Trading and Consultants

“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

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“I’m not saying consultants are inherently evil or anything like that (laugh in the audience, sarcasm), but… 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 for the mistakes along the way and pick one’s self up off the ground, dust one’s self off. Without that process, there is very little real learning.”

Steve Jobs on “Consultants”

When you are training someone to be a trader, at a certain point you can’t hover over every trade. You have to give the trainee space to “get into the zone”, as they say, to feel, independently and assertively, a profitable transaction rhythm. It’s hard to describe until you have experienced it, but it is clearly focused yet at the same time semiconscious. It’s exciting for a newbie, and of course, that is why it usually ends in a risk position error, which is fine, because you want both the success and its devolution into failure to happen, within bounds you have created, as part of the training. This is the key question you must ask the trainee after the close: why do you have the position on? Usually, the response is incoherent, self-contradictory babble, which you need to patiently and calmly organize in the trainee’s brain. Easier said than done! But sometimes a wise-punk will say: “Because the people who hit my bid are idiots! They don’t understand that…” This is where you blow up and yell in the most violent terms, not because you are actually upset, if you have half a brain the capital allocate is trivial, but so that the arrogance in your pupil receives a flaming arrow in the forehead never to be forgotten. The sellers may be stupid, but so what? But above all, hubris will bring the downfall of any new trader. The beast inside the market will at some point humiliate all of us. So stay humble, learn, and grow.

“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

Round Numbers

There is something about round numbers that make traders want to sell. Sometimes it’s just a four-hour pause that won’t even show up on a daily chart. Sometimes it provides days, weeks, even several months of resistance before the round number is superseded. Sometimes it will traverse the round number but refuse to close across it for the longest time. Of course, sometimes the round number has no trading significance at all. But it happens often enough, and dramatically enough, that often the only common-sense reason for the selling is simply because it is a nice, fat, obvious round number. Now, it happens too, that days after the failure at the round number, some actually bad news does come out. And, people being people, traders will say, “Aha! So that’s why there was selling there!”, and occasionally they might even be right, but more often than not the retrospect is false since the news didn’t even begin to develop until after the profit-taking. Sometimes round numbers are convenient price targets and people take profits there out of mental efficiencies. The most common phenomenon is for two more attempts over a period of time before finally overcoming the number. Not a law, just a guideline

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It’s Time for Thought Leadership on the US Dollar

“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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It’s Time for Thought Leadership on the US Dollar
Updated Friday, July 31, 2020, at 4:30 pm ET.

Commodities: Month over Month

Silver +33.3%
Gold +11.1%
Platinum +8.9%
Nickel +7.2%
Copper +7.1%
Palladium +6.3%
Zinc +6.0%
Lead +5.2%
Aluminum +5.1%
Cobalt +2.4%

The weak dollar has been commodities’ best friend over the last month. Late Friday CFTC data shows, short bets on the U.S. dollar are now the HIGHEST since 2011. *UNITED STATES OUTLOOK REVISED TO NEGATIVE FROM STABLE BY FITCH. *THE DOLLAR IS ON TRACK TO POST ITS BIGGEST MONTHLY DROP IN A DECADE (Bloomberg headlines, not ours).

World’s Reserve Currency?

Looking down the road ahead, the best way to dig into the most telling questions is to simply ask them. So here we go. Is the U.S. dollar on the road to losing its “World’s Reserve Currency” status? It’s time for thought leadership on the greenback. This narrative is getting louder by the week, we must listen. First, the VERY fact that we’re asking these questions below in this matter, speaks to just how oversold the greenback is.

How Oversold is the USD?
Dollar bulls have run for the hills at the second most fierce pace in the last seven years. See our bullish view on the metals sector here. 

Fifteen Questions for the US Dollar

USA’s banking system, economy, and foreign policy are based on the US dollar’s reserve currency status. 1) What are the odds of the US dollar losing its reserve currency status? 2) If it were to happen, what are the ways it could happen? 3) If it happened, how exactly would the US banking system be hurt? 4) What industries would be hurt the most? How would it impact the overall US economy? 5) How would it weaken our ability to achieve our foreign policy goals? 6) On the other hand, how would it hurt China’s export economy and banking system and Belt and Road global domination policy? 7) Is the best way to crush China’s plan for global dominance to crush the dollar? (making china exports to the USA a lot more expensive) 8) Does a blasted dollar make foreign governments more dependent on US military hardware as it becomes cheaper in local currencies? 9) Does the benefit to US exports of hard goods generally outweigh the lowering of foreign demand for US financial assets? 10) Is it possible to have an export boom and a weaker financial system? 11) Does the rise in exports help the banks weather the US dollar no longer being the world’s reserve currency? 12) Does the loss of the US dollar’s reserve currency status not merely hurt the US economy in short term transition but save it in new long term stability? 13) Is a US dollar reserve status even a good idea for global long term stability, short term transition pain aside? 14) How much does a weak dollar feed positive economic activity globally, and what’s the positive feedback to the USA supporting US exports? 15) How much does the Fed want a weaker dollar? They turned every world government bond market into USD to prove that (see aggressive use of swap lines).

