Andrea Zacher

As we emerge from our Covid-19 caves and rejoin business, commercial and personal worlds, I have begun to wonder what institutions, interactions, professions, entertainment and lifestyles will be altered in a material way. For most of my life I have been on a hamster wheel of expected behaviors like showing up for work, interactions being face to face, and going somewhere other than home for socializing and entertainment. I never had any reason to consider whether that lifestyle was effective or fulfilling. It was just what you were expected to do.

Business Interaction In Flux

I have written in prior blogs about diminishing business travel and meaningful changes in spending on conferences, business entertainment, and customer retention https://capitalworks.net/covid-19-challenges-the-hamster-wheel-of-sales-marketing/. However, budgets for customer acquisition will probably increase as business reopens and “showing up” for face-to -ace introductions becomes a critical part of new business. Many of our portfolio companies have reduced sales expenses by curtailing “hamster wheel” business travel where time is consumed in travel to meet with existing customers. This line item will be slow to return given the apparent adequacy of online meetings for maintenance of relationships.

Business lodging is probably going to be a casualty as well. There are simply too many rooms for the permanent reduction in overnight business travel. Some entrepreneur will figure out how to repurpose that excess supply.

Medical Experiences Are Also Changing

Medical interactions are also changing. Covid-19 forced many non-surgical interactions with medical professionals online. I wonder about radiology and dermatology where super computers have databases for analyzing x-rays and scans that are more accurate than trained professionals. The biopsy process is at risk for suspicious skin growth. You can take a smart phone picture and data analytics can name the cells.  On the other hand physical therapy will be booming. Active aging comes at a price. The backlog of deferred physical therapies right now is like the “Ever Given” back up in the Suez Canal.

Our Spiritual Fulfillment May Be Virtual

The spiritual life may be undergoing major changes as well. I was shocked at the response I got when I asked several friends who were serious church goers before the Pandemic what they were going to do for Easter. They apparently have found spiritual satisfaction online. A couple in Florida has daily interactions online with broadcasts from Boston and Cleveland. They shocked me when they said they will never go back to accepting the mediocre spiritual content offered up by the parish church when there is such a robust alternative online. My father used to contend that religion was not meant to be entertainment. That opinion may now be turned 180 degrees. For the spiritual experience to survive, it may have to provide engaging and entertaining content including music, song and sermon. This could devastate religious communities already in decline from pedophile priests and swindling preachers.

Going To The Office Is Never Going To Be The Same

Going to office will mean something different as well. More and more employees will walk downstairs at 5:15pm in their apartments or homes and announce “Honey I am Home.” Collaboration spaces and conference rooms will remain, but the idea of the individual office is changing fast. If securities traders can survive in their profession https://capitalworks.net/an-insiders-tutorial-on-programmatic-trading, without any physical proximity, how hard can it be for the rest of us who are not required to make moment to moment decisions worth millions of dollars every 15 minutes? 

The whole business commuting ecosystem is probably going to shrink.  Parking budgets will be slashed. Commuter infrastructure like trains and buses may no longer operate for the primary convenience of the weekly commuter. Anticipating this possible shift, the current infrastructure legislation proposals for public transportation may have to be re-imagined.

Segmentation of Entertainment by Cohorts

National Parks, state and local greenspaces, cityscapes, beaches, and even outdoor recreation in declining sports like skiing and golf made a dramatic Covid-19 comeback. For the short term these are all popular alternatives to indoor entertainment.

I am not sure about more crowded venues like theme parks, movie theatres, stadiums, art museums, performing arts centers, and race tracks?  

Outdoor dining has also become preferable for an older generation who now perceives their longevity is at risk in crowded environments. Group interactions may balance out at about 60/40 physical versus virtual depending on the age cohorts involved. There may be a whole new segmentation of entertainment experiences for the various age cohorts as well. I know for certain I will be limiting my indoor, crowded experiences for a long time. I trust most of my age cohort to act responsibly because of mutually assured destruction, but I am not sure younger cohorts have the same risk equation.

One lesson from the Pandemic is PROXIMITY IS PERILOUS in a connected world where virulent flu seems to be as regular as rain. I am also concerned for the first time about germ warfare. Its disruptions are devastating and hard to trace. History has shown it can change the balance of world power. Germs have toppled some of the most advanced cultures like the Incas. That cannot be lost on groups intending to generate terror and fear.

Education Has Also Changed

Maybe nursery school, kindergarten and grades 1 and 2, will still mostly be face to face education, but after that I think education will be a mix of in person and virtual. The older the cohort, the more likely the experience will be virtual. The big question is what will people pay for 4 years of college when 60% of the experience may be virtual? Technology is inherently deflationary and the virtual product may be perceived as second rate.

Getting Off The Hamster Wheel

We have all been off our normal wheel long enoughto start asking these kinds of questions. Many things I have done without thinking over the last 70 years are no longer automatic. In many ways spinning that old wheel was its own purpose. Covid-19 has left many of us questioning why, where and when we want to jump back on.

The above commentary is for informational purposes only.  Not intended as legal or investment advice or a recommendation of any particular security or strategy. Information prepared from third-party sources is believed to be reliable though its accuracy is not guaranteed. Opinions expressed in this commentary reflect subjective judgments based on conditions at the time of writing and are subject to change without notice.

I have a friend who has spent most of his career upgrading the plumbing on Wall Street.  He is not a pipe wrench plumber, but rather one of the architects of the programmatic trading platforms for some of the 40 providers of liquidity that comprise the US stock market.

He now works for a prestigious principal trading firm where he leads a group that designs and implements both the hardware and software used for proprietary trading. His group will also provide similar infrastructure and software programming for customers of his firm.

I had the great pleasure of interviewing him about Covid-19 risk mitigation and how his world has been changed by retail traders. Let me introduce you to Algo Rim, whose name will be shortened to AR for purposes of this interview.

Rob: AR, thank you for helping us all understand the world of algorithmic systematic or “programmatic” trading. My first question is risk management during the Pandemic. How could you manage risk for your firm and its customers when your group was dispersed and you had to make quick decisions?

AR: Our firm is one of the 20 significant liquidity providers who make up what the consumer calls the stock market. Before Covid-19, our traders managed risk and made critical decisions in a face to face environment. The challenge after our offices shut down was to redesign our risk management systems to manage for the six sigma risk events. We put together a whole new playbook of policies and procedures to eliminate the need for risk management decisions in real time by the trading partners.

Rob: How did it work?

AR: We were quite surprised we were able to manage without any major problems, but we were highly focused on the possible disasters. It was all “need to have, not nice to have.”

Rob: How about March of 2020, when the stock market lost more than 30% of its value in a matter of weeks and then reversed and started rising again?

AR: Our programs worked the way we expected and we survived. We were able to get out early and then return when the order flows reversed.

Rob: This must be attributable to your hardware and software advantage as a programmatic trader? So what is programmatic trading? I don’t think most of us really understand it?

AR: Programmatic trading relies on a high speed, reliable flow of data that can be parsed and analyzed in nanoseconds. The speed is based on an infrastructure we use. The software is based on proprietary trading programs. Trades are executed on the basis of data analytics.  “If-then decision making” is faster than a blink of an eye. That is really fast.

The key inputs for risk management and profitability for us are an infrastructure advantage, a data flow advantage, and an almost automatic decision making execution advantage.

Rob: This reminds me of the book by Michael Lewis called “Flashboys”. Is that what your group does?

AR: Yes, but infrastructure is only one part. We have our own high-speed system like the traders in his book and we will also design a system for our customers who are professional investors. We can customize outcomes based on high-speed receipt and analysis of data.  You can work with us on just the plumbing, or all aspects of your customized trading solutions. It all happens at warp speed, and it is not unusual to close out trades the same day. Two days can be a long term position for any programmatic trader.

Rob: Are the other market makers using similar tools?

AR: Most retail investors don’t understand the stock market is really 14 separate exchanges and 40 private trading venues and a few single dealers. Together they represent a market ready to provide liquidity to both sides of a stock trade. But most of them are also using the high-speed plumbing and have massive data inputs to help them avoid getting stuck with a losing trade.

When you ask Fidelity to buy or sell 500 IBM and Fidelity goes to one of these venues for liquidity, the market makers are informed bidders and often hold a data advantage. This is especially true of the big providers like Citadel.

Rob: The new normal however, is the perception that the Robinhood “wolfpack” is defeating the high speed programmatic traders, and bringing down hedge funds with short positions by using social media to coordinate short squeeze “attacks”.  Is this right?

