“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 tatiana@thebeartrapsreport.com to get on our live Bloomberg chat over the terminal, institutional investors only please, it’s a real value add.

If you’ve never read this classic, the Stan Druckenmiller speech delivered in 2015 at the Lost Tree Club, in Florida – you’re in for a treat. It’s so inspiring – Druck’s passion for markets is like no other. Putting the pieces to the puzzle together means everything to him and everything to us. Above all, today – the words on this page carry a lot more weight. Blow by blow Stan lived and traded through a market much like the 2020 bull run in U.S. equities. Tech stocks in 1998-1999 and 2019-2020 are more like brothers than cousins in our view – we must sit back and embrace the lessons of the past. Make sure you read about the “gun-slingers” (below). 

Stan Druckenmiller and Ken Langone

SD:
I thought I would spend a moment just reflecting on
why I believe my record was what it was, and maybe
you can draw something from that. But the first
thing I’d say very clearly, I’m no genius. I was not
in the top 10 percent of my high school class. My
SATs were so mediocre I went to Bowdoin because it
was the only good school that didn‘t require SATs,
and it turned out to be a very fortunate event for
me.

But I’d list a number of reasons why I think I had
the record I did because maybe you can draw on it in
some of your own investing or also maybe in picking a
money manager. Number one, I had an incredible
passion, and still do, for the business. The thought
that every event in the world affects some security
price somewhere I just found incredibly
intellectually fascinating to try and figure out what
the next puzzle was and what was going to move what.
And the fact that I could bet on that interaction,
those who know me, I do like to bet. One of the
great things of this business, I get to gamble for a
living and channel it through the markets instead of
illegal activity. That was just sort of nirvana for
me that I could constantly be making these bets,
watch the market moving, and get my grades in the
newspaper every day.

The second thing I would say is I had two great mentors. One I stumbled upon and one I sought out.

And I see some young people in the audience and
probably some grandparents who have some influence on some young people in the audience, and I would just
say this. If you’re early on in your career and they
give you a choice between a great mentor or higher
pay, take the mentor every time. It’s not even
close. And don‘t even think about leaving that
mentor until your learning curve peaks. There’s just
nothing to me so invaluable in my business, but in
many businesses, as great mentors. And a lot of kids
are just too short-sighted in terms of going for the
short-term money instead of preparing themselves for
the longer term.

—–

“If you’re early on in your career and they give you a choice between a great mentor or higher pay, take the mentor every time.”

Stan Druckenmiller

—-

The third thing I’d say is I developed partly through
dumb luck ~ I’ll get into that — a very unique risk
management system. The first thing I heard when I
got in the business, not from my mentor, was bulls
make money, bears make money, and pigs get
slaughtered. I’m here to tell you I was a pig. And
I strongly believe the only way to make long-term
returns in our business that are superior is by being
a pig. I think diversification and all the stuff
they’re teaching at business school today is probably
the most misguided concept everywhere.

And if you look at all the great investors that are
as different as Warren Buffett, Carl Icahn, Ken
Langone, they tend to be very, very concentrated
bets. They see something, they bet it, and they bet
the ranch on it. And that’s kind of the way my
philosophy evolved, which was if you see – only maybe
one or two times a year do you see something that
really, really excites you. And if you look at what
excites you and then you look down the road, your
record on those particular transactions is far
superior to everything else, but the mistake I’d say
98 percent of money managers and individuals make is
they feel like they got to be playing in a bunch of
stuff. And if you really see it, put all your eggs
in one basket and then watch the basket very
carefully.

Now, I told you it was kind of dumb luck how I fell
into this. Ken Langone knows my first mentor very
well. He’s not a well-known guy, but he was
absolutely brilliant, and I would say a bit of a
maverick. He was at Pittsburgh National bank. I
started there when I was 23 years old. I was in a
research department. There were eight of us. I was
the only one without an MBA, and I was the only one
under 32 years of age. I was 23 years old.

After about a year and a half – I was a banking and a
chemical analyst – this guy calls me into his office
and announces he’s going to make me the director of
research, and these other eight guys and my
52-year-old boss are going to report to me. So, I
started to think I’m pretty good stuff here. But he
instantly said, “Now, do you know why I’m doing
this?” I said no. He says, “Because for the same
reason they send 18-year-olds to war. You’re too
dumb, too young, and too inexperienced not to know to
charge. We around here have been in a bear market
since 1968.” This was 1978. “I think a big secular
bull market’s coming. We’ve all got scars. We’re
not going to be able to pull the trigger. So, I need
a young, inexperienced guy. But I think you‘ve got
the magic to go in there and lead the charge.” So, I
told you he was a maverick, and as you can already
see, he’s a little bit eccentric. After he put me in
there, he was gone in three months. I’ll get to that
in a minute.

But before he left, he taught me two things. A,
never, ever invest in the present. It doesn’t matter
what a company’s earning, what they have earned. He
taught me that you have to visualize the situation 18
months from now, and whatever that is, that’s where
the price will be, not where it is today. And too
many people tend to look at the present, oh this is a
great company, they’ve done this or this central bank
is doing all the right things. But you have to look
to the future. If you invest in the present, you’re
going to get run over!

—-

“Profits are achieved by discounting the obvious, and placing capital in the direction of the unexpected.”

George Soros

—-

The other thing he taught me is earnings don’t move
the overall market; it’s the Federal Reserve Board.
And whatever I do, focus on the central banks and
focus on the movement of liquidity, that most people
in the market are looking for earnings and
conventional measures. It’s liquidity that moves
markets.

Now, I told you he left three months later, and
here’s where the dumb luck came in in terms of my
investment philosophy. So, right after he leaves,
the Shah of Iran goes under. So, oil looks like it’s
going to go up 300 percent. I’m 26 — 25, excuse me.
I don’t have any experience. I don’t know anything
about portfolio managers. So, I go well, this is
easy. Let’s put 70 percent of our money in oil
stocks and let’s put 30 percent in defense stocks and
let’s sell all our bonds. So, and I would have
agreed with him if I had some experience and I was a
little more experienced, but the portfolio managers
that were competing with me for the top job, they, of
course, thought it was crazy. I would have thought
it was crazy too if I’d have had any experience, but
the list I proposed went up 100 percent. The S&P was
flat. And then at 26 years old they made me chief
investment officer of the whole place. So, the
reason I say there was a lot of luck involved is
because as Drelles predicted, it was my youth and it
was my inexperience, and I was ready to charge.

