Mauldin Economics



December 2, 2015

The Economic Costs of Terrorism Hit an All-Time Peak

By John Mauldin

BY JOHN MAULDIN

The world can change quickly, and last week it did. The most immediate and heartbreaking impacts of the Paris attacks were suffered by the victims themselves and their families, but from there the ripples of terror spread outward around the world.

The Paris events didn’t happen in isolation. Recent bombings in Lebanon, Iraq, Mali, and Nigeria, plus the Russian airline disaster, showed us how far evil can reach.

It isn’t just ISIS: al-Qaeda is getting stronger in some places; Boko Haram continues to strengthen in West Africa; the Taliban is resurgent in Afghanistan; and the list goes on…

In addition to the catastrophic human cost, terrorism has economic impacts. It misallocates resources, distorts prices, and prompts adverse government policies. We all feel these effects, even if we live far from the terror zones.

Terrorism is global. So is the economy. We can’t separate them.

The Direct Cost of Terrorism Reached $52.9 billion in 2014

I saw a report referenced on Bloomberg last week that said 2014 was the costliest year for terrorism since 2001, in both financial terms and human lives lost. That assertion seemed remarkable, so I went to the source.

The Institute for Economics and Peace is an Australian nonprofit think tank. I can’t vouch for their expertise, but their “Global Terrorism Index” is still interesting.

They calculate that the worldwide economic cost of terrorism was $52.9 billion in 2014, an all-time peak. That’s the GDP of a small country gone up in smoke (literally).

IEP arrives at that number by adding up property damage along with medical costs and lost income for victims. But they do not include the indirect costs of preventing or responding to terrorist acts.

Mauldin-Economics-Costs-Terrorism

What About Terrorism Prevention?

How much money does the world spend to cope with the mere possibility of terror attacks? The US Transportation Security Administration’s 2014 budget was $7.4 billion. TSA is only one of several agencies focused on terrorism and the US is only one country.

Think about all the private security guards, construction costs of hardening office buildings, executive and staff time spent dealing with the inevitable headaches and delays, and much more.

Pick a very large number. Whatever that number is, you can bet the cost will go much higher after what happened last week. For instance, how much did it cost to shut down Paris for a weekend?

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November 30, 2015

Connecting the Dots: Kiss Christmas and Retail Stocks Goodbye

By Tony Sagami

In my article from November 17, I touched on the growing number of retailers that report shrinking traffic and disappointing sales:

Our consumer-driven economy is not getting any help from suddenly sober shopaholics. In the most recent report, the Commerce Department reported that retail sales rose by a measly 0.1% in September. And it didn’t matter where you wear Gucci loafers or Red Wing work boots.

Since then, the retail landscape has gotten even muddier.

The Commerce Department reported that retail sales increased by a miserly +0.1% in October, below the +0.3% Wall Street was expecting. Additionally, sales for the month of September were revised downward from +0.1% to 0.0%.

So this is what the last three months look like:

August 0.0%
September 0.0%
October 0.1%

You should pay careful attention to retail sales because there is a strong correlation between plunging retail sales and plunging stock prices!

Walmart, Macy’s, and Nordstrom are the three high-profile retailers to disappoint Wall Street, but they have lots of company.

  • Shoe retailer DSW, Inc. lowered its full-year earnings forecast from $1.80 – $1.90 per share to $1.40 – $1.50 per share. The problem? Slow customer traffic.

  • The Gap reported that its October same-store sales dropped by 15% at Banana Republic and by 4% at Gap stores. Additionally, the company warned that it would miss Q3 expectations.

  • Urban Outfitters reported Q3 sales of $825.3 million, well below the Wall Street pipe dream of $868.9 million. Urban Outfitters’ shares closed down 7.4% to a four-year low after spitting up that revenue hairball.

The biggest confirmation of the retailing woes came from the Port of Long Beach, the second-busiest US port.

The Port of Long Beach handled 307,995 containers in October, down from 310,482 and 0.8% less from the same month last year. More troublesome is the 14% plunge in imported containers since August.

That tells me retailers are cutting back their pre-Christmas orders in anticipation of disappointing holiday sales and due to already bulging inventories.

Speaking of bulging inventories, I want to point out two retailers with ballooning inventories that I think are profit time bombs just waiting to kill investors.

  • Lululemon Athletica (LULU): Yoga-pants maker Lululemon has been suffering from an inventory bulge. Inventory hit $280 million, a 55% year-over-year increase.
  • Under Armour (UA): Inventory ballooned to $867 million at the end of Q3, a 36% increase.

I’m not suggesting that you rush out, sell all your retail stocks, or short Lululemon and Under Armour tomorrow morning. As always, timing is everything. However, it is crystal clear to me that the Grinch is definitely going to steal Christmas… and that retail stocks are one of the worst places to invest your money.

Find out what other stocks are in peril—and how to make money from the demise of the losers.

Tony Sagami
Tony Sagami

30-year market expert Tony Sagami leads the Yield Shark and Rational Bear advisories at Mauldin Economics. To learn more about Yield Shark and how it helps you maximize dividend income, click here. To learn more about Rational Bear and how you can use it to benefit from falling stocks and sectors, click here.

November 25, 2015

Outside the Box: Paris, Sharm el-Sheikh, and the Resurrection of Old Europe

By John Mauldin

 

Soon after the Paris attacks, I picked up the phone to talk over the situation with my friend George Friedman. George is one of the truly world-class thought leaders on geopolitics. We had an animated 20-minute conversation. I didn’t particularly like what I heard.

George thinks we face big difficulties in dealing realistically with the ISIS threat. The more I read—and the more I listen to people like George who have worked these issues for decades—the more I think that we, as a culture, need to face reality.

I asked George to distill his thoughts into a short essay I could publish in Outside the Box, and he agreed.

This is a very thought-provoking piece with a different conclusion—which is what you can always expect from George.

Paris, Sharm el-Sheikh, and the Resurrection of Old Europe

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

 

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By George Friedman

The attacks in Paris last Friday night were part of a long-term pattern of occasional terrorist attacks by jihadists on targets in Europe. In the European context, this stood out for two reasons. First, the scale of the attack was substantially larger than other attacks in recent years, both in the number of participants and the number of casualties. Second, it was different in the level of sophistication and planning. Securing weapons and explosives, gathering at least three teams, identifying the targets and the manner in which these targets were to be attacked involved fairly complex logistics, intelligence and above all coordination. Most impressive was their counter-intelligence and security. There were at least seven attackers and additional support personnel to secure weapons, gather information and help them hide out in preparation for the attack. No one detected them.

The large majority of attacks are detected and disrupted prior to execution by European and American intelligence services, using information, communications intercepts and the other tools available to them. No one detected this group, indicating that the group, or at least its leaders, were aware of the methods used to identify attacks and evaded them. Lone wolves evade detection being lone wolves. These attacks required coordination and support. Their communications, movement and surveillance should have been detected. They weren’t. That means there was a degree of training that could only be obtained through a more sophisticated group like Islamic State (IS).

It is noteworthy that IS took credit for the attacks in Paris because up until recently, such attacks have not been directly ordered by IS. Terrorist attacks on Europe or the United States designed to create maximum casualties were the modus operandi of al-Qaida. IS has generally focused on taking and holding ground in Syria and Iraq, leaving terror attacks to self-actuated lone wolves. IS was capable of terror attacks but their focus was on creating the caliphate, a territory ruled under their interpretation of Sharia, rather than on carrying out terror attacks.

That apparently has changed. The attack on Paris was part of a cluster of strategic terror attacks including the downing of the Russian airliner at Sharm el-Sheikh (which yielded more deaths than Paris) and the attack in Beirut. The planning for the attacks, assuming that explosives and weapons had been secured, probably began no later than Oct. 1, 2015.

When we go back to the days surrounding Oct. 1, there are two things that stand out. First, the French began bombing targets in Syria on Sept. 27 and the Russians started bombing Syria on Sept. 30. IS was not particularly damaged by these events, but it was clear that forces were gathering against them. IS needed to do two things. The first was to demonstrate to their own troops that they would not simply be bombed without response. This was critical to morale. Second, they had to demonstrate to France, Russia and anyone else planning to get into the Syria game, that it does not come without cost. They were not afraid of Russia and France moving against them in response. They were already moving against them. IS wanted to start shaping French and Russian public opinion. Certainly, the first response would be rage but jihadists have learned that the rage dies down in the West and so does the appetite for war. IS needed to demonstrate its reach, speed and deadliness. What followed was the downing of the Russian airliner at Sharm el-Sheikh and the Paris attacks. Most of the operators would have been in Europe already, as well as in the Sinai, if not working at the airport. But the actions took place in a broader European context.

The wave of immigration that has swept into Europe from the Islamic world in general, but particularly the more recent stream of refugees from Syria, has created a political crisis in Europe and one that was particularly raucous prior to Oct. 1. Charges were being levelled by Germany against Central European countries for refusing to accept refugees. In turn, those countries charged that Germany was demanding that small countries transform their national character with the overwhelming numbers of refugees housed there. In addition, these countries, particularly Hungary, argued that among the genuine refugees there would be members of terrorist groups and that it was impossible to screen them out.

