ponzi games - financial newsletters, economic & …€¦ · · 2015-05-06ponzi games are...

of 15

Ponzi Games

“As Rogoff and his co-author Maurice Obstfeld put it in the magnificent, awe-

inspiring Foundations of International Macroeconomics…,’The behavior of

dynamically inefficient economies wreaks havoc with much of our intuition

about the laws of economics.’ Put more bluntly, dynamic inefficiency makes a

large part of macroeconomics worthless. Financial markets are in a sense ahead

of academic macroeconomics in responding: traditional ‘fundamentals’ have

now largely been transformed into one overarching ‘fundamental’: the

assessment of solvency. As a result, markets are exhibiting binary behavior

(‘risk-on’ or ‘risk-off’). Mathematically, dynamic inefficiency, bubbles and

Ponzi games are linked very closely together. The world economy has become a

collection of Ponzi games. And which country’s assets constitute a ‘safe haven’

is largely a question of whether one country’s Ponzi game can attract new

participants (or even hold on to existing ones) longer than another’s.”

Bernard Connolly1

Bernard Connolly has never been one to mince words. In 1997, Mr. Connolly published The

Rotten Heart of Europe: The Dirty War for Europe’s Money which featured an illustration of a young

cherub perched atop a monument bearing the initials “ERM” and urinating on a map of Europe. That

image pretty much summed up Mr. Connolly’s Eurosceptic views, and he remains as dubious today about

the prospects for success of the European experiment as he did 15 years ago. While Europe is hardly the

only region running a Ponzi game, it is certainly running the Ponzi game that is closest to coming apart.

As Mr. Connolly accurately describes it, “what deters new participants in a Ponzi game is not an

accumulation of debt but a destruction of wealth, or more accurately, a realization that the wealth

supposedly backing debt is illusory….if the wealth of debtors is illusory, the wealth of creditors must also

be illusory.” I am unaware of anyone who believes that countries such as Greece or Portugal or Spain are

in a position to service or repay their debts. It must be acknowledged that these countries’ economies are

incapable of generating sufficient income to do so.

For that reason, as Mr. Connolly writes, “the suggestions often put forward (largely driven by

interpretations of Rogoff-Reinhart) that debt forgiveness or a ‘bit more inflation’ to reduce the real burden

of debts can get the world out of the mess are quite wrong. The underlying problem is dynamic

inefficiency, which reduces future consumption possibilities; and this in turn means that much of recent

and current fixed capital formation…has been based on excessively optimistic excessively optimistic

expectations of future demand.” In other words, whatever schemes the European Central Bank (ECB)

may cook up over the next few months will only prove short-term liquidity relief to what are long-term

insolvency problems. Like any Ponzi scheme, the last money in is going to be hurt the worst when the

charade comes to an end. In the meantime, investors proceed at their own risk.

1 Bernard Connolly, “Rethinking the Rogoff-Reinhart Thesis,” in The International Economy, Summer 2012, p.48.

The Credit Strategist September 1, 2012

of 15

Europe

The ECB meets on September 6, at which time it could announce another interest rate cut as well

as release further details of its planned repurchases of Spanish and Italian debt through the European

Stability Mechanism (ESM). No action will be taken at that meeting with respect to the debt repurchases,

however, because everyone is waiting for the ruling of the German Constitutional Court on September 12.

The Court is not being asked to make a final determination on the question of whether the ESM

violates the German Constitution. Rather, the September 12 ruling is limited to requests for an

emergency injunction that would place German ratification of the ESM on hold until the Court decides

the cases in full. A final verdict is not expected until sometime in 2013. According to legal experts,

however, the Court chose to hear the case through an unusual procedure that renders it unlikely that the

final ruling will deviate significantly from its September ruling. Rather than follow the normal procedure

involved when a claimant is asking for a preliminary injunction, the Court chose a different path.

Normally, the Court would evaluate the injunction question without ruling on the substantive issue. It

would determine whether the complaint describes conduct that, if proven, poses an immediate and direct

threat to Germany’s Constitution. The Court would grant an injunction only if it found not only that such

a threat existed but that the potential constitutional violation outweighs the consequences of delaying a

final decision.

In this case, however, the Court decided to adopt a different procedure – one that allows it to

decide the injunction question while also making a preliminary judgment on whether the ESM is

consistent with the German constitution. Such a procedure renders it unlikely that the Court will make a

preliminary finding of constitutionality and then later reverse it. For that reason, the September ruling

will be considered dispositive. What is unusual here is that the Court could permit Germany to enter into

the ESM without rendering a final ruling. Depending on precisely how the Court frames its decision, this

may provide sufficient certainty for the financial markets. Then again, it may not.

Many observers believe that the Court will issue a finding of constitutionality coupled with a

series of conditions designed to preserve German fiscal sovereignty. It may add those conditions the

requirement that the stability of the euro currency be enhanced by the ESM. While I received my legal

training in the United States and therefore hardly qualify as a German constitutional expert, I remain

concerned that matters may become muddled when the German Constitutional Court rules.

First, Germany is already dancing very close to the line set by the Constitutional Court regarding

limits on its economic sovereignty. Germany is facing a bill that is likely to be in the trillions of euros

whether or not the EU survives. It will either be bailing out its banks from their losses on holdings of

defaulted Greek, Portuguese, Spanish and even Italian debt, or continue writing checks into what is

basically a black hole of Target2 and ECB obligations to keep the European enterprise afloat. Either

scenario, it seems to me, could be construed as ceding of its fiscal affairs. The issue will come down to

whether German politicians will be willing to consciously decide to employ German resources to support

other nations. The question is how conscious such a decision can actually be. There is a decision

between “ceding” fiscal control and consciously deciding that devoting enormous amounts of Germany’s

economic resources to supporting other countries is in Germany’s economic interest. There can be little

question that such decisions have a great bearing on what the Court has previously described as

“fundamental fiscal decisions on revenue and expenditure.” But whether such transfers constitute a


of 15

“ceding” of control over such fiscal matters is something that only the Constitutional Court can

determine.

