Submitted by Tyler Durden on 02/26/2016 17:30 -0500
So I’m currently teaching applied financial modeling at Marquette University in the beautiful blue collar town of Milwaukee, WI; home of the Harley, the (Miller) High-Life and SummerFest. It’s a great town and a great school. A few years ago the business college brought in a pretty savvy guy called David Krause who then started a program called AIM, where the top finance students actually manage more than $2M. Because of the program’s success US News & World Report ranked Marquette’s finance program 21st in the nation this year. Not bad for a small Jesuit school in the midwest.
Now I mention this because after 15 years in banking, teaching financial modeling has forced me to reacquaint myself with some of the basic tenets of markets and valuation. Such things tend to get lost in the midst of “getting the deal done” and chasing paper profits. This reacquaintance process has been quite illuminating for me and I thought perhaps for others too.
A reminder of what the market actually represents is a good place to start. The stock market is simply an asset with some intrinsic value based on an expectation of future free cash flows to equity holders. Those cash flows are generated from revenues less costs of the underlying companies that make up the market. Let’s use the Wilshire 5000 Full Price Cap Index as the proxy market for this discussion as it is the broadest measure of total market cap for US corporations. It’s level actually represents market capital in billions.
So the market has put a valuation on those expected future cash flows to equity holders (as of today) at around $19.7T (a 55% increase from Jan of 2012) down from around $22.5T (a 77% increase from Jan of 2012) at the market peak last summer. So let’s take a look at the growth in cash flows of US corporations over that same period.
We should expect to find a growth pattern in free cash flows similar to the above growth pattern in the overall market valuation (the Wilshire is a statistically large enough sample to be representative of total US corporations). Let’s have a look…
The above chart depicts corporate free cash flows (blue line) indexed to 100 in Jan 2012. It is obtained by taking the BEA’s Net Cash Flow with IVA and CCAdj adding back depreciation and net dividends and subtracting net capex. (The actual definitions of these can be found here.)
What we find is that while the current valuation of expected future free cash flows to equity holders (i.e. market cap of Wilshire) has increased by some 55% since the end of 2011, the actual free cash flows of US corporations have only increased by 4%.
This becomes a very difficult fact to reconcile inside the classroom. Why would market participants be baking in so much growth when the actual data simply doesn’t support it?
Well there are plenty of potential explanations. For instance, rarely are investors rational. While buy low and sell high is rational investing behaviour, often market euphoria comes at the market top right before a major sell off, leading to a buy high and sell low strategy. Another reason is that the Fed has been providing a free put to all investors for the past 7 years essentially significantly reducing naturally occurring risk factors. But whatever the reason this dislocation between expected and realized growth begs the question, how long can it last? So let’s explore this issue.
Below is a longer term growth chart of the Wilshire vs US corporate free cash flows to equity holders both indexed to 1995 (i.e. 1995 = 100).
And so over the past 20 years we’ve seen this same type of dislocation three times. That is, we see expectations of growth far exceeding actual growth of free cash flows to equity holders. In the previous two dislocations we reached a peak dislocation (peak stupidity) followed by a reversion to reality (epiphany) where expected growth moves back in line with actual growth. Let’s have a closer look at specific indicators as to when the epiphany takes place.
What we find is that the epiphany trigger occurs when YoY growth of free cash flows to equity holders drops down to or below zero. The last two bubbles began their burst when medium term moving average of free cash flows dropped to zero. We see the very same pattern occurring presently. Today we appear to have just passed the peak stupidity inflection point as seen in the two charts above.
But let’s be sure not to ignore the technical patterns, so let’s do some charting. If we look to volatility and price level patterns between our current market and the last bubble cycle (credit crisis) we find incredible similarities.
The above chart depicts weekly high vs low intra-week price spreads and price level. What we find is that at this point in the last bubble cycle we had a period of reduced volatility (small green box in 08) that followed a period of increased volatility as the market slowly rolled over. Today’s bubble is just entering that period of reduced volatility following the period of increased volatility as the market rolled over.
And so what should we expect from here?
Well the fundamental charts above suggest we have significantly overvalued growth expectations and historically those over-inflated expectations can drop very sharply back in line with actual growth. So from a fundamentals perspective we should expect a significant drop in overall valuations (i.e. market cap).
And from a technical perspective, if we are in fact following the previous bubble cycle pattern (which we seem to be), we should expect a nice bounce in price level from the recent lows (to perhaps somewhere between 2000 – 2030) accompanied by relative calm before an explosion of volatility and a market price plunge that sends us into the next crisis sometime around May (give or take). Happy trading!
