Andrea Zacher

“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.

Bankruptcy is a little bit like the Greeks’ vision of Hell or Hades. There is a river you have to cross called the Styx with a ferryman called Charon whom you have to pay with a coin for safe passage. If your relatives forgot to bury you with a coin, you had to swim the Styx which was much like swimming the Cuyahoga River which caught on fire in Cleveland in the 1960s.

Greek mythology offered hope for those who made a safe crossing, however. They were offered a chance for new life by inhabiting a new body. 

Hertz crossed the river Styx on May 22, when it filed a petition to reorganize itself under Chapter 11 of the US Bankruptcy Laws and is waiting for a new body. Typically, secured creditors in Chapter 11 bankruptcy get cash for some of the par value of their bonds. Unsecured creditors often are left with a swap of their bonds for new equity in the reemerging enterprise. The old equity is almost always deeply impaired or completely lost.

Robin Hood Vs. Vulture Capitalists

The people who speculate about whether a company has enough coin to cross or enough credibility to get a new body are called Vulture Capitalists, and have descriptive names like “Grave Dancer”, a name given to Sam Zell who is famous for picking up real estate assets on the cheap through the bankruptcy process. These people are intimately familiar with every pothole and wrong turn in Hades. This isn’t a place for people named Friar Tuck, Maid Marian or Robin of Loxley aka “Robin Hood.”

Nonetheless, a new day trading site catering to retail investors called Robinhood with products like fractional shares, options, gold and crypto has emerged as a favorite of the younger generation. I guess the lure of no commissions matches well with investors who believe the Fed’s bailout capitalism applies to them?

Here is a chart I saw in “The Wall Street Journal Daily Shot” from ScotiaBank about young speculators trading companies like Hertz, Valaris and GNC Holdings;

Vulture Capitalists See It Differently

The Vulture Capital community has a different opinion about the value of Hertz’s common equity. According to our friends at Wasmer Schroeder who are specialists in fixed income, the trading range for The Hertz Unsecured Bonds maturing in 2022 is currently $0.40- $0.45 which means the bondholders expect to lose 55%-60% of the par value. That does not bode well for Maid Marian and Friar Tuck’s speculative bet on the equity. The bond market is signaling the equity may be worthless.

According to Capital IQ based on Hertz’s first quarter 10Q filing, Hertz has $20.7 billion of debt, and only $1.07 billion of cash. Its net debt is 49.3x its trailing twelve-month EBITDA. Its annual capital expenditures for car fleets and facilities are more than $4.0 billion, and it competes with companies like Uber and Lyft who have minuscule capital expenditures and virtually no debt. Its biggest “real world” competitors include Avis Budget and Ryder which are highly indebted and incented to take Hertz’s market share.

S&P Has Downgraded Hertz

Here are the S&P Credit Rating for Hertz. It is currently a “D” for default, one notch above NR which means no rating.

A Public Offering In Chapter 11

When Hertz announced it was going to raise up to $1 billion of equity in a public offering based on the speculative fervor in the HTZ stock, the existing equity holders sued to stop the deal for fear of being more diluted. A federal district court said the offering could proceed. Here is a chart of the HTZ stock price courtesy of Yahoo Finance. Notice that the speculative fervor has cooled in the last several trading sessions after having peaked around $6.00 per share.

There is a chance the speculators will turn out to be right. The debt that is in default is only $4.5 billion, not the full $20.0 billion. If the speculators can raise more than one billion of new equity, and other assets are sold to pare down the defaulted debt, Hertz may put the Robinhood traders “back in the driver’s seat”. They may be driving a 1968 Ford Pinto, but they will be driving.

The real danger for the speculators is those vulture capitalists who cross the Styx for a living and get names like Grave Dancer are rarely wrong about Hell.

Laura Numeroff writes really popular children’s’ books. She is famous for her series on animals: “If You Give A Moose A Muffin”, “If You Give A Mouse A Cookie”, “If You Give A Pig A Pancake”, and many others. These are fun books for kids because of alliteration and constant action. Most importantly, at bedtime, they are quick reads and, if you fall asleep, the kids can usually finish the books without you.

