BUBBLES AND BOTTOMS: August 2018

August 2018 - Introduction -

My first Bubbles and Bottoms newsletter was supposed to be a one-off finger on the pulse, showing a macro picture of the current financial state of the three “pillars”; consumers, businesses and governments. It was written without too much industry “lingo” because I felt that even if one does not have a financial or economic background, they should be able to understand the content of the newsletter, as the consequences of the 10 year loose monetary policy by the biggest Central Banks in the world will be felt by every single individual.

However, after receiving a huge amount of positive feedback, I decided to start writing this newsletter on a monthly basis. I will use my first newsletter as a “guide” and will dive deeper into each of the pillars over the next months.

“Consider a turkey that is fed every day. Every single feeding will firm up
the bird’s belief that it is the general rule of life to be fed every day by
friendly members of the human race “looking out for its best interests”,
as a politician would say. On the afternoon of the Wednesday before
Thanksgiving, something unexpected will happen to the turkey.
It will incur a revision of belief.”
- Nassim Taleb -

Enough has happened in the past month to write an entire book, but for this newsletter I`ll focus on Turkey and Emerging Markets in general, Tesla, the Chinese Yuan and the “trade war”, millennials, and commodities.

Tesla, and Elon Musk in particular, has made me think a lot about my concept of a bubble, and if there`s any good that can come out of it. Many, if not most, bubbles have resulted in technologies or products that survived the downturn and have made an actual positive change to society in the long term. The Railway Mania, the internet bubble, the United East India company (introducing not only spices to Europe, but also introducing futures contracts, options and short selling to the stock markets), just to name a few, have all created a solid foundation for future use of their products and technologies, even though the “market leaders” during those bubbles often didn`t survive the bear markets that followed.

Which technologies and products have sprung up in the worldwide economic boom of the past decade? There`s 3d printing, drones, affordable mass market electric vehicles, affordable mass market solar panels, peer to peer lending, smartphones and tablets, blockchain, cryptocurrency, and the list goes on. Will all of these technologies and products survive in the long term? Perhaps not, but in the worst case it has still woken up competitors in a similar industry and has forced them to invest more in R&D.
Case in point: Tesla.

Tesla, under the leadership of Elon Musk, has revolutionized the Electric Vehicle industry. Were they the first? Not by a long shot. But they have done something that other car manufacturers couldn`t; they made Electric Vehicles sexy. Tesla`s are fast cars, have an acceleration that is much faster than a regular car, are relatively clean compared to gasoline cars, and are extremely good looking. Did I already mention that they have some of the highest safety ratings, and are semi-autonomous? What is not to love about this car?

The Tesla company could have never existed without access to cheap credit. Period. This now makes me wonder; is cheap credit necessary to boost innovation and create new technologies and products?
Cryptocurrencies are another great example of a technology that wouldn`t have existed without the support of cheap credit, and, perhaps even more interesting, it grew out of frustrations from the housing bubble. In 2009 “Satoshi Nakamoto” started his cryptocurrency out of pure frustration that Central Banks can just print money on demand, and decided to create a currency that does not belong to any single entity, and has a finite supply.
What Satoshi probably didn`t realize, was that a currency might have a finite supply, but there can be an infinite number of currencies with a finite supply! The result? Hundreds upon hundreds of Bitcoin copies, all being hailed as a better version with better technologies. At its peak, all cryptocurrencies combined had a valuation of more than USD 800 Billion. Currently that stands at USD 220 Billion. Hold On for Dear Life!

Enjoy the ride, and don`t forget to stay positive after reading this newsletter, this too shall pass!

Robbert-John Sjollema

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The information contained in this publication is not intended to constitute individual investment advice and is not designed to meet your personal financial situation. The opinions expressed in this publication is that of the publisher and is subject to change without notice. The information in this publication may become outdated and there is no obligation to update any such information.

August 2018 - Bubbles and Bottoms for Consumers -

Millennials, they`re an interesting bunch. They grew up with a computer mouse in their right hand and a phone in their left hand, and despite all these technological advancements compared to their parents, they still don`t manage to earn as much as them. If you`re born after 1980, you have a 50% chance of earning more than your parents. This is in stark contrast to people born during the second world war, who had a 90% chance of earning more than their parents. What has changed?

