Debt: MMT Promise or MMT Threat?

Evaporating Liquidity, Growing Debt, and the Perils of MMT

This is a blogpost from March 2020 that I just added to my Substack.

The Stock Market Outlook

Well, it’s the start of a new year, so I thought I’d once again offer my totally biased take on the stock market (and just about everything else.)  My outlook is a lot more cautious than in the past, if not downright negative.

To make things easier for the reader, here is a brief summary of my subtopics:

1. You Won’t Miss Your Liquidity ‘Till the Fed Runs Dry.In which I discuss the greatest risk for investors: Liquidity, or, more properly, the potential lack thereof. (Kind of technical but important.)

2. The Economy: MMT Promise or MMT Threat? In which I discuss the state of the world economy in light of Modern Monetary Theory (MMT.)

3. Time Bandits. In which I make the case that debt will be our downfall, MMT notwithstanding.

4. Investment Conclusion: A Coward’s Options. In which I finally circle back to the stock market, generate a base case, and reveal how a coward invests.

As I’ve stressed in the past, I’m not in the business of making predictions.  As Keynes observed, the future is a thing of radical uncertainty.  The trick to “forecasting” is to establish a base case for as many of the important outcomes as one can identify, and then assign each a more or less “subjective” probability of occurring.  Then, one can sift through new evidence as it emerges to refine one’s subjective probabilities in light of that evidence.

Assiduously studying incoming data allows an  investor to incrementally bolster or weaken his base-case assumptions.  It also helps to sensitize an investor to developments that she – and the market — may not have considered at all and take appropriate action  (Like the Coronavirus) With every new day and every new piece of data one must make a judgement about how probable an event is to occur over the next month,  and the next year. And the next five years.  And 20 years, should we live that long.  I call my approach “Bayesian.” This makes it sound like I  know something about statistics.

The starting point for my base case this year, like every year, is that the stock market will probably go higher. Cynics like to say that the stock market is just a gamble, like a slot machine.  That statement has a hint of truth, but there’s a huge difference.  In a casino you can’t win because the house is skimming its vig off the top. But in the stock market, the house is working for you.  The economy usually grows, and no matter how screwed up Washington may be, the politicos all want the economy to keep growing.  Managements do everything in their power to keep earnings per share advancing and stock valuations high.  The Fed keeps feeding liquidity into the system, and much of it goes into the stock market.   For every bear hankering for a market downturn there are a hundred bulls who want it to go up.

That said, there is a lot going on in the world today to make a pathological worry wart like me even more anxious than usual.

Most importantly, no one really understands what’s going on in the world economy.  To quote the Dread Pirate Roberts, “Anyone who says differently is selling something.”   The domestic US economy has been growing for a decade with barely a pause. Unemployment is at all-time lows. Yet much of today’s growth depends on sustaining a  trillion dollar budget deficit . This is unsustainable in the long run but may yet continue for years. The world economy seems stuck in a deflationary rut and the Coronavirus greatly complicates matters.  Much more on the economy later..

You Won’t Miss Your Liquidity ‘Till the Fed Runs Dry

First off, I’ll hammer on the thing that I’m convinced looms as the biggest risk to investors;  liquidity, or, more properly, the potential lack thereof.  I am convinced of this for a variety of reasons, some of which I understand, many of which I don’t.

Simply put, liquidity is the ability to buy or sell an asset on short notice without affecting the price of that asset: the ability to readily turn assets into cash. Mostly, liquidity depends on the system’s ability to supply credit.  (See Basel: Faulty at cantercap.wordpress.com page 4 for an extended discussion of liquidity in the 2008 financial crisis.)

Like your reputation, liquidity is something that you never appreciate until it’s gone.  In good times, all assets – even many hard assets like homes – appear to be liquid.  But when things turn bad, as in the panic of 2008, liquidity can disappear in the blink of an eye.  In the near future at least, a lack of market liquidity will greatly amplify market moves both up and down, driving the market higher, and, ultimately, far lower than fundamentals justify.