Had Europe been functioning as an integrated entity, a European security force would have been dispatched to Greece at the beginning of the migration, to impose whatever policy on which the EU had decided. Instead, there was no European policy, nor was there any force to support the Greeks, who clearly lacked the resources to handle the situation themselves. Instead, the major countries first condemned the Greeks for their failure, then the Macedonians as the crisis went north, then the Hungarians for building a fence, but not the Austrians who announced they would build a fence after the migrants left Hungary. Between the financial crisis and the refugee crisis, Europe had become increasingly fragmented. Decisions were being made by nation-sates themselves, with no one being in a position to speak for Europe, let alone decide for it.

From IS’s point of view, this provided two opportunities. Tactically, it gave them an opportunity to insert agents into Europe in the midst of migration. But this was a secondary issue, since IS could insert operatives at somewhat a greater risk if they wanted. However, there was a much more significant problem and opportunity for IS.

First, the mass migration from Syria did not show itself at this level during the first phase of the Syrian civil war, when IS was not yet involved. It showed itself when IS became operational. As such, this posed a political problem for the group. The refugees were overwhelmingly Sunni, and IS presented itself as the guarantor of Sunni rights. The fact that they were fleeing IS affirmed the sense in other parts of its territory that IS represented a threat not only to Shiites, Kurds and others, but also to Sunnis. Ultimately, this represented a threat to IS’s power because if the Sunni base saw IS as a threat, then IS would become unsustainable.

That was the strategic threat of the migrants. There was also a strategic opportunity in two ways. First, Europeans for the most part were not eager to receive large numbers of refugees, and the reception for refugees that made it to Europe was often unwelcoming, particularly as displayed on TV. The ability to demonstrate to the Muslim masses that the Europeans were now hostile not only to the principles of Islam, but to Muslims themselves, would potentially position IS as the defenders of Islam or at least the Sunnis. IS had been careful, in the midst of a rigorous interpretation and implementation of Sharia in areas under its control, to also create a system of social services that provided at least a safety net to Sunnis. Fleeing the IS safety net for Europe, Muslims now discovered how despised they were. From IS’s point of view, the more hostile the greeting to the migrants, the more solid their position. The chaotic arguments in Europe supported their position.

In late October, the atmosphere began to shift, or at least the intensity. Europe remained united, but the decision by Angela Merkel to very aggressively champion the case for sanctuary in Europe for the refugees not only created a battle with some European countries and the European right, but it also began to shift the center of gravity of European positions toward the idea that some sort of sanctuary had to be granted. This shift did not particularly please IS, since a more hostile stance satisfied its needs better.

Whether this was the reasoning that led to the attack in Paris is something we do not know. We do know that a passport for a Syrian refugee was found on one of the attackers. The French authorities have also said that the passport is a fake. Clearly, the organizer of the attack had to know that the passport would be found. Once found, authorities would believe him to be a refugee. Care could have been taken to exclude refugees, or at least take greater steps to hide identities. Instead, the fact that he may have been a Syrian refugee, or at least was holding the passport of one, was discovered in hours. Whoever organized this attack was not careless and he undoubtedly knew the consequences of a Syrian refugee being among the attackers. This was obvious to anyone in Europe or elsewhere. Nevertheless, the attacks went forward, knowing that the attackers would be killed and identified.

Therefore, IS, or the subgroup in command of this operation, had to know that the consequence of this attack would not only be increased hostility to IS, but intense re-examination, in the context of legitimate fear, of the policy of admitting Syrian refugees into Europe. In the most extreme case, the refugees would be either placed in camps under careful guard until their identities and links could be determined, which would take a long time, or alternatively, a program or simple ad hoc expulsion of the refugees would take place. In either case, a process of potential radicalization, one with plenty of historical enmity from which to develop, would begin that would both paint the Europeans as an enemy, clarifying sides, or create a base for recruiting troops for IS. There was only upside in this for the Islamic State.

The point that made this strategy attractive is that once the dead IS operative holding a Syrian passport was found, any reasonable European assumption would have to be that there were more. Given the numbers of dead and wounded, the presence of even a handful of such operatives would be cause for serious alarm. Given the fact that the operation was undertaken without any detection of movements or communications, it followed that the ability to discriminate between harmless refugees and IS operatives was uncertain. Considering this logic, any European not frightened was out of touch with reality.

It may all be an accident, but if it is an accident, it is a remarkable one. With this attack and its threats for more, IS has struck at the heart of Europe’s sense of security and regardless of what they do, the Europeans will be alienating huge numbers of people who not only have no where to go, but also have no way to get there in any reasonable time frame. What comes out of this is something Europe hasn’t seen for a long time: camps, carefully guarded, with interrogation. The refugees must be brought under control from the European point of view. That requires them to be confined. But how do you confine several million people?

It also had an effect that was likely not anticipated by IS, and which poses only tactical problems for them, but which dramatically changes how Europe works. European countries, one after the other, revived their border controls, effectively negating the principle that the EU is about the free flow of goods, money and people. Money still flows, but goods and people must now face a hurdle at some of Europe’s old borders.

I have long made the claim that the transnational nature of Europe cannot be sustained. The divergent economic interests of EU countries, some with unemployment over 20 percent, some with it under 5 percent, meant that it was impossible for all of them to live not only under the same monetary regime, but under the same trade regime, which we cannot call free trade with agriculture, among other things, being protected. This would lead to a focus on national interest and on a resurrected nation-state.

This was the fundamental problem of Europe and the migration crisis simply irritated the situation further, with some nation-states insisting that it was up to them to make decisions on refugees in their own interest. The response of Europe to the Paris attacks brought together all of these matters, and Europe only responded when some nations decided to use their national borders as walls to protect them from terrorists.

It is important to notice that this was not the EU creating checkpoints independent of national borders to trap terrorists or block them. The EU wasn’t built for that. Rather, it was the individual nation-states, reasserting their own rights and obligations to secure their own borders that acted. Despite all the rhetoric of a united Europe, the ultimate right of national sovereignty and the right of national self-defense was never removed.

Once it has been established that this implicit right can be used and the basic boundaries inside of Europe are the old European borders, we have entered a new Europe, or rather the old one. It is not clear when or if the border checkpoints will come down. After all, the war with the jihadists has created a permanent threat. Since there is no one to negotiate with, and no final blow that will end the war, when should the borders be opened again? What IS created, without intending it, is the fragmentation of Europe, with each state protecting itself. When will Europe decide it no longer needs checkpoints at the borders? When is it safe? And, if it is not safe, how do the borders come down?

You cannot control the movement of people without controlling the movement of goods. Whatever the rules at the moment, the nation-state has reasserted its right to determine what vehicles enter. Once that principle is in place, the foundation of Maastricht does not disappear. The agreement is still there, but the claim to ultimate authority is not in Brussels or Strasbourg, but in Madrid and Budapest and Berlin. This causes more than delays at the border, it essentially creates a new mindset.

This started as a counter to Russian and French airstrikes. It has culminated in unintended and unanticipated consequences, as is the norm. An airstrike in Syria, attacks in Paris, and the borders are back. Only to stop terrorists, of course. But that “of course” is dripping with historical irony.

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November 24, 2015

The 10th Man: And Justice for All

By Jared Dillian

 

This chart…

…is driving everything in the financial markets right now.

The Curious Case of Zambia

If you can’t see where I’m going with this, just give it a minute.

I’m fully aware that many people might be unable to find Zambia on a map, so here is Zambia on a map:

A few years ago, Zambia accessed the capital markets and did a dollar bond deal at an incredible 5.625%. People said at the time that the emerging/frontier trade was getting goofy. I disagreed. I thought Zambia was a better credit than, say, Italy.

It hasn’t worked out that way…

As you can see, the yield on that bond has gone from 6% to 11%, just in the last year.

Whoops.

Zambia found itself in a position where it had to issue more debt, at much higher interest rates. It had a huge budget deficit, because the government gets a huge amount of revenues from royalties on…copper mining.

Whoops.

And the reason copper is tanking is because China is in recession, and because of the chart I showed you at the beginning of this essay.

So why is the dollar going up?

Because even though the Fed hasn’t raised rates yet, relative to everyone else, the United States is actually sort of tightening its monetary policy.

When the Fed declined to raise interest rates because of “international concerns,” this is what they were talking about. Zambia, and everyone else like them.

For once, it is actually not Zambia’s fault. They were trucking along, growing at about 6.5% a year, and then a piano fell on their head. They were confident enough in their growth that they thought they would be able to issue dollar bonds.

You know what the problem with dollar bonds is: If your currency goes down, you are screwed.

Zambia was once a frontier-markets darling. No more.