Firstly, millennials spend more time in school, which is great for their long-term income perspective, but in their early years millennials lose out to their parents. The worst part might be that despite the fact that they earn less than their parents, they are much more confident in the fact that they will become a millionaire: this year, a study by TD ameritrade has shown that 53% of millennials are confident that they will become a millionaire and will retire by the age of 56. Sheer optimism? I`m sure of it, because the same research has shown that on average, they only start saving for retirement at the age of 36…

As shown last month in this newsletter, outstanding student loans have now reached a record level of $ 1.2 Trillion, which also puts a serious dent in their disposable income.

Secondly, today`s average wage, after adjusting for inflation, has the same purchasing power as 40 years ago. This means that despite the higher paychecks, people are not actually earning more. When you look at average hourly earnings, we actually peaked 45 years ago in 1973 when $4.03 per hour would be equal to $23.68 today.

But hey, Consumer confidence is reaching all-time highs so it seems that despite depressed millennial wages and purchasing power that has been stagnant for 40 years, people feel more confident than ever! All hail the multiple credit lines!

Remember the Trump tax cut from last November? Remember that employees were promised higher wages? It`s been 10 months now, and here`s the percentage change in wages compared to corporate profits:

Existing home sales have disappointed last July, with a 0.7% decline, while a 0.4% increase was expected. This is now 4 monthly declines in a row, only last seen in 2013. This comes together with a big drop in consumer home-buying sentiment, as surveyed by the University of Michigan. It is now at the lowest level since 2008. As you can see, a recession comes roughly 1-2 years after this consumer sentiment starts bottoming, so there`s ample time to prepare.

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The information contained in this publication is not intended to constitute individual investment advice and is not designed to meet your personal financial situation. The opinions expressed in this publication is that of the publisher and is subject to change without notice. The information in this publication may become outdated and there is no obligation to update any such information.

August 2018 - Bubbles and Bottoms for Companies -

As I mentioned in the introduction, I think that Tesla has been one of the biggest beneficiaries of the low interest rate policies that have been introduced since early 2009. It has given Elon Musk the opportunity to fund his dreams. Is this a bad way of spending money? That`s the question i`m asking myself all the time. Would you rather have a company that borrows billions and spends it on low quality ride-sharing bicycles (i`m looking at you oBike), or one that spends it on reinventing and optimizing the entire car industry, the space exploration industry and so on? I think it`s very clear that IF equity bubbles and low interest rate policies keep on coming back every decade or so, there should be more people like Elon Musk who put that cheap money to good use, even if his companies would go bankrupt during a reversion to the mean of these interest rate levels. (Or if he would be arrested for trying to hurt short sellers by making false claims).

How messy is the current situation at Tesla right now? There are tons of charts out there, that all tell a great story about all the things that are going wrong with Tesla right now, but I guess the below chart is sufficient for now. If this capital bleeding keeps on going at the current pace, it`s lights out before the end of this year.

I have shown last month that corporate debt is at an all-time high and makes 2000 and 2008 look like a walk in the park. The reason why companies are still able to pay off this high debt, is because it comes with a low interest rate. Before the last bubble, interest rates were 5.25%. Right now, it`s only 1.91%. It then becomes much easier to pay off larger amounts of money. As I asked before, what will happen if interest rates will rise back to a “normal” level of 5%?

Already, rating agencies like Moody`s have analysed that 60% of businesses in the US have a “speculative” rating, also known as “junk rating”. When you look at the debt itself, 56% of it is rated “medium grade”, which is only 1-4 levels above the junk rating. Since 2009, this medium grade debt has increased by about 10% per year, to USD 4.1 Trillion.

So, all this new debt is being used to make investments and increase R&D, right?
Yes, this would normally be the case. It would then result in higher profits, of which some will be put into higher employee wages, some in investments, and some in dividends. However, as shown in the consumer chapter earlier, employee wages have been stagnant for decades, and cumulative investment growth has been at the lowest level than any other economic expansion since the 2^nd world war.

