The World Turned Upside Down

John Mauldin
Strange things did happen here
No stranger would it be
If we met at midnight
In the hanging tree.

– Lyrics from the theme song of The Hunger Games
If buttercups buzz’d after the bee,
If boats were on land, churches on sea,
If ponies rode men and if grass ate the cows,
And cats should be chased into holes by the mouse,
If the mamas sold their babies
To the gypsies for half a crown;
If summer were spring and the other way round,
Then all the world would be upside down.

– Lyrics from a 17th-century English folk song entitled “The World Turned Upside Down”

A bull market is like sex. It feels best just before it ends. 

– Warren Buffett
Longtime readers know that I read a wide range of newsletters, articles, and websites every day. There are times when I see patterns in the information flow that are like puzzle pieces begging to be put together. I have been struck in the past few days by the amount of analysis and number of data sets that are all pointing to the same conclusion: There is a bull market in complacency.

Strange things are happening out there. One formerly successful billionaire hedge fund manager after another throws in the towel, sending the money in their funds back to the clients, confessing that they don’t know how to handle these markets. I am reminded of the surrender of Cornwallis to Washington at Yorktown in 1781.
Tradition has it that, as the British surrendered, their band played the old English folk tune “The World Turned Upside Down.”
The inability of so many active funds to find that “edge” that formerly allowed them to produce alpha is quite remarkable. I have written about this phenomenon before, so I won’t go into detail here; but it is the massive move from active to passive funds that is the core of the problem. Passive investing simply allocates among a number of index funds that indiscriminately buy or sell the stocks that are in their indexes.

That means if you buy an index fund for the Russell 2000 (small-cap stocks), not only are you getting the stocks of well-run companies, you are also buying the 30% of the small-caps that have less than zero earnings. And since we’re seeing literally hundreds of billions of dollars moving to passive investing and away from active managers every year, that is a lot of indiscriminate buying. Barron’s estimates that passive investments could make up half of all US equity retail flows in 2018 and 2019, and this calendar year will see the largest ever dollar shift in assets under management from active to passive. Part of the reason is a general move to lower fees, and part is simply that active management has failed to outperform.

Here’s the problem: It is extremely difficult for an active manager to buy the best companies and/or short the worst companies and show much outperformance relative to the passive index funds. No matter how much research you do, no matter how well you know those companies, your research is not giving you an edge over the massive movement to passive investing.

And if you have no edge, you have no alpha. It is just that simple. Personally, I don’t think this is the end of active investing, but the game is going to have to change.
Where Has the Volatility Gone?
I was talking with Ed Easterling of Crestmont Research about the markets, and he asked me if I knew that there have been 39 times since 1990 when the VIX has closed below 10, and that 30 of those times have happened this year. And since the VIX has closed below 10 for the last two days since Ed and I talked, it is now 32 of 41 closes below 10. And 15 of those have been in the last 30 days!

Ed sent me an updated chart last night of the VIX Index through the close of the markets on Friday. Notice that the all-time low of 9.19 was put in on October 5, 2017.
All the previous sub-10 closes occurred in only two periods: Four of them were in the winter of 1993–1994 (around Christmas, which is traditionally a light trading period), and the others were in the winter of 2006–2007, another period of great complacency.

You can’t really draw any conclusions about the next move of the markets, because the VIX could spike to 50 or stay in this low range for a very long time. Essentially, we have trained investors to “buy the dips,” and that mentality removes a lot of volatility. Here is a chart of the VIX since the beginning of the year (from Yahoo Finance):
I got a blitz email tutorial this week from my friend Doug Kass, of Seabreeze Capital, a writer for the and Real Money Pro. He generally puts out two to three short pieces a day with his observations on the markets, and he discusses what stocks he is trading.

I was particularly struck with his observation about the massive – and it truly is massive – short position in the VIX and VIX futures. Look at this chart:
Now, as my friend and fellow Mauldin Economics writer Jared Dillian notes, prior to 2006 it was not possible for retail investors to trade the VIX. Then an ETF was created, and options and futures became available. Prior to that time it was just professionals who could create the effect of the VIX with futures and options trade positioning on the S&P. You almost had to be a pit trader to be able to do it.

Understand, the VIX is a totally artificial construct. It is a derivative of a derivative. In the beginning, around 1993, the VIX basically measured the implied volatility of eight S&P 100 at-the-money put and call options. Let’s go to Investopedia for a quick tutorial:
What is the VIX - CBOE Volatility Index?

VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking, is calculated from both calls and puts, and is a widely used measure of market risk, often referred to as the “investor fear gauge.”

Breaking down the VIX - CBOE Volatility Index

The CBOE designed the VIX to create various volatility products. Following the CBOE’s lead, two other variations of volatility indexes have since been created: the VXN, which tracks the NASDAQ 100; and the VXD, which tracks the Dow Jones Industrial Average (DJIA).

The VIX, however, was the first successful attempt at creating and implementing a volatility index. Introduced in 1993, it was originally a weighted measure of the implied volatility of eight S&P 100 at-the-money put and call options. Ten years later, in 2004, it expanded to use options based on a broader index, the S&P 500, which allows for a more accurate view of investors’ expectations on future market volatility. VIX values greater than 30 are generally associated with a large amount of volatility as a result of investor fear or uncertainty, while values below 20 generally correspond to less stressful, even complacent, times in the markets.

How the VIX’s value is established

The VIX is a computed index, much like the S&P 500 itself, although it is not derived based on stock prices. Instead, it uses the price of options on the S&P 500, and then estimates how volatile those options will be between the current date and the option’s expiration date. The CBOE combines the price of multiple options and derives an aggregate value of volatility, which the index tracks.

While there is not a way to directly trade the VIX, the CBOE does offer VIX options, which have a value based on VIX futures and not the VIX itself.
Additionally, there are 24 other volatility exchange-traded products (ETPs) for the VIX, bringing the total number to 25.