But nothing has changed within Zambia. Same people. Same natural resources. Same government. Same thesis. They just got caught up in the macro s---storm.

Hold that thought.

A Just World

A just world is not one in which innocent third parties get mangled by developed-country economics. But that is what’s happening.

When a big macro/FX trend changes, there’s a lot of pain.

I heard about some research on this. Apparently, when you go from one FX regime to another, there is a period of adjustment that lasts about a year or two, then things start to get better as people get used to it. Lots of people think copper will turn around when the dollar falls.

Maybe not!

Maybe copper will go up when it’s just done going down, and base metals and the dollar will learn to coexist.

One thing I’ve learned about markets over the years is that they have a pretty good sense of karma. In the long run, people get what’s coming to them. Top of the list is Greece. Silicon Valley will have its turn in the barrel someday. I think it is already starting—hearing about private valuations dropping. And of course, the Canadians. Eventually, the markets catch on and will punish excess.

Zambia is hardly a symbol of excess, though. To the extent that it benefited from frontier portfolio flows, it wasn’t very much.

If you want to talk about excess, a lot of people have made a lot of money shorting miners. The market sure is taking its time getting around to redistributing bad fortune.

The Five-Year Plan

It’s pretty rare that bear markets last longer than two to three years. Even the really bad ones.

Crash/Great Depression: 1929-1932
Dot-com: 2000-2003
Financial crisis: 2007-2009

The metals bear market started in early 2011, so we are coming up on five years now.

I actually remember early adopters showing up to the short EM trade when I was still at Lehman. Seven years ago.

This has gone on long enough that I’m sure there is a whole cohort of young traders who think mining companies only go down. I, too, was born in a bear market.

Two things could potentially turn the metals market around:

  • Fed chickens out
     
  • China massively eases monetary policy, rallies

I think the second one is quite possible, and you never know with the Fed.

Or maybe the bear market just gets down to tag ends on its own.

You know, in the dot-com bust, there were literally hundreds of tech stocks that were down 95-99% from the highs. Those turned out to be great trades—at least the ones that didn’t go out of business. But it’s a dangerous game. If you buy something that’s down 98% and then it ends up down 99%, you just lost 50%.

The math behind this explains why bear markets just go on forever.

Jared Dillian
Jared Dillian

If you enjoyed Jared's article, you can sign up for The 10th Man, a free weekly letter, at mauldineconomics.com. Follow Jared on Twitter @dailydirtnap

The article The 10th Man: And Justice for All was originally published at mauldineconomics.com.
November 16, 2015

Connecting the Dots: The Peril and Opportunity of China

By Tony Sagami

 

Last week, I wrote about the massive pollution problems in China and the gigantic investment opportunity in the cleanup. However, China is a volatile, dangerous place to invest, and there is a wrong way and a right way to do so.

Where do you stand on the Chinese economic debate? Is the China economy decelerating so fast that it will pull the rest of the global economy down with it? Or do you think that the reports of China’s economic death are greatly exaggerated?

NOTE: I welcome your comments—GOOD and BAD—and encourage you to take advantage of the message forum at the end of these issues. Please!

No question, China is not growing at the breakneck pace that it has been.

China’s GDP growth slid to 6.9% in the third quarter, the slowest pace of growth since the depths of the 2009-09 Financial Crisis. That’s according to China’s National Bureau of Statistics, whose numbers are always highly massaged.

How massaged? That’s open for interpretation, but a recent Wall Street Journal survey of 64 economists found that 96% of them believe those GDP numbers don’t “accurately reflect the state of the Chinese economy.”

In other words, China’s economy is likely much weaker than the headlines suggest.

However, 6.9% (or slightly lower) is nothing to sneeze at, and China’s leaders are very committed to keeping the country’s economy on track.

“We propose to achieve the goal of creating a ‘moderately prosperous society’ by 2020, which requires annual economic growth of at least 6.5% over the next five years,” Chinese Premier Li Keqiang said.

The dangerous reality is that some parts of the Chinese economy are rapidly shrinking and are accidents waiting to happen.

In particular, I am talking about Chinese factories and Chinese exporters.

China is in the middle of a transformation from a manufacturing, export-based economy into a consumer-driven economy, like the US.

As with any major economic shift, there will be winners and losers.

The chart below from my friends at US Global Funds clearly shows where the growth is: the services industry.

By the way, US Global has a great China-focused mutual fund, the China Region Fund, and portfolio manager Frank Holmes is the best in the business.

The investment implications are simple: invest in Chinese manufacturing stocks and lose money, or invest in Chinese services stocks and make money.

However, the vast majority of investors I talk to have little or no money invested in China and the #1 excuse I hear is that it is too hard to invest in foreign stocks.

Hogwash!

There are 37 different ETFs focused on China and 310 Chinese stocks that are trading on the NYSE, Nasdaq, and OTC market.

That’s right; 310 Chinese stocks are traded here in the US. Click here for a full list of those 310 stocks.

Frankly, I think you’re much better off cherry picking the best individual stocks because all of the Chinese-focused ETFs heavily invest in the lethargic state-owned enterprises and the not-so-healthy manufacturing sector instead of the consumer-driven companies that are growing faster than Jack’s beanstalk.

And I’m not talking about a short-term one- or two-year trend, so make sure that you include a healthy dose of Chinese stocks in your portfolio.

If you haven’t yet, watch Mauldin Economics’ eye-opening documentary, China on the Edge, here.

Tony Sagami
Tony Sagami

30-year market expert Tony Sagami leads the Yield Shark and Rational Bear advisories at Mauldin Economics. To learn more about Yield Shark and how it helps you maximize dividend income, click here. To learn more about Rational Bear and how you can use it to benefit from falling stocks and sectors, click here.

November 8, 2015

The 10th Man: Pulling Out All the Stops

By Jared Dillian

 

When I was a teenager, I had a different sort of part-time job. I was a church organist.

Actually, it was the best job ever because I was something of a piano prodigy as a child. Around age 12, my parents and I had to make a conscious decision about whether I was going to pursue a career in music. I decided not to, which has greatly reduced the amount of Ramen noodles I have eaten over the years.

At age 13, I decided I wanted to play the organ. I took lessons from the organist in the big Catholic church downtown. What an incredible instrument!

Playing the organ is a lot harder than it looks. In case you hadn’t noticed, there is a whole keyboard at your feet—yes, you play with both your hands and your feet. And since you can’t possibly learn all the hymns, you have to be really good at sight-reading three lines of music at once. It takes a great deal of coordination. Plus, you have two or more “manuals” (keyboards) and dozens of stops, which activate the different sounds in the organ. This is where the phrase “pulling out all the stops” comes from.

So I got a job as the organist at the Unitarian church down the street. For the first and only time of my life, I was a member of a union—the American Guild of Organists. I received my union-protected minimum wage of $50 per service, which is a great deal of money if you’re 16 years old in 1990.

$50 a week definitely put gas in my car. And there was a girl in the congregation that I dated a couple of times.

I felt sorry for my poor schlep classmates who were bagging groceries for $4/hour. They had to work 12 hours to make what I made in one.

I felt pretty smug.  The high point was when I transcribed the theme from “A Clockwork Orange” and played it as the prelude for one of the church services. You can see where the subversive streak comes from.

I Got Skills

So why did I make more than 12 times what my high school classmates made?

Because my skills were worth 12 times as much.

Bagging groceries is kind of the definition of unskilled labor. Literally anyone can bag groceries. The supply of labor that has those skills is limitless.

Church organists are in slightly higher demand.

But not by much! I think a church organist these days—if you are hired by the church to play every week, plus run all the choir and music programs, probably pays about $35,000 to $50,000 a year, depending on the church. So not a lot!

It’s a decent living if you like playing the organ, but you also have to deal with church politics. The wages of an organist not only depend on the supply of labor but the demand for labor as well. And church construction has gone way down in recent years. Not to mention the fact that the latest fad in religious services is “contemporary music.”

However, the fact that church organists make more money than grocery baggers does reflect the level of skill the occupation requires. Before I became a church organist, I had been playing either the piano or organ for six years. Six years of practicing 30 minutes to an hour a day, every day.

Nobody practices bagging groceries for 30 minutes a day, every day.

I don’t particularly like manual labor (though I have done it on occasion). That’s why I do my best to acquire skills that are rare and marketable so I don’t have to do things like chip paint.

In this country (and others), we have this unhealthy obsession with manual labor. Politicians talk about “working Americans” all the time. We say things like “putting in a hard day’s work.” The most popular car is the Ford F-150.

Who wants to put in a hard day’s work? Not me!

Instead, I will put in a hard day’s thinking.

Hate and Discontent

A lot of people spend too much time thinking about what other people make. It’s unproductive.

Everyone thinks Wall Street guys are overpaid, for example.

Okay, so let’s take your average ETF option trader at a bank. Say he makes $500,000 a year (which might even be generous these days). Let’s examine one trade of many that he is confronted with on a daily basis.

