An Honest Look at Presidential Stock Market Returns

I put together this table of Presidential returns to illustrate how obscene the stock market bubble in Trump’s first 2 years has been. In putting together this analysis, I don’t use the dates when a President has come into office to calculate the presidential returns because the market tends to front-run the policies of a president before he takes office. The market rise from November 2016 to January 2017 had nothing to do with Obama’s economic policies and everything to do with Trump/GOP plans for a massive corporate tax cut. In addition, I don’t look at where market prices were on Election Day, but instead I look at what is the “net addition” that a President has been able to achieve over the prior president. To do that, I take the maximum S&P 500 (SPX) price achieved under a president and then calculate the difference on top of the max SPX price achieved under the prior president. For example, this table doesn’t give Obama full credit for the recovery of the stock market. It only gives him credit for gains he was able to build on top of Clinton’s stock market gains. This analysis also doesn’t give Bush 43 any credit at all because the stock market under him was flat and the best he could do is return it to Clinton-era all-time highs in 2007.


When you look at Presidential returns in this light, in 2 years, Trump has gained almost as much as Obama did in 8 years. Trump has gained more than Bush 41, Carter and Nixon in 20 years combined. The gain per year under Trump has been 17% per year which is double the long-term SPX annual average (8%) and 3rd only to Reagan and Clinton. However, I need to mention that both Clinton’s and Reagan’s great stock market gains came in their 2nd terms. Reagan and Clinton both had to deal with a recession at the start of their presidencies. They had to work to get their stock market gains.

Regardless of whether it was Trump or Hillary Clinton in 2016, the market was expecting a significant corporate tax cut to bring US rates in line with the rest of the world (around 25%) and the market was going to rally on that tax cut. If Obama had done it, the stock market gains we see today under Trump would have happened under Obama. As such I view Trump’s stock market gains as undeserved. The tax cut was expected. The question is what lies going forward.


Tax cuts and particularly corporate tax cuts inevitably animate the rich vs poor public debates and make progressives more active in politics. You see more worker strikes, work stoppages and more demands for higher wages and for more government benefits. Every action has a counter-reaction. If the rich get richer from a government handout, the poor will want to get richer from a government handout next. When the rich get a government handout, they hoard the money or invest – resulting in low inflation. But when the poor get a government handout, they spend it – which results in high inflation.


High inflation is the greatest enemy of the stock market. After Nixon/Ford ignited the progressive movement in the late 60s/early 70s, the US saw great inflation that obliterated stock market returns. In 12 years under Nixon/Ford and Carter, the US stock market advanced a total of 36%, barely 3% per year. Most of the time, the market was in a heavy drawdown. Inflation advanced 100%+, however, resulting in massive negative inflation-adjusted returns for stocks. Under Nixon/Ford the SPX lost -49% in 8 years on real basis or -6.2% per year! Under Carter, during the final hyperinflationary phase, the SPX lost -9% per year! Under Nixon/Ford/Carter the stock market basically lost all of its real value, going down -85% in real terms. Bush 43 also saw inflation triggered by a massive wave of liberal activism which was compounded by his ill advised housing bubble policies. The Bush 43 housing bubble inflation led to a flat market which also meant that he saw a negative real market return of -2.9% per year. Inflation is indeed the scourge of the stock market. 


Keep these Nixon/Ford/Carter/Bush 43 negative real stock market returns in mind when people on TV advertise the stock market as an inflation hedge. Stocks are not an inflation hedge. Repeat: STOCKS ARE NOT AN INFLATION HEDGE. Inflation obliterates profit growth and compresses the market multiple dramatically resulting a in a double whammy of bad news for stock market prices. Nominally the stock market may thread water, but in real terms your money is being obliterated. In the 70s, in real terms you lost all of your money if you stayed invested in the stock market. In times of higher inflation, the Treasury Yield Curve is heavily inverted and only cash (short-term treasuries) and gold/real assets manage to preserve wealth. The traditional 60/40 portfolio of stocks and long-term bonds tends to suffer disproportionately because institutional investors abandon both stocks and bonds because of their high expected volatility. We are at the onset of such a period – very likely to last one to two decades as President Trump’s extremist conservativism is the trigger that makes many Americans seek refuge in progressive liberalism.


Long story short, Trump is waking up the great obliterator of stock market returns – liberal activism and inflation. His stock market gains so far are unearned – the corporate tax cuts would have happened with or without him – and by the end of his term he will join other Republican Presidential failures with negative real stock market returns despite his best efforts. As it stands right now, this is the most obscenely overvalued market in US history with SPX market cap at nearly 4 trillion over US GDP – a discrepancy between stock market cap and real output of the US economy that has never been observed under any other US president. In recent years, the US GDP averages about $700 billion in nominal GDP addition per year. At current stock market prices, we have already priced in the US GDP output for the next 6 years. Trump’s 2nd term has already been priced in by stock markets. In fact, the potential US GDP output of both Trump terms were already priced in January of 2018! If we do have a market meltup from here, we will be front-running decades of US economic output. As we saw with Japanese stock market bubble in the 80s, this is a dismal prospect for US stock markets in the future. And worse yet, a dismal prospect for the next generation of US savers. 



Blue State Wage Hikes

President Trump likes to brag about the wage gains of average workers during his time in office. Indeed, the 1st quartile of workers (lowest earning 25%) have seen the greatest relative wage gains in the economy since 2018 with wages going up at 4.4% at present and outpacing the upper quartiles (according to the Atlanta FED Wage Growth Tracker). Trump likes to link his tax cuts to the wage gains for bottom tier workers. Unfortunately, the wage gains at bottom tier are not due to the tax cuts signed by Trump, but due to minimum wage laws enacted in many Democratically-leaning states (or as many in the US call them “Blue States” for the color “blue” associated with the Democrat Party). I compiled a list of all major states that have enacted minimum wage increases in the table below. This list covers 16 states which have a combined population of 171 million people, more than half of the total population of the United States. We have California, New York and Illinois on that list and even Florida which probably doesn’t strike anybody as a hard-core Blue State but nevertheless it is a state that mandates cost-of-living adjustments to the minimum wage (adjust the minimum wage according to the consumer price index). All major coastal states where majority of the US population lives is in this list. In those states, minimum wages are scheduled to rise on average 4% in 2018, 5.3% in 2019, 8.4% in 2020, 5.6% in 2021 and 5.2% in 2022. Many states have wages jumping $1 each year until the wage reaches $15 (modeled after Bernie Sanders’ legislation), other states have more modest increases, but in many situation at minimum cost-of-living adjustment increases are being made. Many other not-so blue states like Pennsylvania are also in the process of discussing and enacting minimum wage hikes. In the list below, I have listed only the states that have already passed minimum wage legislation (or in the case of Connecticut, legislation that will be signed imminently by a Democratic governor and legislature).



In 2016, nobody expected Trump to win the Presidency. Most blue states had postponed minimum wage legislation on the assumption that Hillary Clinton would raise the federal minimum wage which hasn’t been updated since 2009. After the Trump win and with the White House blocking Bernie Sanders’ “Raise The Wage” legislation to raise federal minimum wage to $15 by 2024, Blue States took matters in their own hands and raised wages at the state level themselves. While it is true that Trump’s corporate tax cuts have allowed for minimum wage increases to occur in the economy so far without significant layoffs by major corporations, Trump can’t claim that his tax cuts are what propelled wage increases. The tax cuts by Bush in 2001 and 2003 clearly didn’t spike the relative increase in 1st quartile wages that we see today. Corporations will not raise wages unless they are forced to and it is naïve to think that with employment participation ratio still at 40 year lows, low-wage workers have any semblance of bargaining power. The relative increase of 1st quartile wages we see today can only be explained by activist legislation in the major Blue States. As much as Trump likes to brag about the economy, the lower to middle class prosperity we have observed so far is more due to the actions of state governments where legislatures are dominated by the Democratic Party.


The Magical Q4 Earnings Hockey Stick

Lying about future earnings prospects is a national American tradition and amazingly the US government has done little to curb this manipulative practice. Stock market analysts routinely misinform investors by inflating future earnings prospects. As I mentioned in a Seeking Alpha article 5 years ago, the chance of forward projected earnings being higher than actual reported earnings is 80% and the average miss is around -18%. In other words, final reported GAAP earnings routinely are -20% below what was originally advertised to investors. You can say that analyst routinely overstate earnings by about 20%. The S&P 500 earnings per share numbers I use are the numbers that Standard & Poors puts out to investors every week in an excel spreadsheet on their S&P 500 website and I track the changes in the numbers from this spreadsheet.


When the S&P 500 has a year when earnings are about to go into a recession (start declining), analysts magically start to pack further out quarters (where more speculation is allowed) with imaginary earnings for which there is no basis in reality. We see this analyst behavior in 2019 and we observed it in 2015 as well when the S&p 500 had its last earnings recession. Look at the GAAP EPS quarter over quarter change compared to last year’s quarter in the chart above. In Q4 of 2019, we magically are expected to see 43.6% earnings growth. So we have growth projected to be 10% for 3 quarters and then magically – a 43% quarter. Q4 is the quarter when corporations confess to their business failures during the year and take their biggest write-offs (for store closures, failed business expansions, etc).

How is it even possible to project 43% growth in Q4?

In 2016 Q4 we saw a big jump in earnings of +29% because oil prices recovered from the lowest inflation adjusted prices in decades and the US economy recovered from the 2015 slowdown. In 2017 on the back of a stronger economy after election uncertainty was removed and a weakening US dollar, we saw +11% Q4 EPS growth. In 2018, on the back of the Trump tax cuts, a strong economy and even stronger oil prices we saw another +7% growth. Notice how the Q4 growth in earnings has declined despite the EPS number getting bigger and bigger. That is because the EPS base becomes larger and thus it becomes ever hard to post accelerating earnings growth. It is simply the law of large numbers.



So now this year – without tax reform to artificially boost earnings, without 100% increase in oil prices, on the back of the biggest Q4 EPS ever reported, market analysts are expecting 44% growth in earnings? Really?!?

Let’s see if there is even historical precedent for this. In the table below, I look at Q4 GAAP EPS for the SPX for all years since 1988. That is about 30 years of data. In 30 years, we have had only 4 years when Q4 year over year earnings growth has exceeded 40%. In 2009, 2003, 1999 and 1994. In 2003 and 2009, the US economy recovered from a recession so big jumps in earnings like this are to be expected. But the US economy is not in a recession today. In fact GDP growth in 2018 was the highest since 2005. So we can’t use recession recovery years to compare to today.

In 1999, the SPX had negative EPS growth in 1998 and 1997 and the strong EPS number in 1999 simply represented an earnings snapback in what was an otherwise a strong economy. We didn’t have negative EPS in 2018 and 2017, so 1999 is not a proper comparison.

So really the only comparable to 40%+ projected EPS growth is 1994 which was the 3rd year of an economic expansion, not the 10th year.

Color me skeptical. When the final counting is made, 2019 Q4 will be nowhere near what is projected today. For Q4 of 2018, my pessimistic projection was for $30 GAAP EPS and SPX corporations couldn’t even deliver that coming in below at $28.97. I made a $30 projection when the prevailing analyst estimate was $37! I was a big growling EPS bear and corporations came even under me. Wages are rising faster than analysts want to admit and recession in Europe and China is hurting sales more than analyst want to admit.

To put it simply: analysts are lying again and in an outrageous fashion. There is room for speculation but what we have here is not speculation. It is lying. And the problem is that it appears that some investors are listening with the stock market off to the 6th best return in 30 years. My question is, when are going to curb this analyst behavior? How can analysts be allowed to make overly optimistic projections that have less than 10% historical chance of happening?


