Opening Dreams

"The one constant through all the years, Ray, has been baseball. America has rolled by like an army of steamrollers. It has been erased like a blackboard, rebuilt and erased again. But baseball has marked the time. This field. This game. It's a part of our past, Ray. It reminds us of all that once was good and it could be again. Ooohhh...people will come, Ray. People will most definitely come."
--Terence Mann (Field of Dreams)

It's a special day in Cincinnati and elsewhere. It's Opening Day. Today, hope springs eternal. Anything is possible.

For players and their teams, there is optimism that this will be their year. Regardless of what happened in the past, today is the first day of a bright future. This is the year when they'll put it all together.

For the rest of us, today we toss winter onto the scrap heap of history. It's time to get outside, to shed our winter skin. To remind ourselves of all that is good. We feel renewed like the blooms unfolding around us.

Opening Day marks that time once again.

Chinese Ponzi

Louden Swain: Can 800 million people be wrong?
Tanneran: Frequently.
--VisionQuest

There are many who believe that the 21st century belongs to China. By the reported numbers, its economic growth has surely been impressive--rapidly rising thru the ranks to capture the number two slot in the world GDP-wise. It will not take long for China to surpass the US at its current reported growth rates.

At its core, however, the Chinese economy remains a centrally planned one. And central planners are prone to large misallocations of capital over time.

Evidence is mounting that much of the Chinese 'miracle' has been more illusion than substance. At its core is a corrupt and out-of-control credit money system. Rehypothecation of assets has inflated credit on a massive scale. The People's Bank of China (PBOC) has been buying in bonds at a pace that would make the Fed blush (and that's saying something).

China's planners have applied much of the proceeds from this leverage toward bogus building projects in commercial real estate and manufacturing capacity expansion--much of which remains grossly underutilized. 

Like all inflations, things worked like magic on the way up to support the Chinese 'miracle.' When the Chinese credit ponzi breaks, however, people will once again be exposed to the seemingly unlearnable lesson that money-printing ultimately produces pain--not prosperity.

Venice Secession

There used to be a graying tower alone on the sea
You became the light on the dark side of me
--Seal

On the back of Crimea's secession from Ukraine, Venice has voted to secede from Italy. Venice had been subsumed into Italy in 1866.

One can only hope secession fever continues to build. Although Crimea's secession was followed by accession with Russia, disunion from a political affiliation to freely associate with others is a God-given right, and usually results in more localized governance.

Smaller, local governments disable the State. Fragmented governments have many close competitors, and are pressured to encourage free trade and monetary integration.

A world of local governments is a world of peace, voluntary cooperation, and prosperity.

Secession is an expression of freedom.

Occupational Licensing

Standing in line marking time
Waiting for the welfare dime
'Cause they can't buy a job
--Bruce Hornsby & the Range

Interesting data that extend our previous discussion on mandatory licensing. Although proponents argue that it protects consumers, occupational licensing increases the cost of doing business and raises entry barriers to entrepreneurial entry into industries.

Ultimately, licensing limits the quantity of goods and services available to consumers.

Licensing is more pervasive today. Estimates suggest that about 1 in 20 workers were subject to licensing requirements in the 1950s. Today, the ratio is closer to 1 in 3.

Occupational licensing hits lower income workers particularly hard. By making it difficult to enter occupations that have traditionally provided lower income workers with a path to self-sufficiency and upward mobility, licensing makes it tougher to climb the ladder.

Like minimum wage laws, occupational licensing is a form of compulsory unemployment.

Inflation Shortfall?

We're talking 'bout the dollar bill
Now what are we all to do
When the money's got a hold on you?
--Simply Red

Chart depicting change in prices of various core goods and services since January 2000.

If you accept the federal government's 'official' inflation data then you only have yourself to blame.

Palladium and Russia

"You've been playing us off each other, haven't you?"
--James Bond (From Russia With Love)

Although gold and silver are THE traditional precious metals, platinum and palladium are also classified as PM's. Neither are generally considered good candidates for money. Instead, both are better characterized as industrial metals. The largest use of palladium, for example, is in catalytic converters.

However, platinum and palladium are both 'precious' in the sense that an ounce costs a pretty penny. Platinum currently trades above $1400/oz (approx $100/oz higher than gold), and palladium is quoted at nearly $800/oz.

I have never seriously looked at either as investments because I like the monetary characteristics of gold and silver.

I am, however, currently intrigued by palladium as a play on growing tensions with Russia. Most of the world's palladium is currently mined in Russia. As sanctions fly this way and that, it is possible that Russia might restrain palladium exports.

