“We Can’t Welcome All The World’s Poor” – Macron Unveils Crackdown On Criminal Illegal Aliens

Two years after the European Commission carried out the bidding of German Chancellor Angela Merkel by approving a plan to distribute migrants entering the Schengen area through Greece and Italy evenly across the European Union, the people of Europe have made their displeasure with Merkel’s “open door” policy abundantly clear.

Last month, Merkel’s Christian Democratic Union suffered its most embarrassing showing in a federal election in decades, allowing a far-right, anti-immigrant party into parliament for the first time since World War II. The Alternative for Germany party’s unexpectedly strong showing fractured the ruling coalition spearheaded by Merkel’s conservatives as her partners, the Social Democrats opted to rebuild in opposition, complicating Merkel’s attempts to form a ruling coalition.

In what was widely celebrated by the right as an important public capitulation, Merkel announced that her government would consider implementing a refugee cap of 200,000 (far larger than the cap adopted by the Trump administration). While it’s unclear whether the cap will ultimately become law, the fact that Merkel has publicly acknowledged the failure of open doors was interpreted as a sea change in Europe’s response to the worsening migrant crisis.

And now, French President Emmanuel Macron - Merkel’s de facto partner in leading the European project - has himself made a small but important concession to the growing anti-immigrant sentiment in France, which, like many of its neighbors in western Europe, has suffered a horrific string of terror attacks inspired or actively organized by the Islamic State, the South China Morning Post reported.

In a wide ranging interview this week, Macron revealed a new policy whereby illegal immigrants who commit crimes in France will face deportation. Presently, being an illegal immigrant in France isn’t a criminal offense.

Even without new legislation “we can take tougher measures” and expel illegal immigrants if they commit a crime, “whatever it may be,” Macron said.

Shortly before the policy change, a Tunisian man stabbed two women to death in the southern city of Marseille. The man had been arrested two days earlier for shoplifting in eastern Lyon, stoking speculation that it could’ve been prevented.

Ahmed Hanachi, a 29-year-old whose papers were not in order, had been allowed to walk free the day before he attacked the women. Hanachi was known to the police for drug as well as alcohol problems and had a history of petty crime, using seven aliases.

“We are not taking all the steps that should be taken. Well, that’s going to change,” Macron told three journalists who interviewed him for more than an hour at the Elysee Palace.

Macron, who at 39 became the youngest person ever to win the French presidency following after defeating far-right National Front candidate Marine Le Pen in a runoff vote. While Macron ultimately came away with a win, the National Front’s surprisingly strong showing has forced Macron’s centrist government to rethink its stance on immigration and the refugee crisis.

The French president repeated his call for a crackdown on criminal illegal immigrants during a speech to federal police later in the week where he also announced a federal increase in domestic security funding to help combat terrorism, according to France 24.

"We don’t welcome people well, our procedures are too long, we don’t integrate people properly and neither do we send enough people back," he said, while repeating former prime minister Michel Rocard’s axiom that: "We should take our fair share, but we can’t just welcome in all the world’s poor people.”

Notably, Macron’s crackdown on crime comes as his approval rating has slid from 60%  in June to 44% this month, according to polling by Ifop/Fiducial.

Terror attacks have plagued western Europe in recent years as millions of migrants from Africa, Syria, Afghanistan and elsewhere poured across the borders of southern European states like Italy and Greece. The crisis has led to a political divide between western and eastern Europe, as EU members like Poland, Hungary and the Czech Republic have refused Europe’s demands to take in migrants. While we wouldn’t want to confuse correlation with causation, there are several notable gaps in this map of terror attacks since the beginning of the refugee crisis…

...see if you can spot them.

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In The Shadows Of Black Monday – “Volatility Isn’t Broken… The Market Is”

Authored by Christopher Cole via Artemis Capital Management,

A full version of the article is available on the Artemis website.