Hypocrisy Defined: Hank Paulson Tells China “Let Failing Companies Fail”
Submitted by Tyler Durden on 02/26/2016 20:35 -0500
“Do as I say, not as I do” is the clear message of hypocrisy spewed forth by former US Treasury Secretary Henry Paulson this week. Having presided over the largest redistriubution of taxpayer funds to bailout the banking system, while exclaiming fire and brimstone should they not be saved, he now has some advice for an over-levered, over-capacity, systemically-stymied China – “let failing companies fail.”
Some other Paulson comments:
“As Americans, we shouldn’t like bailouts. Where I come from, if someone takes a risk and they’re going to make the profit from that risk, they shouldn’t have the taxpayer pay for the losses.”
“If the financial system collapses, it’s really, really hard to put it back together again.”
“What I’ve said repeatedly is, ‘I think the auto industry is a very important industry.‘”
But for China – screw them all…
“They can show right now they’re very serious about dealing with inefficient state-owned enterprises as they take capacity out of the steel industry, coal industry and others by letting some failing companies fail,” Paulson told CNBC’s Squawk Box on the sidelines of an Institute of International Finance event organized in conjunction with the G20 meeting in Shanghai.
Of course this is exactly what China ‘should’ do – just as America ‘should’ have faced up to its own malinvestment boom, dealt with the bust, and moved on to renewed growth. But that would have meant the elites lost, and that can never happen.
Just remember, risking US taxpayer money to fill a bottomless pit of bank balance sheets was “for your own good.”
How The Seeds Of Revolution Take Root
Submitted by Tyler Durden on 02/26/2016 20:10 -0500
That the dramatic upheavals of war, pestilence and environmental collapse can trigger social disorder and revolution is well-established. Indeed, this dynamic can be viewed as the standard model of social disorder/revolution: a large-scale crisis—often a bolt-from-the-blue externality—upends the status quo.
Another model identifies warring elites and imperial meddling as a source of revolution: a new elite forcibly replaces the current elite (known colloquially as meet the new boss, same as the old boss) or a dominant nation-state/empire arranges a political coup to replace the current leadership with a more compliant elite.
A third model was described by David Hackett Fischer in The Great Wave: Price Revolutions and the Rhythm of History. By assembling price and wage data stretching back hundreds of years, Fischer found that cycles of economic growth spawn population growth, resulting in more workers entering the market economy. Their earnings trigger a demand-driven expansion of essential commodities such as grain and energy (wood, coal, oil, etc.).
In the initial phase, wages rise and commodity prices remain stable as supplies of essential goods expand and the demand for labor pushes up wages.
But this virtuous cycle reverses when the supply of essentials no longer keeps pace with rising population and demand: the price of essentials begin an inexorable rise even as an oversupply of labor drives down wages.
Fisher found that this wage/price cycle often ends in transformational social upheaval.
While proponents of these models have a wealth of historical examples to draw upon, these models miss a key factor: the vulnerability or resilience of the nation-state facing crises.
Some nations survive invasions, environmental catastrophes, epidemics and inflation without disintegrating into disorder. Something about these nation’s social/ economic /political order makes them more resilient than other nations.
So rather than accept the proximate causes of disorder as the sole factors, we should look deeper into the social order for the factors behind a nation’s relative fragility or resilience.
The Decline Of Shared Purpose
Historian Peter Turchin defined a key factor in the resilience of the social order as “the degree of solidarity felt between the commons and aristocracy,” that is, the sense of purpose and identity shared by the aristocracy and commoners alike.
As Turchin explains in War and Peace and War: The Rise and Fall of Empires:
“Unlike the selfish elites of the later periods, the aristocracy of the early Republic did not spare its blood or treasure in the service of the common interest. When 50,000 Romans, a staggering one fifth of Rome’s total manpower, perished in the battle of Cannae, the senate lost almost one third of its membership. This suggests that the senatorial aristocracy was more likely to be killed in wars than the average citizen…
The wealthy classes were also the first to volunteer extra taxes when they were needed… A graduated scale was used in which the senators paid the most, followed by the knights, and then other citizens. In addition, officers and centurions (but not common soldiers!) served without pay, saving the state 20 percent of the legion’s payroll…
The richest 1 percent of the Romans during the early Republic was only 10 to 20 times as wealthy as an average Roman citizen.
Roman historians of the later age stressed the modest way of life, even poverty of the leading citizens. For example, when Cincinnatus was summoned to be dictator, while working at the plow, he reportedly exclaimed, ‘My land will not be sown this year and so we shall run the risk of not having enough to eat!'”
Once the aristocracy’s ethic of public unity and service was replaced by personal greed and pursuit of self-interest, the empire lost its social resilience.
Turchin also identified rising wealth inequality as a factor in weakening social solidarity. By the end-days of the Western Roman Empire, elites held not 10 times as much wealth commoners but 10,000 times as much as average citizens.