An example of the VIX

Movements of the VIX are largely dependent on market reactions. For example, on June 13, 2016, the VIX surged by more than 23%, closing at a high of 20.97, which represented its highest level in over three months. The spike in the VIX came about due to a global sell-off of U.S. equities. This means global investors saw uncertainty in the market and decided to take gains or realize losses, which caused a higher aggregate equity supply and lower demand, increasing market volatility.
So there you have it. The VIX is simply a way to measure the future expectations of investors regarding the volatility of market prices. And lately, investors have been rewarded for shorting the VIX. It is almost like the experiments you see where rats learn that if they punch a button that they get a grape. Investors have learned that if they short the VIX they make a profit.

Except that now there are so many people on that side of the boat that when the boat starts to turn over, the rush to get the other side is going to rock that boat hard, possibly to the point of swamping it. Doug warns that a 2% or 3% move down in the markets could cause short covering in the VIX that could quickly spiral out of control. Not unlike the “portfolio protection” trade that brought about the 1987 crash.
A Bull Market in Complacency
Peter Boockvar sent me a screen capture from his Bloomberg. The University of Michigan’s Surveys of Consumers have been tracking consumers and their expectations about the direction of the stock market over the next year. We are now at an all-time high in the expectation that the stock market will go up.
It is simply mind-boggling to couple that chart with the chart of the VIX shorts. Writes Peter:
Bullish stock market sentiment has gotten extreme again, according to Investors Intelligence. Bulls rose 2.9 pts to 60.4 after being below 50 one month ago. Bears sunk to just 15.1 from 17 last week. That’s the least amount since May 2015. The spread between the two is the most since March, and II said, “The bull count reenters the ‘danger zone’ at 60% and higher. That calls for defensive measures.” What we’ve seen this year the last few times bulls got to 60+ was a period of stall and consolidation. When the bull/bear spread last peaked in March, stocks chopped around for 2 months. Stocks then resumed its rally when bulls got back around 50. Expect another repeat.
Only a few weeks ago the CNN Fear & Greed Index topped out at 98. It has since retreated from such extreme greed levels to merely high measures of greed.
Understand, the CNN index is not a sentiment index; it uses seven market indicators that show how investors are actually investing. I actually find it quite useful to look at every now and then.

The chart below, which Doug Kass found on Zero Hedge, pretty much says it all. Economic policy uncertainty is at an all-time high, yet uncertainty about the future of the markets is at an all-time low.
At the end of his email blitz, which had loaded me up on data, Dougie sent me this summary:

At the root of my concern is that the Bull Market in Complacency has been stimulated by:

* the excess liquidity provided by the world’s central bankers,

* serving up a virtuous cycle of fund inflows into ever more popular ETFs (passive investors) that buy not when stocks are cheap but when inflows are readily flowing,

* the dominance of risk parity and volatility trending, who worship at the altar of price momentum brought on by those ETFs (and are also agnostic to “value,” balance sheets,” income statements),

* the reduced role of active investors like hedge funds – the slack is picked up by ETFs and Quant strategies,

* creating an almost systemic “buy on the dip” mentality and conditioning.  

when coupled with precarious positioning by speculators and market participants:

* who have profited from shorting volatility and have gotten so one-sided (by shorting VIX and VXX futures) that any quick market sell off will likely be exacerbated, much like portfolio insurance’s role in a previous large drawdown,

* which in turn will force leveraged risk parity portfolios to de-risk (and reducing the chance of fast turn back up in the markets),

* and could lead to an end of the virtuous cycle – if ETFs start to sell, who is left to buy?
The chart above, which shows the growing uncertainty over the future direction of monetary policy, is both terrifying and enlightening. The Federal Reserve, and indeed the ECB and the Bank of Japan, went to great lengths to assure us that the massive amounts of QE that they pushed into the market would help turn the markets and the economy around.

Now they are telling us that as they take that money back off the table, they will have no effect on the markets. And all the data that I just presented above tells us that investors are simply shrugging their shoulders at what is roughly called “quantitative tightening,” or QT. I can understand the felt need by central bankers to “reload the gun” by raising rates so they will have a few bullets left to fire during the next downturn. Though frankly, I think that if they simply left the market to itself, very short-term rates wouldn’t be all that high. I mean, if 30-year Treasuries are still below 3%, what does that tell you about inflation expectations, and what does that tell you about expectations for short-term money market instruments?

Admittedly, the amount of QT this year is rather de minimis. But then it begins to rise quickly. At least two of those on the short list for Fed chair, in their recent speeches, have been critical of the Fed for not raising rates more forcibly; and while they haven’t explicitly commented on the balance sheet, they presumably would be inclined to continue with its reduction.

I simply don’t buy the notion that QE could have had such an effect on the markets and housing prices while QT will have no impact at all. In the 1930s, the Federal Reserve grew its balance sheet significantly. Then they simply left it alone, the economy grew, and the balance sheet became a nonfactor in the following decades.

I don’t know why today’s Fed couldn’t do the same thing. There is really no inflation to speak of, except asset price inflation, and nobody really worries about that. We all want our stocks and home prices to go up, so there’s no real reason for the central bank to lean against inflationary fears; and raising rates and doing QT at the same time seems to me to be taking a little more risk than necessary. And they’re doing it in the midst of the greatest bull market in complacency to emerge in my lifetime.

Do they think that taking literally trillions of dollars off their balance sheet over the next few years is not going to have a reverse effect on asset prices? Or at least some effect? Is it really worth the risk?

