Pay it back


In our last commentary we spent a great deal of time focusing on leverage, credit expansion and some of the repercussions these forces have created around us.  Typically in the midst of an easy monetary policy cycle, growth is steady or expanding, the employment picture is rosy, while stocks and other assets are rallying. In short, it’s generally sunshine and rainbows.  If there’s any doubt about that, just take a look at your 401k statement or turn on CNBC.

The folks at the “world leader in business news” are more than happy to tell you how the guest speakers at their Delivering Alpha conference have been right-on in regards to almost all of their stock picks the past 3 years.  With there being 15 stocks at 52 week highs for every stock that’s at 52 week lows, I’m amazed too!  I am pretty sure I could train a chimpanzee to throw darts at a board with stock names and with those odds, we could talk about how impressive the chimp’s investing prowess is too.  Tell me how they’re doing during the next down turn, Leon Cooperman for example lost 36% during the housing crash for example!

All jokes aside, what may be on your mind is what happens when we have to pay back all of those future earnings we borrowed from.  Or perhaps, how does this end?  To answer these questions, I think it’s important to look at a few of the not-so pretty side effects of monetary policy during the past at least 6 years and more precisely since Greenspan’s tenure.

One of the issues I’ve brought up repeatedly through our commentaries is the fact that money like all forces in nature, tends to choose the path of least resistance.  Unfortunately, nowhere along that path is the average working American’s pocket.  Indeed, with investors swimming around in an ocean of money, real estate is booming, stocks are at all-time highs and massaging money has become considerably more profitable than capital expenditures, let alone investing in your people.


“Profits are (at) record highs for US corporations – and yet we’re only reinvesting about twice as much as we’re returning to shareholders in the form of dividends and buybacks. In the 1970′s, corporations were investing 15 times as much – hiring, training, building, R&D, etc.” source:

Wage Growth by Percentile


Will profits trickle down to your average working American’s bottom line? Most likely, but how soon and to what extent are very much in question.  Early indications are that your median household will receive a pay bump not only much later, but at a disproportionately smaller percentage than that of the affluent.  Not only that, but despite the fact that household wealth is at all-time highs, the bottom 50% have actually seen a net loss in wealth since the housing crash.

Furthermore, the divergence between Labor, GDP and Corporate Profits as seen in the chart below is as striking as it is disturbing.  Intuitively, I don’t see any outcome where that trend can be sustainable.  What’s more striking is that the correlation really got out of hand about the same time easy money became the Fed’s Standard Operating Procedure.



Corp Profits vs Labor



However, it’s not just the gap in income between average folks and the so-called “one-percenter’s” that’s startling.  The Cost to get an education has been rising at a similarly absurd pace, much faster than even that of housing.

Young students today are burdened with the choice of taking on $100,000 of debt or entering the job market woefully unqualified for the positions that are available.  Making matters worse, as the data above indicates, if recent trends continue, they are likely to find an environment of falling wages when they graduate with that debt load.


Inflation and school


Unfortunately the problem for students is being exacerbated by a housing market that according to recent data is being fueled by as much as 50% cash buyers.  That’s no typo, 50% of homes are being purchased all cash!  The only people buying homes all cash are investors and developers.  Why would they do this? Two reasons:  it’s widely expected that homes will continue to appreciate at a rate at least equal to inflation.  Second, with real interest rates at essentially zero, rented properties provide substantially better returns than treasuries, all while in theory providing that inflation hedge.

Not only that, but because the Fed has condensed the yield curve down so substantially, a rental return of 5-6% is actually extremely attractive to investors.  This has a two-fold effect; the first being that property owners can now offer rent at substantially lower prices than mortgage/ownership costs for the renters, while simultaneously  being satisfied with the return.   Secondly, and most disconcerting, as many of you may know, it’s the rental price index for which the fed insidiously gauges the cost of housing in the US.

Thus, the Fed’s policies have made housing considerably more “affordable” in regards to payments and cost of capital for investors and borrowers alike, although much more expensive in dollar terms.  Rental costs on the other hand, have not kept pace, therefore, while housing prices have rocketed upwards of 50% in some areas, by the Fed’s measurement there is no inflation in the price of housing.  I truly struggle to find words for that kind of logic.

I question how a young family can start out with 100k in student loan debt, median housing prices in many major metro areas in excess of $500,000 (over $1,000,000 in San Francisco), all while investors continue to bid the prices up?  They can’t and therefore, real property and wealth will continue to shift to the hands of a few in this vicious cycle of low interest rates.

It’s only logical to ask; if the average household is losing out, then who is benefiting?  Other than the super-wealthy, the entities that are perhaps the single largest benefactor of easy monetary policy are central governments around the world.  Insanely cheap bond prices have allowed them to run fiscal deficits and display fiscal irresponsibility like the world has never seen.  How else could the US maintain its 17.5 trillion dollar national debt?  Better yet, how many generations into the future have we borrowed from?  Again, these facts continue to beg the question, how does this end.