So, the next thing that happened when I started at
Duquesne, Ronald Reagan had become President, and we had a radical man named Paul Volcker running the
Federal Reserve. And inflation was 12 percent. The
whole world thought it was going to go through the
roof, and Paul Volcker had other ideas. And he had
raised interest rates to 18 percent on the short end,
and I could see that there is no way this man was
going to let inflation go. So, I had just started at
Duquesne. I had a small amount of new capital. I
took 50 percent of the capital and put it into
30—year treasury bonds yielding 14 percent, and I
owned nothing else. Sort of like the oil and defense
story, but now we’re on a different gig. And sure
enough, the bonds went up despite a bear market in
equities. Right out of the chute I was able to be up
40 percent. And more importantly, it sort of shaped
my philosophy again of you don’t need like 15 stocks
or this currency or that. If you see it, you got to
go for it because that’s a better bet than 90 percent
of the other stuff you would add onto it.

So, after that happened, my second mentor was George
Soros, and unlike Speros Drelles, I imagine most of
you have heard of George Soros. And had I known
George Soros when I made the bond bet, I probably
would have made a lot more money because I wouldn’t
have put 50 percent in the bonds, I probably would
have put about 150 percent in the bonds. So, how did
I meet George Soros? By the early to mid-‘BOs
commodities were having dramatic moves. currencies
were having big moves, bonds were having big moves,
and I was developing a philosophy that if I can look
at all these different buckets and I‘m going to make
concentrated bets, I’d rather have a menu of assets
to choose from to make my big bets and particularly
since a lot of these assets go up when equities go
down, and that’s how it was moving.

And then I read The Alchemy of Finance because I’d
heard about this guy, Soros. And when I read The
Alchemy of Finance, I understood very quickly that he
was already employing an advanced version of the
philosophy I was developing in my fund. So, when I
went over to work for George, my idea was I was going
to get my PhD in macro portfolio manager and then
leave in a couple of years or get fired like the nine
predecessors had. But it’s funny because I went over
there, I thought what I would learn would be like –
what makes the yen goes up, what makes the deutsche
mark move, what makes this, and to my really big
surprise, I was as proficient as he was, maybe more
so, in predicting trends.

That’s not what I learned from George Soros, but I
learned something incredibly valuable, and that is
when you see it, to bet big. So what I had told you
was already evolving, he totally cemented. I know we
got a bunch of golfers in the room tonight. For those who
follow baseball, I had a higher batting average;
Sores had a much bigger slugging percentage. When I
took over Quantum, I was running Quantum and
Duquesne. He was running his personal account, which
was about the size of an institution back then, by
the way, and he was focusing 90 percent of his time
on philanthropy and not really working day to day.
In fact a lot of the time he wasn’t even around.

And I’d say 90 percent of the ideas he were [ph.]
using came from me, and it was very insightful and
I’m a competitive person, frankly embarrassing, that
in his personal account working about 10 percent of
the time he continued to beat Duquesne and Quantum
while I was managing the money. And again it’s
because he was taking my ideas and he just had more
guts. He was betting more money with my ideas than I
was.

Probably nothing explains our relationship and what
I’ve learned from him more than the British pound.
So, in 1992 in August of that year my housing analyst
in Britain called me up and basically said that
Britain looked like they were going into a recession
because the interest rate increases they were
experiencing were causing a downturn in housing. At
the same time, if you remember, Germany. the wall had
fallen in ’89 and they had reunited with East
Germany, and because they’d had this disastrous
experience with inflation back in the ’30s, they were
obsessed when the Deutsche mark and the [unint.]
combined, that they would not have another
inflationary experience. So, the Bundesbank, which
was getting growth from the [unint.] and had a
history of worrying about inflation was raising
rates like crazy. That all sounds normal except the
deutsche mark and the British pound were linked. And
you cannot have two currencies where one economic
outlook is going like this way and the other outlook
is going that way. So, in August of ’92 there was 7
billion in Quantum.

I put a billion and a half, short the British pound…
…based on the thesis I just gave you. So,
fast-forward September, next month. I wake up one
morning and the head of the Bundesbank, Helmut
Schlesinger, has given an editorial in the Financial
Times, and I’ll skip all the flowers. It basically
said the British pound is crap and we don’t want to
be united with this currency. So, I thought well,
this is my opportunity. So, I decided I’m going to
bet like Soros bets on the British pound against the
deutsche mark.

It just so happens he’s in the office. He’s usually
in Eastern Europe at this time doing his thing. So,
I go in at 4:00 and I said, “George, I’m going to
sell $5.5 billion worth of British pounds tonight and
buy deutsche marks. Here’s why I’m doing it, that
means we‘ll have 100 percent of the fund in this one
trade.” And as I’m talking, he starts wincing like
what is wrong with this kid, and I think he’s about
to blow away my thesis and he says, “That is the most
ridiculous use of money management I ever heard.
What you described is an incredible one-way bet. We
should have 200 percent of our net worth in this
trade, not 100 percent. Do you know how often
something like this comes around? Like one or 20
years. What is wrong with you?” So, we started
shorting the British pound that night. We didn‘t get
the whole 15 billion on, but we got enough that I’m
sure some people in the room have read about it in
the financial press.

—–

Every bet when it’s put on has a risk – reward formula. There are some bets where if you risk x you and make y, and others (one-way) if you risk x, you can make x,y and z. The most attractive wager of all is the “one-way” bet, the supreme-optimal risk vs. reward.

—-

So, that’s probably enough old war stories tonight.
I love telling old war stories because I like to
reminisce when I was a money manager and doing better
returns than I have since I retired, but I do think
it’s important maybe let’s try and move me to the
present here a little bit. So, I told you that one
of the things I learned from Drelles was to focus on
central banks. And Sam was kind enough to point out
some very good returns we had over the years.