Volatility and the Alchemy of Risk

The Ouroboros, a Greek word meaning ‘tail devourer’, is the ancient symbol of a snake consuming its own body in perfect symmetry. The imagery of the Ouroboros evokes the infinite nature of creation from destruction. The sign appears across cultures and is an important icon in the esoteric tradition of Alchemy. Egyptian mystics first derived the symbol from a realphenomenon in nature. In extreme heat a snake,unable to self-regulateitsbody temperature,will experience an out-of-control spike in its metabolism. In a state of mania, the snake is unable to differentiate its own tail from its prey,and will attack itself, self-cannibalizing until it perishes. In nature and markets, when randomness self-organizes into too perfect symmetry, order becomes the source of chaos.

The Ouroboros is a metaphor for the financial alchemy driving the modern Bear Market in Fear. Volatility across asset classes is at multi-generational lows. A dangerous feedback loop now exists between ultra-low interest rates, debt expansion, asset volatility, and financial engineering that allocates risk based on that volatility. In this self-reflexive loop volatility can reinforce itself both lower and higher. In a market where stocks and bonds are both overvalued, financial alchemy is the only way to feed our global hunger for yield, until it kills the very system it is nourishing.

The Global Short Volatility trade now represents an estimated $2+ trillion in financial engineering strategies that simultaneously exert influence over, and are influenced by, stock market volatility. We broadly define the short volatility trade as any financial strategy that relies on the assumption of market stability to generate returns, while using volatility itself as an input for risk taking. Many popular institutional investment strategies, even if they are not explicitly shorting derivatives, generate excess returns from the same implicit risk factors as a portfolio of short optionality, and contain hidden fragility.  

Volatility is now an input for risk taking and the source of excess returns in the absence of value. Lower volatility is feeding into even lower volatility, in a self-perpetuating cycle, pushing variance to the zero bound. To the uninitiated this appears to be a magical formula to transmute ether into gold… volatility into riches… however financial alchemy is deceptive. Like a snake blind to the fact it is devouring its own body, the same factors that appear stabilizing can reverse into chaos. The danger is that the multi-trillion-dollar short volatility trade, in all its forms, will contribute to a violent feedback loop of higher volatility resulting in a hyper-crash. At that point the snake will die and there is no theoretical limit to how high volatility could go.

Thirty years ago to the day we experienced that moment. On October 19th, 1987 markets around the world crashed at record speed, including a -20% loss in the S&P 500 Index, and a spike to over 150% in volatility. Many forget that Black Monday occurred during a booming stock market, economic expansion, and rising interest rates. In retrospect, we blame portfolio insurance for creating a feedback loop that amplified losses. In this paper we will argue that rising inflation was the spark that ignited 1987 fire, while computer trading served as explosive nitroglycerin that amplified a normal fire into a cataclysmic conflagration. The multi-trillion-dollar short volatility trade, broadly defined in all its forms, can play a similar role today if inflation forces central banks to raise rates into any financial stress. Black Monday was the first modern crash driven by machine feedback loops, and it will not be the last.

A reflexivity demon is now stalking modern markets in the shadows of a false peace… and could emerge violently given a rise in interest rates. Non-linearity and feedback loops are difficult for the human mind to conceptualize and price. The markets are not correctly assessing the probability that volatility reaches new all-time lows in the short term (VIX<9), and new all-time highs in the long-term (VIX>80). Risk alone does not define consequences. A person can engage in highly risky behavior and survive, and alternatively a low risk activity can result in horrible outcomes. Those who defend and profit from the short volatility trade in its various forms ignore this fact.  Do not mistake outcomes for control… remember, There is no such thing as control… there are only probabilities.

The Great Snake of Risk

A short volatility risk derives small incremental gains on the assumption of stability in exchange for a substantial loss in the event of change. When volatility itself serves as a proxy to size this risk, stability reinforces itself until it becomes a source of instability. The investment ecosystem has effectively self-organized into one giant short volatility trade, a snake eating its own tail, nourishing itself from its own destruction. It may only take a rapid and unexpected increase in rates, or geopolitical shock, for the cycle to unwind violently. It is not wise to expect that central banks will save financial markets if inflation begins to rise.

