Gotta Pay the Debt Collector

This entire rally is being fueled by credit, not real gains in productivity. A tweet:

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Let’s investigate. See: Three body problem. Tl;dr Good companies make good stocks, and high quality, trustworthy governments issue to low yielding, safe bonds. There is correlation, but as an investment strategy the relationship seems to be working less and less. Ben Hunt doesn’t dismiss the corollary, he merely introduces a third party in the market. He believes the third body to be central banks and their whopping balance sheets. Hold that thought…

See: Economic Machine, Ray Dalio. In order for there to be growth in an economy, there must be more transactions. A transaction is exchange of cash or credit for goods or services. More cash and credit available in markets means more transactions. One (wo)man’s spending is another (wo)man’s income. FYI: American’s on average spend $97.10 of all every $100 earned.

Credit cards fuel spending; consumers borrow from their future selves to spend today, in the hopes of having a higher income in the future. If rates on credit are low, the cost (interest) to the consumer to borrow today is less than if rates are high. This encourages borrowing. More borrowing, more spending, more transactions, more “growth”.

Below is a graphical representation of the relationship between interest rates and outstanding credit:

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M2 is the amount of liquid money available in financial markets, it’s clear that the government is printing more, and at a faster rate, than they used to. The best fit line is polynomial, not linear (with an explainability of 98.7%). Also, note the trend of the yellow data set. That’s consumer debt (boat loans, car loans, RV loans, credit card debt) owned by the US Federal Government.

Here’s that same graph less M2 and the Fed Funds Rate since 2007:

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Here’s who owns all outstanding consumer debt:

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Check the rift in 2010. This is the government absorbing the blow from 2007-08, through foreclosures. Notice how the US Govt’s share of the pie gets exponentially bigger every year since 2008.

The Federal Reserve of the US, a government sponsored enterprise, has the power to print money and buy securities (bonds) in the open market. The Fed prints money and lends it to the US Government through the purchase of US Treasuries. The government then takes said cash and buys your debt from the banks who lend you money; the banks receive a lower rate of interest than they would from you, but they also receive a guarantee from the US Government they they’ll get their money back. Your payments pass through your bank and onto the US Government’s bottom line. Theres a quasi-governmental agency that does this with Mortgages called Freddie Mac. And we all know how that worked out.

I posit that the growth realized by the US Stock market is fueled by debt, not “…profitability and growth”. There’s a storm coming, and we best be ready when she does.

Best of luck. Thanks for reading,

– Tommander

What I’m reading: The Money Game – Adam Smith


  2. Economic Machine – Ray Dalio –
  8. FRED –

So let me get this straight…


US Government Treasury bonds are the safest asset in the world today. They are implicitly guaranteed to get you your principal back at the maturity of your bond. Economists and investors commonly consider yields on Treasuries to be the ‘risk-free’ rate; meaning rates on Treasuries are the smallest amount of return an investment should provide.

Higher expected growth in the future means longer term bonds will have higher rates. Similarly, if lower growth is expected in the future, longer term bonds will have lower rates relative to shorter term bonds. A common metric quoted in financial news is the “ten to two”, i.e. the yield on a ten year US Government bond minus the yield on a two year US government bond. The ten to two measures the steepness, or slope of the yield curve. Note: slope is also used as a rate of change, i.e. velocity, in calculus (think, economic growth).

Here’s the yield curve today versus a year ago:

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The yield curve was steeper last year than it is today. We’ve realized some massive growth over the last year (see table below), and the Treasury market is beginning to temper it’s enthusiasm on future growth.

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Note that as home prices rise and wages do not, they’re financed with debt not cash. *cough* 2007 *cough*.

The 10-year Treasury yield minus the 2-year Treasury yield is at it’s lowest level in 10 years. That includes November 2007, right before the market went nose-fuckin-down.

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Disclaimer: the ten to two was already on its way up in November ’07, after inverting in March ’07.