A sales trader stands up and yells to him, “20,000 XLE Jan 75 calls, how?”

What’s happening here is that a client is asking for a two-sided market on the January 75 call options in XLE, which is the Energy Select Sector SPDR ETF, 20,000 times, which means options on 2,000,000 shares, or about $140,000,000. It’s a big trade, definitely, but there are bigger ones.

So let’s think of all the things the option trader needs to know.

He needs to know what an option is, starting from scratch.

He needs to know what XLE is, that it’s an energy ETF, and he should have a good idea of what stocks are in the portfolio. He might have a cursory knowledge about factors affecting supply and demand for crude oil.

In order to come up with a price for these options, he has to have an idea of what implied volatility should be and what realized volatility might be going forward.

This requires a knowledge of an option pricing model like Black-Scholes and many, many years of college mathematics, including probability theory and differential equations.

He needs to know how he is going to hedge this option. Will he hedge the delta all in the stock? Will he hedge with other options? How will he dynamically hedge the trade until maturity? Will he lay off some of the risk in other strikes? Will he buy single-stock options on some of the names in the index, like XOM, CVX, or COP, to effect a dispersion trade?

This means he has to know what a dispersion trade is. More math.

He also needs to understand liquidity. What will be his execution impact by trying to sell 800,000 shares of XLE? This affects how wide he makes his market.

And best of all, he needs to think about all of these things in a split-second, without hesitation.

If he is off by even a penny—he loses money on the trade.

I would characterize that as “skilled labor.” And we haven’t even talked about the emotional fortitude it takes to take that kind of risk.

$500,000 a year seems low.

CEOs

People get the most upset about executive pay. Here you have some dillweed CEO who is the direct beneficiary of the agency problem. If company XYZ does well, he gets paid millions. If it does poorly, he gets fired and loses nothing, personally. We say that he has no skin in the game.

Well, do you have what it takes to run one of the 500 largest companies in the world?

Pretend we’re talking about McDonald’s. Many people think McDonald’s is doing a terrible job. There’s a lot of evidence that they are. They’re losing market share to Chipotle and lots of other “fast casual” restaurants.

But running a company is hard enough. You have 50,000-odd restaurants, you have to manage supply and distribution for this massive network, you have to do all the managerial science behind what is on the menu and how much it costs, you have to directly negotiate, and I mean meet with leaders of foreign governments, you need to go on CNBC from time to time and not be a mutant, and above all, you need to lead inspirationally.

Not many people can do all that. I can’t. Maybe I’m smart enough, but I don’t have the emotional maturity or even the desire for that kind of responsibility.

Everyone wants to be the boss, but nobody really wants to be the boss.

If you think you are underpaid—maybe you are. The labor market is not perfectly efficient. Anomalies can persist.

Take a look at people who you think are overpaid. What are they doing that you aren’t? Maybe you just aren’t willing to do those things (like kiss lots of ass).

The responsibility is yours and yours alone. And that, my friends, is something nobody wants to hear.

Jared Dillian
Jared Dillian

If you enjoyed Jared's article, you can sign up for The 10th Man, a free weekly letter, at mauldineconomics.com. Follow Jared on Twitter @dailydirtnap

The article The 10th Man: Pulling Out All the Stops was originally published at mauldineconomics.com.

November 4, 2015

Connecting the Dots: Dirty Money: The Big Profits of Pollution

By Tony Sagami

 

It started about two hours after I landed. “It” being a persistent, ugly cough that I developed a couple of hours after I landed in Shanghai.

Shanghai is an amazing city. Although it doesn’t have the political significance of Beijing or ancient beauty of the Forbidden City and Great Wall of China, Shanghai holds the key to the Chinese economic-growth engine.

With 24 million residents, it’s the largest city in the world and home to several of the world’s most iconic buildings like the Oriental Pearl Tower and the 128-story Shanghai Tower, the second tallest building in the world.

I stayed at the JW Marriott at Tomorrow Square. I even scored a free upgrade on the 34th floor and smiled in anticipation of some great views of the Huangpu River, the historic Bund, and the glittering, futuristic skyscrapers of the Pudong district.

My room was clean, modern, and luxuriously appointed. But when I opened the curtains, instead of an impressive view, I could barely make out the landmarks through the thick, gray clouds of smog.

The air pollution is as bad as I have ever seen in China… and I’ve been there a lot.

Salted Egg Yolk

The thick haze of pollution obstructed everything beyond 50 yards. I might as well have stayed on the ground floor because my “room with a view” had no view.

Shanghai’s air pollution is getting worse by the year.

  • Earlier this year, the level of airborne particulates in Shanghai soared to 360, or 15 times the World Health Organization safe level of 25 micrograms per cubic meter.
     
  • The neighboring city of Nanjing was forced to close all its elementary and middle school classes because the sky was the color of “salted egg yolk,” and the city of Qingdao canceled all outdoor activities.
     
  • According to official numbers from China’s National Bureau of Statistics, 90% of the 161 cities whose air quality was monitored in 2014 failed to meet official standards.

  • Berkeley Earth, an environmental research group, estimates that 4,000 people per day die in China from air pollution-related illnesses. “Every hour of exposure reduced my life expectancy by 20 minutes. It’s as if every man, woman and child smoked 1.5 cigarettes each hour,” said Richard Muller, scientific director of Berkeley Earth.

Heck, even the air inside Chinese buildings is awful. In 2013, the Galaxy Soho, an upscale retail/office complex, hired Malaysia’s Mayair and Honeywell (HON) to install massive indoor air cleaning systems.

Since then, dozens of companies like China Telecom and CCTV have inquired about installing similar systems in their offices.

There is more than one reason behind China’s air pollution problem, but the primary culprit is the fact that China gets about 64% of its electricity from burning coal, according to National Energy Administration data.

The Chinese government understands that it needs to “do something”; it has pledged to improve the air quality and has taken serious steps to do it.

For example, to cut reliance on coal, Beijing has set the goal to get 20% of its energy from renewables (solar and wind) and nuclear power by 2030, almost double the current share.

In fact, the Central Committee of China’s Communist Party kicked off its fifth plenary session on October 26, a key four-day meeting in which the nation’s economic and social policies for the next five years will be finalized.

(Note: Dirty air wasn’t the only pollution I found in Shanghai. The JW Marriott, one of the city’s nicest hotels, had a bright red sign above the bathroom sink warning “Water Not Potable.” Shanghai’s water is an interesting story with an entirely different investment opportunity. I’ll save it for another time.)

China is going to spend billions—yes, billions with a B—to clean up its air and water, which will make pollution control an industry in itself over the next few years.

How You Can Cash In

Of course, the money won’t all go to one company, but it isn’t hard to identify some of the big winners. Clean-energy providers (solar, wind, nuclear), natural gas producers, clean coal technology leaders, electric cars, emission control equipment, and air purification systems will have the government wind at their backs.

And that doesn’t even count the equally urgent water pollution problem.

If you’re an ETF investor, you have a fistful of choices, including:

  •     Guggenheim Solar ETF (TAN)
     
  •     PowerShares WilderHill Clean Energy Portfolio (PBW)
     
  •     iShares Global Clean Energy ETF (ICLN)
     
  •     First Trust ISE Global Wind Energy ETF (FAN)
     
  •     Market Vectors Solar Energy ETF (KWT)
     
  •     PowerShares Water Resources ETF (PHO)
     
  •     PowerShares WilderHill Progressive Energy ETF (PUW)
     
  •     PowerShares Global Clean Energy ETF (PBD)
     
  •     PowerShares Global Water ETF (PIO)
     
  •     PowerShares Cleantech Portfolio (PZD)
     
  •     Market Vectors Global Alternative Energy ETF (GEX)
     
  •     Market Vectors Environmental Services ETF (EVX)
     
  •     Market Vectors Uranium+Nuclear Energy ETF (NLR)
     
  •     First Trust ISE Water ETF (FIW)
     
  •     First Trust Nasdaq Clean Edge Green Energy ETF (QCLN)
     
  •     Claymore S&P Global Water ETF (CGW)

Clean air and clean water are big business around the world, but especially in China. I think they will be among the easiest, slam-dunk sector winners over the next decade, and this list of ETFs is a good place to start your research.

None of those ETFs really focuses on China, though, so I think you can do much, much better with carefully targeted individual stocks—such as a small-cap leader in clean coal technology that is doing big business in China, or a chip company making air quality sensor chips—than with the shotgun approach of ETFs.

For other stocks with great upside potential, check out my monthly newsletter, Just One Trade.

Tony Sagami
Tony Sagami

30-year market expert Tony Sagami leads the Yield Shark and Rational Bear advisories at Mauldin Economics. To learn more about Yield Shark and how it helps you maximize dividend income, click here. To learn more about Rational Bear and how you can use it to benefit from falling stocks and sectors, click here.