High Capitulation
In the US, fiscal stimulus was supposed to struggle to cap the revenue drop caused by the unprecedented nature of this crisis. To an extent, it has, but what this narrative missed in a distributional sense is, the policy response to deflationary shocks has changed. The government sends out money and the central bank does open-ended QE. Does this mean future growth is promised, no, but it does change the recession landscape in terms of size and duration? Long-drawn out deflationary episodes have to be repriced as we seem to have a better recipe for dealing with them as opposed to 2008.

The Global Wrecking Ball Arrested

1. March – April: Fed expands repo / swap lines, attempts to arrest the global wrecking ball, which is the US Dollar.

2. DXY Dollar index historic plunge, free’s up financial conditions globally.

3. The Rest of the World (RoW) economies get a boost.

Dollar credit to non-bank borrowers outside the US rose to $12.6 trillion at end-March 2020. Bank loans grew at their fastest in 5 years and debt securities issuance stayed high amid COVID, BIS data.  The component of this credit directed to emerging market and developing economies (EMDEs) expanded at an annual rate of 6% (reaching $3.9 trillion)

Global Dollar Funding Winners – Transports
Looking back at the last 5 years’ price action in the US dollar – it’s another example of the enormous power the Fed has over the global economy. How was the Fed going to downstream dollars to EM corporates and Asian non-banks, two huge users of dollar funding? And then from there, was there really going to be a change in global growth composition that would change the world of US asset outperformance continuing in perpetuity? Would previously frugal surplus countries step up with ambitious fiscal plans that would not only plug the COVID hole but transcend the current crisis and serve as an economic accelerant going forward? The immediate answer to a lot of these questions was, the most probable outcome is no, but the market traded the skew and that’s where we are today.

DXY Dollar Index Parallelogram
A clear down parallelogram was formed as a result of March high into the June low. Subsequently, it broke through the bottom line of the parallelogram, which sets up an early resolution, i.e. it sets up an early test of the apex price point. If that fails, it is in free fall.

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A Dedication to Christine Daley, 1958-2020

Christine Daley was a beautiful person, a unique and rare talent. She will be missed by so many, on and off Wall St. Through the years, there are those moments when someone touches you in a profound and special way, changes your life forever. That’s what Christine meant to me.  Nearly everything I know about distressed investing came out of those long, passion-filled discussions with Christine. I am crushed but so grateful for all the good times, the inspiration, and to have been blessed with such an amazing friend. – LGM

Excerpt from the New York Times bestseller, “A Colossal Failure of Common Sense” – Now published in 12 languages.

My opening day was spent meeting and spending time with our most important research analysts with whom I would be in constant touch. The first was Christine Daley, who was in her thirties at the time and head of distressed-debt research. Christine was a vulture’s vulture and Lehman’s finest. They say she could tell you to the penny what General Motors was worth at any given moment in the week, even in the auto giant’s darkest days—particularly in the auto giant’s darkest days. Christine was a beautiful, slim, immaculately dressed Italian-American.  She was watchful and very skillfully set out to find out precisely what I knew. It was crystal clear, her trust would NOT come easily, it would have to be earned in the months and years to come. And she had a towering reputation as a researcher who could slice and dice any big corporation and swiftly come up with an eye-watering correct valuation. A true Hall-of-Famer in the U.S. distressed investing universe. From hedge fund to hedge fund, asset manager to asset manager, everyone had the highest respect for Christine, she was that special. Unsurprisingly, she had graduated magna cum laude from the College of New Rochelle with departmental honors in all semesters. At New York University Stern School of Business, she graduated number one in her class, which was doubtless no shock to anyone.

Especially Christine Daley, for it was she who administered my first serious test of character and knowledge in the first week of my employment at Lehman. The subject was one of the largest energy producers in the United States, the wholesale electricity giant Calpine, out of San Jose, California. At their peak, they owned almost a hundred gas turbines and power plants in twenty-one states, with natural gas fields and pipelines in the Sacramento Valley and 22,000 megawatts of capacity. Calpine ranked among the world’s top ten electricity producers, with assets worth billions and billions. They did, however, have one serious problem. Christine Daley, our iron-souled Lehman researcher, thought they would almost certainly go bust, and she was recommending we take a massive short position in this company. That took a lot of guts, because Calpine’s creed of clean energy—the cleanest possible energy, turbines off which you could eat your lunch, emissions from which spring flowers would sprout, electricity so pure and spotless it would safely caress a newborn child—made it beloved among investors. “Bullshit,” said Christine inelegantly. “They’re going down. That CFO of theirs could dance through raindrops without getting wet.” (Calpine would file Chapter 11, bankruptcy protection a year later).

Serial Convertible Bond Issuers

Chesapeake Energy*
iStar Financial*
Fannie Freddie*
Six Flags*

*Filed Chapter 11

Bloomberg data

Anyhow, to return to my first major meeting, we sat together, and in the first five seconds, I understood why I was there. She knew all about my background in convertible bonds. She knew about the sale of to Morgan Stanley, a game-changer for my career (Steve Seefeld and I founded the company in 1997).  Calpine had loads of convertible debt and Christine understood the capital structure better than anyone on the planet. Instantly, her skepticism toward this darling of the investment world was loud and clear. “What do you know about them?” she asked. “And what do you think about Bob Kelly, the CFO?” I told her I knew two major facts. They had one hell of a debt load, a lot of it was convertible. They were a serial issuer of this flavored bond, a classic warning sign indeed. Over the last 30 years, companies issuing more than one convertible bond in a three year period – filed bankruptcy protection in over 85% of the time, our research showed. I’d never been entirely convinced about Calpine, and in turn, she questioned me about who would get paid, and when, upon the bonds’ maturity. She wanted to know if Calpine could settle their convertible preferred shares for cash, or whether they could just box their way out and issue more shares. We spoke of the convertible preferred stockholders—the guys who stand one-tier higher than equity in the corporate capital structure.