At the head of the Great Snake of Risk is unprecedented monetary policy. Since 2009 Global Central Banks have pumped in $15 trillion in stimulus creating an imbalance in the investment demand for and supply of quality assets. Long term government bond yields are now the lowest levels in the history of human civilization dating back to 1285. As of this summer there was $9.5 trillion worth of negative yielding debt globally. Last month Austria issued a 100-year bond with a coupon of only 2.1%(6) that will lose close to half its value if interest rates rise 1% or more. The global demand for yield is now unmatched in human history. None of this makes sense outside a framework of financial repression. 

Amid this mania for investment, the stock market has begun self-cannibalizing… literally. Since 2009, US companies have spent a record $3.8 trillion on share buy-backs(7) financed by historic levels of debt issuance. Share buybacks are a form of financial alchemy that uses balance sheet leverage to reduce liquidity generating the illusion of growth. A shocking +40% of the earning-per-share growth and +30% of the stock market gains since 2009 are from share buy-backs. Absent this financial engineering we would already be in an earnings recession. Any strategy that systematically buys declines in markets is mathematically shorting volatility. To this effect, the trillions of dollars spent on share buybacks are equivalent to a giant short volatility position that enhances mean reversion. Every decline in markets is aggressively bought by the market itself, further lowing volatility. Stock price valuations are now at levels which in the past have preceded depressions including 1928, 1999, and 2007. The role of active investors is to find value, but when all asset classes are overvalued, the only way to survive is by using financial engineering to short volatility in some form.

Volatility as an asset class, both explicitly and implicitly, has been commoditized via financial engineering as an alternative form of yield. Most people think volatility is just about options, however many investment strategies create the profile of a short option via financial engineering. A long dated short option position receives an upfront yield for exposure to being short volatility, gamma, interest rates, and correlations. Many popular institutional investment strategies bear many, if not all, of these risks even if they are not explicitly shorting options. The short volatility trade, broadly defined in all its forms, includes up to $60 billion in strategies that are Explicitly short volatility by directly selling optionality, and a much larger $1.42 trillion of strategies that are Implicitly short volatility by replicating the exposures of a portfolio that is short optionality. Lower volatility begets lower volatility, rewarding strategies that systematically bet on market stability so they can make even bigger bets on that stability. Investors assume increasingly higher levels of risk betting on the status quo for yields that look attractive only in comparison to bad alternatives. The active investor that does his or her job by hedging risks underperforms the market. Responsible investors are driven out of business by reckless actors. In effect, the entire market converges to what professional option traders call a ‘naked short straddle’… a structure dangerously exposed to fragility.

Volatility is now at multi-generational lows...

Volatility is now the only undervalued asset class in the world. Equity and fixed income volatility are now at the lowest levels in financial history. The realized volatility of the S&P 500 Index collapsed to all-time lows in October 2017. The VIX index also touched new lows around the same time. Fixed income implied volatility fell to the lowest level in its 30year history this past summer. The forward variance swap on the S&P 500 index is now priced lower than the long-term average volatility of the market. In theory, volatility has nowhere to go but up, but lacks a catalyst given the easy credit conditions, low rates, and excess supply of investment capital.

Whenever volatility reaches a new low the financial media runs the same cliched story over and over with the following narrative 1) Volatility is low; 2) Investors are complacent; 3) Insert manager quote saying “this is the calm before the storm”. Low volatility does not predict higher volatility over shorter periods, in fact empirically the opposite has been true. Volatility tends to cluster in high and low regimes. 

Volatility isn’t broken, the market is...

...the real story of this market is not the level of volatility, but rather its highly unusual behavior. Volatility, both implied and realized, is mean reverting at the greatest level in the history of equity markets. Any short term jump in volatility mean reverts lower at unusual speed, as evidenced by volatility collapses after the June 2016 Brexit vote and November 2016 Trump US election victory. Volatility clustering month-to-month reached 90-year lows in the three years ending in 2015.

Implied volatility has also been usually reactive to the upside and downside. In 2017, the VIX index has been 3-4x more sensitive to movements in the market compared to the similar low-volatility regime of the mid-2000s and the mid-1990s (see red line in right chart).

