Trying to Explain Nassim Taleb’s Views on the Economy and Markets

Nassim Taleb just had an interview on Bloomberg discussing the latest topics in finance:

1 nassim Taleb

Modern Monetary Policy – Monetary Policy 3

Trade wars

Budged deficits

Market risk

How to invest

It is a great interview but as often with such interviews, things are not explained in depth. I’ll try to add facts to Taleb’s thinking and you will see how that affects your investing!

The biggest risk for Taleb – Deficits and no skin in the game

Let’s start with deficits, from the Wall Street Journal:

2 budged deficit

In an environment with full employment, thus with the economy doing great, budged deficits are increasing!

3 unemployment

Unemployment rate US, Source: FRED

With a strong economy, the logical thing should be to have budget surpluses so that when a recession or slowdown eventually comes, you have the room to increase government spending. If you check below, during the late 1990s, the budget had surpluses but it seems now most politicians think that debt is something not to worry about now.

4 budged deficitis

Source: FRED

Accumulating deficits mean higher government debt. Total public debt in the US had doubled in the last 10 years, DOUBLED.

5 public debt

Source: FRED

Higher debt, leads to higher interest payments. Despite historically low interest rates on government lending, interest payments have skyrocketed due to the large amount of debt.

6 interest payments

Source: FRED

The US government has to pay $550 billion in interest per year, and to do that, it simply borrows more as the deficits are now at almost $800 billion and expected to hit $1 trillion soon.

7 budget deficit

Source: FRED

Such a situation is unsustainable and for Taleb, and probably for every other rational being, a huge risk that is piling up and will at some point in time blow up. If you borrow just to pay interest on your debt, you are close to a Ponzi scheme and we know how those things usually end up.

In the next recession, budget deficits will explode that will probably increase the borrowing rate and create a spiral of trouble as raising rates will cripple debt servicing. To solve such issues, government tend to print more money and you soon have hyperinflation.

Further, if you increase interest rates, the cost of debt for the government exacerbates. So, a normal option to cool the economy is something the FED can’t use at this point in time.

9 treasury

Source: FRED

A longer term increase in rates where the US borrowing cost go to 5%, where those were in 2007, would double interest payments on the debt, further increasing budget deficits.

The main problem for Taleb is that those who make decisions, like politicians have no skin in the game. What harm will Trump have from current budget deficits if those create havoc in 2029? The main problem for Taleb is that there is no accountability in the current capitalistic system.

The plausible solution to the above problems creates another huge risk.

Taleb on Modern Monetary Policy – Monetary Policy 3

We recently discussed Ray Dalio’s views on the plausible next monetary policy moves that involve helicopter money and a coordination between government spending and money printing. Taleb is against such things because of the risks that pile up where the main risk is hyperinflation.

Even if inflation has been really low over the past years and contained between 1.5% and 2.5%, Taleb mentions how inflation doesn’t work linearly and how just because it hasn’t materialized, it doesn’t mean the risk isn’t there.

8 inflation

Source: FRED

At some point inflation will ramp up, that will make things not manageable; think of Venezuela, Argentina, Zimbabwe. Taleb really agrees with Charlie Munger on this issue.

Don’t own equities

On market risk, Taleb discusses how people should not even own equities and should focus on their jobs as source of income and invest only for capital protection. He says that if you must hold equities, you have to do that and be hedged in a proper way against long tail risks. The problem is that few know how to do that, i.e. buying some puts is not the strategy because of the large cost attached to it.

But, he is clear that what is going on will at some point crash and that we should be ready for it. He also says that if there is a crisis, he will be the first to buy.

How to invest

On how to invest, he advises to avoid the middle, thus the zone where most people invest chasing income and yield and how you should invest in a barbell way where you hold most of your money in safe, wealth protective assets where he excludes equity and especially bonds.

10 barbel investing

Source: Seekingalpha

He mentions how public pensions funds need to hedge properly because if not those are doomed as they promise 7% returns and a crash would require them to reach much higher returns in the long term.

His message is that if you don’t know how to hedge for tail risk protection, you should not hold equities.

He owns some gold, land, some other financial instruments(derivatives) and avoids stocks, long term bonds – hold short term. Tail risk hedging if you know how to do it.

Morale of the story, risks are piling in the form of higher debts, hyperinflation is the probable solution and one should be hedged against tail risks. More about what are tail risks and how to possibly hedge, if we can do that in future videos.

Trade Wars

Oh, on the hot topic, I almost forgot, Taleb says how he loves to chat about things that took him 20 years of thinking to get to have something to say, so he really has nothing to say on trade wars, next year there will be something else people will chit chat about.

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ARE THE STOCK MARKET AND ECONOMY IN A BUBBLE? 7 FACTOR EXPLANATION

I recently summarized Dalio’s last book, Big DEBT CRISES and there he shares his questions, check list, to see whether the stock market or economy is in a bubble or not. In today’s article, in light of the FED’s tightening, we are going to go through his questions, to see whether we are in a bubble or not.