Trying my hardest to impress this high Queen of U.S. distressed investing, I utilized the finest Wall Street jargon, stressing that each one of the convertible preferreds had a different delta and a different gamma. I will not easily forget the speed with which she cut me off in midsentence. “Never mind that mumbo jumbo,” she snapped. “I am concerned with what the company can do to defer paying the dividends and defer their obligations to repay these preferred shareholders because I can see a big fight developing right here.” “What kind of fight?” I asked, a bit lamely. “The kind that starts when the preferred shareholders are senior to about $19 billion worth of debt, some secured, some unsecured,” she replied. “That kind.” “Because the convertible preferred stock matures well before the debt, right? Kind of seniority by maturity,” I said. “Exactly,” she agreed. “But I think the bank debtors will organize, hire some hotshot lawyer, and stage a battle in a courtroom, try to force Bob Kelly’s hand, force him to cram down the preferred stockholders, while the bankers grab what there is of Calpine’s assets.”

“That would be a dividend roadblock, stopping all payments to the preferreds that mature in the next two years.”  Correct I thought. They’d all lose out to the banks. Christine Daley was as sure of her ground as anyone I’d ever met. She was convinced the cash flow of Calpine was nothing like good enough to support the gigantic debt the corporation carried. She knew there were bonds all over the place, many of them in different parts of the capital structure. There were first-lien and second-lien bank debt, senior secured notes, and a ton of unsecured straight debts. The last in line for repayment were three different convertible preferred debts.

In Christine Daley’s opinion, Calpine was constantly robbing Peter to pay Paul, and constantly pushing the legal envelope, ducking and diving around the covenants that governed the financial structure of their debt. The entire corporation was structured to confuse the life out of the analysts as the company moved money from place to place, trying to stay solvent. Our equity department at Lehman had fallen in love with the company, they were long millions of shares and it was now my job to get them OUT of this colossal piece of risk. In each meeting, their excitement, bullish posture grew. Christine did not buy it. The distressed (debt) and high yield fixed income departments despised Calpine, while it was a darling of the equity desk. What a mess. I could see she cared passionately, “we MUST convince those guys to sell, and sell quickly,” she said. (Within a few months everyone was on the same page, short, thanks to Christine).

The look in her eyes was one of pure defiance, and it was backed by a laser beam of logic from which she could not be deviated from. Christine was determined to persuade Lehman Brothers to take a huge short position. I thought of the massed ranks of lawyers and smart-ass execs who must be lined up against her, this one voice of profound certainty that stood alone against them.“ Calpine cannot last a year,” she said as I was leaving. “And we are going to make millions of dollars watching them go bankrupt. It’s just a hall of mirrors. Trust me, they’re already broke.” “I’m with you all the way,” I told her. “I always thought they were suspect. Which is why I never traded their bonds on the long side, just short.” But she needed no encouragement. I never heard anyone express a corporation’s forthcoming woes better than Christine. You don’t often meet a soothsayer with an AK-47. As I walked away from her desk, back to my own space on the trading desk, I pondered that Calpine scenario. It was, of course, the oldest trick in the corporate playbook, building a vast network of separate components, corporations with different identities, and moving cash between them.

One (power) plant needs a few million, so you get it from another, pay it out, then pay it back from somewhere else. It’s a process that can go on for years, removing the money and making big transfers all over the place, until no one knows where the money is, where it came from, where it went, or even whether it’s real. All the while firms like Calpine would keep coming to Wall Street and issuing more debt, the bankers loved them. Christine knew “real” when she saw it. And among all of that vast sea of numbers that made up Calpine’s introverted/extroverted, hot/cold, now-you-see-it-now-you-don’t balance sheet, only two mattered to her: her own year-end prediction of $650 million of Calpine EBITDA (earnings before interest, taxes, depreciation, and amortization) versus a truly daunting debt load of $18.5 billion.“ They have only one real chance,” she had told me. “They’ll have to trip at least one of those bond covenants. They don’t have any choice.”It should be remembered that the end of 2004 was a very rosy time for the fixed-income markets. And for Christine Daley to come out and predict a major bankruptcy in a healthy market and economy was, I thought, an act of supreme daring and high confidence. Also, she was vocal in her views. Her faith and resolve knew no bounds. She knew, of course, that Calpine was continually coming to the convertible market with bond after bond, 6 percent converts—the Last Chance Saloon for an outfit trying to get their hands on heavy capital.

They were always trying to convince one of their largest bondholders, the gutsy Ed Perks of Franklin Mutual Funds, to lend them even more money through those convertible bonds. That probably the soundest way out when you have mounting operating costs, a debt mountain with rising interest expenses, and falling earnings. Meanwhile, out on the Street, there was no letup in the lovefest for Calpine stocks and bonds. For cynics like Christine and me, it seemed nothing short of a cult following, with wide-eyed investors eager to play their part in the world’s cleanest industrial energy program. We could see them rushing to the colors of the green flag with missionary, idealistic zeal. Oh, to be a part of the least-polluting, the newest fleet of gas turbine plants in the world. Oh, to repair that shuddering hole in the ozone layer, re-ice the Arctic, stem the warming tides, save the stranded polar bears, replant the rainforest … Mayday! Mayday! Save our planet! Of course, Christine Daley and I knew it should have been save our ship, not save our planet because the green ship Calpine was holed below the waterline.