It’s pretty much written in stone that money follows performance. Top performing Morningstar funds are given five star ratings. According to this WSJ article, five star rated funds attract massive amounts of assets, only to underperform their past performance: “Only 58, or 14%, of the 403 funds that had five stars in July 2004 carried the same rating through July 2014…”

So let me get this straight, we’ve seen massive performance in the last year. We’ve seen the ten to two at its lowest level in ten years. Why are equities still going up?


  1. The cost of money, i.e. interest rate on loans, is so low that arbitrageurs are borrowing to buy stock, because stock market returns are stable and greater than interest rates on loans. This is called leverage, and is a product of financial engineering. This could be huge once stocks start to fall. (Note: Check leverage levels in the market, thoughts on where to look readers?) Housing growth is also being fueled by easy money, just like last time.
  2. Quantitative easing loaded banks with cash and they’re using it to purchase assets, like money market accounts. Note: I’d like some clarity here, not sure if this is even fundamentally correct. Banks are paid for their excess and required reserves at 1.25%, which is about the same as a 5-year US Treasury bond (1.30%). Why would they get rid of their cash if they’re making 1.25% on every dollar per year; IT’S FREE MONEY FROM THE FED?
  3. We’re hitting the euphoria stage of markets. (See: This is Your Brain on Investing). Markets continue to push all time highs, and the financial media is eating it up. If markets continued at this clip for the next 3 years, both the Nasdaq and the Dow Jones would DOUBLE again (Sauce: Rule of 72). If yearly performance of the Nasdaq and DJIA continued, this is how it would look in November of 2020, does that look right to you?


Good luck, thanks for reading,

– tommander-in-chief

What I’m reading? Wealth, War & Wisdom – Barton Biggs



Discretionary Recessionary Signals

Do you feel more optimistic than a year ago? Despite more negative headlines and political turmoil, bond markets are signaling more optimism surrounding future growth than a year ago.


Nominal yields around the world are much much lower than their historical averages. We actually see negative rates in some European nations. That being said, things are improving. Long-term growth expectations are heating up:


Since a year ago (See: Column “Delta One Year”), all yield curves have steepened, with the Italian yield curve steepening the most severely. In all cases, the 10-year yield rose/fell faster/slower than the 2-year yield. This signals more demand for short term bonds compared to a year ago. Since a month ago (See: “Delta One Month”), all yield curves, save for Italy, have flattened. This signifies more demand for long term debt than short term debt. See Table 1:


It seems sentiment has changed since a year ago. Within the last month, more investors have loaded into longer-term fixed income securities. This is a yield-seeking activity. There has been a global flight to longer term, higher yielding fixed income securities within the last month. This point of view describes investors preference for more yield (less long-term risk).

As yields rise, the opportunity cost of owning stocks rises. More investors will flock to bonds as yields become more attractive. This dynamic causes equity markets to follow bond markets. This point of view describes investors preference for more return i.e. more yield.


Dueling Pianos:

As the yield curve steepens, expectations of future long-term growth have risen relative to short-term growth expectations. As investors become more optimistic on the economy, more money will pile into riskier assets, i.e. stocks. I call this the Future Expectations argument. Under this argument, a yield curve steepening results in higher stock prices. This argument describes an investors preference for risk. More expected growth = more willingness to accept risk. Under this argument, bonds and stocks are inversely correlated.

As the yield curve steepens, yields rise and prices fall on the long end of the curve. As yields rise, equity investors looking for yield will sell equities in favor of bonds. As long term yields rise, equities will fall. This is the Opportunity Cost argument. Under this argument, a steepening yield curve will result in lower stock prices. This argument describes an investors preference for yield. Under this argument, bonds and stocks are positively correlated. (For more on Stock/Bond Correlation, see PIMCO).

Given today’s nominal yields & equity values:

Investors are yield-seeking at current nominal yields, thus the Opportunity Cost argument dominates the Future Expectations argument. When the yield curve flattens today, equities will rise tomorrow and when the yield curve steepens today, equities will fall tomorrow. As nominal yields rise, I believe the relationship will flip, and the Future Expectations argument will dominate.