Remember the TV show Hill Street Blues? Sergeant Phil Esterhaus would end his daily briefing, as he sent the policemen out on their patrols, with the words, “Let’s be careful out there.”
San Francisco, Denver, Lugano, and Hong Kong

I will be going this week to San Francisco (technically, to Marin County) to visit the Buck Institute, which is the premier aging research center in the world. I have been invited join their Buck Ambassadors Council, which will afford me the privilege of receiving once or twice yearly updates on where antiaging research is going. I will give you a report when I return. Then on November 7 I will be speaking to the Denver CFA Society. A week later I will fly to Lugano, Switzerland, for a presentation to a conference – and I’ll try not to push myself quite so hard on this next trip across the Pond. I will also be in Hong Kong for the Bank of America Merrill Lynch conference in early January.

I will admit to being pretty pumped about the next two days of meetings at the Buck Institute. My host, Lou Gerken (famous local venture capitalist), decided to throw a small pre-meeting dinner for me on Sunday night. We thought eight people would be about the right number. Turns out we are now up to 21, and counting. I’m particularly excited about meeting Aubrey de Grey, whom I have talked with over the years but never met. He is probably the first person I read and then listened to who really began to make me understand the potential for solving the riddles of aging – in what may now be my own lifetime.

I remember talking with Dr. Mike West, CEO of BioTime, about 15 years ago. Like Aubrey, he is aggressively focused on figuring out how to turn back the clock on aging. Fifteen years ago he thought we would be able to do it within 40 years – so sometime in the mid-2040s. Now? He thinks the early 2030s is a given and maybe we’ll get there in the late-2020s. The speed at which the research is piling up and accelerating is simply staggering. Part of that gathering momentum is simply faster computers and artificial intelligence, and part of it is some remarkably good fortune and amazing discoveries.

Eric Verdin and his team at the Buck are literally at the center of the spiderweb of antiaging research in the world. If memory serves, the institute has some 250+ scientists across many disciplines doing research on a wide variety of topics. They freely share their findings with scientists all over the world. Since the institute opened in 1999, they have published over 660 papers. They are working on every aspect of aging, working to find ways not only to prevent some of aging’s effects but maybe also to cure them.

The two-day program I’ll attend is literally packed with researchers who will do TED-type talks on what they’re finding. Your humble analyst will be talking about some of the sociological and economic issues surrounding aging. And serendipitously, my great friend and doctor, Dr. Mike Roizen, will be presenting on how the Cleveland Clinic is helping its staff to get younger – until, as he says, the Buck can take over and do the rest. And with the glaring exception of myself, the presenters are all a who’s who of aging research. As you can tell, I am pumped, because this is one of those topics that I find myself really intrigued by and immersed in.

It is time to hit the send button. The gym is calling, and there are weights that need to be pushed, pulled, shrugged, and lifted. I’ve been training with The Beast for over two years now. We do a lot of work on my shoulders and around the neck area. My neck is literally 1.5 inches bigger now than it was 15 years ago, when I hardly ever did anything in the gym that focused on that part of the body. One of the things I’m going to have to do when I’m in Hong Kong is go to a local tailor and get a bunch of new dress shirts so that I can actually comfortably wear a shirt and tie. Not a bad problem to have, all in all. Have a great week!

Your wondering what will end the complacency analyst,

Turkey and the West Clash, Pleasing Russia and Iran

Ankara’s ties with the U.S. and other NATO allies are badly frayed

By Yaroslav Trofimov
Russian President Vladimir Putin, left, and Turkish President Recep Tayyip Erdogan at a September news conference.
Russian President Vladimir Putin, left, and Turkish President Recep Tayyip Erdogan at a September news conference. Photo: MIKHAIL METZEL/TASS/ZUMA PRESS

ISTANBUL—Here’s one measure of where Turkey stands in today’s world.

Russian and Iranian citizens are free to enter the country without a visa. Americans, following the recent spat over the detention of a U.S. consulate employee, are essentially barred from traveling to their fellow North Atlantic Treaty Organization ally.

The unfolding breakup between Turkey and the U.S. goes far beyond that dispute. It is fueled by increasing frustration on both sides—and is encouraged by countries most interested in such a separation, especially Russia and Iran. Even in the Syrian war, Turkey now has found itself in a new convergence of aims with Moscow and Tehran—and opposing American goals.

“This is the worst it’s been since the independence of the Turkish republic,” in 1923, said Asli Aydintasbas, an Istanbul-based fellow at the European Council on Foreign Relations. “The institutional bond [with the U.S.] is really weakening and the distrust is spilling into business ties, into investment decisions, and even into the NATO framework.”

The freeze isn’t just between Washington and Ankara: Turkey’s relations with key European nations, most notably Germany, have frayed just as badly.

Turkey’s traditional alliance with the U.S. already came under strain during President Barack Obama’s administration. At the time, the U.S. chafed at Turkish President Recep Tayyip Erdogan’s systematic assault on democratic freedoms and civil rights. Turkey, meanwhile, viewed as an existential threat America’s support for Kurdish militias that combat Islamic State in northern Syria.

Following a failed military coup against Mr. Erdogan last year, many senior Turkish officials have also concluded that elements of the U.S. establishment were sympathetic to the plotters’ aims or even actively colluding with the putsch, a claim firmly denied by Washington.

Mr. Erdogan, however, entertained high hopes for a reset under President Donald Trump, who refused to criticize Turkey’s deteriorating human-rights record. These expectations seemed to be validated as recently as Sept. 21, when Mr. Trump proclaimed at a meeting in New York that Turkey and the U.S. are “as close as we have ever been” and Mr. Erdogan reciprocated by praising “my dear friend Donald.”

President Donald Trump shook hands with Turkish President Recep Tayyip Erdogan in New York in September.
President Donald Trump shook hands with Turkish President Recep Tayyip Erdogan in New York in September. Photo: SHEELAH CRAIGHEAD/PLANET PIX/ZUMA PRESS

Such optimism, however, belied the accumulating poison in the relationship. In Syria, instead of reversing course as Ankara had expected, the Trump administration essentially doubled down on the Obama policy of arming and backing the YPG Kurdish militia that Turkey considers a front for the Kurdistan Workers’ Party, or PKK, a group that seeks to carve out a Kurdish state in southeastern Turkey and that is considered terrorist by Washington and Ankara alike.

