Passive Negligence II

 

Almost a year ago, we stumbled upon a topic that is currently generating much discussion in the financial media. In Mm Mm Good, published August 2016, we highlighted the Campbell Soup Company (CPB) and the utility sector to show how yield-starved investors were chasing dividend stocks to dangerously high valuations. The following quote from the article highlights the risk inherent in CPB’s valuation: “This concept of a no-growth company with soaring valuations is alarming. The price of CPB would have to drop 30% to return to its post-recession average P/E. If that were to occur, it would take 16 years’ worth of dividend payments to recoup the price loss, assuming dividends remain stable”.

When writing that article, we assumed that a hunger for yield was the primary driver of excessive valuations in those relatively safer sectors. We did acknowledge, however, that there were other factors. Unbeknownst to us at the time, the shift from active to passive investing was one such factor playing a growing role in creating valuation divergences.

We followed up the article in November of 2016 with Passive Negligence. This sequel, of sorts, discussed valuation divergences and economic inefficiencies occurring as a result of the growing popularity in passive investing and the related decline in value/active management strategies. The following quote summed up a concern we had then and one that is even more troubling today: Typically, market index changes are the result of the movement in underlying constituents. Today, market index changes are the driver of the underlying constituents”.

Valuation Regulator

Passive index funds can play an important role in portfolio management. However, when such passive styles of investing grow in popularity to the point that they are overly influential in setting prices, problems tend to arise. In fact, the ongoing massive shift of capital toward passive strategies argues that the healthy process of price discovery is being destroyed.

Value/active managers are vital for efficient asset pricing in the long run. By simply buying what they believe to be cheap and selling what they think is expensive, they help keep valuations and fundamentals in sync over the long run. When their role is diminished, as is frequently seen in bubble manias like today, these investors lose their ability provide the market with necessary checks and balances. For example, in the late 1990’s value/active investors were eschewed in favor of those chasing technology stocks to record-breaking valuation peaks. This type of passive management created absurd pricing distortions that eventually resolved themselves when investors broadly re-awakened to the reality of fundamentals. As the bubble burst in the year 2000, the popularity of value/active investors spiked and valuations normalized.

According to Bloomberg, Vanguard, primarily a passive fund manager, saw net inflows of $2 billion a day in the first quarter of 2017. In the same quarter they raised $121 billion of new cash, beating the prior quarterly record by almost 50%. Vanguard is just one of many passive managers exhibiting massive growth. This growth is coming largely at the expense of value/active managers, the regulators of valuation.

Toilet Paper

The implications of this dynamic may be illustrated through a simple example:

Imagine walking down the paper goods aisle in your local grocery store in search of toilet paper. Instead of picking out your preferred choice you just blindly take the first one you see. This act on its own would not be meaningful, but imagine if most shoppers chose toilet paper in a similar manner. Manufacturers that produced higher quality product could lose the advantage of differentiation and their additional cost of providing a higher quality product would be wasted. In fact, the quality of the product would be irrelevant to the shopper as compared to the ease in which the product can be grabbed from shelf. Without consumers making thoughtful trade-offs between price and value, the price of all brands of toilet paper would converge, rising and falling depending only on how easy it is to grab off the shelf!

As we began the process of writing a sequel to Passive Negligence we watched a video that masterfully explains the effects of the soaring popularity of passive investing. Therefore, we decided that instead of reinventing the wheel, our readers would be best served by providing them links for the video and chart book from Steven Bregman’s presentation at Grant’s Fall 2016 Conference.

Video

Chart Book

The video is courtesy Steven Bregman and Horizon Kinetics. The chart book is courtesy Steven Bregman and Horizon Kinetics as well as Grants Financial Publishing.

Summary

This topic is important if one is to understand why valuations continue to rise despite a fundamental backdrop that has historically been poor for stocks. Watching money flows to and from passive managers may very well help provide valuable insight into how much higher valuations can rise and may offer hints as to when they might begin to normalize.

Based upon the prevailing money flows, it appears few investors realize the benefit that value/active investing provides.  When their role is diminished by indiscriminate buying based only on the market cap or float of a security, as is the case in passive investing, value/active investors have less influence over the price discovery process and asset valuations become broadly exaggerated.

The outperformance of passive investing strategies over active ones is a major reason for the shift in interest and money flows, but there are other reasons as well. By comparison, fees on passive strategy funds are lower than those of active strategy funds and anticipation of the Department of Justice’s Fiduciary Rule is also having an impact on retirement accounts and those who manage them. That said, active managers tend to earn their fees when it matters most to investors – by protecting wealth when it is jeopardized by collapsing markets. Passive investing has no such conscience and will offer no sympathy when the day of reckoning arrives.

Finally, Jesse Felder of The Felder Report clarified the “logic” of such decision-making in simple terms:  “Embracing passive investing is exactly this sort of ‘cover your eyes and buy’ sort of attitude. Would you embrace the very same price‐insensitive approach in buying a car? A house? Your groceries? Your clothes? Of course not. We are all very price‐sensitive when it comes to these things. So why should investing be any different?

 

 

720 Global is an investment consultant, specializing in macroeconomic research, valuations, asset allocation, and risk management.  Our objective is to provide professional investment managers with unique and relevant information that can be incorporated into their investment process to enhance performance and marketing. We assist our clients in differentiating themselves from the crowd with a focus on value, performance and a clear, lucid assessment of global market and economic dynamics.

 

Coming soon 720 Global will offer “The Unseen”, a subscription-based publication similar to what has been offered at no cost over the past year and a half.  In fact, what the subscription offers is precisely what we have delivered in the past, a substance in style and form that provides unique analysis and meaningful value to discerning investors. Those that have read our work understand the comparative advantage they have gained over the vast majority of investors that solely focus on the obvious. Our readers are prepared for what few see.

 

720 Global research is available for re-branding and customization for distribution to your clients.

 

For more information about our services, please visit us at www.720global.com or contact us at 301.466.1204 or email info@720global.com 

 

©720 Global 2017 All Rights Reserved

 

NOTICE AND DISCLAIMER: This material has been prepared by 720 Global, LLC. Opinions expressed herein are subject to change without notification. Any prices or quotations contained herein are indicative screen prices and are for reference only. They do not constitute an offer to buy or sell any securities at any given price. No representation or warranty, either express or implied, is provided in relation to the accuracy, completeness, reliability or appropriateness of the information, methodology and any derived price contained within this material. The securities and related financial instruments described herein may not be eligible for sale in all jurisdictions or to certain categories of investors.

Neither 720 Global, LLC nor its directors accept any liability for any loss or damage arising out of the use of all or any part of these materials.

All rights reserved. This material is strictly for specified recipients only and may not be reproduced, distributed or forwarded in any manner without the permission of 720 Global, LLC. 

 

 

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The Forgotten Path to Prosperity

This article, and those that will follow in this series, describes in simple but compelling form several objective truths about the dynamics of scarcity and prosperity and the role they play in human decision-making within the context of an economy. The simple elegance of the economic system we describe seems to have been long forgotten, buried under an accumulation of overly sophisticated explanations, theories and complex models.

