The New Utilities . . . EXCEPT Lower CapEx and Lower Valuations

It is very hard to argue that the so-called "market" does not crave predictability.  When valuations of Utility and Consumer Staples stocks rise to historically high levels, which has driven their dividend yields toward historical lows, predictability of earnings seems to be an insatiable craving.  This could change rapidly, as thing do in the financial markets on a day-to-day and week-to-week basis.  However, for the time being, volatility is a 'four-letter-word' and predictability is a virtue.

Given the above argument, increasingly-regulated industries are likely to increase in desirability among investors.   In fact, over time, despite our free-market ideals (however "rigged" things are on a regular basis), increasingly-regulated markets like health insurance and utilities and NOW banks usually generate massive stock returns while, in contrast, de-regulated markets attract too much capital from Wall Street investment banking which drives returns-on-invested-capital lower (Wall Street has rarely seen an opportunity not worth over-capitalizing.  In the case of airline de-regulation and utilities de-regulation in the 1990s, Wall Street overcapitalization of those industries led to lower returns that were inadequate to service debt levels, resulting famously in the massive bankruptcy of TXU.  The dot.coms rise and crash is another good example of this overcapitalization phenomenon, which the re-regulation in the Utility industry and in certain sectors such as Health Insurance has deterred new capital into those industries (other than company self-generated cash flows) and higher returns-on-invested-capital.

If the above analysis and argument is accurate, then the U.S. banking system should offer great returns for investors in the next several years.  Few, if any, sectors have been as aggressively and quickly over-regulated than the U.S. banking sector.  Various industry players periodically complain about the increased regulation, but in reality it is that regulation that drives those same companies to monitor, manage and streamline their businesses like never before.  Moreover, the increased regulation deters "shadow-banking" enterprises from being capitalized by those looking to invest in "growth" industries such as mortgage brokers, mortgage insurance, mortgage servicing companies and related financial services businesses.

Finally, this argument is not speculative in its entirety.  The benefits of increased regulation in the U.S. banking industry is already apparent.  Dividends are RISING in the banking industry in the United States, as companies understand that they must generate strong positive returns on internally-generated cash flows.  Moreover, moderate mergers and acquisitions (M&A) activity is occurring, albeit likely at an early stage;  however, this area may accelerate as existing-operations margins and returns-on-capital max out and managements look for opportunities to reduce costs by consolidating operations.  One additional impressive statistical difference between Utilities and Regional U.S. Banks is that the banks have negligible capital expenditures requirements relative to their profits;  this fact too also supports higher valuations and better dividend growth prospects for the regional banks.

I have increased my investment exposure to regional U.S. banks recently and will likely continue to do so opportunistically.

Brexit: It is 'just" a milestone in the ongoing global currency war AND a sign of growing wealth disparity

There was some possible market panic on Friday, June 24, as major world stock indices generally fell more than 3%.  However, some of the financial market turbulence was simply unwinding or reversals of investments established to possibly benefit if the United Kingdom had voted to remain in the European Union.

But it truly seems like the headlines about near-term ramifications to the world economy may be exaggeratedly negative.  More likely, it is the medium- to long-term periods that should be of concern, and those concerns should have existed prior to the Brexit vote outcome.

First, the UK does now have more flexibility to weaken its currency, and thereby make its exports more attractive.  While England did not use the Euro, there was an implied monetary support to the British pound from the European Union.  Without that support, Britain is now more free to exert aggressive fiscal policy (likely through higher government spending) to attempt to improve real GDP growth there.  Any further increase in debt-to-GDP or debt service costs for the UK will likely weaken the pound against the Euro, the US dollar, the Japanese Yen and other major world currencies.  Simply put, the UK just joined the global currency war that has been going on for several years now amongst the European Union members that used the Euro, Japan and the United States.  If in fact,the UK will more aggressively weaken the British pound in coming years, then the future of fiat currencies worldwide is even more uncertain than in prior periods.

Second, and just as concerning, the vote in favor of exiting the European Union was driven by the population outside of the major financial centers of the United Kingdom.   This is quite concerning because it is quantitative validation of concerns regarding the growing worldwide wealth disparity.  When the "have nots" have much less than the "have" by a wide margin, revolutionary forces such as this Brexit vote and in the USA the popularity of candidates such as Bernie Sanders can rise significantly.  This phenomenon is important to monitor because aggressive monetary policy actions (i.e. "printing money") tend to exacerbate wealth disparity; those who own land, stocks, and all forms of "dirt" such as gold and silver experience wealth increases in nominal terms, but those that are on fixed incomes and live paycheck-to-paycheck feel their reduced purchasing power is a growing injustice and form of inequality.