Following is an inventory of the factors that persuade me to be extremely concerned about liquidity:

First, the Repo crisis.  The Repo market is an arcane corner of the financial landscape, but a crucial one. It is through the Repo market that financial institutions obtain short term—often overnight — financing for their inventories of securities.  At least twice in 2019, the Repo market froze up.  In September, Repo rates spiked to around 10% as institutions became desperate to obtain the cash with which to pay their maturing obligations.  It is not clear exactly why this happened. If there were rumors of a bank in trouble I was not aware of them.  More likely, it was the confluence of these factors:

1. The Fed ended its quantitative easing programs in 2014 and had allowed excess bank reserves to gradually run down. After the first Repo episode in September the Fed reversed course and started adding reserves.  Now, it is showing signs of real panic.  It has increased its balance sheet by nearly $400 billion –11% — since September, into the teeth of record low unemployment rates.  Now that the party is really wild, the Fed is spiking the punch.

2. This policy ran smack dab into a more insidious problem created a decade ago by Dodd Frank: bank liquidity constraints. Today, in just one of a myriad of onerous regulations imposed on banks to scapegoat them for the 2008 financial crisis, banks must contort their balance sheets into all sorts of unnatural positions to maintain “liquidity” as regulators define it.  This “Pretzel Logic” (apologies Donald Fagan) makes it a challenge for banks to supply funds on short notice when the system demands it.  It also reflects regulators’ ignorance of how banks work, because supplying liquidity is what banks do.  Banks are the flip side of the real economy.  If banks are forced to hoard liquidity, that means less cash for the rest of us.  In a pinch, the Fed is now the only source of liquidity.

3. A year and a half ago, in October, 2018, the Fed announced it would begin to pursue a less accommodative monetary policy.  This sparked a 3 month market collapse the likes of which I have seldom witnessed. Ultimately, having been battered by the stock market truncheon and strafed by a burst of insulting tweets from the Chief Executive, the Fed relented and once again stepped on the gas.  That change produced 30% gains in 2019.  But do not underestimate what could happen if  the Fed is ever in a position where it cannot or will not ease.

4. Question to keep in mind: Does the Repo crisis suggest we are reaching the limit of the US government’s capacity to borrow?

(Here is a link to the St. Louis Fed’s “FRED” database.  This is very easy to use and includes most of the economic data you could ever want, including the Fed’s balance sheet.  Occasionally the government gets things right.)

https://fred.stlouisfed.org/series/WALCL

ETF’s are among the most useful of recent financial innovations.  They allow investors to invest in a diversified, tradeable group of stocks, rather than having to build a portfolio ourselves.  This is fine if one is buying the QQQ’s or the SPY’s, but today there are a slew of ETF’s that invest in very illiquid stocks and other instruments.  Many of these newer ETF’s are leveraged, and many are what I call “exploding” ETF’s that are constantly depreciating in value regardless of how the underlying asset is performing (check out the 5 year chart of “VIXY.”)  The danger is that ETF’s that appear to be liquid in a rising market like today’s  are comprised of securities that may not prove nearly so liquid in a market downdraft (parallels to the AAA tranches of RMBS in the financial crisis.).

Another problem I see with ETF’s and the whole “passive investing” craze is that the institutional understanding of individual companies is diminishing.  No one except Warren Buffet cares about valuation anymore.  Today, when an individual or a portfolio manager wants exposure to the financial industry, for example, she makes a knee-jerk purchase of the XLF or KRE.  She doesn’t give a second thought to the individual firms that comprise these ETF’s.  This tends to indiscriminately drive higher all the shares within the ETF even though individual firms may have significantly different fundamentals.   Combined with Fed stimulus, this could help to drive many ETF’s (and the underlying shares) higher than is warranted and could worsen a market decline. You can see this happening with utilities, which are selling at a nutty 20 times earnings because their ETFs have been driven higher by people desperate for yield.

Quants and Groupthink.  With every passing year, computers get more powerful, algorithms get more complex, and quantitative investors get more cocksure. Short term moves in today’s stock market are driven more than ever by computers at speeds too fast for humans to comprehend, let alone manage.  I could be too cynical, but my experience tells me that the models used by quantitative investors are mostly very similar.  This means that trillions of dollars and gigawatts of computer power are aligned on the same side of most trades.

The potential danger of these massive quantitative strategies was underscored in January of 2018 with the “Vol” panic.  Without going too deeply into the weeds, it turned out that most quantitative investors at the time were “Short Vol.”  (For market players, Vol is not some Star Trek villain, but an abbreviation of the term “Volatility.”  This is a key ingredient in the pricing of most derivatives and is measured by an index called the VIX.)  Even though Vol was at near record lows, the quants were betting on it to go lower.  When that didn’t transpire, some quants panicked, and a gargantuan “short squeeze” erupted.  The VIX tripled from 10 to 30 in less than a month, and the S&P dropped nearly 10%.  I suspect that a similar trade is in place today.