The current President of the Court, Prof. Dr. Andreas Vosskule, has already expressed his view

that the parameters of Germany’s Constitution are close to being exhausted. If he and his brethren view

the ESM as a step too far in terms of transferring the Bundestag’s budgetary authority to the European

Parliament, they could go so far as to effectively require a constitutional amendment in order for

Germany to lend further support to ECB efforts to prop up Spain and Italy. A decision like that would

throw Europe into chaos. At the very least, it would not be unreasonable to expect for the Court to set a

high bar on the procedural steps that the German Parliament must follow in order to exert control over the

country’s fiscal affairs and prevent them from being overly influenced by the demands of the EU.

Germany already requires parliamentary pre-approval of each and every ESM financing program, a

requirement not found in other EU countries. The Court could require even further parliamentary control

as a condition of further German support.

The formation of the ESM has ripened these issues for decision at the Court. But the conditions

that raise questions about whether Germany is already dangerously close to violating the Court’s prior

rulings have been building steadily as economic conditions throughout the region have deteriorated.

Bernard Connolly tells it like it is: “In the case of the [European Union] Ponzi game, the crisis has arisen

because only one conceivable new participant can prevent collapse: the German taxpayer (and German

demographics mean there will be fewer German taxpayers in the future, even if current taxpayers were to

accept the role of the ‘bigger fool’).” If Germany has not reached the limits of the Constitutional Court’s

rulings already, the ESM may push it right up to the line. We live in an investment world characterized

by fat tails, which is investment parlance for unlikely outcomes that have a disproportionately large

impact on investment returns. The September 12 ruling by the German Constitutional Court has the

potential to be one of those fat tail events.

Figure 1

Spanish Banks

Spain’s economy is not waiting for Germany’s Constitutional Court of anybody else to keep

dropping off a cliff. One-by-one, Spain’s regions are approaching the central government for bailouts.

These are not small bailouts either, but multi-billion bailouts. Moreover, the heads of these regional

governments are demanding assistance while claiming they will not accept any conditions on any support

they receive. At the same time, the Spanish banking system grows more infirm by the day. In July, gross

ECB lending to Spanish banks rose to a record €402 billion from €365 billion in June. This accounted for


of 15

a full 33% of ECB lending to Eurozone banks (see Figure 1 above) and illustrates that Spanish banks

have nowhere else to go to fill their funding needs (would you put your money in a Spanish bank? Or

lend money to one?). This latter point was confirmed by the latest data on capital outflows from the

banks. Private deposits fell another €8 billion in July and have fallen by €158 billion over the last 12

months to €1.58 trillion, the lowest level since June 2008 (see Figure 2 below). Why would capital want

to remain in Spanish banks when a restructuring is imminent? This is the same question that was asked of

Greek banks before that country’s faux-restructuring, and the answer is the same – there is no good reason

for any sane person or business to keep money in a bank inside a nation that is likely to default on its

obligations.

Figure 2

Money Flows Out of Spain

Speaking of Greece, that country is back once again asking for more time to meet its prior

promises to Germany and the rest of EU to cut its expenditures to the bone in exchange for prior support

commitments. It is now asking its police and other previously untouchable civil servants for steep

pension cutbacks, which has triggered the expected protests and strike threats. Greece is being bled dry

by austerity demands from Germany and the result is going to be disastrous. One would think that Greek

leaders would figure out what is abundantly clear to its people by now, that the so-called benefits of

membership in the EU are not remotely worth the years of impoverishment that remaining in this club are

going to cost. For the sake of the Greeks and the sake of the Germans who are going to have to pick up

the tab, it is long past time to let Greece leave the EU in peace. Greece is asking for a two-year extension

to meet austerity demands, but honestly it could ask for two hundred years and it wouldn’t make a

difference. Enough is enough.

The United States

Politics and Regulation

Some people may think that Clint Eastwood embarrassed himself at the Republican National

Convention, but those same people should remember that Mr. Eastwood has been awarded the Legion

d’donneur in France. And France, after all, was the adopted home of the great Irish playwright Samuel

Beckett, author of one of the most profound works of literature of the 20th century, Waiting for Godot.

Mr. Beckett surely would have appreciated the image of Mr. Eastwood addressing Barack Obama as an

empty chair. After all, in Happy Days, Mr. Beckett buried his characters up to their neck in dirt, while in

Play he had them standing in urns. He was never lacking for a sense of the absurd. Then we come to

Mr. Obama, a man who, if truth be told, was little more than a specter when elected, a politician long on


of 15

wind but completely bereft of any tangible accomplishments. Almost four years into office, his signature

accomplishments are a stimulus plan that didn’t stimulate, a healthcare bill that was sold as a faux-civil

rights law and fails to do what it intended , and a financial reform bill that reforms leaves the financial

system more fragile than it was before. The Senate has not passed a budget in three years during his

administration (for which the Republicans share the blame), although that has not stopped the government

from running up another near $6 trillion in deficits. But that is not the worst of it. Some of Mr. Obama’s

most strident supporters, such as Paul Krugman and Robert Reich, complain that the stimulus bill wasn’t

big enough and that the government didn’t spend enough! 2

They claim that had we only spent another

$1 trillion on shovel ready jobs that even the President has joked weren’t as shovel-ready as he thought,

things would be much better! Both Samuel Beckett and Paul Krugman were awarded Nobel Prizes, but

only one of these men had any insight into the human condition – and it surely wasn’t the economist.

