What Do Negative Interest Rates Really Mean?

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More and more of my clients are puzzled about the impact of negative interest rates. Some economists believe there is nothing special about negative interest rates, and that their impact will be just “business as usual”.

I disagree. Interest rates are the price of money. When it is negative, money turns free. When money is free, a lot of bad business decisions are made. Profits are sought in levered, and super-levered constructions of obtuse financial instruments, and real capital formation is postponed.

Remember the tower of Babel?

Confessions of An Unrepentant Bear

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For those of you who have not yet discovered the blog, I recommend HedgeEye, a great place to find those market moving early data insights that can make a big difference to your medium term and long term investment strategies.

As we approach the period of summer doldrums in 2016, I cannot help but scratch my head in wonder as the market makes new highs in spite of all the looming signs of a world economy on the precipice of a severe and prolonged decline. This kind of reminds me of the tech boom of the 2000′s, as ridiculous business propositions earned sky-high valuations based on pumped up “eyeball” counts.

Rather than recounting again the myriad signs of trouble on the horizon, I’d like to simply tell my readers : be very cautious. In this video, Mike O’Rourke, Chief Market Strategist at Jones Trading gives a good explanation of what ill winds blow:

Market Warning Signs At All Time HIgh

So what’s a safe strategy in times like these? Check out my recent article on Steepener Bonds written for Seeking Alpha, combined with a long term bearish option hedge.

Hedged Steepeners: True Yield for Difficult Times

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2015 – A Strategy for All Seasons

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Trounce The Market With Less Risk

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Doomsday Revisited

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Have we dodged the bullet? After the near meltdown of the world international economy in 2008, the central banks of the world rallied. Collectively, they went into a frenzy of money-printing, bank underwriting strategies to avert what they felt was imminent doom, the complete and utter collapse of consumer confidence worldwide.

Fast forward 6 years to today. The US is in the first year of a recovery, albeit an excruciatingly slow one. Europe is showing the first signs of life after its near death experience. Japan may be emerging from its 20 years depressionary funk. Only China – the world’s only bright sign in the recent past – is showing worrisome signs.

So can we all now breathe a sigh of collective relief? Did we the dodge the bullet of all bullets?

According to a few very bright authors and researchers, the answer unfortunately is a very emphaptic NO.
With his somewhat cryptic but equally brilliant book “Anti-Fragile”, Nassim Nicholas Taleb has shown just how fragile our global economic system has actually become and how the least little think could create an avalanche of turmoil that could cause a crisis that is unprecedented in world history.

More recently, and somewhat less cryptically, James Rickards takes the analysis a bit further in his recent New York Times Bestseller “The Death of Money”. That book, in dramatically chilling detail, exposes the many cracks in the world monetary system that are becoming visible for those who care to look.

Rather than try to summarize his book, I’ll let the author speak for himself, as he does in this video interview:

Seeking Alpha – 3D Printing

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The Sun Also Rises

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One of the most significant macro-economic issues facing the world economies today are linked to the availability and cost on electrical energy. Many skeptics believe that this industry exists only due to government magnanimity and without those subsidies, could not survive on its own merits.

This view, in my opinion, greatly underestimates the power of exponential growth in technology, which will cause such a dramatic drop in the price of photo-voltaics, power transmission, power storage and energy distribution, that it is almost impossible to fathom it.

As this article by Amory Lovins, in a recent debate on The Economist, clearly demonstrates, we are already at the stage when solar power is coming into its own. Investors who ignore the solar sector may rue the day they did not take note of these trends:

Amory Lovins
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Amory Lovins

Solar photovoltaic cells (PVs) produced about 0.7% of global electricity in 2012 from 100 gigawatts (billion watts) of capacity, wind power 3% from 283GW and other renewables (excluding big hydro dams) about 1.5% from 97GW. Yet many utilities consider these modest sources’ plummeting costs, increasingly competitive prices and swift scaling to pose a mortal threat, or a transformational opportunity, or both.

Solar-cell prices fall 30% with each doubling of cumulative production. They fell at least 30% in 2012 alone. Once $100 per watt, then $10, they are now around $0.60, soon will be $0.40. Already halved “balance-of-system” costs—customer acquisition, approvals, interconnections, installation, wiring, inverter—keep falling too. By adding 30GW, Germany cut installed system costs to half the American average for the same equipment. Yet even at twice the German cost, utility-scale solar power in sunnier American regions has fallen below $70 per megawatt hour (mWh) net of a 30% federal tax credit (smaller than many non-renewables’ subsidies). That’s three times the lowest Mid-Western wind-power price, half the Hinkley Point nuclear price and cheaper than efficient new gas-fired power plants.