Share buybacks have been a key factor underlying the past decade’s bull market.  Buybacks have enhanced earnings-per-share (EPS) growth for many companies and kept a “bid” under stocks that enhanced investor confidence.  While some companies have misused them, I am a big proponent of buybacks.  They are a far better use of capital than dumb acquisitions. Generally, they are preferable to dividends.  I am not at all persuaded that buybacks are in any way responsible for the low business investment of the past decade.  But the point is that buybacks have contributed a lot of liquidity to the stock market.  This liquidity could disappear if buybacks cease.  Firms have a frustrating tendency to buy their stocks aggressively when prices are high and turn tail when the market goes down.

Market making.  This train left the station decades ago, but it is important to remind newcomers that there was a time when “market makers” were obligated to put up their own capital to maintain “orderly markets” for investors.  This sometimes worked better in theory than in practice, but still, most of the time in a downdraft, even large sellers had someone on the other side whose job it was to buy their shares.

This system has been relegated to the dustbin of history.  But as recently as the 2008 financial crisis there were still institutions – banks and brokers – who were willing to use their balance sheets to serve their customers by buying stock as the market sold off.  The Volcker Rule, along with aforementioned liquidity constraints, put the kibosh on that.  Now, in a market panic banks will not provide any cushion. Further complicating matters are recent innovations like “dark pools” and high frequency trading.  These have yet to be tested in a crisis, but they certainly will not enhance liquidity.  Truth be told, there is no longer anyone except the Fed with any incentive to  step into the breach, and thanks again to Dodd Frank, the Fed has very few arrows in its quiver.

To repeat the bottom Line for Investors:If the Federal Reserve and other central banks ever, EVER back themselves into a corner where they are unable to liquify the system, investors will be in deep, deep trouble. That could happen, hypothetically, if we get a simultaneous credit and inflation scare.  Though this possibility seems remote, the execrable quality of today’s corporate debt does not render it impossible.  But more likely, the panic will come from somewhere totally unexpected.  The point is: Be Prepared and have a plan.

A silver lining.  Luckily, for the United States, at least, there is a silver lining: the US commercial banking system has never been stronger than it is today.  I have been an unremitting critic of US bank regulatory policy since the Financial Crisis.  I am convinced that bad regulation caused the crisis and strangled the ensuing recovery.  But that was then.  Today, US banks are deeply capitalized and highly liquid, and as far as I can tell have not participated in any of the crazier credit fads of recent years (e.g. Leveraged lending without covenants.)  US banks are in a solid position to play a major role in resolving any future economic crisis both here and abroad.  But to do so, they must be set free from the draconian regulatory constraints that currently bind them.

The Economy: MMT Promise or MMT Threat?

“Economists have solved every important economic problem except two: they don’t know where growth comes from and they don’t know where inflation comes from.”                                   — H Jerome Cranmer

MMT (Modern Monetary Theory) is an economic heresy that has received a lot of attention in recent years. For the most part, its ideas have been derided, even vilified by orthodox economists.  That’s not surprising, but there’s a problem: the world economy is behaving as if the MMT’ers are right.

First off, let me say that I have a soft spot in my heart for MMT.  Orthodox economic thought is so calcified and is so clearly off base that we should all try to encourage alternative views.  Behavioral economics is one such alternative that is heading us in the right direction.  MMT is another that may offer promise, although I think there are serious issues with the theory as it now stands.  (Caution: I am not sure that I fully grasp all the ins-and-outs of MMT.)

I have been aware of the MMT movement since its inception.  The epicenter of MMT is the Levy Institute at Bard College, which was founded in the late ‘80’s by Leon Levy of Odyssey Partners, an early and highly successful hedge fund.  I was drawn to the Levy Institute in the 1990’s for two reasons. First, the Institute placed the financial sector front and center in importance along with the “real” economy. Orthodox economics had traditionally “assumed away” the financial sector.  (interestingly, the conservative “Austrian School” of Hayek and Von Mises,  similarly marginalized by orthodox economists, also places great emphasis on banking and credit creation.)  Second, the Patron Saint of MMT is the late Hyman Minsky, an irascible critic of orthodox economics and prophet of financial instability.  Minsky was a professional acquaintance of my Dad and was briefly my advisor at Washington University.

