“History doesn’t repeat itself,
but it often rhymes.” – Mark Twain

Quick quiz…

• Inequality and a major economic crisis have made it increasingly difficult for the poor/ middle class to get ahead, and many feel themselves falling behind.
• As a result, demagogues have begun attempting to seize power in many countries including the United States since existing parties won’t fix things.
• Countries have begin joining or strengthening military alliances and many see the growing prospect for another major World War.

Am I talking about 2008-2023, or 1929-1939’s?

“Coincidence is the word we use when we can’t see
the levers and pulleys.” – Emma Bull

It isn’t a coincidence.  There are similar economic, political, and geopolitical forces working in 2007-2023 as there were in 1929-1939 (as well as in other historical eras).

Since we see the misery those forces are currently causing, and know that the last cycle eventually led to the Great Depression and World War 2, enlightened self-interest should encourage us to disrupt this cycle before it gets worse (and it assuredly will get worse before it gets better).

That doesn’t necessarily mean that 2020’s China/Russia will play the part of 1940’s Germany or that 2020’s US will be the “good guys” and save the world like it did in the 1940’s.

Right now, the US has to save *itself* first…

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“All of this has happened before,
and it will all happen again.” – J.M Barrie

Many things in nature come in cycles.   Whether it is the seasons, sunspots, the tides, life and death.  So it is in politics and economics.    We have the election cycle every 4 years where we determine who leads us, the business cycle of booms and crashes every few years.

These cycles occur on a timescale that is much shorter than a human life.   That is why most people are aware of them:   They have seen multiple recessions, multiple presidents in their lifetimes.   To them such things are a normal part of life.

But there are other cycles that move on longer timescales than a human lifetime, and so most people are unaware of them.  It’s hard for people to learn hard-won lessons about events that might have last occurred when their great-grandparents were still children.

There are three historically significant “cycles of chaos” playing out in our world today that could soon make our lives much more challenging if they aren’t carefully managed:

• Internal Chaos:  Inequality and Demagogues
• External Chaos:  Hegemonic Rivalry, the Thucydides Trap, and World War
• Environment Chaos: Climate Change and the “Tragedy of the Commons”

These cycles are as old as humanity, but historically were local/regional affairs as contemporary technology did not allow global reach.   Today they each pose a global threat.

• A world hegemon such as the United States falling under the sway of a demagogue has vastly higher stakes for both the country and the world than a smaller and less crucial country such as Venezuela.
• Conventional war between 17th century England and France didn’t threaten global catastrophe like nuclear war between 21st century US and China.
• Easter Islanders famously killed themselves off by destroying their island’s ecosystem, but that localized destruction didn’t affect humans elsewhere. Today CO2 released anywhere harms the entire planet’s ecosystem.

The modern era marks the first time in history when all three destructive cycles are capable of global impact at the same time all three are simultaneously flirting with “gimbal lock”.

Sadly these cycles don’t require any exotic sociological “dark matter” to explain.   They’re largely driven by the greed of the wealthy, corruption of political elites, ignorance of commoners, and humanity’s short-sighted nature.

They’re also driven by “normalcy bias”, which is a tendency for people to disbelieve or minimize risks and underestimate the likelihood of disaster.   Despite thousands of years of war, natural disasters, economic collapse and other miseries, there is a strong tendency for a majority of the population to believe “that can’t happen now”, even in the face of strong evidence that it *is* happening now.

So we hope to learn about them here, that we might not have to learn about them elsewhere in much less pleasant ways…

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I.  Inequality and Demagogues

“All the armies of Europe, Asia, and Africa combined … could not by force take a drink from the Ohio or make a track on the Blue Ridge in a trial of a thousand years.

At what point then is the approach of danger to be expected?  I answer…  If destruction be our lot we must ourselves be its author and finisher.” – Abraham Lincoln

Most of us have noticed two seemingly disconnected truths in recent years:   Our politics is getting more toxic and the country less united as time goes by, and the wealthy are doing better than ever while regular people are struggling harder than ever to get by.

As it turns out, those “disconnected” truths are actually joined at the hip, as we will see.

It’s a bit challenging to explain the dangers of demagogues to Americans, because we have been fortunate in our history to have so few of them successfully attain higher office.   In trying to describe to readers how the “inequality -> demagogue” cycle progresses, I found myself returning to a quote by Yoda from “The Phantom Menace”:

1.  “Fear leads to anger.”

A fact which summarizes our inequality problem:  the real wage of a US worker today is less than it was 40 years ago—but there are four times as many multimillionaires.

Looking at one measure of inequality (top 1% vs bottom 90% shares of wealth), which we have data back to 1913, we see that it is to a good degree a zero-sum calculus:   Increases in share of wealth for the wealthy result in decreases in wealth for the poor and middle class, and vice-versa.

Economic historian Peter Turchin discovered a cyclical pattern in US history, as well as other countries.   While a full discussion would require an entire book (read Turchin’s “Ages of Discord” for that), when Turchin graphed the average of trends that primarily affect poor/middle class people (employment, wages, life expectancy, average height, and age of first marriage) against trends that primarily affect the wealthy (largest fortune to average wage, cost of an elite education, political polarization), he discovered that good times for the wealthy come at the expense of the poor and middle class.The peaks for “Popular Well-Being” around 1820-1840 (the “Era of Good Feelings”) and 1950-1970 were widely considered “good times” by the average person in those eras, while the lows (the “Gilded Age” of the 19th century from 1870-1900 and the modern era) were considered relatively bleak and miserable for the average person.    The exact opposite is true for the wealthy:  they’ve never been wealthier than the Gilded Age and our current era.