Technically, the metal is breaking out from a multi-year 'pennant' pattern. Bullish action.

position in gold, silver, palladium

Losing the Bond Market

The highway's jammed with broken heroes
On a last chance power drive
Everybody's out on the run tonight
But there's no place left to hide
--Bruce Springsteen

Fleck laid out a roadmap last night for how the Fed might lose control of the bond market. In his view, this is how market forces will regain control of the system. When the bond market no longer stays stuck at artificially low yields manipulated by the Fed, then the game is over.

He proposes that losing the bond market will not happen overnight. Rather, it will occur in stages over time. We are in the first stage now. The Fed has started to reduce (i.e., 'taper') its bond purchases. Ten year yields have jumped from all time lows of 1.6% to today's 2.8%. Why? Without Fed support, bond prices will likely be lower. Some traders understand this and are already headed for the exits.

But yields are still low by historical measures, which has muted the reaction by market participants thus far. However small the nominal change, though, the fact that rates are higher at a time when the Fed does not want them higher signals that the Fed is beginning to lose its grip on things. 

Fleck also suggests that, although we are early in the process, it is not out of the question that early tapers will put a lid on further stock advances, and may even drive a significant price declines. Essentially, tapered bond purchases parallel early Fed interest rate tightening in past cycles (e.g., early 2000) that reduced liquidity and caused leveraged sentiment to turn negative ahead of other, more visible influences.

The next stage will be when the Fed stops tapering in response to stock market and economic weakness. Although stocks and bonds are likely to rally initially on the Fed's action, Fleck suggests that it will dawn on more people that the Fed is trapped and can't stop printing money if it does not want the price of financial securities to fall. Many investors will connect the dots and realize the implications for prices of goods and services (higher). When this is perceived, then bonds will tank.

The final stage is when markets fear the roll out of any additional easy money policies out of concern for inflationary consequences. This is the exact opposite where we are today--markets generally welcome any and all spectres of easy money.

When the bond market revolts to, rather than cheers, the Fed's easy money ways, then the printing press is effectively taken away.

position in SPX

QE and the Profile of Returns

An angel's smile is what you sell
You promise me heaven and put me through hell
--Bon Jovi

In his weekly letter, John Hussman makes an important distinction w.r.t. the effect of the Fed's QE programs on wealth redistribution. Although Fed policies have jacked prices risky asset classes higher, holders of those assets are only richer on paper. The value of their balance sheet assets has increased.

However, wealth will only be transferred if owners of those inflated assets take their trade. They have to sell those highly priced assets and convert the proceeds into formats that permit acquisition of more economic resources that before.

Ultimately, it is the stock of economic resources owned, not claims on those resources, that determines wealth.

Those who bought Tesla (TSLA) a year ago at 40 are only richer if they sell at today's inflated prices. They are no richer if the stock 'round trips' or worse while on their position sheets.

Rather than changing distribution of wealth, Dr J suggests that the Fed's programs are more likely to change the profile of returns. Return profiles change because QE and similar programs create a cyclical character to asset prices. In bubble-like fashion, QE programs first inflate asset prices, and then deflate asset prices.

Those who buy near the top of the cycle lock-in lower future returns while those who buy near the lows lock in higher future returns.

Stated differently, what Fed programs do is alter who is positioned to realize long term returns from stocks and other risky assets.

We can be confident that those currently holding those risky assets are not well positioned.

position in SPX

A-weem-a-weh

In the jungle, the mighty jungle
The lion sleeps tonight
--The Tokens

Awesome improv by Billy Joel and Jimmy Fallon of "The Lion Sleeps Tonight."

A-weem-a-weh, a-weem-a-weh...

Nosebleeding Corporate Debt

I can't believe the news today
Oh, I can't close my eyes
And make it go away
--U2

Size of the US corporate debt market, currently at $9.8 trillion, has surpassed the size of the mortgage backed securities market in 2007.

The idea of corporate deleveraging is a myth. The current debt orgy puts corporate leverage higher than 2008.

Dallas Fed head Richard Fisher, who has been one of the few central bank bureaucrats to voice concern about the Fed's QE program, stated that he'd "have to hire Sherlock Holmes to find a single distressed company priced attractively enough to buy."

The Fed is blowing the ultimate credit bubble. After MBS popped in 2007, emphasis shifted to Treasuries as risk was shifted from private to public balance sheets. Now, with rates so low, corporations are back in the game at record levels.

Market distortions are massive, as programs of financial repression have influenced investors to play along in risky assets. This has driven asset prices to nosebleed levels.