In a nutshell, MMT takes an essentially Keynesian position that the economy is driven by demand and that deficient demand is what causes slow growth and recessions.  If slack growth indicates that demand is inadequate, says MMT, the answer is simple: get dollars into the hands of consumers.  That is, create demand through fiscal and monetary policy.    Don’t worry about debt, as long as it is denominated in our currency.  We simply owe the debt to ourselves, so we can never default: the government can write a check on its Central Bank account whenever it chooses.  MMT considers the Fed to be the government’s bank and the government effectively has unlimited overdraft privileges.  According to MMT, the only constraint on government spending and money printing is inflation.  When inflation arises, then clearly there is sufficient demand and we can cease our stimulus.

For a deeper understanding of MMT ideas, read “Does America Need Global Savings to Finance its Fiscal and Trade Deficits?” in the  Feb. 20, 2019 edition of American Affairs Magazine  https://americanaffairsjournal.org/archives/#authors.  The author is L. Randall Wray, probably the leading MMT thinker. I believe you are entitled to one free article.

As I say, I am not fully convinced of many of MMT’s precepts.  My main problem is its opaqueness regarding the limits of government spending and the onset of inflation. By the time inflation – and inflationary expectations – gain a foothold it is probably too late to stop it absent heroic measures.  The Fed can raise interest rates on short notice, but we can unwind fiscal programs only with great difficulty.  They will have all developed their own constituencies and offer employment to many. The tipping point between inflation and deflation is not a bright line, and I see little likelihood that brakes would be applied in a timely fashion.  All that said, MMT does seem to offer insight into our current world economy that orthodox economics does not.

In the world at large, there is clearly something deeply wrong that traditional economics can’t seem to explain.  Ten years after the financial crisis, powerful deflationary pressures persist despite massive programs of monetary and fiscal stimulus by the US, China, Japan, Europe and just about everyone else.

Here in the US, the economy is growing, the Fed is highly accommodative, we are near, or possibly beyond full employment and the administration is running a TRILLION DOLLAR annual budget deficit.  Orthodox economics tells us that given those conditions, inflation should be at least an incipient problem and government borrowing should be “crowding out” private borrowing, driving interest rates higher.  But inflation is nowhere to be seen (except for health care and college tuitions) and interest rates are sitting at all-time lows.

In fact the 10 year Treasury yield has slipped back to test its 50 year low of 1.5%, and the yield curve is narrowing once again.  Plus, energy prices are collapsing. These cannot be signs of economic strength.

Or consider Japan. Japan’s economy has been languishing for 3 decades since its economy collapsed  along with its stock market and most of its major banks.  Since 1990, real GDP has grown only 16%, or a measly half a percent a year.  In an effort to stimulate its economy, the government has undertaken colossal fiscal programs and run huge deficits, to no apparent effect.  The Japanese central bank has, in effect, printed money by monetizing not just the national debt, but also a large share of the country’s equities.  The Japanese central bank now owns roughly 15% of the market value of the Nikkei.

Hopefully, Japan is not a precedent for the US.

From an MMT perspective the world economy simply lacks sufficient demand.  And I tend to agree with this, though I shrink from some of MMTs solutions like huge government fiscal programs. I may be wrong, but the global debt load is already so monumental that I can’t believe that more fiscal stimulus and more debt can be the answer.

Time Bandits 

In one sense, all debt is the same.  All debt takes consumption from the future and allows us to spend it today.  Smart debt takes future spending and invests it in a manner that will, hopefully, provide future spending greater (adjusted for time value) than what was borrowed.  This is the idea behind most corporate borrowing, whether for investment, acquisitions, or, even, stock buybacks.  It is the idea behind student loans and most mortgage loans.

Dumb debt borrows from the future so that it can be squandered today.  Credit card borrowing is dumb debt (sometimes it’s just desperate debt.)  Similarly, most government debt falls into this category. But at least with credit card debt the borrower takes future consumption from herself.  Government debt, however, represents a transfer of wealth from future generations to us.  The government of almost all G20 nations are borrowing from the future to lavish benefits on today’s citizens.  Vanishingly little government debt is invested productively.

You might ask who might be stupid enough to lend to the government if this borrowing is so dumb.  The answer, of course, is the government.  That is, the Federal Reserve.  In the best MMT style, the Federal Reserve is enabling the government by buying the bonds that the Treasury issues.