Gas prices are rising, and the market value of their volatility adds at least $10-20/mWh. Yet solar power, like wind power, typically sells on 30-year fixed nominal-price (declining real-price) contracts, hedging the gas-price risk. Moreover, solar power on your roof, like most in Germany, avoids a $30-50/mWh delivery cost.

Bloomberg New Energy Finance recently forecast solar power would reach grid parity in three-quarters of world markets in 18 months. Today in 20 American states, private firms install rooftop solar power with no down payment and beat utility prices. As solar costs fall and utility tariffs rise, “no-money-down” could turn to “cash-back”, further speeding adoption. The San Diego utility expects solar output to idle its fossil-fueled power stations on sunny afternoons by 2015-16. And by 2015, China aims to boost its solar power to 35GW—about what the world installs each year.

Solar power increased by 60% a year during 2007-12 because it is a mass-produced manufactured product. In the decade needed to build a multibillion-dollar electricity-generating cathedral, you can build each year a PV factory, making solar cells each year that can produce each year as much electricity as your central station. Thus solar cells are proliferating faster than mobile phones. In poor countries, 1.4 billion people without electricity can sidestep power lines. In all countries, solar power and other equally unregulated products can add up to a “virtual utility”, bypassing electricity companies just as mobile phones bypassed wire-based phone companies. This gives utility executives nightmares and venture capitalists sweet dreams.

In liberalized power markets, wind and solar power are destroying utilities’ traditional business model: competition makes central stations run less and get lower prices. Germany’s wholesale power price has fallen by three-fifths since 2008, and on hot afternoons when electricity is often most valuable and profitable, solar output is greatest. Some wrong-footed utilities and fuel vendors spread disinformation about their renewable rivals—especially about Germany’s impressive successes.

A persistent fiction holds that because PV and wind power are variable, they are unreliable, needing back-up by “24/7″ or “base-load” fossil-fuel and nuclear stations. Actually, those giant stations’ intermittence (unforecastable failures) requires costly reserves so the grid can back up failed plants with working ones. But well-designed renewable portfolios often need less back-up. The grid can offset varying solar and wind output (both more accurately forecastable than demand) by diversifying their type and location, then integrating other renewables (dispatchable whenever needed), flexible demand, and distributed storage in smart electric vehicles and ice-storage air conditioning. Such a portfolio can reliably power the isolated Texas grid with 100% renewables, with no bulk electricity storage and only 5% leftover renewable energy.

As flexible demand and distributed intelligence make the grid more agile, such choreography made Europe’s most reliable electricity (in Germany and Denmark) respectively 23% and 41% renewable in 2012, and in the first half of 2013, Spain’s electricity 48% and Portugal’s 70% renewable. Ignoring such data, flat-earthers still proclaim minuscule renewable potential.

The renewable revolution is accelerating. Half of American and 69% of European capacity added in 2012 was renewable. China, Japan, Germany and India now produce less electricity from nuclear power than from non-hydro renewables, which in 2012 added more Chinese electricity than all nuclear and fossil sources combined. Globally each year, non-hydro renewables win $250 billion of private investment and add more than 80 billion watts, with solar expected to pass wind power this year.

Modern renewables are taking over the market because they have lower costs and risks than fossil or nuclear energy. Together with rapidly evolving energy efficiency, they more than suffice to power the world profitably and resiliently.

Rocky Mountain Institute’s 2011 synthesis “Reinventing Fire” showed how a 2.6-fold bigger 2050 American economy could eliminate coal, oil and nuclear energy and cut natural gas use by one-third, treble energy efficiency, shift from one-tenth to three-quarters renewable supply, emit 82-86% less carbon, make the grid resilient and save $5 trillion—all without internalization, new invention, or acts of Congress, the transition led by business for profit. So far, solar costs have fallen much faster than we assumed. Efficiency and renewables could well save the world, not at a cost but at a handsome profit. We just need to notice what’s happening.

Profit by Predicting The Future?

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The future is not written, so nobody can predict it right? This thought, whether true or false, remains at the core of our understanding of the cosmos and our role in it. Most of us were raised believing in “free will”, which leads us to believe that any human action is possible. The corollary of that thought, of course, is that “nothing is pre-ordained”. And if nothing is pre-ordained, if follows that change cannot be predicted. If change is not predictable, you cannot benefit in your investments by predicting change.

But I reject that conclusion. At the risk of appearing blasphemous, I think the concept of “free will” is very tenuous at best. While we have the impression that we go through life making choices which we are at whim to alter, the choices we make are entirely framed by our past experiences, by the culture passed down from our parents and societies, by our natural environment and by our biology. So these choices are inevitably predetermined to fall within a predictable range of possibilities.