Each has the same theme. The animal is never satisfied with your act of kindness. He or she just wants more: “If you give a pig a pancake, he will want syrup.” Most of the books end with the animals in charge of the house dispensing havoc and disorder. You hope your child or grandchild gets the idea that being a selfish pig is a bad way to live.

The same sort of great expectations are now a fixture of our political promised land:

These promises are now gaining mainstream acceptance because they are being mislabeled as “stimulus” in the time of coronavirus. While a crisis is always too tempting for a politician to waste, this justification is voodoo economics and utter hogwash.

It Is an Election Year

 If you give a pig a pancake and you don’t make it conditional on how the benefit is spent, you do absolutely nothing for increasing gross domestic product, job creation, or the welfare of the nation as a whole. You are just giving a Republican or Democrat a printing press so he or she can get elected.

When the CARES Act sends $1,200 checks to middle and lower class citizens it is not creating stimulus it is just printing money. Stimulus happens when there is an incentive like “use it or lose it”, to spend that money on goods and services. Having the stock market go up, or having the recipient put it in a savings account, while both desirable, do nothing for GDP. They only benefit a small cohort of already wealthy capitalists. In many cases the response to the pandemic is not meant to stimulate anything other than a mail-in ballot in November.

This begs the question of when the real stimulus will start? A big part of the CARES ACT is conditional loan forgiveness for employers to keep a workforce in place. While not directly incenting employee behavior, a job pays the rent, the grocery bill and utilities. Keeping businesses open and ready for a quick recovery is good for GDP.

Here are some popular political programs already in place or part of national political discussion that will not do anything for GDP because they are not tied to spending on things like autos, rent, health insurance, travel, dining, entertainment or home improvements:

Unemployment Benefits  – many states have programs that incent unemployed not to return to work. I am not aware of any program that dictates how the benefit must be spent. The presumption is these benefits will be spent on the necessities with immediate impact on GDP. I wonder whether someone who works for his pay is more likely to participate in the consumer rebound than a recipient of unemployment?

Student Loan Forgiveness – I am not aware of any carrot or stick in any forgiveness proposal that predicates student loan forgiveness on a commensurate investment in America. Without a quid pro quo, forgiving student loans will not do anything for pandemic recovery.

Bailouts For States and Municipalities – as the Federal Reserve begins to buy bonds from states and municipalities with such poor credit they cannot access traditional debt markets, I wonder what behavior this incents other than continuing reckless management by existing leadership.

Guaranteed Minimum Income – There is a growing drumbeat for an unconditional, annual subsistence payment like you find in many European countries.

A Printing Press For Politicians

Laura Numeroff may have a new career writing economics books for adults:

If you give a politician a printing press he will want:

• paper, ink and engraved currency plates to print money;
• shovel-ready projects to spend money;
• his or her name on those projects; 
• a pay raise;
• guaranteed national income for his or her supporters;
• and free pancakes and syrup for his or her fundraisers.

When I asked my eight-year-old grandson what he thought the message of Laura Numeroff’s books were to children, he blinked a few times and then stated confidently; “THEY ALWAYS WANT MORE”.

Central banks consider deflation a “devil child” because of its pernicious psychology. Deflation encourages waiting for purchases until they get cheaper—which they do every day as demand is delayed. The result is a downward price spiral and slow GDP growth.

Even though this sounds good for the consumer, it is bad for countries and people with debts because the fixed principal amount becomes more expensive as prices sink. There is also persistent joblessness.

Because this devil child is unmanageable, central banks want an inflationary environment where debtors, including countries, are repaying fixed principal amounts with money that is less valuable every day. As a result, central banks will even create inflation simply because, unlike deflation, they can manage it.

Moving From Scarcity to Abundance

Jeff Booth, author of The Price of Tomorrow, has an interesting assessment of the battle being waged between an existing world economic order ruled by scarcity and a coming world order ruled by abundance. His thesis is explained in his book as follows:

              “Our economic systems were not built for a world driven by technology where prices keep falling. They were built for a pre-technology era when labour and capital were inextricably linked, an era that counted on growth and inflation, an era where we made money from scarcity and inefficiency”

Mr. Booth sees digital technology based on computer chips getting half again cheaper every 24 months (Moore’s Law) for at least the next several doublings. Similar exponential technologies are happening in solar power, battery technology, robotics and machine learning.