 

The Forgotten Path to Prosperity

 

“The record of history is absolutely crystal clear. There is no alternative way so far discovered of improving the lot of the ordinary people that can hold a candle to the productive activities that are unleashed by a free enterprise system.”  – Milton Friedman

Whether one thinks of a market as barter, a grocery store, internet commerce or the New York Stock Exchange, the concepts behind each of them are identical.  In all of these marketplaces, people have resources which they are willing to give up in order to gain something else they deem as more valuable.

If I own a coop full of chickens that produces two dozen eggs every week, then I am not likely to pay for eggs in the grocery store.  More likely, a grocer may be willing to buy my eggs for re-sale to his customers.  If my portfolio is over-weighted with technology stocks, then I am less likely to seek new technology stocks to own.  If I need money to pay for my daughter’s college tuition, then I may need to work harder and/or sell some of my assets in order to meet the obligation. This simple set of examples is intended to reflect the decision-making human beings face when considering resource allocation. In the 720 Global philosophy statement we put it this way:

  • Human beings have desires and those desires drive decision-making. Given the desire and the means or ability to fulfill those desires, they will do so. This results in demand.

 

  • At the same time, in order to fulfill one’s desires, human beings will undertake activities that give them the means to fulfill their desires. This results in supply.

 

  • When human beings interact in a manner that allows their desires and their means to intersect, markets are created.

To emphasize the important linkage between resource allocation, economic success and the role of markets, a basic review of the terms scarcity and prosperity is important:

Scarcity is defined as a deficiency in quantity or number compared with demand. It is a universal, natural condition whereby resources such as time, labor and material wealth are limited. In a world where desires are, by nature, unlimited, people are required to make prudent decisions about the use of limited resources.

Prosperity is defined as the condition of being successful or thriving; economic well-being. It is a manufactured condition whereby the economic well-being of a person, community or nation is determined by the millions of choices citizens and government leaders make every day.  Prudent decisions regarding the use of our limited resources produce prosperity.

In the opening quote, the free enterprise system to which Milton Friedman refers is the system whereby people are free to engage in a vocation of their choice as a means of fulfilling their desires by producing something others need or want. Economic value, the basis for free market exchange, is subjective.  What has great value to one person may be of little value to another. Because anything a person could desire is to one degree or another scarce, each of us must prioritize our values by our individual preferences and means.  This not only applies to purchases and consumption but, just as important, how much we produce and how we spend our time.

When people are freely allowed to come together and cooperate in pursuit of their own self-interests, everyone benefits. The fewer needless restrictions imposed on a society, the more the individuals in that society are incentivized to innovate and produce as a means of satisfying their desires. This is how human beings deal with scarcity. Given our infinite desires and the natural limitations of time, energy and capital, markets determine how we navigate these exchanges.

From Scarcity to Plenty

According to Adam Smith, “If men work together and cooperate, they can combine their land, labor and capital to greatly multiply their ability to produce even greater and more complex things.”

Although evident in many ways, the power of Adam Smith’s observation is highly apparent in the technology and innovation that drove the industrial revolution and mass production.  The impact of mass production is seen not only in the technology and specialization of tasks, but also in its effect on prices. When goods are mass produced, the increased quantity of goods and lower costs of production drive down prices, which in turn makes them affordable to even more people.  Increasing productive capacity and deflating the cost of production is one of the primary reasons that western civilization so successfully fought scarcity and experienced prosperity.

 

Law and Liberty

In contemplating how markets allow humans to meet their most basic needs and desires, it is important to discern the mechanisms that have allowed the United States and western civilization in general to be so prosperous. Some nations deprived of resources are prosperous, while others, rich in resources, suffer from acute scarcity. Therefore, one must look to the degree of freedom in markets to determine why scarcity is more problematic in some countries and societies than others.

 

Law and liberty set the context for how markets function.  The United States is a republic that operates under the rule of law.  The rights and laws as originally established by the Declaration of Independence and U.S. Constitution are the principles of right and wrong by which citizens and the government must abide.  Among these, and vital to the engine of wealth creation, is the right to private ownership of property. Through this, a citizen owns what he or she produces or what they are paid by an employer for their production. As originally constructed and put forth in the founding documents, Americans are protected against unwanted intrusions. Simply put, one cannot take what is rightfully owned by another. In all of the aforementioned documents it is established that the government’s primary purpose is the defense of those rights.  Those documents make it perfectly clear that the unalienable rights bestowed upon all citizens are primarily intended as protections against governmental abuse.

 

The rights and protections decreed are not just about right and wrong, as they thoughtfully serve as the bedrock for efficient markets and importantly engender the incentives that drive productive work in America.  The ability to fulfill desires in a vocation of one’s choosing inspires individuals to work, save, invest and consume. In a word, it is the path to contentment.  These incentives compel men and women to deliver goods and services as efficiently as possible.  An individual’s productive effort not only renders the resources by which one can meet their own needs and desires, but taken in aggregate, it propels the wealth of the entire populace.

 

Interestingly, despite simple logic, modern central bankers try to convince the world that deflation is evil. They preach that they must intervene to stoke inflation at all cost for the good of society. The truth of the matter is that deflation is a beneficial by-product of innovation and productivity gains. Said differently, the incentives that inspire work and creative ingenuity produce prosperity and work against scarcity.

 

Productive deflation, which reduces scarcity as described above, benefits a society.  It especially benefits those at the bottom of the economic ladder as the issue of scarcity is a more profound problem for those with less. So why does modern society give central bankers the benefit of the doubt when they undertake such measures as debauching the currency in efforts to incite inflation?

 

Summary

The prosperity of a nation and its people comes about through the availability of goods and services to more people. Free markets, upheld by the rule of law, incentivize people to be productive through work and acquire the means to fulfill their desires. It is in this elegant yet simple virtuous cycle that productivity growth, prosperity and contentment flourishes and scarcity diminishes. The benefits do not solely accrue to those most motivated, the wealthy or those politically well-connected, but to everyone in society.

 

Most local grocers and butchers have been replaced by the likes of Costco and Amazon. The days of trading shares of individual companies has morphed into trading esoteric derivatives, ETFs, and a host of complex products. These intricacies are signs of innovation within maturing markets. The issue with which we must concern ourselves is the friction introduced to markets, not the market’s degree of complexity. When unnecessarily intrusive policies, laws, and regulations restrict our ability to be productive, incentives are diminished. Without proper incentives, productivity falters and the wealth and prosperity of a nation suffers.

 

As Milton Friedman said, “the record of history is absolutely crystal clear”.  A free market, capitalist system, despite all its imperfections, when properly protected by government as required by the founding documents, produces prosperity that benefits all of society.

 

 

 

 

720 Global is an investment consultant, specializing in macroeconomic research, valuations, asset allocation, and risk management.  Our objective is to provide professional investment managers with unique and relevant information that can be incorporated into their investment process to enhance performance and marketing. We assist our clients in differentiating themselves from the crowd with a focus on value, performance and a clear, lucid assessment of global market and economic dynamics.

 

Coming soon 720 Global will offer “The Unseen”, a subscription-based publication similar to what has been offered at no cost over the past year and a half.  In fact, what the subscription offers is precisely what we have delivered in the past, a substance in style and form that provides unique analysis and meaningful value to discerning investors. Those that have read our work understand the comparative advantage they have gained over the vast majority of investors that solely focus on the obvious. Our readers are prepared for what few see.