Where does all the borrowed money go to? it seems like most of it is going straight to the shareholders. Back in the day, shareholders would get their yearly dividends as a “reward” for holding a company`s shares, but f or the past 3 decades, this has also been accompanied by share repurchases; companies buy back their own shares (with borrowed money), which props up the value of the remaining shares, and thus creates value for the shareholders.

To give you an idea of the size of this “scheme”: During the 60`s, shareholders would receive roughly 1.7% of the US GDP in dividends and share repurchases. Right now, it`s closer to 4.7% of GDP. That is a difference of roughly USD 570 Billion a year.

All this debt eventually has to be paid back. As shown last month, in 2018 less than USD 100 Billion of junk debt and leveraged loans are being paid back. In 2 years, that number will already increase to USD 250 Billion, growing all the way to USD 600 Billion by 2022, and staying at that level for the next 3 years.

Many companies will not be able to pay off their loans and will ask for refinancing. This refinancing however, will be done at a much higher interest rate, which can then cause a wave of bankruptcies.

“The real danger with debt is what happens if lots of people decide,

or are forced, to pay it off at the same time”

- Paul Krugman -

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August 2018 - Bubbles and Bottoms for Commodities -

I decided to add a commodity section to this newsletter, since there has been a lot of movement in this industry. As shown in the previous newsletter, Commodity indexes versus US stock indexes are at an all-time low, and as a contrarian, this means that it`s a great time to buy! However, the final phase of a bull or a bear market are always the most irrational, and massive swings can take place. Remember, commodities are often very scarce, and it takes effort (capital) to extract it from the earth. With an ever-growing world population (more demand), a growing world economy, and stable inflation rates, one would think that commodities are destined to go up. However, the opposite is true.

A possible explanation might be that commodities are often seen as a “safe haven asset”, because there is a limited supply, and can`t be theoretically printed to infinity like US dollars or Euro`s. The following chart shows that capital flows towards safe haven assets have definitely reached a bottom and are now at all-time lows. It shows a combination of three safe haven assets: Gold, treasuries and the “volatility index”.

The following charts will show a few individual commodities, and the price slaughtering that has been going on over the past months. Will all of these commodities eventually find their bottom, and continue their way up? Without a doubt.

Gold miners have reached a point of capitulation, and operating costs do not justify the current gold pricing. What happens to the price of gold if gold mines start shutting down and output declines? Yup, the prices go up and the whole cycle begins all over again.

Coffee with sugar anyone? Prices have collapsed by 50% in the span of a year. Sustainable? You ask me. Are price declines being reflected in retail coffee and sugar prices? Nope, go check out your local Starbucks and tell me if prices have declined.

There are lots of conspiracies going around when it comes to precious metals, where people claim that big banks have a continuous massive paper short position on metals like gold and silver, which depresses the price. In the meantime, JP Morgan has accumulated a higher amount of physical silver over the past 7 years than the Hunt brothers did back in the day! (they tried to “corner” the silver market in 1979-1980 by buying up one third of the entire world supply of silver and creating an artificially high demand and thus higher silver prices).

It seems like the perfect strategy: depress silver prices by going massively short on the paper market, and then buying the physical silver at a discount. Mind you, there is a big discrepancy between the amount of “paper silver” and physical silver that is being traded every year. Are you ready to get your mind blown?

in 2016, at an average price of $ 17 per ounce, 2275 Billion dollars’ worth of paper silver was traded on exchanges. Only 4.4 Billion dollars were invested in physical silver that year. This means that the paper silver market is 517 times larger than the physical silver market! Looking at these ratios, it becomes easier to see how the physical silver market can easily be manipulated, and how banks can purchase physical silver at a massive discount. The good news is, you can purchase physical silver at a massive discount too!

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August 2018 - Bubbles and Bottoms for Stock Markets -

I delayed the writing of this newsletter to celebrate the official longest bull market in history (3453 days), surpassing the bull market from 1990 until 2000. To be clear, i`m talking about the S&P 500. This bull market has seen a 323% return, and an average yearly return of 16.5%.

The bull market might not be active for much longer though, as it becomes more and more attractive for investors to just hold cash. How does that work? Currently, the dividend yield of the average S&P 500 company is lower than the yield on a 3-month Treasury bill in the U.S.
3-month treasury notes are often seen as “risk free”. So why would any investor (who only cares about their dividends) still risk their money on the stock market, if the risk-free yield is higher?