Our politics has become noticeably more toxic in recent years *because* inequality and political polarization go hand-in-hand.   The above graph shows a measure of political polarization (differences between political parties DW-Nominate First Dimension) and a measure of inequality (ratio of the largest US fortune to the average annual wage) going back to 1780.

You can see that when one worsens, so does the other, and vice-versa.  The likely cause is the wealthy’s predilection of “buying” politicians to craft laws that help them become ever wealthier, often at everyone else’s expense.   Thanks to that dynamic, inequality has once again approached the immiserating levels of the Gilded Age.

“The problem is that we all too often have socialism for the rich and rugged free enterprise capitalism for the poor. ”
– Martin Luther King Jr.

Today, both major parties have been captured by the wealthy.   The GOP and its historical predecessors (the Federalist and Whig parties) have always been been the party of the wealthy and big business since the founding of the Republic, and the Democratic Party has been spending increasing amounts of time catering to the whims of Wall Street Democrats since Clinton was elected in 1992 (and who helped accelerate the outsourcing-to-China trend that caused an exodus of rural jobs which is fueling discontent today).

When struggling people don’t see either party trying to help them, in desperation they often turn to radical candidates who promise to help them.   Which helps explains the recent rise of Trump, as well as populists in other countries like India (Modi), Brazil (Bolsonero), Hungary (Orbán) and the Philippines (Duterte).

2. “Anger leads to Hate.”

Populists can be relatively benign or even good (think Bernie Sanders or Ross Perot), but some can be malign (Donald Trump). We tend to call the latter “demagogues”.

Demagogues throughout history have had a number of similarities.:

• They are are usually charismatic and often craft a “cult of personality” around themselves.
• They have an anti-intellectual bent and use simplistic messaging with promises of “easy solutions”.
• They foment social division with an “Us vs Them” mentality.
• They are emotionally manipulative and exaggerate threats to stir the fears/anxieties of their supporters
• They have authoritarian tendencies and try to concentrate power around themselves.

It is no coincidence that the last major outbreak of demagoguery was in the run-up to World War 2.  A public that had been economically crushed by the Great Depression was desperate and more receptive to the messages of fascists and communist, much as current inequality has made many receptive to the message of MAGA.   In hindsight the US is quite fortunate that the “demagogue” voters ultimately turned to was Franklin D. Roosevelt.

“As long as there are crazed or crafty leaders to play on old fears, a mob will turn cruel.” – Leigh Brackett

Demagogues are rarely competent leaders, and often attempt to distract the public from their failings by scapegoating other groups (blacks, women, gays, Jews, Catholics, Muslims, etc.)  Those groups often find themselves persecuted by groups and individuals aligned with the demagogue.   Historically, this has often led to sectarian violence, whether low-intensity (the Irish “troubles”), mid-intensity (Jan 6 or Shay’s Rebellion) or full-blown civil war (Unions vs Confederates) .

3. “Hate leads to Suffering.”

Demagogues have an unfortunate tendency to prioritize their political stability and survival over economic considerations, loyalty over capability, which over time breeds economic stagnation, corruption and instability.

History is replete with names of demagogues large and small (Hitler, Stalin, Mugabe, Ceaușescu, Marcos, Gaddafi, Chavez) who did so and are today synonymous with failed countries, ruined economies, and widespread human misery.

Demagogues also often align themselves with authoritarian leaders in other countries due to shared rivals, ideologies, economic interests, or a need for mutual support and recognition.   This has result in alliances such as Napoleon Bonaparte and Grigory Potemkin (late 18th century), Hitler and Mussolini (1930s-1940s), Stalin and Mao Zedong (mid-20th century), Gaddafi and Chavez (2000s), Trump and Putin (today) and numerous others.

“Beware the leader who bangs the drums of war in order to whip the citizenry into a patriotic fervor, for patriotism is indeed a double-edged sword. It both emboldens the blood, just as it narrows the mind.” –  Albert Einstein

Demagogues are usually not blind to their failings, and often turn to war or the threat of war to distract the population, shore up their popularity and power, expand their empires, and/or refill bare coffers.   Not every demagogue turns out to be a Hitler or Stalin, but the more you elect, the greater the odds of getting a historically awful one.

Even “benign” demagogues like Mugabe and Chavez/Maduro tend to eventually mismanage their countries into catastrophic losses.    Which may not affect the world as a whole, but is devastating to the citizens of those countries

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What’s behind the rise in inequality?

*Some* inequality is inevitable, even good.    Humanity is better off when hard work is rewarded and laziness punished.   But the extreme punishing inequality we see today didn’t “just happen”.  It was the result of the American public being plundered in multiple ways over decades, abetted by the policy decisions of elected leaders who often benefited politically and/or financially by those policies.

Over the past 40 years the wealthy have pilfered the poor and middle class by at least three avenues (and possibly others):

1.  The Productivity-Pay gap.    From 1948 – 1979, worker’s incomes grew proportionally to worker’s productivity increases.    Since the 1980’s, several factors (automation/off-shoring, decline of unions, recovery of world manufacturing from WW2) conspired to give the wealthy more bargaining power vs labor.

The erosion of labor’s bargaining power allowed the wealthy to capture an increasing amount of wealth from labor’s productivity increases.   The Economic Policy Institute estimates that the average worker’s salary would be $9/hr higher today if pay had kept up with increases in productivity.

2.  Income tax rates.    Income taxes were drastically lowered on the wealthy, without a proportional drop in tax rates on the poor/middle class.   This had the effect of transferring a large portion of the Federal tax burden from the wealthy to the poor/middle class (or to future Americans, as we’ll see in the next point).