Modern Monetary Theory (MMT)

Originally sent to VIXCONTANGO subscribers on Sep 28th, 2018


Modern Monetary Theory (MMT)

A big reason behind the lack of negative reaction in the market over the past 2-3 months to the prospects of Democrats winning the House is the emergence of Modern Monetary Theory (MMT) in the national economic discourse. A big proponent of MMT is Dr. Stephanie Kelton from Stony Brook University (a tony university at the far end of Long Island, which also happens to be the closest university to the fabled summer house town of New York billionaires (The Hamptons) and also a recruiting base for Renaissance Technologies, the rarely mentioned 30% per annum quant hedge fund owned by Jim Simmons and former Bannon sponsor and Breitbart owner Robert Mercer). She has been making the rounds in the press lately and has gotten significant traction in liberal circles. She published the following articles recently:

Sep 28, 2017: LA Times “Congress can give every American a pony”

Oct 5th, 2017: NY Times “How We Think about the Deficit Is Mostly Wrong”

Sep 24th, 2018: Barrons “Just When Should We Start Worrying About Deficits”

Prior to her recent ascent in liberal economic circles, Stephanie Kelton was mostly an unknown academic specializing in what was considered to be a highly progressive and somewhat fringe economic theory. Her fortunes started rising in 2015 when she was designated Chief Economist for the Democratic Minority Staff of the Senate Budget Committee and during 2016 she left that position to become economic advisor to the Bernie Sanders campaign. Once Bernie Sanders campaign took off, her star was born. Now there is palpable enthusiam about Stephanie Kelton and the economic theory she is a proponent of and once Democrats win back the House, MMT has a high likelihood of becoming governing economic theory in the United States even with Trump in office (I will explain later why).


So what is Modern Monetary Theory?

As we discussed in a prior newsletter the dominant economic theory right now is New Keynesianism. Many people in power including the former FED governing duo of Janet Yellen and Stanley Fischer are big proponents of that theory. New Keynesian economics believes that markets are inefficient, that market competition is imperfect and that market prices don’t adjust quickly to economic conditions thus leading to less than optimal macroeconomic outcomes. The government using fiscal policy or the central bank via monetary policy can correct these market failures and lead to a more efficient macroeconomic outcome than a pure market economy (laissez faire) would.

Modern Monetary Theory (MMT) goes one step further and doesn’t just place the government as a fixer of market failures, but instead postulates that the government is the dominant driver of macroeconomic activity. This is not quite communism as MMT does recognize the existence of a large private sector and private property rights and is also not socialism as it doesn’t think that the government should be responsible for the means of production in large economic sectors. MMT looks at the world from a monetary point of view and recognizes that money in an economy is established and created by a sovereign government. By handling the levers of money correctly in the economy, the government can produce optimal macroeconomic outcomes.

Origin of Money

MMT is seen as an evolution of Chartalism and is sometimes called Neo-Chartalism. The word “Charta” is the latin word for “token” or “piece of paper”. In Russian, the word “karta” means “map”, but I am sure the Russian guy back in the day didn’t get the translation quite right J In other words, Chartalism means theory of “token money”. MMT starts with a different definition of money than what you are probably are used to. The traditional view of money is something the MMTers call “Metallism”. Historically, money is considered to originate from barter between private entities (people). At some point, metal coins was picked to be a medium of exchange because it made facilitation of barter easier – it was easier to carry, it survived through time and disaster (durable commodity) and it was easier to use for measuring worth and wealth (unit of account). At that time people didn’t want the medium of exchange to be completely worthless and wanted money to also be a store of value. Thus they chose to use rare metals like gold or silver which had intrinsic value because of their rarity and use as jewelry (visible display of wealth). Ultimately, in the traditional or “Metallist” view of the world a unit of currency derives its value from the precious metal backing it. A gold-backed fiat currency derives its value from its claim on a certain amount of gold. That was what was considered money for thousands of years, in the USA until 1971 (when Nixon decoupled the US dollar from gold) and by many to this day.

In “State Theory of Money” Georg Friedrich Knapp in 1905 defines money as “creature of law” rather than a commodity. Money’s worth comes from the power of the state to levy taxes and to demand payment for taxes, fees, licenses, surcharges and whatever other payments are due the state in whatever form they desire. That money can take the form of a piece paper, a stamp or any other worthless token. The token itself doesn’t have value, the power of the state is what imbues the token with value. An example often given is when getting a token in exchange for giving up your coat in a theatre. The plastic token has no worth in and of itself but represents a claim on your coat. Because money’s usage in MMT is mainly as a medium of exchange and unit of account and the money itself is a worthless token, the theory is called “Chartalism” or “token” theory of money. The concept of the power of the state imbuing money with value is first articulated in detail by Knapp but this is a concept that goes back as far as Adam Smith’s 1776 book “Wealth of Nations” which contains the following paragraph:

A prince, who should enact that a certain proportion of his taxes should be paid in paper money of a certain kind, might thereby give a certain value to this paper money.

Because governments can demand recurring payment for taxes “at the pay offices” in a their chosen currency that currency then becomes the basis on which business contracts are written because ultimately every entity in the economy whether it is a person or a business has to make regular payments in that currency. Obviously instead of incurring exchange costs, volatility and inconvenience all the time switching between payments in a random currency (let’s say gold) and the state currency, people ultimately do the easy and convenient thing and base majority of their commerce in the government’s currency. Not to mention that government may penalize usage of other forms of money. Thus Alfred Mitchell-Innes writes in 1913 that money is a deferred payment of a debt the government may reclaim through taxation. Money is debt to the government and occassionally the government collects them back as taxes.

Or simply put: Money is credit (Innes, 1913).

Money is a debt relation, a promise or obligation which exists between human beings and cannot be identified independently of its institutional usage. Money is both an asset (credit) and a liability (debit). When two people/entities enter a contract, money is created.

Hierarchy of Money

Because money is credit, there is also a hierarchy of money. Since any token can be money and various organizations can issue tokens (or financial instrumens like stocks and bonds), there is various degrees to which money have credibility. Since money is credit, money basically has a credit rating. It has various degrees of acceptability. And the closer a money token is to the government, the higher its credibility and acceptability is. The pyramid of MMT money consists of debts of households, corporations, banks and the state. With households having the lowest credibility, corporations next, banks next and state sitting at the top. You can measure credibility of debts by the interest rate being charged. For example, interest rates are highest for house mortgages, they are lower for corporations, even lower for banks and for the state money is essentially free (because it can print the money).


Finally, MMT postulates that the state will NOT accept any price for limited goods like gold. In fact quite the opposite, the state will seek to suppress the price of limited commodities like gold. Ideally, it will set it to $35 like it did for decades before World War 2. Why? Because the state views money as a tax obligation. In order to force the population to work and be productive, the government is constantly asking for taxes to be paid. Thus the tax liability is equivalent to a unit of work. If the value of a limited commodity like gold can skyrocket in the token currency, then holders of that commodity can cheat on their tax obligations. In other words, they will be able to pay their tax obligations without putting in the amount of work that the government desires. Thus in MMT, gold (or limited durable commodities) don’t have their own intrinsic value, they do have value but their value is set by the state.

To conclude this origin of money discussion, compared to Metallism, MMT says that money is what the government says that money is (dollars in the US, pesos in Mexico) and I think in the modern day and age, it is very hard to argue with that point.

National Income Identity

The government is considered to be the Treasury and the Central Bank. The private sector includes domestic and foreign private individuals and firms (including the private banking system) and foreign buyers and sellers of the currency. Transaction between the government (or public sector) and the private sector is called a “vertical” transaction. Transactions between private sector entities (including private banks) are called “horizontal” transactions. It is important to understand that in MMT, horizontal transactions don’t result in increase of the “monetary base”. Horizontal transactions (contracts between banks and businesses and people) or bank credit should be considered “leverage” of the monetary base since the private sector money doesn’t have the credibility of state issued money. Thus only the state can expand and contract the “monetary base” and then private sector can only leverage that monetary base. In these terms, by expanding the monetary base, a government can expand the potential economic output of the economy.



The monetary base (or the highest order, government money) constitutes of the spending the government does and of the taxes it collects. In the US, the Congress meets and authorizes a budget every year and by simply authorizing the budget, it creates money. Then when it starts to collect taxes, it takes the money back from the economy and thus it destroys money. A government’s budget can be either in deficit or surplus. Surplus is when the government taxes more than it spends. Deficit is when the government spends more than it taxes. As a matter of accounting government deficits add net financial assets to the private sector. In other words, the government has deposited more money into private bank accounts that it has removed in taxes. A budget surplus means the opposite – the government has removed more money from private accounts via taxes than it has put back with spending. Budget deficits add financial assets to the private sector while budget surpluses remove financial assets from the private sector. The “National Income Identity” formula governing these vertical and horizontal transactions is:

G – T = S – I – NX

G = Government Spending

T = Taxes

S = Private Sector Savings/Wealth

I = Investment

NX = Net Exports (Imports – Exports)

Let’s rewrite this formula in a different way.

S = G – T + I + IM – EX

How do you maximize Savings (S) or private sector wealth? You want more government spending (G). You want less taxes (T). You want more private investment (I). You want more Imports (IM). You want less Exports (EX).

Vertical Transactions: Government Bonds and Quantitative Easing

In MMT, understanding reserve accounting is critical to understanding monetary and fiscal politcy options. The government has an account with the central bank. From that account, the government can spend and receive taxes and other inflows. Each private bank also has an account with the central bank where its “bank reserves” are stored. When the government spends money, treasure debits (takes money out) its account at the central bank and deposits this money in private bank accounts. This government money add to the total deposits in the private bank sector. Taxation works in reverse. Private bank accounts are debited (money is taken out) and total deposits in the private banking sector decline.


In MMT, the issuance of government bonds is an operation to OFFSET government spending rather than finance it. Private bank accounts at the central bank must have positive balance at the end of the day (usually set as proportion of customer desposits or the “reserve requirement”). Every day, a private bank have to examine the status of its reserve accounts. The accounts that are in deficit (have lower balance than they should) have the option of borrowing the funds from the Central Bank and for that they get charged the “lending” or “discount” rate on the amount they borrow. Banks that have excess reserves (balance is higher than it should be) can simply leave them at the Central Bank and earnd a “support” rate from the central bank. In Japan, the support rate is set at zero. In the US, banks actually make money off the support rate. But banks with excess reserves (surplus banks) can also lend money to the banks with deficit reserves (deficit banks) in the “interbank lending market”. Surplus banks want to make higher than the support rate while deficit banks want to pay lower than the discount rate. In a balanced system where the reserves of deficit and surplus banks match up, the overnight “interbank lending rate” will be between the support rate and the discount rate.


Under MMT, government spending injects new reserves intot he banking system while taxes withdraw it. Thus government spending has instant effect on interbank lending. On days that government spends more than it taxes, reserves have been added to the banking system. When you have systemwide surplus of reserves, the interbank lending rate would go down towards the lower Support Rate. Vice versa, on days when government taxes more than it spends, reserves have been removed from the banking system and the systemwide deficit of reserve, sends the overnight interbank lending higher towards the higher Discount Rate.


The Central Bank needs to ensure that there is enough money in the system in case the system isn’t balanced (there is not enough or there are too many overall reserves). The Central Banks manages this by buying and selling bonds on the open market. If Central Bank buys bonds, it adds money to the system. If it sells bonds, it removes money from the system. The Central Banks buys bonds by creating money out of thin air and by selling bonds it destroys money.

This is how “Vertical Transactions” in MMT work. It should be clear by now what this is: Quantitative Easing!

