Aftermath

by James Rickards

  By late 2017, $11.9 trillion of stocks were held by entities that passively track an index, such as ETFs, index funds, or institutional index managers. Another $17.4 trillion of stocks were held by active managers, such as hedge funds and mutual funds. Total passive ownership in U.S. equity funds in 2017 was estimated to be 37 percent, nearly double the 19 percent share for passive ownership in 2009. This growth in passive strategies showed no signs of abating. ETFs attracted over $215 billion in new assets during 2017, while active strategies suffered over $125 billion in redemptions.

  Passive-investment strategies are best understood as parasites on the bodies of active allocators. The active manager expends substantial time and effort either to identify fundamental value in the manner of Warren Buffett or to create inside information in the sense that Merton used the term. Active investors commit capital and catalyze price discovery by placing bids and offers with no certainty their endeavors will hit or miss.

  The best active managers can earn rich returns, yet most fail for reasons we have seen. Passive investors hitch a free ride on the active-investing community. They avoid cognitive bias and adverse skew, while capturing gains created by the insights of the best active investors, including Bruce Kovner. Passive investors contribute nothing to price discovery, yet reap rewards by going along for the ride. Passive parasites may indeed thrive—until they kill the host.

  Passive investing rests on another fallacy of composition, although the composition in this case exceeds $1 quadrillion dollars, the sum total of all stocks, bonds, currencies, and derivatives in the world. What works in the individual case does not work in the aggregate. Passive investing began as a hitchhiker on an 18-wheeler, barely noticeable. Today it is more like a clown car of occupants that threaten to overwhelm the vehicle in which they ride.

  The risk is that passive investors rely on active investors to buy when passives want to sell. As the scale of passive investing grows, the pool of potential active buyers dries up. The active buyers see this dynamic while passive sellers are blinded by algorithms. Eventually this leads to a market where everyone is a seller and no one is a buyer. The market goes no-bid, which in trading means no bottom in price.

  Passive investing and algorithmic trading are not alone in fostering this unstable state of affairs. The Federal Reserve is also to blame for engendering an illusion of safety in the form of the pernicious Fed Put. The Fed Put is jargon for the market’s belief that the Federal Reserve will act decisively to truncate disorderly stock market declines. A succession of these puts have been named after the Fed chairs who offered them.

  The Greenspan Put, named after Alan Greenspan, was exhibited in September and October 1998 when Greenspan cut interest rates twice in three weeks, including an unscheduled emergency cut, to control the damage from the collapse of hedge fund Long-Term Capital Management.

  The Bernanke Put, named after Ben Bernanke, was exhibited on numerous occasions, notably the launch of QE2 in November 2010, after QE1 failed to stimulate the economy, and the September 2013 delay of a taper in the Fed’s long-term asset purchases in reaction to an emerging-markets meltdown resulting from mere “taper talk” in May 2013.

  The Yellen Put, named after Janet Yellen, was frequently on display. Yellen delayed the first Fed rate hike in nine years from September 2015 to December 2015 to calm markets after a Chinese shock currency devaluation and consequent U.S. market meltdown in August 2015. The Yellen Put was used again starting in March 2016, when the Fed delayed expected rate hikes until December 2016 in reaction to another Chinese currency devaluation and a U.S. market meltdown in January 2016.

  In short, there is a long history of the Fed cutting rates, printing money, delaying rate hikes, or using forward guidance to calm nervous markets in order to pump up asset prices in response to disorderly market declines. The new chair, Jerome Powell, installed in February 2018, has given no reason to doubt that a Powell Put will be deployed as needed in accordance with past practice.

  The most extreme example of the Fed Put was the 2008 global financial crisis, when Ben Bernanke and other regulators guaranteed every money market fund in America, guaranteed every bank deposit in America regardless of FDIC insurance limits, pushed interest rates to zero, printed money, acquired bad assets, and engineered over $10 trillion of hidden currency swaps with the European Central Bank (ECB) and other central banks. These Fed actions were an extreme example of the “whatever it takes” philosophy of modern central bankers. The idea of free markets finding a level at which markets clear and rotten banks fail is passé.