One of the things I would say is about 80 percent of
the big, big money we made was in bear markets and
equities because crazy (Dislocations in markets) things were going on in response to what I would call central bank mistakes during that 30-year period. And probably in my mind the poster child for a central bank mistake was actually the U.S. Federal Reserve in 2003 and 2004.

I recall very vividly at the end of the fourth
quarter of 2003 calling my staff in because interest
rates, fed funds were one percent. The nominal
growth in the U.S. that quarter had been nine
percent. All our economic charts were going through
the roof, and not only did they have rates at one
percent, they had this considerable period — sound
familiar? — language that they were going to be there
for a considerable time period (forward guidance).

So, I said I want you guys to try and block out where
fed funds are and just consider this economic data
and let’s play a game. We’ve all come down from
Mars. Where do you think fed funds would be if you
just saw this data and didn’t know where they were?
And I‘d say of the seven people the lowest guess was
3 percent and the highest was 6 percent. So, we had
great conviction that the Federal Reserve was making
a mistake with way too loose monetary policy. We
didn‘t know how it was going to manifest itself, but
we were on alert that this is going to and very
badly.

Sure enough, about a year and a half later an analyst
from Bear Stearns came in and showed me some subprime situation, the whole housing thing, and we were ableto figure out by mid-’05 that this thing was going to end in a spectacular housing bust, which had been engineered – or not engineered but engendered by the
Federal Reserve’s too-loose monetary policy and end
in a deflationary event. And we were lucky enough
that it turned out to be correct. My returns weren‘t
very good in ’06 because I was a little early, but
’07 and ’08 were – they were a lot of fun.

So. that’s why if you look at today — can we get the
charts up please? I’m experiencing a very strong
sense of deja vu. Let’s just play the game I played
with my analysts back in 2003, 2004 and go through a
series of charts. So, this is the United States
households’ net worth per household. And it’s
textbook. You see the big drop in the financial
crisis. It’s textbook when you have consumer balance
sheets torn to pieces by a financial crisis to use
super-loose monetary policy to rebuild those balance
sheets, which the Federal Reserve did beautifully.

What’s interesting though is if you look forward by
2011, we had already exceeded the ’07 levels, which I
think a lot of people would agree was already an
overheated [ph.] period, and since then we’ve gone
straight up for two more years, and household net
worth is certainly in very, very good shape.

Here’s employment. As you can see after another big
problem after the financial crisis, the employment
market has largely healed, and we’re down at 5.6 on
the unemployment rate. Here’s industrial production.
Again, big drop after ’07. Look at this thing. It’s
screaming. Here’s retail sales. Again you see the
damage, but you see where we are now. You’re right
on a 60-year uptrend, which is actually very good.

And then I’m sure for those of you who are
unfortunate enough to watch CNBC and read other
financial statements, you’ll know that the fed is
absolutely obsessed with Japan. They’ve been talking
about this Japan analogy for 10 or 15 years now or
certainly since Bernanke took over. And let me just
show you something. This is the core CPI in the U.S.
I‘m sure you’ve heard the word “deflation” more than
you’d like to hear it in the last three or four
years. We’ve never had deflation. Our CPI has gone
up 40 percent over this time with not one period of
deflation. And at the bottom you see Japan, which is
down 15 percent. I did think there was a case, a
viable case in ’09, ’10 that we may follow Japan.

But you know what, I’ve thought a lot of things when
I’m managing money with great, great conviction, and
a lot of times I’m wrong. And when you’re betting
the ranch and the circumstances change, you have to
change, and that’s how I’ve always managed money.
But the feds‘ thesis to me has been proved dead wrong
about three or four years ago, which is okay, but
there was no pivot.

Here’s another one that I like to look at. Has
anybody heard on CNBC in the last week comparisons
with 1937 and the mistake the Federal Reserve made in
1937 because it is a constant thing they’re bringing
up? But again, here’s the net worth chart I showed
in the first slide in dark blue, but look at the
light blue line, which is net worth in 1935 in
the U.S. We’re not even close to the kind of numbers
we had in 1937. And if I showed you all those other
four charts, they wouldn’t have moved during the four
years either.

And finally, one more comparison with Japan. In
light blue is average net worth per household in the
U.S. In dark blue is Japan. If you took apples to
apples the same time period, there’s just no
comparison.

So, my point is this, if I was giving you a quiz and
you looked at these five charts and you hear all this
talk about a deflation and depression and how
horrible things are, let me just say this, the
Federal Reserve was founded in 1913. This is the
first time in 102 years, A, the central bank bought
bonds and, B, that we‘ve had zero interest rates and
we’ve had them for five or six years. So, do you
think this is the worst economic period looking at
these numbers we’ve been in in the last 102 years?
To me it’s incredible.

Now, the fed will say well, you know, if we didn’t
have rates down here and we didn’t increase our
balance sheet, the economy probably wouldn‘t have
done as well as it’s done in the last year or two.

You know what, I think that’s fair, it probably
wouldn’t have. It also wouldn’t have done as well as
it did in 2004 and 2005. But you can’t measure
what’s happening just in the present in the near
term. You got to look at the long term.

And to me it’s quite clear that it was the Federal
Reserve policy. I don’t know whether you remember.
they kept coming up with this term back at the time,
they wanted an insurance policy. This we got to
ensure this economic recovery keeps going. The only
thing they ensured in my mind was the financial
crisis. So, to me you’re getting the same language
again out of policymakers. On a risk-reward basis
why not let this thing a little hot? You know, we
got to ensure that it gets out. But the problem with
this is when you have zero money for so long, the
marginal benefits you get through consumption greatly
diminish, but there’s one thing that doesn’t
diminish, which is unintended consequences.

People like me, others, when they get zero money –
and I know a lot of people in this room are probably
experiencing this, you are forced into other assets
and risk assets and behavior that you really don’t
want to do, and it’s not those concentrated bet kind
of stuff I met [ph.] earlier. It’s like gees, these
zero rates are killing me. I got to do this. And
the problem is the longer rates stay at zero and the
longer assets respond to that, the more egregious
behavior comes up.