AR: There is a massive divergence between what you see and what is really going on. The Robinhood story, for example, is more about the stock market’s plumbing, Robinhood sold its GameStop trades to large liquidity providers like Citadel.

Citadel has the same high-speed plumbing as the other markets makers, so it began to develop a highly accurate picture of the retail book of orders. This information advantage enables the market markers to know where and how they want to trade. They have the speed, size and information advantage to make the best bet almost all the time, and they do not have the customer relationship with the retail customer because Robinhood sold the customer trade.

Rob: But is the Robinhood experience a true reemergence of the retail trade?

AR:  Yes. We could not believe our statistics, but now 25% of the liquidity in the market is coming from retail. Retail firms will be pressed soon to act like programmatic traders by allowing customized buy and sell programs with trading authorities, but it will still be mostly $2.00 stocks and fractional shares.

The long game is still controlled by a small group that has invested in high-speed infrastructure, has proprietary trading algorithms’ and bottomless capital.  Robinhood is like a little league team playing 160 games with the Yankees. Robinhood may win a few games, but the Algo Rims will always have a winning season.

Rob: Final question. Should we have concern about the concentration of market liquidity leading to long term volatility?

AR: The new paradigm is a really small group of market makers with an information, size and speed advantage with absolutely no obligation to provide liquidity. The programmatic and high frequency traders will be the first group to see a reversal and the first group to get liquidity.

The high frequency and programmatic trading firms represent 40-50% of the daily liquidity. When they disappear it could be a long drop before the value buyers step in to reverse the fall.

But the existing circuit breakers work and traders will have time to pause and reflect.  Whether the retail crowd can settle markets in freefall is yet to be seen.

Rob: Thank You Algo Rim.

If you think trying to understand Bitcoin (BTC) and its blockchain is difficult, wait until you have your first encounter with decentralized banking or insurance products. It will seem as daunting and risky as climbing Everest without a sherpa.

Because I am not qualified to guide in this emerging territory, I have asked Will Mason, founder of Upswing, LLC and an entrepreneur with knowledge about the space, to help me. Will’s commentary is shown in italics.

Will’s first step was to send me an article from Coinbase from January 2020 entitled “A Beginners Guide To Decentralized Finance (“DEFI”). Here is the link: https://blog.coinbase.com/a-beginners-guide-to-decentralized-finance-defi-574c68ff43c4

Here are a few kernels of insight.

• Decentralized finance products are like an app running on an incorruptible blockchain containing the rules of association for that application. Insiders call these apps “dapps”.
• The Blockchain is completely open source code for anyone to audit.  It is permission-less, public, transparent, and provides a very quick settlement.
• These smart contracts can transact a loan or a payment using a stablecoin whose value is pegged by smart contract to any currency, like the USD or with tokens that run on the network. This enables an internal, universal, borderless currency for the specific dapp. People can swap in and out of tokens of their own choosing without any permission. This is where UniSwap is one of the most important parts of the DEFI landscape as will be discussed below. 

Banking the Unbanked

“Using DEFI applications and stablecoins that operate on those blockchains, people around the world, who have never used a bank, will have access to banking services with their mobile phones.  If you live in a corrupt, poorly run government, it won’t matter much.  Many people in the U.S.A. will not realize the necessity of this.  Most of us are quite comfortable putting money into a bank and not worried about seizure by the government.  This is not the case for most of the world.  The ability to transact in algorithmic or collateral backed stablecoins or in a blockchain’s native currency, such as bitcoin or ether, will slowly but surely remove all fiat from the vast majority of transactions.  Smart contracts will allow the sender to send tokens to the receiver instantly, with instant settlement, in a completely public and transparent way, and there is not much any government can do about it.  A perfect example of how this will change things is in remittance.  Western Union’s business model will be challenged.  Why send money through Western Union, get charged a high fee, and have my family member have to go into a Western Union bank in Honduras where gangs are waiting outside  Yes, this happens all the time.  People not only pay a fee to Western Union, but they also have to pay a fee to the local gangs. With alternatives like Bitcoin, stable coins or tokens the unbanked are likely to choose anonymity, lower fees and no physical risk.“

Blockchain’s Security Doubles According To Moore’s Law

The key to all permission-less, decentralized networks, aside from popularity, is security. Security for the blockchain ledger supporting all the BTC transactions since inception follows the power of Moore’s law, which has demonstrated that computing power doubles every 2 years. Here is how Will Mason describes the level of security underpinning the Bitcoin blockchain ledger:

“If we set a difficulty rating of 1 for the first Bitcoin block ever to be mined, what is the difficulty rating now?  11 years of logarithmic adoption and by logarithmic enhancements in computing power bring the difficulty rating now to a staggering 21.7 trillion.  Another way to look at this is the network is 21.7 trillion times more secure then when it started.  This will only continue to grow, and at substantial rates.  More people are adopting it, which brings a higher price, which brings more miners, which secures the network more, which will make more people adopt it; so on and so forth.  This circular feedback loop is still in its infancy.”

Uniswap Is A Decentralized Trading Place

We are used to centralized trading markets being open 5 days a week with hours between 8am and 4pm depending on the exchanges. These trading markets are private businesses and they are usually publicly held and owned by stockholders. NYSE, NASDAQ, AMEX, CBOE, and ICE are all regulated by governmental watchdogs. Some critical parts of the centralized trading system are self regulated like the Depositary Trading & Clearing Corporation. Sometimes these exchanges are fined for not following trading rules and there are periodic audits. However, their information is private and there is little visibility by users into their day to day operations.

Coinbase is one such centralized trading places. Coinbase is privately owned and is in the process of preparing for an Initial Public Offering of its shares. It is regulated by state and federal agencies but it has horrible accountability to users. If a Bitcoin transaction has a glitch, good luck getting anyone to answer your email or call.

I am showing Will Mason’s description of Uniswap below. You will see it is organized and validated quite differently:

“Decentralized exchanges are exchanges with no middle point.  They are a Dapps (Decentralized Apps) that facilitate the exchange of tokens.  Using smart contracts, users can connect their web 3.0 wallet to the interface and swap one token for another with instant settlement. 

These decentralized exchanges run off a blockchain network like Ethereum, Solana, Binance, or Cardano, and there are LP’s (liquidity providers) who earn fees for providing liquidity to pairs of tokens.  Why would people provide this liquidity?  Every transaction that goes through Uniswap is charged .3% of the token that is being exchanged.  Those tokens are given to the LP’s who are providing liquidity.  The biggest liquidity pair on Uniswap right now is WBTC (Wrapped Bitcoin)- Ether.  This currently has $363m worth of liquidity and did $32m in volume over the last 24 hours, generating $96k in fees.  That $96k in fees is paid to the LP’s.  Whatever percentage of the LP pool you are is what percentage of the $96k you get.

Uniswap, which is the biggest decentralized exchange (DEX) on the Ethereum network, is currently doing $1 Billion in volume a day.  Yes, a day.  More than Coinbase.  The more people who use Uniswap, the more fees, which drives more liquidity providers; so on so forth.  At https://info.uniswap.org/home, you can look at total volume, volume for specific pairs, and the amount of liquidity that is locked up on Uniswap as well.  I have personally provided liquidity to several pairs to help bootstrap certain dapps.“

Blockchains operate with their own native currency, which can at times be somewhat volatile.  Stablecoins, such as USDC (which is backed by actual dollars), are the main medium of exchange on any blockchain.  This stable medium allows transactions for insurance products, banking services, and the purchase of goods with significantly less volatility.

Obviously, the aspiration is to eliminate the conversion risk and have the stablecoins become a replacement themselves for the Euro, USD, Renminbi etc. Right now that regime change is just a twinkle in a Bitcoin miner’s eye but centralized finance systems are being tested by the Covid recovery. There may be a Defi product in your wallet sooner than you think.

The above commentary is for informational purposes only.  Not intended as legal or investment advice or a recommendation of any particular security or strategy. Information prepared from third-party sources is believed to be reliable though its accuracy is not guaranteed. Opinions expressed in this commentary reflect subjective judgments based on conditions at the time of writing and are subject to change without notice.

My generation’s interaction with money, wealth, art, music, communication, commercial real estate, credit, finance, personal real estate, insurance and social interaction has mostly been through trusted third parties like Chase Bank, Goldman Sachs, Fidelity, Sotheby, National Title, Experian, Moody’s, Berkshire Hathaway, Depositary Trust Clearing Corp, ASCAP, Facebook, Apple and Google. These middlemen often have well established oligopolies based on controlling information, resources, capital, authentication, licensing or titling rights.