3.   Borrowing and Debt.

“The more you borrow, the less you have.”
– Native American Proverb

The US has been on a debt binge the last 40 years.   Federal debt is the highest it has been in our country’s history, and so is our total debt (federal, state, and local governments; business; personal).   We have accrued a higher debt load than we did when we were fighting World War 2.    (Thankfully we don’t have any countries threatening another World War, like China and Russia, or we’d be in real trouble…)

Productive debt can make you richer in the long term (think buying a home, paying for an education, or building a factory), but an awful lot of debt has been unproductive, whether it’s wasted on big trucks or big wars in the Middle East.

The accumulated $80 trillion in borrowed funds made Americans feel wealthier than we truly are.   While debt often doesn’t truly make you richer, you may *feel* richer with a little extra temporary money in your wallet, even though it must eventually be repaid.

But it definitely makes the companies you spend that extra money with wealthier.  By encouraging a debt-fueled spending binge, wealthy Americans in the 1980’s effectively picked the pockets of poor/middle class Americans in the 2020’s.   But as we will see the bill is about to come due and the debt must be paid down.

That perpetually growing mountain of debt was only sustainable for 40 years because interest rates fell the entire time (from 15.84% in Sep 1981 to 0.54% in March 2020).

Those of you old enough will remember the worry about Reagan’s deficit spending and why politicians of the day were afraid the interest payments would eat the budget alive.  High debt x high early 80’s interest rates = a mountain of interest payments.  Notice in the graph below that the interest payments on Federal borrowing during the Great Recession bubble is much smaller than interest payments due to Reagan’s borrowing, even though similar dollar amounts were borrowed, because interest rates were much lower in 2008 than 1981.

The average US debt has a maturity of 10 years, which is why it took 10 years for interest payments to peak after Reagan’s borrowing spree.  Fortunately a mixture of spending cuts, Clinton’s tax increases on the wealthy, and the fortuitous invention of the Internet helped bring interest payments back to earth.

Now that interest rates have started rising again, we’re in a new era. Rising debt x rising interest rates = interest payments that will rapidly grow and crowd out other priorities like education, defense, science, Social Security, Medicare.   Rising interest payments are the “debt limit” on our credit card, and the point where we need to stop borrowing and pay the debt down, or else face much worse problems down the road.

“Credit buying is much like being drunk.
The buzz happens immediately, and it gives you a lift.
The hangover comes the day after.” – Joyce Brothers

When someone with a credit card hits their limit, they have to start paying down their debt.  They go from feeling richer than they are to poorer then they are until the debt is paid down, which feels like a sharp decrease in their standard of living.

We probably have 5-10 years before the current debt growth starts to cause major issues.  Exactly how that plays out will be “interesting” to say the least. It’s possible that interest rates stabilize at a lower level, in which case the pain will be comparatively mild.

But if interest rates keep growing or borrowing doesn’t slow down, whoever wins election in 2024 or 2028 is likely to face some very painful and extremely politically unpopular decisions. It will require some mixture of low growth, higher taxes, budget cuts, and inflation that will feel like the decrease in standard of living that I mentioned earlier.

I’m concerned that the latter situation (rising rates) is already starting to slowly play out.
Normally interest rates are dictated by the Fed.   The Fed decrees that the Federal Reserve Rate is 3%, and all other US Treasuries tag along at 3% plus a bit extra.

But now we’re entering an era when interest rates will be dictated less by the Fed and more by supply and demand for that debt, and buyers are increasingly growing concerned about the size of the debt.

The US borrows by selling US Treasuries at a monthly auction. In recent months, the Treasury has had problems finding enough buyers for the Treasuries they’re selling at the yield the Treasury would prefer, so the Treasury has been raising rates (and thus profit for buyers) to try to attract enough bidders to sell their monthly allotment.

Think about it from the buyer’s standpoint.  As US debt snowballs, the buyer is taking a greater risk in buying US Treasuries due to the possibility of inflation or default.   So they very rationally want to be compensated for bearing that higher risk.   This is part of why interest rates have gone up the past year.

I’m not sure how all the above plays out. If handled well, it could merely result in an extended period of low growth and “malaise” that isn’t too bad. Or it could cause a truly epic recession. A lot of it depends on political decisions between now and then. All I can tell you is watch the news and be ready for anything.

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Fixing inequality is easy, in the sense that we already know how to do it:  Raise taxes on the wealthy and redistribute the money they took from the poor/middle class right back to the poor/middle class.

It’s hard in the sense that elected officials often don’t have either the incentive or the power to make the necessary changes, the wealthy hate higher taxes and less wealthy, and a lot of voters don’t understand the necessity or are distracted by “culture wars” (funded by those same wealthy) into voting against their own interests.    They think their distraction is a symptom of the world getting worse, but the world is getting worse *because* they are distracted.

The GOP will not voluntarily reduce inequality as they and their predecessor parties have always been the party of the wealthy and big business.  Fixing it will require the Democratic party to win the White House and both Houses of Congress by sufficient margin to push legislation to the President’s desk.

The 50%+1 razor-thin wins of recent election cycles are insufficient.   It will take an election blow-out that gives Democrats unassailable margins.   But the Democratic party is too busy pushing social issues and chasing Wall Street donors to attract enough votes from economically-minded voters to win that necessary margin.  So Democrats aren’t likely to be much help either for the moment.

So I expect inequality to continue worsening, until one day something “breaks” (a war or recession are historically the usual triggers) and forces a redistributive solution.

The graph above shows US unemployment since 1800.    The “Great Depression” is the large and broad unemployment spike in the center of the graph.   It truly was horrific, easily eclipsing other panics or depressions like the Long Depression of the 1870’s or the relatively recent Great Recession of 2008.

The extreme inequality that had festered during the Gilded Era was thus compounded by the mass lay-offs of the Great Depression, and led to the rise of radical movements (fascist, communist), labor strikes, race riots, and widespread social unrest, which is largely analogous to what we’re seeing today.

