Wednesday, October 17, 2018

Is the Greatest Bull Market Ever Finally Ending? (Hint: Follow the Money)

The key here is the gains generated by owning US-denominated assets as the USD appreciates.
Is the Greatest Bull Market Ever finally ending? One straightforward approach to is to follow the money, i.e. global capital flows: assets that attract positive global capital flows will continue rising if demand for the assets exceeds supply, and assets that are being liquidated as capital flees the asset class (i.e. negative capital flows) will decline in price.
Global capital flows are difficult to track for a number of reasons. A significant percentage of global mobile capital is held in secretive offshore tax havens and "shadow banking," and tracking global corporate capital flows is not easy. Capital held in precious metals may not be reported, and assets such as enterprises and collectible art may be grossly undervalued for tax purposes.
Toss in shadow holding companies, LLCs with obscure trails of ownership, etc. and a definitive account of global capital flows is ultimately a guesstimate.
Despite the limitations of tracking global wealth, Credit Suisse Research Institute's (CSRI) issued Global Wealth Report 2017 gives us some clues about where capital is flowing in and where it's leaving for safer, higher-yield climes.
The first step in measuring global capital flows is to note that conventional capital is denominated in currencies which fluctuate in relative value. Of the roughly $300 trillion in global assets (Credit Suisse pegs the total in 2017 at $280 trillion, but other estimates range well above $300 trillion), about $8 trillion or so is in precious metals, and a tiny sliver is in cryptocurrencies. (Bitcoin's total market capitalization is currently around $112 billion and Ethereum's market cap is around $21 billion--signal noise in the $300 trillion sloshing around the world seeking safety, low/zero taxes, capital gains and high yields.)
Foreign exchange matters. Say a money manager moves $1 billion out of U.S. Treasuries (denominated in the US dollar, USD) into bonds paying a hefty 15% in annual yield denominated in an emerging market currency.
If that currency loses 20% of its value vis a vis the USD annually, the capital loses 5% of its value / purchasing power despite the hefty yield.
The trick is to arbitrage yields and currencies so borrow in cheap currencies that are declining and buy higher-yielding assets denominated in currencies that are rising in value. For example, if a manager moved $1 billion out of a bond paying 4% in a currency that subsequently lost 30% of its value vis a vis the USD into a US high-yield bond paying 6%, the manager picked up 30% gains in FX and 2% in yield for a total gain of 32%.
For a variety of reasons, yields are rising in the US and the USD is gaining value relative to other currencies. Combine higher yields, relatively predictable safety and an appreciating currency, and the US has been attracting global capital.
These charts from Credit Suisse reflect this capital flow into the US and out of other nations. The phenomenal expansion of wealth in China is put into a different perspective here:with 4 times the population of the US and an economy roughly comparable in size, China's wealth has registered only 20% of the gains accrued by the US.
If global capital was buying empty flats in China, etc., and selling US-based assets, these numbers would be reversed. This suggests mobile capital is leaving China and other nations and moving into US-denominated assets.
Most of the gains in global wealth have accrued to the US and to the top 1%.The wealthier the entity / individual, the greater the rewards and opportunities for moving wealth into tax havens and safe havens such as Switzerland and the US, which is a massive tax haven in its own right.
Here's another snapshot of the global wealth pyramid: since the Pareto Distribution applies to wealth and income, we can guesstimate that roughly 40% of all global wealth is held by the top .2% or so. The top 8% (350 million people) own 85% of all global wealth.
Where is all this money coming from? Largely from debt which has expanded by over $100 trillion since 2001:
Corporations have poured earnings into stock buybacks at a torrid pace:
The net result is a gargantuan inflation in assets while real-economy wages and GDP have stagnated.
As long as US yields and the USD are ticking higher while the US economy continues expanding opportunities for capital to earn relatively safe yields and capital gains, capital will continue to flow into US assets, despite the nose-bleed valuations of assets such as stocks and left / right coast housing.
The key here is the gains generated by owning US-denominated assets as the USD appreciates. A 3% yield in US Treasuries isn't all that great, but add in 10% annual FX gains and you're netting a very healthy 13% annual return in relatively safe and liquid assets.
The greater the sums at risk, the more compelling these attributes become. If you need to protect $25 billion, and you want a liquid market you can exit without crashing the bid and exposure to FX capital gains, then USD-denominated bonds and stocks are an attractive option at this juncture.
Empty flats in China with zero yield and the potential downside of yuan devaluation--not so much.
In summary: follow the money. Smart money is mobile, opaque and constantly on the move seeking safety, tax shelters, yield and capital gains. If mobile capital continues flowing into US assets such that demand exceeds supply, the Bull Market will continue sloshing higher. Once supply exceeds demand and capital starts liquidating US assets, the Bull Market will end, perhaps with a whimper (stagnation) or with a bang (crash). Capital flows will dictate the outcome.