Imports and Exports

MMT views imports and exports as horizontal transactions. It views foreign trade strictly as currency exchange. An export is the desire on behalf of the exporting nation to obtain the national currency of the importing nation. And vice versa, an import is the desire of the other nation to acquire your currency. Imports are seen as economic benefit to the importing natino because they provide real goods for consumption it otherwise it would not have had. Exports, on the other hand, are an economic cost because it is losing goods it could have consumed. Thus imports are good and exports are bad for the wealth of the nation.

A net importing nation will transfer portion of domestic currency into foreign ownership. The curerncy however will remain with the importing nation because the foreign owner of the local currency can only spend it purchasing local assets (investment) or deposit them in the local banking system (buy government bonds). Ultimately, the holder of the bond is irrelevant to the issuing government. As long as there is demand for the currency, it is all good. The governent can never default on debt obligation in its own currency because after all it can conjure up all the money needed out of thin air. There is no constraints in creating its own currency. The government obviously can default on debt obligations in foreign currencies since it doesn’t have ability to create those and thus that is a fiscal risk to government. If its currency is desired by foreigners there are no problems, but if foreigners dump the currency, foreign obligations will multiply many times over, making impossible to repay. In that case the government can shift to an export-led strategy or raise interest rates to attract foreign investment in the currency. Both of those situations are seen as negative because they reduce the private sector wealth in the nation (exports reduce savings).


Minsky Financial Instability Hypothesis

Minsky is an economist most famous for his “Minsky moment” used in popular financial parlance as a moment when a financial system collapses. Even though he got his PhD from Harvard University under Joseph Schumpeter (an Austrian economist who coined the term “creative destruction”), his work was largely ignored by mainstream monetary powers up until the Financial Crisis. Then people started looking at this work (10 years after he died). It is important to understand that Minsky is an MMT economist and his theory of financial instability is based on MMT. I will describe his “Financial Instability Hypothesis” (FIH) as it acts as a check on what appears to be the possibility of an unlimited economic expansion if you were to apply MMT as permanent monetary and economic policy. I will also need the FIH lessons in my conclusions later on.

In prosperous times when corporate cash flow is beyond what is needed to pay off debt, a speculative euphoria develops (yield chasing) and soon thereafter debts exceed what borrowers can pay off from their incoming revenues which in turn produces a financial crisis. As a result of such speculative borrowing bubbles, banks tighten credit availability even to companies that can afford loans leading to a contraction in the economy. Thus the financial system slowly moves from stability to fragility and ultimately to a crisis and that is what Minsky is best known for. The moment the financial system goes into a crisis or a “Minsky moment”. Minsky showed that financial markets move frequently to excess which is something no other economist has modeled. Because financial system is frequently unstable he was always a big proponent of a counter-cyclical institution like the Federal Reserve to act as a “Lender of Last Resort” and the Government to act as an “Employer of Last Resort”. Minsky’s theories which emphasize macroeconomic impacts of speculate bubbles in asset prices have not been incorporated into central bank policy, but after the Financial Crisis, some central bankers (Janet Yellen) started advocating that central bank policy should now include a countercyclical Minsky factor.

According to Minsky the accumulation of debt by the private sector is what pushes an economy into a crisis. There are 3 types of borrowers that contributed to the accumulation of insolvent debt:

  1. “Hedge” borrowers
  2. “Speculative” borrowers
  3. “Ponzi” borrowers

Hedge borrowers can make debt payments (covering interest and principal) from current cash flows from investments or operations. Speculative borrowers are only able to service the interest of the debt, but not the principal. Speculative borrowers must regularly roll over (re-borrow) the principal. The Ponzi borrowers can not cover neither the interest nor the principal. They borrow based on the belief that underlying asset will appreaciate rapidly in such a fashion that s/he will be able to refinance the debt at a later day.

If use of Ponzi finance is widespread enough throughout the financial system, the eventual disillusionment of the Ponzi borrower can cause the entire system to collapse. When asset prices stop increasing for some reason, the Ponzi borrower obviously can’t make interest and principal payments or refinance and thus he defaults. But then when asset prices stop going up or even worse start to GO DOWN, Speculative borrowers blow up because they are unable to refinance their loans even if still able to make interest payments. Ultimately, the collapse of speculative borrowers brings down even hedge borrowers who are unable to find loans because banks seize all credit activity. Ultimately, these dynamics lead to bigger booms and bigger busts. The self-reinforcing debt accumulation feeds rapid inflation and the debt bust feeds rapid deflation. Human nature is inherently cyclical – there are no value investors. Only momentum investors. People naturally take actions that expand the high and low points of the cycles. Ultimately, policy makers have to implement counter-cyclical policies such as increasing contigent capital requirements for banks during booms and then reducing them during busts.

Policy Recomendations

Since the private sector wants to maximize wealth (or savings), MMT economists advocate for budget deficits (G – T) and trade deficits (IM – EX). MMT claims that government “borrowing” is a misnomer when it comes to issuance of government bonds because the government is accepting back its own debt and nobody can borrow back their own debt instruments. Sovereign government goes into debt by issuing its own liability but those liabilities are financial wealth to the private sector. Private debt is debt, but government debt is financial wealth to the private sector.

In MMT, sovereign governments are not financially constrained in their ability to spend. The government can buy anything that is for sale in its own currency and the only constraints are usually self-imposed (like a debt ceiling law). The only constraint is that excessive spending by any one sector of the economy (whether households, corporations or public) has the potential to cause inflation pressures. But then inflationary pressures can be constrained by the government’s ability to tax and remove money from the economy.

MMT economists also advocate for government funded job guarantee program which would eliminate involuntary employment. This is consistent with price stability as it targets unemployment directly rather than attempting to increase private sector job creation indirectly through a much larger and more inefficient economic stimulus. Ultimately, a job guarantee program maintains a buffer stock of labor that can readily switch to the private sector when jobs become available during the expansion. A job guarantee program is thus an automatic countercyclical stabilizer to the economy expanding when private sector activity cools down and shrinking in size when the private sector activity booms. Minsky refers to this activity of the government as an “Employer of Last Resort”.

Criticisms of Modern Monetary Theory

As you can imagine MMT has its fair share of criticisms. For one, if you can believe that, New Keynesian Paul Krugman argues that MMT goes too far in support for government budget deficits and ignores the inflationary implications of maintaining budget deficits when the economy is growing. Please, wait a second, until I can get up from the floor and get back into my chair! Policies proposed by MMT would cause serious financial instability in an open economy with flexible exchange rates while using fixed exchange rates would restore hard financial constraints on the government and undermines MMT’s main claim about sovereign money freeing government from standard market disciplines and financial constraints. MMT also lacks a plausible theory of inflation particularly in the context of full employment when the government is the “Employer of Last Resort”. MMT also assumes that Treasury and the Central Bank are basically coordinated entities (a “fictitious” consolidation of government and central banking operations) and that there is no friction between them and basically assumes zero interest rates forever. Austrian economists say that MMT is “dead wrong” and that cutting of government deficits only erodes only the portion of private savings that is not invested and that national accounting identities can be sued by the government to completely crowd out private sector investment. Ultimately, the biggest charge is that economics is not accounting and the counterintuitive policy prescriptions in MMT stem from the theory being based primarily on accounting principles and not real world economics.

MMT is Actually Not THAT Fringe

The initial panic about huge government deficits is that the government will later have to increase taxes to pay. The people who are particularly concerned about higher taxes on them are our usual folks in the Midwest and rich guys everywhere. You want to ruin a rich man’s life is tell him that more of his income will go to the government and you’ll never hear the end of it. So Stephanie Kelton who taught in Kansas for a while is very adept at deflecting this particular criticism and making our rich folks feel right at home with her progressive radicalism. Obviously, this is standard leftist subversion tactic until they hold the power and then people finally understand they have been lied to all along. But then it is too late. In any case, when people raise taxation concerns to Kelton she says – don’t look at yourself, point to Congress (the politicians). They approve budgets out of thin air. You don’t have to pay for anything because the government can create money out of thin air. It is not your taxes that funds the government. The government funds itself. If Congress approves the government budget, boom money is created out of thin air.

In particular, Kelton right now is defending the Trump Tax Cuts the GOP just passed. You would think a progressive economist who led Bernie’s economic team will be all up in arms about it but MMT theory says that lower taxes would result in higher private sector net worth. And we did get a good economy after the tax cut, stock market is way higher, consumer and business confidence is at all-time highs. MMT and Kelton predicted this correctly. Deficits don’t matter in MMT – even during a good economy – and rightfully so. Even though we are running a larger budget deficit, everything is great. Kelton doesn’t see the budget deficit as a government problem she sees is a benefit for the private sector. Instead of saying, we have a 860 billion deficit, she thinks people should say – the private sector is 850 billion richer!

So it is very important to understand that Kelton and MMT appeals not only to Bernie folks who want money to be conjured up out of thin air for Medicare-for-all (30 trillion) or Free College (roughly the cost of the Trump tax cut) but also to Trump and neoconservative GOP types like Larry Kudlow. Kelton will walk into a room with Larry Kudlow, Trump and Bernie Sanders and they are all having champagne at the end. The only people who don’t like MMT is the Freedom Caucus but they are a minority right now. So Kelton is a bit more influential than you would think – particularly right now in light of what happened after the tax cuts. The snowflakes desperately need a progressive to explain it to them in terms that they can understand. Modern Monetary Theory is that theory du jour.

Obviously, the Achilles heel of MMT is inflation. We saw immediately after the tax cuts that inflation rose from very low readings in 2015, 2016 and 2017 to decade high readings over the past few months in 2018. This was a very rapid and sharp jump in inflation which everybody is dismissing because the inflation readings finally got to 2%-3%. What they don’t understand (but should because Minsky clearly alludes to that) is that inflation has its own momentum and once people are in an inflationary environment they will act pro-cyclically to push inflation even higher. So what is 2-3% today will be 4-5% a year or two from now and 7-8% in a few years. Kelton never mentions how the government controls inflation in MMT. Which is through raising taxes. That is how government takes money out of the economy in an MMT model, because monetary policy is always pinned at zero interest rates. She prefers to focus on the goodies (bribe the capitalists) instead of how to combat inflation because obviously today we don’t have inflation and she really doesn’t want to deal with this aspect of her theory because it is not politically convenient. That is what everybody is afraid of. Particularly progressive rich people who hate taxes more than anybody. You just have to look at the tariff tantrums being thrown around by Bloomberg (the publication) right now. Ultimately, MMT says that higher taxation is a cure for inflation and points to the reason for most hyper-inflationary crises to be the loss of the ability of the government to tax. For example, the hyperinflationary episodes in the South during the Civil War are attributed to the loss in the ability of the South to tax its citizens (only 5% vs 21% in the North). MMT struggles to explain hyperinflation in Argentina and Peru since the tax systems there didn’t collapse, but suffice it to say if the tax system collapses (which means trust in the government and its money collapses) you will have hyper-inflation. Which is a fair point. But make no mistake about it – if MMT policies do bring about unexpected bouts of inflation, the next step that Kelton will recommend is higher level of taxation.