The threat of violence was such that the wealthy eventually chose to acquiesce to laws like FDR’s New Deal that redistributed their wealth as it was, as one historian put it, “an expression of their preference for a legislative revolution to a violent and bloody revolution in the streets.”

I suspect Gilded Age 2.0 will follow a roughly similar playbook: Things will get worse for the average person, first slowly then all at once, and force change.  We’ve been doing the slow walk for 40 years, so I suspect the “all at once” stage will probably not be much longer in arriving.

“And what rough beast, its hour come round at last,
Slouches towards Bethlehem to be born?”
– William Butler Yeats

Back in the 90’s, outsourcing jobs to China took off.   The prevailing economic theory was that it would make prices so much cheaper that both capitalists and labor would be left better off if they shared the excess.

Problem is, capitalists don’t like sharing money.    So they helped craft laws to ensure that most/all of the gain was steered directly into their pocketbook, leaving little/none for labor.   They’re doing better than ever.

Workers affected by outsourcing saw their jobs moved to China, their factory close down, their livelihoods destroyed, and their hometowns economically shattered, which is a large reason why those same workers showed up in droves to help elect Trump to the presidency.

We’re coming up on another moment like that.   In coming years, AI is poised to rapidly accelerate job destruction, far faster than capitalism can create new jobs to replace them.  And many of the people employed in jobs facing extinction are probably ill-adapted for other jobs, or they won’t be as high paying.

In theory, we could divide the gains from AI in ways that would ensure that both capital and labor would benefit.     But do you really think we’ll actually do that this time if we didn’t do it for those displaced by outsourcing since the 90’s?

Those newly unemployed are unlikely to go quietly into that good night. They are the seeds of radical movements and social unrest of the 21st century, and they won’t take long to sprout.

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I had originally intended my “Wars and Rumors of Wars” to be one post, but it’s proving so fruitful to myself (and probably exhausting for the reader!) that I decided to split it into multiple posts over coming months to keep it manageable.

• Part 2 will cover Hegemonic Rivalry, the Thucydides Trap, and World War.
• Part 3 will cover Environmental destruction, climate change and the “Tragedy of the Commons”.
• Part 4 will cover interactions between the 3 “cycles of chaos” that are likely to compound our miseries, and my broad-stroke predictions of where the near-term future is likely to go over the next few decades.

There appear to be two schools of wildly-diverging thought among investors right now, and I’ve been thinking how to bridge the two camps, since I can’t imagine them being both so incredibly wrong given the trillions of dollars on the line on each side.

On the pessimists side are numerous successful investors (Ray Dalio, Jeremy Grantham, Charlie Munger, Michael Burry) who believe the economy is in a massive bubble.  Both the Buffett Indicator and Shiller PE show the stock market is highly overvalued by historical measures.   Shiller PE in particular shows the stock market as being the 2nd most overvalued in the last 140 years.

On the optimists side is the bond market, where the yield curve is normal and not inverted, and showing signs of increasing but modest inflation.   Which is a sign of a recovering economy.   Rising inflation expectations is telling us that our big problem right now is that the economy is recovering *too* quickly, which is a nice problem to have.

The stock market is likewise showing optimism about the near-term.    VIX is a measure of how much volatility markets foresee in the near future.    When the SP500 is hitting new heights, but the stock market is concerned about an imminent crash, VIX will rise.   When SP500 hits a new heights but VIX is falling, that indicates confidence that a crash is not imminent.   The falling VIX shows the market is increasingly growing confident about the stock market’s near-term future.

With the Fed’s foot firmly on the gas pedal, a massive fiscal stimulus working its way through Congress, and with a de facto second fiscal stimulus in the form of a major infrastructure bill in view, the odds of a recession related to the business-cycle or Fed overtightening this year is basically zero, though some shock like war or natural disaster could still come out of left field.

But we’ve seen instances where the stock market crashed even when the real economy kept growing.  The best example is the “Black Monday” crash of October 19, 1987.   The stock market had risen 44% year-to-date in 1987, and gotten significantly ahead of the underlying economy.   The resulting stock crash on Black Monday hit like a bolt from the blue, for reasons that are still not well-understood.  The S&P 500 dropped 20% in a day, but the real underlying economy (as measured by GDP) kept right on growing.

A scenario similar to a “Black Monday” could easily play out this year.    The stock market has gotten significantly ahead of the underlying economy due to fiscal stimulus, optimism about the pandemic ending, inflation expectations, etc.   The stock market, or at least the most overvalued sectors of it, could experience a significant correction (alongside other overvalued assets like cryptocurrency) out of the blue and wipe out a lot of paper wealth, while the underlying economy keeps on strengthening.

That’s a plausible scenario, but of course doesn’t mean it must happen.    The stock market could keep plowing upwards on sheer momentum regardless of nosebleed valuations.   But it’s a possibility to keep in mind when making investment decisions.   In recent weeks I’ve watched friends on Facebook plowing money into tech stocks and cryptocurrency, not understand that at their current valuations they aren’t an investment, merely a lottery ticket with a substantial chance of leaving them poorer.   If you pay $10 for a $5 bill with the hopes that you can find someone to buy it for $20 tomorrow….   That will eventually fail spectacularly.

The current bubble will eventually run out of steam and pop.   I suspect that, whenever the end of this bubble arrives, it will do so with relatively little advanced notice by historical standards.    Given how artificial and manipulated the current economy is,  I don’t suspect it will “coast” for several years like it did during Obama’s last term/Trump’s first term, but is more likely to experience a Wile E. Coyote moment of running off the cliff, briefly peering down, and then falling precipitously.

Hopefully that’s a blog post for another year.

Disclaimer:   I’m currently invested in BRK.B, DODGX, FSLBX and cash equivalents.