Now. people will say well the PE is not that hard.
Where’s the beef? Again, I feel more like it was in
’04 where every bone in my body said this is a bad
risk reward, but I can’t figure out how it’s going to
end. I just know it’s going to end badly, and a year
and a half later we figure out it was housing and
Subprime. I feel the same way now. There are early
signs. If you look at IPOs, 80 percent of them are
unprofitable when they come. The only other time
we’ve been at 80 percent or higher was 1999.

The other thing I would look at is credit. There are
some really weird things going on in the credit
market that maybe Kenny and I can talk about later.

But there are already early signs starting to emerge.
And to me if I had a message out here, I know you’re
frustrated about zero rates, I know that it’s so
tempting to go ahead and make investments and it
looks good for today, but when this thing ends,
because we’ve had speculation, we’ve had money
building up for four to six years in terms of a risk
pattern, I think it could end very badly. Kenny, do
you want to come up? [applause]

SD:
Okay. I mentioned credit. I mentioned credit.
Let’s talk about that for a minute. In 2006 and
2007, which I think most of us would agree was not a
down period in terms of speculation, corporations
issued $700 billion in debt over that two-year
period. In 2013 and 2014 they’ve already issued $1.1
trillion in debt, 50 percent more than they did in
the ’06. ’07 period over the same time period. But
more disturbing to me if you look at the debt that is
being issued, Kenny, back in ’06, ’07, 28 percent of
that debt was B rated. Today 71 percent of the debt
that’s been issued in the last two years is B rated.
So, not only have we issued a lot more debt, we’re
doing so at much less standards. Another way to
look…

SD: …at that is if those in the audience who know what
covenant-light loans are, which is loans without a
lot of stuff tied around you, back in ’06, ’07 less
than 20 percent of the debt was issued coy-light.

Now that number is over 60 percent. So, that’s one
sign. The other sign I would say is in corporate
behavior, just behavior itself. So, let’s look at
the current earnings of corporate America. Last year
they earned $1.1 trillion; 1.4 trillion in
depreciation. Now, that’s about $2.5 trillion in
operating cash flow. They spent 1.? trillion on
business and capital equipment and another 700
billion on dividends. So, virtually all of their
operating cash flow has gone to business spending and
dividends, which is okay. I’m enboard with that.

But then they increase their debt 600 billion. How
did that happen if they didn’t have negative cash
flow? Because they went out and bought $567 billion
worth of stock back with debt, by issuing debt. So,
what’s happening is their book value is staying
virtually the same, but their debt is going like
this. From 1987 when Greenspan took over for
Volcker, our economy went from 150 percent debt to
GDP to 390 percent as we had these easy money
policies moving people more and more out the risk
curve. Interestingly, in the financial crisis that
went down from about 390 to 365. But now because of
corporate behavior, government behavior, and
everything else, those ratios are starting to go back
up again.

Look, if you think we can have zero interest rates
forever, maybe it won’t matter, but in my view one of
two things is going to happen with all that debt. A,
if interest rates go up, they’re screwed and, B, if
the economy is as bad as all the bears say it is,
which I don’t believe, some industries will get into
trouble where they can’t even cover the debt at this
level.

And just one example might be 18 percent of the
high-yield debt issued in the last year is energy.
And I don’t mean to offend any Texans in the room,
but if you ever met anybody from Texas, those guys
know how to gamble, and if you let them stick a hole
in the ground with your money, they’re going to do
it. So, I don’t exactly know what’s going to happen.
I don’t know when it’s going to happen. I just have
the same horrific sense I had back in ’04. And by
the way, it lasted another two years. So. you don‘t
need to run out and sell whatever tonight.

KL:
Will this unprecedented global money printing ever
stop? And what is your intermediate and long-term
view on inflation?

SD:
Well, the global money printing is interesting
because the United States is the world‘s central
bank. And Japan had this guy named Shirakawa running
the central bank, and he didn’t believe in this
stuff. So, what happened when he didn’t print the
money but the U.S. was printing the money and we’re
[inaud.], the Japanese yen started to appreciate and
it stayed appreciating, and it basically hollowed out
the country. And they were eventually forced, as you
know, two years ago into flooding their system with
money.

You have a very, very similar situation going on in
Europe now. I know Mario Draghi and Angela Merkel
don’t like QE. They don’t like anything about it,
but again, the chump – I have this partner. I don’t
know if he’s in the room, Kevin Warsh who’s on the
Federal Reserve Board. He said Japan used to be the
new chump because they had the overvalued currency.
Now it’s Europe. So, their currency went from 82 say
back in 2000 all the way up to 160, and it was 140
last summer, and they’re absolutely getting murdered.
And now they’re apparently caving in and they’re
going to print money.

I don’t know when it’s going to stop. And on
inflation this could end up being inflationary. It
could also end up being deflationary because if you
print money and save banks, the yield curve goes
negative and they can’t earn any money or let’s say
the price of oil goes to $30, you could get a
deflationary event. If you had asked me this
question in late ’03, I’d have said well, this
probably ends with inflation, but by the time we
needed to, we figured out no, this is going to end in
deflation. So, the fed keeps talking about
deflation, but there is nothing more deflationary
than creating a phony asset bubble, having a bunch of
investors plow into it and then having it pop. That
is deflationary.

KL:
You mentioned some of your biggest winners in your
career. What is the biggest mistake you made and
what did you learn from it?

SD:
Well, I made a lot of mistakes, but I made one real
doozy. So, this is kind of a funny story, at least
it is 15 years later because the pain has subsided a little.
But in 1999 after Yahoo and America Online
had already gone up like tenfold, I got the bright
idea at Soros to short internet stocks. And I put
200 million in them in about February and by
mid-march the 200 million short I had lost $600
million on, gotten completely beat up and was down
like 15 percent on the year. And I was very proud of
the fact that I never had a down year, and I thought
well, I’m finished.