Ankara was also upset with the detention of Reza Zarrab, a Turkish-Iranian businessman with ties to Mr. Erdogan who has been charged in New York with violating sanctions against Iran, and with the continuing presence in Pennsylvania of Fethullah Gulen, the Islamist preacher whom Turkey wants extradited for allegedly masterminding last year’s coup attempt. Both men have denied wrongdoing.

American officials, meanwhile, were frustrated by the yearlong detention of Andrew Brunson, an American Christian pastor whom Turkish officials have accused of links to the coup. Mr. Brunson has denied the charges. The U.S. officials were particularly horrified by recent Turkish suggestions of swapping Mr. Brunson for Mr. Gulen or Mr. Zarrab.

All of this, combined with uproar over the allegedly violent behavior of Mr. Erdogan’s bodyguards during his visit to Washington in May, has cemented a growing perception inside the administration—and Congress—that attempts to mollify Turkey have become increasingly pointless.

“Ankara has few, if any, friends in Washington now,” said Steven Cook, a Turkey expert at the Council on Foreign Relations in Washington.

The detention of the U.S. consulate employee helped ignite the latest conflagration.

“The arrest has raised questions about whether the goal of some officials is to disrupt the longstanding cooperation between Turkey and the United States,” said the U.S. ambassador to Ankara, John Bass. The tit-for-tat visa issuance suspension means that only a small number of Americans with pre-existing Turkish visas can enter the country. U.S. citizens were until now able to get Turkish visas on arrival.

Ever since last year’s coup attempt, Turkish officials favorable to continuing cooperation with the West have been warning about the rise of the ultranationalist “Eurasianist” faction, particularly inside Turkey’s security and military establishment. This current, expounded by its main ideologue Dogu Perincek, a Turkish politician, seeks to reposition Turkey into a new “Eurasian” civilizational alliance with Russia, China and Iran—and to break off traditional bonds with West.

That breakoff intensified as Mr. Erdogan declared that the U.S. consulate in Istanbul was “infiltrated by spies,” and, in a fiery speech Thursday, warned the U.S. that if America doesn’t respect Turkey, “then we don’t need you.”

In a separate case this week, a Turkish court declared a Wall Street Journal reporter guilty of engaging in terrorist propaganda through one of her Journal articles. The Journal condemned the move and the reporter plans to appeal the decision.

“This was an unfounded criminal charge and wildly inappropriate conviction that wrongly singled out a balanced Wall Street Journal report,” said Wall Street Journal Editor in Chief Gerard Baker. “The sole purpose of the article was to provide objective and independent reporting on events in Turkey, and it succeeded.”

It is hard to see what avenues still exist for defusing the tensions between Washington and Ankara. The fates of Mr. Zarrab and Mr. Gulen are “judicial issues the U.S. government has no say in,” said James Jeffrey, a former American ambassador in Turkey. “President Erdogan’s advisers are misleading him if they think otherwise.”

Things are likely to get even worse in the foreseeable future, added Sinan Ulgen, head of the Edam think tank in Istanbul and a former Turkish diplomat. “There is no clear path to de-escalation,” he cautioned, “and therefore we will likely find ourselves on the path to escalation.”

The Global Stock Market’s Hidden Juice

Rising margin lending from Swiss and U.S. wealth managers can make a downturn far more painful

By Paul J. Davies

Loans secured against marketable securities

One common sign of trouble ahead is people borrowing heavily to buy equities.

Investors should be worried then that stocks are being supported by record amounts of margin debt, according to research released last week from the Bank for International Settlements, the Switzerland-based central bank for central banks.

These kinds of loans secured against stocks have often proved dangerous in a downturn because when share prices fall borrowers are forced to sell.

In the U.S., margin debt is more than three-times the level ahead of the 2008 crisis and is greater even than its peak in 2000 before the dot-com crash, according to the B.I.S.

However, lending volume alone isn’t a clear indicator of risk because equity values have increased, too. In the U.S. at least, lending as a share of market capitalization has been relatively steady for the past four years, most recently at 2.12%. But that level is much higher than the period before 2007 and above even the dotcom-era peak of 2.05%.

Swiss private banks, which have among the biggest and most international margin lending operations, have grown this business significantly. Credit Suisse has doubled its volume since 2006 to about $42 billion, while Julius Baer’s has grown by five-times to $24 billion, although it got a big boost from its takeover of Bank of America-Merrill Lynch’s international wealth business in 2013.

UBS with about $92 billion, has also seen strong growth, but an accounting change in 2012 makes it hard to say exactly how strong.

While overall growth appears to have slowed, that is partly due to a decline among Asian investors in 2015 and 2016, which is masking continued strength elsewhere.

Total in U.S. stocks trading accounts, a negative number means they are in debt (2000-2017)

The Chinese market crash in 2015 shattered investor confidence across Asia, according to bankers. But while Asian lending went backward, U.S. loans continued to grow, including at Morgan Stanley , Bank of America Merrill Lynch and UBS’s American wealth arm.

Rich clients’ desire to borrow against stocks has been stoked by the low interest rates and rising stock markets. It is attractive for banks, too. Lending against shares is seen as less risky than mortgages because stocks can be sold more quickly than a house, so banks can hold less capital against margin loans. Also, if the borrowed money is invested with the bank, rather than spent on yachts or cars, that boosts assets under management.

Margin lending at the New York Sock Excahnge as a share of market capitalization (1992-2017)

The banks themselves all say that while lending looks high, their own approach is conservative and the general competition for clients is less aggressive than in the past. But neither the banks nor their investors have a full view of leverage across the system and the risk that may pose.