Let’s revisit the revised National Accounting Identities formula:

S = G – T + I + IM – EX

G = Government Spending

T = Taxes

S = Private Sector Savings/Wealth

I = Investment

IM = Imports

EX = Exports

Now let’s think about what a succession of Democratic and Republican governments have done over the past 30 years. Republicans have cut taxes – reduce the T. Democrats and Republicans have increased government spending dramatically (whether health care or military) – increase the G. They have both worked very hard to expand the Budget Deficit. Both Democrats and Republicans have worked hard to dramatically increase the Trade Deficit as well – increase the IM and reduce the EX. And what is the result of this? Massive twin deficits – both budget and trade which resulted in huge maximization of S (savings) or in other words stock market wealth. This is what the US government (across many administrations) has been doing all along. Tinker with all the ingredients of the National Income Identity formula to maximize savings which in the US today is 401(k) plans – which are more or less the stock market. Obviously, this formula says nothing about how S (savings) is distributed among the society (inequality) and whether having no exports and importing everything serves the national geopolitical interest, but if the private sector wants more wealth, the formula says less exports and more imports and massive budget deficits. Using this formula, you will now understand why the government and mass media (like Bloomberg and CNBC) take on the interesting mix of ideological positions that they do. Notice they are always in favor of more government spending. They are also in favor of tax cuts (which you would think is strange for liberals). Their issue is not the tax cut per se but who gets it. And they are in favor of imports over exports. Budget and trade deficits don’t bother the Mainstream Media one bit. Even though MMT has been described as a “fringe” theory, it really has been the theory that has been driving actions by the US government and US establishment for decades. If you look at what Larry Kudlow advocates all along (higher budget deficits) or what Bernanke has done (ZIRP and consolidation of FED and treasury to do QE infinity), you see MMT in play everywhere.

The Fight Against MMT

A central bank which is independent from Treasury really screws up MMT. You can see how the GOP is trying to fight this ideology today by stacking the FED with distinctly non-MMT types like Powell, Clarida and Goodfriend. The GOP knows that after them comes Bernie (or his ilk) and Bernie/Warren will want to dramatically increase the public sector. To do that he needs the QE spigots to open up again – and this time it will not be for emergency purposes but for “moral” purposes – free education and free medical care for everybody. One way to put a constraint on QE is to have higher interest rates. Another way is to discourage foreign governments from buying US treasuries (which also would hike interest rates). As you can see, the Trump administration is pursuing both of those ends despite public rhetoric. By jacking up interest rates, the FED can prevent a huge spending program from being authorized by Congress because Congress will have to figure out how to service the treasury debt needed to finance (or offset) this new spending. They will then have to raise taxes which is not nearly as popular as unpaid for spending. MMT really depends on zero rates for their grand designs of unlimited government spending. If the Congress falls to Democrats, I expect rates to go up faster as the FED tries to prevent a massive inflationary spending program by a coalition of Trump and Progressive Democrats. The reality is that Trump is a spender and he will not provide the anti-inflationary fiscal policy check needed. The FED has to do it. So expect interest rates and Federal debt service to continue to skyrocket.


The last way, the GOP can fight against MMT if the FED is not helping is by inducing inflation in the economy. How can that be done? Well according to MMT, that can be done by boosting exports. If exports lead to higher inflation, then MMT would prescribe higher taxation which then acts as a brake on inflation. But we know how politically toxic hiking taxes is. That would play right into GOP hands during the next election.

Investing Implications Under MMT

If MMT became the dominant guiding economic theory and the US drove rates back to zero during a good economy and boosted budget deficits a lot to finance Medicare-For-All or Free College or Federal Job Guarantee, there is no doubt in my mind that inflation would spike significantly. The key control for inflation under MMT lies with the power of the state to tax. So whatever industry the state decides to target will suffer deflation (or will get inflation under control). For example, you saw what removing the SALT provision did for New York real estate prices in 2018 – the bubble was immediately burst while keeping housing prices on the rise in the remainder of the country (where property taxes are below the 10K threshold). Congress and what it decides to tax then becomes super important for investing. Obviously, it is very hard to predict what industries or groups of people Congress will selectively tax in the future.

One thing should be obvious under MMT is that the state will try to suppress traditional “metallist” money. Thus any monetary commodity with a futures market will likely have its price suppressed. We saw that clearly with gold in 2011 – whose price I think is absolutely being manipulated down. Most recently we saw government price suppression via a futures market with bitcoin. A futures market in bitcoin was created precisely so that the price could be driven down and make sure bitcoin holders go back to work to pay taxes. In the modern day and age, a government decree to set a price of a commodity is considered “price control” and they will never do it that explicitly. What they will do is create a futures market for the commodity and allow hedge funds to short it and give them unlimited amounts of money to do it.

Absent specific tax interventions to control specific pockets of inflation, I think what does particularly well under MMT is hard assets with a long life span. Basically you buy them now while the monetary base is small and then later as the monetary base expands you can utilize the same equipment bought on the cheap to produce you profits marked to market at the new expanded monetary base. Real estate is one such investment because it has a very long life span. Another such investment would be a big manufacturing plant or for example a rail road. Also airlines – planes have an expect lifetime of 20 years. Or a brand new oil drilling rig. Or used Japanese cars (which last forever). You want to invest in businesses that use equipment with long life where you don’t need to replace it for the next 20 years. For example, I don’t think equipment with short life cycle will fare well – for example software has a cycle of 2-3 years, you will need to rewrite the software in a few years – you will need to pay people new higher wages to do that. I don’t think software businesses will fare particularly well in an MMT world. Also all of these tech companies, as they get more and more data and as equipment gets more expensive will start to have their profitability severely pinched. God forbid, the government takes away their R&D credit.

So I would say the best sectors to invest in an MMT world are Energy (XLE), Real Estate (XLRE), Transports (IYT), Industrials (XLI), Health Care (XLV) and Utilities (XLU) and to a significantly lesser extent Consumer Discretionary (XLY). I think sectors that depend on human capital and intangibles would deliver below market returns under an inflationary MMT framework – those would be Technology (XLK), Communication Services (XLC) and Financials (XLF). And a sector like Materials (XLB) would suffer because metals and durable commodities are specifically targeted under MMT. You want to focus on companies that have a lot of long term debt at low interest rates (that will get whittled away by inflation over time and will be easier to sustain from savings with higher interest rates) and also have invested in the newest industry equipment. For example, Seadrill would be a perfect company to invest in under an MMT scenario. As inflation brings oil prices higher, they would earn money on their brand new equipment in a currency with a wider monetary basis while they bought their equipment via debt in a currency with a much smaller monetary basis. Seadrill shares would be a slam dunk in such a scenario. You have to hunt for companies like that as they will be disproportionate winners in such a MMT world. Highly leveraged and invested in brand new equipment and ready to benefit from higher final output prices.

Rethinking the Crash of 1987

I recently went to the inaugural Real Vision conference in New York City and many of the video segments presented there featured interviews of hedge fund managers who became famous in the 80s like Felix Zulauf and Paul Tudor Jones. I am sure these investing legends are very smart guys, but I couldn’t help noticing that most of their legendary status came about by them simply being in the right place at the right time. It was very hard to make an investment mistake buying long duration bonds or stocks in the early 80s. In 1982, inflation was 10% and FED overnight rates were north of 15%. Certificates of Deposits yielded 20%. 10-year treasuries yielded 15%. Stocks had single digit P/E ratios. Most of these guys were obligated to be invested by the mandates of their funds. If inflation went down and FED cut rates, all of their assets whether bonds or stocks were going to get reflated higher. So was it really investment skill that made them famous? Or was it Paul Volcker?


Let’s look at the infamous crash of 1987. Many of these investment legends went to cash in the summer before the crash. But was the decision to go to cash really that difficult or legendary of a decision? Here is what the top 10 annual S&P 500 (SPX) returns (not including dividends) looked like from 1950 to 1987:


There were only 2 years where the SPX returned north of 35% – 1954 and 1958. The years when Eisenhower was building the Interstate Highway System. To this day in 2019, the SPX has not returned more than 35% in any given year. 1954 and 1958 still sit atop the SPX annual return charts.


In 1987, the SPX first hit 35% year-to-date on August 10. It went as high as 39% on August 25th. On October 5th, a few days before the crash, the SPX was still at 35% on the year. So the SPX is sitting on the 2nd or 3rd best annual returns in nearly 40 years in the late summer for a couple of months from August through October. How many asset managers do you think were thinking “I am up 35% on the year, the CPI is only 4%, the FED is hiking rates, time to put money in a 7% CD and go on vacation till the end of the year”?


And that is why the market crashed.

It didn’t take a legendary mind to make that decision. It is common sense, common risk management given the historical distribution of annual returns. I would give some credit to those who shorted the market that summer but again not too much credit. Going short the SPX at 35% year to date had 95% historical odds of success!

Black Peak Capital Urges Investigation into the Termination of the VelocityShares Daily Inverse VIX Short-Term ETN (XIV)


Black Peak Capital Urges Investigation into the Termination of the VelocityShares Daily Inverse VIX Short-Term ETN (XIV)

Fairfield, Connecticut, February 23rd, 2018

In the aftermath of the termination of the VelocityShares Daily Inverse VIX Short-Term ETN (XIV), Black Peak Capital will start using ProShares and REX Shares ETFs to gain exposure to the VIX futures market in client accounts. For long VIX futures exposure, we will use ProShares VIX Short-Term Futures ETF (VIXY) and iPath S&P 500 VIX short-Term Futures ETN (VXX) for accounts where VIXY is prohibited. For short VIX futures exposure, we will use ProShares Short VIX Short-Term Futures (SVXY) and REX VolMAXX Short VIX Weekly Futures Strategy ETF (VMIN) for accounts where SVXY is prohibited. Due to the preferential Section 1236 tax treatment and absence of underwriter credit risk, going forward we recommend to our clients and to other investors to gain exposure to the VIX futures market via exchange traded funds (ETFs) instead of exchange traded notes (ETNs).

XIV Termination Investigation

As a provider of financial advice for the VIX futures market and related exchange traded products (ETPs) to hundreds of high net worth and mass affluent retail investors, Black Peak Capital urges US government regulatory agencies like the SEC & CFTC and financial self-regulatory agencies like FINRA to undertake a thorough investigation into the events on February 5th between 4:00pm and 4:15pm EST that led to the termination of the VelocityShares Daily Inverse VIX Short-Term ETN (XIV). Between the stock market close at 4pm and the VIX futures market close at 4:15pm when geared VIX ETPs usually rebalance their exposure to VIX futures, we observed a VIX futures seller strike (disappearance of VIX futures sellers). The seller strike resulted in surge pricing of VIX futures that had no fundamental driver in either S&P 500, S&P 500 futures or VIX (S&P 500 Volatility Index) movements due to any new market moving information. As a result of this 15 minute surge pricing in the VIX futures market, the Inverse VIX ETPs set their daily NAV to a level where investors lost -90% of the money they had in these products at the market close at 4pm that day.  The Inverse VIX ETPs failed as investment products that day because they did not provide the short VIX futures exposure that they had promised investors. Investors who shorted February and March VIX future contracts directly at 4pm on February 5th and held those positions through February 6th saw gains. Investors in XIV and SVXY over the exact same time period suffered -90% losses. The products failed to provide the synthetic short 30-day VIX futures exposure they had promised in their prospectus. We think that an investigation is necessary to learn why the surge pricing occurred and whether changes to the VIX futures market structure can be made to ensure stability in the future.

VIX Futures Market and VIX ETPs Need Better Protections

As active investors in the VIX futures market and related ETPs and as advisors to a very engaged community of investors in this asset class, we want to see it expand and grow in the future. We believe volatility is an asset class that should be an integral part of all investor portfolios alongside stocks, bonds, real estate and commodities. Volatility products can provide yield during periods of low market volatility and protection during periods of high market volatility. We would like to see VIX products strengthened through stronger consumer protection regulations and through the introduction of more resilient exchange traded products. We would like to see proper guardrails put in place to ensure trust in the marketplace. Other marketplaces have trade halts and various other techniques to protect investors from surge pricing and we believe the VIX futures market could benefit from some of these best practices. We also think that Option Level 2 clearance should be required for investors who want to trade VIX futures based ETPs due to the toxic combination of inherent complexity and deceptive periods of outperformance.