For the most part, my generation is hooked on middlemen. We would prefer calling someone at one of these brand name organizations rather than dealing with the issue ourselves. We like the idea of someone being in charge who can adjudicate disputes and resolve conflicts. We also have a whole set of industries devoted to influencing people in charge from lobbyists to PR firms.

In a recent article by Tyler Cowen, an economist at George Mason University, writing for “Bloomberg Opinion” on February 7, 2021 entitled “The Future Will Be Decentralized”, Mr. Cowen identifies the first decentralized organizations as the internet and blockchain. He may have forgotten “word of mouth”, but I get his point that no one person or entity owns or controls. For him centralized organizations are Facebook, Twitter, Amazon, Google and Apple. As public companies they are all built on a hierarchy where someone is in charge.

Forget Your BTC Password?

Decentralized organizations are peer to peer like Bitcoin and Ethereum. There is no final appeal to a higher power when you forget your password for Bitcoin. This may be one reason why Fidelity has been exploring custody of Bitcoin? A whole generation of its clients will never trust themselves to procure, store, use and dispose of Bitcoin. The margin of error is too high, and once a mistake is made, the BTC could be lost forever. Speaking about the transformations from centralized to decentralized models, Mr. Cowen comforts me when he admits he would rather put coins in the parking meter than download the parking app:

“Having grown up in an analog world, I find these ambitious visions both unsurprising and bewildering. On one hand, I have seen the transition of so much activity to the digital world that another major revolution should not shock me. On the other hand, (a possibly atavistic) part of me likes knowing that someone or something is in control, whether it’s a government, a bunch of people in Mountain View, or even just my dean.

“Life on the blockchain” feels alienating in a way that goes beyond old-style Marxist concerns. (Remember, I am the kind of guy who prefers to slip coins into the parking meter rather than download the app.) When I ask myself what services I am really missing, I find I’m far more interested in a new Chinese restaurant in my town than new open-source platforms to enable innovations I will never quite understand.”

Creators May Have A Different View

If you are an artist, a song writer, an author, an investor, a collector, a home owner, or a small business owner, you are completely reliant on a centralized authority to help you monetize your intellectual or physical capital. If you want to sell art you have to go through a dealer to sell. The economics favor the dealer, not the creator. If you want to sell your home, you need a realtor. The economics favor the realtor who profits from the flow without any capital at risk. If you are a song writer, ASCAP charges you for monitoring usage of your songs. If you are a collector, you have to sell through a dealer under terms favorable to the dealer who has no capital at risk. If you want to sell your business, a similar mismatch of risk and upside exists.

Economics Favor Creators

New digital platforms are being created to sell digital art. Take a look at SuperRare https://superrare.co/ which is a market place for creators. The economics favor the creator. If digital art is sold its authenticity is supported by an Ethereum based blockchain, with an immutable identifier so your art cannot be forged. SuperRare is paid 15 – 20 % of the original sale price and the creator keeps ownership of the rest. Thereafter, SuperRare creates a market for the previously owned art and awards 10% of each subsequent sale proceeds to the artist. Two problems are solved for the artist. She gets most of the original economics for the first sale, and a tail percentage of each successive sale. It is now an income producing asset and it can never be duplicated.

Can You Put Digital Art On Your Wall?

My only question about digital art is how do you hang it on your wall? We go to museums to view great art for a human connection captured by the painter or sculptor. I do not yet see it duplicated by the SuperRare business model.

The Pieta on my iPhone is not the same as viewing it in person. Michelangelo’s masterpiece captures in stone the universality of a mother’s grief at the death of her son in a way SuperRare cannot duplicate.  The analog world still has a place, albeit with poor economics and risk of theft or forgery. However, the digital world is accelerating and there will be conflict as it challenges the analog world built on well-paid and trusted middlemen. Get ready for viewing your digital art in a virtual reality gallery!

The above commentary is for informational purposes only.  Not intended as legal or investment advice or a recommendation of any particular security or strategy. Information prepared from third-party sources is believed to be reliable though its accuracy is not guaranteed. Opinions expressed in this commentary reflect subjective judgments based on conditions at the time of writing and are subject to change without notice.

Someone’s investment gyroscope is completely out of whack. For most of my investment life I have tried to discover unseen gems among the trash heap of abandoned stocks. These might be stocks with good revenue growth, low debt, high cash flows, a defensible position relative to other competitors and few financial analysts following their story.

However, nothing in my experience prepared me for the “pump and pump” crowd that creates fools gold from spinning straw like Hertz, Game Stop and AMC. The business model is also unique. Find a lousy company with a massive short position and coordinate a “short squeeze” by convincing thousands of followers to buy call options on the stock or the stock itself on margin.  As the short seller is squeezed by the rising prices it must buy stock to cover its margin account deficit positions or add new capital to a trade going awry.  Because the short sellers in Game Stop (GME, NYSE) had sold 110% of the outstanding stock they were actually creating a “naked short” position making them vulnerable to the Captain Crunch of All Squeezes.

I had two immediate questions about Game Stop. What are its fundamentals? If its fundamentals are bad, how will the legion of retail investors ever get out of their position?

Fundamentals Are Poor

Game Stop (GME, NYSE) had a $30 billion market capitalization as of January 28, 2021. Looking over the last 4 years, its fundamentals are bad. It has declining revenues, declining earnings, declining free cash flow, declining dividends and insistent creditors who have removed more than $1.0 billion of capital, but are still owed $1.5 billion. Net debt to EBITDA is now 6.2x.  It has had 5 CEOs in 4 years, and it restated its audited financials for 2018 and 2019. Here is a chart from “The Daily Shot” on February 1, 2021 showing historical sales and earnings:

A Pump and Dump Strategy For Sure

A “pump and dump” strategy makes sense if you can organize a “Captain Crunch” wolf pack of concerted day traders who buy, squeeze, inflate the stock price and then sell to a greater fool. But a “pump and pump” strategy, where you become a long term holder only makes sense if you can sustain the new valuation and then do a public offering or another capital raise at the new, nosebleed market cap. In 2020 I wrote about Hertz (HTZ, NYSE) demonstrating that a bad company cannot access the public markets https://capitalworks.net/hertz-bankruptcy-whos-in-the-drivers-seat/.  Why would Game Stop be different?

Remember Who Owns The Casino

Major Wall Street firms own the Depositary Trust & Clearing Corp (DTCC). This is a private monopoly on the capital requirements, trading restrictions, clearing and custody of almost all the stocks and bonds in the world. It monitors all brokerage firms, including firms like Robinhood, for activity injurious to the safety and soundness of the capital markets. After all this is their casino.

The DTCC stepped into the GME manipulation and said Robinhood was insufficiently capitalized to underwrite the thousands of retail investors who were buying GME call options and stock on margin.

When you buy stock on margin and the stock goes up, there is no problem. But if the stock declines, you must have collateral worth $2X the margin debt. If a retail investor gets a margin call, she must add new capital to maintain the $2X ratio or Robinhood must sell her stock position. The problem with a retail investor base like Robinhood is insufficient outside capital to handle a margin call and the market interest in buying GME quickly evaporated. Robinhood and its capital providers had to absorb the losses in the short term and pray it can liquidate its GME position to pay back its banks. Robinhood may be caught with a large GME position at a high valuation and no counter party to buy on fundamentals. It had to suspend trading to try to save its franchise.

As a consequence, Robinhood has been forced to raise $3.4 billion of new capital which it will deposit with DTCC to allow it to continue in business. I guess Robinhood now understands it is a minor brokerage firm serving at the pleasure of the best firms on Wall Street and the video game trading it promotes just got toxic.

However, it may still own way too much GME from defaulted retail accounts and the price is falling. There is no way out of the squeeze and it may end up just like Lehman Bros.

So the damage from a video game trading foray is massive. The hedge funds who had the naked short position got wiped out, Robinhood and other accommodative online brokers that permitted margin trading in GME are facing massive capital calls, most of the retail investors will lose their investment, and the ownership in GME has come full circle. The short position is now back to 40%.

The above commentary is for informational purposes only.  Not intended as legal or investment advice or a recommendation of any particular security or strategy. Information prepared from third-party sources is believed to be reliable though its accuracy is not guaranteed. Opinions expressed in this commentary reflect subjective judgments based on conditions at the time of writing and are subject to change without notice.

I wish I could join the throng of euphoric pundits who are now advocating Modern Monetary Theory (“MMT”). Most of them equate MMT with the ascendancy of central banks and their invincibility procuring worldwide prosperity even in the face of one of the swiftest business reversals in my lifetime. Politicians also see it as a pathway for transformational social programs like a guaranteed national income, cancellation of student loans, and the new Green Deal. Thoughtful economists are now conceding money printing is OK as long as it does not become inflationary.

