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Sunday, September 29, 2019

Debt Deflation, Irving Fisher & Why The Fed Should Say "No" To Negative Rates: UBI Is The Only Way To Avoid A Global Depression

World leaders are falling in love with the idea of negative rates to save us from a global recession, but can negative rates save the global economy? 

After much research, the answer is no. If you don't make it past the next paragraph, here's the main thing you need to know about negative rates, they push the stock market up, but do not grow the economy (GDP). As a result, many analysts use stock market growth as a sign that negative rates are good for the economy, when they aren't. The stock market is up because wealth is being forced into the stock market, but there's no growth in the economy. In other words, economies are being pimped by low rates.

In a recent article, I researched what Warren Buffet, Alan Greenspan and Jim Cramer had to say about low and negative rates. There was little agreement. The one thing they all agreed on -- it's not good, and we are in uncharted territory. These same words have been echoed by our past and current Federal Reserve Chairs. 

In some ways, they have a point. We are in a period of unprecedented monetary policy, technological growth, overproduction, Brexit, negative rates and trade tariffs. On the other hand, these times aren't really uncharted. If we drill out for a moment, and look at the situation over a longer period of time, we'll see that we have been down this road before. The causes may seem different, but the end result is the same and it has been well documented, especially by a man named Irving Fisher.

Irving Fisher's Debt Deflation Warning  

Irving Fisher was born in upstate New York in 1867. He earned the first Ph.D. in economics ever awarded by Yale. Although he damaged his reputation by insisting recovery was imminent throughout the Great Depression, Fisher attempted to answer the same question we are asking today -- what really happened? Or, in our present case, what's really going on? He asked this question in hindsight and so had the benefit of clarity. This clarity told him that excessive debt and deflation are a bad mix. He referred to the phenomena as debt deflation.

Fisher had much time on his hands after losing his family's fortune and finally came to the conclusion that economic policy had conveniently left out one fact -- debt greatly exacerbates economic cycles, especially when mixed with deflation.

Of course, economists know that debt greatly exacerbates economic cycles. We have all been taught that too much cash or liquidity leads to high inflation. So, tools were put in place to prevent inflation throughout the Fed's massive debt monetization scheme (quantitative easing). Inflation become the primary indicator of economic performance.

All eyes were on inflation.

When the Fed saw no increase in inflation, it ramped up quantitative easing even more, which led to overproduction and lower prices. We were all looking for inflation, when we should have been keeping our eye on deflation.

How did we get here?
The initial stimulus back in 2008 created a shock-wave in the market that has only grown in size and amplitude. It is this shock-wave that Fisher attempted to warn us about some 90 years ago. He warned us that debt and deflation amplify the market imbalance. In other words, a regular market can bounce back from a shock. An amplified market can't because each wave grows in strength until something breaks.

Time and regret fueled Fisher's research which produced the paper: The Debt-Deflation Theory of Great Depressions.

The paper consists of 49 conclusions or observations made about the links between excessive debt and economic decline. What makes his theory unique is that it suggests that the economic decline we're currently experiencing is due to deflation, not inflation. Fisher admits that due to the economic theory at the time, he and his colleagues were all looking in the wrong direction, and at the wrong signs (sound familiar?). He then suggests that a new theory be added to explain what occurs when the economy is faced with excessive debt and lower prices.

The Debt Deflation Theory of Great Depressions

Debt deflation is a phenomena in which excessive debt (or cheap debt) creates overproduction, which drives down prices. Lower prices leads to lower earnings, which creates layoffs. Meanwhile, the dollar value of debt is growing due to deflation. In our case, and unlike in Fisher's case, the phenomena is further exacerbated by the pace of technology and automation.

I want to dig a bit deeper into Fisher's most relevant points for today.

First, he felt that there were many causes for market "dis-equilibrium", but only three main "tendencies":

(A) growth or trend tendencies, which are steady; (B) haphazard disturbances, which are unsteady; (C) cyclical tendencies, which are unsteady but steadily repeated. These are tendencies that can throw off market equilibrium.