Two months ago I wrote a blog post about where I thought the economy was heading.   Since then, I’ve learned some things which suggest more pessimistic outcomes.  I wanted to write them down, both for my memory and to inform others.

Assuming that a recession is headed this way, it would be quite helpful to be able to answer four basic questions:

1. How big is the bubble?
2. What pops the bubble?
3. When does the bubble pop?
4. How do we get back to normal?

For #1, I recently learned a very useful measure to gauge the size of bubbles:   Household Wealth vs GDP.  Household wealth measures the value of everyone’s assets if they were sold at that instant at the current market price.  For instance, if you owned 1,000 shares of Beenz.com, you might be a millionaire in 1999, or dead broke in 2002.

As a rule, household wealth shouldn’t grow any faster than GDP.   It’s a way of saying “the sum of everyone’s individual wealth should grow at the same rate as the entire country’s wealth”.    So when household wealth *does* grow faster than GDP, it indicates that asset prices are in a bubble.

So what does it look like today?

Ruh-roh…

In 2001, stock prices were inflated.   In 2007, home prices were inflated.   Today, it looks like *everything* is inflated.  And the asset bubble is substantially bigger than the one that caused the Great Recession.

To put it delicately, this is unlikely to end well…

As for #2 (What pops the bubble), I have little new information on that, just various bits of speculation on my part.   The bubble doesn’t have to *pop* per se.   A “good” economic correction could slowly and safely let the air out and we could avoid serious problems (though a “good” correction would still feel painful, just less so).   The best advice I can give you is still “whatever it is, don’t be around when it *does* pop”.  And if Italy starts having financial problems, be *very* afraid.

For #3, I mentioned last time about the yield curve, and how yield curve inversions predict recessions.    Since then, the yield curve has reverted to normal.   Isn’t that great?

Nope.   It’s bearish, and a sign that a recession may be coming sooner than I thought two months ago.    For the last three recessions, only a few months passed between the yield curve returning to normal, and a recession striking:

• 1990 Recession: 7 months
• 2001 Recession: 1 month
• 2008 Recession: 3 months

It is difficult for me to believe the economy is going to crash in the next few months.  Honestly, if you pointed a gun to my head I would guess the end of 2020/beginning of 2021.     I certainly don’t *see* anything that could do it in the next few months.   But neither did most folks in 1990, 2001, and 2008 either, so it’s completely possible this time too.

But…   Is there any other way of guesstimating recessions?   Turns out, now there is!  Earlier in 2019, a Federal Reserve economist by the name of Claudia Sahm discovered the “Sahm Rule”, which is garnering a *lot* of attention in economic circles.

The Sahm Rule states that when the three-month average unemployment rate rises half a percentage point above the low of the previous year, the economy has just or is about to enter a recession.

So where does the Sahm rule put us?

Looks like we’re in the clear.  Or maybe not…

It turns out, the unemployment low for the year was 3.5% in September 2019.   Unemployment has since risen to 3.6% in October.   That may merely represent random noise.   Or it could be a sign that things are about to go south.   Using Sahm’s rule, if unemployment reaches 4% in the next few months, something wicked this way comes…

I strongly recommend folks pay attention to unemployment numbers going forward.   If unemployment heads the wrong way a second time, it’s time to at least contemplate scrambling for the exits.

Also, watch how Wall Street behaves.  You can bet that every firm on Wall Street worth its salt is aware of the Sahm rule and is watching it like a hawk.   Wall Street usually has an accurate estimate of unemployment before the government releases the official numbers.  If they determine Sahm’s rule is pointing towards a recession, they may run for the exits simultaneously, which is likely to cause asset prices to plunge dramatically, and may be sufficient to kick-start a market crash.

And as for #4, we know that the Fed is nearly out of monetary ammo.   Except for the recessions in the early 80’s (which were artificially created by the Fed to get 70’s inflation under control), the Fed normally drops their rate by ~5% after a crash to help get the economy moving again.  But they *can’t* do that when the Fed rate is only 1.8%.

And the Trump tax cuts for billionaires increased the deficit by over $1 trillion, limiting our ability to use fiscal stimulus when a recession hits.   So government’s ability to pull us out of the fire is going to be a lot more constrained this time than it was in 2008.

But corporations can also take advantage of crashes to hire new employees and extend into new markets.   Will they help save us this time?    Unfortunately, probably not.

Instead of learning their lesson in 2008, corporations have piled on more debt than ever.   Currently corporate debt is 46.6% of US GDP, an all-time high.

But worse, they *didn’t* use this debt to generate economic value by investing in new products or growing their business.  Instead, they largely used it to finance stock buybacks, which made current stockholders (and the CEO’s running the businesses) quite wealthy.   CEO departures are on pace for a record year, likely because they’re trying to get out of Dodge while the getting’s good.

The consequence of the enormous debt overhang and failure to invest in long-term economic growth are likely to hamstring companies once a recession hits.    You may have read stories about how “leveraged buyout firms” extract the equity of a company, leaving behind a husk that quite often fails due to the burden of debt placed on it.

Instead of a leveraged buyout firm doing it to a single company, CEO’s and executives around the country have done that to a significant number of *their own companies*.     Not only are companies not going to be able to help save the economy, a surprising number of them are likely to fail when a recession hits.

In summary, we know that the asset bubble is *really* big, even bigger than the Great Recession bubble.   Something is likely to happen in the next year.  And our ability to get back to normal is crippled compared to last time.

2020 is looking to be a *mighty* interesting year…   Better buckle your seat belts.