Another Expert With A New Paradigm

Unfortunately, I have been around long enough to have witnessed too many “it is different this time” moments spanning multiple decades. First it was Michael Milken and Drexel Burnham and a seminal white paper from an expert about junk bonds being completely safe. Next it was the dot com bubble where any business plan with a modem could raise public capital. Soon thereafter it was the Big Recession where real estate mortgages on poor properties issued to people with substandard credit were transfigured, like the Wedding Feast at Cana, from jug water to fine wine.

Now you have another white paper episode from a professor at Stony Brook University, Stephanie Kelton who says Federal debt creation does not matter as long as you are issuing debt in your own currency and you are managing inflation. I have not read anything from Ms. Kelton on the question of whether a profit seeking enterprise actually has to be buying that debt for it to be benign instead of the current practice of the Treasury issuing bills, and notes at artificially low interest rates and the Federal Reserve Bank “buying” them. It is estimated that $2.3 Trillion of the Federal debt issued to provide Covid response stimulus is just book entries from the Treasury to the Fed with no third party price discovery.

Janet Yellen is now telling us that stimulus has to “go big or go home”, suggesting that the paltry “stimulus response” to the Big Recession slowed the return of prosperity.

Respected Investors Are Cautious

How about a few contrary theories from respected investors who are seeking profits without speculation, and are smart enough to understand these modern theories?  Seth Klarman, James Grant and Jeremy Grantham are three such giants.

Seth Klarman, the founder of Boston based Baupost Group, a hedge fund with $30 billion under management sees it as a competition between the private sector and the public sector. Here is a summary of his recent letter to his own investors created by The Financial Times on the consequences of money printing:

“Mr Klarman referred to the Fed as an “800-pound gorilla” that has priced out investors who typically provide liquidity in moments of distress. The biggest problem with these unprecedented and sustained government and central bank interventions is that risks to capital become masked even as they mount,” he said.

James Grant in his January 22, 2021 Interest Rate Observer newsletter also questions the central bank playbook: “Prices convey information; artificial prices convey misinformation; interest rates are prices. Ergo suppressed interest rates misinform. They inflate asset values, misallocate capital and fill some pocketbooks while emptying others”.

Jeremy Grantham in his most recent newsletter “Waiting For The Last Dance” also spots a bubble and writes about the herd psychology that underpins the frantic dash to the cliffs:

“This time, more than in any previous bubble, investors are relying on accommodative monetary conditions and zero real rates extrapolated indefinitely. This has in theory a similar effect to assuming peak economic performance forever: it can be used to justify much lower yields on all assets and therefore correspondingly higher asset prices. But neither perfect economic conditions nor perfect financial conditions can last forever, and there’s the rub.”

I have seen a similar competition between governmental stimulus like unemployment insurance and moratoriums on mortgage defaults and rent evictions. The government is making it difficult to find employees and, inadvertently, is inducing businesses to invest in technologies to replace workers. By delaying or suspending creditors rights to keep people housed and fed, the government is making certain parts of the real estate investment landscape highly unattractive. Who wants to build multi-family housing where rents are controlled by the public sector? But if the interest rate for that loan is the lowest ever and I can pass the credit test…well maybe I will give it a try!!!

A recent example is a company we know that manufactures windows. It cannot find enough employees to meet the unexpected high demand for new housing and repair and remodel projects. Its competition for employees is partly a few new employers entering the local economy, but it is also the stimulus programs that incent not working like direct payments, unemployment insurance, mortgage default and rent eviction moratoriums.

The government has no cost of capital as long as the Treasury can issue bills and notes that are purchased by The Federal Reserve Bank at a rate set by The Fed. In essence, the risk free interest rate is zero. That is not true for private sector debt, all of our creditors are quite focused on monthly payments of principal and interest, and while the interest rates are low and the advance rates are aggressive, the debt must be repaid.

So far, I have not read anything from any economist examining the MMT experiment about the crowding out of productive business, but I see it as a significant risk. Here is a chart from The Daily Shot showing the correlation between money supply and stock prices:

Looking at the stock market, the bond market, the proliferation of SPACS, the housing market, Bitcoin and other crypto as validations of money printing presupposes, someone is actually thinking that deeply. Most investors are simply assuming the FED can control interest rates and, implicitly, will underwrite all markets like it just did in March of 2020. There is evidence of the same frantic fear of missing out on the next wave that I have witnessed in every one of the prior bubbles. But I will leave you with Grantham’s assessment from his recent newsletter. He is the expert. He has been wrong, but convicted, for more than a decade. That is courage:

“However, for any manager willing to take on that career risk – or more likely for the individual investor – requiring that you get the timing right is overreach. If the hurdle for calling a bubble is set too high, so that you must call the top precisely, you will never try. And that condemns you to ride over the cliff every cycle, along with the great majority of investors and managers.”

Who knows when but I am in the camp that it won’t be different this time. This is just an amateur’s opinion, but so far I have always had to repay my debts one way or the other.

The above commentary is for informational purposes only.  Not intended as legal or investment advice or a recommendation of any particular security or strategy. Information prepared from third-party sources is believed to be reliable though its accuracy is not guaranteed. Opinions expressed in this commentary reflect subjective judgments based on conditions at the time of writing and are subject to change without notice.

Bitcoin looks like a juicy federal and state revenue source for 2020. Based on the chart shown from the buybitcoinworldwide.com website below, there has been approximately $304 billion of capital appreciation in the cryptocurrency since January 1, 2020. It is pretty much a guess about what portion of that appreciation has been “realized” in 2020, which is why IRS needs taxpayers to self report:

This all stems from the IRS position that Bitcoin (BTC), and all other forms of crypto are capital assets. So, it is a legitimate question to ensure that realizations are taxed. The IRS has clarified that simply transferring BTC between your personal wallets will not be considered a taxable event and not a reportable event in your 1040. It is like transferring custody of stocks from Ameritrade to Fidelity. Here is the 1040 question each of us will have to answer:

I think the issue is certainly about revenue, but it is also about discovering who owns Bitcoin. Early record keeping about knowing your customer was hit or miss. Starting at inception in 2010 many criminals, drug traffickers, and tax dodgers utilized BTC as a store of value and a medium of exchange, but it was a minor blip on global GDP.  Bitcoin promised anonymity and freedom from a closed system where central banks controlled fiat currencies. Early adopters had to convert fiat to BTC and they all ended up in places like Coinbase which developed “fintech” trading platforms that bridged fiat and crypto.

By 2018, the dominant dealer in crypto was Coinbase, and it has announced an intention to file for a public offering of its shares in 2021. It will be interesting to see if there is disclosure about what percentage of Coinbase customers are actually “known” under banking investigation standards created by money laundering legislation enacted in 2013. I expect things were pretty lax from 2010 to 2017 when BTC first spiked to $20,000. During that period it was ridiculed by just about every leader of the fiat economy including JP Morgan’s CEO Jaime Dimon, who called it a “fraud” likening it to the “tulip bulbs”, a craze in Denmark in 1637 where a single rare tulip sold for more than a house. Mr. Dimon has since reversed his opinion. It is clear the leaders of the fiat regime have a lot to lose if there is a challenge to their implicit monopoly.

Revenue Opportunity For Feds and States?

The potential revenue prize for 2020 is probably pretty small. I tried to make a few assumptions about realized gains starting with the common belief that 10% of BTC has never traded. So that leaves 90% that may be trading of which it is estimated 5 % may be lost or destroyed.

Assume the best case for the taxman – that one third of the appreciation in Bitcoin from Jan 1, 2010 to December 31, 2020, was realized as a lump sum in 2020, and the cumulative basis is $0 (best case for Feds), and the effective federal tax rate was 25% (blend of ordinary and capital gains rates), and a 5 % state tax rate. The revenue potential for Feds might be $92 billion, and $18.5 billion for the states. That is not a lot of revenue compared to the potential tax receipts from the US stock market. Its value as of December 21, 2020, was in excess of $50 quadrillion and it appreciated by almost 13.5% in 2020. The big juicy tax target is not Bitcoin, especially because there are paltry records about who owns it and what gains were realized when.

But Bitcoin remains relevant as a hedge against failure of fiat currency systems all around the world. For that reason and the absolute ceiling on the amount of Bitcoin that can be created, it will continue to appreciate in my opinion.