Moreover, past interventionary actions prompt market participants to believe that their risky behavior is insured by policymakers. As in the past, policymakers will surely have their backs if prices once again move against them. Right?

Nosebleed prices, record leverage, massive moral hazard.

Hard to imagine a set up more pregnant with risk.

position in SPX

Planners Hate Spontaneous Order

"Be spontaneous."
--Bruce Lee (No Retreat, No Surrender)

It is straightforward to speculate why so many people, particularly those born with the 'control gene,' are uncomfortable with the idea of free markets. Free markets consist of individuals engaging in production and trade to further their interests. This exchange is voluntary, and there is no aggressive intervention that impairs trade.

The direction that such trade takes is dynamic and unpredictable. What is predictable is that this voluntary cooperation will create a spontaneous order that, when viewed from above, is more efficient, innovative, and robust than could ever be devised by central planners. Leonard Read's classic "I, Pencil" marvelously demonstrates this concept.

Herein lies the rub for the control freaks. The path that free markets take cannot be predicted nor controlled. Moreover, the uncontrolled environments of free markets foster configurations that are more effective and more adaptive than those designed by bureaucrats.

This bothers those inclined to rule and control to no end.

Ag Strength

"The Almanac says it's time to start plantin'."
--Myra Fleener (Hoosiers)

In addition to precious metals, another group of commodities trading well is agriculture. Most broad ag baskets are up about 15% over the past two months.

Does this mark the beginning of when central banks' enormous money printing programs drive food prices higher in a big way?

If commodity prices continue higher at their current pace, then it won't take long to find out.

position in RJA

Playing Along

"A strange game. The only winning move is not to play."
--Joshua (WarGames)

The primary objective of financial repression is to influence investors to take more risk than they otherwise would. By forcing yields on savings accounts, CDs, and other short term savings instruments toward zero, policymakers hope that people will shun savings in favor stocks, bonds, and other risky assets.

It is difficult to argue that financial repression programs have been anything other than wildly successful thus far. Stock and bond prices hover near all time highs. Even real estate prices show renewed strength.

This is so because people have decided to play along. Many if not most sense that financial repression policies are unnatural and likely to have undesirable consequences. Yet they act precisely how policymakers hope they will act anyway--usually because they feel that they have no choice.

But people do have a choice. They can decide that they will not acquiesce to programs of force. That they will not be parties to actions that they think wrong. That they want to be able to look future generations in the eye and say "I refused to be a part of that."

Each of us decides whether we will play along or not.

position in SPX

Debt and Vulnerability

"I can break you, mate. I can buy you six times over. I can dump the stock just to burn your ass."
--Sir Lawrence Wildman (Wall Street)

Former Treasury secretary Hank Paulson claims that Russia sought to collaborate with China to dump large quantities of mortgage backed securities (MBS) on the market to exacerbate the credit market debacle in 2008. The presumed goal was to kick the US financial system when it was down, or perhaps even to kill it.

Whether such plans were actually discussed is not the point of this post. The spectre of large holders of US debt dumping their positions for non-economic reasons was being discussed by people in my network long before the credit crisis began.

Nor is the point to implicate China or Russia here. They merely bought the paper.

The point is to implicate us. We sold the paper.

A wise sage once told me, "Debt reduces freedom." When you borrow from someone else, you enter into a contract of servitude. In exchange for using lender resources today, you agree to work for the lender to pay back those resources, plus interest, in the future. Because you must provide for someone else's interests rather than your own, you are less free.

Jefferson and other founders understood the virtues of saving and the dangers of debt--particularly public debt. Public debt is now north of $17.5 trillion.

The more we borrow, the less we control our destiny. The greater our debt, the more vulnerable we are to the whims of debtholders--whatever their motive.

Moral Hazard and Government

There's a room where the light won't find you
Holding hands while
The walls come tumbling down
When they do, we'll be right behind you
--Tears for Fears

Hard to imagine an environment more laden with moral hazard than the current one. The primary factor contributing to the situation is ever growing size and scope of government.

Moral hazard arises when people think their behavior is insured. If people sense that someone else will cover their losses, then they are prone to take more risk.

Thus, if someone will provide economic resources in the event of unemployment, then people will be less prone to look for work or to build capacity for work.

If someone will provide healthcare resources in the event of illness, then people will live less healthy lifestyles.

If someone promises to regulate consumer goods production, then people will be less prone to vet products themselves.

If someone promises to return deposits in the event of bank failure, then depositors will be less prone to assess the balance sheets of banking institutions.