For mayday read payday—for the Calpine directors, that is. Not for the preferred stockholders, who were about to get crunched by the banks. As were the holders of Calpine equities. The only interested party likely to come out of this laughing was Lehman Brothers because they had Christine Daley and they were listening to her. Go sport, baby, go short, in the biggest possible way. Of course, back in Calpine’s headquarters in San Jose the name Christine Daley was not universally loved. Wall Street has one of the most sensitive radar systems in the world. The network is a 24/7 communications sprawl into which every single member of the finance industry is, on some level, tuned. Christine, conducting her traditional scorched-earth policy while researching critical information, spoke to many, many important people. I am sure they asked her advice, I am equally sure people asked her about any new bond that had just been issued by Calpine. And these people were often clients of Lehman brothers. Christine was honor-bound to provide them with an honest assessment. I am sure that for many months she turned people off Calpine, shared with them her fears that this giant archipelago of power plants carried too much debt to be considered a buy, either shares or bonds. In sunlit San Jose, I have no doubt she was regarded as the Princess of darkness. They did not, I hasten to add, believe she was treating them unfairly because they knew the score as well as she did. Christine was the Wall Streetsleuth who had them nailed. After that first meeting with her, I wondered just how many people around there knew as much as she did.

Lehman Brothers’ distressed and convertible securities departments would end up making over $190 million dollars short Calpine debt and equity, all thanks to the conviction and passion of Christine Daley.



The Cobra Effect

“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

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This is a really important read and expresses our look down the road ahead. Some commodities in the metals space are up more than 20% this month, what gives? Let us explore.

Bloomberg July 24, 2020

Breaking: Silver futures currently on pace to settle 18% higher in three sessions. If that holds, it’ll be the fourth time that’s happened since 1975 and the second time it’s happened in 2020. 

Bespoke July 22, 2020

A Bear Traps Report Excerpt – The Power of the Cobra Effect

Anthropologist Marilyn Strathern paraphrased an observation from British economist Charles Goodhart thusly: “When a measure becomes a target, it ceases to be a good measure.” According to this thinking, a change in inflation from a “measure” to a “target” destroys the informational content value of reported inflation statistics over time. Because the Fed has targeted inflation, reported inflation numbers have become more and more useless in recent years. This, oh by the way – has placed the bond market into a deep sleep. A corollary to this development is found when a policy is anticipated, then the markets subvert it. What’s more, last week’s Fedspeak (Brainard, Harker public speeches) was focused on the topic of a far more aggressive inflation policy path coming from the Federal Reserve. Keep in mind, this was a first and rare public admission that they’ve had it (plain 2% inflation targeting) wrong all along. A shift in the traditional interpretation of the dual mandate is near.** Think of a Fed with an eye on driving policy with a much higher level of heat. The new belief? There will be gains for marginalized workers which will accelerate at very low levels of rates. Think of it as a formal Phillips Curve funeral, complete with trillions of green, dollar shaped roses showered all across the casket. They’re all in the Larry Summer foxhole now, “we must NOT hike rates until we see the white’s of inflations eyes.” As we observed in June, the Fed most certainly will rollout a formal inflation targeting change in the coming months. It’s traditional forward guidance with an inflation-targeting kicker, a game-changer for asset prices. The large move in silver over the last 30 days (nearly 25%), is telling us as much. See our bullish note on the commodities sector here. 

**Inequality’s revenge. The Fed has been a LOUD, growing public target on the inequality front, and THEY SHOULD BE. The solution?  Think of a FAR more “social-justice” focused Fed.  As part of the dual mandate, additional targeting focused on helping marginal/minority workers in the Fed’s revamped policy review. “Modern monetary theory” MMT with social muscle sounds dangerous? We shall see.

Up from the March Lows

Silver Miners SIL: 178%
Brent: +174%
Gold Miners GDX: +152%
Silver: +96%
Oil Stocks XLE: +67%
Nasdaq: +64%
Copper: +51%
Dow Transports: +51%
Russell 2000: +55%
S&P 500: +49%
Gold: +28%

Bloomberg data.

Metals: Investors poured money into precious firms equity offerings. This could be an ‘incredible bull market for gold / silver equities’ – A year ago, you couldn’t get Wall Street to touch most gold miners’ stocks. Today, it’s throwing billions at the industry. Precious-metals miners once seen as too leveraged and high-risk for the typical investor raised $2.4 billion in secondary equity offerings during the second quarter, data compiled by Bloomberg show. That’s the most since 2013 and seven times more than the funds they raised a year earlier.

MMT Overdose, Monetary and Fiscal Engines

Goodhart’s Law grew from monetary policy issues in the mid-1970s. As he put it: ‘Any observed statistical regularity will tend to collapse once the pressure is placed upon it for control purposes.’ It became the primary intellectual counterpoint to the Thatcher regime’s use of broad and narrow money targets in its monetary policy conduct. Today, if we apply it to current monetary and fiscal policy, we should infer that since money is being created and disbursed based upon past relationships between money and GDP, in fact, the longer we continue on the current policy mix, the less of a normal relationship there will be between money and GDP, which is the precise opposite of current consensus.