To be honest, I don’t know, and no one knows for sure, what the limit might be for government borrowing.  A rule of thumb used to be that debt can grow as long as it is at a rate in line with the GDP growth rate.  If past debt binges are a precedent, things can hold together as long as the government can cover interest on the debt.  With interest rates as low as they are today, that’s easy to do without raising taxes or cutting other programs.  But if rates rise, watch out.

Here’s a thought experiment. (I am sincerely unsure what the outcome of this experiment would be.) Suppose tomorrow the Fed bought all $23 trillion of US government debt.  This would create humongous excess bank reserves, but would not become money (M1) until reserves were turned into commercial loans.  So, presumably, this would not be immediately inflationary.  Let’s also say regulators put tight restrictions on bank lending and the Fed stopped paying interest on excess reserves.  Thenceforward, the government would pay all interest and principal to the Fed, who then would remit it back to Treasury.  Have we effectively defeased our government debt?  There must be negative repercussions somewhere, but aside from a borderline profitable banking industry, I’m stumped.

Returning to the real world; in 2020, our national debt is expected to grow at a rate of close to 5% excluding the massive burdens of Social Security and underfunded state and local pensions.  Whatever the theoretical limits on government borrowing, and notwithstanding the claims of MMT, this magnitude of borrowing in a time of prosperity is profoundly irresponsible.  The big danger is that we have a recession (which, at some point, we will) and the deficit balloons to a truly gargantuan number.  Interest rates might have to increase greatly if the debt is to sell, worsening the recession.  Or the Treasury could be reduced to simply writing checks to pay its debts as was done in Weimar Germany in 1923

Not to put too fine a point on it, but I am convinced that, ultimately, debt will be our downfall.

There is no easy way out.  Economist Bill Mauldin anticipates a “Great Reset,”  a sort of one-time “Day of Jubilee” without the jubilation, when debt obligations are expunged and the economy restarts with a clean slate.  If that sounds like an attractive prospect to the progressives among us, consider that it means that old folks will stop getting health care and millions of retired workers will never receive the pensions they were promised.  Mauldin is not specific about how a “Great Reset” would take place in practice, but one thing is for sure: it would engender a level of public disruption that our country has seldom witnessed.

While acknowledging the possibility of a “Reset,” my base case over the long term is that the debt problem will be resolved the old fashioned way – with inflation.  This is by far the less painful of the two possible solutions politically.  If I’m wrong, if deflationary pressures persist or worsen, then either the market will go much, much higher, or the world economy will collapse into a smoldering heap (i.e. the Great Reset.)

Here’s a funny thing about predicting inflation.  If inflation rises, then interest rates will rise.  If interest rates rise, then lots of debt will default and companies will fail.  This will be deflationary.  Maybe that’s the gist of what’s wrong with the world economy today.

If I were running things I would immediately start refinancing our debt with longer maturities.  Thirty year bonds now yield just over 2%.  If we can issue 50 or even 100 year bonds in the 2.5% range, we should do it in size.  This will increase the current deficit a bit, but it will prevent the deficit from growing exponentially if inflation does become a serious problem.  Interestingly, Donald Trump proposed something very similar in his campaign.  If he’d followed through on that proposal rather than stepping on the fiscal gas, my assessment of the future (and of Trump) might be a bit rosier.

Old and in the Way

Following is my attempt to explain the economic quagmire we are stuck in.  In my view, several non-financial factors weigh heavily on the economy both here and abroad:

Demographics dwarfs all other factors in importance.  Developed economies (including China) are aging at an alarming rate with implications that few of us fully appreciate.  Why these demographics should be so profoundly deflationary is not entirely clear to me.  But I will attest, as someone who recently retired, that the reality of retirement can come as a shock even to those who thought they were well prepared financially. The prospect of living on social security or making one’s savings stretch perhaps 40 years would make anyone hunker down.

We are pouring resources into an elderly population that is by definition unproductive and a bad long term investment.  Something like 20% of US medical spending occurs in the last year of people’s lives. I don’t want to say that that money is wasted, but to a hard hearted investor like me it doesn’t seem likely to generate a positive ROI.  Taking care of old folks may be the right thing to do, but it burdens our younger citizens who will sooner or later bear the expense of our dotage.  Meanwhile, old folks are desperate to protect the promises that have been made to them.