What is causing this bizarre behavior? To find the truth we must challenge our perception of the problem... What we think we know about volatility is all wrong. Modern portfolio theory conceives volatility as an external measurement of the intrinsic risk of an asset. This highly flawed concept, widely taught in MBA and financial engineering programs, perceives volatility as an exogenous measurement of risk, ignoring its role as both a source of excess returns, and a direct influencer on risk itself. To this extent, portfolio theory evaluates volatility the same way a sports commentator sees hits, strikeouts, or shots on goal. Namely, a statistic measuring the past outcomes of a game to keep score, but existing externally from the game. The problem is volatility isn’t just keeping score, but is massively affecting the outcome of the game itself in real time. Volatility is now a player on the field. This critical mis-understanding of the role of volatility modern markets is a source of great self-reflexive risk. 

Today trillions of dollars in central bank stimulus, share buybacks, and systematic strategies are based on market volatility as a key decision metric for leverage. Central banks are now actively using volatility as an input for their decisions, and market algorithms are then self-organizing around the expectation of that input. The majority of active management strategies rely on some form of volatility for excess returns and to make leverage decisions. When volatility is no longer a measurement of risk, but rather the key input for risk taking, we enter a self-reflexive feedback loop. Low volatility reinforces lower volatility…  but any shock to the system will cause high volatility to reinforce higher volatility.

Self-Cannibalization of the Market via Share buybacks

The stock market is consuming itself…literally. Since 2009, US companies have spent over $3.8 trillion on what is effectively one giant leveraged short volatility position. Share buybacks in the current market have already surpassed previous highs reached before the 2008.

Rather than investing to increase earnings, managers simply issue debt at low rates to reduce the shares outstanding, artificially boosting earnings-per-share by increasing balance sheet risk, thereby increasing stock prices.

In 2015 and 2016 companies spent more than their entire annual operating earnings on share buybacks and dividends. Artemis isolated the impact of the share buyback phenomenon on earnings, asset prices, and valuations since 2009 and the numbers are staggering.

The later stages of the 2009-2017 bull market are a valuation illusion built on share buyback alchemy. Absent this accounting trick the S&P 500 index would already be in an earnings recession. Share buybacks have accounted for +40% of the total earning-per-share growth since 2009, and an astounding +72% of the earnings growth since 2012. Without share buybacks earnings-per-share would have grown just +7% since 2012, compared to +24%. Since 2009, an estimated +30% of the stock market gains are attributable to share buybacks. Without share buybacks the S&P 500 index would currently trade at an expensive 27x earnings. Not surprisingly, a recent study found a positive relationship between insider equity sales and share repurchases, supporting the idea that buybacks are more about managerial self-interest than shareholder value.

Share buybacks financed by debt issuance are a valuation magic trick. The technique optically reduces the price-to-earnings multiple (Market Value per Share/Earnings per Share) because the denominator doesn’t adjust for the reduced share count. The buyback phenomenon explains why the stock market can look fairly valued by the popular price-to-earnings ratio, while appearing dramatically overvalued by other metrics.  Valuation metrics less manipulated by share buybacks (EV/EBITDA, P/S, P/B, Cyclically Adjusted P/E) are at highs achieved before market crashes in 1928, 2000, and 2007. Buybacks also remove liquidity. Free float shares and trading volume in the S&P 500 index have collapsed to levels last seen in the late-1990s, despite stock prices more than doubling.

Share buybacks are a major contributor to the low volatility regime because a large price insensitive buyer is always ready to purchase the market on weakness.

The key periods are the two to three weeks during and after earnings announcements, when the SEC mandated share buyback blackout period officially ends. The largest equity drawdowns of the past few years (August 2015 and January-Feb 2016) both occurred during the share buyback blackout period. Both times the market rallied to make back all losses when the buyback restriction period expired. The S&P 500 index demonstrates an unusual multi-modal probability distribution during years with high buyback activity. The market flips between a positively or negatively skewed return distribution based on whether the regulatory share repurchase blackout period is in effect. In addition, 6 of the top 10 multi-day VIX declines in history, all 4+ sigma events, have occurred during heavy share buyback periods between 2015 and 2016. Share buybacks result in lower volatility, lower liquidity, which in turn incentivizes more share buybacks, further incentivizing passive and systematic strategies that are short volatility in all their forms. Like a snake eating its own tail, the market cannot rely on share buybacks indefinitely to nourish the illusion of growth. Rising corporate debt levels (see below) and higher interest rates are a catalyst for slowing down the $500-800 billion in annual share buybacks artificially supporting markets and suppressing volatility.