Fisher then goes on to describe the ubiquitous nature of the market, which is seemingly in equilibrium. This is the same "delicate" market he experienced prior to The Great Depression:

There may be equilibrium which, though stable, is so delicately poised that, after departure from it beyond certain limits, instability ensues, just as, at first, a stick may bend under strain, ready all the time to bend back, until a certain point is reached, when it breaks. This simile probably applies when a debtor gets "broke," or when the breaking of many debtors constitutes a "crash," after which there is no coming back to the original equilibrium. To take another simile, such a disaster is somewhat like the "capsizing" of a ship which, under ordinary conditions, is always near stable equilibrium but which, after being tipped beyond a certain angle, has no longer this tendency to return to equilibrium, but, instead, a tendency to depart further from it.

He goes on to say that:

Under such assumptions, and taking account of "economic friction," which is always present, it follows that, unless some outside force intervenes, any "free" oscillations about equilibrium must tend progressively to grow smaller and smaller, just as a rocking chair set in motion tends to stop. That is, while "forced" cycles, such as seasonal, tend to continue unabated in amplitude, ordinary "free" cycles tend to cease, giving way to equilibrium.

So we know that Fisher believed business cycles were natural, but what can his observations tell us about warning signs. Is there anything that would have alerted Fisher that the Great Depression was looming?

To this Fisher would respond,

...I doubt the adequacy of over-production, under-consumption, over-capacity, price-dislocation, maladjustment between agricultural and industrial prices, over-confidence, over-investment, over-saving, over-spending, and the discrepancy between saving and investment. ...each of the above-named factors has played a subordinate role as compared with two dominant factors, namely over-indebtedness to start with and deflation following soon after; also that where any of the other factors do become conspicuous, they are often merely effects or symptoms of these two. In short, the big bad actors are debt disturbances and price-level disturbance. He refers to these two bad actors as the "price-level disease" and the "debt disease".

While quite ready to change my opinion, I have, at present, a strong conviction that these two economic maladies, the debt disease and the price-level disease (or dollar disease), are, in the great booms and depressions, more important causes than all others put together,

He goes on to make the point crystal clear:

Thus over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money. That is, over-indebtedness may lend importance to over-investment or to over-speculation. The same is true as to over-confidence. I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt. ...On the other hand, if debt and deflation are absent, other disturbances are powerless to bring on crises comparable in severity to those of 1837, 1873, or 1929-33. Why is this? It's because deflation due to excessive debt has a greater impact than inflation due to excessive debt. This is due to its cyclical and compounding nature. Debt creates deflation and deflation artificially increases debt levels.

In other words, disequilibrium due to market forces tends to create an initial shock to the system that, over time and like a pendulum, will slowly work itself back to equilibrium. Disequilibrium due to market intervention, however, tends to create an initial shock and that shock is just the beginning. When further compounded by excessive debt, its oscillations gain momentum with each swing. This is the impact of debt deflation. It builds upon itself.

In its most heinous form, deflation (or lower prices) actually pushes up the value of the dollar, which only adds to indebtedness. As a result, the debtor is stuck in a loop and can never pay down his debt. Fisher explains it far better than I can in the following paragraph:

...deflation caused by the debt reacts on the debt. Each dollar of debt still unpaid becomes a bigger dollar, and if the over-indebtedness with which we started was great enough, the liquidation of debts cannot keep up with the fall of prices which it causes. In that case, the liquidation defeats itself. While it diminishes the number of dollars owed, it may not do so as fast as it increases the value of each dollar owed. Then, the very effort of individuals to lessen their burden of debts increases it, because of the mass effect of the stampede to liquidate in swelling each dollar owed. Then we have the great paradox which, I submit, is the chief secret of most, if not all, great depressions: The more the debtors pay, the more they owe. The more the economic boat tips, the more it tends to tip. It is not tending to right itself, but is capsizing.