Wall Street veterans like myself will remember Dick Hokensen, the former head economist at DLJ.  Dick made demographics the centerpiece of his economic analysis.  I’m sure this was partly a marketing strategy to differentiate himself from his peers, but his point of view offered fascinating and unconventional insights into the economy.  To my knowledge, no one has picked up on his work. I wish someone would.  If Dick is still around, I’d love to know what he is thinking.

The US is facing a Presidential election.   Since this this paper is about investing, I don’t want to show my hand regarding any political biases.  But like many Americans, I am in despair about today’s political climate.   I lived in New York for 20 years where, like all New Yorkers, I got my fill of Donald Trump and his penchant for stiffing contractors, body slamming McMahons (fake of course) and cavorting with promiscuous floozies like Roy Cohn.

I have more of a history with Trump than most.  I had the privilege to testify before the House Banking Committee in 1991 when all of Trump’s projects were going belly up, and I’ve been watching him ever since with a kind of bemused bewilderment that has turned to horror. I am appalled that any American would consider this self-obsessed, bloviating buffoon remotely acceptable as a dinner guest, let alone as a president.  A man with no integrity, no compassion, no dignity.  Is this really the sort of person that 40% of Americans admire and want their children to emulate?

The Democratic candidates are another story entirely. Most at least seem like decent people, but the economic policies of Sanders and Warren are fakakta.  Essentially, their platforms are; “Lots of Free Stuff for the 99%.”  Their seething contempt (envy?) for anyone who has actually created jobs or created (horror of horrors) wealth is palpable.  How did we come to this? Thankfully, Michael Bloomberg has finally thrown his hat in the ring.   (Please, if there is a God in heaven.)

While Donald Trump is deplorable, the market is likely to have a benign reaction to his reelection.  He is business friendly to a fault, and the market typically likes the status quo.

The market will not react well to the nominations of either Sanders or Warren, for obvious reasons.  Well, actually, it might not react badly because neither of these crypto-socialists stands a chance of beating Trump.  If either of those two actually does somehow win the election, you’d better batten down the hatches.  And if one of them wins and the Democrats take the Senate, sell everything.

I think that the nomination of Biden, Buttigieg, or Klobuchar would not roil the markets much.  And Bloomberg could be downright positive.  Unfortunately, the kinds of policies a responsible president will need to undertake once elected will probably not be popular, and may not be good for the market.

China is slowing.  Most of us underestimated just how powerful an economic force China was in the first decade of the 2000’s.  China was the engine of growth for the entire world economy.  It was buying on the order of 60% of the world’s copper.  While the United States had not built a new steel mill in decades and had closed many, China was building dozens of new ones every year.  Since China is a socialist system, much of this investment was directed, or at least guided, by the government.

Much of China’s growth was fueled by debt, and it seems that much of its investment was wasted.  China is now paying the price.  I would not go so far as to predict a total collapse because Socialist governments have a lot of strings to pull that democracies don’t have.  But I will point out that the parallels to Japan in 1990 are stark.

I believe that the conduct of the current trade war with China is deeply misguided.    Our trade deficit, like all trade deficits, is as much our doing as China’s.  Probably more so.  Americans like cheap stuff and really don’t like to save money.

China’s theft of intellectual property and corporate espionage is certainly a major concern.  This issue should have been addressed by previous administrations, but it should be remembered that every US corporation knew exactly what the deal was when they established joint ventures with Chinese companies.  Plus, I doubt that Trump’s strategy of threat and retreat will produce  an enforceable, lasting solution to this problem.

While I do not predict a collapse in China, it could happen. The coronavirus outbreak piles an especially burdensome load onto an economy that is already precarious.  Donald Trump seems to think in simpleminded terms of “winners” and “losers” but NO ONE WOULD BENEFIT FROM A CHINESE ECONOMIC COLLAPSE.  To the extent that our trade war destabilizes the Chinese economy, it is bad for all involved.

Debt is growing everywhere. I’ve discussed this earlier, but it bears repeating because it is a global problem.  Most of this growth has been Sovereign debt, created by countries running massive fiscal deficits. But corporate debt is also growing worldwide, and much of this debt is of low credit quality —  rated BBB or lower. As low interest rates force savers to reach for higher yields, they have inevitably taken on more risk. I suspect that many of them may not fully understand the risks.   Unfortunately, if governments do succeed in stoking inflation, interest rates will spike, and many of these credit instruments will default.