 

720 Global research is available for re-branding and customization for distribution to your clients.

 

For more information about our services, please visit us at www.720global.com or contact us at 301.466.1204 or email info@720global.com 

 

©720 Global 2017 All Rights Reserved

 

NOTICE AND DISCLAIMER: This material has been prepared by 720 Global, LLC. Opinions expressed herein are subject to change without notification. Any prices or quotations contained herein are indicative screen prices and are for reference only. They do not constitute an offer to buy or sell any securities at any given price. No representation or warranty, either express or implied, is provided in relation to the accuracy, completeness, reliability or appropriateness of the information, methodology and any derived price contained within this material. The securities and related financial instruments described herein may not be eligible for sale in all jurisdictions or to certain categories of investors.

Neither 720 Global, LLC nor its directors accept any liability for any loss or damage arising out of the use of all or any part of these materials.

All rights reserved. This material is strictly for specified recipients only and may not be reproduced, distributed or forwarded in any manner without the permission of 720 Global, LLC. 

 

 

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Echo Chamber

 

Since the U.S. economic recovery from the 2008 financial crisis, institutional economists began each subsequent year outlining their well-paid view of how things will transpire over the course of the coming 12-months. Like a broken record, they have continually over-estimated expectations for growth, inflation, consumer spending and capital expenditures. Their optimistic biases were based on the eventual success of the Federal Reserve’s (Fed) plan to restart the economy by encouraging the assumption of more debt by consumers and corporations alike.

But in 2017, something important changed.  For the first time since the financial crisis, there will be a new administration in power directing public policy, and the new regime could not be more different from the one that just departed. This is important because of the ubiquitous influence of politics.

The anxiety and uncertainties of those first few years following the worst recession since the Great Depression gradually gave way to an uncomfortable stability.  The anxieties of losing jobs and homes subsided but yielded to the frustration of always remaining a step or two behind prosperity.  While job prospects slowly improved, wages did not. Business did not boom as is normally the case within a few quarters of a recovery, and the cost of education and health care stole what little ground most Americans thought they were making.  Politics was at work in ways with which many were pleased, but many more were not.  If that were not the case, then Donald Trump probably would not be the 45th President of the United States.

Within hours of Donald Trump’s victory, U.S. markets began to anticipate, for the first time since the financial crisis, an escape hatch out of financial repression and regulatory oppression.  As shown below, an element of economic and financial optimism that had been missing since at least 2008 began to re-emerge.

nfib earnings

Data Courtesy: Bloomberg

What the Federal Reserve (Fed) struggled to manufacture in eight years of extraordinary monetary policy actions, the election of Donald Trump accomplished quite literally overnight. Expectations for a dramatic change in public policy under a new administration radically improved sentiment. Whether or not these changes are durable will depend upon the economy’s ability to match expectations.

Often Wrong, Never in Doubt

The institutional economists searching for a coherent outlook for 2017 are now faced with a fresh task. President Trump and his cabinet represent a significant departure from what has come to be known as “business-as-usual” Washington politics over the past 25 years.  Furthermore, it has been 89 years since Republicans held control of the White House as well as both the House of Representatives and the Senate. The confluence of these factors suggests that the outlook for 2017 – policy, the economy, markets, geopolitical risks – are highly uncertain.  Despite what appears to be an inflection point of radical change, most of which remains unknown, the consensus opinion of professional economists and markets, in general, are well-aligned, optimistic and seemingly convinced about how the economy and markets will evolve throughout the year.  The consensus forecast based upon an assessment of economic projections from major financial institutions appears to be the result of a Ph.D. echo chamber, not rigorous independent analysis.

Economic Outlook – Consensus Summary

After a thorough review of several major financial institutions’ economic outlooks for 2017 and market implied indicators for the year, below is an overview of what 720 Global deems to be the current consensus outlook for 2017.

  • The consensus is optimistic about economic growth for the coming year with expectations for real GDP growth in the 2.0-2.5% range
  • Recession risks will remain benign
  • The labor market is now at or near full employment
  • Wage growth is expected to increase to the 3.0-3.5% level as is customary for the economy at full employment
  • Inflation is expected to reach and exceed the Fed’s 2.0% target level
  • The Fed is expected to raise the Federal Funds rate in 25 basis point increments two or three times in 2017
  • The Fed will maintain the existing size of its balance sheet
  • Some form of fiscal stimulus will occur by the second half of the year
  • Fiscal stimulus is expected to be modest and unlikely to have a big impact on fiscal deficits
  • Tax reform will occur by the second half of the year and is viewed as highly supportive of corporate profits
  • Regulatory reform will begin to take shape in the first half of the year
  • Trade will be affected by some form of border tax adjustment, the economic impact of which is expected to be low
  • The combination of fiscal stimulus, tax reform, and regulatory reform in conjunction with an economy that is growing above trend and at full employment easily offsets Fed rate hikes supporting the optimistic outlook for economic growth

Despite the low probability of accuracy, the consensus outlook for 2017 is the starting point from which a discussion should begin because it is reflective of what markets and investors expect to transpire. Markets are pricing to this set of outcomes for the year.

Deviations

Having established a consensus baseline, further attention is then paid to those areas where the consensus may indeed be wrong. Will inflation finally exceed the 2.0% level as expected? Will growth for the year end in the range of 2.0-2.5%? Can the new administration negotiate a fiscal stimulus package this year? These and many others are important questions that will dictate the strength of the U.S. dollar, the level of interest rates and the ability of equity markets to sustain current valuations.

If economic growth for the year is stronger than current projections and inflation is higher than forecast, then the Fed will appear to be behind the curve in hiking interest rates. In this circumstance, the Fed may begin to telegraph more than three rate hikes for the current year and a higher trajectory for rates in 2018. The interest rate markets will likely front run growth expectations and push interest rates higher. Given that investors have so little coupon income to protect them from price changes, such a move could occur in a disorderly manner, which will tighten financial conditions and choke off economic growth.

If, on the other hand, economic growth for the year falters and continues the recent string of disappointing, sub-2.0% readings, then fears of recession, and likely an abrupt change in confidence, will re-emerge.

This exercise undertaken each year by economists is akin to a meteorologist’s efforts to predict the weather several weeks in advance.  The convergence of high and low-pressure systems will produce a well-defined outcome, but there is no way to ascertain weeks or even days in advance that those air masses will converge at a precise time and location, or that they will converge at all.  It does in fact, as they say, very much depend on the “whether.”  Whether consumers borrow and spend more, whether companies hire and pay more or even whether or not confidence in a new administration promising a variety of pro-growth policies can fulfill those in some form.

The Lowest Common Denominator

Interest rates have already risen in anticipation of the consensus view coming to fruition.  Although higher interest rates today are reflective of an optimistic outlook for growth and inflation, the economy has become dependent upon low rates. Everything from housing and auto sales to corporate buybacks and equity valuations are highly dependent upon an environment of persistently low interest rates.  So, when the consensus overview expects higher interest rates as a result of higher wage growth and inflation, it is difficult to reconcile those expectations with the consensus path for economic growth.