In 12 out of those same 12 markets, yield curves have steepened over the last year. In 11 out of 12 markets in our sample, yield curves have flattened within the last month. Should this change of sentiment continue, yield curves will flatten and equities will continue to rise. However, I expect the long-term trend to prevail, with yield curves continuing to steepen throughout the next year.

When the ECB and BoE decide to stop QE and raise short term rates, I expect yield curves to steepen. As yield curves steepen, equity markets will fall as investors switch to bonds from stocks. Investors will flock to safety, rallying bond markets.

Watch the ECB and BoE for signals on bond markets. See German Bund Yields.

Thanks for reading,

– Tommander-in-Chief


Further: “What the hell are you talking about?”

A common measure of bond market sentiment is the different between the yield on a 10-year government bond and a 2-year government bond. For example, the spread below is 1.25%. (Note: not the actual yield curve below.)


Review: There are two types of yield curve steepeners: Bull and Bear. A bull steepener short term rates are falling faster than long term rates. This means the 2-year fell faster than the 10-year (and both rates fell); recall, prices rise as yields fall. A bond bull market is one where yields fall. A bear steepener is one where the 2-year rises less than the 10-year, and both rates rise. Prices on bonds fall as yields rise.


Why are Markets so Calm?

Valuations are stretched and economic data is cooling, yet markets are complacent. Why? The following are rationalizations of current market values.

1.) Massive movement from active management into passive strategies. Why pay someone to under-perform the S&P 500? Passive investing implies no trading, which means less volatility.

2.) Increased regulation has permanently caused a decline in the riskiness of markets. Insurance companies and financial institutions no longer have autonomy over what they can invest in. With more oversight comes less risk…

3.) Lower interest rates globally have caused investors to flood into riskier assets. With more investors seeking risk, demand is high, creating inflated but stable asset prices. Argentina, who has defaulted on Government debt SEVEN TIMES, just issued a 100-year bond at a 7.9% yield. Demand for the high yielding asset was strong.

4.) JPMorgan estimates that stock pickers account for just 10% of trading volumes, with 60% done by quantitative trading strategies and passive investing. With more trading done by ’emotionless’ quantitative algorithms rather than hot-blooded traders, market risk has declined permanently. We’re in a “new normal” of low volatility and interest rates. Sounds firmiliar… *cough* Tech bubble in 2000 *cough*

5.) “Stocks always go up.” 😉

6.) Quantitative Easing in Europe and Japan cause inflows to higher yielding assets. The Bank of Japan (BOJ) or the European Central Bank (ECB) pumps liquidity into markets through open market operations (bond buying initiatives). Sellers of the bonds use the Yen or Euros to buy US Dollars. They use the Dollars to buy equities and debt. QE by foreign governments is inflating assets prices. As they continue to ease, i.e. flood markets with liquidity, we should see the trend continue. However, we have seen the USD decline since December ’16. Keep an eye on foreign monetary policy moves. A sudden move by the ECB or BOJ might cause fluctuation in US asset prices.


Thanks for reading.

– Tommander-in-Chief

Trouble in Yellen-Land

Bond markets and the Fed aren’t making sense.

The Fed (“Yellen”) rose the Federal Funds Rate (FFR) last Wednesday, June 12th to a range of 1.00% to 1.25%.

The Fed has two mandates: (1) to keep prices stable (i.e. keep inflation around 2%) and (2) to minimize unemployment. In other words, stabilize the economy by cooling it off when growth gets too fast and heating the economy up when growth slows.

The mechanisms to do this are two fold. The Fed can raise the “Federal Funds Rate” (FFR), making short term credit less available. The FFR is the lowest rate at which a financial institution can borrow. If you raise the lowest rate available in US markets, everything else should follow. Right?

Wrong. The FFR is a very short term instrument. Changes in the FFR only change short term interest rates. (See: Term Structure of Interest Rates). This brings us to our second weapon in the Fed’s arsenal: the Balance Sheet. The Fed can buy and sell securitized mortgages and government debt. They can hold assets on their balance sheet to synthetically alter the supply of debt at longer tenors.

