Saturday, March 7, 2015

The Big Picture

Each day I spend an hour or two scanning the stories and memes that are circulating that day, and then maybe another hour thinking about how they fit into the big picture. Everything is, of course, connected, and aside from filtering out the nonsense and the noise, putting it all together into a single comprehensive and cohesive picture is, IMO, the only way to understand what is really happening.

Without such a context, it can seem like nothing makes sense, like we live in a madhouse where inexplicable things just happen out of the blue. But of course it all does make sense; you just have to tune out the nonsense and understand how the rest fits together. You can jump down to the conclusion now if you'd like to see my big picture, or you can bear with me as I explain and then string together a few different memes on the way there.

A recent meme has been how a number of countries are running down their dollar reserves. As we've seen in the monthly TIC reports, official support is basically flat, but now we see a few primarily oil producing countries like Saudi Arabia, UAE and Russia running down their reserves. This is, of course, related to the decline in the price of oil which has made otherwise-strong net-producer currencies weak relative to the dollar. But the declining oil price is only half of the equation. The other half is the rising price of the dollar. They are not just two sides of the same coin, but two different-yet-related things that are happening simultaneously.

Russia has recently declared a clean float while Saudi Arabia and UAE both still peg to the dollar, yet all three are now supporting rather than weakening their currencies due to the double whammy of weak oil and a strong dollar, which means selling dollar reserves to buy back their own currencies. Back in early 2008 when oil was strong and the dollar was weak, both the UAE and Saudi Arabia considered adjusting their pegs and revaluing their currencies upward, but they didn't, instead planning on a GCC monetary union by 2010 which still hasn't happened. So, for the time being, everyone is responding as they see fit to the current state of affairs as if it is a temporary state of affairs, which of course it is.

Another recurring meme over the past few months has been this $9T in foreign, dollar-denominated debt. The problem with this debt is a little more complicated than just the lack of dollars available, and it cannot be solved with a simple currency swap. The problem is that most of this debt was contracted on the basis of an emerging market growth story that is now failing to play out as expected.

This is non-bank debt, meaning the borrowers are not banks, and most of the borrowers are not in the financial industry either. They are real companies, mostly in emerging market countries like Bulgaria, Brazil, Chile, China, Colombia, Czech Republic, Estonia, Hong Kong SAR, Hungary, Indonesia, India, Iceland, Korea, Lithuania, Latvia, Mexico, Malaysia, Peru, Philippines, Poland, Romania, Russia, Singapore, Slovenia, Thailand, Turkey, Venezuela and South Africa, that borrowed in dollars over the past five years because it was cheaper than borrowing in their local currencies, and they did so by issuing bonds.

About half of this $9T was borrowed from private bond investors, and ¾ of it came from lenders outside of the US. And now a few different things are happening to this debt all at the same time leading to a vicious feedback loop that could blow the whole thing up. One thing is that the strong dollar means these companies' local currencies are relatively weak, so you can imagine the impairing effect on their balance sheets as their debt burden grows relative to their local currency-denominated assets and income. Add to that the fact that their growth prospects have diminished over the last five years as well, and you can understand why Western asset managers are now pulling money out of these emerging market bonds.

Pulling money out of these markets means selling bonds, which drives down bond prices and drives up their effective yields. These higher effective yields then compete with new bonds being issued which drives up borrowing costs to the same rate as the effective yield on old bonds. This rise in borrowing costs eliminates credit growth, and exacerbates already-sluggish real growth by causing these companies to tighten their belts and cut back on capital expenditures, which causes more asset managers to pull more money out of these markets, and therein you have the basic vicious cycle. You will find it explained with more detail in this BIS presentation pdf.

Another meme that has been making the rounds is an increase in US oil production even as the price of oil is tumbling, some say contributing to the glut that is causing the price to tumble. It certainly makes sense that a glut or oversupply of a commodity would cause the price to tumble, but I want to explain to you a different causal relationship, where a declining price actually causes some producers to increase production, leading to another vicious feedback loop.

The curse of the commodity producer (as opposed to the producers of end-user products) is that the price you can obtain for your production is out of your control, determined on global markets, and thoroughly detached from your input costs. If your expenses exceed your income because the price of your product drops below your costs, then you're simply out of business, right? Well, not necessarily. That's probably true for a rational operator like yourself, but not necessarily true in the irrational world of the $IMFS with debt-addicted publicly-traded corporate shells operating on slim profit margins and beholden to both creditors and shareholders.

