Francis J. Sheed

Sometimes we are met with a rationale for some event or action and, after some brief reflection, we may then think, "Yes, that makes an infinite amount of sense."

An example may be when a friend describes the way that his house has been oriented so that it can take advantage of the prevailing regional breeze. So it was when I learned an interesting fact regarding Catholic apologist and publisher Frank Sheed (and his wife, Maisie Ward).

Catholic World Report described Sheed this way:

Although Frank Sheed (1897-1981) authored over twenty books—including Theology and Sanity, A Map of Life, Society and Sanity, Knowing God, and To Know Christ Jesus—and founded, with his wife Maisie Ward, the Sheed & Ward imprint, he is not nearly as well known as G.K. Chesterton and C.S. Lewis. Many, however, think Sheed is the equal of Chesterton and Lewis as a Christian apologist, deserving of more attention as not only a defender of the Faith, but as an evangelist, catechist, and communicator.

It may have been fifteen years ago that I was first introduced to Sheed's writing by a priest that I know. The book he suggested was excellent. Sheed's writing was clear, articulate and persuasive. I read another two books of his over the years and grew to be more impressed by his Catholic apologetics and I also learned that the Sheed & Ward publishing firm was thought of as the Tiffany of the Catholic world until Sheed's death in 1981.

Yet it wasn't any of his writings that most stunned me about what Sheed accomplished in his life, but it was something that he published that would seem, initially, to most observers to have no direct Catholic connection at all.

Perhaps five or six years ago I was reading a book on Austrian economics at Mises.org and I noticed something unusual, the book had been published by Sheed and Ward.

No, I thought, this can't be the same Sheed and Ward, the Catholic publishing firm. It, of course, was.

Why, I wondered, had Sheed published a book concerned with Austrian economics? In fact, it wasn't just  one book, a search at Mises.org reveals numerous publications by Sheed and Ward of Austrian economists. Sheed and Ward may have even been the dominant publishing house of Austrian economics in the 1970s.

What was it that caused him to publish such works?

I haven't come across any quotes from Sheed about his decision to publish those volumes, so everything from here on out will simply be my conjecture. Quite simply, I believe that Sheed pushed into the publishing of Austrian economics because it has, at its very core, a belief that following natural law is the imperative for all individuals, for all of mankind. Failure to heed this law will, inevitably, result in catastrophe. This belief in the centrality of natural law is also core to Catholicism and all of Christianity.

This Austrian/Catholic centrality of natural law, of course, is very different than the view maintained by the Keynesian/Monetarist oriented portion of the economics profession. Their focus on GDP, regulating money growth as a way to maximize GDP, state intervention to achieve an end are all decidedly anti-natural law. For them, the ends justify the means. This type of world has no room for the rights of the individual.

Here is how Sheed viewed the importance of the individual:

Never think that the way of man is prosaic. We are a mixture of matter and spirit, and … the only beings who die and do not stay dead: it seems an odd way to our goal that as the last stage on the way to it all of us, saint and sinner, should fall apart. We are the only beings with an everlasting destiny who have not reached their final state. By comparison there is something cozy and settled about angels, good and bad. Men are the only beings whose destiny is uncertain. There is an effect of this in our consciousness, if we choose to analyze it. There is a two-way drag in all of us, and nothing could be more actual and less academic than this curious fact. How actual it is we can see if we compare our knowledge that the planet we live on is not anchored in space. This ought to be, one would think, the first thing we should be aware of, yet it was only a few centuries ago that scientists arrived at it; and most of us still have to take the word of scientists for it. No one of us has ever felt the whizz of the world through space and the counter-drag of whatever power it is that keeps us upon the earth’s surface. But we do feel the almost continuous drag in ourselves downwards towards nothingness and the all too occasional upward thrust. Man is the cockpit of a battle. We are the only creatures who can choose side and side in this battle. We are the only beings left who can either choose or refuse God. All the excitement of our universe is centered in [us]. 

Compare this to a quote from Austrian (and atheist) Murray Rothbard:

I am convinced that it is no accident that freedom, limited government, natural rights, and the market economy only really developed in Western civilization. I am convinced that the reason is the attitudes developed by the Christian Church in general, and the Roman Catholic Church in particular. Christianity, with its unique focus on (a) the individual as created in the image of God, and (b) in the central mystery of the Incarnation, God created his Son as a fully human person- (this) means that each individual and his salvation is of central divine concern….

Thus, even though I am not a believer, I hail Christianity, and especially Catholicism, as the underpinning of liberty.

The Austrian/Catholic understands that man's purpose is to use his free will to follow natural law. If government makes a decision about the desirability of some outcome, maximizing GDP as an example, other rights must be sacrificed by force to reach this end. The individual's right to choose must be sacrificed.