During the convention, Mitt Romney asked people if they were better off today than they were

four years ago. Figure 3 suggests that many people are not better off. While there is blame enough to go

around, there is only one incumbent President. It would be very surprising for any incumbent to retain

office in the face of plunging hourly earnings or endless months of 8%+ unemployment. Mr. Obama can

look to the fact that unemployment has come down sharply in some key battleground states as Ohio,

Michigan and Wisconsin, but whether that will be enough remains to be seen. Mr. Obama was dealt a

bad hand, but nobody put a gun to his head and forced him to run for president, and more importantly

nobody compelled him to focus on a deeply flawed healthcare bill that lacked public support at the

expense of putting more people back to work. If Mr. Obama becomes a one-term president, he may try to

blame George W. Bush, or John Boehner, or Mitch McConnell, but the truth is he should only blame

himself.

Figure 3

Obama’s Worst Nightmare

2 Mr. Krugman is not alone; he has been joined by Michael Grunwald, who has a new book describing the stimulus

as too small. And of course we know that Christina Romer and Larry Summers thought more was needed (as much

as $1 trillion more in Romer’s case according to Noam Scheiber in his book The Escape Artists) but realized that a

larger plan was thankfully politically impossible. The argument is that economic growth and job growth would be

even smaller without the stimulus, and would have been more robust with a larger stimulus; the counter-argument is

that the stimulus was poorly designed, wasteful, and was one more attempt to cure a debt problem with more debt. I

am firmly in the latter camp. The economy was suffering from overcapacity heading into the crisis; the last thing it

needed was more debt-financed capacity.


of 15

The outlook for Wall Street has deteriorated significantly during Mr. Obama’s administration.

That does not mean that the financial system is more stable than it was prior to the financial crisis – I

would argue the opposite. But Wall Street’s profitability has been severely diminished by the Volcker

Rule and virtual elimination of proprietary trading. To the extent some institutions thought they could

out-clever the rule, the London Whale put an end to that hope. Large banks, led by J.P. Morgan’s Jamie

Dimon, spent a great deal of money and political capital fighting off the restrictions contained in Dodd-

Frank, but thus far they have had far more limited success than I would have expected. The London

Whale pretty much snuffed out any hope that the Volcker Rule will go gently into that good night. Where

the banks did succeed, unfortunately, is in neutering many of the necessary restrictions on derivatives

trading. Dodd-Frank, which in addition to insultingly bearing the name of the politician who single-

handedly did more than virtually anyone else in Washington to enable the GSE’s to cripple the economy,

fails where it matters most – in reducing systemic risk.

The global financial system is even more fragile today than it was before the crisis. This fragility

is not only a result of there being fewer too-big-to-fail institutions (Tim Geithner still doesn’t get it, and

will likely never get it), nor of the massive government borrowing used to prevent a total systemic

collapse, but of an abject failure to regulate derivatives in any meaningful or intelligent manner. Today,

the 25 largest institutional derivatives traders collectively have approximately $230 trillion of gross

derivatives positions on their books. Their net derivatives positions are probably about 10% of that, or

somewhere around $25 trillion.3 As Jim Rickards reminds us, in a systemic crisis, it is the gross rather

than the net figure that matters since many counterparties will be unable to fulfill their contractual

obligations. Accordingly, the derivatives market is not merely out of control; it is uncontrollable. The

folly that requiring derivatives to be traded on an exchange demonstrates just how unqualified those

charged with regulating these instruments are for the job. All the creation of an exchange will do is bring

into existence another entity that will have to be bailed out in a crisis. The CEOs of the institutions that

trade these derivatives don’t understand them, the regulators don’t understand the, legislators don’t

understand them and many of the people who trade them don’t understand them. Allowing them to trade

in volumes that dwarf the footings of the global financial system is so reckless that one has to wonder if

even the self-interested [fill in the blank] who lobbied against their regulation don’t have a death wish.

As you will see, this is not merely a theoretical discussion for me. It has led me to seriously alter my

investment recommendations at the end of this newsletter. Ignoring this issue is going to come back to

haunt every one of us, mark my words.

Economics

I am not pointing out these problems because I enjoy being critical but because the failure to

effect meaningful regulatory change is something that is likely to affect investors in an extremely

negative way in both the short and long term. A weak economy coupled with systemic fragility and

insufficient regulatory architecture is a combination that requires investors to proceed with caution in

their investments. These dangerous conditions offer little in the way of support for the view that stock

prices should move higher from here on any sustained basis. At some point investors will reach the top

of the wall of worry and fall off. Economic fundamentals are sluggish at best. 2Q12 GDP growth was

revised to 1.7% from its initial 1.5% reading, which was actually better than I expected (I thought it

would be lowered to about 1.2%). But a closer look at the numbers is hardly cause for confidence (thanks

3 I didn’t even have to do press a button to make those numbers red – they just turned red by themselves!


of 15

to friend David Rosenberg for this analysis). One sign of unexpected strength was higher consumer

spending, but it turns out that most of this came in the form of higher spending on utility bills resulting

from the hotter summer and higher air conditioning bills. The trade deficit was also slightly lower than

expected thanks to a combination of stronger exports and weaker imports. In particular, import growth

was only 2.9%. Inventory accumulation slowed and actually subtracted 0.2% from growth, while

business capex dropped grew at only a 4.7% rate from 7.2% prior to the revision. Of more concern is

what we will see in 3Q12. Exports will likely be weaker as Europe falls deeper into recession and

China’s economy weakens further. Businesses are likely to continue to sit on their hands as they wait for

the outcome of the election. The odds of 3Q12 growth coming in higher than 2Q12 growth are about as

high as the odds of Joe Biden not putting his foot in his mouth from now until Election Day.