In the $IMFS, many companies not only operate at a loss, but they actually increase production when operating at a loss, and they do so for different reasons. One reason is government subsidies. The rational thing to do with a company that is operating at a loss is to shut it down and liquidate it, selling it off cheaply enough to someone else so that it, or at least its capital, can become profitable once again. But for some industries, primarily labor-intensive industries like auto making, governments will often subsidize losing businesses just to keep people employed in what become, essentially, make-work jobs if the company is operating at a loss. But I don't think that's the case with US oil.

Oil, unlike cars, is a commodity and is not as labor intensive to produce, and in the US, unlike in Saudi Arabia, it is a debt-addicted, publicly-traded industry operating on a relatively slim profit margin. Now, even if you can't turn a profit for your owners, you can still at least service your debt while running at a loss. And even though your reserves are limited by definition, you can actually reduce your short term losses by increasing your long term losses, i.e., running down your limited reserves faster at a loss than you were at a profit.

We see this in the gold mining industry as well, where the large, publicly-traded and debt-financed mines ramp up production on their lowest-hanging fruit right when it is least profitable to do so, because the alternative would be bankruptcy. I think this is why we saw new mining supply rise when the price dropped below their cost of production.

This has been happening in China in a whole slew of different industrial sectors for a few years now, ever since emerging market growth potential within the current $IMFS peaked and the commodity bear market began. The Chinese government itself has identified nine key sectors that are now operating at a loss in China just to service their debt, some with the help of government subsidies. Those nine industries are steel, aluminum, rare earths, cement, electronics, pharmaceuticals, autos, shipbuilding and industrial agriculture.

Think about this for a minute. Would you buy a business whose price is so high that it would not be profitable for you to operate? You might, but only with the intention of reselling it to a greater fool and not with the intention of operating it indefinitely at a loss. I actually did this once, and barely got out alive! Any of you who have bought or sold a business know EBITDA, which is often used to compare the relative profitability of comparable businesses. It's kind of like a P/E ratio.

Imagine buying a car wash that's priced so high that it would take you decades to break even, or if the operating costs associated with it were so high that you'd be operating at a loss and never turn a profit. Imagine you had to pay your car dryers $50 per hour as per union rules and couldn't reduce their numbers or hours. That's operating a business at a loss. It's not that a car wash isn't necessarily a good idea in that neighborhood, but just that its price or its related expenses simply make it unprofitable.

My point is that prices determine what is profitable and what is not. In the car wash scenario, maybe you go bankrupt with your unprofitable car wash and it is liquidated for pennies on the dollar. The new buyer who gets it for a song could then operate it profitably because his income will exceed his costs. In this latter case, isn't the neighborhood better off having cleaner cars?

This is an overly-simplified example, but just consider whether or not much of the world today is completely priced out of profitability. Think about my simple example of a neighborhood car wash. If owning the business itself is priced too high, either its purchase price or its operating costs (not the price of getting your car washed), then it will probably either fail or never get started in the first place without a government subsidy. If the employees have to be paid too much, there will be either fewer jobs or no jobs at all, so few in the neighborhood will even be able to afford a car wash, let alone a car.

To what end does such a system lead, in which asset prices are driven so high that the businesses themselves are not profitable in the real economy? It's called a Ponzi or pyramid system, in which profits are made not from the real economy but from the greater fool, the greater fool in aggregate being the savers. Which brings me back to these companies that should be going out of business but are instead ramping up production to service their debt and stay in business long enough for the insiders to get the hell out and pass on the greater losses to the savers.

This ties in to my next and final trending meme, which is corporate buybacks. The buyback meme is a true sign that we're in the final Ponzi phase of this system, in my opinion. Buybacks are a way for corporate shells to fall on the grenade while the insiders get out. They are also a way to juice stock prices that would otherwise be falling.