In a normal market, most stock are either making 52-week highs, or near 52 week lows. But if both occur at the same time, a technical indicator called the “Hindenburg omen” is triggered. There are a few more prerequisites to triggering this indicator, but for the sake of clarity, i`ll stick to the above description. This Hindenburg omen is normally triggered at the end of an uptrend in the market, when many new 52-week highs are registered, but more and more companies can`t keep up with the constant growth and start showing 52-week lows. It is controversial, because often a single trigger of this indicator does not warrant a bearish position for the investor. However, if the indicator gets triggered many times in a certain period of time, a pattern starts appearing:

Looking at this chart, it becomes clear that the Hindenburg omen is triggered many times when a long-term peak starts forming in the markets. Do take note that this chart only goes back about 20 years, and that out of the 3 past spikes (2016, 2008, 2000) only two were correctly predicted to turn a bear market.

“Why did nobody see it coming?”
- Queen Elizabeth, 2008 -

I often hear that bear markets are great buying opportunities, because eventually we will come back to reaching all time highs. But how long can this “eventually” take? It took the Nasdaq-100 16 years (2000-2016) to come back to all time high levels. That`s half a generation! The Japanese Nikkei reached an all time high in 1990, and still, after 28 years, it has only reached a level that is 60% of what it used to be.

Hold on, I forgot to adjust this for inflation...

30-year-old Japanese investors who jumped into the stock market in 1990 and decided to “sit and wait”, are now 58 years old and still have a loss of 75%. I`m not saying that it could happen to the current stock markets in the U.S., but there is always the possibility. Are you financially strong enough to “HODL”, as the poor crypto community would say?

Is it only the U.S. that are currently witnessing massive stock market bubbles? On the contrary. It seems that the entire world is going bonkers, despite the declines in certain emerging markets like Turkey. The total global stock market capitalization compared to the global GDP is close to the all-time highs from the dot com bubble and housing bubble.

"Celebrating the longest bull market ever without mentioning 10 years of

artificial stimulus and intervention is like celebrating Lance Armstrong's

Tour de France record without mentioning doping."
- Sven Henrich -

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August 2018 - Bubbles and Bottoms for Governments -

Turkey has been in a currency crisis over the past weeks. The Turkish lira has dropped more than 30% in a matter of days. Many claim that statements from Turkey`s President Erdogan are to blame, but if you look closer, you can see that there`s more than meets the eye.

Emerging markets have been heavily borrowing U.S. Dollars over the past decade due to the low interest rates that were offered. Now that the U.S. is increasing interest rates, and, even more important, is engaging in Quantitative Tightening instead of Quantitative Easing, it becomes harder and harder for emerging markets to pay back their debt. During the Quantitative Easing period, the U.S. Federal Reserve (FED) was buying up bonds to revive the flow of credit to a shrinking economy. Currently, the FED is doing the exact opposite and is pulling out USD 40 Billion every month from the financial system by letting these bonds mature and not replacing them. This means that the supply of U.S. Dollars is declining, which results in higher demand (from emerging markets) and thus higher prices.

Picture a country that has borrowed U.S. Dollars at 2% interest rates, and also incurs an increase of 2% in the U.S. Dollar against their own currency. They now effectively have a 4% interest rate! When a country faces problems paying back their debtors, they can normally just print more money and the problem is gone. But if this debt is denominated in a currency that is not yours, then your best tool suddenly becomes your worst enemy; the more you print, the more the U.S. Dollar will rise against your own currency!

As you have probably guessed, Turkey is the largest holder of U.S. Dollar denominated debt as a percentage of GDP, coming in at almost 55%.

Some of the countries on this list might still be lucky: they receive lots of U.S. dollars because of their oil exports, or because of their trade surplus with the U.S.

China has the largest trade surplus with the U.S. in the world and has therefore always managed to easily pay off their U.S. denominated debt. This trade surplus has always been seen by the U.S. as an unfair advantage for China, especially because it seems like they control their currency and do not want it to increase against the U.S. Dollar (The economics of supply and demand dictate that when demand is high (trade surplus), prices rise, and the currency appreciates in value).