The Gun Slingers

So, the next thing that happens is I can’t remember
whether I went to Silicon Valley or I talked to some
22-year-old with Asperger’s. But whoever it was,
they convinced me about this new tech boom that was
going to take place. So I went and hired a couple of
gun slingers because we only knew about IBM and
Hewlett-Packard. I needed Veritas and Verisign. I
wanted the six. So, we hired this guy and we end up
on the Year — we had been down 15 and we ended up
like 35 percent on the year. And the Nasdaq’s gone
up 400 percent.

—-

There’s nothing in this world, which will so violently distort a man’s judgment more than the sight of his neighbor getting rich.

JP Morgan, 1907

—-

So, I’ll never forget it. January of 2000 I go into
Soros’s office and I say I’m selling all the tech
stocks, selling everything. This is crazy. [unint.]
at 104 times earnings. This is nuts. Just kind of
as I explained earlier, we’re going to step aside,
wait for the net fat pitch. I didn’t fire the two
gun slingers. They didn’t have enough money to
really hurt the fund, but they started making 3
percent a day and I’m out. It is driving me nuts. I
mean their little account is like up 50 percent on
the year. I think Quantum was up seven. It’s just
sitting there.

So like around March I could feel it coming. I just
– I had to play. I couldn’t help myself. And three
times during the same week I pick up a – don’t do it.
Don’t do it. Anyway, I pick up the phone finally. I
think I missed the top by an hour. I bought
$6 billion worth of tech stocks. and in six weeks I
had left Soros and I had lost $3 billion in that one
play. You asked me what I learned. I didn’t learn
anything. I already knew that I wasn’t supposed to
do that. I was just an emotional basket case and
couldn’t help myself. So, maybe I learned not to do
it again. but I already knew that.

KL:
Here’s one you may not be able to answer. Why are
the regulators so intent on penalizing our best
banks?

SD:
Because the regulators are appointed by politicians
and the banks make a perfect punching bag for what’s
going on. And I will say this, I think there were
very, very bad actors in ’06, ‘07. Let’s not kid
ourselves in the banking industries.

KL:
I agree.

SD:
But the point I was making earlier is there was a
great enabler, and that was the Federal Reserve…

KL:
Yeah.

SD:
…pushing people out the risk curve. And what I
just can’t understand for the life of me, we’ve done
Dodd-Frank, we got 5,000 people watching Jamie Dimon
when he goes to the bathroom. I mean all this stuff
going on to supposedly prevent the next financial
crisis. And if you look to me at the real root cause
behind the financial crisis, we’re doubling down.
Our monetary policy is so much more reckless and so
much more aggressively pushing the people in this
room and everybody else out the risk curve that we’re
doubling down on the same policy that really put us
there and enabled those bad actors [ph.] to do what
they do. Now, no matter what you want to say about
them, if we had had five or six percent interest
rates, it would have never happened because they
couldn’t have gotten the money to do it.

KL:
What’s the future of the euro?

SD:
The currency or the union?

KL:
The currency

SD:
I think the euro needs to continue to go down because
eight of those countries have such a cost
disadvantage versus Germany right now. It’s about 40
percent because they haven’t been behaving themselves
since the euro was put together that you have severe
outright deflation not like pretend deflation like we
talk about on the board. It’s real deflation. And
they’ve got sclerosis. I can’t see Europe surviving
without the euro going down to somewhere in the
mid-80s. And if you think that’s a ridiculous
forecast, when I restarted Duquesne in 2000, the euro
was 82. Now, that was extreme. But let me ask you
this, think of the Europe and United States back in
2000 and think of them today. Do you think Europe
has made incremental gains versus the United States
or declines? So, to me it’s not unreasonable to see
the euro continue to go down.

The other thing I‘ll say, I do analyze currencies,
and it would be almost unprecedented to have a
10-month currency trend. Because all the
dislocations happen when your currency is overvalued
and it’s up long enough, it takes years to unwind
those dislocations. And it’s hard to argue the euro
is not in a trend. It’s down from 140 to 117. And
using the rule of time, I don’t think it’s
unreasonable to expect it to break 100 sometime in
the next year or two.

In terms of the euro region itself, there’s still a
lot of questions. That was put together for
political reasons really to create political unity.
And as most people in this room know, it’s doing just
the opposite. It’s creating political disunity. So,
I don’t think it’s even a given that that thing stays
together.

KL:
Okay. You put money out with other managers. What
qualities and characteristics do you look for in
those people that you place money with?

SD:
Number one, passion. I mentioned earlier I was
passionate about the business. The problem with this
business if you’re not passionate, it is so
invigorating to certain individuals, they’re going to
work 24/7, and you’re competing against them. So,
every time you buy something, one of them is selling
it. So, if you‘re with one of the lazy people or one
of the people that are just doing it for the money,
you’re going to get run over by those people.

The other characteristic I like to look for in a
money manager is when I look at their record, I
immediately go to the bear markets and see how they
did. Particularly given sort of the five-year
outlook I’ve given, I want to make sure I’ve got a
money manager who knows how to make money and manage
money in turbulent times, not just in bull markets.

The other thing I look for, Kenny, is open-mindedness
and humility. I have never interviewed a money
manager who told you he’d never made a mistake, and a
lot of them do, who didn‘t stink. Every great money manager I’ve ever met, all they want to talk about is
their mistakes. There’s a great humility there. But
and then obviously integrity because passion without
integrity leads to jail. So, if you want someone
who’s absolutely obsessed with the business and
obsessed with winning, they’re not in it for the
money, they’re in it for winning, you better have
somebody with integrity.

KL:
You’ve expressed concerns about entitlement. What’s
the solution? You got a loaded crowd here now. Be
careful.

SD:
That’s a rough one. So, if you go back to 1965, the
senior poverty rate in this country was 30 percent,
and it’s 9 percent now. I think everybody can
applaud that’s a great achievement. The problem is
you go back to 1965, your child poverty was 21
percent, and now it’s 25 percent. So, all the gains we’ve made in terms of poverty the last 40 years have accrued to the
elderly. If you look at the average per capita
income in this country, we’re spending 56 percent of
every worker’s dollars on the elderly, and we’re
spending 7 percent on children.