Global Short Volatility Trade

The short volatility trade is any strategy that derives small incremental gains on the assumption of stability in exchange for substantial loss in the event of change, whereby volatility is a critical input to the allocation of risk. Short volatility can be executed explicitly with options, or implicitly via financial engineering. To understand this concept, it is helpful to decompose the key risks. The investor holding a portfolio of hedged short options receives an upfront premium, or yield, in exchange for a non-linear risk profile to four key exposures 1) Rising Volatility; 2) Gamma or Jump Risk; 3) Rising Interest Rates; 4) Unstable Cross-Asset Correlations. Many institutional strategies derive excess returns by implicitly shorting those exact same risk factors despite never trading an option or VIX future.  As of 2017, there is an estimated $1.12 to 1.5 trillion USD(2) of active short volatility exposure in domestic equity markets.

In this paper we will focus on short volatility in US equity markets, however the short volatility trade, in all its forms, is widely practiced across all major asset classes. In world of ultra-low interest rates shorting volatility has become an alternative to fixed income. For the first time in history the yield earned on an explicit short volatility position is competitive with a wide array of sovereign and corporate debt (see below).

Explicit Short Volatility are strategies that literally sell options to generate yield from asset price stability or falling stock market variance. The category includes everything from popular short volatility exchange-traded-products to call and put writing programs employed by pension funds. Despite the headlines, this is the smallest portion of the short volatility trade. Explicit short volatility contains upward of only $60 billion in assets, including $45 billion in short volatility pension put and call writing strategies, $8 billion in short volatility overwriting funds, $2 billion in short volatility exchange traded products, and another $3 billion in speculative VIX shorts.  Explicit short volatility strategies are active in the short term, fading short and intermediate volatility spikes. Volatility spikes that mean revert quickly help the performance of these strategies (August 2015). Explicit short volatility is most harmed by an extended period of high volatility that fails to mean revert, such as in 1928 or 2008, or a super-normal volatility spikes such as the Black Monday 1987 crash.

Implicit Short Volatility are strategies that, although not directly selling options, use financial engineering to generate excess returns by exposure to the same risk factors as a short option portfolio. Many investors, and even practitioners, are ignorant or in denial that they are holding a synthetic short option in their portfolio. In current markets, there is an estimated $1.12 to $1.42 trillion in implicit short volatility exposure, including between $400 billion in volatility control funds, $400 to $600 billion in risk parity, $70-175 billion from long equity trend following strategies, and $250 billion in risk premia strategies. These strategies are similar to a short option position because they produce efficient gains most of the time, but are subject to non-linear losses based on variance, gamma, rates, or correlation change. The strategies tend to have longer time horizons for rebalancing than explicit short volatility. In practice, exposure to equities is reduced based on the accumulation of variance over one to three months. 

The next few pages will focus on some of the hidden risks in the short volatility trade, both explicitly and implicitly.

Gamma Risk

Imagine you are balancing a tall ruler vertically on your palm. As the ruler tilts in any one direction, you must to overcompensate in the same direction to keep to the ruler balanced. This is conceptually very similar to a trader hedging an option with high gamma risk. The trader must incrementally sell (or buy) more of the underlying at a non-linear pace to rehedge price fluctuations.