He goes on to say:

Unless some counteracting cause comes along to prevent the fall in the price level, such a depression as that of 1929-33 (namely when the more the debtors pay the more they owe) tends to continue, going deeper, in a vicious spiral, for many years. There is then no tendency of the boat to stop tipping until it has capsized. ...On the other hand, if the foregoing analysis is correct, it is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged. In other words, the only way to right the ship is to increase prices.

Reflate The Price Level

The market is full. It has eaten everything in sight for the past 10 years and now it needs a moment to pull back and digest, but glutton has gotten the best of him. The only self-correcting mechanism left for the Federal Reserve is something that relieves bloat.  

In economic terms, the market is asking for a distribution.

It is more commonly known as universal basic income or helicopter money. Presidential candidate Andrew Yang has rebranded it as the Freedom Dividend. You can call it whatever you want, but I like to think of it as a banking and automation distribution. These are the two "bad actors" that got us here and the market is demanding reparations.

Deutsche Bank reportedly said that "helicopter money," a term that refers to giving cash directly to households, "could be highly effective if properly deployed." Some reports claim that the Japanese central bank considered dropping payments to residents, but later decided to approve a $274 billion stimulus package instead.

Most central banks know we're in crisis mode. They know we need to raise prices, but they don't know how to do it. Japan's foray into negative rates in January of 2016 was, in actuality, an attempt to reflate prices, but they failed, over and over again. And now, the Federal Reserve is considering negative rates as well. Thankfully, we not only have the words of Irving Fisher, but our own Federal Reserve Bank of San Francisco to steer us in the right direction.

In August, two Federal Reserve Bank of San Francisco economists wrote a paper assessing Japan’s experiences with negative rates. The paper was titled: Negative Interest Rates and Inflation Expectations in Japan. 

They came to the following conclusion:

Because of the long period of low inflation in Japan, its experience provides an interesting example of the impact of negative monetary policy rates when inflation expectations are well-anchored at very low levels.

...Our results suggest that this movement resulted in decreased, rather than increased, immediate and medium-term expected inflation. This therefore suggests using caution when considering the efficacy of negative rates as expansionary policy tools under well-anchored inflation expectations.

In other words, negative rates don't work. The market loves them because it means free candy from the Fed, but the boat is only tipping over further.

The only thing negative rates are good at producing is higher stock prices, which is why the market rallied on Trump's negative rate tweets. But, does this market approval mean the central bank is acting in the best interest of the economy?


This is the reason Robert Holzmann, the European Central Bank's newest Governing Council member and Austrian central bank governor, went on record as saying the ECB's latest move to lower rates to -.5% was a mistake.

 "Frankly speaking," said Holzmann, "I'm not so sure whether we are playing with the market or if the market's playing with us. Because, if my economics is right, at the moment the market is gaining for getting more and more in the negative territory, so perhaps it wants to lead us to believe that's the way. So, I don't think this market reaction is an indication that this is the way we have to go."

While it may be hard to find agreement on the calculus behind negative rates, everyone does agree on one thing -- quantitative easing and low rates created an unprecedented amount of debt around the world. Now the conundrum for economists worldwide has become: how do we raise prices after quantitative easing? If negative rates don't work, what will raise prices in a world of overproduction and automation?

Some say the answer is trade tariffs, but while trade tariffs raise prices, they also decrease spending. The only answer the market will accept is cash. Not debt, just cash.

This is anathema to the world's power structure, but it is the only answer the market will accept. It is the only answer that has the strength to keep the ship from capsizing.

In normal situations, giving $1,000 a month to every American would lead to inflation. Ironically, many opponents of UBI actually use Fisher’s theory of exchange to support their argument saying that:

...any increase in the supply of money must result in proportional reduction of the purchasing power of money. Since UBI is bound to reduce the economic output by reducing the workforce participation one could expect price-inflation even if the supply of money remained constant, creating another economic hurdle for UBI proponents in the form of net inflation equal or greater to the overall benefit of UBI.