This is morally wrong. The Keynesians and Monetarists believe that it is fine to utilize a central bank to print money from thin air and forcibly steal from some to give to others. To the Catholic/Austrian, this isn't any different than knocking over a liquor store even if you intend  to give the money to the poor. You can't violate natural law, not even to achieve a good outcome. To the Austrian/Catholic, the ends do not justify the means.

For Sheed, the individual is locked in a battle with evil. This evil is an attempt to get us to abandon the following of natural law. When Rothbard talks about Catholicism as the underpinning of liberty, he is recognizing that choice is critically important to the nature of man. Rothbard referred to man as a learning creature. He must make choices and accept consequences in order to learn and grow. The limiting of those choices by government decree to him was decidedly anti-human.

In the same way, Christianity recognizes that the soul needs to grow. It needs to learn to express love for one's neighbor, the ultimate commandment. The only way that this is possible is by the utilization of one's free will to follow natural law. Love involves choice and freedom.

The Catholic apologist recognizes that the Creator could have made us as automatons (per C.S. Lewis), always doing the right thing. He did not do this, because without the ability to choose, no love is possible. In my mind, there is no way that Catholicism can support any other economic theory than Austrian economics. The two seem to be beautifully intertwined.

So, on that day several years ago when I discovered that Frank Sheed had pushed into the publishing of Austrian economics in the years before his death, I very quickly realized, "Yes, that makes an infinite amount of sense."

Disclaimer: Nothing on this site should be construed as investment advice. It is all merely the opinion of the author.





 
 

An Austrian Takes on Prevailing P/E Wisdom

The equity market trades at only 17 times earnings (or some such number) and this isn't too very different from past historical numbers; ergo, there is no bubble in the equity market. This is an argument that I have heard often in the past couple of years.

The bears have offered something of a counterpoint argument by mentioning that corporate earnings are historically high at about 10% of GDP, and normalization at 6% presumes weak equity returns going forward.

I thought that I would take a look at these arguments and see if we could put a little Austrian spin on the debate. This debate is especially relevant given the extraordinary "inflation" that the economic system has been generating under the direction of central bankers.

I propose to do this by utilizing a simple model, one that uses data that looks very much like data from recent and past U.S. data, but I am going to simplify everything somewhat in our model by eliminating overseas earnings and overseas claims on the domestic system so that we can focus on a closed system and see how inflation and corporate profitability should impact P/E multiples in a system of financial market inflation.

Let's start by looking at  a relatively healthy economy for our model,  one that looked much like the economy of the U.S. before Bretton-Woods died and the dollar became untethered from gold. Our model will use some similar data from back in the 1950s and 1960s, real GDP expands almost 4% per year, corporate profits are 6% of GDP and the savings rate is 10% of GDP. In this environment, real wealth creation is equal to 14% of GDP per year, the savings rate plus real GDP growth. With corporate profits equaling 6% of GDP, corporate equity owners have a claim on about 43% of all of the increased wealth in society, that is their 6% of GDP profit margin divided by the 14% rate of wealth creation, and all of these incremental claims on wealth are 100% backed up by savings in this model. The corporate equity holders have a claim equal to 6% of GDP in terms societal output and savings per year then.

Now, let's take a look at how inflation, particularly if it is focused in the financial sector, can impact corporate equity holder's claims.

Since the equity market peak in 2000, household net worth doubled (hhnw) as it increased from about $43 trillion to about $85 trillion. On average, this represents a net worth increase of $2.8 trillion per year. GDP in 2000 was about $10 trillion and today is about $17 trillion and, therefore, averaged about $13.5 trillion over this period. The simple math shows that hhnw increased at a rate of about 20% of GDP per year for the past 15 years as compared to the 14% rate in the above example.

Corporate profits as a percent of GDP have been extraordinarily high recently, about 10% of GDP. The central bank's crushing of interest rates has destroyed the savings rate and secular real GDP growth rates however, and these figures have been running at 1% and 2% of GDP respectively.

Even if we allow for 5%  equity price appreciation in addition to their 10% profit margins so that equity holders feel like they are generating a 15% rate of return, there  exists a problem. Asset inflation is stoking 20% more claims against output every year, but society is only generating an incremental 3% in real wealth per year relative to GDP. That is, there exists almost $7 in incremental claims against every dollar of real output.

Equity holders in this world own 75% of these incremental claims (15%/20%), but those claims can only go up against the 3% of real wealth creation. That is, equity holders are only able to generate a real return of .75 x 3% = 2.25% of GDP.