A short gamma risk profile is not unique to option selling, and is a hidden component of many institutional asset management products. The portfolio insurance strategy credited with causing the 1987 Black Monday Crash is a classic example of a short gamma profile gone awry. When large numbers of market participants are short gamma, implicitly or explicitly, the effect can reinforce price direction into periods of high turbulence. Risk parity, volatility targeting funds, and long equity trend following funds are all forced to de-leverage non-linearly into periods of rising volatility, hence they have synthetic gamma risk. At current risk levels, we estimate as much as $600 billion in selling pressure would emerge from implicit short gamma exposure if the market declined just -10% with higher vol. Many of these strategies rely on accumulation of one to three month realized variance to trigger that de-leveraging process. Hence the short gamma buying and selling pressure operates on a time lag to the market. During the drawdowns in the fall of 2015 and early-2016, share buybacks helped the market rebound quickly minimizing the effect of ‘short-gamma’’ de-leveraging. This further emboldened explicit short volatility traders to continue to fade any volatility spikes.

If the first leg of a crisis is strong enough to sustain a market loss beyond -10%, short-gamma de-leveraging will likely kick-start a second leg down, causing cascading losses for anyone that buys the dip. 

Correlation and Interest Rate Risk

The concept of diversification is the foundation of modern portfolio theory.  Like a wizard, the financial engineer is somehow able to magically reduce the risk of a portfolio by combining anti-correlated assets. The theory failed spectacularly in the 2008 crash when correlations converged. You can never destroy risk, only transmute it. All modern portfolio theory does is transfer price risk into hidden short correlation risk. There is nothing wrong with that, except for the fact it is not what many investors were told, or signed up for.

Correlation risk can be isolated and actively traded via options as source of excess returns. Volatility traders on a dispersion desk will explicitly short correlations by selling the variance of an index and going long the weighted variance of its constituents. When correlations are stable or decreasing, the strategy is very effective, but when correlations behave erratically large losses will occur. The graph to the right shows the collapse of correlations between normal and stressed markets. 

Many popular institutional investment strategies derive excess returns via implicit leveraged short correlation trades with hidden fragility

Risk parity is a popular institutional investment strategy with close to half a trillion dollars in exposure. The strategy allocates risk and leverage based on variance assuming stable correlations. To a volatility trader, risk parity looks like one big dispersion trading desk. The risk parity strategy, decomposed, is actually a portfolio of leveraged short correlation trades (alpha) layered on top of linear price exposure to the underlying assets (beta). The most important correlation relationship is between stocks and bonds. A levered short correlation trade between stocks and bonds has performed exceptionally well over the last two decades including in the last financial crisis. From 2008 to 2009 gains on bonds offset losses in the stock market as yields fell. To achieve a similar benefit in a crisis today, the 10-year Treasury Note would need to collapse to from 2.32% to -0.91%. This is not impossible, but historically there is a much higher probability that bonds and stocks rise or fall together when rates are this low.

The truth about the historical relationship between stocks and bonds over 100+ years is illuminating (please see our 2015 paper “Volatility and the Allegory of the Prisoner’s Dilemma” for more detail). Between 1883 and 2015 stocks and bonds spent more time moving in tandem (30% of the time) than they spent moving opposite one another (11% of the time). Stocks and bonds experienced extended periods of dual losses every 50 years.  It is only during the last two decades of falling rates, accommodative monetary policy, and globalization that we have seen an extraordinary period of anti-correlation emerge. At best the anticorrelation between stocks and bonds may cease to be a source of alpha, and at worst it may the driver of significant reflexive losses. 

Volatility Risk

With interest rates at all-time lows shorting volatility has become an alternative to fixed income for yield starved investors. The phenomenon is not new to Japan. For nearly two decades banks packaged and sold hidden short volatility exposure to Japanese retirees via wealth products called Uridashi. Uridashi notes pay a coupon well above the yield earned on Japanese debt based on knock-out and knock-in levels to the Nikkei index. In 2016 there was an estimated $13.2 billion USD in Uridashi issuance. Now that low rates are global the short volatility trade is expanding to retail investors beyond Japan.  In the US short volatility has emerged as a get-rich-quick scheme for many of these smaller investors. The short VIX exchange traded complex, at approximately $2 billion in listed assets, is the smallest but most wild segment of the global short volatility trade.  In the past you had to be a big Wall Street trading desk (‘Bear Stearns’) or hedge fund (“LTCM”) to blow yourself up shorting volatility. Not anymore. The emergence of listed VIX products democratized the trade. A story in the New York Times details the exploits of an ex-Target manager who made millions shorting a 2x leveraged VIX ETP. Such stories harken back to the dotcom bubble of the late 1990s when day-traders quit their jobs to flip internet stocks before the crash. 