The media and many pundits were making a great deal of fuss about Federal Reserve Chairman

Ben Bernanke’s speech at Jackson Hole on Friday, August 31 (it was a slow August for news I guess).

Mr. Bernanke’s speech has come and gone and as I expected he suggested he stands ready to step in if the

economy falters. That said, I doubted before the speech and continue to doubt that the Federal Reserve

will act before the election for several reasons. First, as I’ve said before, the stock market may have

performed its own intervention with its summer rally. High stock prices arguably remove the urgency for

action, and it is certainly clear that Mr. Bernanke is highly conscious of stock prices. In his speech, he

said the following: “it is probably not a coincidence that the sustained recovery in U.S. equity prices

began in March 2009, shortly after the FOMC’s decision to greatly expand securities purchases. The

effect is potentially important because stock values affect both consumption and investment decisions.”

Second, while the economic data has been flaccid, it has arguably not been sufficiently weak to meet the

high hurdle that would be necessary two months before a Presidential Election. The risk of appearing to

be acting politically, which could harm the central bank’s legitimacy (and despite criticism it still

maintains great legitimacy in the market’s eyes), is greater than the risk of waiting two or three more

months before acting. Third, it appears that opinion on the FOMC is not uniform with respect to the

efficacy or wisdom of engaging in further quantitative easing, and it would be prudent to wait for a couple

of months of additional data before acting. For these reasons, I believe the Fed will err on the side of

inaction in September, which effectively takes it out of the game until after Election Day on November 6.

This, by the way, is a good thing since further quantitative easing would likely have a limited effect and

would extend policies that were unwise in the first place.

China

China is more than doing its part to complete the global slowdown trifecta. In his most recent

report on China, ISI’s Donald Straszheim writes the following: “We are still using 7.0% y/y real GDP in

our 3Q12 forecast because we still believe that is about the number that Beijing will announce. China’s

GDP data are opaque at best. But when we go through the exercise of trying to add up the pieces that get

to 7% we fall a couple of percentage points short. Bluntly, a 7% y/y real GDP growth number announced

for 3Q12 will severely strain Beijing’s credibility among essentially independent outside observers.” Mr.

Strazsheim is more polite than me. A 7% GDP print is nonsense. Those pouring over China’s PMI

reports like Zen masters reading koans are wasting their time. The numbers are phony. If you want to

really know what is going on in China, you are much better served by looking at the prices of the key

commodities that China uses like iron ore and steel (according to The Gartman Letter, steel futures in

China have moved to new life-of-contract lows), or listening to multinational companies such as Joy

Global, Siemens, BASF, United Technologies, or Hitachi, all of whom have announced lower results and


of 15

profits warnings attributed to lower Chinese demand. Some of China’s domestic consumer products

companies are hurting as well such as Suning Appliance and Gome, two of the country’s largest

electronics retailers, or Air China, who reported that profit will drop more than 50%. Profits at state-

owned enterprises dropped 11.6% in the first half of the year from a year ago (which likely means they

dropped even more since the source of this information was the state-owned companies themselves).

Donwu Cement, which went public only a couple of months ago, has issued a profit warning (and cement

along with electricity is a key indicia of economic health in China). It is little wonder then, as Figure 4

below illustrates, that China’s stock market is back to 2009 levels.

There are all kinds of reports about the heroic stimulus efforts in which the Chinese government

is about to engage. China’s government took extraordinary steps during the financial crisis to prop up its

economy as well as the world economy. The result has been even more overcapacity than what existed at

the time. Stephen Roach, for whom we hold the highest respect, argues that China must build ahead in

order to be prepared for the shift of hundreds of millions of people from rural areas to the cities. This is

no doubt true, but the interim period before the newly built real estate and other capacity is absorbed is

still likely to require adjustment and involve some degree of slowdown. This doesn’t mean that China’s

economy has to fall off a cliff, just that the 10% growth rates that were seen in the last decade may be cut

in half for a period of time. The problem is that growth in the U.S. and Europe is so sluggish that the loss

of 4 or 5% of Chinese growth will be extremely damaging to a global economy that can’t pick up this lost

growth from somewhere else. Rather than acting as a shock absorber for the global economy as it has

been in the past, China will be reinforcing the slowdown. The question then becomes how to identify

another source of global growth.

Figure 4

Chinese Stocks – Back to the Future?

Iran

Iran’s nuclear centrifuges continue to spin while the Obama administration continues to rely on

sanctions to stop them. Unfortunately, while the sanctions may be making life difficult for Iran, they

appear to be doing little to stop their nuclear progress. The International Atomic Energy Agency (IAEA)

issued its quarterly report on Iran’s nuclear program on August 30 and the news was alarming. The

agency accused Iran of cleansing the military site south of Tehran known as Parchin to prevent the agency

from inspecting it. Iran has also reportedly been moving more of its nuclear fuel production into an

underground facility known as Fordow near the holy city of Qom. This site is buried in a mountain and is

seen by many experts as impregnable to attack. The IAEA believes that Iran has doubled its capacity to


of 15

enrich uranium to 20% purity at Fordow over the last three months, and the number of centrifuges there

has risen to 2,140 from 1,064 over that period (although most of the new ones are not yet purifying

uranium gas). Iran has now produced about 190 kilograms of uranium enriched to 20% purity since 2010,

of which 71 kilograms have been used to power Iran’s research reactor. Experts believe that Iran would

need about 250 kilograms enriched to 20% purity for one atomic weapon.