I expect that my views on the important ramifications of Brexit are not mainstream or consensus, which is nothing new for me and that is not something I am uncomfortable with.  Someone said (and I agree), great investments are made in the dark, and I agree.

Jim Lane

Sometimes Conspiracy Theories Are Correct

My Concerns with the Dollar and What I am Doing About It

Two Competing Theories.  Among the most controversial conspiracies among financial market participants is the controversy over currencies and the related topic of inflation versus deflation risk.  In one camp, prognosticators argue that central banks are fighting a valiant fight against deflation;  the fight is considered valiant largely because global deflation was a dominant factor in the mid-1900s Great Depression and therefore a trend of declining asset prices should be prevented.  In the other camp, the less mainstream voices assert that aggressive deflation fighting through monetary and fiscal expansionary policies merely delay inevitable reallocation of less efficiently-deployed capital and merely raise nominal price levels;  longer-term, sustained increases in nominal prices at best enhance the per share earnings of publicly-traded companies, and at worst may drive increasing gaps in standards of living as low- and lesser-skilled workers' wages tend to rise more slowly than monetary-induced inflation.

So who is probably right?  I am convinced that the latter group is correct, and therefore I have invested 40% of my liquid assets in the currency that prevails when the prices (or as economists put it "opportunity costs") rapidly rise in nominal currency:   gold.  I own gold in physical bars, asset-backed (not derivative-backed) gold ETF shares, and through stakes in gold mining stocks.  In my view, gold likely has downside risk to $1000 (from recent prices near $1300) but upside of $10,000 given that the $3 trillion in excess U.S. bank reserves ultimately may be lent out approximately 10x given the current U.S. bank required reserve ratio of 10%.  My $1,000 downside risk estimate is based on the face value of $4,000 trillion in "printable" U.S. dollars today compared with the approximately $1 trillion of printed U.S. dollars before the financial crisis, and given that gold was trading around $250 per ounce in the late 1990s.  However, that $1,000 downside risk estimate is likely extremely conservative given that our U.S. banking system is a fractional reserve banking system in which one newly-lent dollar from a bank, can result is $10 of eventually-created new U.S. currency under current banking rules.

So what is the catalyst?  Currently, some of the most desirable currencies in the world include the Japanese Yen, the Chinese Yuan, and the U.S. Dollar.  There are possible good reasons for the preferred status of these currencies, including liquidity, tradition, government systems that value 'Rule of Law' and current widely-accepted business practices.  However, the countries that manage these currencies are not rich in basic materials natural resources, and have steadily-rising or rapidly-rising debt service dynamics.  While debt-to-GDP is a widely accepted ratio among financial market participants with regard to the fiscal health of a nation, debt service (the annual cost of interest and principal repayment requirements) expense risk is probably a more telling risk factor.  The debt service expense risk of Japan, China and the United States is rising.  I believe eventually this will become a consensus view and that will cause a global shift away from these currencies and toward the currencies of more resource-asset-rich countries, such as Australia, Canada, and others;  perhaps fiscally-conservative nations like Switzerland will also experience investment fund inflows.    However, those nations' currency liquidity and availability is much more limited than the existing preferred global currencies.  Therefore, the ultimate long-term global history currency, gold, is likely to benefit from substantial inflows as well.    While I cannot and don't even attempt to try to predict the timing of when this thesis will play out, global near-zero interest rates have lowered my opportunity cost of placing my savings into gold and related investments.  Similarly, every investor needs to determine their own ideal investment allocation mix, but I believe that every investor should should consider whether there are any risk scenarios that their current portfolio allocations do not incorporate.

Unconventional Wisdom: It’s a Friggin’ Fact – Buy Assets (including a home) When Interest Rates are High

Unconventional Wisdom:  It’s a Friggin’ Fact – Buy Assets (including a home) When Interest Rates are High

Like most of my best lessons as a teacher, this blog entry is inspired by a great conversation with my Economics students in the last few weeks.  One student, in response to my assertion that successful investments are more likely when interest rates are high than when interest rates are low, asked “Mr. Lane, is that your opinion or a fact?”  “It’s a friggin’ fact,” I replied.  After reflecting further on the student’s question, I decided to create an economic model theory to help illustrate my assertion to the class.  In mathematics, such mental exercises are called ‘proofs,’ and the longer that I teach Social Studies, the more convinced I am that we are all better off when we develop similar deductive theoretical proofs.

