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Mark's Market Blog

11-10-13: Janet L.Yellen, Super-Genius.

By Mark Lawrence

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The Dow hit a record high on news that, um, that it hit a new high. It has become clear to me that this market will continue up until we start to taper. Thursday the market nose-dived for no apparent reason. Friday it recovered, for no apparent reason. Some time ago I argued that tapering would begin with the Fed meeting in March. Now I'm not so certain - Ms.Yellen has been talking about her view, "optimal control," which would tend to indicate that tapering may be delayed even further. And it's clear when we do begin to taper other measures will be taken to keep interest rates down. We're going to quit smoking QE, really, we are, really, we're just waiting for the right time. . .


S&P 500 May 20 2012 to November 8 2013


S&P 500 May 20 2012 to November 8 2013

Standard and Poors downgraded France from AA+ to AA, citing high unemployment as stressing the government. The European Commission just released their forecasts. They say European growth will remain subdued through next year at about 1% and unemployment will remain high at about 12%. Europe's welfare states cannot fund such unemployment forever: unemployment like this means payouts remain high, tax revenues remain low.

Deutsche Bank recently said that government bonds are the most over valued asset class in the world. Interest rates remain artificially low due to intervention by the Fed and the ECB, which means bonds have artificially high prices. If interest rates return to normal - their 20 year average, for example - or worse yet overshoot in a correction, the bond values will drop and banks will find themselves scrambling to call in other loans and find new money in order to keep up their required reserve levels. This would represent, imho, the end game, the end of the myth that we can borrow indefinitely from future generations and give everyone free health care.

To solve their crises the last couple of years, the European Central Bank has been having major banks in each country buy their own country's debt, funding their own country's deficit. Now banks in several countries have hit their saturation point. The ECB will be making health checks on member banks this year and deciding if they're going to continue to supply low interest loans to these banks - this is the money the banks use to fund their country's deficits. This is all show: if the ECB cuts off the money, Italy and Spain will quickly come crashing down and likely bring France and then everyone else with them. We're setting up for another huge banking crisis in the coming years, this time with European banks taking the lead instead of American banks. I have no timetable in mind, but sooner or later all addicts return to earth. AA has a slogan: "Being a drunk is like riding an elevator with the cables cut: you can't get off until you hit the bottom." Central bank funding of deficits, even using member banks as buffers, cannot go on indefinitely - it must end in out of control inflation and monetary collapse. It's been tried hundreds of times and it's failed every time. My advice: try not to stand underneath any Fed elevators.

Carbon taxes: Europe has 'em, Obama wants 'em. How's that working out for Europe? Electricity bills there are up by 17% for homeowners and 21% for businesses as Europe taxes oil and coal and pushes towards more expensive renewables. Some in the UK are spending 10% of their household income to heat their homes. Germans pay about a 10¢ per kilowatt hour surcharge on their electricity to fund more renewables - just that tax surcharge almost matches what I pay for electricity. All this to do their part to end global warming. This is rapidly becoming an election issue - politicians in both the UK and Germany are promising to freeze the tax. Meanwhile, while here in the US we're turning more and more to relatively clean natural gas for our electricity, the quickest growing source in Europe is nasty, dirty coal.

Two Fed economists recently released papers saying that the Evans Rule, which says that the Federal Funds rate should stay low until unemployment hits 6.5%, should be revised to 6%. It's striking that watching the Fed is a lot like Kremlin watching 30 years ago or Chinese Central Committee watching these days: you look for little hints to deduce changes in policy and behavior. However you look, it looks to me like the Fed will continue supplying easy money to at least the government and likely the top seven banks for at least another year. This was supposed to be an emergency measure to stave off total economic collapse, now it's become a way of life. We're still paying the "temporary" excise tax on car tires left over from the rubber shortages of WW II, before I was even born. How long will the "temporary" Fed extreme measures continue? helpful hint: they've been ongoing in Japan since their 1990 crash, coming up on 25 years soon. We're only 5 years into our extraordinary measures.