In our first example, where the level of corporate profitability was far lower, but the savings and growth rates were higher, equity holders had a real claim every year equal to 6% of GDP, while in the world of financial asset inflation, their real claims on society's incremental wealth creation amounted to only 2.25% of GDP despite very high levels of profitability and soaring stock prices (5% per year on top of their earned profits).

Not only that, but growth rates in the first example are twice as high as in the latter example. So, if a P/E multiple of 17 was historically supplied in the first market, does the world of financial asset inflation justify as high a multiple?

With a claim on real wealth creation that is only 37.5% as high (2.25/6) and with half the growth rate, perhaps a multiple of 3-4 times earnings is more appropriate today.

All of this is a long winded way of saying that debasement is very high in the current environment. Bond holders are earning 1% in many cases, while total claims (hhnw) are rising at a rate of 20% of GDP. Equity holders think they are earning profits, but what can they claim with them in the future with so little in the way of savings and growth? Not much!

The reality is, you are much better off owning a decent sliver of a big pie than the entirety of an empty pie tin. The central banker's artificial crushing of interest rates has emptied the pie tin of savings and real growth. Equity holder's claims on real wealth creation are, in reality, very small relative to history despite soaring equity prices and high levels of corporate profitability. P/E multiples are way too high, even if corporate profitability could remain at these levels. 

Disclaimer: Nothing on this site should be construed as investment advice. It is all merely the opinion of the author.

State Plan 14.25

There were a couple of items that caught my eye today that may seem unrelated, but they fired a few synapses in my brain and I thought that I would relate them here.

First, Bloomberg ran a couple of stories on the ever-inflating asset bubble.  Of course, they don’t outright call it this, but they reported on a home on offer in Los Angeles by a spec builder for $500 million. In the story no one is screaming “top of the market,” because the market has been so stupid for so long that things like this are becoming normal.

The second story that they reported on was the torrid returns being generated in Chinese stocks. Today, in just a single trading session, 250 companies listed on the Shenzhen Exchange were limit up 10%.

The third item that caught my eye was an obscure swimming story where Hungarian swimming sensation Katinka Hosszu was implicated in a doping scandal by Swimming World Magazine.

Of course, I have no knowledge of Hosszu’s guilt or innocence other than to say that her performance over the past two years has been so superlative that it has people wondering.

If she is innocent, I hope that she is allowed to compete. She has passed all her drug tests, but there gas been enough smoke in terms of incredible athletic performances in past years being drug fueled that questions are bound to be raised.

So, instead of talking about Ms. Hosszu, let us turn our attention to East German State Plan 14.25. This was the directive issued by the East German government to utilize steroids on their international athletes during the 1970s and 1980s.

The introduction of systemic doping made the tiny GDR a world athletic powerhouse, and nowhere was this power more visible than in women’s swimming.

Starting in 1973, East Germany’s women swimmers became the best in the world, surpassing their chief opponent, the U.S. By the time the 1976 Olympics rolled around, there remained a bright hope for U.S. women’s swimming in Californian Shirley Babashoff. It was hoped that Babashoff would be the new Mark Spitz, but it was not to be. The East Germans thoroughly dominated the 1976 Olympic swimming competition and Babashoff left with four silver medals and one gold. In each instance where she finished second, Babashoff lost to an East German.

Babashoff, then a teenager, did not go quietly into the night, however, as she openly accused the East Germans of cheating, citing their masculine voices and incredible musculature. Without any proof other than the startlingly obvious physical make-up of those East German women and their coming from nowhere to dominate the sport in just three years, the press mercilessly laid into Babashoff, nicknaming her “Surly Shirley” and a sore loser.

Babashoff was correct, however. The doping scandal involved at least 10,000 East German athletes and all of their female swimmers. Of course, this information all came out decades after the damage was done to Babashoff’s career, a career that should have her remembered as one of the greatest female swimmers in history. Instead, she is largely an afterthought, an asterisk. 

What I love about her story is that she had the courage to speak the truth, to call a spade a spade. Yes, she paid a terrible personal price for her integrity, but her integrity remains intact. Sometimes, having the courage to simply state the obvious truth, the one staring you in face, is all that is required to maintain your integrity, and Shirley Babashoff had it!

The East German athletes, it appears, were largely unaware that they were being fed massive doses of steroids and many have seen their lives destroyed as a result. The physical damage for those athletes of such massive, long-term steroid use has been terrible: Leukemia, sterilization and birth defects were just some of the consequences.

Now, back to our $500 million house and 250 Chinese stocks on a single exchange surging more than 10% in a day. As easily as Shirley Babashoff could just look at her 1976 Olympic opponents and understand that something was not right about the appearance of those East German “women,” so too should we be able to look at the increasingly obvious distortions in the financial markets and understand that something is seriously wrong.

Babashoff could rightly have asked, “Do these women look normal to you?”