To prove my theory to the students, I asked them to accept the following premises:

(   (1) there are a fixed number homes for sale at any one time, and that every home is for sale at a price of $1,000,000

(   (2) there are a fixed number of buyers for the available homes for sale, and every buyer has $5,000 per month (or $60,000 per year) in income available for a mortgage payment

(   (3) there is one single mortgage interest rate available to home buyers: 5%

Under these conditions, every buyer can “afford” to purchase one of the available homes because Year 1 interest would be $50,000 and the additional $10,000 of payments could be applied to modest principal repayment.  Therefore, sellers would not be deterred from buying, and all buyers would be able to achieve their asking price of $1,000,000.

However, I then asked students to consider what would happen if some of those premises change a s follows:

   (1) as in the above scenario, there are a fixed number homes for sale at any one time, and that every home is for sale at a price of $1,000,000

   (2) as in the above scenario, there are a fixed number of buyers for the available homes for sale, and every buyer has $5,000 per month (or $60,000 per year) in income available for a mortgage payment 

   (3) there is one single mortgage interest rate available to home buyers: 10%

Under these conditions, no buyers can “afford” to purchase one of the available homes because Year 1 interest would be $100,000, well above $60,000 that each buyer has to put toward annual mortgage payments.  Therefore, sellers would be completely deterred from buying, and all buyers would be required to lower their asking price of $1,000,000;  the result is downward pressure on the price of homes.

The simple example above proves that assuming “all other things equal,” home prices are lower when interest rates are higher.  Perhaps more importantly, the interest-rate relationship to asset prices is a truism such that “all-other-things-equal” assets can be acquired more cheaply when interest rates are high than when interest rates are low.  Therefore, by behaving in a fiscally-disciplined manner and waiting for prevailing interest rates that are substantially above long-term averages, one can buy assets that are quite likely to appreciate in value as prevailing interest rates regress toward long-term averages.  Therefore, the absolute truth is that the best time to buy an income-producing entity (a home, a rental property, or a business) is when prevailing interest rates are higher than long-term average rates.

Two Schools that Need New Curriculums: We Need to Replace Keynesian and Austrian Economics with a Standard of Living Paradigm

As an Economics teacher of some extremely bright students, I frequently am asked by some of the strongest, "Mr. Lane, are you a Keynesian or a Classical Economist?"   My first reaction is a laugh because I have convinced my students that I am an Economist at all!  But hearing this question every semester, I finally have a decent answer, "Neither, I am a standard of living economist."

These days Keynesian economics by and large encourage government deficit spending and central bank policies that maintain low interest rates, with the goal of muting the magnitude of the business cycles.  While most skilled business people prefer periodic downturns and upturns in economic growth rates due to the business cycle, Keynesians prefer government and quasi-government agencies to act to mute such cycles.  In contrast, laissez-faire Classical economists encourage a default response to economic recession or economic acceleration that demands patience of both households and firms to let markets and human behavior adjust to excesses and shortages.  As anyone who even periodically notices current events knows, Keynesian enjoy-today "because we're all dead eventually" economics is currently en vogue globally, but at some point the pendulum will swing toward the Classical school.

Despite the dominance of these two camps, in working with my students every day, I am becoming more optimistic that the a new camp may emerge:   Standard-of-Living economics.   If policymakers would pick and choose from existing policy options while carefully considering the potential long-term impacts of such options on the average citizen's potential to increase their standard of living over coming years, then it is more likely that policymakers will choose options that provide such a setting.  Unfortunately, I haven't seen or heard much about monetary or fiscal policy focus on standard of living mobility since the very early months of current Federal Reserve chairman, Janet Yellen, took office.  Hopefully these great students I get to teach will be part of a movement to shift economic policy toward upward social mobility tools and paths for the masses, rather than muting the natural business cycle associated with a capitalist economic system.

Why there might not be a surge in inflation . . . or not.

Historically, the amount of money that has been created and in circulation, relative to the amount of gross domestic product (GDP) has had a fairly constant relationship.  Today, the United States real GDP is approximately $18 trillion annually.  There is U.S. money in circulation of approximately $1.4 trillion, which is a ratio of approximately 13 to U.S. real GDP currently.  Following the strong economic growth of the post-World War II era, in 1975, the United States GDP was approximately $1.5 trillion, according to the World Bank, while U.S. money in circulation was approximately $75 billion, which was a ratio of 20.  Additionally, in 1950, the United States GDP was approximately $250 billion, while U.S. money in circulation was approximately $25 billion, which was a ratio of approximately 10.  Expansion in the ratio of money-in-circulation to United States GDP suggests that the United States became more efficient with putting new available money to work, while a decline in the ratio would suggest that new money came into circulation, but was used in a manner that was less productive than the existing uses of available money for investment.