If someone promises to compensate investors for losses in securities markets, then investors will take positions in riskier securities.

The greater the government intervention in human affairs, the greater the moral hazard.

Enabling the Great War

"Today, while the earth shakes beneath the heels of marching troops, while a great portion of the world trembles before the threats of acquisitive power-mad men, we of America have little time to remember an astounding era in our own recent history. An era which will grow more and more incredible with each passing generation until someday people will say it never could have happened at all. April 1918: almost a million American young men are engaged in a struggle which, they have been told, will make the world safe for democracy."
--Narrator opening lines (The Roaring Twenties)

David Stockman considers how WWI changed the world, and how different (better) things would be today had the Great War not occured.

WWI set in motion various arcs that would plague the world. Totalitarianism, the Great Depression, permanent warfare and welfare states, Keynesianism, bankrupt monetary and fiscal policies, chronic national debt.

However, it is doubtful that many of these consequences would have materialized had it not been for two policies that enabled the United States to enter the conflict with great strength in 1917. Those policies were both enacted in 1913, a year before the outbreak of war in northern France.

The Federal Reserve Act and the Sixteenth Amendment gave the federal government access to vast quantities of resources. Without such access, the US could not have funded the war effort.

Shut down the Fed and repeal the Sixteenth Amendment, and you'll keep vast quantities of resources away from the federal government.

Keep vast quantities of resources away from the federal government, and you'll keep the peace.

Freedom vs Liberty

No more running down the wrong road
Dancing to a different drum
Can't you see what's going on
Deep inside your heart
--Michael McDonald

Interesting discussion of differences between the words "freedom" and "liberty." Like the author, I tend to use the words interchangeably. Also like the author, my sense is that liberty more precisely captures the essence of unencumbered pursuit of one's interests.

He uses the example of FDR's "Four Freedoms" speech, which became the basis for FDR's proposed Economic Bill of Rights, to demonstrate the imprecise nature of the word freedom. Freedom of speech and freedom of religion can be enjoyed universally, as one person's exercise of these freedoms does not impede others from doing so. The sole role of government here is to help people defend against unwanted intrusion by others.

Freedom from want, however, cannot be enjoyed universally. Because of axiomatic scarcity of earthly resources, reducing some peoples' want for goods and services requires that other peoples' freedom to acquire goods and services must be restrained. For some people to become more free of want, others must become less free of want. Government's role here is an offensive one--forcibly intruding on the interests of some to advance the interests of others.

Over time, the concepts of negative and positive freedom have been developed to capture these very different meanings of freedom.

Liberty, on the other hand, has maintained a relatively high degree of fidelity in its meaning. Mises said it as well as anyone: liberty is freedom from government--i.e., freedom from the power of rulers to intrude on individual interests.

This is the context in which liberty is used by the founders. When Patrick Henry famously proclaimed, "Give me liberty or give me death," he was not talking about liberty as freedom from want.

He was talking about liberty as freedom to pursue his wants unencumbered by government interference.

Sanctions

Everybody spread the word
We're gonna have a celebration
All across the world
In every nation
--Madonna

Sanctions imposed by one country on another, such as trade embargos, quotas, or account freezes, are not peaceful. They are acts of aggression. They seek to alter behavior via government force.

Truly peaceful actions would be to open borders, deregulate, permit free trade. Removing government aggression, whatever its nature, facilitates voluntary cooperation and exchange between people.

Fractional Slavery

"They are going to take you."
--Bryan Mills (Taken)

Two good points made by the author who reflects on a recent appearance of Judge Nap on Jon Stewart's Daily Show. Stewart's objective was to challenge Judge Nap's recent remarks concerning Lincoln, the Civil War, and slavery--remarks that, if you have been reading these pages, are not new nor original to the Judge.

One point was that Thomas Jefferson condemned slavery in his draft of the Declaration. Unfortunately, like so many of the stands against slavery taken by various founders (see Fleming (2013) for a nice review here), it was edited out or ignored for the sake of political expediency (read: compromise).

The other point is his question about what constitutes a slave. Is a slave someone who is completely robbed of his labor? Suppose a person is forced into the fields to labor for someone else one day in seven. Is not that person still a slave?

Taking a person's property by force is theft. Institutionalizing such theft is slavery.

If a fraction of an individual's production is routinely confiscated under conditions of force or threat of force, then that person is a slave.

Reference

Fleming, T. 2013. A disease in the public mind: A new understanding of why we fought the Civil War. New York: Da Capo Press.