Wall street is all abuzz with speculation about the Yellen Fed. She made a set of speeches last year about "Optimal Control" of monetary policy. Frankly, as an engineer, I find these words insulting. There's a field of control theory called Optimal Control Theory invented by Robert Kalman of the Huntsville Redstone Arsenal. It's all full of tensors and other mathemagical thingies that, I assure you, Yellen doesn't know from a dirty sock. When a rocket is lifting off, at the very beginning it's going very slow and the steering vanes don't do very much. A few seconds later it's going much faster and the steering vanes really bite into the air. A minute or two later it's leaving the atmosphere and again the steering vanes don't do much. Your feedback control loop has to adapt to all these changes or bad missile things happen - I'm sure you've seen the NASA launch movies from the late 50s before Kalman did his work. We can't even agree on a definition of money, we have at least 6 definitions that are commonly used. There's widespread disagreement on what the real effect of monetary policy is in a recession - I believe we're in a liquidity trap and monetary policy doesn't do squat for the economy, it's just a way to make banks pile up money in their vaults. There's more and more evidence that as populations age deflation becomes a norm. Plus we're running out of many key resources like oil and water and prices are skyrocketing. And in the midst of all this, Yellen thinks she can "optimize" Fed policy? This is seriously scary, no one even knows if the steering wheel she's holding is actually connected to anything and she wants to enter the Monaco Formula 1 race. This is going to be like the Monaco race in Iron Man II, except Yellen isn't a super-genius like our comic book hero Tony Stark. In fact I'm getting concerned she's more like Wile E.Coyote, Super-Genius.

What does optimal control mean to Yellen? Yellen says the Fed should decide on unemployment and inflation targets. Then they make a forecast for the economy, and solve a large-scale economic model for the federal funds rate path that splits the error to the target unemployment and inflation rates. In practice this is going to mean that if your unemployment rate target is 6% and your inflation rate target is 2%, then you will cause inflation to exceed the 2% target in order to keep moving towards the 6% unemployment rate. In other words, "optimal control" is an excuse to run higher inflation rates than the previously agreed maximum. We all knew this was coming: the national debt will never be paid down without the help of inflation. Now we see the first crack in the inflation dam. Below is a chart Yellen used in a speech she gave last year, showing clearly that "optimal" means lower federal funds rates for longer and higher inflation than is currently considered acceptable. In a piece of doublespeak that would leave even Orwell breathless, high inflation is being redefined right before our eyes from a serious problem to optimal control.

And if the "optimal" path doesn't lower unemployment? Will businessmen hire because the Federal Funds Rate is low? Can Yellen and the Fed actually cause inflation to increase? The Japanese central bank has been trying to do this for 20+ years and failing - can Yellen pull it off here? Frankly, doubtful. And what if Yellen manages to get the inflation rate up but unemployment stays persistently high? We invented a word for that in the '70s: stagflation. Remember the cure? Volker's Fed raised interest rates as high as 19% causing a major recession that cured us of inflation. He was able to do this because government debt was low by historic standards and the increase in government interest rate payments was not a big deal. But this time if a future Fed were to decide to raise interest rates to cure this inflation the resulting huge increase in government bond interest payments and enormous drop in bond values would likely bankrupt us and collapse the entire world economy. Yellen's Optimal Control is like taking off in a 747 and leaving your landing gear behind so you can carry a bigger load - it just has that smell of ending badly. Remember this historic time: when your grandchildren ask you when high inflation became not only acceptable but a major government policy, tell them "January 2014, when Janet L.Yellen, Super-Genius, became chairman of the Fed."

To be fair, in a recent survey a majority of academic economists agreed that auditing the Fed is a bad idea (67%), and that tapering down the Fed's QE program is a bad idea (56%). There it is: there's no middle ground on any substantive issue in this country.