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Sunday, October 14, 2018

How Many Households Qualify as Middle Class?

By the standards of previous generations, the middle class has been stripmined of income, assets and purchasing power.
What does it take to be middle class nowadays? Defining the middle class is a parlor game, with most of the punditry referring to income brackets as the defining factor.
People tend to self-report that they belong to the middle class based on income, but income is not the key metric: 12 other factors are more telling measures of middle class membership than income.
In Why the Middle Class Is Doomed (April 17, 2012) I listed five minimum threshold characteristics of membership in the middle class:
1. Meaningful healthcare insurance (i.e. not phantom insurance with $5,000 deductibles, etc.) and life insurance.
2. Significant equity (25%-50%) in a home or equivalent real estate
3. Income/expenses that enable the household to save at least 6% of its income
4. Significant retirement funds: 401Ks, IRAs, etc.
5. The ability to service all debt and expenses over the medium-term if one of the primary household wage-earners lose their job
I then added a taken-for-granted sixth:
6. Reliable vehicles for each wage-earner
Author Chris Sullins suggested adding these additional thresholds:
7. If a household requires government assistance to maintain the family lifestyle, their Middle Class status is in doubt.
8. A percentage of non-paper, non-family home hard assets such as family heirlooms, precious metals, tools, etc. that can be transferred to the next generation, i.e. generational wealth.
9. Ability to invest in offspring (education, extracurricular clubs/training, etc.).
10. Leisure time devoted to the maintenance of physical/spiritual/mental fitness.
Correspondent Mark G. recently suggested two more:
11. Continual accumulation of human and social capital (new skills, networks of collaborators, markets for one's services, etc.)
And the money shot:
12. Family ownership of income-producing assets such as rental properties, bonds, etc.
The key point of these thresholds is that propping up a precarious illusion of consumption and status signifiers does not qualify as middle class. To qualify as middle class (that is, what was considered middle class a generation or two ago), the household must actually own/control wealth that won't vanish if the investment bubble du jour pops, and won't be wiped out by a medical emergency.
In Chris's phrase, "They should be focusing resources on the next generation and passing on Generational Wealth" as opposed to "keeping up appearances" via aspirational consumption financed with debt.
What does it take in the real world to qualify as middle class?
Here are my calculations based on our own expenses and those of our friends in urban America. We can quibble about details endlessly, so these are mid-range estimates. These reflect urban costs; rural towns/cities will naturally have significantly lower cost structures. Please make adjustments as suits your area or experience, but please recall that tens of millions of people live in high-cost left and right-coast cities, and millions more have high heating/cooling/commuting costs.
The wages of those employed by Corporate America or the government do not reflect the total cost of benefits such as healthcare insurance. Self-employed people like myself pay the full costs of benefits, so we have to realize there is no ideal average of household expenses. Some households pay very little of their actual healthcare expenses, other pay for part of these costs and still others pay most or all of their healthcare insurance and co-pays.
1. Healthcare. Let's budget $15,000 annually for healthcare insurance. Yes, if you're 23 years old and single, you will pay less, so this is an average. If you're older (I'm 64), $15,000 a year only buys you and your spouse stripped down coverage: no eyewear, medication or dental coverage--and that's if your existing plan is grandfathered in. (If you want non-phantom ObamaCare coverage, the cost zooms up to $2,000/month or $24,000 annually.)
Add in co-pays and out-of-pocket expenses, and the realistic annual total is between $15,000 and $20,000 annually: Your family's health care costs: $19,393 (this was before ACA).
Let's say $15,000 annually is about as low as you can reasonably expect to maintain middle class healthcare.
2. Home equity. Building home equity requires paying meaningful principal. Let's say a household has a 15-year mortgage so the principal payments are actually meaningfully adding to equity, unlike a 30-year mortgage. Let's say $5-$10,000 of $25,000 in annual mortgage payments is interest (deductible) and $15-$20,000 goes to principal reduction.