Equities have to fall 20% to 30% before margin loans are underwater. That protects the banks, but doesn’t stop a wave of selling to repay debt when a downturn comes. That could spell real pain for everyone else.

Time spent thinking about the next financial crisis is not wasted

Crises have increased in frequency, but do not flee risky assets

by John Authers

The generation that now includes key decision-makers in finance and investment has experienced several huge financial bubbles © iStock

We are all prisoners of our own experience. For me and the people of my generation who now tend to make the key decisions in finance and investment, our experience has included several huge financial bubbles and crises in the western world, and an unprecedented range of crises in the emerging world.

Does that mean that we spend too much time thinking about potential future crises?

The markets research team at Deutsche, led by Jim Reid, think not. This week they produced the latest edition of their annual long-term assets survey, and devoted almost all of it to “The Next Financial Crisis”.

It is an enormous and excellent piece of research, from which I will try to gloss the most interesting points. First, the era we live in does indeed have more financial crises than those that went before. This is true globally, demonstrated with a welter of statistics, and there is a clear point at which the crises began to accumulate — August 1971, when President Richard Nixon brought the Bretton Woods agreement to an end, ending the tie of the dollar, and ultimately most other currencies, to the price of gold.

Before this point, gold had in real terms lost an average of 1.5 per cent each year since 1900.

Since the end of Bretton Woods, it has averaged a return of 3.7 per cent. The equivalent figures for US equities are 6.4 and 6.2 per cent.

Meanwhile, the authors hold that the move to currencies backed by governmental fiat rather than the supply of gold being extracted from the ground has enabled a build-up of debt without parallel. Their global estimate for the total amount of stimulus in the decade since the crisis, which combines extra money printed plus widening of government budget deficits, is $34tn.

Leaving the straitjacket of the gold standard (and they do not advocate a return), has at least given governments the option to deal with a crisis by injecting new money, and they have taken it.

In a system that has grown prone to crises, and with unprecedented debt, that is enjoying its longest lull in two decades, the chances of a future crisis are overwhelming. I cannot dispute this argument.

But perhaps the most alarming part of Deutsche’s study is the sheer range of possible triggers for the next crisis that they mention. It could be driven by; an economic recession (which would find governments out of bullets and asset prices exposed); a central bank unwind, as attempts to retreat from extreme stimulus (which the Federal Reserve will start in a very gentle way next month) push up rates and trigger a collapse; deflation, which would bring more monetary stimulus and more negative rates, and finally force a banking collapse; stretched asset prices, in which obviously overpriced equities and bonds would at last begin to collapse under their own implausibility; or a lack of financial market liquidity, as trading has steadily evaporated particularly in corporate bonds, allowing relatively minor sales to magnify into a catastrophic fall.

If you want more specific trigger points, Mr Reid and his team mention Italy (a big and heavily indebted economy with a stricken banking system and an unpredictable election upcoming); China, which still has deep financial imbalances with the west, and where the rate of debt growth post-crisis appears unsustainable; Japan, which has been in a demographically driven slump for decades, but where the Bank of Japan’s huge balance sheet now adds a greater dimension of risk; and Brexit, which could endanger the financial and defence architecture of Europe. Then there is the risk of populism everywhere. Take your pick.

What conclusions should investors draw from this?

The first point, I think, is that the sheer range of disaster scenarios shows that the experts at Deutsche simply do not know what will happen next. Several of their scenarios are mutually contradictory. They have shown that the status quo cannot be sustained indefinitely; they have not shown how long it will last or how it will end. They are not alone; there is a lack of historical precedent. We should all work on the assumption that we do not know what will happen next.

On that basis, it would be an unacceptable risk to get out of risky assets altogether. Putting all your money in cash, if you need your nest egg to grow, is in some ways as risky as putting it all in stocks. You could miss out on that one great spurt of growth in the stock market that would have enabled you to fund your pension, pay for your kids’ university education, or whatever.

And as the risks spread from Italy to China with many points in between, it would be wise to stay diversified.

Second, however, Deutsche have made clear that a crisis is coming, and therefore it is imperative to prepare for it. That might mean gold and precious metals — but they can be hard to trade in some circumstances and would do badly under deflation.

The wisest course is to carry rather more cash than you usually would. Cash itself could be endangered in some Armageddon scenarios. And if the equity rally continues a while longer, which it well might, it means reducing your gains — although you will still have gains.

But the point is that it gives you optionality. It is easy and costless to get out of it and move into something else in a hurry once the shape of the crisis begins to grow clear. Best to be prepared.

The Blockchain Is the Internet of Money

Silicon Valley visionary Balaji Srinivasan explains how bitcoin works and why he regards it as revolutionary.

By Tunku Varadarajan

Balaji Srinivasan’s distrust of authority began as early as first grade, when boys less cerebral than he was would beat him up at recess for reading a book. “Literally, like, ‘Oh, look at that nerd,’ and they’d go attack you.” That was in 1986, in Plainview, N.Y., an undistinguished Long Island hamlet where his parents, immigrants from South India, worked as physicians.

“Being the only brown kid among hundreds of people, lots of kids would gang up on you and call you ‘ Gandhi, ’ and you could say, ‘It’s not an insult,’ and run, but they’d just chase you.”

Mr. Srinivasan is now 37 and an eye-catching innovator in the world of digital currency. “I learned that the first guy who comes at me, I need to hit him—Bam!—with the book, and just act crazy so the other folks don’t jump on you.” Later, at the principal’s office, the assailants would have “crocodile tears” about how the little Indian boy had started the fight. “Their parents knew the principal,” Mr. Srinivasan recalls. “He’d say, ‘Balaji, why did you attack young Jimmy and Jamie?’ So, I learned early on that you’ve got to stand up for yourself, that the fix is in. . . . The state is against you.”