Quantitative Easing (QE) by the Fed flooded markets with cash by purchasing bonds in the open market in order to promote lending (i.e. liquidity). The Fed’s balance sheet exploded… I mean EXPLODED. Check this post for relativity. In the most recent Fed statement, the Committee agreed it would soon be time to bring the balance sheet back to “normal”. This means they will no longer buy new treasuries or redeem matured securities.

Once balance sheet normalization begins, there will be less demand for Treasuries and yields should rise, ceteris paribus. Right?

However, longer term treasury yields have fallen while short term rates rose. This results in a flatter yield curve. Growth in the US and the world remains tepid; and inflation in the US remains under the 2% target rate, but the Fed sees fit to continue tightening monetary policy.

So what gives Janet? 

This morning, Lisa Shalett, Head of Wealth Management Investment Resources at Morgan Stanley, wrote: “… we believe the Fed has embraced a new narrative that extends beyond its mandate of full employment and 2% target inflation.”

The Fed isn’t raising rates because our economy is heating up; they’re trying to combat the next recession proactively. They’re ‘normalizing’ the FFR and the balance sheet back to levels where they can reasonably combat the next recession.

OK, but why the flatter yield curve?

A colleague of mine introduced the idea of relative interest rates as an additive theory. The risk/reward profile of US debt is one of the best in the world. For example, the 10-year government debt yield in Singapore is comparable to the same rate in the US. Would you rather have Singaporean dollars or US dollars given current market conditions? That being said, we have seen a sell off in the US dollar since the beginning of the year. Take a look at what has happened to the US dollar since President Trump took office:


The dollar has rallied and subsequently sold off since the election. In my colleague’s argument, the dollar should rise. If there is a high demand for Treasury bonds, we will see a rise in demand for dollars. You can’t buy US government debt with foreign currency; you have to convert it to US dollars first. More buying of USD pushes up the price.

The recent bond market rally on the long end of the yield curve has pushed rates lower. This could be from more demand as per my colleague’s point; or the bond market is calling bullsh*t on the Fed’s optimistic outlook for the economy because a movement from stocks into bonds signifies a move to safety. When the 10- to 2-year spread tightens, it signifies lower growth expectations in the future.


When Trump was elected, stock markets rallied. The so called “reflation trade” became all the buzz and a “risk-on” mentality became popular. Check out the pop in the 10 to 2 on November 8-10th. This was a spark of optimism that the US economy might see some fiscal stimulus. Since, the bond market has postulated that the current administration might not be able to meet goals in respect to healthcare and infrastructure stimulus, thus spreads have narrowed and expectations tempered.

To review:

The Fed says we’re growing at a healthy clip, with inflation rising. Their reflation narrative is weak, and the bond market isn’t buying it.The Fed is trying to stockpile ammo before the next recession.

What I’m watching:

An inverted (i.e. negative) 10- to 2-year spread has preceded EVERY recession in recent history. Check it out:


Keep an eye on the 10 to 2.

What I’m Reading:

Thanks for reading,

– Tommander-in-Chief


Disclaimer: there are SO MANY moving parts in finance. It’s impossible to point to any one factor because it’s always a combination of several or many factors that affects markets.

In the grand scheme of things, how big is Apple?

Apple, Inc., producer of the iPhone, announces quarterly earnings on Tuesday.

This WSJ article claims that the cash and cash equivalents on APPL’s balance sheet will exceed $250 billion dollars. I put this article together to give you some idea what that looks like.

Relative to the World:

$250 billion is about the same size as the nominal GDP of Venezuela, Pakistan, Chile, Bangladesh, or Finland. It’s about the same size as the combined GDP’s of the smallest 61 countries in the world. I repeat, Apple could afford to buy the smallest 61 countries in the world using ONLY CASH!!

Switching to revenue as a metric:

Apple, at $233.72b, would be the 47th largest country in the world, between Vietnam and Peru. For relativity, Toyota Motor produces $236.6 b in revenue each year. The largest company in the world is Walmart at $482.13 b in revenue. Walmart would sit between Poland and Belgium if you allow sales to be a metric compared with GDP. Walmart is bigger than Belgium, UAE, Norway, Hong Kong, South Africa, Denmark; the list goes on and on.