Gold Thru $1350

I tried to call you before
But I lost my nerve
I tried my imagination
But I was disturbed
--Tommy Tutone

Strength in gold continues. The yellow metal has powered through its 50 day moving average and has crossed the 1350 level. The next technical bogey is resistance at 1400.

Stochastics are 'toppy' but not 'twisty,' meaning that, although gold is due for a rest, additional movement higher from here would suggest a move with considerable energy behind it.

position in gold

Credit Stress in China

I could escape this feeling
With my China girl
I feel a wreck without my
Little China girl
--David Bowie

Concern is rising about the health of credit markets in China. Recently, a Chinese company was 'permitted' to go bankrupt--apparently to the chagrin of the bond buying crowd who thought the Chinese government would navigate moral hazard for them.

Of greater importance is growing awareness that the Chinese government has been permitting, and perhaps even engaging in, re-hypothecation of assets to facilitate even greater degrees of credit creation.

For example, there is now chatter that a large fraction of Chinese copper imports hase been put up as collateral for credit projects. Copper markets have dropped about 10% in a matter of days.

Why would copper drop? Because once people fear that they don't 'own' the assets on their books--that instead someone has broken the chain of custody and lent those assets to someone else--then they will sell those assets to offload risk seven ways till Sunday.

The re-hypothecation situation helps explain how the PBOC balance sheet has grown orders of magnitude greater than the Fed's--which is saying something considering that the Fed balance sheet assets are now north of $4 trillion.

It also rekindles thought about a 'risk out' scenario--where investors flee securitized assets in general in the midst of a waterfall decline of deleveraging.

position sin copper, SPX

Fairness Rules

John Kinsella: Is this heaven?
Ray Kinsella: It's Iowa.
--Field of Dreams

Nice observation by Prof Williams. The best rules are those that we would be satisfied with even if our worst enemy is in charge of decision-making.

Such rules promote true fairness. Fairness occurs when all are treated equally according to the rules. Equality under the law.

When rules are not subject to discretion or bias by those who govern, then those rules are fair.

Williams notes that the Bill of Rights were written because the founders did not trust those in power to govern fairly on their own. Instead, government officials would be looking for favors.

He suggests that if, after we die, we find anything like the Bill of Rights at our next destination, then we'll know that we are in hell. Because they seek to protect against rulers that cannot be trusted, the Bill of Rights would be appropriate in hell, as Satan can never be trusted.

Only in heaven would rules in the name of fairness, where all are treated equally, be unnecessary.

Secession and Freedom

"Should the American colonies govern themselves independently? I believe that they can and they should."
--Benjamin Martin (The Patriot)

Secession is formal withdrawal from a political affiliation. Secession has marked the history of man, as individuals and communities have frequently broken ties with governments in pursuit of their interests.

The United States has been profoundly shaped by secession. The country was born from an act of secession. Subsequently, and quite ironically, we fought a bloody civil war over the validity of secession.

As articulated by Jefferson, secession is a strategy for coping with oppressive government. Moreover, secession is a means for ensuring freedom of association. In a free society, people associate with whom they want--and they can break those affiliations as they see fit.

Wherever in the world that it occurs, secession expresses freedom.

$100 Trillion in Debt

I was dreaming when I wrote this
So sue me if I go too fast
But life is just a party
And parties weren't meant to last
--Prince

Bloomberg reports that global debt exceeds $100 trillion and is up more than 40% since the first signs of the credit crisis in 2007.

This number under-reports total credit obligations, as it does not consider unfunded liabilities (e.g., future entitlements) or derivatives.

The key graph is the one on the left. Government debt comprises about half the total and has nearly tripled in size since 2001. This is largely the consequence of interest rate suppression by central banks that has enabled governments to borrow at ultra low rates.

An important takeaway is that credit did not 'collapse' during the crisis. Debt grew--an inflationary thing.

What has been occuring is shifting of credit risk. Less on private balance sheets and more on public balance sheets.

This is not austerity. By definition, austerity means living below one's means by borrowing less, paying down debt, and saving more.

What we have is profligacy.

Robert A. Taft, Isolationist

"Power is not a toy we give to good children. It is a weapon. And the strong man takes it and uses it. If you don't go down there and beat Joe Cantwell with this very dirty stick, then you've got no business in the big league. Because if you don't fight, the job is not for you. And it never will be."
--President Art Hockstader (The Best Man)

Nice article on Robert A. Taft. Born in Cincinnati and son of former president and chief justice William Howard Taft, Robert Taft served as a US senator from 1939 until his 1953 death from cancer.