Investment Conclusion: A Coward’s Options

In this paper I’ve discussed an awful lot of things that may not seem germane to the stock market.  I don’t think this was entirely an exercise in self-indulgence.  Especially these days, you’ve got to consider as many scenarios as possible to understand events as they unroll.  As I’ve said, the thing that will trigger a liquidity squeeze is likely to come out of right field.  If you already know that Roberto Clemente is playing right field, you might be able to react before the ball hits you on the noggin.

Valuation.  Before we proceed to strategy, I should offer a brief comment on valuation.  Simply put, there is a big problem with stock valuations.  Ifthe current economic environment – 2% GDP growth, 2% interest rates, 2%ish inflation – can be sustained indefinitely, then the stocks of most companies, and especially a company like Apple with a 50% return on equity, are worth far more than where they are selling today.  This is because the market’s “Discount Rate” (the risk-adjusted return that investors require to buy an equity) will only be maybe 6-7%.  Even Apple’s dividend yield is higher than one can get in most bank accounts.

While I believe our economic outlook is likely to change radically sometime over the next decade (and not for the better), I don’t dismiss the possibility of this more congenial environment continuing for at least the next year or two.  It’s clear that fiscal imbalances can persist much longer than I would have expected.  As long as there is no apparent constraint on the Central Bank (e.g. inflationary pressures) they can continue to monetize government debt to their heart’s content.  For this reason, I think it is essential to keep a major piece of one’s assets in the stock market and remain vigilant for the kinds of problems we have discussed.

The Base Case.  Here is my promised probability weighted “Base Case.”  One of the benefits of this analysis is it helps one check whether one’s expectations are internally consistent.  For instance, despite my conviction that governments will ultimately need to inflate their way out of their debt burden, my near-term assumptions underscore just how weak the world economy remains.  Deflationary forces remain very powerful.

Base Case Probabilities for 2020 Stock Market  ( I apologize for the sub-optimal formatting.  I’ll keep trying to improve it.) 

• China                                                                                  Probabilities

  • Economy grows faster than 6%                                     20%

  • Economy grows slower than 6%                                   60

  • Severe economic problems                                             20

  • (I have hiked most probabilities of extreme outcomes due to Coronavirus)

• Coronavirus

  • Gradually dissipates worldwide                                    30%

  • Gets worse through midyear, then fades                     55

  • Becomes seriously virulent worldwide                         15

• Europe

  • Muddles along like the past decade                                   40%

  • Muddles along a little better than the past decade         40

  • Muddles itself into the tank                                                 20

• Trade / China

  • Token trade deal prior to election                                      70%

  • Substantive trade deal before election                              10

  • No trade deal                                                                           20

• Elections

  • Trump re-elected                                                                     50%

  • Sensible democrat elected                                                     20

  • Socialist elected                                                                        25

  • Socialist elected / Dems take Senate                                       5

  • (As volatile as POTUS is, anything could happen. But nothing will shake his base.  Say Hallelujah)

• Exchange Rates

  • Dollar stays strong                                                                  55%

  • Dollar weakens                                                                        20

  • Dollar sharply higher                                                             10

  • Dollar sharply lower                                                               15

• US “Real” Economy

  • Another year of 2% ish growth                                            60%

  • Growth greater than 3%                                                        10

  • Growth less than 1%                                                               20

  • Recession                                                                                   15

• Inflation

  • In the 1-3% range                                                                   55%

  • 3-6%                                                                                          20

  • Greater than 6%                                                                     10

  • Less than 1%                                                                           15

• Fed / Monetary Policy

  • Fed stays accommodative all year                                     30%

  • Fed ceases bond buying at midyear                                  40

  • Liquidity problems, source unknown                               20

  • Fed raises Fed Funds rate                                                     10

  • (Chairman Powell has indicated he will cease the Repo support in April.)

• Bonds (10 Year)

  • Bond rates rise                                                                        35%

  • Bond rates fall                                                                         30

  • Bond rates rise sharply                                                          20

  • Zero or negative rates                                                            15

• Credit problems

  • Credit is stable                                                                           50%

  • Credit problems emerge in leveraged loans                        30

  • Credit problems energy sector                                               20

  • (A major share of junk paper is energy related.)

