5. It encourages war.

6. It destabilizes the economy.

7. It is an instrument of totalitarianism”

Like I said, no punches pulled and, undoubtedly, some were definitely below-the-belt.  If, like me, you’ve never read the book, apparently a major part of his ire about the Fed was how it was launched in secrecy by seven rich men, or representatives thereof (such as J.P. Morgan and John D. Rockefeller). Directly or indirectly, they allegedly controlled one-quarter of the world’s then-existent wealth.  This supposed cabal gathered on the QT (not to be confused with QE or its polar opposite, QT, Quantitative Tightening) at an island in Georgia by the same name, a vacation playground of some of America’s wealthiest families.

“GAAP accounting, which S&P 500 companies use, allows for a stock option to be granted and then expensed over time using the value of the option at time of the grant. NIPA accounting only expenses the option once it has been exercised, usually at a much later date and with a much higher expense.

The ‘large discrepancies’ between corporate profits and S&P 500 profits then can probably be explained, in part, as a product of the difference in using tax accounting and using GAAP accounting for stock options. Tax accounting has resulted in a much larger expense than GAAP accounting in recent years simply because the value of the options have grown a great deal along with stock prices over time.

In short, it seems that the boost in earnings over the past few years in S&P 500 profits could be, to a large degree, merely a product of the bull market rather than the other way around. Investors have crowded into a smaller number of firms that have inordinately benefitted during the current cycle and, in part, due to this crowding, these same firms have been able to report even greater profits by way of a quirk in stock option accounting.

The question investors should now be asking is this: ‘Is this recent earnings trend sustainable or is it merely the product of an equity bubble?’ As the 2000 experience shows, it’s more likely to be the latter.”

RE:  Graphic examples of imprudent share buybacks that led to emergency sales at depressed prices to prevent a solvency crisis (and a questionable move involving Boeing’s retirement plan):

For all of you who are based in the Pacific Northwest, our local aerospace juggernaut, Boeing, is another case study in mismanaging buybacks. Fortune Magazine, certainly no foe of big business, pointed out in an article in early 2020 that, since 2013, Boeing splurged to the tune of $43 billion on repurchases (paying as high as $385 for a stock that would sink to $95 in the spring of 2020).  This was in contrast to just $15.7 billion it spent on research and development (R&D) for its commercial aircraft division.

The Fortune article asserted part of the blame for the 737 Max fiasco – which had already cost the firm $9 billion, a tab that is almost certain to rise much higher – was due to the diversion of resources to buybacks.  (Since those words appeared in our 2/14/2020 EVA, the tab has doubled and continues to climb.) Boeing compounded its previous errors by borrowing money to pay dividends at the same time it was reducing R&D spending. 

More egregiously yet, to alleviate its extreme cash crunch caused by the Covid convulsions, it did the following in the company’s own words: “In the fourth quarter of 2020, we contributed $3 billion of our common stock to our pension fund. In the fourth quarter of 2020, we also began using our common stock in lieu of cash to fund Company contributions to our 401(k) plans for the foreseeable future, which we estimate will conserve approximately $1 billion of cash over the next 12 months. Under this approach, common stock is contributed to our 401(k) plans each pay period. We expect this measure to further enable the Company to conserve cash. We have retained an independent fiduciary to manage and liquidate stock contributed to these plans at its discretion.”

In my opinion, such activities should be illegal.  Boeing is almost certain to be a survivor but imagine the hit to plan participants had it failed, as many once blue-chip companies have in past decades (Kodak, Polaroid, Sears, K-Mart, Enron, WorldCom, Lucent, to name a few). 

Airlines, of course, were in even worse shape than Boeing, which had a highly profitable defense division to help it stay aloft, as travel came to a virtual standstill and their revenue crashed to a previously unseen degree.  The entire industry was spewing red ink at a rate that made the Great Recession look like boomtimes.  American Airlines, for example, lost roughly $10 billion or around $20 per share.  To stay in business, it sold 200 million shares for $  billion at the yard-sale price of $  . This almost precisely reversed the shares it had bought back since 2015 at prices as high as $50 per share.  In other words, it caused massive value destruction for shareholders. 