Past performance is not indicative of future results. The above commentary is for informational purposes only.  Not intended as legal or investment advice or a recommendation of any particular security or strategy. Information prepared from third-party sources is believed to be reliable though its accuracy is not guaranteed. Opinions expressed in this commentary reflect subjective judgments based on conditions at the time of writing and are subject to change without notice.

“Tell Her No” was a classic rock hit from a British rock group The Zombies. The 1965 lyrics should be exhumed and applied to the runaway market appreciation in those public stocks where operating earnings do not even cover the annual interest expense:

“And if she should tell you come closer
And if she tempts you with her charms
Tell her no no no no no-no-no-no
No no no no no-no-no-no
No no no no no.”

The big deal about Zombie stocks is they now account for almost 15% of the 3,000 companies with market capitalizations above $300 million according to research from Arbor Research and Trading as shown in this chart from “The Daily Blog”.

What shocked me about the chart was the X axis showing 10 Year Treasury “Real” Yield which means actual yield less inflation. At a time in 2020 when risk free money is returning nothing a whole swath of small cap investors may, unwittingly, be investing in companies that can’t even afford their interest expense which is near all time lows.

If these companies were being selected by a deep value turn around fund with the expectation a few of them could recapitalize themselves, deep value investors might be interested. What I think is happening, however, is the passive index funds are just including the zombies as component members and it is forcing their stock prices to a point where they now exceed healthy S&P 500companies as shown in the chart below:

A Playlist For Stocks

Do you want to exclude the zombies from your index fund ? How about excluding oil, coal, cigarette, and liquor stocks? How about an index with first time CEOs or CEO’s with a major equity ownership stake? Blackrock just paid $1Billion for Aperio which is a platform that allows customization of indexes.

As I understand it, Aperio will allow you to start with an index like The Russell 2000 (which is the smallest 2,000 of the 3,000 public companies by market capitalization). You could then get rid of the zombies and the offensive ESG components and, if you want some yield, all of the components that do not pay a dividend. This would be YOUR OWN separately managed account, sort of like a playlist for stocks; Taylor Swift but no Katy Perry.

More Active Management For 15 BPS !!!

I like the idea of customizing my index. No zombies.  Levered free cash flow exceeds dividends by a comfortable margin. Debt to market cap is less than 50%.  Revenues have grown at a compound growth rate exceeding 5%.  Stock buy backs have not consumed more than 10% of free cash flow.  The CEO and CFO team have been part of management for at least 10 years.  My “Mac Index” will come with cheese, no lettuce or onions, but special sauce on a sesame seed bun all for the same price I can now get with most passive funds.

This is clearly why Blackrock paid $1 Billion for Aperio.  The coming mass customization should be great for high net worth investors, but it could be highly disruptive for many incumbent managers who are not able to customize like BlackRock.

The above commentary is for informational purposes only.  Not intended as legal or investment advice or a recommendation of any particular security or strategy. Information prepared from third-party sources is believed to be reliable though its accuracy is not guaranteed. Opinions expressed in this commentary reflect subjective judgments based on conditions at the time of writing and are subject to change without notice.

For the last three months we have been so fixated on red and blue states we hardly noticed how many “black and blue” states are struggling from the pandemic’s onslaught. Unlike the Federal system where money printing of all kinds and deficit spending are accepted monetary policy tools, states are prohibited both from printing money and running annual budgets deficits.

The situation is bleak, but fixable if we can form a consensus. The Center On Budget And Policy Priorities updated their projections on November 6, 2020.   The two charts below show the 2020 budget projections both before and after “rainy day funds” have been used and spending cuts applied. 

BEFORE RESERVES

AFTER RESERVES AND BUDGET CUTS

The real story will be 2021, when reserves are gone and citizens have reacted to increases in taxes, cuts in essential services, shuttering of schools and infrastructure needs. Here is a comparison of the state deficits from major economic reversals in my lifetime:

Here is also link where you can find the 2020 and 2021 projections for your state. For those of you who don’t want to know I will give you the top ten problem states (https://www.cbpp.org/research/state-budget-and-tax/states-grappling-with-hit-to-tax-collections). Without peaking, guess which states are in the worse shape?

Here are the top ten problem states in alphabetical order.

State	2021 Projected Revenue Deficit	Reason
Alaska	15%	ENERGY
California	17-21%	ALL SOURCES
Hawaii	23%	TOURISM
Massachusetts	9-31%	ALL SOURCES
Nevada	26%	TOURISM/GAMING
New York	17%	ALL SOURCES
Oklahoma	26%	ENERGY
Texas	15%	ALL SOURCES

The Dollar Deficits are Substantial

Remember you cannot spend percentages, so the top 5 projected dollar deficits are pretty eye opening as well.  It took me 21 state cumulative dollar deficits in alphabetical order from Alaska to Minnesota to equal California’s projected dollar deficit:

State	2021 Projected Dollar Deficit	Solution
California	$26.0 to 32.0 Billion	CUTS+TAXES
New York	$16.0 Billion	CUTS+TAXES
Texas	$8.0 Billion	CUTS+TAXES
New Jersey	$6.0 Billion	CUTS+TAXES
Massachusetts	$2.8-9.6  Billion	CUTS+TAXES

Congressional Action Is Needed

There should be bi-partisan support for some measure of federal relief, but the gap between states with small deficits and large ones is problematic. Take the example of Georgia, where the balance of power in the U.S. Senate turns on two run-off elections in January. According to the November 6, 2020, update from The Center On Budget And Policy Priorities, some states like Georgia, Maryland and Florida have already made cuts:

“In Georgia, policymakers approved a 10 percent cut for 2021, including a nearly $1 billion cut for K-12 public schools and cuts to programs for children and adults with developmental disabilities, among others. Maryland enacted $413 million in emergency spending cuts including large cuts to colleges and universities. Florida’s governor vetoed $1 billion in spending that lawmakers approved before the crisis and ordered agencies to look for 8.5 percent more in possible cuts for fiscal year 2021. The state also cut money for community colleges and services related to behavioral health, including opioid and other substance use treatment services, crisis intervention services, and services for people experiencing homelessness.”

A Solution Will Revisit 1776 Large State/Small State Viewpoints

With the country split just about 50/50 on everything, and the possibility of Congressional gridlock, it will take incredible leadership to craft a funding solution. If responsible states are treated the same as irresponsible ones, this will be a repeat of the student loan forgiveness debate.

Should aid flow on the basis of the relative revenues of the states? That would mean high tax states would get more relief.   Should it flow on the basis of the relative deficits?  That would reward profligacy and punish states with balanced budgets.  Should it just flow like a modern monetary policy river and wipe out all deficits? That might make sense if you could be assured that Covid-19 alone created the problem. Should it flow to states that made cuts to give them new rainy day funds?

Solomonic Wisdom and The Right Policy Response

This debate, more than climate control, abortion, taxation, immigration and socialism, will rekindle pioneer ideals of self rule and self determination at the state level.  Based on freedom of choice and willingness to “vote with your feet”, freedom of movement has been an island of sanity for a polarized America. Many people have relocated to avoid punitive tax regimens.

Getting the right policy response is critical and it may be impossible in our gridlocked environment. The politicians may see it as a matter of red and blue, but for too may Americans it is really a “black and blue” experience that will certainly outlast the pandemic.

Few people really understand how currencies work. It requires math to figure out how much more or less a cup of coffee (Starbucks), or a hamburger (Big Mac), costs in Boston versus the same products in Moscow, Shanghai or Hamburg. If we had a universal currency like Bitcoin or Libra (Facebook), the currency math would be done for us.  You could simply compare the relative prices in Bitcoin or Libra of the same product around the world.

The Big Mac Index

Lacking a world currency, the next best thing is the Big Mac Index which is something The Economist invented in 1998 to compare the relative purchasing power of each country’s currency in USD based on the price of Big Macs.

For example, according to Statistica (https://www.statista.com/statistics/274326/big-mac-index-global-prices-for-a-big-mac/) in July 2020, the average price for a Big Mac in the USA cost $5.71, but the USD price for the same product was wildly different depending on the country you were visiting and the currency you were exchanging. The chart below shows the Big Mac Index for the top twenty strongest currencies. You will see that a holder of US Dollars, the world’s reserve currency, can buy almost twice as many Big Macs in South Korea as he can in Switzerland.

So, if your local business is manufacturing and exporting a commodity like Big Mac’s in competition with the rest of the world, you want the relative purchasing power of your currency to be as low as possible compared to your worldwide market. Their stronger currencies will mean they can buy more of your Big Macs than others and they become your natural trading partners.