That experience informs his current work. Mr. Srinivasan has called the stateless digital currency bitcoin “the most important technology of the decade.” I ask him to explain why, and he says, in fact, that he’s amped up the description. “I’d update that today,” he tells me, “to say that the blockchain—which is not just bitcoin—is the most important invention since the internet.” My eyes widen, and he says: “Yep. I’m not sure if that’s consensus among Silicon Valley now, but it’s getting there.” The “blockchain,” he will explain, is like the internet of money—with similar decentralizing and liberating potential.

Mr. Srinivasan, who describes his school years as “completely wasted,” founded his current company,, in 2013 with $115 million in seed money from Silicon Valley’s leading venture capitalists. Plainview is now, mercifully, out of sight. “Life in the United States starts with a 13-year mandatory minimum K-12.” Mr. Srinivasan calls it the “school-ag archipelago,” an awkward pun on the Solzhenitsyn tome about Soviet prison camps. He has a 1-year-old son, whom he will not send to school. Instead he plans to band together with like-minded parents from the tech world and “crowd-fund a tutor.”

With his ill-fitting sweatshirt and sweetly inexpert haircut, Mr. Srinivasan doesn’t look much older than a schoolboy. One would be inclined to think of him as a typically arrogant tech-meister were he not so earnest and amiable. In 2006, immediately after earning a doctorate in electrical engineering at Stanford, he co-founded a genetic testing company, which was “conceived in a dorm room.” He was on President Trump’s shortlist to lead the Food and Drug Administration before ruling himself out for the job, and he has courted controversy by calling for Silicon Valley to “exit” from as much government control as possible. He has, in the past, invoked the notion of the “inverse Amish,” a society that “lives nearby, peacefully, in the future,” where “we can experiment with new technologies without causing undue disruption to others.”

Some of Mr. Srinivasan’s views were distorted in news reports, with the now-defunct Gawker describing him as a “secessionist” (and, for good measure, as “bats— insane”). With evident distaste, he describes the Gawker story as “fake news, avant la lettre,” and notes: “Last I heard, they’d been sued into bankruptcy by profiting from revenge porn. Bitcoin is at $4,000, and Gawker is dead.”

Mr. Srinivasan’s present company enables people to be paid in digital currency for replying to emails. It cost me $20 to reach him, payable upon his response, which was almost instant. We met for lunch at his office earlier this week.

“Initially, and in the near future, is like a better version of LinkedIn InMail,” Mr. Srinivasan says. “Senders attach digital currency to messages to pay people they don’t know to reply.” That’s better than LinkedIn, he suggests, “because users are actually paid to reply, senders can mass-message people, and they can send complex surveys to people rather than just simple emails.” The ultimate goal is to facilitate paid work: “Anywhere there’s a phone, there’s a job. You just pick up a phone and whatever your skills, people will send you digital-currency-based jobs. You can click buttons and make money anywhere in the world.”

When I ask him to explain the “blockchain,” Mr. Srinivasan starts to roll with relish. “Short version? Bitcoin is a way to have programmable scarcity. The blockchain is the data structure that records the transfer of scarce objects.” I ask him to regard me as a dummy, and to give me the longer version.

We can understand bitcoin and blockchain in four steps, he says. “One, cash. When A gives a dollar bill to B, he’s transferring a physical object. B has it, and A no longer does. There’s implicit scarcity in the physical world.”

Step 2 supposes that we treat the serial numbers on those Federal Reserve bills as “a form of naive digital cash. Then A emails those numbers to B. Now B has a copy. But A still has a copy!” So if those serial numbers were treated as cash, A can “double-spend” the numbers by sending them to another party, C. This, Mr. Srinivasan says, is the fundamental issue with digital cash: “the double-spend problem. How do we introduce scarcity into the digital system?”

The way we resolved this problem before bitcoin, Mr. Srinivasan explains in his third step, “was through the use of centralized institutions called banks. Whenever you use PayPal or a similar technology to send money from A to B digitally, the bank is trusted to debit A and credit B.” This, he says, is how “scarcity” is introduced into a digital system; but it is “inelegant, from a computer-science perspective, to have a central, trusted node in any networking topology”—a word my dictionary defines, in this context, as being the way in which constituent parts are interrelated or arranged.

Mr. Srinivasan doesn’t care for this arrangement: “There are downsides to implicitly trusting banks, as the 2008 financial crisis showed.” So rather than require a bank to approve transactions, “Bitcoin figured out how to split this power across many different transaction approvers, called ‘miners.’ ” They “compete to approve transactions and integrate them into the so-called blockchain. Every time they integrate a new block of transactions into the blockchain, they receive a ‘block reward’ and are entitled to print digital currency.” The key point, he says, is that any computer could, in theory, approve transactions, and no single computer could block transactions.

Mr. Srinivasan concedes it’s “a big claim” to say the blockchain is the most consequential technology since the internet. “The internet is programmable information. The blockchain is programmable scarcity.” He elaborates: “All of these previously disparate things—from physical mail to television to music to movies to telephony—basically got turned into packets of information and got remixed by the internet. Plus things that we normally didn’t even think of as information—your Fitbit , your steps, your Facebook settings—became programmable.” It’s fair to say, he continues, “that the internet and all things downstream—search engines, social networks, ride sharing, and so on—have basically been the technological story of the last 25 years.”

The blockchain is the next phase, Mr. Srinivasan says with some zest. “With the blockchain, everything that was scarce now becomes programmable. That means cash, commodities, currencies, stocks, bonds—everything in finance is going to be transformed, and aspects of finance baked into everything else.” By way of example, Mr. Srinivasan suggests that there could be “a spot market for the cost of storing one megabyte on 1,000 remote computers.” He then offers a slogan for the new age: “If you deal with information, you need the internet. If you deal with money, you need to deal with blockchains.” Pretty much everyone, he adds, deals with information and money.