Today, we should we be asking, “Does a $500 million spec house and 250 companies in a single market going up 10% in a day look normal to you?”

Sometimes, all you have to do is open your eyes and accept the truth. The markets everywhere are loaded up on central bank administered steroids and the consequences will be, over time, as disastrous for market participants as they were for East German athletes.

Just open your eyes people. You can’t miss it.

 Disclaimer: Nothing on this site should be construed as investment advice. It is all merely the opinion of the author.

Amazon Addendum

In my last post I pointed out two things regarding AMZN:

1) It appeared as if AMZN had dropped capital spending below the rate of depreciation, and...

2) Their R&D spend had ramped up dramatically. I also pointed out that if this R&D spending were capitalized and written off over three years then the company still isn't very profitable, they really aren't growing and their returns on investment were probably non-existent.

I used these two items as an example of what the central bank policy of ZIRP has brought us. There isn't any way to earn a return on your invested capital and many businesses, AMZN excepted, are giving up.

My perusal of AMZN's balance sheet was where I picked up (1) above, A friend has since pointed out that AMZN is now heavily using a form of capitalized leasing for much of its capital spending. The result is that the line item for this doesn't appear separately in their cash flow statement, but the equipment does show up in their balance sheet. The lease payments for this run through the income statement. In short, AMZN's capital spending is far higher than what their cash flow statement reveals.

Obviously, this makes (1) above untrue.

Unfortunately, for AMZN shareholders, this means that AMZN's return on investment is substantially below what I assumed in my previous post. AMZN's R&D and incremental capex spend is higher than what I had assumed and this is further pressuring their ROI.

 Disclaimer: Nothing on this site should be construed as investment advice. It is all merely the opinion of the author.

On the Difficulty of Profitably Growing a Business in a World of 0% Interest Rates

Amazon’s share price catapulted another 14% higher on Friday. The shares added more than $25 billion of market capitalization in a single day. AMZN’s market cap. now stands above $200 billion and, by the way, they are still losing money. AMZN is the proverbial “spend money now, make a big profit later” growth company.

I have noticed another nice little oddity about this growth company: they are now expensing more in terms of depreciation than they spend on capital expenditures. This is extremely rare behavior for a company whose shareholders expect it to grow future profits at a maniacal rate so that the exorbitant share price can be justified.  Growth companies have, by definition, lots of great high return investment opportunities.

I pointed this out to a friend of mine and he said, “Yes, but they are spending nearly $10 billion per year now on R&D (Technology and Content in Amazon’s income statement)." 

This is true, with the inference being that the company’s current business would be wildly profitable without this expense and they have plenty of profitable investments still in front of them.

To find out how expensing R&D upfront impacts AMZN’s operating income, I went back and adjusted their 2012-2014 income statements by capitalizing R&D and writing it off over three years. This adjustment, roughly, increases reported operating profits by $2.5 billion in 2014, $1.8 billion for 2013 and $1.4 billion for 2012.

This would result in adjusted operating profits of ($ billions):

2014  $2.7

2013  $2.5

2012  $2.1

AMZN’s massive $15.8 billion spending spree on R&D over the past two years could only push adjusted operating profits up by $600 million, the type of return a passbook savings account might have earned in the past. Last year’s massive $9.3 billion spend (investment) pushed operating profits up just $200 million. Yes, the spending of the last two years is expected to have impact in 2015, and beyond. My point, however, is that this is not a very profitable company and, even if you capitalize R&D, they aren’t growing very fast.

Investors must assume that the ROI will improve dramatically at some point in the future because deploying capital at such a pitiful ROI means that it will take AMZN forever and a day for its profitability to grow into its valuation. If we include the Austrian concept of malinvestment to AMZN’s investments, it is quite likely that AMZN is losing money on its R&D spending.

But just how likely is it that ROIs will improve in the future if interest rates remain pegged at zero? Unlikely. If businesses invest down to the point where marginal costs equal marginal returns, growth in operating profits will be very tough to come by.

Already, AMZN has dropped capital spending below its rate of depreciation, and their current bet is that R&D will offer better returns. This analysis suggests not. Amazon is a business that would cost you $200 billion to buy, it generates an adjusted operating profit of just over 1% of this figure and they are spending furiously on R&D and getting precious little to nothing to show for it.

It is very difficult to profitably grow a business over time with rates set at zero. I am not here to pick on AMZN, I am here to pick on AMZN’s shareholders who are, IMO, far bigger fools than AMZN management and the central banks. Yes, the central banks have fostered this mess, but nothing says that investors of the world must participate.

 Disclaimer: Nothing on this site should be construed as investment advice. It is all merely the opinion of the author.