Of the top 15 largest corporations in the world (FORBES), six are commodity producers, two are automotive producers, two tech (Apple, Samsung), and two conglomerates, one is utilities, one pharma, and one financial. Apple makes up 6% of the revenue of the top 15 companies in the world.


In terms of Geography:

Five are USA based, four Chinese, and one from each of the following: UK, Germany, Japan, S. Korea, Switzerland, and Netherlands.


This is the world represented by the top 15 companies sorted by sales revenues. Note: Eight (8) countries represented.

This is the world represented by the top 8 economies sorted by GDP. Strangely similar eh?


Grexit: Should we be worried?

Without another bailout, Greece is set to default in June on yet another debt payment of $7.0b.  If Apple agreed to pay instead of the Greek government, it would represent just 2.8% of the cash on Apple’s balance sheet.

The entirety of Greece’s nominal debt in dollars is $375.6 billion. Apple’s total debt is around $100 billion. Apple’s total cash is around $250 billion. Apple could afford to buy two-thirds of Greece’s debt using ONLY CASH. It would only need about $125 billion in nehw debt to completely refi te whole country.

Remind me, why are we worried about Greece again?

Food for thought. Thanks for reading.

– Tommander-in-Chief





Relative Performance: Equal or Market Capitalization Weighted Index?

Using SCHA and SCHX as proxies for Small and Large cap equity markets, I attempt to measure cumulative relative performance over one (1), two (2), and three (3) year time periods.

The S&P 500 is a market capitalization weighted index, meaning the biggest companies have the biggest weights in the index. The Dow Jones Industrial Average (DJIA) is a price weighted index. So companies with large stock prices are weighted heavier. (Example: Goldman Sachs at $230 has much more weight than Intel at $34). There are also equal weight indexes (Ticker: RSP). These weight each stock in the index equally, regardless of price or market cap. (Ex: 60 stocks, each gets 1/60th weighting.)

Investing your money in a market cap weighted index leaves you relatively more exposed to larger companies, where equally weighted indexes leave you more exposed to smaller caps. Price weighted indexes have very little mathematical basis, other than they’re easy to understand. Price weighted indexes are not good representation of changes in value of the stock market, thus we ignore them in this exercise.

Small cap stocks tend to exhibit more price movement, i.e. more volatility. More risk, more reward. On average, small caps will outperform in a bull market, but under-perform in a bear market. The strategy goes, overweight small caps when times are good, overweight large cap value (Walmart, Walgreens) when times go sour.

Here’s the relative cumulative performance of Small/Large Cap equities. A number above one (1) means small cap is outperforming, while a number less than one (1) means Large Caps are outperforming.



The above graph shows relative cumulative performance starting in March of each year. Example, blue line shows 36 month relative cumulative returns, while the green line shows the 12 month relative cumulative returns.

Since Trump took office in November of last year, we’ve seen a bump in small caps, then a subsequent sell off, relative to large caps. Small caps popped first, then large caps followed. However, small caps have outperformed relatively since last year, while large caps have performed better since three (3) years ago.

We need to compare this to an average ratio for each time period (far right column). Note: these are weekly returns (March thru March).


Large Cap have outperformed Small Cap over the last three years, pretty significantly, and under-performed over the last twelve (12) months.Thus, equal weight has outperformed over the past year as we see below. However, Large caps have made a *Huge* rally relative to small caps since February. Here we used RSP and SPY as proxies for equal and market weighted indexes.


Strategy: Large Caps were over valued last March, but Small cap valuations are catching back up. Buy equal weight for the 6-9 month time period, then re-evaluate relative performance. Note: Tax reform will help Small cap over Large cap, so watch for tax reform in late summer,early fall (LINK, Fortune).

Disclaimer: this article is designed to help you choose between Equal or Market cap weighted indexes; I’m not advocating specific securities. This is only one measure of relative valuation, do more research on your own before purchasing securities. I do own SCHA.