I.  Introduction

“For now we see in a mirror, darkly; but then face to face:
now I know in part; but then shall I know fully” – I Corinthians 13:12

The past year I have spent a lot of time contemplating the economy, what is likely to happen the next few years, and how to invest accordingly.  Having spent a decade struggling to emerge from the shadow of the Great Recession, it is uncomfortable to think that another recession is lurking just around the corner, yet there are growing signs that one is.

I am writing this to help organize my own thoughts, as well as help others understand and encourage conversation.   I may not be exactly right.   In fact I’d be rather shocked if I were.   But as John Maynard Keynes ventured, “It is better to be approximately right than precisely wrong.”  And what’s the point of making predictions if you don’t make them public so other people can ask questions and challenge your thinking?

To be clear, it’s nigh impossible to predict exactly *when* a recession will occur.  A recession is rather like an avalanche in that regard. You can’t predict *which* snowflake will start an avalanche. But when you see a large pile of snow perched precariously on the mountain, you should probably think twice before going skiing that day.

Similarly, you can’t really predict in advance which event (Brexit, Trump tariffs, Hong Kong, war with Iran, collapse of consumer confidence, sovereign debt crisis in southern Europe, or one of those mysterious Unknown Unknowns) will puncture the economic equilibrium and tilt us into a recession. But you *can* say with good confidence that conditions are coming into focus to allow something like that to happen.

II. Sign that a recession is coming – The Yield Curve

“Why is it when you yield, I feel like the one who has been conquered?”
– Judith McNaught

When it comes to economic indicators for forecasting recessions, the “yield curve” is usually considered the most reliable.  So what is the yield curve? 

Our government sells Treasury bonds that have different maturities (3 months, 2 years, 10 years, and several others). The yield curve is simply the interest rate on the longer-term Treasury minus the interest rate on the shorter-term one.   For example, if a 10 year Treasury has an interest rate of 3%, and a 3 month Treasury has an interest rate of 2%, then the “10 year/3 month” yield curve would be 3% – 2% = 1%.

Investors love making money but hate risk.   The longer you remain invested in something, the more risk you take, of inflation wiping out your investment, or of missing a better investing opportunity elsewhere.  Investors want compensation for the risk of locking their money up for a longer time.  So interest rates on longer-term bonds are usually higher than rates on shorter-term bonds, and the yield curve is normally positive.

When the yield curve inverts, it means that short-term Treasuries have *higher* interest rates than longer-term Treasuries.  Investors buying short-term Treasuries see higher risk on the near-term horizon, and want to be compensated for bearing that risk.

A so-called “yield curve inversion” has preceded every recession since the 1950’s except one (the economy slowed but avoided a recession during the 60’s). And once the yield curve inverts, a recession almost inevitably follows within 12-24 months.  Looking at the yield curve, we can see it inverted in May 2019.   Which doesn’t bode well for 2020.

How does the yield curve “predict” recession?  Banks earn a profit by “borrowing short and lending long”. That is, when you go to the bank and ask for a mortgage or car loan, they borrow money at the (usually lower) short-term rate, and lend it to you at the (usually higher) higher-term rate, and make money from the difference between the two rates.

When the yield curve inverts, the “high” rate is lower than the “low” rate.  It makes lending unprofitable for banks, so they compensate by tightening lending requirements and refusing to lend to marginal borrowers. This makes it difficult for weaker companies, which often have to let employees go or cut back their growth in other ways.  Eventually the economy is sufficiently weakened that an event can tilt the economy into recession.  So an inverted yield curve doesn’t *predict* recessions, it actively helps *cause* them.

While I believe the yield curve is pointing the way to a recession in the next 6-18 months, there are also important signs that as of yet do *not* show any sign of a recession.  For example, if Wall Street was overly worried about the overhang of corporate debt, the interest rate on so-called “junk bonds” would be rising to compensate for the perceived risk.   In the 2001 recession, there was a long, slow rise on “junk bond” spreads that actually started 3 years earlier in 1998, and in 2007 there was a steep and rapid rise in junk bond spreads roughly 6 months before the Great Recession was officially called.  And yet, looking at junk bond rates,  there is no sign of that happening yet. 

A recession will happen when it happens, and not when economists want it to happen.   In fact, it’s completely conceivable that the US economy manages to dodge all the potential dangers and avoids a recession altogether.   That said, I wouldn’t bet on it.

III. What shape will the next recession likely take? – A US “Lost Decade”

“All happy families are alike.
Each unhappy family is unhappy in its own way.” – Leo Tolstoy

The good news: there are few signs that the next recession will be as *deep* as the Great Recession. Consumers aren’t in nearly as much debt as before, and banks are better capitalized.   So we are unlikely to see a repeat of the Great Recession.

The bad news: there are signs that the next recession may last *longer* than the Great Recession.

• When a recession hits, the Federal Reserve normally lowers interest rates by ~5% to help stimulate the economy. Since the Fed rate is currently below 2%, the Fed has less headroom to stimulate the economy like they used to.
  
  
• The Fed can also engage in what’s called “unconventional monetary policy” like quantitative easing. But quantitative easing has a substantial negative trade-off, in that it transfers wealth from the poor/middle class to the wealthy, exacerbating inequality and increasing the likelihood that future recessions will be *worse*.
  
  This is most visible in real estate, where years of easy money have allowed wealthy investors to purchase a large number of homes and rent them on AirBNB, which has inflated home prices dramatically, and putting extraordinary financial pressure on many poor/middle class folks looking to buy a home.
  
  
• After a recession hits, Congress often passes a “fiscal stimulus” bill to help the economy by borrowing money and using it to help put Americans back to work.
  
  But today our government’s ability to borrow is constrained due to the size of the deficit. Since Trump was elected, Congress has been on a deficit spending streak, largely to pay for tax cuts for the wealthy, in stark contradiction with what macroeconomics says is prudent.   And increased partisanship increases the risk that fiscal stimulus may be too small, or even not passed at all.
  