Investors and markets continue to give the hoped-for outcome the benefit of the doubt, but that outcome seems quite inconsistent with economic reality.  That outcome is that policy will promote growth, growth will advance inflation and interest rates must therefore rise.  The problem for the U.S. economy is that the large overhang of debt is the lowest common denominator.  The economy is a slave to the master of debt, which must be serviced and repaid. The debt problem is largely the result of 35 years of falling interest rates and the undisciplined habits and muscle memory that goes with such a dominating streak.  Marry that dynamic with the fact that this ultra-low interest rate regime itself has been in place for a full eight years, and the economy seems conditioned for an allergic reaction to rising rates.

Episodes of rising interest rates since the 1980’s, although short-lived, always brought about some form of financial distress. This time will likely be no different because the Fed’s zero-interest rate policy and quantitative easing have sealed the total dependency of the economy on consumption and debt growth.  Regaining the discipline of a healthy, organic economic system would mean both a rejection of policies used over the last 30 years and intense public sacrifice.

Summary

Given the altar at which current day politicians’ worship – that of power, influence, and self-promotion – it seems unlikely that this new Congress and President are inclined to make the difficult choices that might ultimately set the U.S. economy back on a path of healthy, self-sustaining growth.  Rather, debt and deficits will grow, and the enthusiasm around overly-optimistic economic forecasts and temporal improvements in economic output will fade as has been the case in so many years past.  Although a new political regime is in store and it brings hope for a new path forward, the echo chamber reinforcing bad policy, fiscal and monetary, seems likely to persist.

 

720 Global is an investment consultant, specializing in macroeconomic research, valuations, asset allocation, and risk management.  Our objective is to provide professional investment managers with unique and relevant information that can be incorporated into their investment process to enhance performance and marketing. We assist our clients in differentiating themselves from the crowd with a focus on value, performance and a clear, lucid assessment of global market and economic dynamics.

 

Coming soon 720 Global will offer “The Unseen”, a subscription-based publication similar to what has been offered at no cost over the past year and a half.  In fact, what the subscription offers is precisely what we have delivered in the past, a substance in style and form that provides unique analysis and meaningful value to discerning investors. Those that have read our work understand the comparative advantage they have gained over the vast majority of investors that solely focus on the obvious. Our readers are prepared for what few see.

 

720 Global research is available for re-branding and customization for distribution to your clients.

 

For more information about our services, please visit us at www.720global.com or contact us at 301.466.1204 or email info@720global.com 

 

©720 Global 2017 All Rights Reserved

 

NOTICE AND DISCLAIMER: This material has been prepared by 720 Global, LLC. Opinions expressed herein are subject to change without notification. Any prices or quotations contained herein are indicative screen prices and are for reference only. They do not constitute an offer to buy or sell any securities at any given price. No representation or warranty, either express or implied, is provided in relation to the accuracy, completeness, reliability or appropriateness of the information, methodology and any derived price contained within this material. The securities and related financial instruments described herein may not be eligible for sale in all jurisdictions or to certain categories of investors.

Neither 720 Global, LLC nor its directors accept any liability for any loss or damage arising out of the use of all or any part of these materials.

All rights reserved. This material is strictly for specified recipients only and may not be reproduced, distributed or forwarded in any manner without the permission of 720 Global, LLC. 

 

 

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Villanova vs. Kansas : Outcome vs. Process Strategies

 

email image

 

It is that time of year when the markets play second fiddle to debates about which twelve seed could be this year’s Cinderella in the NCAA basketball tournament. For college basketball fans, this particular time of year has been dubbed March Madness. The widespread popularity of the NCAA tournament is not just about the games, the schools, and the players, but just as importantly, it is about the brackets. Brackets refer to the office pools based upon correctly predicting the 67 tournament games. Having the most points in a pool garners office bragging rights and, in many cases, your colleague’s cash.

Interestingly the art, science, and guessing involved in filling out a tournament bracket provides insight into how investors select assets and structure portfolios. Before explaining, answer the following question:

When filling out a tournament bracket do you:

  1. A) Start by picking the expected national champion and then go back and fill out the individual games and rounds to meet that expectation?

 

  1. B) Analyze each opening round matchup, picking winners and advance round by round until you reach the championship game?

If you chose answer A, you fill out your pool based on a fixed notion for which team is the best in the country. In doing so, you disregard the potential path, no matter how hard, that team must take to become champions.

If you went with the second answer, B, you compare each potential matchup, analyze each team’s respective records, strengths of schedule, demonstrated strengths and weaknesses, record against common opponents and even how travel and geography might affect performance. While we may have exaggerated the amount of research you conduct a bit, such a methodical game by game evaluation is repeated over and over again until a conclusion is reached about which team can win six consecutive games and become the national champion.

Outcome Based Strategies

Outcome-based investment strategies start with an expected result, typically based on recent trends or historical averages. Investors following this strategy presume that such trends or averages, be they economic, earnings, prices or a host of other factors, will continue to occur as they have in the past. How many times have you heard Wall Street “gurus” preach that stocks historically return 7%, and therefore a well-diversified portfolio should expect the same thing this year? Rarely do they mention corporate and economic fundamentals or valuations. Many investors blindly take the bait and fail to question the assumptions that drive the investment selection process.

Pension funds have investment return assumptions which, if not realized, have negative consequences for their respective plans. Given this seemingly singular aim of the fund manager, most pension funds tend to buy assets whose expected returns in aggregate will achieve their return assumption. Accordingly, pension funds tend to be managed with outcome-based strategies.

For example, consider a pension fund manager with an 8% return target that largely allocates between stocks and bonds.

table revised

Given the current yields in the table above, and therefore expectations for returns on sovereign bonds of approximately 1%, the manager must instead invest in riskier fixed income products and equities to achieve the 8% return objective. Frequently, a pension fund manager has a mandate requiring that the fund hold a certain minimum amount of sovereign bonds.  The quandary then is, how much riskier “stuff” do they have to own in order to offset that return drag? In this instance, the manager is not allocating assets based on a value or risk/reward proposition but on a return goal.

To illustrate, the $308 billion California Public Employees Retirement System (CalPERS), the nation’s largest pension fund, has begun to shift more dramatically towards outcome-based management. In 2015, CalPERS announced that they would fire many of their active managers following repeatedly poor performance. Despite this adjustment, they still badly missed their 7.5% return target in 2015 and 2016. Desperate to right the ship, CalPERS maintains a plan to increase the amount of passive managers and index funds it uses to achieve its objectives.

In speaking about recent equity allocation changes, a CalPERS spokeswoman said “The goal is to eventually get the allocation to the right mix of assets, so that the portfolio will likely deliver a 10-year return of 6.2%.” That sounds like an intelligent, well-informed comment but it is similar to saying “I want to be in Poughkeepsie in April 2027 because the forecast is sunny and 72 degrees.” The precision of the 10-year return objective down to the tenth of a percent is the dead giveaway that the folks at CalPERS might not know what they’re doing.

Outcome-based strategies sound good in theory and they are easy to implement, but the vast amount of pension funds that are grossly underfunded tells us that investment policies based on this process struggle over the long term. “The past is no guarantee of future results” is a typical investment disclaimer. However, it is this same outcome-based methodology and logic that many investors rely upon to allocate their assets.