Wealth inequality is both a cause and a symptom: it is a cause of weakening social resilience, but it also symptomatic of a system that enables the concentration of wealth and power in the hands of the few at the expense of the many.
Diminishing Returns On Complexity & Expansion
Thomas Homer-Dixon’s excellent book The Upside of Down: Catastrophe, Creativity, and the Renewal of Civilization outlines two systemic sources of increasing fragility: diminishing returns on complexity and the rising costs of continuing strategies that worked well in the past but no longer yield positive results.
Successful economies generate surpluses that are skimmed by various elites to support new layers of complexity: temple priests, state bureaucracies, standing armies, etc.
All this complexity adds cost but beyond the initial positive impact of rationalizing production, it reduces productivity by draining potentially productive investments from the economy.
Building temple complexes and vast palaces for the aristocracy appears affordable in the initial surge of productivity, but as investment in productivity declines and the population of state dependents expands, surpluses shrink while costs rise.
Meanwhile, strategies that boosted yields in the beginning also suffer diminishing returns. Conquering nearby lands and extracting their wealth paid off handsomely at first, but as the distance to newly conquered territories lengthen, the payoff declines: supplying distant armies to maintain control over distant lands costs more, while the yield on marginal new conquests drops.
Expanding land under production was easy in the river valley, but once water has to be carried up hillsides, the net yield plummets.
What worked well at first no longer works well, but those in charge are wedded to the existing system; why change what has worked so brilliantly?
As the costs of complexity and state dependents rise, productive people grow tired of supporting an economy suffering from terminal diminishing returns.
Empires do not just suddenly collapse; they are abandoned by the productive citizenry as the burdens become unbearable. The independent class of tradespeople (a.k.a. the middle class), driven into serfdom by taxes, lose their shared identity with the aristocracy. Beneath the surface, social cohesion frays. Once the benefits of the status quo no longer outweigh its costs, the system is vulnerable to an external disruption that would have been easily handled in previous eras.
The Suppression Of Social Mobility
There is another key factor in the resilience or fragility of social order: the permeability of the barrier between the ruling class and everyone below. We call this permeability social mobility: how easy is it for a working class family to rise up to the middle class, and how easy is it for a middle class family to enter the political and financial aristocracy?
I recently read Venice: A New History, a fascinating account of Venice’s rise to regional empire and its decline to tourist destination.
What struck me most powerfully was Venice’s long success as a republic: it was the world’s only republic for roughly 1,000 years.
How did the Venetians manage this? Their system of participatory democracy accreted over time, and was by no means perfect; only men of substance had much of a say. But strikingly, key political turning points were often triggered by mass gatherings of craftsmen and laborers.
Most importantly, the system was carefully designed to enable new blood to enter the higher levels of power. Commoners could rise to power (and take their families with them if their wealth outlasted the founding generation) via commercial success or military service.
The Republic also developed a culture that frowned on personal glorification and cults of personality: the nobility and commoners alike deferred to the Republic rather than any one leader.
In Venice, the political leadership (the doge and the Council) were elected via a convoluted series of steps that made it essentially impossible for one clique to control the entire process.
The doge was elected for a term, not for life, and he had to be acceptable not just to the elites but to the much larger class of movers and shakers–roughly 1,000 people in a city of at most 150,000.
Venice’s crises emerged when the upwelling of social and financial mobility was capped by elites who were over-zealous in their pursuit of hegemony: all those blocked from rising to power/influence became the source of political revolt.
If you cap the volcano, eventually the pressure beneath rises to the point that the cap gets blown off in spectacular fashion.
The suppression of social mobility and the monopolization of power by the few at the expense of the many are universal dynamics in social orders.
Broadly speaking, Venice’s 1,000-year Republican government, with its complex rules to limit concentrations of power and insure the boundaries between elites and commoners were porous enough to diffuse revolution and social disorder, speak to what is once again in play around the world: social unrest due to the concentration of power and the suppression of social mobility.
I don’t think it’s a stretch to say that the greater the concentration of power, the lower the social mobility, the greater the odds that the system will collapse when faced with crisis.
When the entire economy is expanding faster than population, and this tide is raising all ships, the majority of people feel their chances of getting ahead are positive.
But when the economy is stagnating, and those in power are amassing most of the gains, the majority realizes their chances of securing a better life are declining. This is the pressure that is being capped by the status quo that first and foremost protects the privileged.
How porous are the barriers to social mobility in our society? That a few people become billionaires from technological innovations that scale globally is not a real measure of social mobility for the masses.
In Part 2 we identify the wellspring of revolution, and reach a conclusion that may surprise many.