Central Banks Cannot Create Investment Via the Printing Press

Richard Duncan, a former World Bank employee, has posted an article that discusses his belief that QE is a form of debt cancellation that will allow governments to leverage up and make new growth inducing investments.

http://www.richardduncaneconomics.com/qe-is-debt-cancellation/

The Duncan argument runs as follows:

1) Central banks create money from thin air and buy government debt.

2) As governments owe money now to the central banks, and since central banks return all of their proceeds to the government, governments actually become less leveraged as central banks print.

Conclusion: This means that governments can really lever up now and invest in things that will create growth for the future in combination with central bank money creation from thin air.

The problem with this argument is that the second premise is demonstrably false. When central banks buy government debt, they issue a new form of debt, currency. This currency is also debt. Look at any central bank balance sheet and you will see it show up as a liability, just like every other form of debt.

Currency is slightly different from government debt in that it doesn't have a maturity date or pay interest. It is zero coupon perpetual debt. Nevertheless, it represents the same kind of claim on goods and services as the government bond. That is, $1000 in cash has the same purchasing power as a bond that sells for $1000. Nothing has really changed with the central banks money creation gambit, except for one small wrinkle.

Unfortunately, the small wrinkle completely destroys Duncan's conclusion that central bank printing will allow us to create new investment for future growth.

When central banks print money from thin air and buy bonds, they artificially push interest rates down. That is, to induce the holder of the bond to sell to them, the central bank must bid up the price of the bond above where it would normally trade, driving down the interest rate associated with the bond.

There is a funny thing that happens to the rate of savings when you do this however, it falls. As the central bank shifts the supply curve of money to the right, we see that rates will fall, all else being equal. This means that the interest rate is now below the equilibrium rate for the supply and demand for savings. This induces people to save less and consume more.

We can see now that Duncan's prescription of more central bank printing will bring about the exact opposite outcome of what he believes will happen. There will be less savings and investment available with more central bank printing. Investments require savings as someone somewhere has to defer consumption of their output in order to be able to lend it out so that the workers erecting a plant, or software coders creating an app or actors and technicians filming a movie can be paid and survive until the fruits of their labor are completed and their investment can start to earn a return.

Duncan, like most economists, confuses cash with savings. They are not the same thing. Savings, deferred consumption, is required for actual investment. Cash gives you a claim on that savings, but it not only doesn't create savings, the creation of cash destroys the incentive to save. Cash creation causes less investment, not more as Duncan hopes.

Duncan's argument is the equivalent of saying that central banks can create output, that they can just print up barrels of oil, employee retraining systems and jobs. They, of course, can do no such thing. Their money creation from thin air actually destroys future output (less savings means less growth) and creates malinvestment (malinvestment being a topic for another time).

Think about it like this, if money creation from thin air creates investment opportunities as Duncan proposes, why is the rate of savings and investment so weak? Why don't business invest more with the free money?

The reason that they don't is that they couldn't even if they wanted to as the savings doesn't exist at this level of consumption given the artificially low interest rates. If you want more savings and investment, you need higher rates and, therefore, less central bank printing. Duncan has it all backwards.

 Disclaimer: Nothing on this site should be construed as investment advice. It is all merely the opinion of the author.

Larry Fink's Muddled Thoughts

Larry Fink, CEO of the world’s largest asset manager, has sent a letter to the CEOs of the 500 largest companies in the U.S. admonishing them for returning too much capital to shareholders.

The New York Times story on this tells us that Mr. Fink believes that such activity is detrimental to investors and the companies themselves. He believes that everyone is thinking too short-term, that we have become a “gambling society.”

Well, Mr. Fink is correct, there does exist a capital allocation problem in the world today. The problem is that Mr. Fink is chastising the wrong groups.

  

Investors and businesses alike have an incentive to maximize their own profits. When interest rates are set at zero, as they are today in the U.S. and below zero in much of the rest of the world, it is quite impossible to get these two groups to focus on the long-term.

  

When central banks peg rates at artificially low levels, two things will happen:

First, savings will fall. At artificially low interest rates, savers have less incentive to put off consumption.

Second, investment rates will naturally decline with the decrease in the savings rate. Also, the natural reaction of businesses to artificially low rates is to reduce investment. Since businesses will invest to the point where marginal cost equals marginal return, with interest rates set at zero, the marginal return on investment will also be zero. There is no incentive to invest. In fact, without savings, they couldn’t invest even if they wanted to.

This is why businesses want to return capital to shareholders. Business and people are reacting rationally to the interest rates forced upon them by central banks. There is no point to saving and investing if returns are set at zero. At an interest rate artificially set at zero, you will get neither savings nor investment.