  In ways that Fed governors and staff cannot comprehend, the Fed Put has bled into passive investing and algorithmic trading by training market participants to buy every dip. In effect, savvy investors front-run the Fed by buying on weakness before the put is activated. This results in the smoothing of volatility and an asymmetry of returns, where markets persistently rise and seldom fall. Diminution in volatility causes risk parity strategies to overallocate to formerly risky asset classes. Index strategies blithely tag along. Active managers throw in the towel and become closet indexers. At that point the market is primed for catastrophic collapse.

  This brings the analysis full circle. If alpha strategies are likely to fail for all but a few, and beta strategies are fated to follow indices to near extinction, are there investment processes that produce superior returns in most markets yet preserve wealth in market crack-ups? Such processes are possible, but only by utilizing science that accords well with how markets function.

  These new alpha models begin with complexity theory, a branch of physics that perfectly describes the dynamics of capital markets. Complexity theory includes concepts such as emergent properties (black swans), phase transitions (the switch from fear to greed), scaling metrics (how large systems produce diminishing marginal returns before collapsing), network effects (contagion), and hypersynchronicity (herd behavior).

  The next input in an alpha model that works is behavioral psychology. This is simply a matter of identifying cognitive biases so they can be factored out of AI-based trading systems.

  An effective alpha model would use Bayesian updating to test an initial investment hypothesis to increase or decrease the probability of an expected outcome, based on the likelihood that posterior events would or would not occur if the anterior guess were correct. Bayes’ rule uses a rigorous statistical method that acknowledges the inexactness of real-world behavior relative to expected outcomes. Bayes’ rule teaches that it is better to be approximately right than exactly wrong.

  The final element in an effective alpha model is history. This input is not seriously considered by the quants and developers who rule Wall Street modeling because historical narrative is subjective and nonquantitative. That’s their loss. Anyone who studied how President Grant broke the gold corner in 1869 would have foreseen the collapse of the Hunt Brothers’ silver corner in 1980. Anyone who studied how J. P. Morgan saved the banking system in 1907 would have known how to manage a soft landing for LTCM in 1998. There really is nothing new under the sun.

  These elements—complexity, psychology, Bayes’ rule, and history—can be combined in neural networks as nodes populated with market data and plain text read with meaning by machines like IBM’s Watson using advanced cognitive linguistic techniques. The nodes are linked with weighted recursive functions to produce actionable third-wave AI predictive analytics.

  Wall Street and central banks are a long way from adopting these twenty-first century risk-management techniques. In the meantime, the passive index-investing bubble grows. The alpha trap is baited. The odds are close to nil that capital markets will embrace efficacious models before the next financial failure.

  Investment Secret #4: Seek diversification away from exchange-traded markets by allocating to cash, gold, and alternatives.

  The best strategies for investors in the face of these embedded structural risks are:

  Avoid less-liquid ETFs and those with exotic features such a
s inverse performance or leverage. These products will not find ready buyers in a market crash.

  Maintain a 30 percent cash allocation at all times. This reduces the overall volatility of your portfolio and gives you “dry powder” to shop for bargains in the aftermath of a crash.

  Maintain a 10 percent physical gold allocation. This performs well in inflation and provides insurance in the event that a futures-market meltdown results in account freezes or exchange closures.

  Allocate 10 percent of investible assets to private equity and venture capital by investing in firms where you personally know the founders and operators. These firms will not offer liquidity, yet they may offer huge upside and low correlation to traded markets. Worthwhile sectors to explore are financial technology and natural resources.

  CHAPTER FIVE

  Free Money

  The poor you will always have with you, and whenever you wish you can do good to them.