October 30, 2015

Outside the Box: The Financialization of the Economy

By John Mauldin

 

Roger Bootle once wrote:

The whole of economic life is a mixture of creative and distributive activities. Some of what we ‘‘earn’’ derives from what is created out of nothing and adds to the total available for all to enjoy. But some of it merely takes what would otherwise be available to others and therefore comes at their expense.

Successful societies maximise the creative and minimise the distributive. Societies where everyone can achieve gains only at the expense of others are by definition impoverished. They are also usually intensely violent….

Much of what goes on in financial markets belongs at the distributive end. The gains to one party reflect the losses to another, and the fees and charges racked up are paid by Joe Public, since even if he is not directly involved in the deals, he is indirectly through costs and charges for goods and services.

The genius of the great speculative investors is to see what others do not, or to see it earlier. This is a skill. But so is the ability to stand on tip toe, balancing on one leg, while holding a pot of tea above your head, without spillage. But I am not convinced of the social worth of such a skill.

This distinction between creative and distributive goes some way to explain why the financial sector has become so big in relation to gross domestic product – and why those working in it get paid so much.

Roger Bootle has written several books, notably The Trouble with Markets: Saving Capitalism from Itself.

I came across this quote while reading today’s Outside the Box, which comes from my friend Joan McCullough. She didn’t actually cite it but mentioned Bootle in passing, and I googled him, which took me down an alley full of interesting ideas. I had heard of him, of course, but not really read him, which I think may be a mistake I should correct.

But today we are going to focus on Joan’s own missive from last week, which she has graciously allowed me to pass on to you. It’s a probing examination of how and why the financialization of the US and European (and other developed-world) economies has become an anchor holding back our growth and future well-being. Joan lays much of the blame at the feet of the Federal Reserve, for creating an environment in which financial engineering is more lucrative than actually creating new businesses and increasing production and sales.

There are no easy answers or solutions, but as with any destructive codependent relationship, the first step is to recognize the problem. And right now, I think few do.

What you will read here is of course infused with Joan’s irascible personality and is therefore really quite the fun read (even as the message is sad).

Joan writes letters along this line twice a day, slicing and dicing data and news for her rather elite subscriber list. Elite in the sense that her service is rather expensive, so I thank her for letting me send this out. Drop me a note if you want us to put you in touch with her.

I am back in Dallas after a whirlwind trip to Washington DC. I attended Steve Moore’s wedding at the awe-inspiring Jefferson Memorial; and then we hopped a plane back to Dallas and Tulsa to see daughter Abbi, her husband Stephen, and my new granddaughter, Riley Jane, who was delivered six weeks premature while we were in the air. The doctors decided to bring Riley into the world early as Abbi was beginning to experience seriously high blood pressure and other problematic side effects. Riley barely weighs in at 4 pounds and will spend the first three years of her life in the NICU (the neonatal intensive care unit). Having never been in one before, I was rather amazed by all the high-tech gear surrounding Riley and all of the usual medical devices shrunk to the size where they can be useful with preemie babies. The doctors and nurses assured me that the frail little bundle I was very hesitant to touch would be quite fine. And Abbi is much better and already up and about.

As I was flying back to Dallas later that afternoon, it struck me how, not all that long ago, in my parents’ generation, both mother and daughter would have been at severe risk. Interestingly, both Abbi and her twin sister were significantly premature as well, some 30 years ago in Korea. The progress of medicine and medical technology has allowed so many more people to live long and productive lives, and that process is only going to continue to improve with each and every passing year.

And now, I think it’s time to let you get on with Joan McCullough’s marvelous musings. Have a great week!

Your glad I’m living at this time in history analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

 

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The Financialization of the Economy

Joan McCullough, Longford Associates
October 21, 2015

Yesterday, we learned that lending standards had eased and that there was increased loan demand from institutions and households, per the ECB’s September report. (Which was attributed to the success of QE and which buoyed the Euro in the process.)

This has been bothering me. Because it is a great example of the debate over “financialization” of an economy, i.e., is it a good thing or a bad thing?

The need to further explore the topic was provoked by reading this morning that one of the larger shipping alliances, G6, has again announced sailing cancellations between Asia and North Europe and the Mediterranean. This round of cuts targets November and December. The Asia-Europe routes, please note, are where the lines utilize their biggest ships and have been running below breakeven. So it’s easy to understand why such outsized capacity is further dictating the need to cancel sailings outright. G6 members: American President, Hapag Lloyd, Hyundai Merchant Marine, Mitsui, Nippon and OOCL. So as you can see from that line-up, these are not amateurs.

We have already discussed in the past in this space, the topic of financialization. But seeing as how the stock market keeps rallying while the economic statistics have remained for the most part, punk, time to revisit the issue once again. Is it all simply FED or no FED? Or is the interest-rate issue ground zero and/or purely symptomatic of the triumph of financialization over the real economy?

Further urged to revisit the topic by the seemingly contradictory developments of the ECB banks reportedly humming along nicely while trade between Asia and Europe remains obviously, significantly crimped.

Let’s make this plain English because it takes too much energy to interpret most of what is written on the topic.

Snappy version:

Definition (one of quite a few, but the one I think is accurate for purposes of this screed):

Financialization is characterized by the accrual of profits primarily thru financial channels (allocating or exchanging capital in anticipation of interest, divvies or capital gains) as opposed to accrual of profits thru trade and the production of goods/services.

Economic activity can be “creative” or “distributive”. The former is self- explanatory, i.e., something is produced/created. The latter pretty much

simply defines money changing hands. (So that when this process gets way overdone as it likely has become in our world, one of the byproducts is the widening gap called “income inequality”.)

You guessed correctly: financialization is viewed as largely distributive.

So now we roll around to the nitty-gritty of the issue. Which presents itself when business managers evolve to the point where they are pretty much under the control of the financial community. Which in our case is simply “Wall Street”.

This is something I saved from an article last summer which ragged mercilessly on IBM for having kissed Wall Street’s backside ... and in the process over the years, ruined the biz.

... “And of course, it’s not just IBM. ... A recent survey of chief financial officers showed that 78 percent would ‘give up economic value’ and 55 percent would cancel a project with a positive net present value—that is, willingly harm their companies—to meet Wall Street’s targets and fulfill its desire for ‘smooth’ earnings.... http://www.forbes.com/sites/stevedenning/2014/06/03/why-financialization-has-run-amok/

IBM is but one possible target in laying this type of blame where the decisions on corporate action are ceded to the financial community; the instances are innumerable.

You probably could cite the well-known example of a couple of years back when Goldman Sachs was exposed as the owner of warehouse facilities that held 70% of North American aluminum inventory. And how that drove up the price and cost end-users dearly. (Estimated as $ 5bil over 3 years’ time.)

First link: NY Times article from July of 2013, talking about the warehousing issue.

http://www.nytimes.com/2013/07/21/business/a-shuffle-of-aluminum-but-to-banks-pure-gold.html?pagewanted=all&_r=0

Second link: Senate testimony from Coors Beer, complaining about the same situation.

http://www.banking.senate.gov/public/index.cfm? FuseAction=Files.View&FileStore_id=9b58c670-f002-42a9-b673- 54e4e05e876e Well, here’s another from the same article which makes the point quite clearly:

... Boeing’s launch of the 787 was marred by massive cost overruns and battery fires. Any product can have technical problems, but the striking thing about the 787’s is that they stemmed from exactly the sort of decisions that Wall Street tells executives to make.

Before its 1997 merger with McDonnell Douglas, Boeing had an engineering-driven culture and a history of betting the company on daring investments in new aircraft. McDonnell Douglas, on the other hand, was risk-averse and focused on cost cutting and financial performance, and its culture came to dominate the merged company. So, over the objections of career-long Boeing engineers, the 787 was developed with an unprecedented level of outsourcing, in part, the engineers believed, to maximize Boeing’s return on net assets (RONA). Outsourcing removed assets from Boeing’s balance sheet but also made the 787’s supply chain so complex that the company couldn’t maintain the high quality an airliner requires. Just as the engineers had predicted, the result was huge delays and runaway costs. ... Boeing’s decision to minimize its assets was made with Wall Street in mind. RONA is used by financial analysts to judge managers and companies, and the fixation on this kind of metric has influenced the choices of many firms. In fact, research by the economists John Asker, Joan Farre-Mensa, and Alexander Ljungqvist shows that a desire to maximize short-term share price leads publicly held companies to invest only about half as much in assets as their privately held counterparts do.” ...

That’s from an article in the June, 2014, Harvard Business Review by Gautam Mukunda, “The Price of Wall Street’s Power” also cited in the Forbes article. This is the link; it is worth the read though you may not agree with parts of the conclusion: https://hbr.org/2014/06/the-price-of-wall-streets-power

The upshot to this type of behavior is that the balance of power ... and ideas ... then migrates into domination by one group.

Smaller glimpse: Over-financialization is what happens when a company generates cash then pays it to shareholders and senior management which m.o. also includes share buybacks and vicious cost cutting. This is one way, as you can see, in which the real economy is excluded from the party!