Take the example of Brazil and Canada above. Both export commodities. If they are both trying to sell commodities to Switzerland, based on the Big Mac Index, Brazil can sell 29% more than Canada for the same exchange price in USD.

The currency markets are a little bit more sophisticated than the Big Mac Index, and they consider many local factors. The Statistica survey shown above explains the more sophisticated approach as follows:

“Purchasing power parity (PPP) is the idea that items should cost the same in different countries, based on the exchange rate at that time. This relationship does not hold in practice. Factors like tax rates, wage regulations, whether components need to be imported, and the level of market competition all contribute to price variations between countries. The Big Mac index does measure this basic point – that one U.S. dollar can buy more in some countries than others.

To see what the real currency markets think of the Big Mac Index, you have to look at the purchasing power parity index for July 2020. Econlife did just that in an article dated August 13, 2020 by Elaine Schwartz titled “What We Can Learn From A Big Mac”.  They cited a chart from The Economist that corroborated the Big Mac Index ranking above and then showed how undervalued the Chinese Yuan is relative to the US Dollar:

The currency markets seem to agree with The Economist’s conclusion because the Chinese Yuan has appreciated from August 2020 by almost  4.5%, versus the USD. Here is a one-year chart from XE.com that shows the sprint to the bottom from May 2020 by the USD versus the Chinese Yuan (CNY). Based on the Big Mac index , though, the Yuan still has a long way up.

 Desired Policy Objective

Normally, you would think this is bad for America, but because our economy (like almost all the other economies in the world) is propped up by mountains of debt, it is actually a desired policy objective. The Chinese hold more than $2.0Trillion in USD debt. If the U.S. can get the purchasing parity index to move closer to the Big Mac Index, repaying Chinese creditors in USD at a $3.80 exchange rate versus a $7.00 exchange rate is almost 46% less dollars.  This is how a weaker currency helps an indebted nation.

So, like many things in this Bizzaro world, having the weakest, least desirable currency – having the lowest Big Mac score – is really the best debt policy objective. I am confident the rest of the world wants the same thing and we will see an amazing race to the bottom. However, the rest of the contestants don’t have to worry about losing the status of being the world’s reserve currency. The U.S. can’t win it all.

The world has 10 major stock exchanges, three of which are either controlled or influenced by China. Here are those exchanges:

Exchange	Established	Mkt. Cap
New York Stock Exchange	May 1792	$19.3T
NASDAQ	February 1971	$13.8T
Tokyo Stock Exchange	January 2003	$5.7T
Shanghai Stock Exchange	November 1990	$4.9T
Hong King Stock Exchange	February 1891	$4.4T
Euronext	September 2000	$3.9T
Shenzhen Stock Exchange	December 1990	$3.5T
London Stock Exchange	January 1571	$3.2T
Toronto Stock Exchange	October 1861	$2.1T
Bombay Stock Exchange	December 1990	$1.7T

Source: “Business Insider” article by Ben Wick dated June 19, 2020

The three Chinese markets are poised to grow dramatically as prosperity in the south China region of the world becomes reflected in ownership of listed stocks. There is a fourth trading market linked to the Shanghai Exchange and patterned after the NASDAQ called the China Star Equity Market, which is also known as Shanghai Stock Exchange Science and Technology Innovation Board (the “Star Market”).  It is a market for early stage technology companies.

Trade War May Be An Accelerant

The current trade war between the United States and China may also hasten the rise of the south China region exchanges, especially if the U. S. forces smaller Chinese public companies with inadequate financial disclosures off its domestic exchanges like the NASDAQ.  Evidence of this trend is shown by the U.S. Senate voting by unanimous consent in May 2020, to curtail access to U.S. stock exchanges for Chinese companies unable or unwilling to make financial and other disclosures required of U.S. companies.

Jack Ma Is Betting on Chinese Capital

A real test for capital formation will come when Ant Financial Services Group Co., Ltd ,a Chinese financial platform, goes public later this month. With the world’s largest mobile payments platform called “Alipay”, and Asian dominance in retail credit rating, online banking, insurance, and wealth management,  Ant could be the largest IPO in history. Today it is 33% owned by Alibaba (Baba, NASDAQ) from which it was spun out as an independent private company. Alibaba’s founder, Jack Ma, has influenced Ant’s meteoric growth.

Unlike the previous biggest IPO in history (Saudi Aramco), Ant will only raise capital in its IPO from the three south China region exchanges. This will mean institutional capital from all over the world will have invest in “H” shares through The Hong Kong Stock Exchange, and then through a conduit called Stock Connect to Ant. Domestic retail capital and mainland China institutional capital will be allowed to invest in “A” shares trading on the Shanghai Stock Exchange as well as The Star Market.

The interesting question for the Hong Kong Exchange will be whether institutional investors will be content to own “H” shares in Ant trading on the Hong Kong Exchange when direct ownership through the “A” shares is allowed only on Shenzhen, Shanghai and Star Exchanges? Current mainland China capital flight rules prohibit mainland capital from “travelling south” to the Hong Kong Exchange so any mainland retail or institutional investors interested in Ant must purchase on one of the two mainland exchanges. The “H” shares have always traded at a discount to the “A” shares because their trading market is tethered to China and its capital restrictions.

Conventional Approaches May Be Challenged

For investors outside mainland China the conventional way to invest in mainland China for most institutional investors has been “northward” from Hong Kong through “Stock Connect”, or through approved dealers like Qualified Foreign Institutional Investor (“QFII”)or, Renimbi Qualified Foreign Institutional Investor (“RQFII”) entities.

With the recent mainland “thumbprint” for Hong Kong under the National Security Act there is increasing concern about Honk Kong’s long-term role in Chinese capital formation. I know I would be concerned if my ownership of Ant was through H shares and not the pure “A” shares available to mainland citizens. What do you really own if mainland company dividends can be restricted by capital flight laws or if H shares trade at ever steeper discounts to the “A” shares? The Security Act may portend a slow decline in the Hong Kong Exchange as the preferred institutional trading exchange for the south China region. This will come at a time when institutional capital relies on the rigor and transparency of the Hong Kong Exchange to winnow out fraudulent mainland companies.

Chinese Stocks Have Been Under Represented in World Stock Indexes

Morgan Stanley Capital International World Index (MSCI) seeks to represent a balanced approach to owning the “investable” (my emphasis) world through one index. Until June 2018, however, the MCSI had no weighting for Chinese A shares presumably because A shares were largely owned by Chinese retail investors and the A shares market was thinly traded and quite volatile. Beginning in June 2018, the A shares were included in the MSCI index for the first time. It is not clear, however, whether this index is still reluctant to include “A” shares as a more important market cap weighted component because of the fear they are not safely investable due to skimpy disclosures, thin trading and market manipulation? Here are a couple of charts from the MSCI website(https://www.msci.com) that show the MSCI index does not reflect China shares as a separate component. Only its MSCI ACWI Index which includes emerging markets has a 5% China allocation:

MSCI INDEX COMPONENTS

MSCI ACWI COMPONENTS

It will be interesting to see how the south China markets evolve over the next five years. Clearly, Chinese public companies are underrepresented in major world indices like MSCI relative to their GDP contribution. Attaining a level of transparency, liquidity and security found in the NYSE and NASDAQ will be a daunting task, but the Ant IPO will be a first step and a telling adolescent breakout.

This is the time of year when you can actually find child like joy in your Major League Baseball (MLB) teams. Take the Cleveland Indians with their small market budget as an example. Not-withstanding, their loss of an important starter, Mike Clevinger, the Tribe has actually secured a playoff spot by dominating the division leading Chicago White Sox in a 4- game series. They have done this with a Cy Young worthy start from Shane Bieber, great relief performances and walk off home runs from Jose Ramirez and Jordan Luplow.

Tom Hamilton’s call “Hit Hard to Left, Way Back, Gone” three nights in a row has created hope for all of us who have been waiting since 1948 for a World Series crown.

The excitement of MLB playoffs in a 60 game season with 8 teams from each league has actually made me forget about hockey, basketball and football, all of which are providing their own excitement and relief from the stress of 2020.

Minor League Bargaining Position Has Deteriorated

However, as September 30 approaches, the joy in the MLB is not resonating in small towns across the country like Batavia,  Lowell, Idaho Falls and Billings. I wrote in November 2019, about how the Professional Baseball Agreement between MLB and Minor League Baseball (MiLB) was set to expire September 30, with a threatened contraction of 160 minor league teams to 120 teams (https://capitalworks.net/major-league-baseball-will-cut-42-minor-league-teams/). Since that blog, the situation has worsened due to the cancellation of the 2020 MiLB Season. The Office of the Commissioner of Baseball is negotiating less and dictating more and most MiLB owners expect MLB to have complete power and authority over the surviving MiLB franchises.