Israel is running out of patience. Iran has been very clear that it would like nothing better than to

wipe Israel off the face of the earth. The New York Times reported on September 3 that the United States

is rushing to take additional steps short of war to reassure Israel that it is serious about restraining Iran

(“To Calm Israel, U.S. Offers Ways to Restrain Iran,” p. A1). Among the actions that the U.S. plans to

take are naval exercises in the region, installation of new antimissile systems in the Persian Gulf, more

forcefully clamping down on Iranian oil revenues, and potentially new declarations by President Obama

clarifying what would prompt American military action. As always, what is right is being governed by

what is political. “The question of how explicit Mr. Obama’s warnings to Iran should be,” writes the

Times, “is still a subject of internal debate, closely tied to election-year politics.” No doubt Mr. Obama’s

amanuensis, Valerie Jarrett, will be guiding that debate, which means it is likely to sell Israel short.

Frankly, none of these mooted next steps impresses me in the least. If the U.S. wants to

demonstrate real support for Israel, the next step it should take is to lead an immediate land and sea

blockade of Iran. The U.S. should ask other Western nations to join in this blockade, but should not wait

for them to debate the matter. Moreover, when Russia and China object to this action and run to the

United Nations to block it, the U.S. should smile and tell them to take a hike. The blockade should not

allow for any exceptions – not food, not medicine, not any type of humanitarian aid. If Iran challenges

the blockade with military force, the U.S. should be prepared to use whatever force is necessary to defend

itself and insure that Iran is confined to its borders. When the Iranian people revolt, the U.S. and other

Western nations should provide whatever military and other support they can. The U.S. should not repeat

the mistake of waiting as long as it did in Libya or doing nothing (as it is doing today) in Syria as Bashar

Assad butchers his people in plain sight. America needs a president who understands that allowing a

radical Islamic regime to gain nuclear capability is simply unthinkable. Frankly, I find the fact that this

issue is open for debate further evidence that America has entered a lapsarian state from which it may

never recover. If the U.S. does not do more and prevent Iran from getting the bomb, we will all look back

at this period not only with regret but with a burning anger that we allowed something so obviously

contrary to our interests to occur when we could have stopped it.

Investment Recommendations

I continue to view the odds of a systemic crisis as uncomfortably high. Europe is a powder keg.

Financial markets are not priced for a negative ruling from Germany’s Constitutional Court on September

12. The U.S. stock market is not priced for four more years of an Obama presidency with a Republican

Congress. At this point, the odds of either of those events occurring are a toss-up. Fortunately, we will

hear from Karlsruhe in only ten days, so one risk will be clarified very shortly. The outcome of the

Presidential Election will likely go down to the wire on November 6. In the meantime, the U.S. economy

is slowing, corporate earnings are flattening or declining, and despite its summer bump the Treasury

market is still signaling asset deflation (consumer price deflation in terms of food and gasoline prices is

another matter, however). In short, the case for higher stock prices is a difficult one to make, particular

after the market’s 10% run since June. Yet experience teaches us that times of extreme negative


of 15

sentiment are often periods when the markets rise, and that is exactly what happened this summer. The

market has successfully navigated this wall of worry since June, rising by 10% albeit on low volume.

Yet unless we get undiluted good news from Europe, or unless the market becomes convinced of a

Romney victory between now and Election Day, I expect that the stock market has seen most if not all of

its gains for 2012.

Equities

With those thoughts in mind, here are my current thoughts on stocks (an updated chart of my

stock recommendations are attached to the end of the newsletter):

Bank Stocks: Every time I repeated my recommendations of large bank stocks over the

past few months, I asked myself if I had lost my mind in view of the tens of trillions of

dollars of derivatives that these institutions are sitting on. As someone who has written

and spoken extensively about the danger of these derivatives, and in view of the obvious

ignorance of bank managements and regulators about the workings and dangers of these

instruments, I would be blind not to acknowledge the incalculable risks associated with

their Brobdingnagian derivative exposures. Further, as a general matter, the

managements of these institutions have hardly distinguished themselves with their

acumen, judgment or moral leadership in recent years. Let’s face it – if Jamie Dimon

can’t get it right, who can? Further, the business models of these institutions are

changing dramatically, and their profitability is rapidly diminishing in an environment in

which the cost of their key raw material – money – is almost zero. If they can’t make

money now, how will they make money when they have to pay something to borrow?

The Volcker Rule has prevented these firms from gambling with taxpayers’ money, and it

turns out that they have few other tricks up their sleeves. The paltry returns on equity

reported by the large banks in recent quarters demonstrates that they have not found

another way to profit from other people’s money yet, and it may take them some time to

do so. For these reasons, and despite the fact that I suspect that stocks trading at sharp

discounts to book value are more likely to rise than fall, I am no longer comfortable

recommending large bank stocks for others. Personally, I may still continue to invest a

modest percentage of my personal portfolio in BAC, C, WFC or JPM. But I do not think

it is prudent for me to advise others to do so (or to invest my clients’ money in them). I

have absolutely no interest in owning MS stock because I have no confidence in the

management of the company. As for GS, at certain prices the stock is an interesting

speculation but again I would not recommend it as anything but a trading vehicle for

myself. GS is no longer the earnings machine it was just a few years ago. I am also

withdrawing my recommendation of the SPDR Wells Fargo Preferred Stock ETF – PSK

– for these reasons.