1 bubble questions

Source: Big Debt Crises

Good day fellow investors,

my name is Sven Carlin and I am an independent investor, independent thinker who doesn’t really like to follow the crowd, that has served me well in my life and, I have the feeling it will serve me well in the future too. Let’s go through Dalio’s questions one by one and then conclude with what to do, where Dalio’s option is to have an all-weather portfolio.

We are going to look at whether the US economy and stock market are in a bubble. As for Europe, I’ll make a special article about it due to the many economies.

  1. PRICES ARE HIGH RELATIVE TO TRADITIONAL MEASURES

The US stock market is expensive and prices are much higher than traditional measures.

2 stock market price

Source: Multpl

A look at the cyclically adjusted price to earnings ratio for the S&P 500 that takes into account 10 years of earnings, shows how stock prices were higher only during the dot-com bubble. But, let’s not focus only on stocks, let’s look at housing.

3 house price to income ratio

Source: Longtermtrends

The home price to income ratio is not higher than it was in 2007 but is getting close to it and it is much higher than it was in the past 50 years. Incomes were low in the 1950s so that isn’t really comparable.

To answer question one: yes, prices are high relative to historical measures.

2. PRICES ARE DISCOUNTING FUTURE RAPID PRICE APPRECIATION FROM THESE HIGH LEVELS

If we take a look at the S&P 500 and at S&P 500 forward expected earnings, all we can see is fast growth.

4 price and earnings

Source: FACTSET

So, huge growth is expected, S&P 500 actual earnings are at 116 points while the market expects them to be at 175 points in the next 12 months.

5 s&p 500 actual earnings

Source: Multpl

As for home prices, the huge run up in prices up to 2018 showed bubble characteristics but it has been cooling of as interest rates go up.

6 new home prices in the us

Source: FRED

So, perhaps what we have seen up to December of 2017 will again be called a bubble as higher interest rates inevitably put pressure on asset prices. Not yet on stocks as the sentiment is still strong but you can’t escape when it comes to housing.

ANSWER: YES, prices are discounting fast future price appreciation, certainly in stocks, whereas it might be over for housing.

3. THERE IS BROAD BULLISH SENTIMENT

Let’s see, Kudlow states the US economy is crushing it.

7 kudlow

Source: CNBC

While consumer confidence is close to record highs.

8 consumer confidence

Source: FRED

Answer: YES, sentiment is bullish! Even with stocks, the sentiment has been extremely greedy in 2018.

9 greed

Source: CNN

4. PURCHASES ARE BEING FINANCED BY HIGH LEVERAGE

This is not in a bubble, consumer credit is just 50% higher than where it was in 2008 and is just 10 times higher than where it was in 1980. (allow for some irony here)

10 consumer credit

Source: FRED

As for the stock market, margin debt is at historical highs. Just to mention as a comparative note, margin debt was $263 billion in February of 2010 and $314 billion in July of 2008.

11 margin debt

Source: FINRA

Answer: YES, purchases are increasingly being financed by debt.

5. BUYERS HAVE MADE EXTENDED FORWARD PURCHASES

If we look at the level of business inventories, those are 33% higher than in 2008 and I don’t think the economy grew 33% since 2008.

12 inventories

Source: FRED

Answer: a mild yes in this case.

6. NEW BUYERS HAVE ENTERED THE MARKET

Now, the percentage of Americans owning stocks didn’t really go up that much lately as millennials don’t invest that much in stocks.

13 people invested

Source: Gallup

The middle class left after 2008, typical behaviour, buying high and selling low. If we see another bump like in 2007 where the participation jumped from 61% to 65%, we will know it’s a bubble. Those aged 35 and above are investing a bit but not yet like it had been the case.

14 americans invested

Source: Gallup

However, not investing in stocks but definitely saving for a house. New buyers are rushing into the home market.

15 new mortgages

Source: Bloomberg

Answer: with stocks it is a no but with houses it is a yes. Also, it is important to note the widening wealth gap where those that have invest more and push stocks higher while those that don’t have, simply don’t have to invest.

7. STIMULATIVE MONETARY POLICY THREATENS TO INFLATE THE BUBBLE EVEN MORE (and tight policy to cause its popping)

Interest rates have been already tightening and we can expect more in December.

16 interest rate

Source: FRED

However, just take a look at historical interest rates.

17 historical interest rates

Source: FRED

On top of monetary stimulus, there is huge fiscal stimulus.

18 budged deficit

Source: FRED

On top of the already huge deficit, the deficit is expected to breach $1 trillion in 2019.

So, to summarize on the questions:

19 summary

WHAT TO DO:

Now, that depends on where you are in your life, about to retire or just starting, but in any case, an all-weather portfolio is the key as we are in the late part of the cycle.

debt dalio

Source: Big Debt Crises

We are at bubble top – so a lot of opportunities to diversify by selling what is in a bubble and buying what is in depression. In a global world you can do that today.

If you wish to check how am I building my portfolio as I cashed out of most my long investments during 2015-to 2018, the last being Nevsun – you might want to check my Stock market research platform where I am slowly building my model portfolio that should do very well in this environment.

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