the market
July: $71B / 5% of the market
January: $71B / 5% of the market

*Fitch Leveraged Loan data, defaults spike to the highest level in 2 years, forecast year-end 2020 retail and energy default rates at 8% and 13%, respectively. A five-year-old can tell you the rating agencies are the last to get the joke in any default cycle.  Looking back over the last 70 years, credit cycles are littered with embarrassing flashes of rating agencies playing catch up on defaults. Hence, if the Fitch “problem loan” basket is up to $112B, it’s safe to assume that the number is substantially higher in reality.

Cash vs. Low Quality “B” Holdings

To assess the risk for redemption fails, we looked at two key measures for the top 10 leveraged loan funds (about $60B in total). Specifically, pay attention to the percentage of holdings of Single-B rated and below assets and the percentage of cash held by the fund (cash being a proxy for the ability to meet a spike in redemptions).

Houdini Liquidity, now You See it Now You Don’t
As the chart above shows, most funds have over 60% invested in single-B and lower-rated assets, yet typically have cash positions at just 5% on average. One fund held only 0.32% in cash and yet had over 70% in single-B and below assets. In a prolonged sell-off, the 5% cash would likely prove grossly inadequate in the face of reduced overall market liquidity, lengthening settle times and a spike in redemptions. In a severe downturn, it’s likely that a significant percentage of the loans would be downgraded to CCC, rendering sale much more difficult and all the while prices likely would be collapsing.

Cash Shortfall, Implications

While some funds may supplement cash liquidity with access to a line of credit and/or holdings in more liquid bonds, it’s not clear either of these would be sufficient. Lines-of-credit may not be available when needed and even if they are drawn they may create a senior claim on the remaining assets thereby amplifying risk for those who remain in the funds.

Credit Leads Equities
The Blackstone GSO credit fund is loaded with lower quality (B rated) leveraged loans. It’s interesting with stocks ripping to new highs, B rated loans are under meaningful selling pressure as downgrades mount. If credit is weakening at this pace with a U.S. economy near full employment, what will happen when stresses mount?

Redemption Risk isn’t Theoretical

There is a history both during the financial crisis and more recently of funds having to freeze redemptions due to lack of asset liquidity (most recently the Neil Woodford managed funds in the UK). In fact, in 2015 the Third Avenue Focused leveraged loan fund collapsed amidst a flood of redemptions.

Finally, cascading redemption freezes would likely reverberate through the entire leveraged loan markets including CLOs which would face greater difficulty in trading distressed loans and a deterioration in recoveries.

Rod Dubitsky has over 30 years of experience in the financial services and global development sectors.  Founder of The People’s Economist (TPE).  The bulk of his career had been spent in financial services working for rating agencies, wall street dealers, banks and money managers developing a range of market-leading, award-winning research, and analytical platforms. Frequently quoted in the media including Time Magazine, Forbes, NY Times, WSJ, FT, and Bloomberg.  While working in finance, he was a top-ranked analyst for Credit Suisse in the consumer ABS finance sector and led the newly create advisory analytics division for PIMCO with responsibility for overseeing some of the largest post-financial crisis bailout consulting engagements.

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