  
• There is an *enormous* bubble in corporate debt. Corporations have been borrowing trillions of dollars and giving it back to shareholders in the form of stock buybacks.   But eventually that debt will have to be repaid…
  
  
• Japan and Europe are in worse economic shape than the US.  *Nominal* BOJ interest rates are negative, and negative interest rates are popping up in several EU countries as well.  China’s economy is proving to be much weaker than expected.   It is thus difficult to find countries with sufficient size and economic vitality to stimulate demand here and help us get back out.

At some point in the next year or two, some event is likely to knock the economy into recession, and once there, we won’t have the usual tools to get ourselves back out.  And the corporate debt bubble is likely to constrain growth for years.

This scenario is similar to Japan’s “Lost Decade”.   Japanese companies experienced vigorous growth in the 70’s/80’s, which encouraged speculation.   When their stock market crashed, those companies suddenly found themselves trapped by debt payments they could no longer afford and could not refinance.   So over-leveraged companies were forced to prioritize debt repayment over growth/hiring, which kept Japan’s unemployment rate high, and helped extend Japan’s recovery into a decade-long slog.

Japan’s “Lost Decade” was a textbook example of what economists call a “balance sheet recession“.   However, while there are certain similarities (most notably the overhang of corporate debt as well as the impotence of conventional monetary policy), the US situation is somewhat different from Japan’s.   

On the positive side, unlike Japan, most US companies are unlikely to be in true danger of insolvency.  The ones borrowing the most debt have plenty of money stashed away, but that money is often held abroad to avoid triggering US corporate taxes.  So even though they have funds on hand, they may still choose to curtail hiring to avoid paying taxes.  This suggests that Congress might be able to spur the economy by passing legislation encouraging/compelling companies to repatriate money from foreign subsidiaries.

IV. How do we recover and get back to normal? – Fixing inequality

“All of this has happened before, and all of it will happen again.”
– Battlestar Galactica

You may have heard someone mention inequality without understanding what it meant.   Inequality is simply a measure of how unequal income or wealth is.   By definition, the wealthy have more money than the poor.    But inequality can grow or shrink, and have extremely consequential economic effects.   

As you can see in the graph above, inequality hit record highs right before the Great Depression *and* the Great Recession, and the 1950’s-1970’s that are normally regarded as a golden age of prosperity for most Americans had much lower inequality.   That is highly unlikely to be a coincidence.

The poor and middle class spend most or all of their income, often from necessity.  Houses, food, utilities, cars, children, healthcare, education often use up their entire salary, so that they couldn’t save even if they wanted to.  But the wealthy have the ability to save a significantly part of their income, which they invest so they can become even wealthier.   

But over the long term, this can cause serious economic problems.   The wealthy earn the lion’s share of their wealth from the stock market, while the poor and middle class see their incomes increase roughly at the same rate as GDP.   On average, the stock market grows ~7%/yr in real dollars, significantly faster than the average 3.2%/yr of the economy as a whole.  So not only do the wealthy start off with *more* money, their money grows *faster* than everyone else’s, which causes inequality to increase over time.   (In fact, historically inequality has only been reduced by war, plague, or other natural disasters, which is one reason why I hope we choose to do so voluntarily this time.)

Please note that I’m not calling the wealthy “evil” or “selfish” (though a certain subset of them *have* used their wealth to game our nation’s laws to their benefit at the expense of everyone else).   They’re merely doing what’s in their own best interest, without regard (and often without realization) about the deleterious effects their wealth has on the economy as a whole.

Some may denigrate worrying over inequality as mere “greed”.   Who cares if a wealthy person has a luxury mansion, as long as you’re doing good?    And if it were that simple, it would probably be true.   While I would love to own a home like Bill Gates, I certainly don’t *feel* poor just because his home is nicer home than mine. 

The problem is that inequality has macroeconomic effects which *hurt* the poor and middle class.   US’s tax policy since the 1980’s has allowed the wealthy to accumulate a “savings glut“.  The pile of money the wealthy wants to save has grown larger than the available investment opportunities. Econ 101, when supply exceeds demand, profit falls.

For example, we can see here how the “savings glut” has caused yields on 10 year US Treasuries to fall since 1980:

We can also see similar effects in the stock market.   Below is a graph of the Shiller PE ratio.  The ratio gives the Price/Earnings ratio based on average inflation-adjusted earnings from the previous 10 years, and as such, provides a useful estimate of whether the stock market is “overvalued” or “undervalued”. 

 From the graph above, you can see two things:   1) a long-term growth trend in “overvaluation” started in 1980, and 2) today the stock market is highly overvalued by historical standards, exceeded only by the Great Depression and Great Recession.  

Just as a *falling* bond yield means less profit for new investors, a *rising* stock market overvaluation makes it relatively more expensive for new investors to buy stocks, as they are paying a growing premium price relative to earnings.   The profit here is falling too…

As the “savings glut” has persisted across both Republican and Democratic tenures in office, the fault doesn’t lie with any particular political party, as they both have a largely unblemished track record of kowtowing to the wealthy at everyone else’s expense.  And as inequality has been a problem decades in the making, it will likewise probably require decades to correct.   So the sooner we start, the better.

Falling long-term interest rates are great if you’re borrowing for a home or car. But they are bad if you’re a retiree depending on CD/bond income for your retirement, or if you’re trying to save for retirement.   The average 50-59 person only has $174,100 in their 401k, and a 5% return only yields $8,705 per year.  Even combined with Social Security, the average person will only have ~$25,000 per year to live on.   Meaning that many retirees will likely be working until they die of old age because they simply *cannot* afford to retire.