Taft's term spanned the end of the New Deal through World War II to the Korean War and start of the Cold War. Taft, a Republican, was labeled an 'isolationist' because of his opposition to US involvement in wars and other foreign affairs grounded in aggression.

Such a position would put him at odds with the mainstream GOP today--a party with a general prediliction for meddling in foreign affairs and in war. In fact, Taft's non-interventionist position conflicted with many Republican views of his day as well, and likely costed him critical support in his several attempts to obtain his party's nomination for president.

Taft began his career as a vocal critic of the New Deal and FDR's back door foreign policy. FDR publicly proclaimed intentions to stay out of foreign conflicts, a policy clearly supported by the American people, while privately supporting efforts in Britain and elsewhere that encouraged war.

Taft warned that entering wars and military alliances, including NATO, would compromise liberty and standard of living at home. He cautioned that helping struggling foreign democracies and fighting totalitarian regimes could easily cause the US to slip into an 'empire' role similar to the 19th century Britain. The US might become the world's policeman, and take exception to any matter of consequence anywhere in the world that was executed without first asking America's advice.

Years after Taft's death during the angst of the Vietnam War, a Washington Post columnist reflected on Taft's non-interventist positions. "It turns out that Taft was right on every question all the way from inflation to the terrible demoralization of the troops."

Taft's foreign policy, the columist said, "was a way to defend the country without destroying it, a way to be part of the world without running it."

Reminiscent of one of the principles uttered by our founding ancestors: Free trade with all, entangling alliances with none.

Food and Diet Trends

Scent and a sound
I'm lost and I'm found
--Duran Duran

Have found articles on this site interesting as I reorient my diet back toward better habits. Not saying I subscribe to everything mentioned on the site, but I find the thought food here interesting to chew on (sorry).

For example, this article presents data from several (unfortunately uncited) studies. Let's examine of few of the charts.

Line graph of long term sugar consumption and obesity trends. Source is apparently JAMA article but no specific cite provided. Not sure how historical levels were estimated, but long time series usually catch my attention.

Average US caloric intake since 1970 (up about 20%).

Consumption of various fats over the past 100yrs. The theme is less fat from 'natural' sources like butter and lard and more fat from high trans-fat rich hydrogenated oils.

Forty year obesity trends with a time stamp for first low fat USDA guidelines in 1977.

Trends in % lineolic acid in US body fat since 1961. Lineolic acid comes from omega-6 fat-laden hyrdrogenated oils which has been linked to various poor health conditions.

Consumption of various oils, including hyrdogenated soybean oil since the turn of the 20th century.

Declining mineral content of wheat. Modern processed wheat is also high in glutens which are thought to be linked to various poor health conditions.

Personally, these data suggest that I can make smarter food choices. Less sugar, less hydrogenated oil, less wheat-based carbs. Not necessarily to eliminate 'bad'--but to reduce them in favor of more 'good.'

Treasury Truth in Advertising

But if you look for truthfulness
You might as well be blind
It always seems to hard to give
--Billy Joel

Representatives of the US Treasury hung this banner above its booth at last weekend's ANA show in Atlanta.

As one of guys in my college freshman dorm corridor was fond of saying, "Yeah, boy!"

Seth Klarman Excerpt

Relax, said the nightman
We are programmed to receive
You can check out anytime you like
But you can never leave
--Eagles

Wanted to record this excerpt from Seth Klarman's recent letter to shareholders for posterity:


When the markets reverse, everything investors thought they knew will be turned upside down and inside out. "Buy the dips" will be replaced with "What was I thinking?"

Just when investors become convinced that it can't get any worse, it will. They will be painfully reminded of why it's always good to be risk averse, and that the pain of investment loss is considerably more unpleasant than the pleasure from any gain.

They will be reminded that it's easier to buy than to sell, and that in bear markets, all too many investments turn into roach motels: "You can get in but you can't get out."

Correlations of otherwise uncorrelated investments will temporarily be extremely high. Investors in bear markets are always tested and retested. Anyone who is poorly positioned and ill-prepared will find there's a long way to fall. Few, if any, will escape unscathed.

Six years ago many investors were way out over their skis. Giant financial institutions were brought to their knees when untested structured products that were too-clever-by-half turned toxic and collapsed. Financial institutions and institutional investors suffered grievous losses. The survivors pledged to themselves that they would forever be more careful, less greedy, less short-term oriented.

But here we are again, mired in a euphoric environment in which some securities have risen in price beyond all reason, where leverage is returning to many markets and asset classes, and where caution seems radical and risk-taking the more prudent course.