VIX Formula Needs Improvement

The CBOE S&P 500 Volatility Index (VIX) uses a bid/ask mid-point pricing for options included in its formula. Mid-point pricing for far “out-of-the-money” (OTM) long dated options can be highly volatile on a day-to-day and intra-day basis without change in market conditions. Such an option position can often double quickly in value simply because a bid was withdrawn and then a much higher bid was entered. Likewise such an options position can quickly halve in value. We think that a mid-point valuation technique can be subject to manipulation in options where there is lack of adequate volume. But even if not manipulated, this valuation technique introduces a high degree of volatility that should not be welcome in an index that is as central to modern financial markets as the VIX. We urge the SEC, CFTC, FINRA and other government agencies to investigate the allegations of VIX index manipulation. We also urge the CBOE to modify the VIX formula and make it less susceptible to manipulation attempts by market participants. We strongly believe in the VIX as the premier measure of risk in the financial markets and we want to see it function properly and free of allegations of impropriety.

Short VIX Products Remain Dangerous

Nominal price bears no inference to value

We have a warning for investors who look at the exceptional returns of short VIX products like SVXY from 2016 and 2017 and estimate that similar returns will be available this year and are rushing to invest after the February 5th crash lured by low nominal prices. The nominal price of a VIX futures product bears no inference to its inherent value because it holds a mix of VIX futures contracts which expire every month.  SVXY gains during periods of low or declining market volatility and loses during periods of high or rising market volatility. The price of SVXY can go up infinitely or it can go down infinitely depending on market conditions. SVXY can go from $100 to $10 to $1 to 10 cents and vice versa.

Volatility drag is at historical highs

SVXY is an Inverse ETF and the process of daily rebalancing of VIX futures holdings can make its NAV lose value during volatile periods for VIX futures. This is a phenomenon called “volatility drag”. Measures of volatility drag in February like the CBOE VIX Volatility Index (VVIX) are at the highest levels in recorded history which means that SVXY is more susceptible to volatility drag losses now than ever before.

Stocks and volatility can go up together

The stock market is at historically high valuations and periods of high valuations are often marked with heightened market volatility. The S&P 500 can have a very positive year in 2018 but if that return is achieved through a path of high volatility, the SVXY can lose money on the year. 2014 is an example of a year when the S&P 500 made more than 10% while the SVXY lost nearly -10%. Many investors think that short VIX products are strongly correlated to the stock market because there is academic research out there that states that short VIX products are similar to leveraged S&P 500 products. We think that this academic research is not correct because of insufficient data. Short VIX products have not existed long enough to be evaluated through all market environments and particularly through a rising interest rate and hyper inflationary market environments. It is possible for the stock market and for volatility to rise together in tandem for an extended period of time. That would lead to the market gaining and short VIX products losing at the same time. Investors who are considering investing in short VIX products as a proxy for leveraged stock market exposure should consult with registered investment advisors who are well versed in the risks of these products and can provide qualified advice.

About Black Peak Capital

Black Peak Capital, LLC is an investment advisor registered in Connecticut specializing in the VIX futures market and related exchange traded products. Black Peak Capital’s owner Stephen Aniston is a publisher of the weekly State of Volatility investment newsletter and the VIXCONTANGO.COM website which is a leading provider of investment analysis for the volatility asset class. Our clients are primarily high net worth and mass affluent retail investors who together have dedicated over $200 million to volatility strategies. More at


VIX: The CBOE VIX (S&P 500 Volatility Index) is a measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. The VIX is forward looking and seeks to predict the variability of future market movements. This is in contrast to realized (or actual) volatility which measures the variability of historical (or known) prices.

Short VIX, Short Volatility or Inverse VIX: A “Short VIX”, “Inverse VIX” or “Short Volatility” investment is one that is designed to correlate negatively or move opposite of the Chicago Board Option Exchange Volatility Index (VIX). These investments may take many forms but are typically Exchange Traded Funds (ETF) or Exchange Trades Notes (ETN) that hold short exposure to VIX futures contracts.

Geared ETPs: These are Exchange Traded Funds (ETF) or Exchange Trades Notes (ETN) that provide a leveraged or inverse exposure to an asset class. They may be designed to have various ratios to the daily movement of an asset class (for example 2 times or .5 times) or the inverse of the daily movement (-1 times or -2 times). Geared ETPs are forced to rebalance their exposure to the underlying asset class every day.

SVXY: ProShares Short VIX Short-Term Futures ETF seeks daily investment results, before fees and expenses, that correspond to the inverse (-1x) of the daily performance of the S&P 500 VIX Short-Term Futures Index.

XIV: The VelocityShares Daily Inverse VIX Short Term ETN provides -1x leveraged exposure to an index comprising first- and second-month VIX future positions with a weighted average maturity of 1 month.

VVIX: The VVIX is a volatility measure that represents the expected volatility of the 30-day forward price of the Cboe Volatility Index (the VIX®). It is usually called a volatility of volatility measure. It is this expected volatility that drives the price of VIX nearby options. The VVIX is forward looking and seeks to predict the variability of future VIX movements. This is in contrast to realized (or actual) volatility which measures the variability of historical (or known) prices.

Media Contacts

Black Peak Capital, LLC

Stephen Aniston


Is The Holy Grail of VIX Investing Finally Here

Is The Holy Grail of VIX Investing Finally Here?

Today, May 3, 2016 two new volatility ETFs will start trading on the BATS electronic exchange – the REX VolMAXX Long VIX Long VIX Weekly Futures Strategy ETF (VMAX) and the REX VolMAXX Inverse VIX Weekly Futures Strategy ETF (VMIN). Both will start with an NAV of $25 per share. These ETFs are the first products on the market that will provide exposure to the VIX Weekly Futures market which started trading on July 23 of 2015, roughly a year ago. I had a chance to sit down with the team that created these ETFs and discuss their goals and aspirations for these new products.

The issuer of these two new volatility ETFs is REX Shares, a new start-up ETF outfit headed by Greg King. Greg King, largely unknown to the retail volatility investor, has an impressive track record in the ETF industry. He headed the iPath ETN platform at Barclays where he came up with the concept of the Exchange Traded Note (ETN) and created the first volatility ETN in 2009 – the iPath S&P 500 VIX Short Term Futures ETN (VXX). Subsequently, he founded the ETF company VelocityShares, which was eventually acquired by Credit Suisse and which gave us the second and most popular volatility ETN in 2011 – the VelocityShares Daily Inverse VIX Short Term ETN (XIV). Today VXX and XIV are the 2 oldest and most popular volatility products and command a combined AUM of more than $2 billion on any given day. Greg King is a true visionary in the ETF world and we owe much of what we see on the ETF scene today to him. You can think of him as the Elon Musk of ETFs.

Like a good movie producer, Mr. King wasn’t satisfied with his original VIX ETF creations and wanted to go bigger and better. The result of these efforts are these new VMAX and VMIN ETFs that are going to start trading today.

How Do VXX and XIV Fall Short?

Before we delve into VMIN and VMAX, let’s look first at the issues the REX Shares team is trying to fix in the current leaders in the volatility ETF world – XIV and VXX.

Beta and Correlation

A common criticism of VXX and XIV are that while they provide exposure to the VIX, they do so only in a half-baked manner. As I discussed in the Seeking Alpha article But Why? VXX and XIV Are Already Just Perfect, these ETNs are constrained by the products in which they invest. Since these ETNs are composed of monthly VIX Futures and monthly VIX Futures represent what investors think the VIX will be further out in time, they do not provide a perfect VIX exposure. The VXX and XIV essentially give you exposure to a synthetic VIX future with an average time to expiration (TTE) of 30 days (I will call this VIXFUT30 for the remainder of this article). The farther the average time to expiration, the more disconnected the ETF or the synthetic future will be from the VIX itself.



 As you can see in this graph, the 30 day TTE VIX Future would result in Beta of roughly 0.5. This is confirmed by my own observations. I calculated the Beta of XIV, VXX and the VIXFU30 against the VIX for the entire history of these products (starting in 2009 for VXX, 2011 for XIV and 2004 for the VIXFUT30) and those values came out to be -0.46, 0.46 and 0.46 respectively (the XIV being the inverse of the VIXFUT30 obviously).


What do these numbers mean?

A correlation means how often that does one product move with the other. How often does the VXX go up when the VIX goes up? Well, it turns out that is 88%. This is very good but not perfect. As VXX investors are well aware, there are many days when the VIX goes up but the VXX doesn’t.

A beta means how much of the move is captured. How much does the VXX go up when the VIX goes up? Well, it turns out the VXX goes 46 cents for every $1 that the VIX moves. So if the VIX moves 10%, on average the VXX goes up 4.6%. As most of volatility investors have observed, that has roughly been the case.

The Contango Effect

Another concern is that the XIV and VXX are heavily influenced by the Contango present in the front month VIX futures. The VX1-VX2 contango of which these ETFs are composed, has averaged 5.4% since 2004 and that has resulted in steady but consistent decline especially in the VXX. Most, even sophisticated, investors don’t understand the inner workings of the ETFs and are often surprised at how much money they lose in them since they think they are an exact VIX replacement. The VXX is -99.8% since its inception in 2009 while the XIV is +191.7%.


However, the issue of daily roll is not limited to the ETFs. If an investor was to manage his own VIX futures position, the fact that futures do expire every month would force him to be engaged in the same kind of rollover the ETFs do. The advantage of the ETF rollover is that it is done on a preset schedule, it is cost efficient, it is done when liquidity is present and bid-ask spread minimized. It is doubtful that the average investor would handle this rollover as well as the ETFs. But even if done well, the rollover is present and it would affect long term returns just like with the ETF.

Legal Structure

Yet another concern is the legal structure of these products, which is the Exchange Traded Note, which is essentially a debt with a maturity date. For example, the XIV maturity date is December 4th, 2030. This is far out enough not to concern most people today, but some investors are concerned nonetheless.

Bankruptcy Risk

Yet another concern is the bankruptcy risk. Technically, the XIV can go bankrupt if a sufficiently large move in the VIX transpires. We need the VIXFUT30 to move 100% up for the XIV to go bankrupt. A 100% move in the VIXFUT30, given the 0.46 beta is equivalent to a 217% move in the VIX. Historically, the largest move in the VIX came on February 27th, 2007 and that move was 64.2% when the VIX moved from 11.15 on 2/26 to 18.31 on 2/27. This is not a date that anybody associates with any particular event, yet that is when the biggest VIX percentage move happened. Well, a 67% move is only 30% of the 217% move required to bankrupt the XIV (if it existed then). So historically, the XIV hasn’t come within 30% of bankruptcy. Some people fear the effects of a nuclear attack on US soil. Well, we had a similar catastrophic event on 9/11 when the World Trade Center was attacked and most of the downtown New York exchanges went out of operation. The exchanges were closed for a week and when they did open, the volatility shorts actually made money on the open before the VIX was allowed to spike. The point is regulators simply will not allow a catastrophic event to bankrupt majority of market participants. In fact, the VIX jump on 9/17/2011 when the VIX started trading again was only 31% or only the 21st largest move in the history of the VIX (at the time the 8th largest).


VIX Weekly Futures Primer

The VIX Weekly Futures started trading last year on 7/23/2015. The first contract VX1Q15 expired on 8/5/2015. After a few weeks in operation, volatility investors got very excited about the weeklies because finally there was product out there that closely followed the spot VIX.