And on a larger scale, the “savings glut” is hindering the Federal Reserve’s ability to fight a recession.   As mentioned earlier, when a recession strikes, the Fed has normally lowered rates by ~5%.   This makes borrowing cheaper, which encourages investors to borrow and spend on homes, factories, infrastructure, and other things which help put people back to work and rev the economy back up.     But with rates that will likely hover below 2% within a few weeks, the Fed simply *can’t* stimulate the economy as much as it used to.  Once a recession hits, the end result is likely to be more poor and middle-class people unemployed for longer periods of time.

The flip side of the wealthy’s “savings glut” is an “income deficit” for the poor and middle-class.  For several decades starting in the late 1940’s, whenever worker productivity increased, their incomes increased proportionately, which helped inequality relatively low and led to a strong and growing middle class.  Starting in the mid-1970’s, that relationship broke down.   Money that had previously been shared with workers increasingly started to be horded by the owners of the companies instead.   Consequently, for many workers their incomes either haven’t grown in real terms in decades, or have actually fallen. 

America has previously experienced eras of “creative destruction” from automation that have eliminated entire job sectors.   You’ll notice there’s no longer a huge horse and buggy industry, as those jobs were destroyed when the automobile was invented.  The current problem with automation is two-fold:   The rate of automation is increasing so that jobs are being destroyed faster than new ones can be created, and the rewards for automating are accruing to an ever-shrinking portion of wealthy Americans.   So automation is hastening an already painful increase in inequality.

There are two ways of tackling the “savings glut” at the heart of inequality:  From the “demand side”, by using deficit spending to “create” new investments, or from the “supply side”, by taxing the wealthy so they have less to save, and distributing it to the poor/middle class to counteract their “income deficit”.

The deficit spending required by the “demand side” has a huge downside. Except for a brief period during Bill Clinton’s presidency, the federal debt has increased unabated since shortly after World War 2. But someone, someday will eventually have to pay that debt. And there are growing signs that it will be *this generation*. This is no longer our grandchildren’s problem.  It is our grandchildren’s grandparent’s problem.

There are three ways to pay for deficit spending: by raising taxes on the wealthy, by cutting services (mostly used by the poor/middle class), or by debasing the dollar via inflation (which mostly hurts wealthy lenders).  As no politician is likely to get elected on the promise of raising taxes or cutting services, seeing the dollar debased is the most likely outcome.

By contrast, increasing taxes on the wealthy has fewer negative side-effects. Not only does it eliminate the savings glut, we can use those taxes to pay the debt, pay for infrastructure, pay for healthcare and education, and cut taxes on the poor/middle class to reduce the income deficit.  And their increased income would likely yield a roaring economy.

As our country is run by the wealthy, for the wealthy, our elected officials have only tried deficit spending over the past 4+ decades.  And all most of us have gotten from it is more debt, more inequality, and a more unstable economy.   Inequality will keep us caught in a cycle of worse-than-usual recessions and weaker-than-usual recoveries until such time as we get serious about fixing it.

The yield curve inverting is one of the most reliable indicators that a recession is looming in the not-too-distant future. And last Friday, the 10 yr/3 mo yield curve (considered the most accurate) inverted for the first time since January 2006.

Right on cue, the “This Time Is Different!” people started crawling out of the woodwork in every financial news outlet to tell us why the economy is booming, everything is hunky-dory, and an financial indicator with a near-flawless track record is wrong this time.

Most conspiracy theories are mere paranoid delusion, whether it’s “They actually filmed the moon landing on a set in Hollywood” to “9/11 truthers saying jet fuel isn’t hot enough to burn steel”. But occasionally there is a real one. And I suspect that many “This Time Is Different!” articles are published to keep stock market prices propped up long enough for the wealthy to unload their shares on a “greater fool” before the market crashes.

The stock market is mostly owned by the wealthy (84% of the entire stock market is owned by the wealthiest 10%). They know that if they want to sell their stock, they have to convince someone else to buy it. To twist Warren Buffett’s phrase, they need to convice others to be greedy when they should be fearful. And I believe one of the avenues for that is planting “good times lie ahead!” stories in the financial news at the end of the business cycle.

Talking heads will correctly point out that when the bond market inverts, it’s usually 12-24 months before a recession happens. As an investor, I don’t care when a recession officially starts. I care about “when will stock market prices start tanking”, because stock prices usually start falling months before a recession is officially called. The start of the Great Recession was officially December 2007, though the stock market started sliding downhill in July 2007. Similarly for other recessions as well.

Forecasting the stock market is like forecasting the weather. You can see humidity, warm air, sunshine, wind shear several days in advance, but you have no idea if it’s going to mix just right to spawn tornadoes, or merely cause grey skies. Likewise, when I see Brexit, trade wars with Europe and China, Europe and China’s economies slowing down even before the trade war, bad fiscal decisions by Congress, companies starting to downsize and close locations, I can’t tell you whether economic storms lie ahead, or merely grey skies. But I can tell you I’m going to have my umbrella handy, just in case…

Since I’m a big believer in putting my money where my mouth is, I will disclose that I sold 60% of my stocks back in September 2018 and bought bonds (right before the market fell, which was luck on my part). I sold another 20% back in early March. And I will likely sell the last 20% by April, before “Sell in May, go away” season arrives.

I am leaving money on the table by doing this. But the first rule of making money is “don’t lose money”. The second rule is “the reward you earn should be proportional to the risks you bear”.

I have outlined the risks I’m aware of above. The reward? Judging by Tobin’s Q and CAPE, the stock market is already highly overvalued. And while the stock market can continue to climb even when overvalued, the stock market loses predictability when its price is based on optimism instead of fundamentals, and can revert to the mean quickly and viciously. So the potential risks are high, while the potential reward is probably low.

Let’s check back here in a year to see if I’m right or Chicken Little…