Process Based Strategies

Process-based investment strategies, on the other hand, have methods that establish expectations for the factors that drive asset prices in the future. Such analysis normally includes economic forecasts, technical analysis or a bottom-up assessment of an asset’s ability to generate cash flow. Process-based investors do not just assume that yesterday’s winners will be tomorrow’s winners, nor do they diversify just for the sake of diversification. These investors have a method that helps them forecast the assets that are likely to provide the best risk/reward prospects and they deploy capital opportunistically.

Well managed absolute return and value funds, at times, hold significantquote amounts of cash. This is not because they are enamored with cash yields per se, but because they have done significant research and cannot find assets that offer value in their opinion. These managers are not compelled to buy an asset because it “promises” a historical return. The low yield on cash clearly creates a “drag” on short-term returns, but when an opportunity develops, the cash on hand can be quickly deployed into cheap investments with a wider margin of safety and better probabilities of market-beating returns. This approach of subordinating the short-term demands of impatience to the long-term benefits of waiting for the fat pitch dramatically lowers the risk of a sizable loss.

A or B?

Most NCAA basketball pool participants fill out tournament brackets starting with the opening round games and progress towards the championship match. Sure, they have biases and opinions that favor teams throughout the bracket, but at the end of the day, they have done some analysis to consider each potential matchup.  So, why do many investors use a less rigorous process in investing than they do in filling out their NCAA tournament brackets?

Starting at the final game and selecting a national champion is similar to identifying a return goal of 10%, for example, and buying assets that are forecast to achieve that return. How that goal is achieved is subordinated to the pleasant but speculative idea that one will achieve it. In such an outcome-based approach, decision-making is predicated on an expected result.

Considering each matchup in the NCAA tournament to ultimately determine the winner applies a process-oriented approach. Each of the 67 selections is based on the evaluation of comparative strengths and weaknesses of teams. The expected outcome is a result of the analysis of factors required to achieve the outcome.

Summary

It is very likely that many people filling out brackets this year will pick Villanova. They are a favorite not only because they are the #1 overall seed, but also because they won the tournament last year. Picking Villanova to win it all may or may not be a wise choice, but picking Villanova without consideration for the other teams they might play on the path to the championship neglects thoughtful analysis.

The following table (courtesy invest-assist.blogspot.com and Koch Capital) is a great reminder that building a portfolio based on yesterday’s performance is a surefire way to end up with sub-optimal returns.

asset classes

Winning a basketball pool has its benefits while the costs, if any, are minimal. Managing wealth, however, can provide great rewards but is fraught with severe consequences. Accordingly, wealth management deserves considerably more thoughtfulness than filling out a bracket. Over the long run, those that follow a well-thought out, time-tested, process-oriented approach will raise the odds of success in compounding wealth by limiting damaging losses during major market set-backs and by being afforded opportunities when others fearfully sell.

 

720 Global is an investment consultant, specializing in macroeconomic research, valuations, asset allocation, and risk management.  Our objective is to provide professional investment managers with unique and relevant information that can be incorporated into their investment process to enhance performance and marketing. We assist our clients in differentiating themselves from the crowd with a focus on value, performance and a clear, lucid assessment of global market and economic dynamics.

 

Coming soon 720 Global will offer “The Unseen”, a subscription-based publication similar to what has been offered at no cost over the past year and a half.  In fact, what the subscription offers is precisely what we have delivered in the past, a substance in style and form that provides unique analysis and meaningful value to discerning investors. Those that have read our work understand the comparative advantage they have gained over the vast majority of investors that solely focus on the obvious. Our readers are prepared for what few see.

 

720 Global research is available for re-branding and customization for distribution to your clients.

 

For more information about our services, please visit us at www.720global.com or contact us at 301.466.1204 or email info@720global.com 

 

©720 Global 2017 All Rights Reserved

 

NOTICE AND DISCLAIMER: This material has been prepared by 720 Global, LLC. Opinions expressed herein are subject to change without notification. Any prices or quotations contained herein are indicative screen prices and are for reference only. They do not constitute an offer to buy or sell any securities at any given price. No representation or warranty, either express or implied, is provided in relation to the accuracy, completeness, reliability or appropriateness of the information, methodology and any derived price contained within this material. The securities and related financial instruments described herein may not be eligible for sale in all jurisdictions or to certain categories of investors.

Neither 720 Global, LLC nor its directors accept any liability for any loss or damage arising out of the use of all or any part of these materials.

All rights reserved. This material is strictly for specified recipients only and may not be reproduced, distributed or forwarded in any manner without the permission of 720 Global, LLC. 

 

 

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Second to None

Today’s equity market valuations have only been eclipsed by those of 1929, and 1999.” Given the continuing equity market rally and multiple expansion, the quote above from prior articles, had to be modified slightly but meaningfully. As of today, the S&P 500 Cyclically Adjusted Price to Earnings ratio (CAPE) is on par with 1929. It has only been surpassed in the late 1990’s tech boom.

A simple comparison of P/E or other valuation metrics from one period to another is not necessarily reasonable as discussed in Great Expectations. That approach is too one-dimensional.   This article elaborates on that concept and is used to compare current valuations and those of 1999 to their respective fundamental factors.  The approach highlights that, even though current valuation measures are not as extreme as in 1999, today’s economic underpinnings are not as robust as they were then. Such perspective allows for a unique quantification, a comparison of valuations and economic activity, to show that today’s P/E ratio might be more overvalued than those observed in 1999.

Secular GDP Trends

Equity valuations are a mathematical reflection of a claim on the future cash flows of a corporation. When one evaluates a stock, earnings potential is compared to the price at which the stock is offered. In most cases, investors are willing to pay a multiple of a company’s future earnings stream. When the prospects for earnings growth are high, the multiple tends to be larger than when growth prospects are diminished.

To forecast earnings growth for a company, one needs to do an in-depth analysis of the corporation, the economy and the markets in which it operates. However, evaluating earnings growth for an index comprising many companies, such as the S&P 500, is a relatively straight-forward task.

Corporate earnings are a byproduct of economic activity. Earnings growth can differ from economic growth for periods of time, but in the long run aggregate earnings growth and GDP growth are highly correlated.  The two graphs below offer an illustration of the durability of this relationship. The graph on the left plots three-year average GDP growth and its trend since 1952, while the graph on the right highlights the correlation of GDP to corporate profits.

gdp-and-earnings-2x

Data Courtesy: St. Louis Federal Reserve (FRED), Bureau of Economic Analysis (BEA) and Bloomberg

Given the declining trend of GDP and the correlation of earnings to GDP, it is fair to deduce that GDP and earnings growth trends were healthier in the late 1990’s than they are today. More specifically, the following table details key economic and financial data comparing the two periods.

99-vs-16-fundamentals

Data Courtesy: St. Louis Federal Reserve (FRED), and Robert Shiller http://www.econ.yale.edu/~shiller/data.htm

As shown, economic growth in the late 1990’s was more than double that of today, and the expected trend for economic growth was also more encouraging than today. Trailing three- five- and ten-year annual earnings growth rates contrast the current stagnant economic growth versus the robust growth of the 90’s. Additionally, various measures of debt have ballooned to levels that are constricting economic growth and productivity. Historically low interest rates are reflective of the current state of economic stagnation.