Part of the financialization process also includes ‘cognitive capture’ where the big swingin’ investment banking sticks have the ear of business managers.

And the business managers/special interest groups, in turn, have the ear of the federal government. See? The control by Wall Street is still there, but sometimes the route is a tad circuitous! The clandestine formulation of the TPP agreement is a perfect example of this type of dominance. (Congress shut out/ corporate lobbyists invited in.)

So the whole process goes to the extreme. Therein lies the rub: the extreme.

So that business obediently complies with the wishes of these financial wizards. Taken altogether, over time, our entire society morphs to where it assumes a posture of servitude to the interests of Wall Street.

An example of that? John Q.’s sentiment meter (a/k/a consumer confidence) is clearly known to be tied most of the time to the direction of the S&P 500. Which of course, is aided and abetted by the foaming-at- the-mouth Talking Heads who pretty much .... dictate to John Q. how he is supposed to be feeling.

Forty years on the Street, I am still agog at the increasing clout of the FOMC to the extent where we are now hostages to their infernal sound bites and communiqu├ęs. Another example of the process of creeping financialization? I’d surely say so!

This is not an effort to try and convict “financialization” as indeed it has its place. When it is used prudently. Such as to facilitate trade in the real economy! Sounds kind of Austrian, eh? You bet. The simplest example of this which is frequently cited is a home mortgage. The borrower exchanges future income for a roof via a bank note.

And so it goes. Financialization humming along nicely, facilitating trade in the real economy.

Unfortunately, along the line somewhere, it got out of hand. Which is where the World Bank comes in.

http://data.worldbank.org/indicator/FS.AST.PRVT.GD.ZS

As they have the statistics on “domestic credit to private sector (% of GDP)”

Why do we wanna’ look at that? Well the answer is suggested by yet another institution who has studied the issue. Correct. The IMF. Which espouses the notion that:

... ““the marginal effect of financial depth on output growth becomes negative ... when credit to the private sector reaches 80-100% of GDP ...

https://www.imf.org/external/pubs/ft/wp/2012/wp12161.pdf

Does the above sound familiar? Right. Too much financialization crimps growth.

That’s when we turn to the above-referenced World Bank table. Which shows the latest available worldwide statistics (2014) on domestic credit to private sector % of GDP.

Okay. Maybe we oughta’ read this bit from the World Bank before we get to the US statistic:

... “Domestic credit to private sector refers to financial resources provided to the private sector by financial corporations, such as through loans, purchases of nonequity securities, and trade credits and other accounts receivable, that establish a claim for repayment. ...

The financial corporations include monetary authorities and deposit money banks, as well as other financial corporations ...

Examples of other financial corporations are finance and leasing companies, money lenders, insurance corporations, pension funds, and foreign exchange companies.” ...

Clear enough. Again, the IMF suggests that 80 to 100% of GDP is where it gets dicey in terms of impact on growth:

In 2014, the US ratio stood at 194.8. In 1981 (as far back as the table goes), our ratio stood at 89.1.

For comparison, also in 2014, Germany stood at 80.0; France at 94.9. China at 141.8 and Japan at 187.6. Which is suggestive of what can be called “over-financialization”. So what’s the beef with that, you ask?

For all the reasons mentioned above which led to increasing dominance by the financial sector on corporate and household behavior, the emphasis leans heavily towards making money out of money. Which I’d like to do myself. You?

But when massaged into the extreme which is clearly, I believe, where we find ourselves now ... at the end of the day, we create nothing.

By creating nothing, the economy relies on the financialization process to create growth. But the evidence supports the notion that once overdone, financialization stymies growth.

“ ... The whole of economic life is a mixture of creative and distributive activities. Some of what we “earn” derives from what is created out of nothing and adds to the total available for all to enjoy. But some of it merely takes what would otherwise be available to others and therefore comes at their expense. Successful societies maximize the creative and minimize the distributive. Societies where everyone can achieve gains only at the expense of others are by definition impoverished. They are also usually intensely violent.” ... Roger Bootle quoted here: http://bilbo.economicoutlook.net/blog/?p=5537

In short, corporate behavior is dictated by Wall Street desire which in turn results in a flying S&P 500. Against a backdrop, say, of a record number of US workers no longer participating in the labor force.

So instead of cogitating the entire picture and all of its skanky details, we have so farbeen willing to accept a one-size fits all alibi for stock market action where financialization still dominates; the only choice is what financialization flavor will trump the other: “FED or no FED”.

I now wonder if when Bootle said a few years back ... “they are usually intensely violent”, if this wasn’t prescience. Which can be applied to the current political landscape in the US where the financialization of the economy has so excluded the average worker ... that he is willing to put Ho-Ho the Clown in the White House. Just to change the channel. And hope for relief.

As you can see, I am trying very hard to understand how as a society we got to this level.

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October 9, 2015

The 10th Man: Being the 10th Man

By Jared Dillian

 

I was going to give you this big macro rundown of what happened since the payroll number, but I changed my mind. Anybody can give you the play-by-play. Let’s talk about it in the context of true contrarian investing.

Being contrarian doesn’t just mean doing the opposite of what everyone else is doing. It means doing what is really unpopular and may make you subject to ridicule.

If you went on CNBC before the payroll number and said that you were a raging emerging markets bull, they would have put the clown nose on you and given you the hook.

And yet…

This may not seem like a big deal to you. If you are an individual investor, you can have the iShares MSCI Emerging Markets Index ETF (EEM) in your portfolio and lose money on it, and the only one who cares is you.

But if you run a mutual fund or a hedge fund, you have to file a 13F and then everyone can see EEM in your portfolio, and you have to explain to your investors why you have this dumb EEM position that everyone hates and that’s obviously going down—and if you lose money on indefensible things, it becomes difficult to defend your continued employment.

For example, if Nike (NKE) were to miss earnings and gap lower 15%, nobody would get fired, because everyone owns it.

But if you go down with the emerging markets ship, you are definitely getting fired.

So being a contrarian is hard if you’re a professional, because if you are wrong, you are wrong publicly, and you experience shame, and as we said before, shame is the most powerful motivator.

I did not pick up my moniker The 10th Man by accident. Do you know where it came from? It came from the zombie movie World War Z.

Spoiler alert: In the movie, Israel survived the zombie invasion because they employed a 10th man whose job it was to disagree when everyone else agreed. Israeli intelligence intercepted emails from India saying that they were being attacked by “undead,” literally, zombies.

Everyone in Israeli intelligence figured that the Indian government was using the word “zombies” to refer to something else.

The 10th man said, “What if they are actually talking about zombies?”

Leading up to the payroll number, we got a lot of ultra-bearish articles hitting the tape, but the Big Kahuna was the slickly produced Carl Icahn video, Danger Ahead, whose release perfectly coincided with the low tick in stocks.

His argument was compelling, as it always is. But the bearish argument is always most compelling on the lows.

It’s tough to take the other side of Carl Icahn. His market timing is almost as legendary as his activist investing.

Here’s the point: If Carl Icahn comes out with this video on the highs, he gets the clown nose and the hook. If he comes out with it on the lows, he sounds like a freaking oracle.

It takes a lot of guts to publicly call Carl Icahn a loser. That’s what I did in my professional publication, The Daily Dirtnap. There is often blowback when you do things like that.

I do not care. I have never cared what people think of me, which is my greatest asset.

If people want to think I’m crazy, fine by me.

I may only be right about half the time, but I seem to be right when everyone else is wrong, which keeps me out of a lot of trouble.

Consensus Thinking

Somehow, over the course of the last month or so, this idea developed that a rate hike would be good because it removes uncertainty.

What?

So people were cheering for a rate hike.

What?

Rate hikes are always, always bad for asset prices. Removing liquidity is always bad (in the short term). More liquidity is always good.

When the payroll number turned out to be very weak, it pretty much ruled out a rate hike for 2015 (and longer).

Two-year notes rallied the most in years, with yields dropping a full 20 basis points.

And stocks…

It wasn’t hard to identify the consensus thinking. As usual, it was wrong.

Operant Conditioning

The Bank of Japan is likely to quantitatively ease again, now that the Fed is not hiking. Now the Bank of England might not raise rates until 2017. Suddenly, we are once again in a world awash with liquidity. Gold is up quite a bit, and silver up even more (disclosure: I am long both gold and silver in a variety of forms, including GLD and SLV).

Wouldn’t it be interesting if we got a big precious metals rally? That would blow apart consensus thinking.

The dominant investment thesis is that a stronger dollar will murder emerging markets. What if that turns out not to be true? What if the dollar doesn’t strengthen, or all currencies weaken equally (relative to hard assets)?

This short EM trade is so old and so tired that people will stubbornly cling to it for the next six months, even in the face of overwhelming evidence to the contrary.

We’re not altogether different from the pigeons in B.F. Skinner’s box. If you could make money by pushing a button, how many times would you push the button?

Or: if you stopped making money by pushing the button, how long would you continue to sit there and push the button like an imbecile?