  —Jesus Christ, Mark 14:7

  The Trouble with Debt

  In his 1925 poem, “The Hollow Men,” T. S. Eliot wrote, “This is the way the world ends / Not with a bang but a whimper.”1 These lines, which end the poem, are the most quoted not just in Eliot, but all of twentieth century English poetry. “The Hollow Men” was Eliot’s response both to the horrors of the First World War and the burdens of the Treaty of Versailles, which imposed humiliations on Germany and presaged new conflicts. Taken at first glance, the lines contrast customary notions of the end of the world as a violent apocalypse on the one hand with a gradual dimming and darkness on the other. The darkness vision, also expounded by the late physicist Stephen Hawking, says processes simply end without much ado.

  Yet the “bang” ending was also noted. In a Saturday Review interview in 1958, Eliot said he was not really sure how the world will end. He pointed to the paradox of one whose home was bombed. From an external perspective, there was certainly an explosion, but the victim herself never heard it; darkness and death came before the sound reached her ears.

  Poetic ambiguity aside, these lines have provided ample ammunition for analysts and writers to create their own metaphors in the past century. Eliot himself borrowed from Joseph Conrad’s Heart of Darkness in his opening epigraph, “Mistah Kurtz—he dead,” a reference to Conrad’s Kurtz. Filmmaker Francis Ford Coppola extended the reference in his epic film Apocalypse Now, which featured Marlon Brando as Kurtz reading lines from Eliot in the film’s final scenes.

  Now, it’s the economists’ turn to extend Eliot’s meaning. America, and the world, are inching closer to what Carmen Reinhart and Ken Rogoff refer to as the “bang” point, the unquantifiable yet real point where an ever-increasing debt burden triggers creditor revulsion, forcing a debtor nation into austerity, outright default, or sky-high interest rates.2 The bang point is when, to paraphrase Eliot, the debtor’s world ends not with a whimper, but a bang.

  The bang point is described by others using different names, including fiscal limit, but the phenomena is the same. A country begins with a manageable debt-to-GDP ratio commonly defined as less than 60 percent. In a search for economic growth, perhaps to emerge from a recession or simply to buy votes, policymakers start down a path of increased borrowing and deficit spending. Initially, results can be positive. Some Keynesian multiplier may apply, especially if the economy has underutilized industrial and labor-force capacity and assuming the borrowed money is used wisely, in ways that have positive payoffs.

  Over time, the debt-to-GDP ratio pushes into a range of 70 to 80 percent. Political constituencies develop around increased spending. The spending itself becomes less productive; more is spent on current consumption in the form of entitlements, benefits, and less productive investments in amenities, community organizations, and public-employee unions. The law of diminishing marginal returns starts to bind. The Keynesian multiplier shrinks to less than zero.

  By now, the public’s appetite for deficit spending and public goods is insatiable. Politicians lack the will and foresight to reduce spending, balance budgets, and restore a sustainable debt-to-equity ratio. The public is indifferent and fails to appreciate the dynamic now under way. The debt-to-GDP ratio eventually pushes past 90 percent.

  Next comes the endgame. Reinhart and Rogoff’s research reveals that a 90 percent debt-to-GDP ratio is not just more of the same, but what physicists call a critical threshold at which a phase transition commences. The debt-creation process and effect of more debt is transformed the way water turns to gas when heat is applied. The first effect is that the Keynesian multiplier, already at zero, turns negative. No growth is created by added debt, while interest on the debt increases the debt-to-GDP ratio on its own. Creditors grow anxious while continuing to buy more debt in a vain hope that policymakers reverse course or growth spontaneously emerges to lower the ratio. This doesn’t happen. Society is addicted to debt and the addiction consumes the addict.

  The United States is a particularly difficult case to discern under Eliot’s bang and whimper dichotomy. The United States is the best credit in the world; for that reason alone, it can pursue a nonsustainable debt dynamic longer than other nations. The United States also borrows in a currency it prints. This sets the United States apart from countries like Argentina, which print pesos but borrow in dollars. In that case, a default is easier to forecast, because the decline in hard currency reserves is observable; the local printing press plays no role. The only major economy like the United States in these respects is Japan, which is also highly creditworthy and borrows in a currency it prints—the yen. The Japanese debt-to-equity ratio at year end 2017 was 253 percent, more than double the U.S. ratio. If Japan is the canary in the coal mine of developed economy insolvency, this suggests the United States is far from a bang point.