The graph below charts price-to-earnings (CAPE) divided by the secular GDP growth (ten-year average), allowing for a proper comparison of valuations to fundamentals.

pe-vs-gdp-graph

Data Courtesy: Robert Shiller http://www.econ.yale.edu/~shiller/data.htm

The current ratio of CAPE to GDP growth of 19.77 has far surpassed the 1999 peak and all points back to at least 1950. At the current level, it is over three times the average for the last 66 years.  Further, based on data going back to 1900, the only time today’s ratio was eclipsed was in 1933. Due to the Great Depression, GDP at that time for the preceding ten years was close to zero. So, despite a significantly deflated P/E multiple, the ratio of CAPE to GDP was extreme. Looking forward, if we assume a generous 3% GDP growth rate, CAPE needs to fall to 18.71 or 35% from current levels to reach its long term average versus GDP growth.

Summary

Equity valuations of 1999, as proven after the fact, were grossly elevated. However, when considered against a backdrop of economic factors, those valuations seem relatively tame versus today. Some will likely argue with this analysis and claim that Donald Trump’s pro-growth agenda will invigorate the outlook for the economy and corporate earnings. While that is a possibility, that argument is highly speculative as such policies face numerous headwinds along the path to implementation.

Economic, demographic and productivity trends all portend stagnation. The amount of debt that needs to be serviced stands at overwhelming levels and is growing by the day. Policies that rely on more debt to fuel economic growth are likely not the answer. Until the disciplines of the Virtuous Cycle are understood and followed, we hold little hope that substantial economic growth can be sustained for any meaningful period. Given such a stagnant economic outlook, there is little justification for paying such a historically steep premium for what could likely be feeble earnings growth for years to come.

 

720 Global is an investment consultant, specializing in macroeconomic research, valuations, asset allocation, and risk management.  Our objective is to provide professional investment managers with unique and relevant information that can be incorporated into their investment process to enhance performance and marketing. We assist our clients in differentiating themselves from the crowd with a focus on value, performance and a clear, lucid assessment of global market and economic dynamics.

 

Coming soon 720 Global will offer “The Unseen,” a subscription-based publication similar to what has been offered at no cost over the past year and a half.  In fact, what the subscription offers is precisely what we have delivered in the past, a substance in style and form that provides unique analysis and meaningful value to discerning investors. Those that have read our work understand the comparative advantage they have gained over the vast majority of investors that solely focus on the obvious. Our readers are prepared for what few see.

 

720 Global research is available for re-branding and customization for distribution to your clients.

 

For more information about our services, please contact us at 301.466.1204 or email

info@720global.com

 

©720 Global 2017 All Rights Reserved

 

NOTICE AND DISCLAIMER: This material has been prepared by 720 Global, LLC. Opinions expressed herein are subject to change without notification. Any prices or quotations contained herein are indicative screen prices and are for reference only. They do not constitute an offer to buy or sell any securities at any given price. No representation or warranty, either express or implied, is provided in relation to the accuracy, completeness, reliability or appropriateness of the information, methodology and any derived price contained within this material. The securities and related financial instruments described herein may not be eligible for sale in all jurisdictions or to certain categories of investors.

 

Neither 720 Global, LLC nor its directors accept any liability for any loss or damage arising out of the use of all or any part of these materials.

All rights reserved. This material is strictly for specified recipients only and may not be reproduced, distributed or forwarded in any manner without the permission of 720 Global, LLC. 

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The Sure Thing

The Sure Thing

The New England Patriots pulled off a stunning come-from-behind victory in Super Bowl LI, and one that was truly unprecedented in American football. Throughout modern NFL history, playoff teams that had a 19 point lead or greater in the fourth quarter, as the Atlanta Falcons did, were 93-0. A Patriots comeback was deemed virtually impossible by the odds-makers. There is an important lesson here worth considering. The Patriots improbable victory follows a variety of other unlikely, but surprising high-profile events in the past several months, some of which will have far greater impact on our lives than we may realize.

The British referendum to leave the Euro

Last summer, the odds of Brexit gaining a majority vote briefly dipped below 5% in the days preceding the vote. In a premonition to the upcoming U.S. election, The Sun newspaper in London mistakenly announced that the head of the Brexit campaign, Nigel Lafarge, conceded to the “Remain” vote.

 

Graph and Newspaper cover courtesy: Hypermind.com and The Sun respectively

Leicester City’s improbable Premier League Championship

Leicester City entered the 2016 Premier League season as a 5,000 to 1 underdog to win the league championship. Fortunately for Leicester City, the existence of long odds bear no direct influence on outcomes as they went on to win the Premier League Championship. For the sake of comparison, the worst team in the NFL, the Cleveland Browns who finished the 2016 season with one win, started the year with odds of 200-1 to win the Super Bowl. According to odds-makers, the Browns were 25 times more likely to win the Super Bowl than Leicester City was to win the Premier League Championship.

 leicester

Image Courtesy: ESPN

The U.S. Presidential Election

In the days leading up to the U.S Presidential election, Donald Trump was a serious underdog with only a 20% chance of winning the election.  Even after some states had closed their polls and results were trickling in, a Hillary Clinton victory was all but a foregone conclusion. Newsweek infamously released their upcoming issue with a picture of Hillary Clinton under the words “Madam President.”

 

Graph and magazine cover courtesy: New York Times and Newsweek respectively

Super Bowl LI

With the Patriots trailing 28-3 mid-way through the third quarter, the odds of a Patriots Super Bowl victory were placed at 0.3% or 333 to 1. The Falcons were a virtual lock to win. The graph below charts the progression of the in-game odds for each respective team winning. The gray line highlights the point where the Falcons had the greatest chance of winning.

super-bowl-2

Graph Courtesy: Matthew Cascio @mattcascio

Why?

Given that “impossible” events are seemingly occurring with regularity, we must ask, “Why?”

Maybe another question that should be entertained is why the favorite, at any point in the contest, is given such commanding status? Given what we have seen out of Tom Brady in his illustrious career, why would experts count him out with a seemingly eternal 23:29 remaining to play in the biggest game of the biggest sport in America?

To apply this concept to another great global sport, do U.S. equity market valuations imply similar false confidence in future outcomes for the pace of earnings and economic growth?

The Dow Jones Industrial Average just crossed the 20,000 mark with great fanfare. Immediately following the celebration, the media and market “experts” began discussing the next benchmarks they expect to fall, Dow 25,000 and 30,000.  Like those supporting the aforementioned clear favorites, everyone seems to be caught up in euphoria and the absolute certainty of an outcome. Like the attitudes that prevailed in 1929 and 1999, market experts appear to be convinced that the equity markets are moving in one direction, higher.

Spot VIX, an indicator that conveys confidence or concern about future equity price moves, is near-record lows. This implies tremendous confidence that stock prices will indeed move higher. Conversely, however, lesser followed VIX futures currently trade at historically steep premiums which suggest more than a few market participants harbor anxieties about the future.

We have been vocal in our thoughts about the confluence of historically high valuations, economic headwinds and the uncertainties of a new administration. It is hard for us to get on a bandwagon that is not supported by fundamentals. We feel like the sole Patriots fan listening to everyone around us debate whether Falcon’s quarterback Matt Ryan or star receiver Julio Jones will be the MVP.