Donald Trump has now tried to reverse this unfair advantage by introducing tariffs on goods from China coming into the U.S.
China has retaliated not only by also introducing tariffs, but by lowering their currency against the U.S. Dollar. Do remember that the Chinese government is the world`s largest holder of U.S. Dollar reserves: USD 3 Trillion worth. Chinese corporations hold another USD 850 Billion. If China wanted to really retaliate against the U.S., they would sell it all and flood the market with these reserves, consequently crashing the U.S. Dollar. However, this would make their own currency more expensive, and thus crash their own exports. In my opinion they have created the best alternative that one can think of: the Belt and Road Initiative (BRI).

The BRI is giving out loans to 68 different countries to fund infrastructure projects. These loans have largely been in U.S. Dollars, aside from their own currency, the Yuan. This initiative has started 4 years ago but has really kicked off last year. Already, there are a few countries who have trouble paying back their debt. I wonder if any collateral has been given out for this debt? Sri Lanka had borrowed USD 1 Billion from China to finance a port. The port has not been a success, and Sri Lanka couldn`t pay back their debt. In exchange, they offered China a 99-year lease for debt relief.

From a macro perspective, China`s Belt and Road initiative is hugely beneficial in three ways:

They can make use of their U.S. Dollars without devaluing the currency.
They put their own currency on the world map, in the hopes of becoming a reserve currency.
If a debtor can`t pay back its debt, they will just take the collateral (ports, roads, mines) which can fuel their own economy in return.

Will Trump eventually win the trade war? He will definitely claim that he has, but I think China will have many more tricks up their sleeves. My prediction is that they will eventually both lose in this trade war, which will be amplified during the next economic downturn.

I`ll leave you with a great chart depicting the size of the USD 63 Trillion in debt that the governments worldwide have accumulated.

Click to enlarge

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August 2018 - Summary -

Millennials are the first generation to earn less than their parents. This will affect everything from buying their first house, getting their first car, all the way to deciding whether to have 1 or 2 kids, or no kids at all. All of these decisions (or actually non-decisions) impact the economy in a negative way and might create a “lost generation”.

Baby boomers are still leaving the job market in droves, going on their well-deserved retirement. This shift can be clearly seen in the all-time lows in unemployment rates, which is a good thing for millennials. The bad thing is that the labor force participation rate has also gone down, from 67% in 2002, to 63% now. This means that less workers have to pay welfare and pensions for more citizens.

The companies that these millennials work for have amassed record amounts of debt, which has not resulted in higher wages. It has only benefited shareholders; corporate profits distributed to shareholders went from 33% in the 70`s, to more than 70% in the past decade. It pays to be a shareholder!

The downside however is that all this corporate debt eventually has to be paid back, and although the past years have shown record low interest rates, the future rates will be reverting to the mean, which will result in mass defaults.

If you`re a mine operator, chances are that you`re already close to defaulting; most mines are currently operating at a loss, due to the declining commodity prices. This sector has been going through an extremely rough period, despite all the claims from “experts” that populations and incomes are growing, and that commodity prices will rise along with them.

I see a long bottoming process taking place, especially in metals, and expect the prices to rise again soon. Technology has assisted us in finding new resources, and ingenuity has assisted us in removing the need for certain commodities, but eventually the supply of all these commodities is finite, and demand will certainly catch up.

The U.S. stock markets have been on a tear over the past decade, and all signals point to a slowdown in the future. You can already see the dividend yields dipping below the 3-month Treasury bills, which is a strong indication that investors will likely take a step back soon. When looking at the global stock market capitalization compared to world GDP, it becomes clear that not only the U.S. is in bubbly territory, but all the largest stock markets in the world.

Stock markets are a reflection of a nation`s economic health, and this is greatly visible in countries like Turkey, where both the currency and stock market have taken a plunge. Turkey`s debt is mostly denominated in U.S. Dollars, which becomes a problem now that the U.S. Federal Reserve is tightening their balance sheet and lowering the supply of U.S. Dollars, consequently increasing the price of it.

Thank you for reading, and don`t forget to stay positive!

Robbert-John Sjollema

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