When everyone is on one side of the volatility boat, it is much more likely to tip over. Short and leveraged volatility ETNs contain implied short gamma requiring them to buy (sell) a non-linear amount of VIX futures the more volatility rises (falls). The risk of a complete wipe out in the inverse-VIX complex in a single day is a very real possibility given the wrong shock (as Artemis first warned in 2015). The largest one day move in the VIX index was the +64% jump on February 27, 2007. If a similar move occurred today a liquidity gap would likely emerge.

The chart above estimates the volatility notional required for a +60% shock in the VIX given supply-demand dynamic over the past five years. For a +60% move in VIX we estimate ETPs would be required to buy $138 million in vega notional in the front two contracts alone, equivalent to 142k VIX contracts(12). This is over 100% of the average daily trading volume.  In this event, inverse-VIX products will experience an “unwind event” resulting in major losses for scores of retail investor. Those shorting leveraged VIX products will have unmeasurable losses. The products are a class-action lawsuit waiting to happen.

Shadow Risk in Passive Investing 

Peter Diamandis, the entrepreneur and founder of the X prize, said it best, “If you want to become a billionaire, find a way to help a billion people”. The purpose of efficient markets is to allocate capital to institutions that add the most value. In a market without value, the only thing left to do is to allocate based on liquidity. The massive stimulus provided by central banks resulted in the best risk-adjusted returns for passive investing in over 200 years between 2012 and 2015. Today investors are chasing that historical performance. By the start of 2018, 50% of the assets under management in the US will be passively managed according to Bernstein Research. Since the recession $2 trillion is assets have migrated from active to passive and momentum strategies according to JP Morgan.

Passive investing is now just a momentum play on liquidity.  Large capital flows into stocks occur for no reason other than the fact that they are highly liquid members of an index. All stocks in the index go up and down together, regardless of fundamentals. In effect, the volatility of the entire stock market can become dominated by a small number of companies and correlation relationships. For example, the top 10 stocks in the S&P 500 index, comprising only 2% of index membership, now control upward of 17% of the variance of the entire market. The largest 20 companies, or 4% of companies, are responsible for 24% of the variance.

The shift from active to passive investing is a significant amplifier of future volatility. Active managers serve as a volatility buffer, willing to step in and buy undervalued stocks when the market is falling, and sell overvalued stocks when the market is rising too much. Remove that buffer, and there is no incremental seller to control overvaluation on the way up, and no incremental buyer to stop a crash on the way down.

Shadow Risk in Machine Learning

Let’s pretend you are programmer using artificial intelligence (“AI”) to develop a self-driving car. You “train” the AI algorithm by driving the car thousands of miles through the desert. AI learns much faster than any human, so after a short period, the car able to drive at 120 miles per hour with perfect precision and safety. Now the car is ready for a cross-country trip. The self-driving car works flawlessly, driving with record speed through the city, desert, and flatlands. However, when it reaches the steep and twisting roads of the mountain the car drives right off a cliff and explodes. The fatal flaw is that your driving algorithm has never seen a mountain road. AI is always driving by looking in the rear-view mirror.

Markets are not a closed system. The rules change. As machines trade against machines, self-reflexivity risk is amplified. 90% of the world’s data across history has been generated over the last two years. It is very hard to find quality financial data at actionable time increments going back past 20 or even 10 years. Now what if we give all the available data, most of it extremely recent, to a machine to manage money? The AI machine will optimize to what has worked over that short data set, namely a massively leveraged short volatility trade. For this reason alone, expect at-least one major massive machine learning fund with excellent historical returns to fail spectacularly when the volatility regime shifts… This will be a canary in the coal mine.