From Campbell to Goodhart 

Goodhart’s Law grew out of Campbell’s Law, which states: “The more any quantitative social indicator is used for social decision making, the more subject it will be to corruption pressures and the more apt it will be to distort and corrupt the social processes it is intended to monitor.” Applying this law to the current governmental approach, we predict the current capital disbursements from the Treasury and Fed are destroying the relationship between capital and labor, as well as between the profit motive and capital formation. There is no more creative destruction. There is merely gaming the system.

Dollar Taking at Beating at the Hands of the Yen (Japan)
Has the Japanese yen become the world’s risk-off currency? Hard to process a $4 to $5 trillion federal deficit under a Republican Administration without concluding that either inflation is around the corner of the dollar is going to substantially weaken or most likely both. Some feel a blue-wave will lead to even more MMT experiments (modern monetary theory)?

The Cobra Effect

Campbell’s Law is in turn an example of the “Cobra Effect,” which highlights the unintended negative consequences of public policy and government intervention in economics. The Cobra Effect is when the solution to a problem makes the problem worse, specifically by incorrectly stimulating an economy. All of this has rendered incoming economic data relatively meaningless in 2020. The utility value today of an economist is far less than it was just 18 months ago, the data has become far too erratic with little predictive value.

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The Cobra Effect comes from a story from the British rule of India. Once upon a time, there were too many cobras in Delhi. So a bounty was offered for each dead cobra delivered. This proved initially successful, until, that is, entrepreneurs began breeding cobras for the income. Once the British authorities were aware of this unforeseen consequence, they stopped the program. So the breeders released their inventory, resulting in a larger cobra population than before the bounty was initiated. Hell hath no fury as a Cobra breeder scorned!

Inflation Expectations Surge
Real bond yields are plunging. Say you’re a billionaire in the middle-east with loads of short-term treasuries. Your return on investment, after inflation expectations, is paltry. What can you do? Buy commodities as a hedge, insurance. The TRUE cost of capital has never been this distorted. We now have $110T of debt on earth < 1.50% in yield, up from $35T in 2018. Inflation expectations rising with bond yields artificially suppressed by central bankers is a potentially toxic cocktail. When you do NOT allow the cleansing process of the business cycle to function over longer and longer and longer periods of time, there are two primary outcomes. 1) You create a proliferation of bad actors. Just picture 1000 Bernie Madoffs running around the Hamptons from one beach party to the next.  2) More and more money is searching for a “safe” new home. On earth today, there’s a lot more capital in the convexity risk zone, for sure. As more and more capital is sitting in places with an artificially suppressed cost of capital, return on investment – the potential wealth destruction becomes larger and larger if something goes wrong. “Don’t fight the Fed” in February, became trillions lost in March 2020.

After Years of Putting Up the Austerity Fight – The Iron Chancellor Caves

We believe we are at the early stage of the biggest Cobra Effect in the history of economics. As the massive monetary and massive fiscal stimuli (over $15T globally) conjoin to save the economy from a deflationary depression, they will cause instead a hyperinflationary economic collapse. If the government becomes aware of this beforehand and withdraws current policies, then indeed a deflationary depression will follow, but one much more severe than if the government had done nothing. How far has the world turned in twelve months? The “Iron Chancellor” in Angela Merkel has formally capitulated this week, agreeing to issue common debt on a large scale. We’ve gone from a “black zero” – Germany’s austerity obsession, over to fiscal handouts to mathematically unsustainable debtors in the periphery. Somewhere Alexis Tsipras (Greece’s Syriza) and Dick Fuld (Lehman) are into their 4th bottle of burgundy wondering why they were born twelve years too early. They were dealt a far different austerity and moral hazard sword, one that doesn’t exist on planet earth today. On the fall of Lehman, in our New York Times bestseller – now published in 12 languages – we end the book with the words, “it didn’t have to happen.”

 Gaming the System

Returning to Goodhart’s Law, we note that any system can be gamed, as Jerome Ravetz’s research has shown, especially if the goals are complex. Essentially, those who are most capable of implementing a complex task, do so to their own benefit and thus to the detriment of the task. When these goals are quantified, used as a measure, and targeted, we have Goodhart’s Law.

Real Yields and Gold – Bonds Driving the Bus
The gold bugs have been lost for decades, precious metals have always been a game played on the fixed income field. Just take a look at 5-year U.S. Treasuries, after inflation your yield is -1.17%, that’s well on its way to a ten-year low – pure precious metals afterburner fuel.

“If I had to bet my life on higher or lower inflation, I’d bet a lot higher.”

Warren Buffett, Berkshire Annual Meeting, May 2018

Lucas Critique and Unintended Consequences 

This leads directly to the “Lucas Critique” on macro-economic policy when it is based purely on observed historical aggregated data. The basic idea of the Lucas Critique is that the consumption function used in Keynesian models cannot be structural (i.e. invariant) because they vary too much under pressure from government policy, which is to say, the relationship between consumption and disposable income varies according to many different stressors, and is much complex and difficult to predict than in standard neo-Keynesian models. In other words, if you change the rules of the macro-game, the structure you assumed wouldn’t change, in fact, does change, thereby destroying predicted outcomes. The Lucas Critique led directly to an increased focus on micro-economics. We may thus be assured of one thing, whatever the Fed and the Executive and the Legislature are doing, will have massive unintended consequences that are simply unimaginable.