I guess you can take the position that MiLB owners are all “fat cats” who bought play toys with “pin money”. They took a capitalist risk in buying a MiLB franchise and lost!

MLB Made A Nice Pick Off Move

However, this is not the whole story. MiLB league owners were duped by the MLB in 2018 into supporting the “Save America’s Pastime Act” congressional legislation.  Politicians from both parties like Chuck Grassley, Republican Senator from Iowa, Tom Tester, Democrat Senator from Montana, understood these important small-town assets and wanted to encourage MLB to keep the minor league experience alive for towns like Lowell, Massachusetts whose voters could not afford Red Sox tickets but could afford a whole lot of Spinners games. As a Red Sox Class AAA affiliate, many hoped they could see the next Mookie Betts swing a bat at a park in Lowell. 

That legislation allowed the MLB to pay minor league players a $7.25 per hour federally guaranteed minimum wage with favorable work rules even though state minimum wage and hour rules were often significantly tougher, especially in states like Arizona and Florida.  Even savvy political operative like Chuck Schumer, Democratic Senator from New York, fell for the sales pitch and he and cross-aisle supporters like Shelley Moore Capito, Republican Senator from West Virginia, were quite astonished that two years later there was a proposed 25% reduction in the number of minor league teams. In the rear view mirror it sure looks like crony capitalism prevailed at the expense of small-town America.

More importantly, the Save America’s Pastime legislation reinforced the antitrust exemption for MLB at a time when meaningful wage and hour lawsuits were pending against MLB for past wage, hour and benefits discrimination. In my prior blog this is how I described the serious contingent liability facing MLB owners:

“Whenever something does not make sense to me, I always say “FOLLOW THE MONEY”.   In this case the real money at risk is when the world learns the MLB pays these 42 teams, and the rest of the minor leaguers about $3.75 per hour for a full year of work.  This is the average contractual wage based on contract responsibilities, and it is currently being challenged as a violation of Fair Labor Standards Laws as below Federal minimum wage and overtime rules.  That lawsuit (Senne v. The Commissioner of Major League Baseball), has been pending since 2014 and has been tied up in dilatory appeals by The Office of the Commissioner of Baseball.”

Minor League Teams Have No Value Right Now

My joy for the Tribe is truly muted by the future fate of a town like Montgomery Alabama. I have visited it and its downtown visitor experience is built around a Riverpark Stadium where the Montgomery Biscuits, a Class AA affiliate of Tampa Bay play their games. WhileIMontgomery is not currently on the closure list its minor league team is emblematic of the small town roots of American baseball. Losing the Biscuits would devastate their wonderful downtown experience.

A friend of mine who owns several MiLB teams thinks a new agreement will be announced soon. It does not look like the MiLB owners will have much influence or authority and the value of their MiLB teams – once trading in a range of $10 million to $50 million – is completely speculative right now. As the “boys” of a Covid-19 summer begin their innovative bracket play this week the lesson about the power of a congressional monopoly is fully understood by all the MiLB owners who won’t open for business in April 2021 as locally controlled and operated anymore.

I remember the Over-The-Counter Trading Desk at a regional securities firm called Prescott, Ball& Turben (PBT) where I was employed in the Mergers & Acquisitions group from 1987-92.  Trading small stocks was an art with high commissions and limited liquidity.  Good trading desks did not “position” securities by holding them in inventory, rather they preferred making markets in securities where they could know they had a buyer for every seller. They strongly preferred “round lots” of 100 shares [1].

There was nothing worse than a customer who wanted to sell an “odd-lot” of 73 shares of General Electric. Matching an odd-lot book was hard work. Ending up with those shares on your balance sheet was not unusual and quite disturbing if your trading desk, like PBT, had limited capital.

As a consequence, odd-lot trading was quite expensive and the odd-lot seller or buyer often paid 2x the trading commission or more.

Forty years later the marvels of electronic trading and apps that put a trading desk on your mobile device have changed the reputation of odd-lots. A retail investor who wants to own Amazon or Berkshire Hathaway cannot afford a round lot of 100 shares because the cost would exceed $100,000, but a one share slice of Amazon or Berkshire Hathaway is more affordable at $1000.

The major custodians like Fidelity, Schwab, and E Trade, now offer stock trading without any commissions. A whole new industry of phone trading has also been enabled by new entrants like Robinhood who have created trading desks on individual phones. As a consequence, the odd-lot, once a pariah, is back in the highlights as demonstrated below: [2]

Part of the reason is electronic trading can easily bundle odd-lot trades and then unbundle proceeds. A large position can be sliced and traded in small increments to disguise the size of the party seeking liquidity. This is especially helpful for small capitalization stocks with limited trading volumes.  As a consequence, the individual investor has returned to the trading markets:

I am not sure what this change portends? In my past experience, whenever large swaths of individual investors started day trading it was a sure sign of the coming apocalypse.  If you look at the crowd favorites you see a mixed bag of sexy tech stocks like Apple, Amazon and Google, disruptors like Tesla and, more concerningly, complete moon shots like Hertz and Kodak where the results are binary. The good news for these individual traders is the trading cost of winning and losing is no longer a deterrent.

The movement for slices doesn’t stop with stocks. A recent New York Times article published on July 31, 2020, written by Paul Sullivan titled “Can’t Afford A Birkin Bag or a Racehorse? You Can Invest in One”, explores the fractional ownership of otherwise unaffordable assets or goods.  Most investor’s experience with fractional ownership harkens back to condominium time shares where the monthly fees continue to escalate but valuations have cratered. The promoters and managers made all the money in fractional ownership of condos.

However, the Securities & Exchange Commission must feel differently about fractional ownership of start-ups, Birkin bags and racehorses, because it has relaxed the rules on small securities offerings. Some of the riskiest investments are now affordable. Here is how Mr. Sullivan describes the opportunity:

“The market for investing in fractions of items otherwise seen as collectibles — and largely reserved for the wealthiest people — has seen an uptick in interest during the pandemic as people spend more time at home.  Rally Rd. began by selling shares in exotic cars several years ago but has expanded to art, books, wine and whiskey, memorabilia and Birkin bags.”

This slicing up of everything is a trend that will probably continue until the fractional owners who often have neither possession nor liquidity, decide it may be they who are experiencing financial death by a thousand slices.

[1] References herein to a specific company or its securities do not constitute investment advice with regard to such security and no implication of a recommendation to buy, sell or hold any such security should be attributed to such reference.

[2] References herein to brokerage firms do not imply a recommendation of any such brokerage firm.  References to commission charges are based on publicly available data and are subject to change.

For most politicians the US economy is a fable, like the magic coffee grinder in the story about “How the Sea Got Salty”. According to legend the owner of the coffee grinder was a poor farmer who first used the magic grinder to provide food and shelter for his family, then all of his neighbors and then all their neighbors.  All he had to say was “Presto Change-O Domino Allloto” and a wish could be granted. The poor farmer was careful to use the grinder for just the basic necessities of life for himself and his community.

Every four years the US electorate determines who holds the magic grinder and who knows the magic phrase. For at least the last two decades the electorate has been so polarized it has been reluctant to share the magic phrase with any politicians. Instead, voters have chosen deadlock and little substantive legislation has been passed. It has become so tribal even the surrogate kings like Obama and Trump have resorted to Executive Orders, not the magic grinder, to shape their legacies.

The tragedy of the fable about “How the Sea Got Salty” is news of the grinder’s magic properties reaches a greedy king who steals the coffee grinder from the farmer.  In his ship on the way back to his homeland the king tries every imaginable phrase. Finally, in frustration he says “Presto, Change-O, Domino, Alllotto if you can’t grind anything else Mill Grind Salt!” 

The gears of the mill began to creak and the ship was soon so full of salt it was near sinking, but the king would not throw the magic grinder overboard. The salt accumulated quicker than the crew could shovel it overboard and soon the ship sank. The mill is still at the bottom of the ocean grinding out salt.

The election in 2020 may be one of the few times in my life where the mill and the magic phrase may be reunited, and the king will have the opportunity to use the magic phrase to grind out endless “stimulus” supported by massive tax increases. Without stimulus being tied to policies for restoring jobs and promoting growth, the magic mill may as well just be grinding salt, and the taxes to support the mill might just sink the ship.