Regional banks are an entirely different story, and I continue to recommend KRE, the

SPDR S&P Regional Banking ETF, as well as the following stocks: USB, PNC, CFR,

BBT and BOH. After reading Mike Mayo’s book, I would no longer recommend KEY.

Regional banks can still continue to take advantage of the Federal Reserve’s zero interest

rate policy to make profitable loans, and I expect their earnings to be strong provided

they exercise discipline in their lending operations.


of 15

AIG continues to be extremely undervalued and I continue to recommend it.

Public PE Firms: CG has surprisingly traded above its IPO price, a first for a public PE

firm. CG has been extremely active as a dealmaker in recent months, unlike the other

large PE firms. I continue to believe the stock is a bad investment for many reasons, not

the least being David Rubenstein’s comments that his first duty is to his LPs and not his

shareholders. The other public PE stocks are still giving their shareholders nothing but

losses: BX, APO, FIG and even the best of them, KKR. But while their public

shareholders are suffering, these firms’ executives are feeling no pain, extracting tens of

millions of dollars (actually more than $100 million in many cases) of compensation on

an annual basis, much of it taxed at low capital gains rates. Moreover, it’s not as though

their LPs are enjoying fantastic returns, because they are not. These firms are

compensation schemes for management disguised as public companies, no more, no less.

The amount of money that trickles down to shareholders gives trickle-down economics a

bad name.

In additional to setting abhorrent examples of corporate governance and pay-for-

performance, private equity executives are exhibiting that their greed knows no bounds in

the political arena (and I am not speaking of Mitt Romney). In a series of separate

interviews in recent months, Henry Kravis, Stephen Schwarzman and David Rubenstein

were each asked about their willingness to forego the egregious “carried interest” tax

break. Each of these men – without exception – said they were willing to do so only

provided that “everything” was on the table in terms of tax reform. In other words, they

said that they are only willing to pay the same tax rate on their labors as their chauffeurs

and maids if other tax breaks are repealed as well. Obviously our president’s example of

leading from behind is rubbing off even on those whom he claims he wants to tax more.

Facebook: Until FB came along, BX and other PE stocks were among the worst

performing IPOs in history. But FB has blown them away and is far from done. With

more than 1.5 billion shares due to come on the market between now and year end, FB

has much further to fall. I would not be surprised to see the stock hit single digits before

year end. The real question remains whether the company’s business is anything close to

what it was cracked up to be. I suspect not. One thing is for sure – the stock is nothing

close to what it was cracked up to be, and its drop is far from over. It is a screaming

short in the high teens.

Odds and Ends: I continue to recommend the following stocks: CHK, MGM, CPN

because of their huge discounts to asset value; DOW; NLY.

Shorts: Of course, as soon as I withdrew our short recommendation on SHLD, the stock

was pulled from the S&P 500 and dropped by several percent. I still wouldn’t short it –

there is still too much Eddie Lampert can do to manipulate the stock with his control over

the float. Other shorts we continue to recommend are CRM (Saleforce – we incorrectly

gave this as the symbol for Chipolte last month) and CMG (Chipolte).


of 15

Fixed Income

High Yield Credit

Bank Loans: We were happy to learn that one of the best performing high yield mutual funds of

the last decade had greater exposure to bank loans and CCC-rated bonds than its competitors since that is

precisely the strategy I have been following in the accounts I manage at Cumberland. Bank loans sold off

during the financial crisis primarily due to technical rather than fundamental credit reasons, and their

recovery since then has been nothing short of heroic. Today, bank loans continue to provide extremely

attractive risk adjusted returns due to the combination of their seniority, strong collateral coverage, and

floating rate payment structure. I continue to strongly recommend KKR Financial Holdings, LLC (KFN)

as one of the most attractive ways to gain exposure to bank loans for non-institutional investors. KFN

recently raised its quarterly dividend to $0.21/share. At its August 31 closing price of $9.03/share, it pays

a 9.3% dividend and trades at a 7.7% discount to book value. It has superb management that is focused

on delivering value and cash to its shareholders. This contrasts sharply with Tetragon Financial Holdings,

Ltd. (TFG1.EU), which trades at a 42.2% discount to book value and pays a 5.7% dividend despite

having the ability to pay a much higher dividend. Until last month, I was still recommending TFG1 as

well as KFN but withdrew my recommendation on the former after the company only increased its

dividend by $0.01 in the second quarter. TFG1’s management is nothing short of a disgrace. It is too

cowardly to answer anything other than pre-screened questions on its quarterly conference calls, and

continues to put its own interests before those of shareholders. Even the egregious discount to book value

at which its stock trades is insufficient for me to continue recommending the stock, and as I wrote last

month I sold my shares in TFG1 and shifted my capital into KFN. I will repeat what I wrote then: life is

too short to do business with people I don’t trust or respect, and I neither trust nor respect the

management of TFG1. I urge my readers to do exit the stock and move to KFN – you will do much better

in the hands of an honest, professional and mature management team.

Investors looking for a decent place to park cash can also look to the PowerShares Senior Loan

Portfolio ETF – BKLN – which I’ve been recommending for months. It yields about 4.5% and tracks the

100 largest and most liquid high yield loans outstanding. It is a safe way to earn a decent yield on your

money with limited downside through exposure to the bank loan market.