So, how would I solve it? Well, I couldn’t because
if I wanted to do it, nobody would ever vote me in
office. But I would just say that some solutions are
a combination of tax reform dealing specifically with
the problem because the longer this goes on, the more
you’re either going to have to raise taxes or cut
spending down the road because of compounding. I
would freeze — forget COLAs. I would freeze all the
entitlement payments right now because they’ve
already taken such a tremendous share away from the
rest of our population.

You know, it’s funny. if you go back to as late as
1970, entitlements were 28 percent of all federal
outlays. Now they’re 72 percent. And when you start
talking about oh my God, we can’t freeze this stuff,
why not? You just picked up 50 points of share on
everybody. Why not freeze it? And, you know, Ken
and I have talked. I mean it’s ridiculous that our
Social Security is not means tested. It’s
ridiculous. I mean the fact that he’s getting – what
is your monthly check?

KL:
Twenty-five hundred dollars a month.

SD:
It’s ridiculous.

KL:
And Elaine gets another thousand.

SD:
While we have 24 percent of the kids in this country
in poverty and probably, you know, the elephant in
the room is obviously the health care system. You’ve
got to get the market into the equation so people see
the cost and they have to make an economic decision.
A lot of this goes into end-of-life payments. You
wonder if you had to pay 30 to 40 percent of the bill
instead of not even knowing what the bill is, whether
different choices would be made.

But you talk about entitlement. The federal debt
right now is $17 trillion. The reason it‘s
$17 trillion and not higher is because all those
payments that are promised to Kenny, a lot of the
people in this room, myself not too far in the
future, they’re not on the government balance sheet.
Any company in America if you owe payments of that
certainty, it would be a debt. In the U.S.
government accounting it’s revenue.

If you present valued what we have promised to
seniors in Medicare and Social Security and Medicaid
payments, the federal debt right now under gap
accounting would be $205 trillion, not 17 because we
have a demographic boom, which is the other side of
the baby boom. As everybody knows in this room, it’s
the grey boom. We are creating 11,000 seniors in
this country every day. Every day we’re creating
11,000 new seniors, and we’re only creating about 18
percent of youth employed to support those payments
to them. So, we’ve got a big problem, and it really
doesn’t start until 2024, 2025, but if you wait ’til
2024, it’s too late. It’s not unlike climate change.

It’s probably not a problem for 30 years, but if you
wait 30 years, you can’t fix it. So, you got to
start now.

KL:
This is my question, is there any way possible you
think that we could have a soft landing from all the
excesses we’ve had in the last 10 or 15 Years?

SD:
Anything’s possible. I sure hope so.
And I haven’t committed. I’m not net short equities. I mean the
stock market right now as a percentage of GDP is
higher than – with the exception of nine months from
’99 to — it’s the highest it’s been in the last
hundred years of any other period except for those
nine months. But you know what, when you look at the
monetary policy we’re running, it should be – it
should be about where it is. This is crazy stuff
we’re doing. So, I would say you have to be on alert
to that ending badly. Is it for sure going to end
badly? Not necessarily. I don’t quite know how we
get out of this, but it’s possible.

KL: Okay. Stanley, fabulous. Thank you so much.

SD:
Thanks, Ken.

KL:
Great, great night.

“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

*The Bear Traps Report’s institutional client flatform includes; financial advisors, family offices, RIAs, CTAs, hedge funds, mutual funds, and pension funds.

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

This is Part II of our Cobra Effect Series.

What are Commodities Pricing In?

The Price of Gold

Days to reach Round Numbers

$1900-$2000: 7  (All-Time record achieved Aug 4, 2020)
$1800-$1900: 5
$1700-$1800: 121
$1600-$1700: 61
$1500-$1600: 155
$1400-$1500: 43
$1300-$1400: 1228

Bloomberg data

Breaking: “Fed Weighs Abandoning Pre-Emptive Rate Moves to Curb Inflation” WSJ, Sunday, August 2, 2020

“The Federal Reserve is preparing to effectively abandon its strategy of pre-emptively lifting interest rates to head off higher inflation, a practice it has followed for more than three decades. Instead, Fed officials would take a more relaxed view by allowing for periods in which inflation would run slightly above the central bank’s 2% target, to make up for past episodes in which inflation ran below the target.” – WSJ

Our Larry McDonald: “Since mid-May, we have stressed to clients, this type of policy action is coming. This is a historic adjustment for the Fed. They’re all in the Larry Summers’ Camp now, ‘don’t hike interest rates until you see the whites of inflation’s eyes’ is the thinking – laid out publicly by the former, Sr. Clinton Administration Treasury official. Larry is now on the OUTSIDE looking in – and VERY loud doing so. It’s a far-more social justice focused central bank now. The push-back the Fed has received on the “inequality” front is at all times highs. It’s a heavy topic of conversation around Capitol Hill. Make NO mistake about it, politics’ heavy hand in central bank policy is entering a whole new level.”

Stagflation Triggers on the Rise

The probability of stagflation is soaring, its impact on asset prices and your portfolio will be profound. Let us explore.

The week we learned, Bank of America’s private client wealth hedges using precious metals are surging. More and more investors feel uncomfortable with extremely low bond yields – sky-high bond prices, they’re looking at a risk-parity conundrum (we address this dynamic below). In 2011, these protective measures reached a 9.6% allocation. Today, it’s down at 2.5% and moving NORTH from 1.3% last year. Their strategist Harnett has referenced 20-25% exposure.

See our bullish note on the commodities sector here. 

Supply shocks rear their ugly head when governments institute policies that slow down the economy while dramatically increasing the money supply. Both of these events transpired in 2020. First, January’s shut down of China’s $13T economy was a wake-up call for the planet, creating a colossal supply shock. Total nonfarm employment there – much of it manufacturing – is 580 million, almost four times the U.S.’s labor force. Then in March, the West instituted lockdowns while dramatically increasing the money supply. The causes of stagflation are well known and have been thoroughly studied by economists for decades. We can tell you with certainty, more than a half-century of economic theory will be upended if stagflation doesn’t arrive in fierce force in the 2020-2022 period.