Source: CBOE

So let’s delve into the weeklies a little more. The VIX Weekly Futures always expire on a Wednesday. The weekly future contract notation follows one of 2 conventions – either VX{consecutive Wednesday number in the year}] or VX{Wednesday number in the month}{month code}{year}. So for example, the first weekly future contract is represented by either VX31 or VX1Q15. VX31 means that the contract expired on the 31st Wednesday that year. VX1Q15 means that the contact expires on the 1st Wednesday of August of 2015 (Q15). Both of these amount to the same Wednesday 8/15/2015.


Source: CBOE

There is no VIX Weekly Future for the Wednesday when the monthly future expires. As such you will see gaps in the weekly notations. For example, in 2015, there was VX31, VX32 and VX34. VX33 was skipped because the expiration date would’ve coincided with the August monthly contract VXQ15. So the proper sequence of contracts is VX31, VX32, VXQ15, VX34 or VX1Q15, VX2Q15, VXQ15, VX4Q15 in the alternate notation.

There are usually 5 weekly contracts active at any given time. You can view the active weekly contracts on the website on the “VIX Term All” tab.



Since the VIX Weekly Futures are relatively new (they have been around for less than a year), liquidity is not abundant. However, they have been a relative success compared to other CBOE products targeted at other asset classes such as Oil and Gold. In the past, Oil (OV) and Gold (GV) VIX futures were discontinued due to lack of interest (volume). Initially, VIX Weekly Futures were doing better than the OV and GV, but as of late not much better. Average daily volume is 44 contracts with a big decline lately probably because the market just won’t go down. Compare this with the 22,408 daily contract average for the monthly futures.


Source: CBOE (data) and (graph)


How Are VMIN and VMAX better than XIV and VXX?

VMIN and VMAX intend to provide investors with a cleaner access to the VIX. Let’s count the ways.

Beta and Correlation

The first notable difference between VMIN/VMAX and XIV/VXX is that the new ETFs will invest in VIX Weekly Futures as well as the monthly VIX Futures (for the week when a VIX weekly future is not available). The stated goal for the ETFs in the fact sheet is:

“The funds seek to invest in VIX futures contracts that are near to expiration, subject to overall liquidity and roll cost considerations, and intend to maintain a weighted average time to expiration of less than one month at all times

So VMIN/VMAX intend to better the XIV/VXX by holding contracts that are closer than 30 days to expiration. Unlike the XIV/VXX, the VMIN/VMAX are “actively managed” ETFs. In other words, there is no clear cut formula that is made available in the prospectus. However, the obvious goal would be to reduce the time to expiration as much as possible and do so in a systematic matter. Given the liquidity constraints in the VIX weekly futures, a simple formula probably couldn’t be achieved at this time so that is why they opted to “actively manage” the ETF, although I suspect computers will be doing most of the work.


In order to find out what the time to expiration of the ETFs are, I calculated based on VIX Weekly Futures historical data 3 synthetic VIX weekly futures – VXWFUT7 with 7 days to expiration (holding VXWK1 and VXWK2), VXWFUT14 with 14 days to expiration (holding VXWK2 and VXWK3) and VXWFUT21 with 21 days to expiration (holding VXWK3 and VXWK4). Based on these synthetic futures, if they achieve Beta of 0.95  for VMAX, then the VMAX is most likely to be rolling over VXWK1 and VXWK2 contracts on a weekly basis (just like VXX rolls over VX1 and VX2 monthly contracts).

The actual Beta achieved remains to be seen due to the present liquidity issues in the weekly futures. If they are not able to find liquidity in the weeklies, I assume they will have to find liquidity in the nearest monthly VIX future which is a very liquid contract, but depending on the time to expiration that may hurt the beta and correlation a little bit.

In any case, regardless of the initial implementation difficulties, the VMIN and VMAX should be able to provide a cleaner access to the VIX than the VXX and XIV, but whether their ultimate objectives will be achieved remains to be seen.

REX Shares will be publishing the daily holdings of both VMIN and VMAX on the product website as well as the correlation and the beta. You can monitor that website to see what actually is transpiring in these ETFs.

The Contango Effect

There is contango present in the weekly contracts but not nearly as pronounced as in the monthly contracts. The monthly average contango is north of 5% as we discussed. The average contango in the weekly is roughly 1% per week which over an entire month would be roughly what the monthly contango is.


If you are short term holder of the VMIN/VMAX, the contango effect should be somewhat less pronounced than the monthlies, but if you do hold VMIN/VMAX over a longer period of time, the decay from roll yield would roughly be similar to VXX and XIV.

Legal Structure

VMIN/VMAX are not Exchange Traded Notes, they are proper Exchange Traded Funds. However, they are not organized as investment partnerships and as such will not issue a K-1 the way SVXY does. So from a legal perspective VMIN and VMAX are unicorns. They have everything a volatility investor could possibly want.

I found a 30% leveraged facility in the prospectus, which is going to be used for cash management purposes. I am very sensitive to utilizing leverage in the ETFs due to the daily rebalancing decay effect and the “actively managed” part concerned me whether the leveraged facility would be used to improve the beta (for example UVXY achieves better beta than VXX by using leverage). But it appears, that the leverage facility would be used for cash management purposes only to facilitate investor redemptions and not for the actual holdings of the fund.

Bankruptcy Risk

Given that the time to expiration is dramatically reduced, it was a bit of concern whether we could have a bankruptcy situation with VMIN. Since VMIN aims to achieve -0.945 beta, that means that the VIX would have to jump 105% for the VMIN to go bankrupt. As I discussed above, we have never had a bigger than 65% move in the VIX so in this case we haven’t even gotten 62% of the way to a bankruptcy on a historical basis. While the actuarial probabilities are higher so to speak, given that it has never happened before even during catastrophic events such 9/11, it makes it very unlikely that it will happen in the future. In any case, a VIX move that could bankrupt the VMIN can only happen during times of extreme complacency when the VIX is down to 10 or 11 and at those times you shouldn’t be long VMIN anyways.  Why pick up pennies in front of steamroller when you can collect dollar bills raining from the sky after the storm.


The two new REX Shares ETFs VMIN/VMAX are sure to be a welcome addition to the toolset of any volatility investor especially those with a shorter term trading horizon. They are well designed and well implemented and they will allow day traders to capture most of the daily fluctuations of the VIX without the use of leverage. Professional and institutional investors are likely to use these to hedge their S&P500 exposure more effectively. Hedging directly in the futures market is a headache due to the constant roll over work that has to be done, so even large professional investors like George Soros and other hedge funds would gladly utilize a more efficient way via an ETF. These ETFs will be the closest trading vehicle to the VIX that is out there. At the end of the day, I think these ETFs will be well accepted by the market place unlike some of the bombs of the recent past (VXUP/VXDN). For those who want to jump right in, you have to be aware of the low liquidity in the VIX Weekly Futures market today. The effectiveness of these ETFs is currently limited by the available liquidity in the VIX Weekly Futures market. Eventually, I think VMIN and VMAX will dramatically increase the liquidity of the VIX Weekly Futures market just like VXX and XIV did for the monthly VIX Futures market back in 2010 and 2011. As it stands right now, proceed with caution.

For more information about these ETFs, you can contact REX Shares directly at 1-844-REX-1414 or you can visit for more information.

What Is The Market Trying To Front-Run Now?

When confronted with inexplicable market action, the answer usually is not “Look, everybody else is crazy”. The market is comprised of millions of very rational investors (some vastly more informed than others) and as a result, if the market action does not conform to your present theory, a new theory must be formulated. There are always legitimate reasons behind the major market moves and as market observers, analysts and investors we need to find out what these reasons are. Unfortunately, for most investors, the reasoning becomes clear in retrospect usually months and years later. Here, we will try to keep pace with this incredibly fast paced market.

Since the lows of August/September, there have been a few notable developments:

1. Prospects of Negative Interest Rate Policy regime are heating up

a. Mixed/weak economic statistics have silenced the rate hike discussion.

b. A number of FED governors have reiterated the stance that rates should not go up and Bill Dudley, the most prominent one, even discussed the concept of Negative Interest Rate Policy (NIRP) with Steve Liesman.

c. On October 14th, John Williams, Janet Yellen’s right hand at the San Francisco Fed publishes a paper advocating Negative Interest Rate Policy (NIRP). In the paper, they state that -2% is the present natural rate of interest in our stagnant economy and as result zero interest rates are far too high to be stimulative for growth.

d. On October 22nd, Mario Draghi of the ECB, discussed the usage of a combination of QE and NIRP in his bid to revive inflation and economic growth in the ECB. While that immediately strengthened the dollar and put earnings growth for SP 500 companies at even more risk for 2016, what is more important is the precedent. In other words, if the ECB recommends a combination of NIRP & QE as a policy tool, the FED will certainly consider it.

2. Prospects of Tax Reform that favors corporations are heating up

a. Donald Trump is looking more and more like the nominee of the Republican Party. Donald Trump openly advocates tax reform that will

i. Lower corporate tax rates to 25% from 39%

ii. Remove the global tax regime for American corporations and replace it with territorial

b. Paul Ryan looks like a shoo-in to be the next House Speaker. Paul Ryan’s tax policy is very much in line with Donald Trump’s.

There was also the China interest rate cut. I’ll leave the China and the Tax Reform discussions for future newsletters. Today, I’ll discuss the most important of these macro drivers– the Negative Interest Rate Policy.

Negative Interest Rate Policy

One of the key valuations criteria for stocks is the Dividend Yield. In asset management theory and practice, when SPX dividend yield is higher than 10-Year Treasury Yield, you should buy stocks (the stock index SPX) – not only do you get higher yield, but you can also get capital & earnings appreciation. The reverse is also true. As a result, the Dividend Yield in the SPX looks over a long period of time to equal the 10-Year Treasury Yield. In fact at present they are virtually equal with the S&P 500 Dividend Yield at 2.03% and the 10-Year Treasury Yield at 2.08%

If the FED undertakes a negative interest rate regime in the near future (next 6 months to a year), this will have the following effects on the market:

1. The dollar will stop its massive move up as the 10 Year German Bund – Treasury spread will go down from 1.5% to a more reasonable level and the massive government and institutional manager money flows will stop seeking US treasuries nearly as much.

2. If the dollar stabilizes, oil and metal prices will stabilize, the prospects of massive defaults in the energy and materials sectors go away (currently the only weak point in the market) and the prospects of continual negative earnings growth go away as well.

3. If the dollar stabilizes, SPX corporate earnings will stop cratering on the way down as foreign earnings will not have to discounted so much

4. Stock buyback bonanza continues unabated and is actually amplified

But the most important effect is this:

5. The 10-Year Treasury Yield will do down below 2%

I have put together the following table with possible implementations of NIRP and associated Treasury Yield and Dividend Yield levels. The table assumes that annual SPX GAAP earnings will stay stable at the latest reported value of $93 per share and that the dividend will also stay stable at the latest reported value of $42.12 per share

The take away from this table is this: the FED still has an enormous power to drive the SPX higher by implementing a NIRP regime. A mere -0.10% on the FED rate can move SPX valuations up to the 24 P/E level. -0.25% FED rate can move valuations to the 26 P/E level and the SPX all the way up to 2400 level.

For a reference point, the current 2-Year German Bund yields -0.32%, so a -0.25% FED rate is NOT out of the question.

I am borrowing this table from Charlie Bilello, just to illustrate that NIRP is not only a possibility but a present day reality in most of the biggest European economies

So what’s going on here is the market is trying to front run as fast as it can FED policy. If those “in the know” know that the FED is seriously considering NIRP, by the time the announcement is made in March or September of 2016, all the gains in the SPX will have been made. If you look for a driver behind the spectacular rise in the market this week, this is probably it.