3. Savings. Anything less than $5,000 in annual savings is not very meaningful if college costs, co-pays for medical emergencies, etc. are being anticipated, and $10,000 is a more realistic number given the need to stockpile cash in the event of job loss or reduced hours/pay. So let's go with a minimum of $5,000 in cash savings annually.
4. Retirement. Let's assume $6,000 per wage earner per year, or $12,000 per household. That won't buy much of a retirement unless you start at age 25, and even then the return at current rates is so abysmal the nestegg won't grow faster than inflation unless you take horrendous risks (and win).
5. Vehicles. The AAA pegs the cost of each compact car at $7,000 annually, so $14K per year assumes two compacts each driven 15,000 miles. The cost declines for two paid-for, well-maintained clunkers and increases for sedans and trucks. Let's assume a scrimp-and-save household who manages to operate and insure two vehicles for $10,000 annually.
6. Social Security and Medicare Taxes. Self-employed people pay full freight Social Security and Medicare taxes: 15.3% of all net income, starting with dollar one and going up to $127,200 for SSA. But let's take a household of two employed wage-earners and put in $8,000.
Property taxes: These are low in many parts of the country, but let's assume a level between New Jersey/New York/California level of property tax and very low property tax rates: $10,000 annually.
Income tax: There are too many complexities, so let's assume $2,000 in state and local taxes and $5,000 in federal taxes for a total of $7,000.
7. Living expenses: Some people spend hundreds of dollars on food each week, others considerably less. Let's assume a two-adult household will need at least $12,000 annually for food, utilities, phone service, Internet, home maintenance, clothing, furnishings, books, films, etc., while those who like to dine out often, take week-ends away for skiing or equivalent will need more like $20,000.
8. Donations, church tithes, community organizations, adult education, hobbies, etc.: Let's say $2,000 annually at a minimum.
Note that this does not include the cost of maintaining boats, RVs, pools, etc., or the cost of an annual vacation.
Here's the annual summary:
Healthcare: $15,000
Mortgage: $25,000
Savings: $5,000
Retirement: $12,000
Vehicles: $10,000
Property taxes: $10,000
Income and Social Security/Medicare taxes: $15,000
Living expenses: $12,000
Other: $2,000
Minimum Total: $106,000
Vacations, travel, unexpected expenses, etc: $5,000.
Realistic Total: $111,000
That's almost double the median household income of $59,000. Note that this $111,000 household income has no budget for lavish vacations, luxury vehicles, large pickup trucks, boats, second homes, college expenses, etc. There is no budget for private schooling. Most of the family income goes to the mortgage, taxes and healthcare. Savings are modest, along with living expenses and retirement contributions. This is a barebones budget.
$111,000 household income is right about the cut-off point for the top 20% of household income. How close are you to the top 1%?
Toss in a jumbo mortgage, college tuition paid in cash, an aging parent to care for or any of a dozen other major expenses and the minimum quickly rises to $155,000, which puts the household in the top 10% of household income.
How can we even talk about a "middle class" when the minimum thresholds put the household in the top 20%? And we haven't even considered the ultimate  minimum threshold of middle class membership: family ownership of income-producing assets such as businesses, rental properties, bonds, etc.
The key takeaway of this chart is the concentration of the household wealth of the bottom 90% in the family home. The wealthy and upper-middle class own income-producing assets, while the bottom 90% own some life insurance, cash and pensions, but their largest asset by far is the family home. (They also "own" a tremendous amount of debt.)
The problem is life insurance, cash and pensions don't generate much income, and neither does the family home. Households counting on the equity in bubble-priced housing are not factoring in the unwelcome reality that all bubbles pop, even housing bubbles that can't possibly pop.
To have the equivalent security and generational wealth enjoyed by the middle class two generations ago, households have to check off all 12 minimum thresholds. I'm not sure there is a "middle class" any more; if we use these 12 minimum thresholds, the U.S. now has a super-wealthy class (top .01%), a very wealthy class (top .5%), an upper class (top 9.5% below the wealthy) and the rest (bottom 90%), with varying levels of security and assets but at levels far below what median-income households enjoyed in bygone eras.
By the standards of previous generations, the middle class has been stripmined of income, assets and purchasing power.