Stagflation vs. Depression

The spread between the U.S. ten year Treasury bond yield and the S&P 500’s dividend yield is Grand Canyon Esque, near 60-year wides. Central banks are forcing capital into very strange places. Investors have fewer and fewer choices each day. The thinking? Stagflation beats depression all day long, see our Cobra Effect here.

Uncle Sam Needs a Loan

On Monday, the U.S. Treasury said it needs to raise nearly $950B in the three months through September to fund COLOSSAL deficit spending, that’s $270B more than they projected in May. One large problem, the Treasuries average weighted maturity across its portfolio is down to 63 months, that’s the shortest window since 2012. Look for the U.S. Treasury to seel a large bundle of longer-dated bonds this month and next.

Distorting the True Cost of Capital, COMES with A PRICE
As central bankers distort the true cost of capital, the side effects are mathematically incalculable. We’ll never know how many Bernie Madoffs maybe sipping mint juleps on the Hamptons this summer? If Lehman didn’t fail, would Bernie have ever been caught? Failure is a good thing, a cleansing thing and so is a “true cost of capital” which the free-market used to forge each day, but NO more. Many people think Keynes was a lower interest rates kind of guy, using the cost of capital – monetary policy – to stimulate an economy. That part is true, but it just might be the most significant half-truth coming out of the last 100 years of modern economics. Above all, he was a believer in the natural rate of interest. When you juice fiscal policy in a short period of time by $5T and hit the monetary policy accelerator at the same time by $3T, the spread between the true cost of capital and the artificial, or the central bank suppression rate – is COLOSSAL.  Today, by our calculation – over 85% of the planet’s bonds yield less than 2%, just two years ago this number was 36%, using the Bloomberg terminal. Keynes even warned against distortions/side effects of lowering the cost of capital BELOW a market-driven, natural rate. Keynes might be considered a right-wing radical today, complete with an Antifa mob on his front doorstep every morning. We delve into the explosive side effects here in the Cobra Effect.  

Will the Real John Maynard Keynes Please Stand Up

The U.S. recession of 1973-1975 marked the end of the post-WWII expansion and was considered unusual in having both high unemployment and high inflation. However, the term “stagflation” was invented in the UK by British politician Ian Macleod back in 1965, again in 1970, and again in 1973. John Maynard Keynes actually outlined how the components of unemployment and inflation could co-exist in his writings. Sadly, important parts of Keynes’ body of work were ignored by many establishment economists during that era and beyond. The point is – Keynes was very nuanced and complex. The following generation dumbed and pared him down. For instance, he wrote that if interest rates were too low for too long, financial interest rates would flow to financial assets (stocks, bonds, real estate) and be diverted away from labor, which explains the slow employment growth and financial asset boom during the post-Lehman failure years, circa 2008-2016. We argue large chunks of Keynes’ writings have been ignored by the modern economic establishment. Keynes was redefined and simplified such that the critiques of the simplified Keynes often used ideas that later economists had purged from. There are passages in the original Keynes doctrine that a neo-Keynesian would find horrifying. Pure comedy indeed. From the dominant economic theory from the end of World War II to the early 1980s was really a Keynesians-for-dummies policy wherein recession and inflation were mutually exclusive, a view symbolized in the now debunked, Phillips curve.

Death of the Phillips Curve**

Being a single-equation economic model, the Phillips curve was readily embraced by politicians, because it was so simple, even a politician could understand it. A rare accomplishment, bravo. Phillips argued increased employment causes increased wages i.e. follow-on inflation. Ironically, Phillips himself viewed this as a trivial observation. It was Milton Friedman who destroyed it on theoretical grounds and who correctly predicted the 1973-1975 recession. Unfortunately, in the 2015-2020 economic regime, the Phillips Curve has thoroughly embarrassed scores of economists globally.  Employment gains, NOT only didn’t lead to inflation pressures but also fueled disinflation. Economists spent far too much time focused on economic theory and not enough on economic risks tied to a runaway U.S. dollar which proved to be HIGHLY deflationary, exponentially so.

**The Phillips curve is an economic theory developed by A. W. Phillips stating that inflation and unemployment have a stable and inverse relationship. The theory claims that economic growth comes inflation, which in turn should lead to more jobs and less unemployment.

Beware of Economists too Deep on the Weeds

It was in Manhattan, February 2015. As I stepped out of a cab, freezing cold ice-water filled up my right shoe. The dreaded pothole got me again.  Late for a meeting, I scurried up the 36 marble stairs leading to the entrance of 245 Park. Moving into the crowded elevator, a few minutes later, 22 of us were in the conference room on the 28th floor. The topic of discussion; the Phillips curve and 8-10 rate hikes our Soc Gen economists saw coming over the next 24 months. Their conviction was on a high perch that day and I brought just two questions. First, why and how could the Fed hike rates 8 times -heading into the 2016 Presidential election? Second, wouldn’t the side effects from a strong dollar cut the Fed off at the knees as they tried to hike rates 8x – while the rest of the developed world was easing monetary policy? In a world filled with far more dollar-denominated debt, each rate hike in 2015 carried the power of 3 rates hikes in the 1990s. Financial conditions would tighten dramatically I argued. Economists would hear NONE of it, their Phillips curve had all the answers. By the end of 2016, the Fed hiked rates just two times and the Phillips curve sent a busload of the Street’s economists into temporary retirement. The lesson?  Economists should spend far more time focused on leverage and risk metrics, than out-dated models.

Major US Pension Fund

Risk-Free Rate vs. Risk-Adjusted Return Target

2020: 0.55% vs. 7.0%
2010: 4.00% vs. 8.5%

*So, a decade later – US ten year Treasuries are yielding 3.5% less, but pension funds are still targeting 7%. How’s that work? Risk-Parity Conundrum or nightmare?