RE:  Sen. Marco Rubio’s harsh words about buybacks:

“The justification for corporate buybacks is a company has no better investment available. This may be true for any company from time to time. But what does it say when it is true for many companies year after year? Since 1980 (there has been) a trend of corporate profits flowing back into financial markets and less of these profits invested in increasing productivity through innovation, technology, equipment, etc.

The result is not enough increase in productivity, growth, or widespread prosperity. The argument buybacks are good because (they free up) money to reinvest in other businesses growth isn’t backed up by the facts. Over the last 40 years money back to shareholders has tripled as a percentage of GDP but investment into businesses has dropped by 20%.

Right now, (we) don’t have a ‘free market’. We have a tax code which engineers the economy in favor of inflating prices of shares at the expense of future productivity and job creation.”

The following are widely used but also frequently come up with wildly different conclusions on whether stocks are cheap or dear…or something in between: 

Ø  Median price-to-sales ratio

Ø  Total stock market value vs GDP (adjusted for overseas sales)

Ø  Enterprise value (equity market capitalization plus debt) compared to gross cash flow (EBITDA)

Ø  The earnings yield relative to interest rates, or

Ø  The P/E ratio based on next year’s (hoped for) earnings; i.e., the forward P/E

RE:  The Swedish housing crash and banking crisis of the early 1990s, a disaster that it managed to repeat a generation later, this time with considerable company, including the U.S.

This normally staid country, outside of its coed sauna culture, was nearly bankrupted by a massive housing boom-cum-bust in the early 1990s. This crash was so severe that it caused the Swedish government to nationalize all of its banks, at a GDP cost of about 4%. In the process, it guaranteed and protected all deposits in return for complete ownership of its banking system. In a sneak preview of what happened in the U.S. with the Troubled Asset Relief Program (TARP) in 2008, Sweden’s policymakers took equity positions in their banks; eventually, it sold these stakes for an amount that repaid half of its outlays.  (During the frantic panic of 2008 and 2009, one of the wildest predictions I made was that the very unpopular TARP would turn out be a windfall for U.S. taxpayers.  This view was ultimately vindicated as the U.S. treasury eventually sold off the equity it received in banks like Citigroup for tens of billions of profits – back when that seemed like serious money.)

Yet, less than twenty years later, Sweden was right back in full-blown bubble mode again (showing that the Swedes are adept at more than just blowing glass). Of course, during the first decade of this century/millennium, it wasn’t only Sweden that had a monstrous mania in housing.  Iceland, Ireland, Portugal and Spain were all fully caught up in the hysteria.  The subsequent implosion nearly brought down these countries and triggered horrific suffering for their citizens.  During the worst of the housing crash induced Great Recession, Spain’s unemployment hit 30% – far worse than the 20% rate seen in America during the depression-wracked 1930s.

The experience of the Yellow Vest protests in France (referring to the color of the vest protestors wore), are instructive in this regard.  France is a generally left-leaning country.  Despite that, a proposed fuel surtax in November 2018 to fund a renewable energy transition triggered such widespread civil unrest that French president Emmanuelle Macron rescinded it the following month.

RE: Possible Russian involvement with Europe’s Green Energy movement.

It may surprise you that NATO has accused Russian intelligence of avidly supporting the anti-fracking movements in Western Europe which has made it reliant on Russian gas shipments.  The European Union’s domestic natural gas production has been in a rapid decline phase for years.  This is in graphic contrast to the shale output boom in the U.S. that has not only made us natural gas self-sufficient but also an export powerhouse of liquified natural gas (LNG).

This refers to its first-ever effort to both raise interest rates and shrink the size of its balance sheet.  As a reminder, when the Fed creates money to buy government bonds using funds it simply generates from its computers, this expands its balance sheet.  As noted several times earlier, this is what is known popularly as quantitative easing even though the Fed prefers the term “large scale asset purchases”.  Either way, these are effectively interest rate reductions, typically done once the fed funds rate has been lowered close to zero.  Reversing this process, by selling off its bond holdings, or merely allowing them to mature without reinvesting the proceeds, represents de facto rate increases.  Therefore, hiking rates at the same time it is allowing its balance sheet to shrink is truly a double-tightening event.