Inquiring minds want to know.

Jared Dillian
Jared Dillian

If you enjoyed Jared's article, you can sign up for The 10th Man, a free weekly letter, at mauldineconomics.com. Follow Jared on Twitter @dailydirtnap

The article The 10th Man: Being the 10th Man was originally published at mauldineconomics.com.

Outside the Box: A Worrying Set Of Signals

By John Mauldin

 

There is presently a bull market in complacency. There are very few alarm bells going off anywhere; and frankly, in reaction to my own personal complacency, I have my antenna up for whatever it is I might be missing that would indicate an approaching recession.

It was very easy to call the last two recessions well in advance because we had inverted yield curves. In the US at least, that phenomenon has a perfect track record of predicting recessions. The problem now is that, with the Federal Reserve holding the short end of the curve at the zero bound, there is no way we can get an inverted yield curve, come hell or high water. For the record, inverted yield curves do not cause recessions, they simply indicate that something is seriously out of whack with the economy. Typically, a recession shows up three to four quarters later.

I know from my correspondence and conversations that I am not the only one who is concerned with the general complacency in the markets. But then, we’ve had this “bull market in complacency” for two years and things have generally improved, albeit at a slower pace in the current quarter.

With that background in mind, the generally bullish team at GaveKal has published two short essays with a rather negative, if not ominous, tone. Given that we are entering the month of October, known for market turbulence, I thought I would make these essays this week’s Outside the Box. One is from Pierre Gave, and the other is from Charles Gave. It is not terribly surprising to me that Charles can get bearish, but Pierre is usually a rather optimistic person, as is the rest of the team.

I was in Toronto for two back-to-back speeches before rushing back home this morning. I hope you’re having a great week. So now, remove sharp objects from your vicinity and peruse this week’s Outside the Box.

Your enjoying the cooler weather analyst,

John Mauldin, Editor
Outside the Box
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A Worrying Set Of Signals

By Pierre Gave
Sept. 28, 2015

Regular readers will know that we keep a battery of indicators to gauge, among other things, economic activity, inflationary pressure, risk appetite and asset valuations. Most of the time this dashboard offers mixed messages, which is not hugely helpful to the investment process. Yet from time to time, the data pack points unambiguously in a single direction and experience tells us that such confluences are worth watching. We are today at such a point, and the worry is that each indicator is flashing red.

Growth: The three main indices of global growth have fallen into negative territory: (i) the Q-indicator (a diffusion index of leading indicators), (ii) our diffusion index of OECD leading indicators, and (iii) our index of economically-sensitive market prices. Also Charles’s US recession indicator is sitting right on a key threshold (see charts for all these indicators in the web version).

Inflation: Our main P-indicator is at a maximum negative with the diffusion index of US CPI components seemingly in the process of rolling-over; this puts it in negative territory for the first time this year.

Risk appetite: The Gavekal velocity indicator is negative which is not surprising given weak market sentiment in recent weeks. What worries us more is the widening of interest rate spreads—at the long-end of the curve, the spread between US corporate bonds rated Baa and treasuries is at its widest since 2009; at the short-end, the TED spread is back at levels seen at the height of the eurozone crisis in 2012, while the Libor-OIS spread is at a post-2008 high. Moreover, all momentum indicators for the main equity markets are at maximum negative, which has not been seen since the 2013 “taper tantrum”.

These weak readings are especially concerning, as in recent years, it has been the second half of the year when both the market and growth has picked up. We see three main explanations for these ill tidings:

1) Bottoming out: If our indicators are all near a maximum negative, surely the bottom must be in view? The contrarian in us wants to believe that a sentiment shift is around the corner. After all, most risk-assets are oversold and markets would be cheered by confirmation that the US economy remains on track, China is not hitting the wall and the renminbi devaluation was a one-off move. If this occurs, then a strong counter-trend rally should ramp up in time for Christmas.

2) Traditional indicators becoming irrelevant: Perhaps we should no longer pay much attention to fundamental indicators. After all, most are geared towards an industrial economy rather than the modern service sector, which has become the main growth driver. In the US, industrial production represents less than 10% of output, while in China, the investment slowdown is structural in nature. The funny thing is that employment numbers everywhere seem to be coming in better than expected. In this view of things, either major economies are experiencing a huge drop in labor productivity, or our indicators need a major refresh (see Long Live US Productivity!).

3) Central banks out of ammunition: The most worrying explanation for the simultaneous decline in our indicators is that air is gushing out of the monetary balloon. After more than six years of near zero interest rates, asset prices have seen huge rises, but investment in productive assets remains scarce. Instead, leverage has run up across the globe. According to the Bank for International Settlements’ recently released quarterly review, developed economies have seen total debt (state and private) rise to 265% of GDP, compared to 229% in 2007. In emerging economies, that ratio is 167% of GDP, compared to 117% in 2007 (over the period China’s debt has risen from 153 to 235% of GDP). The problem with such big debt piles is that it is hard to raise interest rates without derailing growth. Perhaps it is not surprising that in recent weeks the Federal Reserve has backed away from hiking rates, the European Central Bank has recommitted itself to easing and central banks in both Norway and Taiwan made surprise rate cuts. But if rates cannot be raised after six-years of rising asset prices and normalizing growth, when is a good time? And if central banks are prevented from reloading their ammunition, what will they deploy the next time the world economy hits the skids?

Hence we have two benign interpretations and one depressing one. Being optimists at heart, we want to believe that a combination of the first two options will play out. If so, then investors should be positioned for a counter-trend rally, at least in the short-term. Yet we are unsettled by the market’s muted response to the Fed’s dovish message. That would indicate that investors are leaning towards the third option. Hence, we prefer to stay protected and for now are not making a bold grab for falling knifes. At the very least, we seek more confirmation on the direction of travel.

Positioning For A US Recession

By Charles Gave
September 29, 2015

Since the end of last year I have been worried about an “unexpected” slowdown, or even recession, in the world’s developed economies (see Towards An OECD Recession In 2015). In order to monitor the situation on a daily basis, I built a new indicator of US economic activity which contains 17 components ranging from lumber prices and high-yield bond spreads to the inventory-to-sales ratio. It was necessary to construct such an indicator because six years of extreme monetary policy in the US (and other developed markets) has stripped “traditional” cyclical economic data of any real meaning (see Gauging The Chances Of A US Recession).

Understanding this diffusion index is straightforward. When the reading is positive, investors have little to worry about and should treat “dips” as a buying opportunity. When the reading is negative a US recession is a possibility. Should the reading fall below – 5 then it is time to get worried – on each occasion since 1981 that the indicator recorded such a level a US recession followed in fairly short order. At this point, my advice would generally be to buy the defensive team with a focus on long-dated US bonds as a hedge. This is certainly not a time to buy equities on dips.

Today my indicator reads – 5 which points to a contraction in the US, and more generally the OECD. Such an outcome contrasts sharply with official US GDP data, which remains fairly strong. Pierre explored this discrepancy in yesterday’s Daily (see A Worrying Set Of Signals), so my point today is to offer specific portfolio construction advice in the event of a developed market contraction. My assumption in this note is simply that the US economy continues to slow. Hence, the aim is to outline an “anti-fragile” portfolio which will resist whatever brickbats are hurled at it.

During periods when the US economy has slowed, especially if it was “unexpected” by official economists, then equities have usually taken a beating while bonds have done well. For this reason, the chart below shows the S&P 500 divided by the price of a 30-year zero-coupon treasury.

A few results are immediately clear:

  • Equities should be owned when the indicator is positive.
     
  • Bonds should be held when the indicator is negative.
     
  • The ratio of equities to bonds (blue line) has since 1981 bottomed at about 50 on at least six occasions. Hence, even in periods when fundamentals were not favorable to equities (2003 and 2012) the indicator identified stock market investment as a decent bet. 
Today the ratio between the S&P 500 and long-dated US zeros stands at 75. This suggests that shares will become a buy in the coming months if they underperform bonds by a chunky 33%. The condition could also be met if US equities remain unchanged, but 30-year treasury yields decline from their current 3% to about 2%. Alternatively, shares could fall sharply, or some combination in between. 
Notwithstanding the continued relative strength of headline US economic data, I would note that the OECD leading indicator for the US is negative on a YoY basis, while regional indicators continue to crater. The key investment conclusion from my recession indicator is that equity positions, which face risks from worsening economic fundamentals, should be hedged using bonds or upping the cash component.

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Important Disclosures

The article Outside the Box: A Worrying Set Of Signals was originally published at mauldineconomics.com.
August 11, 2015



The 10th Man: A Correction Fireside Chat

By Jared Dillian

 

I don’t really enjoy these things like I used to. Keep in mind, I’ve traded through a lot of blowups, going back to 1997.

1998
2001
2002-2003
2007-2009
2011
Today

They all kind of feel the same after a while.