Not surprisingly, lessons learned in 2008 were only learned temporarily. These are the inevitable cycles of greed and fear, of peaks and troughs.

Can we say when it will end? No. Can we say that it will end? Yes. And when it ends and the trend reverses, here is what we can say for sure. Few will be ready. Few will be prepared.

Jefferson and Decentralization

It's getting rough, off the cuff
I've got to say enough's enough
Bigger, the harder he falls
--The Fixx

Previously we noted that many of the nation's founding group, including Thomas Jefferson, had developed a sense that the limited government design expressed in Constitution would not work out.

In his later years, Jefferson was particularly concerned with the principle of decentralization. In 1821 he wrote:

"It is not by the consolidation, or concentration, of powers, but by their distribution, that good government is effected."

The Constitution enumerated a limited set of federal powers with the remainder reserved for the states. But Jefferson saw the limited scope of "real Constitution" being overrun by political factions who saw great benefit in centralized power.

Jefferson saw early Supreme Court decisions, such as Marbury v Madison, as instrumental in "the annihiliation of constitutional State rights."

The reasoning behind decentralized government is straightforward. Bringing more power to state and local governments permits representatives familiar with the community to focus on local needs. Closeby government is also much easier for citizens to monitor than is complex bureaucracy thousands of miles away.

Centralized government, wrote Jefferson, is liable to be subject to "the most extensive corruption, indifferent and incapable of a wholesome care over so wide a spread of surface."

That the Constitution would ultimate drive consolidation of power was one of the chief objections of the Anti-Federalists during the ratification process. Almost 50 years later, Jefferson acknowledged that the Anti-Federalists were right in their "fear of [consolidation] which produced the whole of the opposition to the Constitution at its birth."

Jefferson was pessimistic that the centralization process in motion by the 1820s could be reversed. In 1825 he wrote:

"I see...with deepest affliction, the rapid strides with which the federal branch of our government is advancing towards the usurpation of all the rights reserved to the States, and the consolidation in itself of all powers, foreign and domestic; and that too, by constructions which, if legitimate, leave no limits to their power."

If this is what he saw in 1825, then what would Jefferson be saying today?

Dispatch from Ukraine

"Morale is crucial right now. Keep the men in secured areas. You'll see how they forget about these 'Wolverines.'"
--General Bratchenko (Red Dawn)

On-the-ground recount of protests against Ukraine's increasingly dictatorial regime over the past three months and the regime's attempts to put down the protesters via intimidation and acts of aggression.

Protesters are now taking to the streets wearing helmets and masks, and carrying sticks. They do this for self-defense purposes. They are standing up in the face of aggression. The protesting demographic is weighted toward the young who grew up in post Soviet years and oppose dictatorship.

Why is Russia invading Ukraine? Russia contests the legitimacy of a newly installed president and regime of a neighboring country. Moreover, much of Russia's natural gas exports flow through pipelines on Ukraine soil, and Russia depends on Ukraine's Crimean warm water ports.

Nevertheless, Russia's invasion of Ukraine to 'protect its interests' is no more legitimate than US involvement in the Middle East to do the same. Russia is aggressing on another sovereign. (Which, btw, makes President Obama's recent comments about the illegitimate nature of Russia's actions all the more hypocritical. We have no standing here.)

It is easy to construe Russian motives as purely opportunistic. Not only is the current Ukraine government is weak and vulnerable, but the country is geopolitically attractive. It possesses a large European country landmass that can buffer Russia against NATO. Its pipelines and ports are strategic assets that Russia would love to own.

In fact, Russia used to own the ports. The southernmost Ukrainian republic of Crimea, with the strategic port of Sevastopol, was part of Russia until the break up of the Soviet Union in 1991.

Maybe Russia wants Crimea back. After all, Crimea has been the focus of Russia's military action thus far. Sources report that the Russian Navy has advised Ukraine forces in Crimea to surrender or face military assault, although Russia has denied these reports.

Meanwhile, the on-the-ground reporter asks for empathy and prayers for the protesters. They will need them. Not only is the Ukraine government seeking to strike them down, but guns of world powers are mobilizing to escalate the matter.

position in natural gas

High Frequency Risk

Eager for action
Hot for the game
The coming attraction
The drop of a name
--Eagles

The domestic market set-up on the Ukraine situation finds bears scared of their own shadow, bulls buying all dips, and high frequency black boxes doing key word searches of news feeds so that size trades can be placed milliseconds after news hits the tape.