The blockchain, Mr. Srinivasan continues, “is a religion that works.” Here’s why: “If you take 10,000 people and put them in a circle and they close their eyes hard and say, ‘Let this plane fly,’ it’s not going to fly. But if they close their eyes hard and say, ‘Let this thing have value,’ and they all value it, they’ve suddenly got a price for it.” They will exchange things of economic value among themselves, and the external world can interact with them. “In the same way that once you’ve got enough people, you’ve got a nation, you’ve also got a currency. So, belief is actually something you can now materialize into currency.”

I steer our conversation, here, toward China, where the government has cracked down hard on digital currencies, banning citizens from exchanging them online. Is this the first major blockchain crisis? Mr. Srinivasan ponders the question before noting that “the Chinese government is actually run by engineers. Hu Jintao was an engineer, as is Xi Jinping. One of the things they do in China is that they actually give seats in government to folks who are successful in technology.”

He tells me—“not necessarily in an admiring way”—that there are “probably not many people in the U.S. government who could explain to you exactly what a ‘firewall’ is, but that’s a fundamental instrument of policy in China.” Chinese politicians, he says, are more conversant with the long-term implications of information technology than their American counterparts.

But what does China’s crackdown on bitcoin mean? Mr. Srinivasan believes that Beijing is doing something similar to what it did when it deployed the so-called Great Firewall in the early 2000s. “It wanted the internet, but it wanted a controlled internet.” It now has a vigorous and competitive Internet economy, with Alibaba, Tencent and Baidu, “but it also takes measures that Western societies would not, in terms of explicit internet censorship.”

If the Chinese government wants the benefits of the blockchain “without the decentralization of bitcoin,” Mr. Srinivasan says, “we might see a ‘Great Blockchain of China’—perhaps a ‘Chinacoin’ issued by the People’s Bank of China.” It may seem too early for “something of that magnitude” to happen, Mr. Srinivasan says, “but sometimes the future happens more quickly than we expect.” An interesting question, he adds, “is whether this ‘Chinacoin’ would just be directly pegged to the renminbi, as seems most likely, or whether it would be freely floating like bitcoin.”

A more plausible short-term alternative, in Mr. Srinivasan’s view, may be that “the Chinese government asserts its jurisdiction over the Chinese miners who provide most of the world-wide mining capacity of bitcoin and Ethereum,” the latter an open-source blockchain-based platform. Mr. Srinivasan imagines a “cat-and-mouse game would likely ensue, after which the Chinese government would gain control of a fork of bitcoin and Ethereum chains, but the rest of the world would fork to different versions of those chains.” The Chinese government could even attempt a hostile takeover of bitcoin.

Mr. Srinivasan is confident, however, that the protocols that sustain a decentralized, global digital currency will weather a crisis of this sort. “This is the kind of test these protocols were built for. If they survive, which I think they will, then we’ve proven something amazing.” We’ll have proven, he says with a smile, “that there’s now a new kind of digital asset which even a very technically competent and motivated government cannot seize.”

Mr. Varadarajan is a fellow in journalism at Stanford University’s Hoover Institution.

Up and Down Wall Street

Dow 1,000,000

Warren Buffett predicts that the benchmark will hit that number by 2117. That’s a modest goal, but one that could be difficult to reach.     

By Randall W. Forsyth 

Jemal Countess/Getty Images for Time Inc.
“It’s tough to make predictions, especially about the future,” Yogi Berra supposedly said, as he channeled Niels Bohr, the atomic scientist.

Not so for David Meade, a so-called Christian numerologist who has been predicting that the apocalypse will arrive on Sept. 23, which, if correct, would mean you’re probably not reading this. He based this prediction on prophesies he gleaned from the New Testament, but like any good forecaster, he revised it late last week. “The world is not ending, but the world as we know it is ending,” he said to the Washington Post.

Either way, Meade evidently skipped over the admonition in Matthew’s Gospel, that “you do not know the day or the hour.”

At the other extreme, Berkshire Hathaway’s Warren Buffett offered a far happier forecast last week: The Dow Jones Industrial Average will reach 1,000,000 in a century. Yes, 1,000,000, with six zeros, a seemingly incomprehensible feat, relative to Friday’s close of 22,349.59.

Yet the Sage of Omaha actually was proving Einstein’s purported observation that “compound interest is the eighth wonder of the world.” To reach 1,000,000, the Dow would have to increase at a compound annual rate of just 3.87% for the next century. That moved longtime Barron’s Roundtable sage Mario Gabelli to quip in a tweet, “Has Buffett turned bearish?” In actuality, over the past 100 years, the Dow’s compound annual growth was 5.5%, boosting the index from 95 at the end of 1916 to 20,069 this past January.

That doesn’t take into account the effect of inflation, however. With inflation averaging 3.1%, the Dow’s real compounded annual growth rate was 2.3%, according to the R Street Institute, a free-market think tank.

Inflation over that span meant that at the end of 2016, it took $2,116 to buy what $100 did in 1916, based on Bureau of Labor Statistics data. (As a frame of reference, 1916 was two years after the Federal Reserve began operations.)

Although Buffett’s prediction represents a relatively modest goal for 2117, given the magical math of compounding, the mention of such big, round numbers for the Dow echoes hubristic forecasts that tend to appear around market tops. The most notorious was the book Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market, published in 1999, just before the dot-com bubble burst.

The Dow was supposed to hit that vaunted 36,000 level by 2004. Moreover, the authors asserted, equities were no riskier than riskless government securities, and therefore shouldn’t have any risk premium (that is, the required return over the risk-free interest rate), even though Treasury securities, unlike stocks, come with a money-back guarantee, at maturity, at any rate. Well, we know how that turned out. From a peak of 11,722.98 in January 2000, the Dow plunged to 7286.27 by October 2002, and wouldn’t top the previous high until October 2006.