Ridiculously affordable fiction sale: 7 of my 8 novels are now a ridiculously affordable $1.29 (Kindle digital edition)--the first two have never been available digitally until now:
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Friday, October 12, 2018

Here's Why the Next Recession Will Spiral Into a Depression

Here's the difference between a recession and a depression: you can't get blood from a stone, or make an insolvent entity solvent with more debt.
There are two basic differences between a recession and a depression:
1. Duration: a recession typically lasts between 6 and 18 months, while a depression drags on for years or even decades, often masked by official propaganda as "slow growth" or "stagnation."
2. The basic dynamic: recessions are business / credit cycle events that wring out the excesses of credit expansion (i.e. lending to unqualified borrowers who subsequently default) and mal-investment in low-yield, high-risk speculations and projects that only made financial sense in the euphoria of bubble psychology (i.e. animal spirits acting as if bubbles never pop).
Recessions are brief because the basic dynamic is to write down defaults, tighten up credit and absorb the losses from failed speculations. As consumers and enterprises cut back borrowing, they trim spending, leading to lay-offs, reduced tax revenues, contraction of credit and all the other consequences of wringing excesses out of the economy.
But once the losses have been absorbed and insolvent households and enterprises have worked through bankruptcy, then the decks are cleared for a renewed credit / business cycle expansion.
Depressions, on the other hand, are generated by self-reinforcing feedback loops: insolvencies beget more insolvencies, reduced prices for assets beget lower prices for assets, and so on.
There are two critical differences between the two dynamics: high fixed costs and dependence on credit / asset bubbles for "growth." Recessions clear excesses in otherwise healthy economies with low fixed costs, rising productivity, broadly distributed gains in earned income, safe yields on capital set aside for savings and retirement and high returns on productive investments. Growth is the result of rising productivity of labor and capital.
Depressions are the result of the opposite set of dynamics: growth is the result of a vast expansion of credit that drives mal-investment and risk-laden speculation. Productivity stagnates as capital flows to speculative gambles ("sure things" in a bubble euphoria) and expansions of capacity that far outstrip demand.
In these credit / speculative driven economies, capital is forced to "chase yield," i.e. seek a return in risk assets rather than in low-risk secure investments. Soon, everyone is dependent on credit / asset bubbles for their paychecks, increases in wealth, pensions, sales, tax revenues, etc.
Economies prone to depressions have high debt levels and high fixed costs.Both generate self-reinforcing feedback loops: as loans issued to uncreditworthy borrowers default, liquidity dries up and marginal borrowers are pushed into default. As credit dries up, sales decline, profits drop, employees are laid off to cut operational costs and previously sound borrowers slide into default.
As defaults beget more defaults, lenders are pushed into insolvency, sparking a banking crisis. Borrowers sell assets at fire-sale prices to raise cash, pushing assets prices lower, putting borrowers underwater. As this insolvency is liquidated in bankruptcy / defaults, lenders must sell assets, driving prices ever lower in a self-reinforcing feedback loop.
The key here is to understand the difference between fixed costs and operational costs. Fixed costs are, well, fixed: they don't decline even if income, sales or tax revenues decline. Fixed costs include: rent, mortgage payments, debt service, mandated healthcare insurance premiums, etc.
Operational costs decline rapidly in recessions; fixed costs don't. Operational costs include wages paid to recent hires, fuel for the company trucks, etc. As business slows, some employees are laid off, reducing costs, and company vehicles log fewer miles, reducing fuel costs, and so on.
Fixed costs remain the same even as sales, profits, income and tax revenues plummet. Economies burdened with high fixed costs have very little wiggle-room (i.e. buffers) before reductions in sales, profits, income and tax revenues trigger losses, i.e. expenses are no longer covered by income.
Here are some examples of fixed costs:
For state and local governments, pensions and benefits due retirees are fixed:they don't go down in recessions. Rather, what drops in recessions are the tax revenues needed to fund the pensions.
California pension funding:
New York City pension funding:
Insulin is another fixed cost. Those needing insulin don't stop needing it in recessions. Notice the enormous increase in the cost of insulin, i.e. inflation.
Notice how all the big-ticket essentials (i.e. fixed costs) are rising in price: the only items with declining prices are those that are generally optional-- TVs, clothing, etc.
Everywhere we look in the U.S. economy, we see sky-high fixed costs. Investors who overpaid for commercial real estate will default once their business tenants close down, homeowners who overpaid will default once one of the household's primary jobholders loses his/her job, state and local governments that have feasted on a decade of rising tax revenues will suddenly face staggering deficits as tax revenues crater--the list of those with high fixed costs and no wiggle room other than bankruptcy is essentially endless in America.
Here's the difference between a recession and a depression: you can't get blood from a stone, or make an insolvent entity solvent with more debt. Losses will have to taken, and nose-bleed fixed-costs will have to be slashed; reality will eventually have to be dealt with.
But everyone will resist this process because high fixed costs are the gravy train everyone depends on. Slashing fixed costs destroys the income needed to support asset valuations which are the collateral for the stupendous mountains of debt that define the U.S. economy. Once that debt is written down, the entire financial system collapses.


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