Like all of the instances listed above, the odds are clearly wrong. The fundamentals governing each event were carelessly neglected, and probabilities radically miscalculated, sending the experts and their followers, in the wrong direction. While sports or politics may not be your thing, we urge you to pay attention.

The odds of equity market victory are very near 100%.  What could go wrong?

 

 

 

 

720 Global is an investment consultant, specializing in macroeconomic research, valuations, asset allocation, and risk management.  Our objective is to provide professional investment managers with unique and relevant information that can be incorporated into their investment process to enhance performance and marketing. We assist our clients in differentiating themselves from the crowd with a focus on value, performance and a clear, lucid assessment of global market and economic dynamics.

 

Coming soon 720 Global will offer “The Unseen”, a subscription-based publication similar to what has been offered at no cost over the past year and a half.  In fact, what the subscription offers is precisely what we have delivered in the past, a substance in style and form that provides unique analysis and meaningful value to discerning investors. Those that have read our work understand the comparative advantage they have gained over the vast majority of investors that solely focus on the obvious. Our readers are prepared for what few see.

 

720 Global research is available for re-branding and customization for distribution to your clients.

 

For more information about our services, please contact us at 301.466.1204 or email

info@720global.com

 

©720 Global 2017 All Rights Reserved

 

NOTICE AND DISCLAIMER: This material has been prepared by 720 Global, LLC. Opinions expressed herein are subject to change without notification. Any prices or quotations contained herein are indicative screen prices and are for reference only. They do not constitute an offer to buy or sell any securities at any given price. No representation or warranty, either express or implied, is provided in relation to the accuracy, completeness, reliability or appropriateness of the information, methodology and any derived price contained within this material. The securities and related financial instruments described herein may not be eligible for sale in all jurisdictions or to certain categories of investors.

Neither 720 Global, LLC nor its directors accept any liability for any loss or damage arising out of the use of all or any part of these materials.

All rights reserved. This material is strictly for specified recipients only and may not be reproduced, distributed or forwarded in any manner without the permission of 720 Global, LLC. 

 

 

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Fed Up – A Look Behind the Curtain

 

Danielle DiMartino Booth, a former Dallas Federal Reserve official, released a new book this week entitled Fed Up. The book, a first-person account of the inner-workings of the Federal Reserve (Fed), provides readers with unique insight into the operations, leadership, and mentality of what is unquestionably the world’s most powerful financial force.  What it reveals about the Fed is neither flattering nor confidence-inspiring. By pulling back the curtain to reveal the Fed’s modern-day machinations, DiMartino Booth provides an assessment of the highest levels of economic thinking and how it is afflicting our economy.

Throughout the book, it is clear her purpose is equal parts entertainment and education with a dash of sermon to underline the gravity of the situation.  Fed Up is compelling, well-written and its objectives are clear; expose the hubris at the Fed which results in poor decision-making and generate much-needed debate to bring about change in how the Fed functions. As you read this review, and hopefully the book as well, we remind you the Fed is sworn to serve the American public and should be held accountable to this obligation.

We thank Danielle for giving us the privilege of reading an advance copy of her book so that we can provide this timely review to you. Neither 720Global, LLC nor its owners have received any form of direct or indirect compensation in exchange for the review of this book.

Confluence of Events

Skill, talent, temperament and career path often have a funny way of converging at just the right time to produce something that is needed at a particular moment to change the course of events. Danielle DiMartino Booth’s Wall Street experience and tenure as a journalist converge with her personal traits of curiosity, healthy skepticism and integrity to expose the powerful forces of the Fed and the means by which they use their influence.

DiMartino Booth spent enough time on Wall Street to become “enlightened” as to the ways of high finance and then went on to pursue a career in journalism at the Dallas Morning News.  Her insight and warnings in the years preceding the Great Financial Crisis of 2008 are well-documented and stand in stark contrast to the mindset of the Fed and then-chairman Ben Bernanke who “found little evidence to support the existence of a national home price bubble.” Fortunately, the President of the Dallas Federal Reserve Bank, Richard Fisher, was a rare exception within the Fed and took notice of DiMartino Booth’s articles. In the fall of 2006, Fisher convinced her to join the Dallas Research Department.

Theory Versus Practice and a Dose of Hubris

From her early days at the Dallas Fed, DiMartino Booth recognized that the Federal Reserve is run by Ph.Ds. from the premier economic schools of the nation. Referring to them as the “MIT mafia,” she notes that the large concentration of academicians at the Fed is a recent trend. Traditionally, Fed governors hailed from the banking sector where they came equipped with a deeper understanding of the workings of the main street economy and a real-world perspective of the benefits and consequences that accompany monetary policy. In years’ past, the practical experience of leadership naturally guided academically-oriented researchers and analysts on staff. According to DiMartino Booth, Richard Fisher was a Fed President of this mold. Unfortunately, the influx of Ph.Ds. over the last 15 to 20 years with virtually no practical experience changed the Fed’s thinking. In her words, “the overwhelming dominance of academics goes a long way toward explaining why the financial crisis of 2008 blindsided the Fed”.

Prominently throughout the book, DiMartino Booth highlights the arrogance and hubris that these academics-turned-central bankers possessed and the control they garnered. They believed that their textbooks, unproven theories, and complex research papers provided new sophistication and certainty with which to manage the domestic and, indeed, the global economy. They shelved simple models, and all but ignored real-time market data and the word on the street. In their pursuit of certainty, they forgot that human behavior could not be replicated in a petri dish.

This myopic academic perspective affected the staff economists and spread to the upper echelons of the Federal Reserve.  As DiMartino Booth writes, “not that Bernanke wasn’t listening, but over time, he fixated on academic theories. Real life reports by Fisher and other District Bank presidents counted for little.”  She added that current Fed Chairwoman Janet Yellen, who at the time ran the San Francisco Fed, was “more married to her models than Greenspan and Bernanke combined.

Despite warnings from DiMartino Booth and Fisher, the Fed failed to see that Malignant stars were aligning for a once-in-a-century global economic meltdown. Though precious few inside the Fed saw the crisis coming, it is patently false to suggest insiders hadn’t been fairly warned”.

As concerning as the Fed’s myopia was, she found their hubris equally troubling. From the Fed Governors and district presidents down to the staff Ph.Ds.’ the air of royalty and elitism permeated the atmosphere. Many of these economists lived in vacuums, where assumptions about human behavior and intricate modeling replaced real world experience and observation. It should be no surprise therefore that DiMartino Booth and Fisher, lacking Ph.Ds.’ were generally ignored despite their repeated expression of concern and warning.

Driving Animal Spirits

In giving us the proper perspective on the events of the financial crisis and the Fed response, DiMartino Booth effectively lays the ground work for historical events that influenced future course.  She describes the sequence of events beginning ten years earlier that would formally establish the ultimate term describing financial moral hazard, “the Greenspan Put.”

The once-mighty hedge fund, Long-Term Capital Management (LTCM), run by the so-called best and brightest Ph.Ds. (a theme that should start to sound familiar by now), including two Nobel Prize winning board members, thought they had developed a means by which they could guarantee profits from derivative trading. When their theories and models didn’t align with reality, massive losses ensued, and Wall Street was holding the risk. Fed Chairman Alan Greenspan, along with Treasury Secretary Robert Rubin and Treasury official Lawrence Summers, orchestrated a government-sponsored bailout of the hedge fund.