In essence, our thesis is that Goodhart’s Law, Campbell’s Law, and the Lucas Critique are all being ignored by those implementing current monetary and fiscal policies. Basic economic assumptions, or structures, will turn out to be much more fluid than policymakers can anticipate. Therefore the results will be disastrous and unimaginable, we’ll survive and thrive after the adjustment process for sure. Assumptions on how markets work are derived from a shattered past. All predictions derived from the past are meaningless at best, counterproductive at worst.

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Gaming the S&P 500 Inclusion Process

“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

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Breaking: TESLA GAAP income was $104MM. This means that without a record $421MM in regulatory credit sales it would have negative GAAP earnings… – ZH
The Big Day

Our view on ‘Earnings” as of 6 pm ET, July 22, 2020

Warning: Tesla appears to be “selling” regulatory credits based on cars they may not have yet sold to people who have not paid for them. They gave a fresh, weird explanation for accounts receivable. The quarter is a conjured profit to get in the S&P (no surprise there).

This is the TSLA accounting disclosure: “We recognize revenue on the sale of automotive regulatory credits at the time control of the regulatory credits is transferred to the purchasing party as automotive revenue in the consolidated statement of operations.”

Our Conclusion on S&P 500 Inclusion

One question. How on earth can the committee at S&P, vote to include Tesla at this point in time?  Such a declaration would be built on the basis of the last twelve months “earnings” in the red to the tune of $675m to $685m.  After we exclude the EV credit sales, there is NO there, there. Even Tesla’s CFO says; “we don’t manage the business with the assumption that regulatory credits will contribute in a significant way in the future.”

In summary, S&P 500 inclusion needs the sum over the past 4 quarters to be profitable on a GAAP EPS basis, with the most recent quarter being profitable as well, thus TSLA has NEVER been in the index.

A Dramatization

Translation: “Recognize revenue… at the time control… is transferred to the purchasing party”

Hello: “Hey FCA CFO – this is Frenchy over at Tesla. Do you understand that pooling arrangement? I’m passing control of those credits now to you over to the second half of the year. Relax, you will NOT have to make payment at this point. On our end, we will place this in the accounts receivable accrual process. With our multi-year contract, it won’t impact you one bit.”

They admitted it’s all in accounts receivable. Smells like a fraud???

Tesla reported Wednesday, July 22 after the close. The implied move (↑↓) on the earnings – as priced by the options market – was ~20%.

**For our previous report on gaming the S&P 500 index inclusion process, see our post here. 

Credit Markets Are Sending a Message to Mr. Musk
This is remarkable data, Tesla’s five-year bonds are yielding nearly 400bps more than their possible market capitalization neighbors in the S&P 500.

A $30B Bid?

Tesla more than a week ago reported that Q2 deliveries totaled 90.6K, strongly beating consensus of 70.3K. In a recent email, Musk told employees “breaking even is looking super tight,” seemingly suggesting a substantially greater outcome in 2Q than the loss many analysts were looking for. Musk can inflate these results with one-time items such as ZEV credit sales or releasing deferred revenue associated with autonomous driving features. He’s done that before and he has every reason to do so now. If Q2 is profitable, TSLA is eligible to enter the S&P. On our calculations, funds tracking this bellwether index would then need to buy $30bl of TSLA stock (see calculation below).

Note that Wall St is still expecting a modest non-GAAP loss of 22 cents and a GAAP loss of $1.8.

Free Float and Influence

*Buying pressure from S&P inclusion: There is approximately $3.9Tr of pure index capital following the S&P 500. These are mostly index funds, including ETFs and mutual funds that mimic the S&P. TSLA market cap is $278bl but Musk owns 18.4% of the stock. The free-float market cap is therefore $220bl. Base on the S&P 500 market value of 27.8TR that means TSLA should get a 0.8% weight in the S&P. This implying $30bl of buying power from index buyers. Note that every $100 on TSLA stock price means $3bl additional buying power from index trackers and vice versa.

The Musk Payday

Musk’s big payday: Based on the 2018 performance award program, TSLA has achieved its 3rd milestone needed to unlock the first of the twelve tranches of stock option awards to Musk. The first tranch unlocks if TSLA has a market cap of $100bl for 6 months (and sales/EBITDA milestones) and allows Musk to buy 1.7ml shares at $350 p.s. That means he locks in a cool $1.8bl. The caveat being that Musk would need to hold these shares for 5 years.

The Great Front-Run

In summary, S&P 500 inclusion needs the sum over the past 4 quarters to be profitable on a GAAP EPS basis, with the most recent quarter being profitable as well, thus TSLA has NEVER been in the index. After years of consistent negative EPS prints, starting in Q3 2019 Tesla began reporting positive EPS. The past 3 quarters have now been positive, meaning if this quarter is also positive (sum of past 4 positive + most recent positive), Tesla will be eligible for S&P 500 index inclusion. Keep in mind, even if they post a small loss, the company could still be eligible next quarter if they report positive EPS and the sum of the previous 4 quarters is positive. With a total enterprise value now close to $300B, and Tesla reports on July 22., people are betting the people at S&P are eager to add. By buying up the stock now, speculators are forcing the S&P to give the stock a higher and higher weighting. Thus, ETFs / Indexes will be forced to pay up, buying even more shares. Then the hot money exits, leaving indexes holding the bag.