  Those considering endgame scenarios agree the bang point may not be imminent. This does not mean all is well. The salience of the Reinhart-Rogoff research is not the bang point but the whimper of structural headwinds to growth. Of particular importance to the United States and Japan is their paper “Debt and Growth Revisited” (2010).3 This study focused on developed economies, in contrast to their other work, which included both developed and developing economies. Their main conclusion is that for debt-to-GDP ratios above 90 percent, “median growth rates fall by 1%, and average growth falls considerably more.”4 Importantly, Reinhart and Rogoff emphasize “the importance of nonlinearities in the debt-growth link.”5 For debt-to-equity ratios below 90 percent, “there is no systematic relationship between debt and growth.”6 Put differently, the relationship between debt and growth is not strong at lower ratios; other factors including tax, monetary, and trade policies all guide growth. Once the 90 percent threshold is crossed, debt is the dominant factor. Reinhart and Rogoff are not complexity theorists, yet the emergent nonlinear property they identified through empirical and historical studies is immediately recognizable to a student of complexity. Above 90 percent debt-to-GDP, an economy goes through the looking glass into a new world of negative marginal returns on debt, slow growth, and eventual default through nonpayment, inflation, or renegotiation. This bang point is sure to arrive, yet it may be preceded by a long period of weak growth, stagnant wages, rising income inequality, and social discord—the whimper phase where dissatisfaction is widespread yet no dénouement occurs.

  Research in support of the bang point hypothesis is extensive and convincing. In September 2011, the Bank for International Settlements, sometimes called the “central banker’s central bank,” published research that agreed with the Reinhart-Rogoff thesis that 90 percent debt-to-GDP is a critical threshold beyond which negative effects on growth overwhelm stimulus effects (the report suggests 85 percent). Titled “The Real Effects of Debt,” the BIS study states, “Used wisely and in moderation, [debt] clearly improves welfare.7 But, when [debt] is used imprudently and in excess, the result can be disaster. For individual households and firms, overborrowing leads to bankruptcy and financial ruin. For a country, too much debt impairs the
government’s ability to deliver essential services to its citizens.”

  Another study published by the European Central Bank in 2010, titled “The Impact of High and Growing Government Debt on Economic Growth,” reports the same result.8 That ECB report concludes, “a higher public debt-to-GDP ratio is associated, on average, with lower long-term growth rates at debt levels above the range of 90–100% of GDP.”9

  These BIS and ECB studies on the impact of government debt on growth are sponsored by central banks. This is not research from the fringe of economics; it comes from the heart of the international monetary system. Other respected research reaches the same conclusion. Reinhart and Rogoff may have led the way in this field, but they are not out on a limb. Evidence is accumulating that developed economies, in particular the United States, are on dangerous ground and possibly past a point of no return.

  Neo-Keynesian critics Brad DeLong and Anatole Kaletsky are apoplectic about the Reinhart-Rogoff results. They cling tenaciously to a belief that debt is always and everywhere good policy to stimulate aggregate demand when the private sector is not spending enough. In particular, neo-Keynesians are bitter about government-dictated austerity policies applied in Europe in the wake of the global financial crisis. While G20 leaders agreed in November 2008 that fiscal policy could play a role in helping global recovery, dissent emerged almost immediately. Angela Merkel, chancellor of Germany, saw debt-to-GDP ratios for the Eurozone as a whole rising past the 60 percent level specified in the Maastricht Treaty that created the euro. In some cases, especially Italy and Greece, those ratios were far higher. Beginning in 2011, Merkel slammed the brakes and insisted on cuts in government spending, sales of public assets, and increased tax collections as the price of German and EU help in refinancing existing sovereign debt.