Now I'm going to tell you Janet Yellen's most secret fear: it's that she will be unable to make inflation happen. The high priest of monetarism, Milton Friedman, said "Inflation is always and everywhere a monetary phenomenon." This would seem to indicate that if Yellen prints enough money she will get inflation. However, for inflation to happen that money also has to get into circulation and chase goods and services. What if the banks, her own little helper dwarves, hoard the money deep in their underground vaults? What if the population, her target, is an aging group of baby boomers saving for their retirement who already own all the houses, cars, washing machines that they want? What if the youngsters, the 20-something millenials, can't find work, or can't find work at a decent wage, and have no money to start families, and then buy houses, cars, washing machines? What if the young women who are having children are mostly unmarried and living on government welfare which doesn't give you the resources to buy houses, new washing machines, new cars? What if this new unmarried and uneducated class is causing a huge income disparity, so that the rich only buy things that don't count, like stocks and bonds? Of course all this is largely happening, and all this is a recipe for deflation, not inflation. In spite of her best efforts, it's entirely possible that Ms.Yellen will succeed only in continuing to blow up several bubbles: stocks, bonds, New York and London real estate.

I see two possible outcomes here: Ms.Yellen will fail in her "optimal control," no inflation will happen, no big changes in unemployment will happen, and we'll continue to live in this semi-functional world of bubbles and deflation; or she will succeed in lighting this fire and it will get out of control. About 15 years ago I was telling my friends that economic theory told us inflation and deflation could not possibly coexist, therefore I was predicting that in the next major recession that would be exactly what we would get. Today we have asset inflation and product deflation. I think my charts have made clear that with QE1, QE2 and QE3 the Fed has had absolutely no discernable impact on the unemployment rate, and behind their backs our culture is now completely failing to educate and motivate a generation of young men. It's only worse in Europe. Conventional thinking would tell us that runaway inflation should have already started, and perhaps it has: there are now a couple dozen companies making $1m+ sports cars that go 200mph+; $100m sports contracts are now common; movie stars make $10m to $25m per movie; executive pay and perks are widely considered unsupportable and out of control; Wall Street is famously packed with people getting hugely rich while contributing absolutely nothing to society; you have to have a couple billion to make the Fortune 500. Meanwhile the majority of our children are being raised in poverty, shoppers are fleeing Nordstroms for on-line shopping, fleeing Macy's for Target, fleeing Walmart for the Dollar Store. Can there be an inflationary crash at a time when the majority of the world is living with deflation and lower living standards? Yes. In 1981 stock market capitalization was less than 40% of GDP and total credit market debt was 130% of GDP. Today stock market capitalization and total credit market debt have risen to more than 100% and 300% of GDP, respectively. We no longer live in a "real economy" that produces goods and services, we now live in a "financial economy" that pushes dollars around. On present trends, the financial economy can and will crash. Stay tuned for more twists and plot complications in As The World's Economy Turns.(1)

Is this peculiar to Ms.Yellen? Nah, on Thursday Super Mario Draghi announced a cut in European interest rates. The various European stock markets immediately jumped up, the Euro fell against the dollar, and he took the trouble to mention that inflation was falling in Europe.

Blackstone, a large hedge fund, has been quietly buying up lots of houses - about 150,000. Now they have revealed their strategy: they're going to rent them out and issue securities that will pay the rental income to investors. The price of these securities would be determined by this payout compared to the interest rate payout on various bonds. If the securities wind up valuing the homes considerably higher than their purchase price Blackstone will be a big winner. One wonders what happens as the homes age and need more and more repairs; one also wonders what happens when the management companies find inferior tenants who don't pay the rent and do damage. Robert Schiller, our newest Nobel Prize winning economist, says this will improve market efficiency and is a good thing. I have trouble believing that anything hedge funds do is a good thing for anyone other than the hedge funds themselves. Generally real estate is a declining asset - as homes age their repair requirement goes up and their value goes down. So you would expect these securities to also be declining assets. If the underlying houses were in neighborhoods that somehow later deteriorated even faster - consider Detroit, Cleveland - the securities would take an even bigger hit. I project that Blackstone will do very well selling off piece by piece the houses they bought, and the huge retirement funds that buy the pieces will once more be on the losing end of the deal.