The LTCM bailout – to be clear, the American taxpayer bailout of a hedge fund and in turn Wall Street – sent a very clear “risk-on” signal to major financial institutions and investors which elevated Greenspan and company to a status akin to deity. Per DiMartino Booth: “They were hailed as geniuses. I imagined my fellow Wall Streeters going to the cathedral in my neighborhood and lighting candles. Thanks be to God and Greenspan”.

Fast forward to the aftermath of the 2008 crisis, and through many different forms of extraordinary and highly questionable monetary policy, DiMartino Booth makes a case that the Fed remains overly concerned with spurring animal spirits. In other words, they believe that continually boosting investor confidence and driving financial asset prices higher is a necessity. In DiMartino Booth’s words “and yet here was the Fed, with Yellen as its biggest cheerleader, once again trying to build an economic recovery on the back of frenetic animal spirits.” In the Fed’s mind, Bear Stearns, Lehman, Fannie Mae and other institutions lay testimony to what happens when the free markets are left to their own devices. Left out of their discussion, however, was the role the Fed might have played in creating the problems through ill-advised policy.

DiMartino Booth makes clear that Fed officials have both the free hand and the lack of humility to disregard the potential negative implications for the average citizen while at the same time emphasizing the needs of their primary constituent – Wall Street.  The Fed’s tactics are not just about investor confidence but backed by a faulty theory called the wealth effect. They erroneously associate financial asset inflation to wealth generation and wealth generation to prosperity for all. In retrospect, they either failed to recognize that artificially manipulating markets higher would predominately benefit the wealthy or they knew this but elected not to disclose it. In DiMartino Booth’s words “The problem was the bulk of these trillions was in the hands of a few. Those who were most insulated from the needs to earn a living were driving the rally. Any middle-class recovery was an illusion.” Further “Who will pay when this credit bubble bursts? The poor and the middle-class, not the elites. If those injured most by Fed policy could understand, they would be marching at Yellen’s door with protest signs, screaming show us the wealth effect!

Transparency

Touted increasingly by the Bernanke and Yellen regimes, emphasis on improving Fed transparency appears to be nothing more than a self-serving ruse designed to deflect congressional efforts to regulate the Fed. DiMartino Booth explains that, although intended to highlight the substance of Federal Open Market Committee (FOMC) meeting discussions, published FOMC minutes are altered well after the meeting to mollify Wall Street’s and the markets’ interpretation of the original statement.  She also discloses that Bernanke and Yellen brazenly “leak” information to the press to suit various purposes. Such purposes may include efforts to “correct” markets when desired or even as a bully tactic aimed at Fed members that may have stepped out of line with the Chairman’s preferences.

Fixing the Fed

DiMartino Booth is not supportive of the extreme call by some to “end the Fed”, but she firmly believes there needs to be dramatic reform. The various recommendations she offers include specific suggestions involving the way monetary policy is formed and implemented as well as the objectives of such policy.  Many of the economic woes facing the nation are either a direct or indirect result of an over-imposing and ham-handed monetary policy approach based on intellectual arrogance. She makes a compelling plea for change, listing numerous reasonable actions that should be undertaken to improve the Fed’s influence over the economy to the benefit of all Americans, not just the wealthy.

Summary

Wealth inequality, wage stagnation, massive debt loads, feeble economic growth and weak productivity growth are but a few of the economic and social problems that are the legacy of poor monetary policy.  Less than a decade after the Financial Crisis, we are again confronted with asset prices perched well above fundamentals, an unfettered shadow banking system and an even larger concentration of too-big-to-fail banks. Additionally, unprecedented interest rate policy is complicit in allowing lawmakers and the U.S. Treasury to shirk their fiscal responsibilities and recklessly expand the national debt.  It is unbecoming and irresponsible for Fed officials to continually neglect to accept any role in the prior two economic bubbles and the one now festering.

What DiMartino Booth describes in Fed Up is the manifestation of years of central bank evolution. To the academics who occupy the chairs in the Marriner Eccles Building today, it is the blooming flower of the seeds planted by John Maynard Keynes and nurtured by Alan Greenspan, Ben Bernanke, and Janet Yellen. The reality, as so well described by DiMartino Booth, is that of an intellectual contagion. The role the Federal Reserve has assumed today better resembles that of a global virus. By way of multiple global financial crises over the past 30 years, their influence and power have adapted and spread to cover all of the developed world.

By pulling back the curtain on this reality, DiMartino Booth accomplishes what may be the first meaningful step toward properly diagnosing an important source of present day economic illness. Fed Up provides a post-crisis update of how the Federal Reserve runs the country with substantial evidence of the short-cuts and manipulations employed as a means to their ends. The recommendations offered in the book are reasonable and actionable but will certainly be viewed as a threat to Fed independence. It is that independence which has served as the enabler of a powerful, un-elected governing body which bears no accountability or burden of proof for its actions. The time to reign in and redefine how the Fed operates is past due and Fed Up offers not only the rationale but a potent and lucid blueprint for doing so.

 

If you would like to order Fed Up by Danielle DiMartino Booth click here – LINK

 

Neither 720Global, LLC nor its owners have received any form of direct or indirect compensation in exchange for the review of this book.

 

Within the next two weeks 720Global will offer “The Unseen”, a subscription-based publication similar to what has been offered at no cost over the past year and a half.  A subscription offers what we have delivered in the past – clear, independent and unconventional perspectives, substance in style and form as well as macro and micro idea generation of meaningful value to discerning investors. Additionally, our soon to be released mobile-friendly website promises state-of-the-art publication delivery, access to 720Global archives and many other new features.


Those that have read our work understand the comparative advantage they have gained over the vast majority of investors that solely focus on the obvious. Our readers are prepared for what few see.

 

 
720 Global is an investment consultant, specializing in macroeconomic research, valuations, asset allocation, and risk management.  Our objective is to provide professional investment managers with unique and relevant information that can be incorporated into their investment process to enhance performance and marketing. We assist our clients in differentiating themselves from the crowd with a focus on value, performance and a clear, lucid assessment of global market and economic dynamics.

 

 

720 Global research is available for re-branding and customization for distribution to your clients.

 

For more information about our services please contact us at 301.466.1204 or email

info@720global.com

 

©720 Global 2017 All Rights Reserved

 

NOTICE AND DISCLAIMER: This material has been prepared by 720 Global, LLC. Opinions expressed herein are subject to change without notification. Any prices or quotations contained herein are indicative screen prices and are for reference only. They do not constitute an offer to buy or sell any securities at any given price. No representation or warranty, either express or implied, is provided in relation to the accuracy, completeness, reliability or appropriateness of the information, methodology and any derived price contained within this material. The securities and related financial instruments described herein may not be eligible for sale in all jurisdictions or to certain categories of investors.

Neither 720 Global, LLC nor its directors accept any liability for any loss or damage arising out of the use of all or any part of these materials.

All rights reserved. This material is strictly for specified recipients only and may not be reproduced, distributed or forwarded in any manner without the permission of 720 Global, LLC. 

 

 

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