Colossal Complacency equals Danger

As a global investment community, our recent experience with this economic theory train wreck coming out of the Phillips Curve’s demise is the foundation for today’s rich complacency around the prospects of stagflation and or inflation. You can’t cut it with a knife – it’s that thick – downright dangerous. The Risk-Parity Conundrum: We now have over $110T of the planet’s wealth yielding less than 1.50% (a few years ago this number was less than $25T). Up until a month ago, everyone trusted risk-parity modeling in protecting their hard-earned capital. Some more hard-earned than others! Faith is risk-parity is in full retreat today with metals up 30-40% in Q2, see our bullish note on the commodities sector here. 

In the UK of the 1960s and 1970s, the relationship between inflation and the money supply was not understood by the government. The money supply grew untethered, resulting in inflation. Every trick in the book was used to combat inflation except for reigning in money supply growth. The result was a slower economy with higher prices.

Stagflation and Money Supply
Many people forget, from 1971 to 1974, gold was 325% higher, while everyone remembers the 475% surge from 1977 to 1980. The U.S., stagflation commenced after an egregious expansion of the money supply was initiated to counter the precipitous increase in oil prices caused by the October 1973 oil embargo announced by the Organization of Arab Petroleum Exporting Companies to punish those countries that had supported Israel in the Yom Kippur war which lasted from October 6th to October 25th, 1973, led by Egypt and Syria against Israel. Oil prices initially increased by 17%, but at its peak, prices shot up 400%.

Bretton Woods

The groundwork for the subsequent expansion of the money supply was laid once the US had its adjustment during the Bretton Woods Agreement on August 15th, 1971 (the United States halted the conversion of dollars into gold and devalued the dollar by 10%. One catalyst, France was aggressively redeeming its dollars for gold, which helped precipitate the emergency move by U.S. President Richard Nixon). The expansion in the money supply caused a classic price/wage spiral, wherein price increases driven by the oil shock caused wage increases allowed by the expansion of the money supply which of course was in turn allowed now that the US was no longer on the gold standard strictures under Breton Woods. “Wages chase prices and prices chase wages”, as the saying goes. This is the genesis of the Fed’s continuous blather about inflation expectations, which now virtually has been laid to rest by the current pandemic.

Supply Shocks

Current Keynesians argue that monetary and fiscal policies are effective against adverse variations in demand but wholly useless in adverse variations in supply. There are several ways to cause a supply shock, but one way is for the government to severely restrict production, as of course is happening now! By our calculation, entering Q2, over 415 – gold, silver, copper, iron, coal, and uranium mining, development, and exploration assets across the globe have ceased or scaled back production (meaning operating stockpiles and with limited workforce).

The standard Keynesian model tells us supply increases as price increases. However, when supply is artificially restricted, that relationship breaks down. Instead, inflation jumps as production collapses. An updated view would add that as money is created to give to those out of work, inflation is later inevitable.

The question is, why don’t we see inflation? The answer is: you don’t have to see inflation initially simultaneously but subsequently before economic recovery. In other words, we aren’t there yet, but metals are predicting we soon will be.

“Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. […] Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

John Maynard Keynes, 1938

The sad fact is, if Keynes was alive today, he would NOT be considered a Keynesian. We know because we have lived through it, that an increase in money supply alone doesn’t cause inflation. But an artificially restricted economy, by the government, by fears of Covid-19, have set the table for stagflation. Society cannot possibly quantify the unintended consequences, silver is screaming this fact. It’s NOT every month you see a 35% surge in silver – unless your names are Sonny and Cher. 

And by the way, not all firms lose during stagflation. It is a well-observed phenomenon that the largest firms have the greatest pricing power.

Oddly enough, the largely Keynesian analysis above is not intellectually inconsistent with the Austrian school view that an increase in money supply benefits most of the initial recipients of the money, at least not under the circumstances we see currently. The producers receive the money later, thus benefit less. Traditionally, this has been viewed as anti-Keynesian, at least by members of the Austrian school. But as in so many other examples, they overlap more than the proponents care to admit.

“The increase in the money supply rate of growth coupled with the slowdown in the rate of growth of goods produced is what the increase in the rate of price inflation is all about. (Note that a price is the amount of money paid for a unit of a good.) What we have here is a faster increase in price inflation and a decline in the rate of growth in the production of goods. But this is exactly what stagflation is all about, i.e., an increase in price inflation and a fall in real economic growth. Popular opinion is that stagflation is totally made up. It seems therefore that the phenomenon of stagflation is the normal outcome of loose monetary policy. This is in agreement with [Phelps and Friedman (PF)]. Contrary to PF, however, we maintain that stagflation is not caused by the fact that in the short run people are fooled by the central bank. Stagflation is the natural result of monetary pumping which weakens the pace of economic growth and at the same time raises the rate of increase in the prices of goods and services.”

Frank Shostak, Austrian School Economist

Many may well conclude that supply disruption coupled with monetary expansion combined should lead to stagflation since either one alone might.  How long does it take? About a year. 2021 will see inflation outpace GDP, and noticeably. That is to say, stagflation.

“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 tatiana@thebeartrapsreport.com to get on our live Bloomberg chat over the terminal, institutional investors only please, it’s a real value add.

“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

“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 tatiana@thebeartrapsreport.com to get on our live Bloomberg chat over the terminal, institutional investors only please, it’s a real value add.

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.

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

SunEdison*
Chesapeake Energy*
Molycorp*
Lehman*
iStar Financial*
Calpine*
Fannie Freddie*
Enron*
Tyco*
Adelphia*
Six Flags*
eToys*
Avaya*
Worldcom*
SunEdison*
Tesla

*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 ConvertBond.com 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 ConvertBond.com 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.

“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

*The Bear Traps Report’s institutional client platform includes; financial advisors, family offices, RIAs, CTAs, hedge funds, mutual funds, and pension funds.

Email tatiana@thebeartrapsreport.com to get on our live Bloomberg chat over the terminal.

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.

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

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.

“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 tatiana@thebeartrapsreport.com to get on our live Bloomberg chat over the terminal, institutional investors only please, it’s a real value add.

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.