I'll get into this more in the next section, but if we look at specifically who is profiting from the most recent outrageous buyback trend, it is not the oil companies. Some companies are really profiting from the outrageous buybacks. From the top-ten list of buybackers, Apple is at the top and its stock is up 40% YoY. Others in the top ten are Cisco Systems, up 35% YoY. Oracle, up 20%. Intel, up 53%. Microsoft, up 30%. Wells Fargo up 27%, Home Depot up 30% and Pfizer up 6%. Exxon Mobil is third on the list, and it's down 7%, which I read as it would have fallen harder than that if not for the buybacks which were to slow the decline giving the insiders time to GTFO.

It's not that I think US oil production will end, just that it's currently unprofitable even as production ramps up at record rates, presumably to service the debt and keep the shares trading while their shell corporations borrow more money to buy back some of the shares (from insiders?) even as the share prices decline. Or maybe it's a conspiracy by the USG to hoard a bunch of cheap oil in old tanks so that it can continue to wage war and dominate the ROW even after the ROW turns against us (j/k ;). Exxon (the shell corporation and its employees) is not giving up, BTW, but that still doesn't mean its shares are a good store of value right now for its owners. There is a difference.

And that brings me to my final meme or story that is just starting to circulate, which is these corporate buybacks, where debt-addicted, publicly-traded companies are taking advantage of extremely low interest rates to issue bonds and then use the borrowed money to buy back their own shares. Sounds positive for business, right? I don't think so, but it's probably helping to levitate the stock market.

Buybacks have been happening at the incredible rate of $46B per month for the last year, nearly the same rate as our trade deficit!

(Bloomberg) -- The biggest source of fresh cash in American equities isn’t speculators or exchange-traded funds -- it’s companies buying their own stock, by a 6-to-1 margin.

Chief executive officers, who just announced the biggest round of monthly repurchases ever, executed about $550 billion of buybacks last year, according to data compiled by S&P Dow Jones Indices. That compares with a net $85 billion of deposits by customers of mutual and exchange-traded funds, the biggest gap since 2012, data compiled by Bloomberg and Investment Company Institute show.

If you sell a share of stock in the U.S. market, there’s a fair chance the buyer is the company that issued it -- and it’s buyers who’ve been on the right side of the trade since 2009. Buybacks are helping prop up a bull market that is entering its seventh year just as investors bail out and head back to bonds.

“Buybacks have come up in every meeting with clients and always have, because of the observation that the largest buyers of stocks have been companies themselves,” Dan Greenhaus, chief strategist at BTIG LLC in New York, said by phone. “For the last few years, that’s been the right call.”

Repurchases by U.S. companies averaged $46.1 billion a month in 2014, compared with $7.1 billion in ETF and fund inflows. Investors have pulled more than $10 billion out of equity funds in January and February and sent $38 billion to bonds -- even as companies announced $132.7 billion more in buybacks. February’s total of $104.3 billion was the highest on record, according to TrimTabs Investment Research.

Buyback Index

Companies with the most buybacks are beating the market. The S&P 500 is up 1.6 percent on the year after falling from a record on Monday to 2,092.21 as of 11 a.m. in New York. The S&P 500 Buyback Index, which contains the 100 companies with the highest repurchase ratio, has climbed 4 percent this year.

“It’s amazing that people are still sitting on the sideline getting zero-something percent returns,” Howard Silverblatt, senior index analyst at S&P Dow Jones Indices, said in a phone interview. “Usually when you get where everyone says we’re in a bull market you see big money coming out of lifeboats and chasing yield, yet we haven’t seen the mass money come in.”

The reluctance of investors to pile into equities has left corporate America the larger source of cash throughout the bull market. [thanks to capital inflows from the ROW which financed low interest rates for corporate bonds!] Buybacks exceeded inflows [from actual investors] by $468 billion last year when the S&P 500 climbed 11 percent and $318 billion more in 2013, when the gauge had its biggest advance since 1997.

Companies in the S&P 500 have spent more than $2 trillion on their own stock since 2009 [$2T is comparable to the $9T borrowed outside the US], underpinning an equity rally in which the index has more than tripled. They were on pace to spend a sum equal to 95 percent of their earnings on repurchases and dividends in 2014, data compiled in October showed. [Why not all on dividends?]

Buyback Incentives

Not everyone is convinced buybacks are good. They’re used to boost per-share earnings in a way that enhances the pay of chief executives, according to William Lazonick, a professor of economics at the University of Massachusetts Lowell.