High Yield Bonds: The most attractive sector of the high yield bond market continues to be short

maturity CCC-rated bonds. This will, of course, sound like anathema to traditional high yield bond

investors and managers, which is even more reason why it is correct. There are many companies that

overleveraged themselves heading into the financial crisis. Those that survived remain highly leveraged,

but in order to survive they not only demonstrated that their businesses are durable but repaired their

capital structures by extending debt maturities or engaging in exchange offers that reduced their debt

burdens. Many of these companies are owned by large private equity firms. While I am no fan of these

firms’ executives, their business practices, or their returns, I am the first to acknowledge that they are not

idiots and that their self-interest (which is always their focus) is to preserve the value of their investments

in these companies – which are often in the billions of dollars. For these reasons, these private equity

firms have already supported these companies through the crisis and are continuing to support them and

nurse them back to health. For these reasons, these companies – despite their low ratings – pose a very

low risk of default. Some of these names include Harrahs Operating Company/Caesar’s Entertainment,

First Data Corp., Ply-Gem Industries, and Apria Healthcare Group. All of these companies have bonds


of 15

that mature within four years that will provide double digit returns. One doesn’t need to chase yield to

earn high returns – one just has to know where to look. More details on these types of investments are

available to those for whom I manage money.

One sector of the high yield bond market that I would run away from is homebuilder bonds. The

Bank of America/Merrill Lynch High Yield Index (BAML) shows that homebuilder bonds are now

trading at a spread of 4.82%, or a yield of about 5.5%. Moreover, spreads on homebuilder bonds have

tightened nine times faster than the overall market since February. This has occurred while new home

sales remain 75% below their 2005 peak and overall recovery in the market is tepid at best. U.S.

homebuilders have an average debt/EBITDA ratio of 9.78x compared to an average of 3.64x for all high

yield companies. This sector has returned 17.4% this year compared to the overall high yield market’s

10.1% return. It is fair to say that these bonds have come too far too fast and that further gains are

unlikely. Investors holding these bonds should be selling them as quickly as possible. By the time I

began managing assets at Cumberland, these bonds were already too tight for my taste. By now, they

should be too tight for everybody’s taste.

Municipals/Investment Grade/Governments

Needless to say, yield is very hard to come by in the investment grade, municipal or government

bond markets. Treasuries remain certificates of confiscation and should be avoided except as an

Armageddon trade (i.e. if the end is nigh, Treasuries are a good alternative to holding cash in a bank

above the amount that is protected by government insurance). While the likely direction of interest rates

remains either flat or downward – particularly in view of recent statements by Ben Bernanke that he is

prepared to do more to stimulate the economy – it is hard to justify loaning money to the U.S. government

for 10 years hoping that rates will move down from 1.6% to 1.0%. For institutions or investors who need

to keep a certain amount of money in such instruments, the best they can hope for is to remain even to

slightly ahead on a real return basis. Investment grade bonds offer very little yield although their 2012

returns have been respectable, and municipals are starting to be haunted by credit concerns, particularly in

California. California is a financial train wreck. While there was promising news last week about

pension reforms, California has been required to eat into the corpus of government and educational

services in order to balance its budget. It has also been required to raise taxes to the point that it is

chasing some of its most productive citizens into other lower tax jurisdictions. It is a human and

governance tragedy that the state is shifting billions of dollars out of education into incarceration,

particularly when the manner in which it incarcerates and punishes does little more than further

criminalize the incarcerated. Rather than running schools, the state is running prison schools that leave

the state cannibalizing its own resources in a hopeless effort to protect its citizens from itself. This is a

hopeless path that will only end in bankruptcy and anomie.

Currencies/Sovereign Credit

The euro strengthened in August on the idiotic premise that the ECB is going to somehow be able

to prevent the inevitable deterioration of the European economy. This has only rendered shorting the euro

even more attractive than before, regardless of whether the euro appreciates further against the USD. In a

world where all interest rates and currencies are manipulated, it need not be frustrating to watch financial

instruments move in ways that seeming don’t make sense. Rather than get frustrated, it is much wiser to

get even and take advantage of such moves. The Japanese Yen is also stronger than fundamentals would


of 15

suggest it should be. The country is stuck on a terminal demographic course, and in the near-term its

economy is likely to be hurt by the weakness in China, its largest trade partner. The currencies that make

sense to own remain first and foremost gold, then the Singapore dollar and Swiss franc, then hard money

currencies like the Canadian dollar and perhaps the New Zealand and Australian dollars, in that order.

We prefer gold to all of the above but offer the others are reasonable alternative to those who want a little

variety in their lives. It is the least we can do when there is little variety in the folly of central banks.

Michael E. Lewitt

September 4, 2012

2012 Equity Recommendations

(NR=no longer recommended, R=new recommendation)

Stock 1/3/2012 2/1/2012 3/1/2012 4/2/2012 5/2/2012 6/1/2012 7/2/2012 7/30/2012 8/31/2012

Gain/Loss

(%)