Fastest VIX drop from 40 to 14 In History

The SPX sliced through a number of important technical levels over the past couple of weeks – the 50MA, 100MA, 200MA as if they don’t matter. The fact is those levels are extremely important and there are a lot of automated investment algorithms that invest based on those levels. Now, however, from resistance these levels have turned into support. With that in mind, with each breakout, volatility plunged down further and further.

In fact, this is the fastest drop from a closing value of above 40 in the VIX down to 14. It took only 42 trading days. In previous VIX spikes, it took at least 216 trading days (Oct 2011 to Aug 2012) – almost a full year (a year has 252 trading days) for the VIX to do that. On most occasions, this is a multi-year decline.

This was the reason why in prior emails I called for a secondary VIX spike at least to the 30 level. If 50MA and 200MA presented meaningful resistance that would’ve happened and that is what has always happened in the past. But the markets are more informed now, more automated, faster and as result more schizophrenic and fast moving. And more surprising as well – always moving ahead of historical precedent. If people loaded up with shorts at the 50MA and 200MA expecting resistance, the market makers would look to hurt the most amount of people and they would move the futures up forcing the shorts to cover once at the 50MA level and then at the 200MA level. So add positioning to the fundamental NIRP story and you have the massive W recovery we’re observing right now.

Volatility Summary

The volatility situation continues to improve dramatically without a pause since we identified the turn in the September 22nd newsletter:

a. Volatility Curve is now in a normal Rally Formation with the VX8 below the Historical Average with a steep front-end.

b. Short Term Structure measures (VDelta) is now in a 0-2 band meaning that VXST is below VIX and that doesn’t portend a big VIX jump soon

c. Medium Term Structure measures (Contango & VCO) are now itching to turn green. The VCO of 25 and Contango of 5% are in sight. Roll Yield is also at 14.6% with Contango Roll at 19%. High Contango Roll, high VCO and Contango the best predictors of XIV success and XIV looks poised to launch another winning streak.

d. Long Term Structure measures (VRatio & VTRO) are solidly in the green with no reversal in sight pointing to solid volatility situation going forward over the next 3 months.

e. Volatility of Volatility (VVIX) has now spent weeks below 100 suggesting that the mania of August is somewhat over.

f. Volatility Momentum (VForce) is now very negative at -34%. This is a positive development for the market and this has happened only 3 times before – 1998-11-23, 1991-03-14 and 1991-03-15. In prior instances, the market ended up moving higher and the VIX 50MA moved down

g. Volatility Risk Premium (VRP) is slightly positive but expected volatility is dropping faster than historical meaning the market feels much better about its prospects going forward

Trade Recommendations

The entirety of the Volatility Curve and VIX Term Structure are now in a state that portends positive performance for the Short Volatility ETF (XIV) going forward. The 50MA and 200MA now act as support instead of resistance. Unless we break below the 2060 level for good, we can expect volatility to continue to be suppressed.

Over the next week, there is one remaining risk, however. The House Speaker election and the Debt Ceiling resolution. Historically, a couple of days before the event, volatility has spiked, a successful resolution has been implemented and then volatility resumed its decay downward. Buying on those pre-event VIX spikes has often resulted in daily gains for the XIV of about 8-10% which have later extended to 60-70% gains over the next 2-3 months. For example, the Debt Ceiling and Fiscal Cliff of 2012 resulted in a 60% run in XIV from Nov 9th 2012 to Mar 19th 2012. After the Debt Ceiling of 2011, we had a 75% run from Nov 11th 2011 to May 14th 2012.

Primary Expectation

My expectation here is that over the next week, we may have a brief spike in the VIX with a rather neutral performance for both XIV and VXX. Once the Debt Ceiling gets resolved, I expect the market to slowly grind higher or back and fill into the New Year as it reprices to a new P/E multiple (it has already breached the 22 PE level at the close this Friday). At this point, the only resistance area on the horizon is the 2131 all-time high from May, but given the multiple expansion, I am not so sure it will present meaningful resistance.

On news of the resolution, I expect the VIX to drop below 15 and stay in a 12-15 range for a few months. In such a market neutral or market positive scenario, the XIV would benefit greatly as Contango stays above 5% and Contango Roll stays above 15%. The XIV will outperform the SPY dramatically and looks poised for another 50-60% run into the New Year and beyond.

Devil’s Advocate Scenario

Alternatively, you have to consider that if the long trade gets overcrowded, the market may throw another 3-5% dip for a couple of weeks in November or December to clear out the weak hands. However, now I view that as an XIV buying opportunity. The probabilities and term structure now favor XIV far more than VXX. The VXX will only gain over the long term if we have a major VIX spike to above 30 at which point the Volatility Curve inverts. That can only happen if the market drops and drops fast like in August. We have to top out at a lower low in the 2080-2120 area, then drop down fast below the support areas listed below (200MA = SPX 2060 or mid-year support of 2040) for an extended period of time.

Final Words

The market’s natural tendency is to grind higher with some volatility episodes like the past few months thrown in. If it wasn’t for Central Bank intervention, we definitely had the beginnings of a bear market on our hands, but Central Banks are intervening and we can’t ignore that. At this point the SmartXIV and UltraXIV strategies are on the cusp of issuing a “BUY” signal for XIV. Sometime after next week, I expect the signals to trigger once the Debt Ceiling situation gets resolved.

The Curse of Falling Earnings

Carl Icahn just published a great video “The Danger Ahead” in which he outlines the major issues facing the US economy, US corporate earnings and the unwelcome side effects of the FED’s prolonged zero interest rate policy regime (ZIRP). In the video, with very easy to understand charts and graphs, Carl Icahn makes the case that ZIRP has elevated valuation levels of stocks and their underlying corporate earnings to unhealthy and more importantly unsustainable levels. We have been writing about that theme for years now and we think that Carl Icahn is doing a great service to investors and to US citizens overall by highlighting and explaining these issues. Mistakes in monetary policy inevitably lead to bubbles and consequently recessions in which real people lose their jobs and we can’t afford as a society for the FED to be continuously making mistakes. While we attend Global Citizen concerts which put front and center the issue of “Sustainability” (sustainable planet, sustainable economy, etc), it is very ironic that the most important economic institution in the United States – the Federal Reserve – is pursuing a monetary policy that promotes economic and corporate activity that is extremely short-sighted and is anything but sustainable in the long run. Maybe Janet Yellen should show up next time to the Global Citizen concert and learn about sustainability. At the very least she will enjoy some good music along with Michele Obama and Joe Biden.

As I mentioned in my March article Beware of the Imminent Decline covering our expectations for 2015 Q1 earnings, US corporations (S&P 500) have continued to deliver well below expectations. Lost in the daily CNBC coverage highlighting Nike (NKE) or some other winning company blowout earnings in the US and China, it is very easy to lose track of the big picture. And the big picture is not as fantastic as Nike’s earnings. For every Nike, there are 5 Glencores (GLEN) that are on the verge of bankruptcy. For every Apple, there are 5 Blackberries struggling to make ends meet. The irony is that while Nike employs about 50,000 people world-wide, Glencore employs 150,000. A company’s profitability and success is not necessarily equivalent to its real-world impact on the economy. Some of the most important companies from economic standpoint that employ hundreds of thousands of employees are in the mining, construction and manufacturing industries. Industries which are currently under duress. Industries that require metal, machinery, hard physical work, blue collar employees and real-world management. Those industries require a lot of investment, a lot of high-yield debt to finance construction and if things don’t work out, tens of thousands lose their job and tens of millions of investor money is lost. Not every company can be Facebook (FB), operate $500 million dollar data center in Oregon run by a bunch of guys who have never gotten out of a chair and print money from state-of-the-art targeted advertising to a billion users at a 90% margin. Not every company can be Google (GOOG) or Amazon (AMZN) and benefit from the network effect widely present in virtual commerce. Most companies deal with the real world and the real world involves physical locations and moving a lot of people and machinery and product at a low margin with the constant threat of capable competition.

So while I sincerely wish that the big picture is good, the world is what it is, not what I want it to be. And as investors we have to stay with our feet planted firmly on the ground and be realistic. A lot of the earnings analysis out there deals primarily with breaking earnings down by sector and figuring out where money is being made or lost. I prefer to stick to a macro approach and try not confuse my thinking with potentially unimportant details. A rising tide lifts all boats, a falling tide grounds all boats. Like the great Yogi Berra said “You can observe a lot by just watching”. At least a couple of times a year, we need to climb on top of the hill and observe the situation from above.

Review of Q1 and Q2 Earnings

Now that Q1 and Q2 earnings this year have been completely reported, let’s take a look at the situation:


The 1st and 2nd Quarters of this year were a relative disaster from an earnings stand point. GAAP EPS for Q1 came in 40% below original estimates (also called Forward Earnings Expectations). For Q2, the miss was a slightly better 38% (I hope that makes you feel better)! On a Trailing 12 Month basis, Q1 was relatively down 22% and Q2 came in with a terrible 30% miss. Just to illustrate what that means, the average miss from forward expectations on a T12M basis is about 18%. So both in Q1 and Q2 earnings disappointed quite a bit above the usual disappointment level. The great falling earnings expectations are best seen on a chart for which the data is getting retrieved consistently on a weekly basis:




Earnings Data Source: S&P 500

On a sequential basis, earnings in Q1 only declined 1.52%, not too worrisome, but Q2 served a whopper at 8.17% miss. An 8% miss for trailing 12 month earnings (1 year period) is a big reason to start questioning the P/E multiple because if the price stays where it is the SPY is starting to get real expensive, dividend yield starts to become miniscule and Brazilian government bonds start to look real good with a 16% yield, devaluation of the Real and Dilma Rouseff be damned.



Earnings Data Source: S&P 500

So it is not a surprise that the market has struggled of late. In fact the 12% correction so far has been right in line with the steady earnings decline present throughout this year. And I have this unfortunate news for the uber-bulls – unless the earnings picture improves going forward it will be very hard for the market to reclaim its all-time high of 2131 from May 21st. There is one positive during this rather sharp decline is that the P/E ratio has finally let up a bit, we are no longer at the nosebleed level of 22. We are back down to 20, which historically is still pretty expensive. The high end of what is considered “fair-value” historically is the 16-18 P/E range with 18x levels usually achieved during period of Central Bank accommodation. Unfortunately a 16x P/E valuation given that the earnings are now only $94 would mean that the SPX has to trade down to the 1520 level, a full on bear market and a disaster for the 401(k) of most investors.




S&P 500 Index closing prices: Yahoo

Preview of Q3 Earnings

Unfortunately, Q3 does not bring much of a respite. Q3 earnings are expected to be at $26.46, which is a 16% gain over Q2 which I think is highly unlikely to happen. Even at this level, this is still a dramatic decline from original March 2014 expectations of $37.2. On a T12M basis, earnings are expected to come in at 93.9 down from $142– a 34% miss already. But even more worrisome is the decline from 2014 – down 11.38% from Q3 of 2014.



So if you are looking for a sharp rebound in the market, it has to come at the expense of higher valuation. I think new highs are highly unlikely at this point until earnings for the index as a whole start to move upwards and show growth. At present we are dealing with year on year declines and I see nothing that will change that in the next few months.