Mr. Fink does not properly recognize who the culprit is in our live for today, gambling culture. It is the central banks that have created the mess. Everyone is forced to deal with the state planners and their arbitrary and foolish interest rate edicts.

Given that he doesn’t understand the problem, Mr. Fink moves on to proposing the wrong remedy.

Mr. Fink’s solution to our problem is to adjust the tax code. He wants to increase the tax rate on holdings of less than three years to the ordinary income tax rate, whereas today we tax holdings of longer than one year at a lower capital gains rate.

Mr. Fink states this, “would create a profound incentive for more long-term holdings and could be designed to be revenue neutral.”

It would do no such thing. Without a higher, market-based rate of interest, savings levels will be artificially low. Remember, if returns are set at zero, there will also be no income to tax. Taxes are not the driving factor here. If you want more investment, eliminate the Federal Reserve. Let the market determine rates.

The New York Times seems to believe that Mr. Fink’s asset management business has something to gain and little to lose via these suggested changes to tax policy, as they tend to hold investments for some time.

I suspect that Mr. Fink’s real concern is, or at least it should be, that his business is tremendously threatened by the choices that people and businesses are making today. Mr. Fink’s business is managing the savings of people and investing those savings in businesses. If there is no savings, and businesses liquidate, there will not be much for Mr. Fink or his employees to do in the future. Societal capital is being liquidated and Mr. Fink’s business is, therefore, under threat.

No one can rationally allocate capital in this environment. Savings and consumption patterns are being massively distorted by central bank interest rate policies. No one knows the real demand for their products, where they should be sourced from, where they should find the capital to produce them or if they should produce them at all.

Under such conditions, I am certain that corporate CEOs are paying too much to buyback their shares, but they feel forced into this situation because they know that returns on capital that they may invest in plant and equipment are guaranteed to earn zero. They are being as rational as possible given the information that they have been provided by the artificially driven financial markets. Additionally, the real capital, savings, required to increase investment does not exist. Even if executives were to heed Mr. Fink's plea, they couldn't comply.

They think their current cap rate on share buybacks is maybe 3%, and this far exceeds the zero percent that they will earn if they reinvest in their businesses. Share repurchases also push share prices up, and this is not something that too many shareholders, other than Mr. Fink, complain about. Unfortunately, the three percent is also overstated since they will certainly see returns fall in the future as they continue to liquidate their businesses. In the minds of CEOs this is a problem for tomorrow, however.

Central banks have created quite a mess, and tax policy cannot fix it. There can be no rational capital allocation or an increase in the amount of savings and investment as the interest rate required to produce such a result is being massively suppressed by the central banks.

Disclaimer: Nothing on this site should be construed as investment advice. It is all merely the opinion of the author.

I, Pencil

Jon Hilsenrath is at it again, a front page story in the WSJ on whether the word "patient" will remain or be removed from the Fed's release today. I cannot comprehend just how emasculated the free market has become.

Our energies as investors are now singularly tied to a few words from a dozen extraordinarily powerful people in Washington D.C. (powerful, because they can create money from thin air and legally steal from some to give to others) setting interest rates for a planet of billions of people, and they have absolutely no idea of what they are doing. Yet, they set the single most important price in the world on nothing more than a whim. Their actions then distort the actions of the billions of hard working people of this planet, and all this is because investors want to seemingly believe that these few people know how to price money, the basis for the  allocation of savings and, therefore, the creation of all goods and services.

As I was thinking about this my mind wandered back to an article I first read close to 20 years ago as I began this, I shall call it perilous, journey towards the discovery of Austrian Economics. It was entitled I, Pencil, and it was written in the late 1950s by Leonard Read, the founder of FEE.

It is just a few paragraphs long, and it is about just how miraculous is the manufacture of a simple pencil. It has just a few ingredients, wood, graphite, metal and rubber, but it so complex that not a single person on the planet could make one alone.

He talks about the wood, cut down from cedar trees in Oregon by loggers using tools. Tools like chainsaws, rope and logging equipment, each manufactured by thousands of others. The metal for the equipment was mined in far away places, treated and processed in plants built by countless thousands.

The logs are shipped to a plant on roads built by people who had no idea that their efforts were critical to the manufacture of the pencil on your desk. Read goes through a little exercise like this for each of the basic parts of a pencil and demonstrates that the manufacture of a pencil is really a miracle.

Most importantly, he points out just how fluid is the entire process. No mastermind is required to produce a pencil. No single mastermind could comprehend it all. Millions of freely associating individuals around the globe must voluntarily act to achieve the miracle of a manufactured pencil. Socialism, however, marches on and today  I sit here awaiting the command from above on the word "patient" and what it will mean for the price of money. They, the Federal Reserve, will get it wrong with regard to interest rates because, just as in pencil manufacturing, no mastermind can comprehend the workings of an entire market. The game that we are forced to play as investors today is ridiculous.