If you accept my contention that most human actions are shaped by our biology, our natural environment, our culture and our life experiences, does that then allow us to predict the future?

Of course not. We don’t have all the relevant data at our disposal – and if we did – we certainly don’t know yet how to factor in all the variables that impact a given process. You may expect the be able to
watch the morning news report tomorrow morning as you eat breakfast, but your electricity could be taken out by a natural disaster you did not foresee. As computer processing advances, our abilities in to study, weight and incorporate more and more variables that impact our lives will grow, but we’ve still got a long way to go.

Despite this caveat, it still makes sense to try anticipate changes, and to weigh how those changes create trends upon which we can successfully make investment decisions. We’ll be wrong at times, but we can hope to be right far more often then we are wrong.

To understand change, we can start by classifying it into three types:

  1. Cyclical change
    • planting and harvesting
    • birth and death
    • day and night
    • tides and phases of the moon
    • seasons
    • migrations
    • stock prices
    • economic recessions and expansions
    • building and real estate activity
    • seasonal sales
    • interest rates
  2. Linear Change
    • aging (of individual)
    • growth of population
    • cell growth and senescence
  3. Exponential Change
    • technological process
    • spread of disease
    • growth of data and knowledge
    • growth of networks

The most difficult part of attempting to predict change is to analyze whether the force or forces under consideration fall into the first or the latter two categories.  Cyclical changes revert in a fairly predictable manner (the bell curve) back to a given starting point, then subsequently swing to its opposite. Linear and exponential changes feature trends that never revert to their starting point.

If a force is found to be guided by cyclical patterns, reaping profit from that takes a careful application of determining when a cycle is likely at its peak or trough and betting (or investing) on the impending reversal. By being patient, one is bound to be right. Thus has Warren Buffett, America’s most successful investor, made his fortune, following his motto: “Be greedy when others are fearful, and fearful when others are greedy.”

Similarly, look for biological roots in cycles and identify how those cycles impact economics. For those thinking that America’s real estate slump is purely a question of greedy bankers and lax regulators, you may want to more closely examine the 5 and 7 year cycles of the adjustable loans granted to home mortgage owners. It is more than coincidence that the boom of 2002 finally burst in 2007 – the same year all those balloon payments started coming due.

Recognizing that cycles exist – and are overpowered by other cycles – adds complexity to these issues, but does not prevent their analysis.  Thus anyone predicting a resurgence of real estate in another 5 to 7 years – a turn of that cycle – would be wise to pay attention to the larger generational cycle : namely how 80 million people are going to retire and downsize their homes due to aging of the population at a time only 50 million new generation X’s step into the markets to buy homes. The laws of supply and demand allow a confident prediction of continued pricing declines.

A trader recognizes cyclical changes and knows how to benefit from them. As Shakespeare wrote: “There is a tide in the affairs of men which, taken at the flood, leads on to fortune.”  A modern-day Wall Street trader might reword that as “sell when the price is overbought on both the stochastic and rsi charts”.

Linear and exponential changes are what bring about the “new” in change, and actually permit progress over time. Identifying those trends accurately  is probably what  distinguishes an  investor from a trader. Finding investments in companies or industries likely to benefit from linear and exponential growth are the essence of successful long term investments.

One of the foremost scientific and literary minds of our time is Ray Kurzweil, who in his book “Approaching the Singularity”,  dissects the forces guiding technological change.  Understanding these forces – the distinction between linear and exponential growth – is actually one of the most difficult processes of human understanding.

Our brain is naturally wired to think things in the future will change at about the same pace as things changed in the past. We have grave conceptual problems dealing with exponential growth.

There is an old fairy tale that perfectly exemplifies this inability to conceptualize exponential growth. The fairy tale starts with a king who is very thankful towards one of his counselors who delivers a simple herbal remedy that saves the kingdom’s livestock from a fatal disease. The king is so thankful that he offers the counselor a castle, or the hand of one of precious daughters or anything the counselor wishes, if it is withing his means to grant. To his infinite surprise, the counselor asks for nothing more than one grain of wheat for the first square on a checkerboard. But for each subsequent square, the king is to double the quantity of grains. Thus 2 grains for the second square, 4 for the 3rd square and so forth.  

The king immediately grants the counselor his wish. Little does he realize, that by the time he’s gotten to the 64th square, he owes the counselor more grain than is produced in his entire kingdom. Such is the power of exponential growth.