Nobody wins from corrections except for the traders, which today mostly means computers. I forget who said this: “In bear markets, bulls lose money and bears lose money. Everyone loses money. The purpose of a bear market is to destroy capital.”

And that’s what is going on today.

For starters, long-term investors inevitably get sucked into the media MARKET TURMOIL spin cycle and puke their well-researched, treasured positions at the worst possible time.

But I’m not trying to minimize the significance of a correction, because some corrections turn into bona fide bear markets. And if you are in a bear market, you should get out. If it is only a correction, you probably want to add to your holdings.

How can you tell the difference?

My Opinion: This Is a Correction

So what were the two big bear markets in the last 20 years? The dot-com bust, and the global financial crisis. Two generational bear markets in a 10-year span. Hopefully something we’ll never see again. In one case, we had the biggest stock market bubble ever and in the other, the biggest housing/debt crisis ever. Both good reasons for a bear market.

What are we selling off for again? Something wrong with China?

Again, not to minimize what is going on in China, because it is now the world’s second-largest economy. Forget the GDP statistics. After a decade of ridiculous overinvestment, it is possible that they’re on the cusp of a very serious recession, whether they admit it or not.

But the good news is that the yuan is strong and can weaken a lot, and interest rates are high and can come down a lot. China has a lot of policy tools it can use (unlike the United States).

Let’s think about these “minor” corrections over the last 20 years:

1997: Asian Financial Crisis
1998: Russia/Long-Term Capital Management (LTCM)
2001: 9/11
2011: Greece

All of these were VIX 40+ events.

In retrospect, these “crises” look kind of silly, even junior varsity.

The Thai baht broke—big deal.

Russia’s debt default was only a problem because it was a surprise. And the amount of money LTCM was down—about $7 billion—is peanuts by today’s standards.

After 9/11, stocks were down 20% in a week. The ultimate buying opportunity.

And in hindsight, we can see that the market greatly underestimated the ECB’s commitment to the euro.

So what are we going to say when we look back at this correction in 10-20 years? What will we name it? Will we call it the China crisis? I mean, if it’s a VIX 40 event, it needs a name.

I try to have what I call forward hindsight. Like, I pretend it’s the future and I’m looking back at the present as if it were the past.

My guess is that we will think this was pretty stupid.

What to Buy

I saw a sell-side research note yesterday suggesting that this crisis is marking the capitulation bottom in emerging markets. I haven’t fully evaluated that statement, but I have a hunch that it is correct.

China is cheap, by the way. But if China is too scary, they are just giving away India. I literally cannot buy enough. And I have a hunch that Brazil’s president, Dilma Rousseff, is going to be impeached and the situation in Brazil is going to improve relatively soon.

Think about it. The most contrarian trade on the board. Long the big, old, bloated, corrupt, ugly, bear market BRICs.

Also the scariest trade. But the scary trades are often the good trades.

There’s more. If you think we’re in the midst of a generational health care/biotech bull market, prices are a lot more attractive today than they were a few weeks ago.

I also like gold here because central banks are no longer omnipotent.

That reminds me—there was something I wanted to say on China. The reason everyone hates China isn’t because of the economic situation. It’s because they made complete fools of themselves trying to prop up the stock market. So virtually overnight, we went from “China can do anything” to “China is full of incompetent idiots.” Zero confidence in the authorities.

You want to know when this crisis is going to end? When China manages to restore confidence.

When they have that “whatever it takes” moment, like Draghi.

If they keep easing monetary policy, sooner or later there will be an effect.

I Am Bored

I used to get all revved up about this stuff. That’s when I made my living timing tops and bottoms. I don’t do that anymore. I do fundamental work, and I go to the gym and play racquetball. The mark-to-market is a nuisance.

Also, if you can’t get excited about a VIX 50 event, you have probably been trading for too long.

There is a silver lining. The disaster scenario, where the credit markets collapse due to lack of liquidity, isn’t happening. Everyone is hiding and too scared to trade.

Honestly, high-grade credit isn’t acting all that bad. And it shouldn’t. I don’t see any big changes in the default rate.

Anyway, if you want to go be a hero and bid with both hands, be my guest. It’s best to be careful and average into stuff. These prices will look pretty good a couple of months from now, I think.

Jared Dillian
Jared Dillian

If you enjoyed Jared's article, you can sign up for The 10th Man, a free weekly letter, at mauldineconomics.com. Follow Jared on Twitter @dailydirtnap

The article The 10th Man: A Correction Fireside Chat was originally published at mauldineconomics.com.
August 11, 2015


Connecting the Dots: Xiaomi: the Apple iPhone Killer?

By Tony Sagami

 

If you own Apple stock, you better pay attention.

A Chinese company named Xiaomi is eating Apple’s lunch in China, and its popularity is slowly spreading across the globe.

Don’t feel bad if you have never heard of it, because very few Americans have. However, Xiaomi is a household name in Asia and may soon become one in the US too.

Xiaomi—pronounced SHOW-em—is a smartphone maker, and it happens to make the #1 bestselling smartphone in China. Yup, Xiaomi is even more popular than the Apple iPhone.

The most recent market share numbers show that Xiaomi grabbed 15.9% of the mobile phone market in China during the second quarter of this year. In 2014, Xiaomi sold 420 million smartphones and pulled in $12 billion in revenues.

The Xiaomi phone that is generating those big sales is the Mi Note. Its screen is considerably larger than the iPhone’s. It is thinner, weighs nearly half an ounce less, has longer battery life and a higher-resolution camera that takes beautiful photos, and is compatible with all the Android apps on Google Play.

Best of all, it costs only $370 without a contract!

“Mi” Fans

Chinese consumers are crazy about Xiaomi. Really crazy!

They call themselves “Mi-fans.” They have fan clubs and a “Mi-Fan Day” on April 6, when tens of thousands of Chinese travel all across China to attend new product launches. The crowds are so large—as many as 170,000—that security is required for crowd control.

At the recent 2015 Xiaomi festival, the company sold over 2 million smartphones and pulled in 2.08 billion yuan (US$335 million) in just 12 hours.

Part of the euphoria comes from charismatic founder Lei Jun, who inspires loyalty in his customers in much the same way the late Steve Jobs did for Apple. Lei even wears jeans and a black turtleneck like Jobs.

Charisma can create excitement, but a company needs to deliver a great product too. Xiaomi is known for delivering high-quality products at very affordable prices and has built a dedicated consumer base that absolutely loves its products.

Heck, Apple isn’t even #2 in China; a Taiwanese company called Huawei was a close second with a 15.7% market share. Xiaomi and Huawei together now control one-third of the smartphone sales in China.

The iPhone has fallen to third place with 10.9% of the market, closely followed by Samsung.

Third place is bad enough, but China, which was supposed to power Apple’s growth going forward, is now a drag for Apple: China sales plunged by 21% in the second quarter from Q1.

By comparison, Huawei’s sales surged 48% over the prior quarter.

What’s an investor to do?

I’m not suggesting that you buy Xiaomi stock.

Why not?

Because you can’t!

Xiaomi is one of the world’s largest smartphone makers, but it is privately held and estimated to be worth $46 billion, which makes it the second-highest valued private tech company in the world (behind Uber).

On April 28, 2015, I wrote this about Apple: “My expectation is that we’ll have a chance to buy it at a much cheaper price later this year.”

Apple closed at $130.02 that day, just a couple bucks off its 52-week high of $134.54, but is now substantially cheaper, as I predicted.

What I’m suggesting is that Apple’s best days are behind it, and I don’t say that just because Xiaomi and Huawei are kicking its ass in China:

  • Apple missed expectations on shipments for all its major products. In particular, investors were expecting a monster iPhone quarter, but Apple sold only 47.5 million iPhones instead of nearly 49 million as predicted.
     
  • Microsoft’s Windows 10 will provide more competition to the iPad and Mac.

  • Apple hasn’t revealed specific sales figures for the Apple Watch, but analytics firm Slice Intelligence says that sales have dropped from an average of 35,000 a day in April to 5,000 a day in July.
     
  • The smartphone market is maturing. Global mobile phone shipments grew a paltry 2%, from 428 million units in Q2 2014 to 434.6 million units in Q2 2015.

Look, the iPhone accounts for 70% of Apple’s total revenues, and the Chinese weakness is trouble because China passed the US as Apple’s biggest iPhone market in the first quarter of this year. Today, China is the world’s largest smartphone market, and Apple isn’t doing well there.

Heck, even CEO Tim Cook has acknowledged that China is creating “speed bumps” for Apple.

I’m not telling you to sell your Apple stock tomorrow morning. But I am telling you that you need some type of exit strategy to protect yourself because Apple’s stock is headed lower.

Let the hate mail begin!

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Tony Sagami
Tony Sagami

30-year market expert Tony Sagami leads the Yield Shark and Rational Bear advisories at Mauldin Economics. To learn more about Yield Shark and how it helps you maximize dividend income, click here. To learn more about Rational Bear and how you can use it to benefit from falling stocks and sectors, click here.