Buffett’s mathematically modest expectation of a 3.87% compounded annual rate of return is more defensible. Assuming no expansion of the price/earnings ratio—now approximately 18 times expected earnings on the Standard & Poor’s 500 index—stocks should track the increase in corporate profits. That, in turn, should parallel the growth in the U.S. economy.

Assuming 2% inflation, the Fed’s as-yet-unattained target, that means roughly 2% real growth is needed to produce 4% nominal growth. Real growth consists of labor-force increases multiplied by gains in productivity. On the former, the fertility rate in the U.S. has slid below the replacement rate (2.1 children per woman over her lifetime), which limits the size of the labor force without immigration. As for productivity, it remains sluggish, growing at just 0.6% annually since 2011.

Economist Robert Gordon has been a prominent dissenter in projecting the prosperous past of the U.S. into the future. He foresees productivity growth of 1.3%, well below the 2% achieved from 1891 to 2007. In his much-discussed 2012 paper, he concluded that the information-technology revolution of the internet and mobile phones hasn’t brought gains similar to those of the “second industrial revolution” (electricity, the internal-combustion engine, running water and indoor plumbing, communications, entertainment, petroleum and chemicals), which generated robust 20th century economic growth.

In a 2014 follow-up, Gordon added that the U.S. economy faces four headwinds: demographics (baby boomers retiring, plus lower labor-force participation by people of working age); plateauing of educational attainment; growing income inequality; and increasing debt, which will force higher taxes or reduced transfer payments in the future.

In terms of demographics and debt, Japan offers an example. The Nikkei 225 peaked at the end of 1989 at just shy of 39,000, almost twice Friday’s close of 20,296.45. In the 1980s, many predicted that Japan would rule the global economy, just as many expect of China. On the latter score, S&P lowered its rating on China’s sovereign debt last week to single-A-plus from double-A-minus, owing to too-rapid credit growth.

Buffett suggested that it is foolish ever to bet against America. He, along with most Barron’s readers, has been lucky to live through a golden age for the U.S. economy. Perhaps the future will be like the past. Maybe it will be better, maybe it won’t.

Attainment of a 4% nominal growth rate for the U.S. economy, implied by his Dow 1,000,000 prediction, may seem like a modest goal, but we’re falling short of it currently.

Godot has finally arrived. The Federal Open Market Committee last week announced that the long-anticipated shrinkage of the central bank’s $4.5 trillion balance sheet will begin in October.

To review the mechanics of monetary policy, when the central bank purchases securities, it pays for them with money created out of thin air, which then goes into the private economy.
Conversely, when the central bank sells or redeems those securities, the real cash it receives is withdrawn from the economy. So, as the Fed allows its Treasuries and agency mortgage-backed securities to mature, Uncle Sam and his niece, Fannie Mae, and nephew, Freddie Mac, will have to replace those funds in private markets. Some of the $2.2 trillion of excess reserves sloshing around the banking system will probably be taken up in the process, which will still leave a surfeit for some time.

This, however, fails to capture the reality of a world in which money crosses borders freely in search of the highest returns. The Fed isn’t the dominant player around the globe by a long shot, notes Mark Grant, chief strategist of Hilltop Securities. Citing data from Yardeni Research, Grant points out that the People’s Bank of China has the Fed beat with $5.2 trillion in assets, followed by the European Central Bank with $5.1 trillion and the Bank of Japan with $4.7 trillion. The money created by the Fed is no different than that from the Swiss National Bank, the ECB, or the BOJ, Grant observes. And that foreign money heads to American shores for higher returns than its home markets’ sub-1%, or even negative, yields.

Similarly, JPMorgan economist Nikolaos Panigirtzoglou writes, the shrinkage of the Fed’s balance sheet will be offset by the central banks of the other G4 countries. JPMorgan estimates that the Fed will shrink its balance sheet by about a third, to $3 trillion, by 2021. But that will be mitigated by estimated ECB monthly purchases of 40 billion euros ($47.8 billion) of bonds in the first half of 2018, €20 billion in the second half, and no more after that. The BOJ is also projected to buy 60 trillion yen ($535.77 billion) a year.

“The Fed’s cutback is about $300 billion a year, while the other central banks are pumping in $300 billion a month,” as Hilltop’s Grant points out. “The money will go somewhere and, given that American yields are so much higher than those in Japan or Europe, a lot of it will find its way here.”

Jesse Fogarty, who manages U.S. investment-grade corporate debt for Insight Investment, a unit of BNY Mellon Investment Management, remarks that there has been a persistently strong bid for U.S. corporate bonds from global buyers—especially since the ECB began buying European corporates.

Fed Chair Janet Yellen insists that running down the central bank’s balance sheet from its crisis levels should be as uneventful as watching paint dry. While its counterparts abroad continue to expand their assets, the impact of the Fed’s shrinkage should be limited. Yellen also says that the Fed’s main policy tool will remain the federal-funds rate, which the FOMC indicated is on course for another quarter-point hike in December, from the current 1% to 1.25% target range.

In addition, the FOMC has penciled in three more hikes for 2018, based on its so-called dot plots. Less certain is who will be making those calls next year, given that Yellen’s term as chair will be up. In addition, until the Senate confirms Randal Quarles’ nomination, there will be four other vacancies on the seven-member Board of Governors after Vice Chairman Stanley Fischer retires next month.

Perhaps the most important fact to emerge from last week’s FOMC meeting is that the panel further lowered its estimate of the long-term “neutral” federal-funds rate by a quarter-point, to 2.75%. Put together with the dampening effect from foreign central banks on the Fed’s balance-sheet reduction, that points to bond yields remaining lower for longer, which is consistent with a low-growth U.S. economy.