Long

JPM $34.98 $37.60 $40.37 $46.13 $43.20 $31.93 $36.28 $36.14 $37.14(NR) 6.17%

BAC 5.80 7.36 8.12 9.68 8.16 7.02 8.05 7.28 7.99(NR) 37.76%

C 28.33 31.6 34.13 36.87 32.7 25.39 27.46 27.14 29.71(NR) 4.87%

MS 16.08 19.39 19.19 19.81 16.95 12.73 14.94 13.51 15.00(NR) -6.72%

GS 95.36 113.45 121.13 124.9 113.77 92.64 97.13 100.88 105.72(NR) 10.86%

WFC 28.43 29.89 31.54 34.51 33.57 30.16 33.55 33.96 34.03(NR) 19.70%

USB 27.58 28.56 29.71 31.71 32.04 29.6 32.44 33.75 33.41 21.14%

AIG 24.07 26.60 29.45 31.17 34.76 27.21 31.84(R) 31.72 34.33 42.63%

KRE 25.00 26.29 27.00 28.67 28.14 25.38 27.59 27.04 27.79 11.16%

PNC 59.03 59.86 60.29 64.72 66.73 58.07 61.49 59.82 62.16 5.30%

BBT 25.86 27.95 29.22 31.34 32.19 28.35 31.11 31.71 31.54 21.96%

KEY 7.77 7.85 8.09 8.48 8.02 7.14 7.72 8.06 8.43(NR) 8.49%

CFR 53.99 56.63 56.95 58.66 59.2 55.05 57.76 55.47 55.6 2.98%

BOH 45.08 46.52 46.38 48.22 49.31 44.69 46.11 46.86 46.23 2.55%

KFN 8.74 8.93 9.47 9.25 9.22 8.08 8.87 9.21 9.03 3.32%

TFG1 6.55 6.44 6.98 7.10 7.88 7.15 7.40 7.37 8.02 22.44%

BKLN 23.93 24.42 24.5 24.6 24.64 23.75 24.42 24.54 24.77 3.51%

DOW 29.79 33.94 34.1 34.97 33.35 30.36 31.51 28.84 29.31 -1.61%

GM 21.05 24.37 26.47 26.76 22.93 22.01 19.57 19.36 21.35 1.43%

PSK 42.48 44.4 45.32 44.92 45.15 44.62 45.41 45.81 46.29 8.97%

CHK 23.60 20.97 24.93 23.31 16.74 15.58 18.73 18.70 19.35 -18.01%

NLY 16.07 16.89 16.5 15.87 16.29 16.33 16.95 17.36 17.31 7.72%

Short

NFLX 72.24 122.97 112.75 113.97 82.23 62.95 67.85 57.75 59.72 -17.33%

RIMM 15.51 16.7 13.58 14.37 12.8 10.26 7.49 7.23 6.69 -56.87%

FB NA NA NA NA NA 38.00 30.77 23.15 18.058 -52.48%

SHLD 31.43 41.95 69.24 66.69 62.07 48.45 59.97 49.96(NR) 52.75 67.83%

BX 14.64 16.64 15.73 15.86 13.25 11.88 13.33 13.96 13.49 -7.86%

APO 13.05 14.68 13.96 14.4 12.65 11.36 12.73 13.34 13.26 1.61%

FIG 3.45 3.66 3.87 3.66 3.64 3.06 3.49 3.74 3.93 13.91%

CG NA NA NA NA 22 21.02 22.9 24.21 26.215 19.16%

CRM 101.2 119.32 144.98 157.18 158.94 130.99 139.07 125.87 145.18 43.46%

CMG 341.27 370.41 394.1 418.4 422.8 397.14 383.46 291.13 288.64 -15.42%


of 15

Disclaimer

All opinions and investment recommendations expressed by Michael E. Lewitt in The Credit Strategist as well

as on Twitter under the Twitter name @credstrategist are solely the opinions of Mr. Lewitt and do not reflect

the opinions of Cumberland Advisors or its affiliates or employees, managing directors, owners or principals.

Disclosure Appendix

This publication does not provide individually tailored investment advice. It has been prepared without

regard to the circumstances and objectives of those who receive it. This report contains general information

only, does not take account of the specific circumstances of any recipient, and should not be relied upon as

authoritative or taken in substitution for the exercise of judgment by any recipient. Each recipient should

consider the appropriateness of any investment decision having regard to his or her own circumstances, the

full range of information available and appropriate professional advice. The editor recommends that

recipients independently evaluate particular investments and strategies, and encourages them to seek a

financial adviser’s advice. Under no circumstances should this publication be construed as a solicitation to

buy or sell any security or to participate in any trading or investment strategy, nor should this publication or

any part of it form the basis of, or be relied on in connection with, any contract or commitment whatsoever.

The value of and income from investments may vary because of changes in interest rates or foreign exchange

rates, securities prices or market indexes, operational or financial conditions of companies, geopolitical or

other factors. Past performance is not necessarily a guide to future performance. Estimates of future

performance are based on assumptions that may not be realized. The information and opinions in this report

constitute judgment as of the date of this report, have been compiled and arrived at from sources believed to

be reliable and in good faith (but no representation or warranty, express or implied, is made as to their

accuracy, completeness or correctness) and are subject to change without notice. The editor may have an

interest in the companies or securities mentioned herein. The editor does not accept any liability whatsoever

for any loss or damage arising from any use of this report or its contents. All data and information and

opinions expressed herein are subject to change without notice.

The Credit Strategist

Michael E. Lewitt, Editor

The Credit Strategist is published on a monthly basis by The Credit Strategist, LLC. Address: 5030

Champion Blvd., Suite G11, #161 Boca Raton, FL 33496. Telephone: (561) 239-1510. Email:

[email protected]. Delivery is by electronic mail. Annual subscription rate is $395 for

individuals and $995 for institutions. Visit our web site at www.thecreditstrategist.com. Copyright warning

and notice: It is a violation of federal copyright law to reproduce or distribute all or part of this publication

to anyone (with the exception of individuals within the same institution pursuant to the subscription

agreement) by any means, including but not limited to photocopying, printing, faxing, scanning, e-mailing,

and Web site posting without first seeking the permission of the editor. The Copyright Act imposes liability

of up to $150,000 per issue for infringement. Information concerning possible copyright infringement will be

gratefully received.

http://www.thecreditstrategist.com/

ponzi games - financial newsletters, economic & …€¦ · · 2015-05-06ponzi games are...

Documents