I couldn't agree more, but we are not in a normal situation. Indeed, the impact of UBI (as described above) is the only thing that can get us out of the current debt deflation spiral we're in.  Universal basic income, however much you may not like it, is the only way to reflate prices.


Monday, September 16, 2019

What Do Alan Greenspan, Warren Buffett And Jim Cramer Think About Negative Rates?

Everyone's talking about negative rates, but it's hard to find two people that are willing to say the same thing. In light of this, I thought it might be prudent to see what Alan Greenspan, Warren Buffett and Jim Cramer have to say about negative rates. As on overview,
  • Alan Greenspan thinks negative rates are a sign of an aging population.
  • Warren Buffett thinks that if interest rates are nothing, values can be almost infinite.
  • Jim Cramer thinks negative rates are a sign that we're not in a robust economy (talk about stating the obvious).

Let's start with Alan Greenspan.


Greenspan thinks negative rates are a sign of an aging population.

What's his logic? You can't have negative rates unless you have buyers. Greenspan thinks the buyers represent an aging population that's willing to pay money to secure their cash for the next 20-30 years.

After an awkward start, the host asks Greenspan:

What about the notion of the economy weakening?

Greenspan's response,

It's going to depend in large part on the stock market. We underestimate the wealth effect on the economy...

But then adds,

Overall the economy seems to be sagging.

These feel like conflicting statements, but I digress.

Later, when asked about what negative rates signify, Greenspan had this to say:

What it signifies is that the world population is aging. People are recognizing that they are dying off at a much later date than when they contemplated when they started to save.

He goes on to make a quick comment on gold (XAU):

One of the reasons gold prices are rising so much... that's telling us that people are looking for resources, which they know are going to have a value 20 or 30 years from now as they age. And they want to make sure they have the resources to keep themselves in place. That is clearly the fundamental force that's driving this, but we don't know how far it will go.

This makes sense from an economics perspective, but it assumes negative rates are a common market phenomenon. They aren't.

Warren Buffett disagrees with Greenspan as well.

In an interview on CNBC, Buffett had the following to say about negative rates:

What's happened with interest rates is really extraordinary. You could go back and read everything that Keynes wrote, everything that Adam Smith or Ricardo or Paul Samuelson -- you won't see a word about sustained negative interest rates. I mean we are doing something the world has never seen. It does have the effect of making assets more valuable. Interest rates are like gravity in valuations. If interest rates are nothing, values can be almost infinite.

He goes on to explain what impact negative rates are already having on his company:

So Berkshire Hathaway (#BRK.A) is sitting with billions of dollars of euros in an insurance company in Europe and they will bear a negative rate. We would be better off putting them in a big mattress that we could stick it in -- if I could just find someone that I trust to sleep on the mattress.

If we have a billion euros at minus 35 basis points, it would be $3.5 million euros a year that it's costing us just to have that....It [negative rates] distorts everything...we do not know how this movie plays out.

$3.5 million euro for sitting on a mattress? You can trust me, Buffett. If you're reading this, I've got your back.

He follows up with some Buffett wisdom, spoken like the king of insurance that he is:

In economics the most important thing to remember is that you always want to ask yourself "and then what". After anything that happens, if someone tells you that "this" thing is going to happen, there's always the need to ask "and then what". And then what? In terms of sustained low interest rates the answer is, I don't know.

Jim Cramer does. He thinks thinks negative rates are a sign that we're not in a robust economy.


In response to Trump's negative rate tweets, Cramer had this to say:

I want them to cut rates, but negative rates though, we don't want negative rates. That's just a sign that we're not a robust economy.

To which the host responded:

Is bonehead appropriate for a Fed chief that he appointed?


He appointed him, that was his appointee.


Yes, it was, well as we all know he tires of people quickly.




In this case though, he can't fire them. Because one would think, given the frequency of Tweets, if he could, it would have happened a long time ago.


David, I think you got a keen eye for the obvious there partner.


Thank you. Yeah, a keen sense for the obvious is what I've made a career out of.


Yeah, you really have.