“Companies use a phony ideology saying if you maximize your shareholder value you somehow increase the efficiency of the economy,” Lazonick said in a phone interview. “But the only justification for doing it that holds water is that executives [who are employees, not owners, other than the restricted portion of their compensation that is locked in shares] get a lot of their income from buybacks.”

Home Depot Inc., Comcast Corp. and TJX Cos. were among 123 companies that disclosed repurchases in February. The increased buybacks came as plunging oil and a strengthening dollar threaten to stall five years of earnings expansions. [So they borrowed at almost no cost and used the new debt money to buy up the publicly-traded share price which increased their bonuses even as earnings stagnated or declined? Brilliant!]

Profits from S&P 500 members will decline at least 3.2 percent this quarter and next [but hopefully not share prices!], according to analysts’ estimates compiled by Bloomberg. For the full year, growth will be 2.3 percent, down from 5 percent in 2014.

Profit Contractions

Buybacks will boost per-share earnings, with the potential of helping avoid the first back-to-back profit contractions since 2009, according to Yardeni Research Inc.

“In the last earnings season, the strength of the dollar clearly had a negative impact on earnings guidance by a lot of companies,” Dan Miller, who helps oversee $23 billion as director of equities at GW&K Investment Management, said by phone. “In some cases, the announcement of buybacks was perhaps meant to soften the blow a little bit. It shows the management is committed to their own stock.” [Yeah, sure. That's the interpretation "management" wants its owners to think. ;D]

Switching Positions

Corporations and investors have switched positions as the bigger buyer of stocks. Inflows from equity funds exceeded corporate buybacks every year in the late 1990s, contributing a total of $640 billion over the three years through 2000. That compared with $418 billion from share repurchases. [So the roles have reversed in this particular stock market run-up. It's not being driven by actual investors like all rallies were in the past!]

Companies have since taken the lead, with buybacks setting a record $589 billion in 2007. Last year, corporations beat all other groups as the biggest source of fresh [-ly borrowed] cash to the stock market, according to a January report by Goldman Sachs Group Inc., which tracks money flows from pension funds, foreign investors and ETFs.

The S&P 500 will increase about 7 percent to 2,238 by the end of 2015, according to the average of 21 equity strategists surveyed by Bloomberg. The Nasdaq Composite Index closed above 5,000 for the first time in 15 years on Monday and is within 2 percent of a record.

S&P 500 companies hold $1.75 trillion in cash and marketable securities, data compiled by Bloomberg show.

“These companies do this because they can,” Richard Sichel, chief investment officer at Philadelphia Trust Co., which oversees $2 billion, said in a phone interview. “So many have tremendous amounts of cash historically and the investment rates on short-term cash are not too attractive. It’s good for the company and good for stockholders.”

Here's my take on buybacks. The shareholders are the owners of these companies, and if the company is making a profit it should go to the owners. If the owners agree to take on a new interest payment in order to concentrate the shares by reducing the number of shares outstanding, those interest payments come out of profits, so total profits go down by the amount of the new interest payment. So a bond-financed buyback is a transfer of some portion of total profits from owners to creditors at the very least.

If a company buys back its own shares with cash profits, in essence it is using its profits to reduce the number of shares outstanding rather than paying its owners a dividend (a profit). So the owners see their percentage of ownership in the company increase while the liquidation value of the company declines (because it either used up some of its cash for the buyback or it contracted some new debt). That's what owners (shareholders) actually own, the liquidation value of a company as well as the right to the profits (dividends).

As outsiders (non-shareholders), we see the price of the shares rising, but that's an illusion because what has actually happened was the equity (the liquidation value) of the company was reduced by either decreasing cash or increasing debt, and the number of outstanding shares was also reduced at the same time, a net-neutral operation. A company holding its own shares is like a bank holding its own liabilities, or like me holding an IOU to myself. The net asset value remains the same, only the percentage that each share represents has changed.

Think about it in reverse. If a company that bought back shares decides to reverse that action and sell them for cash, that is essentially the same thing as diluting its outstanding shares to raise capital. So buybacks are essentially reducing capital (actually reducing liquidation value, either by decreasing cash or increasing debt) in order to concentrate shares.

The problems with this, as I see them, are manifold. Since this is really just a rebalancing of net liquidation value versus share concentration, the optics of a rising share price send a false signal to the market. And if this is the driving force "underpinning an equity rally in which the index has more than tripled," then perhaps the rally was an illusion.