This same difficulty of thinking in anything but linear fashion caused the entire American Academy of Sciences to predict it would take 30 years to map the human genome by deploying a majority of scientists to the task. It took scientific maverick, J. Craig Venter,  to understand the impact on genome research of an exponential increase in computer power. Venter confidently predicted he could do it with a small team in one – sixth that time, and one hundredth the budget. The academe of science scoffed at the notion but Venter went on to do just that.

Similarly, today, we repeatedly hear technological experts and investments gurus scoff at the idea that solar power will play an important role in solving energy problems within our lifetimes.  They are once again demonstrating the human brain’s reluctance to accommodate exponential growth.  They are thinking that a technology that represented about 1% of our total energy consumption in 2003 could not possibly make a meaningful difference over the next few decades. What they ignore is the fact that technology improvements are doubling the capacity and halving the costs of solar energy every two years.  Consequently, as pointed out by  Ray Kurzweil in a 2011 University of Florida speech, solar energy will overtake oil-based energy in cost efficiency within 6 years , most likely by the year 2017.

The implications for any investing strategy are obvious: expect the sales of solar energy companies to grow at rates of 35% and more over the next decade.

From there to knowing which solar company to invest in is more difficult, but their is little doubt this will be a dominant industry within the next decade. The stock prices of the leading companies in the sector will increase manifold.

Do you like investing in the automobile sector? If you think people will still be driving cars – and I do – you’d better make sure the car companies you invest in are leaders in electric car technologies.

More and more fields of discipline and human endeavour are being impacted by the digitalization of knowledge. Identify those fields, and you can make savvy investments in industries sure to grow.

Medicine, for example, for years was a field that was labeled a science of discovery. New advances resulted from careful observations and trial and error of the administration of different remedies, some of which proved beneficial and others fatal. Consequently, the advance of knowledge in the medical field was one that grew in a linear fashion.

The advent of the personal computer and the exponential power increases in chip technology changed all that. These gave tremendous impetus to new developments in the fields of microsurgery, biotechnology, drug testing and microphotography, which in turn led to our understanding of the human body as a complex mechanism which responds to the software embedded in our DNA. Having mapped the human genome, we are now not only learning which gene controls which bodily function, but also are able to directly manipulate those genes to affect our health outcomes. As a consequence, medicine itself has now become a field of knowledge growing at
an exponential pace, rather than a linear one.

One simple implication of that, but a far reaching one, is that human longevity will increase at a faster pace than most of us can conceive of. For a middle-aged Americans, their grandparents lived into their late 60′s, parents into their 80′s. They tend to see themselves living into their 80′s and perhaps their 90′s. Yet many of them – due to the rapid pace of scientific advances – will live to be centenarians. Their grandchildren, futurists like Kurzweil claim, will be able to choose to live forever.

An investor today who wishes to successfully invest over the next 10 years must keep the following precepts in mind:

  1. Learn to distinguish the cyclical trends that affect the investment.
  2. Assess when a larger cyclical trend will override a smaller one.
  3. Distinguish between linear and exponential changes, and favor investments that benefit from the latter
  4. Do not ignore our tendency to overestimate the speed of technological change at first, then to grossly underestimate it thereafter.
  5. Finally, realize that the pace of change is increasing constantly, so whole fields of human endeavour will rise and fall ever faster. Yesterday’s burgeoning software giant (Microsoft or Intel ?) quickly can become today’s dinousaur. Conclusion: don’t fall in love with any one company or industry.

Singing The Big Bad Bond Blues

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Hey, can you remember those good old days when bonds were the safest investment around? For over 30 years, right up to the recent 2008 financial meltdown, a good bond allocation provided steady earnings and even long term capital appreciation.

From 1962 to 2011, a portfolio invested in 10 year treasuries yielded an average return of 5.22%, and in corporate bonds an average of 7.24%. ( source:stern.edu.nyu). Since inflation averaged 3.78% during that period ( inflationdata.com), retirees investing in bonds not only generated steady dividends, but in fact could even grow their nest eggs.

This period, often labeled the The Great Moderation, lasted so long some investors have come to think that situation was the norm. They have come to believe bond investments should provide income as well as an inflation hedge.

Two recent academic studies of historical bond returns concluded that this period was a historical aberration, unlikely to be repeated. One study was conducted by the Credit Suisse Global Investments and the other by the London Equity Gilts Study , commissioned by Barclay’s. The conclusions of both were similar. They found that while long term bonds had beat short term bonds by 5.2% since 1982, they had only beat them by 0.8% since 1900. Barclay’s called the period from 1982 to 2007, an “exception”, concluding “hoping bond returns will match the period since 1982 is a fantasy.”

The remainder of this article can be read in our
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