There are effectively two kinds of law in this country - criminal law, where the government must prove their care beyond a reasonable doubt, call it 98%, and civil law, where you win with the preponderance of the evidence, call it 51%. In criminal law you have constitutional rights; in civil law you have almost none - no right to an attorney, no right against self-incrimination, no right to a speedy trial, no right to a jury. Governments have been turning to civil law as a quick way to grab money. For example, one of my sons was a day late paying a ticket, he got hit with a $300 civil charge. Terry Dehko and his daughter Sandy Thomas are learning about this. They run a small grocery store in Michigan; each day they bring cash to the bank, always under $10,000 because that's the largest amount insured by their carrier. The IRS recently accused them of violating money laundering rules by willfully structuring their deposits to avoid the $10,000 reporting threshold. The IRS seized the contents of their account, $35,651.11, in a civil action. The IRS offered no evidence that there was any money laundering going on; indeed last year the IRS audited them and gave them a clean bill of health. But the Dehkos can't get their cash back. The IRS offered to settle by giving them back 20% of their money. Under civil forfeiture rules the IRS can seize now and ask questions later. You'll recall my story a few weeks ago about a friend who got a warning letter from his bank on just this topic. I've been through family court and I have no illusions about the government being on my side, or that just because I paid for some property or had money in a bank account that meant it was mine.

Signs of the Apocalypse: In early 1929 Joe Kennedy stopped on Wall Street for a shoe shine; the shoe shine boy gave him a stock tip while working. Joe immediately called his broker and told him to sell everything - he said he couldn't be in a market when shoe shine boys gave tips as good as brokers. Today we have 16 y/o Rachel Fox, a minor character on the now defunct show Desperate Housewives making stock trading videos; Ashton Kutcher played Steve Jobs in the new movie and was immediately hired by Lenova as a product engineer; Michael Birch started an internet company, Bebo, and sold it to AOL for $850 Million. A couple months ago he bought it back from AOL for $1m.

In the last month or so my spam has ramped up rather drastically. I'm getting about 120 spams a day. That's counting and averaging, not estimating. I've been forced to turn my normal email into a forwarder to my gmail account to use their spam filters. So far they're pretty impressive. They've labeled 1 good email as spam, and missed 3 that were spam. Out of 747. This spam / virus thing - this is incredibly easy to fix at the switch level. I can't believe we as a nation tolerate it. If I were Esther Dyson, I would put a few countries on notice (Philippines, Nigeria, China, a couple others) that they had 6 weeks to clean up their act and then we were shutting them out. They have much more to lose than we do. Try to guess what my lifetime sales into Nigeria and the Philippines are. hint: in any known currency, it's a single digit number.


(1) From The Bonfire of the Vanities. Our hero, Bond Trader Sherman McCoy, is having brunch with his wife Judy, his daughter Campbell, and his parents Mr. and Mrs.McCoy:

CAMPBELL is tugging at Judy's sleeve, asking repeatedly, "But what does he do? What does Daddy do?!"

JUDY replies, "He sells bonds."

CAMPBELL But what's a bond?

MRS.McCOY (delighted) Oh, yes, Sherman, do explain it.

MR.McCOY Yes. Your mother and I really want to hear this, Sherman.

SHERMAN A bond is a way of lending people money. Let's say you want to build a road or a hospital and you need a lot of money. Well, you issue a bond...

CAMPBELL Do you build roads?

SHERMAN No, I don't actually build them...

MR.McCOY I think you're in over your head. (laughter)

JUDY Here. Let me try. Darling, Daddy doesn't build roads or hospitals or anything, really. Daddy just handles the bonds for the people who raise the money.

CAMPBELL That's what he said. Bonds.

JUDY Yes. See, just imagine that a bond is a slice of cake. Now you didn't bake that cake, but every time you hand somebody a slice of that cake, a little bit comes off, little crumbs fall off. And you're allowed to keep those crumbs.

SHERMAN Crumbs? Really...

MR.McCOY (pointedly) And many a man has sold his soul for those little crumbs.

JUDY (enjoying this) Yes. And that's what Daddy does. He passes somebody else's cake around and picks up the crumbs. But you have to imagine a lot of crumbs. And a great golden cake. And a lot of golden crumbs. And you have to imagine Daddy running around picking up every little golden crumb he can get his hands on. That's what Daddy does.

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