If a company has surplus cash, why not just pay out dividends to the owners? It doesn't matter how many shares are outstanding because their price can change, just like it doesn't matter how much gold exists. From a net asset value perspective, nothing is gained in a buyback, just like from a market capitalization perspective nothing is lost in a stock split.

In fact, these buybacks are done for a purpose. They are done to boost employee compensation at the expense of the owners. The answer to cui bono in a buyback is certain employees, not owners, of the company, more specifically the executives (the CEO etc...), the managing employees. This is a way to convert net asset value into executive bonuses right under the noses of the owners, even at a time when the business is not profitable. It is also done to boost share prices more than they would otherwise rise, or keep them from falling as fast as they would otherwise decline.

In my view, buybacks are little more than a bookkeeping trick used by CEOs to fleece their unsophisticated owners (shareholders), kind of like a body that begins consuming itself and concentrating its energy in the core while starving the extremities, just to maintain the status quo of its heart a little bit longer. Yet if it happens en masse as it has been, due to cheap corporate debt financed by a flood of foreign capital, it's not just the shareholders who'll end up getting hurt—it's everyone invested, saving or speculating in any kind of paper.


What is happening is a massive inflow of private capital into the US and the dollar. This is not new surplus revenue being invested in the US right after it is earned, nor is it (any longer) the result of structural support or the systematic weakening of foreign currencies, also known as neomercantilism. This is, as far as I can tell, a massive shifting of existing private investment funds from other places into the US and its dollar. The simplest way I can put it is that it seems to me like the world is running into our bomb shelter that's rigged to blow up once everyone is "safely" inside. I suppose from another angle, still using my own past imagery, we could call it the head-fake.

The reason for this massive capital inflow is, I think, quite simply that the rest of the world has become unprofitable under this dying $IMFS, so you want to move toward the focal point where presumably everyone will be moving in order to capitalize on being early to the bubbles that will ensue. And in this case, the dollar and the US markets are the perceived focal point, with AAPL at the very center.

What we've seen with foreign currencies is that, whether loosely or strictly pegged to the dollar, their foreign reserves tend to correlate inversely to the strength of the dollar. Whenever the dollar is weak, their foreign exchange reserves rise, and when the dollar is strong, they decline. Comparing a chart of the USDX with Russia's foreign exchange reserves shows this quite clearly.

An inflow of capital into the dollar makes the dollar strong, and an outflow makes it weak. This is a function that is peculiar to the $IMFS, because in a different system the dollar's capital account would be subservient to its current account or physical plane trade balance. But similar to how paper gold drives the price with the physical gold market being subservient to the paper one, so too is the US physical plane trade balance and the price of the dollar subservient to the paper markets and capital account flows.

When capital is flowing, it affects two things in combination. It affects the US trade deficit and it affects the price of a dollar on the DX. It is a combination of these two that is the result of the flow in the capital account. If the DX is not moving, then the trade deficit represents the entire net flow in the capital account. If the DX is moving, then the capital flow is either more or less than the trade deficit. If the DX is rising, then the capital inflow is greater than the trade deficit, and if the DX is declining then the capital inflow is lower than the trade deficit. And, of course, in the past, structural support worked in tandem with private sector capital flows to keep the DX and the US trade deficit more or less stable, but right now it's private sector flows that are driving everything.

As private sector capital moves into the US, it needs dollars to buy US assets. So first it sells its foreign assets for foreign currency, then it uses that foreign currency to buy dollars needed to buy US assets. This drives down the local currency and drives up the dollar. The local CB can absorb some of that pressure by providing the dollars its locals want to buy from its foreign exchange reserves. This neutralizes the locals' effect on the FX, and this is how countries like Saudi Arabia and the UAE keep their currencies pegged to the dollar.

Any reduction in their foreign exchange reserves represents a net outflow of private capital, since their currencies are hard pegged to the dollar. These are still strong currencies, it's only the $IMFS that is making them appear weak. Even though the oil price has declined dramatically, all three of the countries I mentioned are still running a positive balance of trade, but in the $IMFS as I said, the capital account is in the driver's seat.