If people could comprehend the miracle of the pencil and its manufacture I think that we could quickly kill the socialistic Federal Reserve and all of the other central banks of the world.

If you have never read I, Pencil, I encourage you to do so. It takes five minutes. There is also a five minute companion video that is excellent:

http://www.econlib.org/library/Essays/rdPncl1.html

https://www.youtube.com/watch?v=IYO3tOqDISE

 Disclaimer: Nothing on this site should be construed as investment advice. It is all merely the opinion of the author.

Even Squirrels Fall From Trees

Shanghai Gold will change the current gold market “consumption in the East priced in the West” situation.

Xu Lode

Chairman

Shanghai Gold Exchange

May 2014

Confidence in our determined cabal of global central bankers had never been higher than on the morning of January 15, 2015. Investors were convinced that central bankers had the global stock, bond and currency markets under their complete control and no great harm cold be done to them.

Then everything changed.

The Swiss, who had pegged their currency to the euro in 2011, and who had pledged to maintain the peg just days prior, suddenly had a change of heart and the let the peg go.

Instantly, the Swiss franc vaulted as much as 30% higher versus the euro. Those who had been shorting Swiss francs against the euro in order to generate cheap carry-trade financing were destroyed.

This was something investors had not prepared for. For the past fifteen years, central bankers had been telegraphing their intentions to investors well ahead of acting. Investors felt that central bankers now owed them a heads-up before they changed policy and invested as if this were a pact ordained by God.

Like seeing a squirrel fall from a tree, no investor ever expected to see a sudden and rash move from a major central bank, though both of these things do happen.

The peg seemed to have been set in concrete, allowing investors to utilize leverage in this carry-trade. The lifting of the peg, therefore, was catastrophic for those positioned the wrong way.

For those unfortunate speculators, the trade had seemed to be a sure and simple one. With the peg in place, there seemed as if there was no risk in leveraging up and shorting the franc versus the euro. For those on the other side, buying protection was cheap because everyone believed the peg would never be broken.

This set up a potentially very asymmetric outcome; the franc almost couldn’t fall against the euro while the upside for the franc was enormous.

This ends our history lesson.

As I look around the world today, it seems to me that nearly every investment opportunity possesses an asymmetric outcome quality. Equity market capitalizations seem to be at all-time highs relative to GDP. Interest rates are at multi-century lows. Art prices are in the stratosphere as a Gauguin painting just went for $300 million.  Everything seems to have been taken to an extreme. Everything seems to be a one-way bet with no possibility given to any chance of a reversal.

The gold market is another of these places that appears to have all of the hallmarks for a potentially asymmetric outcome. In gold’s case, however, market participants scream that “down” is the only possibility for gold’s price.

For years, commercial participants (namely bullion banks) going short gold has been a signal to the marketplace that gold’s price is headed lower. Below, crushthestreet.com shows us graphically the relationship between aggressive commercial shorting and the subsequent downturn in gold’s price:

The relationship has been a strong one and, like the Swiss franc trade, there seems as if there is some easy, low risk money to be made here.

There are a few caveats, however.

First, despite some serious effort on the part of the bears, it has been difficult to move gold’s price below $1200/oz. for any length of time. That is, with the price today at $1233, there doesn’t seem to be much money to be made by aggressively shorting gold.

The reason that the bears haven’t been able to push gold’s price to new lows is that China has been an insatiable buyer at these low prices. As Koos Jansen at Bullion Star informs us, Chinese off-take in the month of January was 255 tonnes, nearly all of the gold mined in the world in the month of January.

We can see via this graph from goldbroker.com that China has been serious about accumulating gold for quite some time:

 

https://www.goldbroker.com/news/shanghai-gold-exchange-gold-withdrawals-601

The curious thing about all of this shorting of gold that happens at the COMEX and is reported via their weekly commitment of trader’s report is that there exists almost no physical gold to back up the trades. Currently, there exists about 770,000 ounces of registered gold in COMEX warehouses that are available to settle open trades.  Open interest is about 430,000 contracts and represents potential claims on 43 million ounces of gold. That is, there are potential claims on about 56 ounces of  gold for every actual ounce of gold in COMEX warehouses.

It remains shocking to me the level of potential risk that the shorts on the COMEX are taking in the gold trade.

This brings us back to our opening quote from the chairman of the Shanghai Gold Exchange. He is expressing frustration that China now dominates the physical gold market while unbacked paper gold sales in the West dominate pricing, and he intends for this to change.