Gotta love that Cramer. Let's skip forward a bit to see what he really thinks about negative rates:


And now you have JPMorgan's Diamond saying they're preparing for zero interest rates. Lowering their guidance on interest income.


Yeah, but I was looking on Twitter and someone also posted that they're looking at 5% yesterday, and it was the best Tweet of the day because it just shows that they're prepared for anything or you could say that they don't know what they're doing.


The truth is, negative rates have been around for a while. Denmark’s policy rates fell below zero in July 2012, followed by the European Central Bank, the Swedish Riksbank, and the Swiss National Bank. Japan set its leading policy rate below zero on January 29, 2016. Now there's over $20 trillion in negative yielding debt in the world (both central banks and corporate). Put another way, banks and corporations around the world are already making money on $20 trillion in debt/cash they issued. It's really a brilliant scheme when you think about it.

What do I think? I think this makes me want to avoid Treasuries and buy bitcoin (BTC), gold and real estate.

That said, negative interest rate policy (NIRP) is a last-ditch attempt to generate spending investment. When combined with more QE, it makes asset prices go through the roof, as Buffett said. At some point, central banks will run out of assets to buy, but if rates do go negative, the market is about to have one last run and that run is going to be explosive.

I think that's the essence of this. If there is ANY one major takeaway from these three views on negative rates, it's that you need to be prepared for anything because what started out as a short-term emergency experiment has become the new norm. And now that new norm has created the need for more short-term emergency experiments because what used to work has stopped. As Buffett would say, we have run out of "and then whats".

Tuesday, September 10, 2019

Herd Behavior In Financial Markets: A Study On Contagion Theory

 "Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly and one by one." Charles Mackay (1841)
This is the opening quote in the paper Herd Behavior in Financial Markets by Sushil Bikhchandani and Sunil Sharma published as an International Monetary Fund staff paper in 2001. Marco Cipriani and Antonio Guarino decided to take another look at this paper, published by the Federal Reserve Bank of New York, to see if its conclusions could help to better understand the market in 2015. Likewise, I want to use it to see if it can help to gain a better perspective on the level of volatility in the market today.

Herd Behavior Defined

First, let's define herding. Herding is when a trader disregards their own knowledge or trading plan to follow the behavior of the crowd. The reasons for the Fed's interest in the subject is clear -- to understand how to get ahead of, or put tools in place to counteract, contagion, specifically information contagion as discussed in the article Federal Reserve Bank Of New York: A Study On Contagion Theory.

The authors split the identification of "herding" from the use of data into two categories: spurious and real. Some herding, characterized by clustering in statistical data, may be the result of a public announcement rather than true herd behavior. In response to this the authors present another way to measure herd behavior through a theoretical model.

The Theoretical Herding Model

The model used to test the theory is based on an asset that is traded over a period of time. An event occurs at the beginning of each day the asset is traded. Some traders receive or find public or private information about the asset -- these are considered "informed" investors. All other traders are therefore considered to be uninformed and are therefore considered to be trading due to liquidity or re-balancing. If no event occurs, all traders are uninformed.

So how does this scenario generally play out. In a nutshell, the herd convinces the trader to put its theory over the traders own knowledge about the stock. Here's the thought process:
  1. The informed investor knows something happened to change the fundamental price of the asset.
  2. The investor realizes that their position is the opposite of what's occurring in the market.
  3. The informed investor weighs the importance of their own private information or trading plan against the asset's movement in the market.
  4. If the market movement is deep enough the trader will go against her own plan in favor of the market. The rationale being that the information traders are trading on in the market must be better than what she knows.
In this way, herd trading is a made into a rational decision, at least in our minds.