Even the dramatic decline in the price of oil is attributable to the $IMFS. As I've said in the past, speculative paper markets (futures markets in particular) when properly subservient to the physical market, absorb and reduce the risk and price volatility that real producers and real consumers do not want to be exposed to. But in the $IMFS the opposite is true; the paper markets actually cause the risk and volatility, simply because this system promotes saving in money and its derivatives.

"Capital flows" is really just another way of describing all this paper money sloshing around from one thing into another, causing the risk and volatility that real producers and real consumers would rather not be exposed to. It's just that when it crosses foreign exchange currency boundaries, you have to be careful when thinking about it because the currency effects can be confusing.

Many things changed through the financial crisis in 2008, and one of them was the driver of dollar-denominated credit expansion outside of the US. Before 2008, non-US dollar credit growth (sometimes called Eurodollars) was driven mostly by banks making the loans, but in 2009 the banks pulled out of that sector and private sector capital flooded in. That's why half of that $9T in foreign dollar denominated debt is held by private bond investors today, and why "capital flows" or "all this paper money sloshing around from one thing into another" is such a dynamic problem for that debt and those stagnating economies. If that debt had all been bank credit like before 2008, then interest rates would move slowly in concert with interest rates elsewhere. But because today it is private money, capital outflows can cause interest rates to be much more volatile and deadly.

Now think about how that $9T in debt meme—$4+ trillion of which is in private bonds which asset managers are pulling out by selling those bonds—might relate to the corporate buyback meme. As that money is being pulled out of emerging market corporate bonds, where do you think it is going? Could it perhaps be going into US corporate bonds?

The article above says that US corporations have bought back $2T of their own shares since the stock market started rising in 2009, and a quarter of that, half a trillion, was bought back last year alone. And it was largely financed by issuing bonds and borrowing that money from the bond market. So you see, everything is connected! A massive capital inflow into the US bond market can result in crazy-low interest rates while also, as the article says above, "underpinning an equity rally in which the index has more than tripled." Isn't the $IMFS great? ;D


The picture's far too big to look at, kid.
Your eyes won't open wide enough.
And you're constantly surrounded
By that swirling stream of what is and what was.
Well, we've all made our predictions,
But the truth still isn't out.
But if you wanna see the future,
Go stare into a cloud.
And keep trying to find your way out
Of that maze of memories.
It all sort of looks familiar,
Until you get up close,
And then it's different, clearly.
But each time you turn a corner,
You're right back where you were.
And your only hope is that forgetting might
Make a door appear.
Well, is it your fear of being buried
That makes you so afraid to speak?
An avalanche of opinions,
Like the one that fell that I'm now underneath.
It was my voice that moved the first rock,
And I would do it all again.
So, I mean it's cool if you keep quiet,
But I like singing.
So, I'll be holding my note,
And stomping and strumming
And feeling so very lucky.
And there is nothing I know,
Except this lifetime's one moment,
And wishing will just leave me empty.
So you can try and live in darkness,
But you will never shake the light.
No, it will greet you every morning,
And it will make you more aware with its absence at night,
When you're wrapped up in your blankets, baby-
That comfortable cocoon.
But I've seen the day of your awakening, boy,
And it's coming soon.
So, go ahead and lose yourself in liquor,
And you can praise the clouded mind.
But it isn't what you're thinking, no,
It's the course of history,
Your position in line.
You're just a piece of the puzzle,
So, I think you'd better find your place.
And don't go blaming your knowledge on some fruit you ate.
Cause there's been a great deal of discussion, yes,
About the properties of man.
Animal or angel, you were carved from bone,
But your heart, it's just sand,
And the wind is gonna scatter it,
And cover everything with love.
So, if it makes you happy,
Then keep kneeling, momma,
But I'm standing up.

Because this veil, it has been lifted, yes,
My eyes are wet with clarity.
I've been a witness to such wonders.
Oh, I've searched for them all across this country.
But I think I'll be returning now
To the town where I was born.
And I understand you must keep moving, friend,
But I'm headed home.
Yeah, I'm gonna follow the road
And let the scenery sweeping by easily enter my body.
And I'll send ya'll this message in code-
Underground, over mountains,
Through forests and deserts and cities.
All across electric wire, it's a baited line.
Yeah, the hook's in deep, boys,
There's no more time.
So you can struggle in the water-
Be too stubborn to die.
Or you could just let go
And be lifted to the sky.