Here is an inflation scorecard for the last five years, a period of full employment and prosperity in the US, based on the reported CPI from the Bureau of Labor Statistics. It shows a timid inflation tiger and confirms the Fed is losing the inflation battle:

March 31, 2016	April 30, 2020	5 Year Inflation Rate
238.04	255.09	1.45%

Central Bank Playbook Is Predicated on Scarcity

Meanwhile world central banks are printing trillions trying to save debt-ridden economies with massive unemployment profiles. Without jobs, worldwide growth will be impossible. Mr. Booth wrote his book before Covid-19, but even without a pandemic he fears job-destroying technologies alone will upend the old paradigm. He sees the central banks’ playbook as impossibly flawed and inefficient: (quote is partially paraphrased).

              “Since 2000, the world economy has grown from US$33.5 trillion to about US$80 trillion, but to achieve that growth, the total debt has grown from US$ 62 trillion to over US$247 trillion as of the third quarter of 2018, according to the Institute of International Finance. In other words, it has taken approximately $185 trillion of global debt to achieve $46 trillion of global growth”

Deflationary Technologies Are Everywhere

It is hard to argue with the emergence of cheap technology. The deflation culprits are everywhere. Many have monopoly or oligopoly power and they seem to be converging right now:

• Google Search, Google Maps, Google Earth
• Amazon, Amazon, Amazon
• Smartphones based on IOS and Android
• Tesla with only 20 moving parts
• Facebook—free community for the social you
• Linked In—free community for the business you
• Airbnb—the biggest landlord with no properties
• Shopify—online platform for sellers
• 5G—always on high-speed connectivity
• Self-driving cars—a data advantage for incumbents
• Solar power—no extraction costs
• Virtual and augmented reality
• Additive manufacturing—cheap knock offs
• Artificial intelligence and machine learning

Unlike traditional scarcity monopolies, which harm consumers by raising prices or constraining markets, these new deflationary monopolies are quite popular because they drive prices lower and service higher. Breaking them up won’t be a popular choice.

Post-Pandemic Reemployment Will Be Tough        

Who thinks anything post-pandemic except taxes, cable TV, health insurance, Clorox wipes and hand sanitizers will be more expensive next month, next year, in two years, in five years? Autos? Rent? Travel? Lodging? Dining? Energy? Insurance?

The only place you have sure inflation is the stock market. Despite Fed intent, the printed money always seems to end up there.

Fed May Be Fighting Deflation on Two Fronts

Given the rapid shutdown of the American economy and the resulting loss of more than 30 million jobs, the Fed now may have a fight on two fronts. It must slay the deflationary dragon of digital technologies and simultaneously counteract the loss of demand for goods and services from Corona Virus. A pandemic could not have happened at a worse time.

Take the example of lodging. Airbnb became the largest property rental name in the world by harnessing unused capacity in people’s rooms, homes and apartments. Without any investment in bricks and mortar Airbnb started technology deflation in rental, vacation and lodging properties by dramatically increasing supply.

Double Deflation Whammy

A sudden drop in demand because of 30 million lost jobs and you have a double whammy: almost endless cheap marginal worldwide capacity from digital platforms like Airbnb and an almost empty installed base of traditional lodging dedicated to travel. This has to be deflationary for hospitality and many other traditional industries.

The same is true for the cab business (Uber and Lyft), the internal combustion auto industry (Waymo and Tesla), the retail industry (Amazon), the entertainment industry (virtual reality, e-sports, e-gambling and Netflix), the news and media business ( Google, Facebook, Twitter). Even if technology is not free, the platforms with a “network effect” are doubling capacity at alarming speed. They will be cheaper tomorrow.

This brings us back to the deflation devil child. As Jeff Booth points out in his book “cheaper next year” should be good for every consumer. Whose life will not become more productive because of free Google Maps, free Google Search, free Google Earth and an Apple phone? Unfortunately, Mr. Booth has an apocalyptic view of war, civil unrest and isolationism as a possible by-product, much like 1933. No summer jobs for youth and slow reemployment in 2020 and 2021 combined with an election year and a distrustful and polarized electorate could make Mr. Booth’s predictions come true. Let’s hope he is wrong!!!