• Commodities

  • Oil, copper stay soft                                                                50%

  • Oil, copper spike                                                                      20

  • Oil, copper go much lower                                                     30

  • Gold is acting very well as other commodities drop

• The Stock Market (Full Year)

  • S&P up 15% or more                                                              20%

  • S&P up 5-15%                                                                          35

  • S&P Flat (+ or – 5%)                                                                 20

  • S&P down 5-10%                                                                     15

  • S&P down big ( > 10%)                                                           10

Well, you get the picture.  This could, and should, go on and on.  You may want to run similar numbers on industry groups and individual companies.  But this paper is long enough.

Long story short, I think there is a high probability that the stock market performs well in the first half of the year at least through September.  If the Fed stays on the accelerator and the economy keeps producing numbers like January’s payrolls, the market could do extremely well, say up 15 -20%. By July we will know who the Democratic nominee is and will need to readjust our odds on a Democrat winning the Presidency.  The two things we must watch like hawks are: 1. The progression of the Coronavirus and 2. The inclination of the Fed to tighten policy even a little bit.

I see no reason to stray from buying the larger cap shares (or related ETF’s), especially the techs. I would avoid most smaller cap, illiquid shares.  I should note that if interest rates clearly start to rise, bank shares will perform extremely well.  Actually, they have been acting well recently despite record low interest rates.

I see no reason to load up on foreign stocks just now.  European stocks are cheap but there is little growth.  Germany, the economic engine of the Eurozone, seems to be teetering on the brink of recession.

Emerging nation stocks are EXTREMELY cheap and very tempting, but you must do your work on the individual nations.  Right now I have small position in these stocks but I’m cautious.  The US dollar continues to strengthen, which is not good for any nation that borrows in dollars.  With their poorly developed health care systems, Coronavirus could seriously affect them.  Bear in mind that if you buy any of the popular ETFs for developing countries like the EEM, you are mostly buying exposure to China.

For my own portfolio, I’m being even more of a coward than usual.  As I pointed out earlier, my objective is to capture as much upside return as possible while protecting against a real blowout loss.  I figure that my family will be fine as long as we can achieve 4 – 6% pretax returns over the next 25 or so years: pretty modest by historical standards.  My strategy hinges on writing options, mostly covered calls.

Many people shy away from options in the belief that they are too risky.  Certainly, if not used and monitored carefully, options can produce huge losses.    However, simple strategies like “buy / write” (aka covered calls) are great ways to protect somewhat against losses and still capture a good bit of equity return. The downside is that if the market really spikes, your returns won’t keep pace.  For professional portfolio managers, this is seldom an attractive option.  But for individuals, I think it’s often quite prudent, although I would not necessarily recommend it for younger folks.

Here’s an example

1. Buy 100 shares of Apple at $327 per share ($32,700 cost)

2. Sell (“write”) 1 contract (equivalent to 100 shares) of AAPL call options which expire in January, 2021 (338 days away) at a “strike” price of $340. (This option is “out of the money” by $13 (340 – 327.) By writing this call, you will be credited with $2,775  which is the price of the option contract (also known as “premium”),.

There are 3 possible outcomes to this strategy.  Bear in mind, in all scenarios you will collect $308 in AAPL dividends (a .94% yield.)

1. If AAPL’s price in a year is unchanged at $327, you will collect the option premium ($2,775) over the course of the year. This is a return of 8.5%.

2. If AAPL’s price in a year is $299 (a drop of 8.5%), you will break even because the gain on your option ($2,775) is the same as the loss on your stock (327-299) x 100.  Any price for Apple below that and you lose money dollar for dollar.

3. The best case for this strategy is if AAPL’s price in a year is $340 (up 4%).  In this instance, your profit is the value of the option ($2,775) plus your $1,300 profit on AAPL’s stock.  This is a return of 12.5%, which is excellent in historical terms.  But this is the most you can make.  At any price above $240, the option is “called away” along with your shares

In practice, I usually write shorter-dated options which almost always have more premium.  (There is no free lunch. They have a higher premium for a reason.)  For instance, instead of writing the January 340 call I could write the May 340 call, which is priced at $10.50.  If I repeat this four times during the year, I can collect $4.200 in premium, for a return of 12.8%.

I was hoping to think up a dramatic conclusion to this piece, but could not.  So I think I’ll just wind it up — not with a bang but a whimper.

There are times when investing is pretty easy.  It’s like you are out sailing one evening and you have a strong current and a following wind and the sky is glowing red.  You can’t predict what conditions will be in a year, but at least you can be pretty sure that tomorrow will be clear sailing.  This is not one of those times.  Keep your sails trimmed for a gale, and be careful out there.