To sum up, China is buying huge quantities of physical metal supporting gold’s price at around the $1200 level for most of the past two years. They are upset that the West still dominates the pricing of gold in the marketplace. There exists only about $1 billion in registered gold in COMEX warehouses and everyone seems to think that gold’s future price has only one possible direction, down. 

For as little as $1 billion, China could break the COMEX gold shorts at any moment that they choose. Sure, at higher prices some more gold could be made available, but suppose China owned half of the open contracts on COMEX and demanded delivery. We are still talking about peanuts here to destroy Western short positions, and all the while central banks continue to print unbacked fiat money like crazy.

I am not suggesting that I know which way gold’s price will move in the near future, but I can see that the gold market has all of the hallmarks of a potentially very asymmetric trade.

Then again, why should gold be any different than any of the other markets that I see around the world?

It may be wise to remember that despite the present understanding of market participants that every trade is just a one way bet these days, squirrels do sometimes fall from trees.  When everyone is on one side of a trade, as we saw in the Swiss franc market, reversals can be violent. 

 Disclaimer: Nothing on this site should be construed as investment advice. It is all merely the opinion of the author.

Theater of the Absurd

Central bankers are the key actors in our current economic theater of the absurd. It would be impossible for me to take them seriously if not for their nearly unlimited power. Watching these people operate in the financial markets is sort of like watching a ten year old drive a Ferrari. There is just a little too much horsepower under the hood given the limited abilities of the driver.

Finally, Mario Draghi appears to be able to deliver on his “whatever it takes” promise and we will see the Eurozone commence with a 60 billion euro per month money printing and financial asset buying orgy.

This is having the typical inflationary impact on financial asset prices that we have come to expect from the out of control world of central bankers.

In the Eurozone alone yields on more than 1.4 trillion of assets have now gone negative as prices are bid up in front of the coming central bank buying:

 

Worldwide, Bloomberg reports that more than $4 trillion of sovereign bonds carry a negative yield.

The implications of this are fascinating. For example, quite soon we should expect gold to become the world’s highest yielding asset as a result of this latest central bank foolishness, and I am sure that this move to ultra low and negative bond yields is putting the recent bid under the price of the yellow metal.  Central banks are powerful, but they can’t control everything and I am sure that gold’s recent lift in price has annoyed them somewhat.

The new European QE is going to see central banks trading away currency that yields zero in order to buy assets with a negative yield. Just brilliant!

No private investor would enter a carry-trade like that, but it is just another day at the office in the world of central banking.

The absurd implications of negative sovereign yields are also quite incredible:

Governments can deleverage by increasing the amount of debt they now issue. Issue enough debt with a negative yield and at maturity you can be debt free, or even generate some equity.

Taxes are not required in a land where investors are keen to finance the government with negative yields.  Just imagine the social implications of this once the voters figure it out.

Heck, if money printing can create wealth and if sovereign bonds really are worth more in real terms because of the printing press, then not only can taxes be easily dispensed with, but so can all work. 

Adding to all of the absurdity of negative yields is the fact that it is occurring precisely because of central bank induced inflation. In a bizarre “Emperor’s New Clothes” sort of way, Draghi can’t see the obvious inflation that he is creating, and the crowd of investors, for the moment, is going along with it.

Draghi at his recent press conference when asked if money printing will lead to inflation:

 I think the best way to answer this is, have we seen lots of inflation since the QE program started? Have we seen that? And now it's quite a few years (since) we started. You know, our experience since we have these press conferences goes back to a little more than three years. In these three years we've lowered interest rates, I don't know how many times, four or five, six times maybe. And each time someone was saying, ‘this is going to be terribly expansionary. There will be inflation.’ Some people voted against lowering interest rates way back at the end of November 2013. We did OMT. We did the LTROs. We did TLTROs. And somehow this runaway inflation hasn't come yet. So what I'm saying is that certainly the jury is still out. But (there) must be a statute of limitations also for the people who say there will be inflation. Yes, when please? Tell me within what?”

Clearly, in Draghi’s mind the increase in prices, and yield declines, in the sovereign bond market that he has induced (with the aid of other central banks, of course) doesn’t represent inflation. I beg to differ as this sure looks like price inflation to me:

Greece Ten Tear Bond Yields

Italy Ten Year Bond Yields

Portugal Ten Year Bond Yields

Source: Trading Economics

Negative sovereign bond yields in major countries and a collapse in the yields of the bonds of less fiscally sound countries like Greece, Italy and Portugal are symptoms of monetary inflation and they serve to distort the structure of the economy and create malinvestment as do all prices that are artificially manufactured.

The financial world has entered the realm of the surreal, and it would be fascinating to watch if its consequences weren’t quite so dire. 

 Disclaimer: Nothing on this site should be construed as investment advice. It is all merely the opinion of the author.