The Facebook Lessons

S&P 500 Index Committee; all members are full-time professional members of S&P Dow Jones Indices’ staff. The committee meets monthly. At each meeting the Index Committee reviews pending corporate actions that may affect index constituents, statistics comparing the composition of the indices to the market, companies that are being considered as candidates for addition to an index, and any significant market events. Facebook $FB – S&P published its decision on Dec 11, 2013, front-runners pushed the stock 140% higher from June into the big day. $FB was eligible for several months to enter that index the Committee passed over $FB at several meetings until deciding to include the company.

Facebook $FB vs. Tesla $TSLA

IPO Date: May 2012 vs. June 2010
S&P Entry: Dec 2013 vs. ???
Market Cap on Entry: $150B vs. $300B?

In Conclusion, Three Key Points, July 20, 2020

1.       They will almost certainly make a profit.  Last year they lost $400 MM in Q2.  This year they sold almost exactly the same number of cars.  They sold them at lower prices.  They operated two car factories instead of one, which drives up fixed costs.  There is no reason they should genuinely do better this year than last.  But, since we are all willing to be blind to this obvious book cooking, they will, for sure, announce a profit.

2.       Eligibility in the S&P does not equal inclusion.  TSLA stock is up many billions of dollars on the most widely discussed catalyst (S&P inclusion).  It’s up to the committee to decide whether the millions of investors who have chosen to index will be forced to sell 499 other stocks to make room for TSLA.  Even if they don’t believe its fraud, they may understand that they are being gamed.  They may add it right away…or they may take a wait and see.  Tough spot for them.

3.       There is something called “completion funds” which own all the stocks, not in the index.  There is a ton of money in these, as well.  Due to TSLA’s outsized market cap, it is by far the largest component of completions funds.  The completion funds will have to sell TSLA when it gets added to the index.  This will offset a great deal of the index buying power.

Josh Brown and Larry McDonald Break it Down
See our video analysis here.

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Leadership Failure, Sending a Message

“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.

Email to get on our live Bloomberg chat over the terminal, institutional investors only please, it’s a real value add.

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Tremors Before the Quake

At close to 7% off this month’s sky highs, U.S. equity market leadership found in Microsoft is fleeting. Trading at nearly 12x sales, MSFT investors have started to rotate out of big tech this week. The insanity of paying 12x sales for large-cap stocks speaks to the greater fool theory. You really need the next guy to come in and lift you out of your shares at an even higher price. At nosebleed valuations, that’s your ultimate investment philosophy. After founding Sun Microsystems in 1982, years later Scott McNealy once said, “At 10x revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years and dividends. That assumes; shareholders approve, zero-cost goods sold, zero expenses, no taxes, zero R&D, + we maintain the current revenue growth run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency, any footnotes. What were you thinking?”

“If everyone is thinking alike, then someone is NOT thinking.”

General George S. Patton

Size Matters

It’s now very close to 40% of the S&P 500, yes BIG TECH. Looking back, the only other sectors to ever position themselves even remotely close to this lofty level is Energy** at 29% in December of 1980, and Financials*** at 28% in 2007. We know what happened next to those two sectors. Beware, the inmates are running the asylum.

**Exxon $XOM lost 45% 1980-1982
***JP Morgan $JPM lost 74% 2007-2009

Microsoft Earnings Come Wednesday

Wall St.’s collection of brain trusts just love Microsoft MSFT, they’re falling all over themselves to upgrade the stock. With the energy of a mad mob, thirty-six analysts cover Microsoft equity; 32 “buys” vs. 4 “holds” and ZERO sells. Of course, when MSFT was on sale in March-April we heard crickets from this crowd, they were too focused on the “great depression.” Today, they’re in a better mood, expectations for MSFT’s sales growth are up at 8%, near $37B, with earnings per share close to $1.40. The situation is much like the analysts’ former darling, Exxon $XOM. In the summer of 2014, the stock was priced for absolute perfection. There wasn’t a bear to be found across all the Wall St. banks -then shares lost 71% of their value. By now, who doesn’t know Microsoft’s cloud portfolio products are clear beneficiaries in the “work from home” boom? The Information points out, “In this quarter, it is worth watching the rate of growth for Microsoft’s Slack-killer product, Teams, which saw surging usage in the March quarter. A related question is whether people are taking advantage of Teams’ video function, which competes with Zoom. And will Microsoft executives talk about their success in dealing with capacity shortages in their cloud business?”

Memories of 2011

Of course, back in 2011 when the stock traded at 12x earnings (vs. 36x today) and sported a healthy 4% dividend yield (vs. 1% today), the Street was all beared up on Microsoft at $28, comedy.  Keep in mind, from 1999 to 2016, the stock was unched – bulls were hard to come by. In Q1 2002, it looked like Microsoft was on a comeback, the stock rallied to $35 and the Wall St. upgrades came rushing in, by September of that year the shares were down to $21. They wouldn’t see $35 again until 2007, but by the end of 2008, the shares were back down at $15. The stock goes on sale a lot, don’t chase.