I’d like to present two distinct possible outcomes.  Starting with the optimistic hypothesis first, I’m of the opinion that in order to support the leverage and insanely high prices of real estate, stocks, not to mention the reputation of the US and other debtor nations, interest rates must stay exceptionally low.  They must stay exceptionally low for a long-time, much longer than anyone wants to talk about, perhaps a minimum of 15-20 years.  The abundant leverage in the world is so extreme, that it may take decades to normalize the curve.

To illustrate my point, imagine if you will just a small rise in the fed funds rate, to perhaps 3%.   Such a rate environment would cripple the housing market as suddenly only the cash buyers would be able to afford the payments and why would they when they could get 6% for a 30-year bond?  It would likely cut the stock market in half again, and put the US in a situation where it’s ability to repay its debt obligations would be very much in question.

I’m afraid that Janet Yellen and the rest of the voting members of the Federal Reserve agree all too much with my sentiment.  Why else have they essentially dropped the employment portion of their mandate?  Why else are we still in crisis mode relative to historical standards?

I think it’s because they are well aware that a semi-permanent low rate environment, would avoid all of this.  Equity valuations would be cheap to fairly priced, real estate would stay affordable and the US could continue to maintain its ridiculous fiscal policies.  Of course all of the problems aforementioned would continue, most notably the continuation of the biggest wealth shift in the history of our nation.  Which could of course bring about destabilizing social unrest, but such is the price of pursuing a mythical world of indefinite growth.

With that said, I must admit, I’m not convinced such a low rate environment can be maintained, that the market forces will not rise up and break the world’s central banks.  However, let’s suppose it can; would it not simply be nothing more than the greatest act of Sleight of Hand the world has ever seen?  Let me elaborate using a simple analogy.  Regardless of whether you’re borrowing at 3% to buy a million dollar house or 6% to buy a million dollar house, you’re still borrowing to buy a million dollar house.  Over the long-run that house should not be worth more because interest rates were lower when you purchased it.  At some point, you will have to sell that million dollar house, will there by a buyer?  I’d suggest buyers would only buy the home if they deem it worth a million dollars, which intuitively should have nothing to do with your payment. Of course the low rates would provide a temporary burst of economic activity (sales, building, remodeling) as more transactions are facilitated by rising prices and a cash rich environment.  But in reality all the low rate environment has done is expedited the time it took to take what was recently a half a million dollar house to a million dollar house.  Expand the concept of our hypothetical house to the broader economy and you begin to see what the Fed is attempting.  With that said, the Fed has not created a perpetual motion machine, although they may try to convince you otherwise.

What if the market won’t bear the ultra-low rates on a semi-permanent basis?  This leads me to my second theory, which I believe to be the less likely of the two; the end of the World’s greatest credit cycle, one that’s been playing out for nearly 40 years.  It has been an era of growth and advancement to behold.  However, if it ends, I’m afraid the Peter Schiff’s of the world will be right and the “Great Recession” will look like nothing more than an opening act.  All of the hypothetical high interest rate events I mentioned earlier would come true and possibly with a hyper-inflationary bubble first.  I’ve said it so many times by now, we all know what leverage does when the music stops playing.  Please, do not be fooled into believing the world deleveraged during the crash of 2008.   Only the private market deleveraged.  Their bad debt was simply transferred to the public sector, a much less appropriate venue might I add.

So how to invest?  That depends on which of the outcomes we laid out you are in favor of.  In the very long-term we lean towards a low interest rate environment being maintained.  Thus, in the near-term we expect the status quo to go on unchallenged.   Therefore, you can refer back to our last commentary in which we expected the Market would burst to fresh new highs, which it did.  We also suggested a nimble portfolio, with some sort of hedge if you insist on holding long-term.  We continue to reiterate those suggestions.  Since the S&P broke above 1940 we have been using both Short Calls well above recent highs as well as bear put spreads to protect our index positions.  This has worked quite well and served to limit volatility in our Index Portfolio.

Our fixed-income holdings continue to include short to medium-term Cash US Treasuries overlaid with short futures contracts for price discovery.  However, we have reduced our short position and even have deep out of the money calls in place as we expect yields to fall and prices to rise.  Such a position may come as a shock to many, however if you look at the 10-year bond yields for Italy, Spain and Britain and it becomes clear that there’s a cap on US rates.  Unless these foreign bond yields rise, we think demand for US treasuries will remain strong.

We still believe exposure to physical assets is warranted as well, particularly if they produce an income, like rental property.  Five to six percent return on rental property is stellar in a time when the Fed is bent on keeping rates near zero.

  • Hedge or reduce equity exposure on any sort of burst higher, we think options work best currently
  • Fixed income in the duration of 3-5 years appears to be the sweet spot for yield, particularly if you can hedge yourself in the futures or other derivative.  Avoid anything longer than 5 years
  • Invest as though the Fed can hold rates low indefinitely, what does that do to your risk curve?
  • Have exposure to physical assets (particularly those with deep-retracements or that produce income)


In summary, as we venture deeper into uncharted monetary policy, at DCM we ask if this is destined to become the status quo?  It certainly is the least painful route for market participants, but it also effectively sterilizes the Fed.  However, for the time being, it seems to be the least painful route, the path the Fed has chosen most often in the past, socio-economic consequences be damned.


Best Regards,



Duane Cronin