Is this bullish or bearish on the margin?

position in SPX

Russia's Ukraine Moment

Well the Ukraine girls really knock me out
They leave the West behind
--The Beatles

After Russia's invasion of Ukraine over the weekend, the Russian ruble hit multi-year lows vs the USD. Capital is flowing out of the country.

Today, the Russian central bank hiked interest rates 150 bps in attempts to quell currency collapse and capital flight.

In a leveraged, rate suppressed world, however, such a move sets other dominos in motion. Russia stocks are down 11% in response to the events. Russian banks have been hit particularly hard--intuitive as that's where lots of leverage is.

No telling what other paths the dominos take. EU stocks closed lower. Domestics markets are down a percent or so at midday.

It does bring to mind Long Term Capital Management's leveraged episode with Russian bonds...

position in SPX

Lessons from Rome

"There was once a dream that was Rome. You could only whisper it. Anything more than a whisper and it would vanish...it was so fragile."
--Marcus Aurelius (Gladiator)

Freedom remains the radical idea. Its place in history is tiny compared to designs of conquest, tyranny, and aggression. When they have been tried, designs of freedom have not lasted long.

Take Rome, for example. In its prime, Rome was the marvel of the world. Rule of law rather than discretionary rule. Productivity unleashed by freedom to produce and trade. Standard of living far ahead of its time--unmatched anywhere on earth.

However, the free state of Rome lasted only a couple of hundred years. The true republic of Rome was dead before the time of Christ.

If we are to reverse our own failing design of freedom, then we should learn the lessons of failed designs before us. Here is an interesting summary of some factors contributing to the decline of the Roman republic.

Gradual decline. Although Rome was born out of revolt against monarchy (similar to the US) around 500 BC, the end came gradually. As decline set in, no person or event ended the Roman republic overnight.

Empire building. At some point, Rome set out to build an empire, to conquer other lands. Power shifted toward military leaders. Taxes diverted resources from individual pursuits to projects of conquest. As more civilians went away to fight battles abroad, mischief increased at home. People's attention was spread thin, and agency problems arose.

Welfare state. To fix 'economic injustice,' welfare programs were implemented to redistribute resources by government force. Taxes increased further, the central government bailed out profligate locales, and inflationary monetary policies were deployed to 'stimulate' the economy. Even in Rome's twilight, public welfare was enshrined as a right rather than as a program of temporary assistance.

Constitutional erosion. Although the Roman constitution was unwritten, it featured characteristics similar to the US Constitution such as separation of powers, guarantee of due process, and habeas corpus. Over time, however, Rome's rule of law was displaced by discretionary rule. By the time barbarians overran the remnants of Rome in 476 AD, Rome's constitution was a distant memory.

Can we learn from history's rhyme?

We Blew It

It's my own design
It's my own remorse
--Tears for Fears

Many people are coming to the conclusion that the Constitution is dead--that its limited government design has been overthrown by those seeking to employ the stong-arm of the State to pursue their interests at the expense of others.

While it has taken centuries to build the current degree of collective awareness that the design is not working, it appears that many of the founders sensed pretty quickly that things would not work out as intended.

In a 1824 letter, Thomas Jefferson wrote that the bicameral legislature had become "representatives of property rather than persons," meaning that Congress had assumed the unintended power to forcibly take property and redistribute it. He lamented that the original design did not go far enough to "break up all cabals"--those factions that naturally form when government favor is for sale.

George Washington expressed similar concern in his 1796 Farewell Address. He observed that the federal government was subject to the organization of "factions" (a term previously employed by James Madison in the Constitution's formative years). Such factions were "likely to become potent engines by which cunning, ambitious, and unprincipled men will be enabled to usurp for themselves the reigns of government."

Many founders wondered how corruption could be avoided even prior to the development of the Constitution. In a letter to a friend in 1781, Sam Adams wrote, "Is there not Reason to think that even those who are opposed to our Cause may steal into Places of the highest Trust? I need not remind you that Men of this Character have had Seats in Congress from the beginning."

While the central government framework was still being hammered out in 1787, Benjamin Franklin said to the Constitutional Convention:

"I believe, farther, that this [Constitution] is likely to be well administered for a course of years, and can only end in despotism, as other forms have done before it, when the peope shall become so corrupted as to need despotic government, being incapable of any other."

It appears that many of our ancestors who put together the original federal design sensed it flawed from the start. Within 50 years those flaws were already visible to the likes of Jefferson and Washington.

Stated differently, the best of the founding group were getting the feeling that they had blown it.

Subsequently, over the course of 200+ years, the structure succumbed to those flaws. And freedom collapsed.