Example: Ashland's Herd Traders

The authors use Ashland Inc. (NYSE: ASH) in 1995 to further illustrate the theory.
We find that herding on Ashland Inc. occurred quite often: on average, the proportion of herd buyers was 2 percent and that of herd sellers was 4 percent. Additionally, we find that not only did herding occur but also it was at times misdirected (that is, herd buying in a day when the asset's fundamental value declined and herd selling in a day when the asset's fundamental value increased).
The authors go on to find that "the price was 4 percent further away from its fundamental value than it would otherwise have been." This seems like a rather small percentage, but the data supports these findings and according to the VIX, contrary to perception, the market is no more volatile in 2015 than it was in 1995. Based on the chart below, it appears the same can be said for 2019. 

So What

What are the implications of this for the Fed and for the individual investor? The implication is that what we think is volatility due to fundamental changes in the market's value may actually be due to the herd behavior of traders with greater levels of capital to spend. They'll have even more to spend if rates go negative.

That said, it's hard to make definitive conclusions about the application of this data until we have a way to measure a stock's "herd" appeal.
  • Perhaps companies with a higher degree of volume or volatility also have a higher percentage of herd traders. 
  • Perhaps this is the reason stock runs are often followed by corrections. 
  • Perhaps stocks with a high P/E have a higher degree of herd buyers? 
A "Herd Index", theoretically, would be able to provide buy and sell signals that were even more reliable than P/E multiples in finding over- or under-priced stocks. As of this writing I am unaware of any such measure. That said, JPMorgan recently created the “Volfefe Index” to measure the impact of President Trump's tweets on the market so anything is possible. 

Monday, September 9, 2019

Should You Diversify Your Portfolio With Bitcoin?

To buy bitcoin or not to buy bitcoin...that is the question.

It can be a hard question to answer and rightly so. 

The good news is that you don't have to draw a line in the sand. This is not a do or die situation (unless you make it one). You have the liberty to invest your wealth wherever you want. And, if there's anything I've learned in all my years of studying financial markets, it is that diversity is the key to riding out economic cycles. Your portfolio gains strength from diversifying your assets, especially if those assets aren't correlated with one another. 

I know the media is politicizing the recession, but this has nothing to do with Trump. This is about a global 'bow' that is about to break. All signs are pointing south, from negative interest rates to declining GDP levels. There may be those that have a vested interest in telling you otherwise, but if we use the same barometers of economic health that we've used over the past 60 years, we are due for a recession.  

For example, Fed Chairman Powell was heard across financial media last week saying that he did not think a recession was looming. Meanwhile, his own NY Fed just published the chart below suggesting otherwise. The blue represents periods of recession.

And, if a recession isn't a concern, why are you lowering rates? 

What do I think is going on?

Personally, I think central banks figured out they could make more money from negative rates than by raising the IOER. They're going for the big whale con.

It's hard to know what's going to happen for sure, but one thing is certain, a downturn is coming. The best way to guard against the inevitable downturn is to diversify your asset base. In simpler terms, you never want to put all your eggs in one basket. You certainly don't want to ban the fastest growing asset class in the world from your portfolio. 

Jeff Sprecher (pronounced “Sprecker”), the founder, chairman, and CEO of Intercontinental Exchange (ICE) is also a believer in bitcoin. And, I don't mean that in a general sense. Sprecher is a true believer; an evangelist of sorts. 

Sprecher's name may sound familiar because ICE is also the world’s second largest financial exchange by revenue. ICE also owns NYSE American, the leading platform for mid-cap companies. 

In the bitcoin community, however, Sprecher is known more so for his work as founder of Bakkt, one of the most talked about bitcoin ventures happening this year. ICE is partnering with Microsoft, Boston Consulting Group, and Starbucks to make bitcoin accessible to the world’s largest financial institutions. It gives these uber-large institutions a way to buy and take custody of bitcoin within an end-to-end regulated system approved by the CFTC and NYDFS, and it is "backed" by the reputation of ICE. The venture just went live last week.

Not surprisingly, lots of value changed hands last week as well -- $780 million BTC was moved earlier in the week followed by a $1 billion (94,505 BTC) move that made crypto headlines.

The point is, if you decide to diversify your portfolio with bitcoin you'll be in good company. The largest institutions in the world are preparing to do the same.

The revolution is digital...