                                                                        $ in billions

                YEAR               1950               1975               2000               2015

                  GDP                $250               $1,500         $10,000           $18,000

                 Money               $25                 $75                 $600            $1,400

                 Ratio                    10                   20                   18                   13

                Sources:  U.S. Federal Reserve Bank of St. Louis.

The above table shows that from 1950 through 1975, the increase in money in circulation resulted in a greater increase in real (inflation-adjusted) GDP.  The primary driver of the increase in money in circulation is when banks create new money in the system through loans when there is a proposed productive use for that money in the form of business expansion, construction opportunities, equipment replacement requirements for consumers and businesses and sometimes governments.  During this time period, a tripling of the money in circulation resulted in a six-fold increase in real GDP.  This suggests that the new money created, mainly through new credit creation in the form of bank lending, generated very high productive and economic-expanding returns.  Similarly, the roughly flat trend in the ratio of real GDP to money from 1975 to 2000 also suggests highly productive money creation at or near 1975 levels.  However, in the more brief period of 2000 through 2015, the GDP-enhancing impact of new money created has fallen; approximately $800 billion of new money in circulation more more than a 100% increase, and yet annual real GDP increased by approximately 80%.  This suggests that the new money in circulation, again largely generated through new lending from banks, was not as stimulative to economic growth as such money supply increases in prior periods.  This suggests that more money is chasing incrementally less productivity, which can be inflationary.

Going forward, the United States banking system currently is flush with lending capacity, as there is more than $3 trillion of available lending power that, due to the multiplier effect, represents approximately $15 trillion in potential new money creation capacity.  In the absence of incremental real GDP growth at a minimum ratio of 13 dollars of real GDP growth for each one dollar of money creation through bank lending, such new money creation would be inflationary.  Therefore, in a scenario that our money in circulation increases from approximately $1.4 trillion to $16.4 trillion without U.S. annualized real GDP expansion from approximately $18 trillion to $213 trillion, inflation will likely result.

While economic expansion from $18 trillion to $213 trillion may seem unlikely, and therefore may stoke inflationary panic, there are some checks that naturally reduce the potential for inflation.  First, banks scrutinize loan requests and have capitalistic profit-seeking motivations for limiting loans to strong-return investment opportunities.  Second, if banks begin to see existing loans produce less-than-productive returns through loan quality deterioration, the money multiplier will fall from the maximum of the formula: money multiplier = loanable funds * (1/required reserve ratio);  if the required reserve ratio is 20% for most banks, then the maximum money multiplier would be 5, but in times when loans do not perform well, banks will slow lending due to profit goals, and new money creation will slow until higher productivity opportunities arise.  Third, if the pace of credit creation is methodical over many decades or even a century, then the odds that the $15 trillion of potential incremental new money created does in fact generate an incremental $195 trillion of real GDP probably is greater.

In summary, it would be overly speculative, and probably irresponsible, to stoke the flames of inflationary panic that some gold bugs tend to rely on with regard to money creation as a definitive driver of coming hyper-inflation.  However, the decline in productivity of new money creation from roughly 20 dollars of incremental real GDP to 13 dollars of incremental GDP for each new dollar created does warrant vigilance.  In the context of a highly-Keynesian global economic environment, where foreign central banks are using the Great Recession-induced U.S. experiment with quantitative easing in unprecedented levels, such vigilance seems even more warranted than otherwise.

What does the recent heightened financial markets volatility mean (if anything)?

In one episode of my favorite show, Seinfeld, Jerry Seinfeld sells his shares of a stock when the price falls below the price he purchased the stock, while his buddy George holds on and the stock makes George a small fortune in George's context.  Jerry's girlfriend at the time reminds Jerry that he wouldn't have made his ill-timed sale if Jerry had listened to her when she told him that "stocks fluctuate."  Like most comments from women to Jerry on the show, this comment ended the relationship.  And while it is true that markets "fluctuate," recent intra-week, intra-day, and even intra-pre-market so-called fluctuations have been in excess of 2% on many days during these past few months.

It is hard to know what this heightened volatility means, but based on 2007 and 2008, I would not be surprised if this heightened volatility is signaling that there is a high level (relative to historical averages) of financial leverage being used to buy financial assets.  In addition, the increase in the size of the financial derivatives market is likely to blame as well, as is the increasing size of the exchange-traded fund (ETF) market, which must amplify the impact of any gyrations in the financial markets as selling or buying of securities may beget more selling and buying of such securities as investors re-size their ETF holdings.

My sense is that heightened volatility is associated with near-term downside in financial markets indices, and that opportunities for long-term value investors to buy world class businesses at bargain-basement prices relative to the businesses' free cash flows will arise soon.