Even including dividends during these years of sideways price performance, the so-called total return of the Dow was 36.4% from 1966 to 1973.  However, inflation averaged 4.25% per year during this period; thus, the after-inflation return, inclusive of dividends, was a meager 0.4% annually.  The S&P 500 fared better with a real dividend plus price appreciation rate of 21% or 2.75% per year in real terms. (Interestingly, the 4.23% average inflation rate from 1966 to early 1972 occurred while the U.S. was still on the gold standard almost the entire time.)  As noted in Chapter 5, the next two years were catastrophic.  Even after multiple rallies off of the 1974 low, which created one of the most undervalued stock markets ever, the Dow essentially flatlined from 1966 to 1982 on a price-only basis.

Money velocity is the value added by the economy per year in nominal terms — GDP including inflation, or nominal GDP — divided by the money supply.  When there is a lot of money being created and the economy expands sluggishly, as was the case for most of the post-financial crisis era, money velocity falls.  Essentially, it is the rate that money circulates.  However, it is fair to say it is a “dependent variable”. Based on the trillions of dollars the Fed has created since the virus crisis, and are still in the system, should velocity accelerate, inflation will become an even bigger problem.  There is evidence this was happening in early 2022.

RE:  The government’s equity kicker via the TARP

As was done with the Chrysler bail-out of the early 1980s, the federal government received warrants on their common stock from the banks and insurance companies it was rescuing from collapse.  These were essentially long-term call options, giving the Treasury the right to purchase shares at an exceedingly low “strike” or exercise price.  If, for example, Bank XYZ was trading at $10 (likely down from $50 months earlier due to the panic), the government had the option to acquire shares at that price on a multi-year basis.  Once the crisis had passed, a powerful rally in financial stocks ensued, providing the federal government with immense windfall profits. 

RE:  Maestro Alan Greenspan’s fall from grace

Mr. Greenspan had ruled the Fed from right before the Crash of 1987 until 2006; not coincidentally, nearly all of the Great Moderation’s lifecycle.  Almost fortunately for his reputation, the Maestro had the good sense to retire the year before the wheels came off the sub-prime mortgage market which would prove to be the death-knell of the Great Moderation.  “Almost” because it wasn’t early enough to avoid a guilt-by-association reaction from both the media and Congress that would forever tarnish his once impeccable legacy.

While Richard Nixon is broadly blamed for the elimination of the convertibility of U.S. dollars into gold it was, in reality, a privilege only enjoyed by foreign central banks. (It had been illegal for American citizens to hold gold since the 1930s due to legislation passed by the Roosevelt Administration.) These overseas institutions had the ability to convert their trade surpluses, if they had them, from U.S. dollars into gold.  As the U.S. ran an overheated economy in the mid- to late-1960s, due to the “guns and butter” policies of Lyndon Johnson, America’s trade deficits soared relative to other countries.  It became clear there wasn’t enough gold in Fort Knox, and other repositories, to satisfy its trading partners should enough of them demand actual bullion.  France was the country that called America’s bluff, forcing Nixon either to endure a politically painful recession — that would have been caused by the necessary high interest rates to defend the dollar — or close the gold window.  Like almost all politicians, especially these days, he took the politically expedient route, one that would lead to a persistent and dramatic 50-year loss of the dollar’s purchasing power.

In plain language, “tranching” meant that a given pool of dodgy mortgages was sliced into pieces from the most- to the least-protected. It also followed that once the inevitable defaults began to roll in during the next recession, the lowest-rated tranches would take the first hits. Considering the increasingly toxic credit characteristics of mortgage lending during that era — “Liars” and “Ninja” (No Income, no job, no assets… no problem) loans, and negative amortization mortgages, plus the very widespread use of ARMs — it didn’t take a financial wizard to realize it wouldn’t require much of an economic downturn to totally nuke the riskiest tranches.  This is precisely what happened.   

Re: the Fed’s missed chance to stabilize financial markets, a lesson it learned and applied in 2020

The Fed’s response to the pandemic panic would move this from the counter-factual to the proven.  In late March of 2020, during the worst of the Covid-driven market collapse, the Fed announced it would buy corporate bonds, including those with a junk rating.  Befitting its new operating style, it would do it with funds it just willed into existence.  This immediately put a bottom in for the stock and corporate bond markets, triggering one of the fastest and most powerful rallies ever seen. As discussed in Chapter 5, this validated one of my most controversial predictions.

RE:  the housing bubble, aka, Bubble 2.0

What’s remarkable about this entire debacle, and there is a plethora of remarkable aspects to it, was that it had happened not that many years before in some of the same countries that were doomed to repeat the tragedy.  Let’s use Sweden an example.