Microsoft MSFT From the Lows

Mar 2020 Lows +63%
Dec 2018 Lows +130%
Feb 2016 Lows +350%
Mar 2009 Lows +1354%

Love this Quote

“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

Major Trend-Break Alert – Microsoft
Microsoft, very quietly lost $100B this week. On Friday, MSFT equity closed BELOW its March 2020 trendline, a VERY bearish signal for BIG Tech. When leadership acts poorly, lookout.

Passive Overdose

ETFs now hold nearly $5T up from $500B a decade ago. Per Bloomberg Intelligence, new research has directly connected the explosive growth of passive investing to deteriorating corporate performance over the long haul.  In a paper posted this month, a trio of academics tracked share-buyback activity for a range of companies and found those with higher passive ownership spent more on stock repurchases but saw worse financial outcomes. Having disengaged owners “lowered the association” between buybacks and future performance, according to authors Brian Bratten and Jeff Payne of the University of Kentucky and Meng Huang of the University of Toledo. It was also positively associated with “suspect” repurchases — those that resulted in companies meeting or beating near-term earnings expectations. “Our study provides evidence that passive investment may allow opportunistic management behavior that negatively affects future firm performance,” they wrote. “The growing influence of passive investment may lead firms to make repurchase decisions that are inconsistent with the interests of investors.”  The findings are the latest twist in the raging debate about the rise of passive investing. A growing body of literature has raised issues such as the erosion of rivalry between companies, but research over the role of index-tracking funds in corporate governance has delivered mixed conclusions. One notable study in 2016 strongly connected passive investing to improved management.

The Active vs. Passive Debate
As passive flows surge, they flow into MSFT, not Berkshire*. Over the last 5 years, there’s an additional $2T that’s flowed into the passive bucket relative to active asset management. Total returns last 5-years? MSFT 380% vs. BRK/B’s 32%. But the flows since March are all about the colossal overweight tech crowd (pure madness) and the perception of a new US cloud-based economy. So you have a double barrel mania going on here. First, the explosion of PAM (passive asset management assets under management) and then the afterburners kicked in. You have a large number of asset managers trying to keep up with the S&P 500 index performance, and a panic that they’re not long enough of our new cloud-based, remote living world companies (like Microsoft). Over the last 50 years, Berkshire BRK/A does not trade at valuations of < 1.2x book for very long. Most times, significant rallies ensue regardless of the rest of the market’s performance. In the summer of 2016, there were only $32B of (passive) assets in QQQs vs. $121B today. A large portion of those new assets have been forced into MSFT shares, there is NO choice on the matter, see below.

*For every $100B slowing into passive asset management (S&P 500 Index Funds), close to $6B of those new assets under management moves into MSFT vs. a little over $1B into BRK/B.  The QQQs offer the real juice, for $100B of new AUM, $11B flows into MSFT vs. $0B for Berkshire. Some of the AUM above is price appreciation, not necessarily new dollars in the QQQs.

Indexing and Share Ownership Structure, Beware

Indexing doesn’t ramp value like growth because “value” has a far more dispersed ownership-base and higher float. Growth tends to be “new” money with high internal ownership, with a small float easily pushed around.  The bottom line, the distortion is caused by indexing.

Microsoft MSFT Key Technicals
In another disturbing turn of events, for only the second time since the March lows, MSFT closed BELOW its 20-day moving average (purple line above). In our view, this is sure to bring in algos and momentum selling next week. Some of the high impact machines are (programmed) triggered to exit on key technical levels. MSFT has held the 20-day since March. Holding this level brings in momentum buyers, failing will bring in a flush of exiters. The SELL Signals are lining up at the traffic light.

The Great Rotation
The Russell 2000 Index ripped higher by nearly 4% on Wednesday while the Nasdaq was relatively flat. Looking over the past 2 decades, when the Nasdaq (growth stocks) experiences this severe an underperformance vs. the Russell 2000 (value) it has usually coincided with the peak and/or downtrend of a cycle. A similar dynamic has played out with Berkshire Hathaway which as of yesterday’s close, has outperformed the Nasdaq by over 6.5% in the past 3 days. This is only the 3rd time since 2012 where BRK outperformed the Nasdaq by this much.

Watch Global Capital Flows

This week it’s important to note, as the US technology sector moved close to correction territory – capital was flowing into China. The total value of shares trading on the Shanghai and Shenzhen exchanges surged to near $10T, the best level since 2015. The U.S. dollar’s recent plunge puts big tech in an uncomfortable position. In recent years global calamities (Brexit, Trade Wars, COVID Phase 1) have pushed capital into the USA, NOT out.  As the U.S. struggles relative to the RoW (rest of the world), for the first time in years, dollars are leaving U.S. shores. 

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Volatility Divergence, Sending Us a Message

“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.

Email to get on our live Bloomberg chat over the terminal, institutional investors only please, it’s a real value add.

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Nasdaq Volatility Surge, Divergence from VIX
The Chicago Board Options Exchange NDX Volatility Index rose to 38 on Tuesday, an 8+ points premium to the CBOE VIX Index. That’s the widest spread since 2004. The gap between volatility in large-cap high fliers and the broader index has run the gamut in a matter of months, going from negative to non-existent to a multi-year high. Investors are paying-up for downside protection on NASDAQ high flyers.