Final Words

It is important to understand that corporate earnings will continue to face pressure into 2016. S&P 500 corporate operating margins are down 7% on a year over year basis. The margin compression is driven by a few factors which will not cease to exist any time soon:

  1. Rising wages because of low unemployment levels
  2. Stretched consumer.
  3. Strong dollar

While the US economy now employs more people than ever at 149+ million and the overall consumer stats look good, on a per consumer basis, the economy is struggling with a “rent crisis”. In a lot of locations, people pay 50% of their income for rent and housing, an all-time high level. They have to pay back credit card debt because it is really hard to get a loan these days. Luckily, the vibrant private economy employs more and more people making the government statistics look good, but if there is the sense that the economy is not working for people it is because their personal finances are stretched and the great happiness elixir of cheap and easy credit is here no more (I mean who doesn’t feel good about spending money they haven’t earned yet?). As a result, consumers are feeling kind of unhappy, are really price conscious, they reject higher prices and only buy deals – hence our low consumer price inflation. When faced with low prices how do companies protect their profits? By producing more output which they sell at lower prices with more automation and fewer workers. So the economy will keep humming while everybody is unhappy. Welcome to 2015!

On the strong dollar, earnings have been partially helped by a relative stagnation in the dollar growth this year, which is a temporary development. ECB and BOJ have taken a break from their QE programs, but they will resume them soon enough as economic growth in Japan and Europe needs cheaper currency and more monetary accommodation. In addition, the upcoming inclusion of the Yuan in the SDR basket in March or later and subsequent at least 50% devaluation of the yuan will be a major trigger for strengthening of the dollar. At this point the dollar is not in the hands of the FED, but in the hands of Mario Draghi and Haruhiko Kuroda and Tian Guoli (Bank of China Chairman), regardless of whether the FED implements rates hikes or not. Currency movements at present are all about relative size of central bank balance sheets and the appetite in the US for expanding the balance sheet is pretty much over for the foreseeable future. In another article I published in March King Dollar Is Here To Stay, I calculated that the fair value of the US dollar index is 124. So some time over the next year or so, the US dollar will have another rapid 3-month ramp from 95 to the 115-120 level, which will add another punch to the decline in earnings. The US dollar is in a massive bull flag and bull flag always get followed by another bull flag. So both technically and fundamentally another big move up is coming eventually.


Stay flexible, the V-shaped recoveries are a thing of the past. New all-time highs will be very hard to come by. The US stock market is a facing a lot of headwinds and it will take time for those headwinds to play out. Unfortunately, this may even bring about a bear market over the course of 2016. While I think this current correction is near its capitulation point, we could very well be in for a long path down a la 2007 with many 50% retraces and then resumptions of the downtrend. You never want to be looking up at the 200 day moving average and have another 5-10% to go to reach it. The one thing I am optimistic about is that we will not have a Lehman like disaster – junk bonds are not as widespread systemic risk as mortgage asset backed securities were, energy is only 6% of the US economy vs 35% for banking and finance. In addition, US banks hold north of $600 billion in cash and are ready to withstand a collapse of an institution the size of Lehman or 3 Greek economies. So while we may have a few notable bankruptcies, I don’t see any too-big-to-fail events on the horizon and I don’t see a credit crisis. While GAAP earnings are facing headwinds, US banks and corporations are not facing the massive write-offs of 2008 and 2009 that brought GAAP earnings down from $80 to $7 in a short year. So be worried, but don’t panic. And if you decide to panic, you know where to go.

The Best Investment Theme of 2015 And The Myth of Economic Stagnation

Is the US Economy Stagnating?

This year I have heard a lot of arguments about the stagnating US economy. GDP is not growing at 3%. Labor participation is at an all time low. Retail sales are failing expectations. PMI indexes are coming down from the 60s to the mid 50s. Monthly job gains can’t go beyond the 300,000 level. First quarter GDP was negative. Margin levels are at all time highs. There is a financial crisis just around the corner. Sometimes, the chorus is so overwhelming from a number of online pundits I highly respect, that I just feel like I should pack my bags, put all my money in cash and gold and forget about investing in the stock markets.

Yet, the financial market continue to disprove this investment thesis. Commodity bloodbath continues – gold (GLD) and silver (SLV) continue to bleed down. Oil (USO) and natural gas (UNG) just can’t engineer a recovery. The S&P 500 (SPY) is trading in a range and rarely gives you an opportunity to buy at 3% discount. Bonds (AGG) continue to hang on. Here are the Year-to-Date returns of all major asset classes with the ones mentioned highlighted in yellow:


Does this look a collapsing economy? The answer is a resounding NO. The markets just don’t think the economy is collapsing.

Economic Stagnation is a Myth

And it is not just the markets that think that the economy is doing fine. The reality is such. The US economy is doing just fine. In order to answer some the “slow growth” or “growth slowing” arguments out there, I went to and got the US GDP and US Population data from 1990 till 2014. Put it in a spreadsheet. Drew a chart. 10 minute exercise. Here is what I discovered:

Source: Trading Economics

The US since 2010 has far outperformed the golden 90s in terms of GDP added. The US economy routinely adds north of $600 billion in new gross domestic product. Keep in mind that the GDP is already inflation adjusted (GDP is gross receipts divided by the GDP deflator – a chained CPI inflation measure). $600 billion – this is Apple’s market cap. Since 2010, the US has been adding the equivalent of one company the size of Apple per year! That is no small feat.

Ok, obviously there are more people working today than in the 90s. Let’s look at per capita GDP addition:

Source: Trading Economics

Again the picture doesn’t look bad at all. Americans work hard and continue to be very productive. Yes, some people may be out of a job, but those that do work, work hard and productively. So no, the US economy is not heading for a recession. Quite the opposite. Times have rarely been better. Here is the raw data for these charts in case you are interested:

Source: Trading Economics

The Ends Justify The Means

Ok, so let’s say that the markets and the economy are artificially goosed by FED/ECB/BOJ money printing and generally available liquidity. As an investor and a person, I generally fall in the Machiavelian “Ends Justify The Means” school of thought. It doesn’t matter how you do it, so long as you get it done.

So what if the Central Banks have unlocked the printing press? Prosperity is prosperity no matter how it is accomplished. Would we like the economy to grow without being coddled? Absolutely, yes. But what if it doesn’t grow without being coddled? What if coddling is required?

If this was your child, would you drop it on the streets on Day 1 after turning 18 and let it beg for food to teach it a lesson? Sink or swim? Yes, some tough parents would do exactly that. Yet other parents might try a different approach. They might try to slowly remove levels of support, allow for an adjustment, before they take the next iterative action leading their kids slowly to complete independence. Might take 5 years. Might take 10 years. However long it reasonably takes. Well, this is exactly what the Bernanke/Yellen FED has been doing. Maybe putting a woman at the highest leadership position in finance is not such a bad thing. Maybe the US economy can benefit from some motherly instincts.

The Central Bankers of 2015 have had a lot of lessons to learn over the past 30 years. Sharp interest rate rises have lead to financial maladjustments and panics. Financial panics and stock market drops lead to what should be completely unrelated consequences where the business community in general panics and tightens the investment purse. That in turn leads to job losses and economic recession. That script has played out so many times, I mean at some point, you’d think the Central Bankers will learn their lesson. And it seems that they have. They have to worry about 2 things – inflation and employment. If inflation is not a threat, then they should do everything at their disposal to improve employment.

Are We In a Bubble?

The end result of a policy such as this is a financial bubble. The first question is there a bubble. A very compeling argument can be made that the SPX is at bubble-like valuation levels. Price to Earnings ratio of 21 or 22 is not for the faint of heart.


Yet a dividend yield of nearly 2% is not far from 2.18% yield for 10 year Treasury Bonds. Earnings yield (the inverse of P/E) is at 4.6% (1/21.5) – far higher than the 2.18% level. According to the FED Earnings Yield Model first revealed by Alan Greenspan a few years ago, the S&P 500 P/E ratio could double from here to 45 and once Earnings Yield hits long-term treasury bond yield at 2.5%, stocks will have a achieved valuation parity.

May be. At the end of the day, investors invest for the hard cash they receive not for the ability of some corporate honcho to produce outstanding profits so that he can then turn those into a mind-boggling year-end bonus. I mean nobody really wants other people to use their money, leverage them and make a ton of money without sharing, right? So dividend yield which measures the hard cash investors receive is probably a better marker to use in our comparison with the 10-year bond. And those are roughly the same. Stocks are actually slightly overvalued based on this marker. But companies have the ability to increase dividends. And the FED does not want to increase interest rates and thereby bring bond yields up higher. As it stands at present, stocks are fairly valued so longs as this interest rate regime persists and earnings and dividends don’t decline precipitously.

Financial Regulation Works

In addition, Central Banks will not use the crude tool of rising interest rates to contain a financial bubble. They will use other tools – macroprudential tools as they call it – to contain a financial bubble. They will raise cash requirements at banks, they will make it harder to go public, they will bury the compliance departments of companies in paperwork, they will send black Chevy vans with FED agents over to look over books and do penetration tests. Once they see the black vans, the last thing on a corporate honcho mind is how to lever up to keep his bonus big. At that point, he is in a battle for his own job. The question is, is he going to have a job tomorrow? Centralized regulation works and the Central Banks have finally abandoned the Alan Greenspan counter-party check system in favor of centralized financial regulation. So long as regulation doesn’t escalate into dictatorship, the outcome will be good.

The Most You Can Lose is 100%

The financial bubble in venture capital can also be contained very quickly. But the powers that be have deliberately decided that a venture capital is good for the country. The experience of the 90s taught them that young people need young companies. Startups may not make money, but startups are a perfect training ground for young people. Young people learn practical job skills which they can later translate into real jobs at real companies that make profits. So the FED will let the entrepreneurial spirit of America thrive even if some inconsequential app maker gets a ridiculous valuation. And private equity and venture capital investors are more than willing to play along. Recently, I heard these words of wisdom from somebody who was in early on Facebook and Twitter and countless other companies that went public the past couple years at his six figure annual membership country club:

“After all, if you invest, the most you can lose is 100%. If you don’t invest, you may give up 10000% gain. “

So venture capital groups together, individually they put small bets, but taken together big bets and they let the startups of America help improve the job outlook for our young graduates. That is not going to change any time soon.


Low volatility continues to be the best investment theme of 2015. On this list of 60 major ETFs, the Short Volatility ETF (XIV) continues to be a resounding winner over any other ETF this year beating by 40% the next closest runner up the Japan Currency Hedged ETF (DXJ) :

July proved to be a very treacherous month for the SPX, featuring surprise rips and dips that didn’t align well with historical averages. The XIV was also rather volatile, but still ended up with a 18%+ gain on the month. On the charts below the light blue bars are the daily average for that trading day within the month since 1990 (that being the year the SPY and VIX were introduced and modern financial markets started). The purple bar is the actual daily return for July. The red line is the average month-to-date return through that trading day for the month. The purple line is the actual month-to-date return for July:

Data Source:

August Outlook

August tends to be the worst month for the SPX. On average, the month starts with a 3% drawdown which then it slowly recovers from to post a slight average loss of -0.5%. That in turn leads to a rise in volatility and XIV consequently suffers. XIV drops 7% in the first 2 trading weeks of August and continues to drop until it posts an average 12% loss for the month.

Data Source:

Given that July was very choppy on a day to day basis and daily moves didn’t conform to historical averages, I think August will be more of the same. In fact, I kind of expect August to be a positive month given that it has been so negative in the past. This year, Market Makers have been very adept at moving averages against historical performance and given the low volume of August, I expect more of the same. Given the historical risk, I would tighten stops in XIV and SPX, but if the month starts on a positive note, you should continue to ride the low volatility train.

This year looks very similar to 2012 and 2013 when the XIV posted bigger than 50% YTD return through the end of July. In both of those years, the XIV continued to gain an additional 38% and 27% to close the year with 154% and 107% gains respectively.

So to summarize, continue to be short volatility.