This normally staid country was nearly bankrupted by a massive housing boom-cum-bust in the early 1990s. This housing crash was so severe that it caused the Swedish government to nationalize all its banks, at a GDP cost of about 4%. In the process, it guaranteed and protected all deposits in return for complete ownership of its banking system. In a sneak preview of what happened in the U.S. with the Troubled Asset Relief Program (TARP) in 2008, Sweden’s policymakers took equity positions in their banks; eventually, it sold these stakes for an amount that repaid half of its outlays.  (During the worst of panic of 2008 and 2009, one of the wildest predictions I made was that the very unpopular TARP would turn out be a windfall for U.S. taxpayers.  This view was ultimately vindicated as the treasury eventually sold off the equity it received in banks like Citigroup for tens of billions of profits, back when that seemed like serious money.)

Yet, fewer than twenty years later, Sweden was right back in full-blown bubble mode again, showing that the Swedes are adept at more than just blowing glass. Of course, during the first decade of this century/millennium, it wasn’t only Sweden that had a monstrous mania in housing.  Iceland, Ireland, Portugal and Spain were all fully caught up in the hysteria.  The subsequent implosion nearly brought down these countries and triggered horrific suffering for their citizens.  During the worst of the housing-crash-induced Great Recession, Spain’s unemployment hit 30%--far worse than the 20% rate seen in America during the Depression-wracked 1930s.

RE: my billion-dollar whiff. 

It is with great embarrassment that I will now relay a story that has become the stuff of legends in my family. In November of 1995, one of my close friends at the time called me about investing in an internet start-up. Over the years prior to this, I had invested repeatedly side-by-side with this individual, typically on a no-questions-asked basis. We were, at that stage, virtual partners.

Right before Thanksgiving of that year, as I was rushing to get out of town with my young family for a ski trip, he called to tell me of a presentation by a 30-something tech innovator who had blown him away. When I asked what they did, he explained their uncomplicated business plan. Unlike with most tech companies I’d heard about, which were doing things I could only dimly understand, this one was so simple and obvious that I remarked: “But can’t anyone do that?”

After listening to him further, I took my criticism to the next level by invoking Warren Buffett: “Where’s their moat?”. In other words, I couldn’t figure out their competitive advantage. It seemed to me that their much larger and well-established competitors could easily replicate what they were attempting and rapidly drive them out of business. My friend agreed with me but at the end of our conversation, when I said that I would think about the deal on my trip, he ended with this: “I get your points, but the CEO is really, really smart.” He added that he was investing $50,000, a sizable sum back then to put into something as risky as this venture.

Now, my pal had heard a lot of pitches in his career, and he was the furthest thing from a pushover to a dreamer with a sexy story, so his words stuck with me… to this day. But between Thanksgiving and the usual year-end craziness of being a portfolio manager, plus all the upcoming Holiday activities, I forgot about our call for a month or two. In the new year, early 1996, I thought about it periodically and fleetingly, but figured that, given the astronomical odds they faced, they’d be coming back for more money, and probably at a lower offering price (known in the VC game as a “down-round”).

To say that I made a miscalculation is just a bit of an understatement. In May of 1996, my friend called me again asking me if I remembered our chat six months earlier. The sharp pain in my gut told me I knew what was coming—or so I thought. What he was about to tell me rendered my apprehension reaction a shadow of what it should have been…

The tiny company he’d invested in mere months earlier had already attracted a multi-million-dollar “up-round” (i.e., they paid a higher, not lower, price) from one of Silicon Valley’s most prestigious VC firms, Kleiner Perkins. But the worst news, at least for me, was coming: Wall Street was already interested in taking this entity public. Less than a year earlier it had been headquartered in the garage of a 1950s-era house in a Seattle suburb, just a few blocks from where I lived. Now it was poised to realize the oft-dreamed of, and rarely attained, mega-payday (at least for early-stage investors) of an IPO.

As you know from the in-chapter mention, the Seattle-based internet star I’m referring to is the one that, when it comes to its increasingly besieged competitors, plays by jungle rules... as in Amazon jungle rules. Yes, I whiffed on the chance to be a first-round investor in mighty AMZN. It was no big deal; it only cost me about a billion… actually, more like several billions.