We have received reports, including in some cases from certain of our portfolio companies, that businesses are experiencing difficulties in getting workers and they believe this shortage has been caused, at least in part, by unemployment insurance keeping workers at home. This has the potential to encourage businesses to consider production automation which may permanently remove jobs. Unemployment insurance is not the answer. It does not incent job training, return to the job force or relocation. It does not encourage productivity and innovation.  It is like the king’s salt – great for preserving votes, but worthless when it comes to keeping the economy afloat.

When the Israelites fled Egypt under Moses’ leadership they were constantly attacked by the Amalekites.  In the valley of Rephidim the Israelites under the command of Joshua, met Amalek in a battle where Moses guaranteed his general a victory as long as Moses could oversee the fighting. According to the Book of Exodus, the Israelites had the better part of the battle as long as Moses held his arms in the air but the Amalekites would rally when he tired and dropped his arms. According to the Book of Exodus 17:10-13 the solution was some help from his family:

¹⁰ “So Joshua fought the Amalekites as Moses had ordered, and Moses, Aaron and Hur went to the top of the hill. ¹¹ As long as Moses held up his hands, the Israelites were winning, but whenever he lowered his hands, the Amalekites were winning.¹² When Moses’ hands grew tired, they took a stone and put it under him and he sat on it. Aaron and Hur held his hands up—one on one side, one on the other—so that his hands remained steady till sunset. ¹³ So Joshua overcame the Amalekite army with the sword.”

A modern-day reenactment of that battle is being waged on Wall Street as Jerome Powell and central bankers all over the world are battling for control of prosperity in all markets against obvious descendants of the Amalekites — banks, credit card companies, value investors short sellers, cryptos and owners of gold and silver. Chairman Powell has Stephen Mnuchin and Larry Kudlow holding up his hands and he is winning the fight.

Here are a few charts from The Wall Street Journal Daily Shot over the last few weeks predicting his staying power as well as demonstrating the enormity of his accomplishment given the lack of any fundamental attraction for many of his investments:

First, he has spent more money than Khloe Kardashian:

Next, he has tamed the exodus from High Yield:

The day traders’ favorite stocks are beating the hedge fund managers:

Zombie companies are performing best:

Public offerings for blind pool investment vehicles are booming;

Ironically, Mr. Powell appears to be fighting a war to restore an economic order that a Fed predecessor, Paul Volker, eradicated at great pains to the nation in the 1970’s and 80’s. Here is how an article by the NYT  by Binyamin Appelbaum and Robert D. Hershey Jr., Published Dec. 9, 2019, Updated Dec. 13, 2019, described Volker’s economic battle and triumph over Amalekitic inflation:

“He prevailed by delivering shock therapy, driving the economy into a deep recession to persuade Americans to abandon their entrenched expectation that prices would keep rising rapidly.

The cost was steep. As consumers stopped buying homes and cars, millions of workers lost their jobs. Angry homebuilders mailed chunks of two-by-fours to the Fed’s marble headquarters in Washington. But Mr. Volcker managed to wring most inflation from the economy.

His victory inaugurated an era in which the leaders of both political parties largely deferred to the central bank, allowing technocrats to chart the course of monetary policy with little political interference.”

The Fed has come full circle in 50 years. We now desperately need inflation to relieve every heavily indebted asset class and prop up phony prosperity based on credit, not production, innovation or a current account surplus – all measures of a healthy economy.

Modern Monetary Theory has given money printing new license because we are told a country cannot default in its own currency as long as it has the power to print more. When you are the reserve currency for the entire world your flexibility is even greater. However, no one is asking whether this is prudent or even if this is legal?

I wish I had the vision to understand where money printing will lead? You can look at Japan as a guidepost. They bought into Modern Monetary Theory early and they have printed with impunity. They have struggled to inflate their economy even after buying ETFs and propping up Zombie companies and insolvent banks. The Bank of Japan has had its hands in the air since the 1980’s and there is no sign of inflation. Here is a chart from Inflation.eu showing a deflationary pattern in Japan:

Just as Moses vanquished the Amalekites so, too, has Chairman Powell rewritten the rules for investment success. He is committed to defeating deflationary trends brought on by Covid-19’s destruction of jobs. As long as the markets are in his hands you cannot lose and there is no sign he is tiring.

I have written before about moon tides (and how they remind us about investment markets tending to exaggerate fear or greed) https://capitalworks.net/moon-tides/. Dangerous shoals are hidden when the tide is 20% higher and keels are in the mud or on the rocks when the moon tide has fully ebbed. But this part of nature is quite orderly and safe in most parts of the globe. You can predict with precision when the tides will turn and you have a period of hours to adjust your strategy. The average tides rarely exceed 3-4 feet.

For Most Times Markets Work Like Tides

Nonetheless, if you are in a kayak and you want to paddle against a rising or falling moon tide you better get an engine. If you want to fish at the bottom of a moon tide you better check the harbor to see if it has any water. The important thing is you have the knowledge and information to work with nature in most parts of the ocean.

For most of my investment lifetime, investment markets have operated like tides. Fortunes ebb and flow as markets advance and retreat with almost harmonic oscillations. I experienced high tides in 1999, 2007, and 2019 and then low tides in 1974, 2000, 2008, and 2020. In 2020 the high tide was January, the low tide was February and March, and then the high tide returned in April through June. The market’s tidal harmony was interrupted by the Fed.

There are parts of the world, however, where the tides are epic – like the Bay of Fundy in Nova Scotia. It has more water flowing in and out of that Bay in one 12 hour period (100 billion Tonnes), than the flow in all the rivers of the world for the same period!  They have moon tides as high as a five story building. The tides are so strong they can actually create tidal bores that stop the flow of rivers and create tidal waves of 10-12 feet.

The Fed Has Created A Permanent Bay of Funding

Jerome Powell and The Federal Reserve Bank are creating a special Bay of Fundy moment for markets all over the world by sustaining a perpetual 60 foot high tide. Of course, if you had to pick a tide (high or low) I would always take the high tide. It hides the rocks and shoals, puts nutrients in the water and traps baitfish for fantastic fishing and permits navigation into corners of the coastline where you have never been. But after a few days it begins to create distortions for small craft like sailboats, dinghie’s, kayaks, and paddle boards. They all forget about risk.

You can always catch fish. You can always move from place to place by water. You can always navigate tidal rivers. You never have to swim against the tide. You begin to rely on the permanent flow often forgetting how different life is at low tide and how recently it just occurred.

A Worldwide Liquidity Crisis

In  March of 2020, the Fed adopted emergency measures spawned by Modern Monetary Theory to create the first ever perpetual moon tide.

The reason was market liquidity was receding fast and the world economy was about to be left high and dry from a natural pandemic that halted worldwide commerce and crippled GDP. There simply was not enough liquidity in any market anywhere to handle the massive outflows from a leveraged world scrambling for cash.

Some of those really strange things were the highest quality bonds in the world started to trade like junk, and gold was crashing just like the stock market.

For example on February 19, just as the implications of Covid-19 were being digested, the price of the gold index, GLD, was 151.19 and the price of the S&P 500 index, SPY, was 338.34. On March 6 , when the enormity of the crisis was being recognized, GLD was 157.55, a 4.2% increase and SPY was at 297.46, a 12.08% decrease. This inverse relationship is what you would expect. But then on March 19, GLD was at 138.04, a 8.6% decrease from February 19. The SPY was  at 240.51 on March 19, a 28.9% decrease from February 19.

Some short duration high quality bonds such as Apple and Wells Fargo saw their yields spike and their trading prices plummet. If Apple with the largest equity market cap in the world and billions of cash on its balance, was trading at massive discounts because investors were desperately trying to raise cash, the capital markets were about to disintegrate (see graphs below).

The Fed Turned The Tide

Prior to February 2020, massive capital inflows fueled by dirt cheap leverage sustained a whole swath of high risk assets like Zombie corporations, high yield bonds, collateralized loan obligations and questionable municipal credits.   Portfolios picked for yield with excessive principal risk were commonplace. Investors and speculators alike thought they had boarded the SS Vanguard, Blackrock, and Fidelity on a coming tide and what they really owned was a flotilla of leaky kayaks sitting in the Bay of Fundy just as the liquidity tide was starting to go out!!!

That flotilla is still there enjoying a perpetual high tide from the Fed’s “Bay of Funding”. They are recently joined by Gilligan, Skipper, Mary Ann and Ginger  and a whole boatload of day traders who think they are on a three hour cruise.

We know how it ends for the SS Minnow, but for those of you who don’t understand the meaning of no liquidity, here is what is left when the Bay of Fundy empties after a Moon Tide. We better hope the Fed can sustain this high tide until the economy gets back on track.