Conceptual Mistakes in Shorting Volatility

“I can’t wait for the next crisis because I can sell volatility at even higher levels!” said one institutional asset manager at a conference. This is a commonly held but very dangerous assumption. Many investors compare shorting volatility to selling insurance. The option seller collects an upfront premium with frequent gains but large negative exposure to uncommon events. It is typical to erroneously conclude that selling volatility can never lose money if you keep systematically rolling the trade forward. The flaw in this logic is the assumption risk events are independent and probabilities consistent. In markets this is never the case.

Let’s play a game. You get to bet on a rigged coin with a 99% probability of landing on heads in your favor. If the coin lands on heads, you win +1% of your bankroll, but if it lands on tails, you lose -50%. Do you play? Yes, the game has a positive expected return, and given the law of large numbers you will always succeed if you keep playing. Consider that if the probabilities decrease to a 98% success rate, the game becomes a net loser. Remarkably, a 1% change in probability is the only thing that separates a highly profitable strategy from cataclysmic loss (see the statistics below). Small changes in probabilities have an outsized effect on the profitability of any strategy with small frequent gains and large infrequent losses.

The coin game is similar to a systematic short volatility strategy, except in life you never know which coin, positive or negative, you are betting on at any given time. Worse yet, in self-reflexive markets the probabilities between coin flips become correlated based on outcomes. For each loosing coin flip, the likelihood for another loss increases and vice versa! You start with 99% odds and a positive expected strategy, but after the first loss, the odds reduce to 90%. After two losses in ten, the odds fall to 50%.  It is not the first loss, or leg down in markets that hurts you, but rather the second and third. Systematic short volatility without accounting for shifting probabilities is akin to doubling down at a casino into bad odds. Don’t fool yourself… this is exactly how financial crises develop.

Shorting volatility, in of itself, is not necessarily a bad thing if executed thoughtfully at the right margin of safety. In our 2012 paper “Volatility at World’s End” we correctly argued, against our self-interest, for the overvaluation of portfolio insurance in what we coined a “Bull Market in Fear’ between 2009 and 2012. At the time tail risk hedging was very popular and investors shorting volatility had a high margin of safety.  For the reasons detailed in this paper, we believe the exact opposite today.

Intrinsic Value and Volatility

This past summer the ever-wise Jim Grant of Grant’s Interest Rate Observer asked for my thoughts on the low volatility regime. In the middle of my explanation on the short volatility trade, out of nowhere, Jim says, “What does any of this have to do with intrinsic value?” I was floored… I honestly didn’t know how to answer his question. The truth… the short volatility trade is about the absence of value. In a bull market, when investors can’t find value in traditional assets, they must manufacture yield through financial engineering. In a mania the system begins to devour its own tail.

The difference between risk and outcomes...

Imagine your friend invites you over for dinner. In his dining room is a barrel of highly explosive nitroglycerin.

You: “What is that barrel of explosive nitroglycerin doing in your living room!”


Friend: “Oh that, no big deal.” 


You: “It’s DANGEROUS! That could blow up the entire block!!! Where did you even get that?”


Friend: “Calm down,  the bank pays me good money to store it here, it’s the only way I can afford the mortgage."


You: “WHAT! ARE YOU CRAZY? All it takes is a small fire to set that thing off!”


Friend: “What fire? There is no fire. Look, it’s been here for five years without a problem.”

Risk alone does not guarantee any outcome, it only effects probabilities. The global short volatility trade, in all of its forms, is like a barrel of nitroglycerin sitting in the market portfolio. It may or may not explode. What we do know is that it can potentially amplify a routine fire into an explosion. The real question is what causes the fire?

The death of the snake...

Volatility fires almost always begin in the debt markets. Let’s start with what volatility really is. Volatility is the brother of credit...  and volatility regime shifts are driven by the credit cycle. Volatility is derived from an option on shareholder equity, but equity itself can be thought of as a perpetual option on the future success of a company. When times are good and credit is easy, a company can rely on the extension of cheap debt to support its operations. Cheap credit makes the value of equity less volatile, hence a tightening of credit conditions will lead to higher equity volatility. When credit is easily available and rates are low, volatility remains suppressed, but as credit contracts, volatility rises.

In the short term we do not see the credit stress required for a sustained expansion of volatility, but this can change very quickly. Storm clouds are gathering around 2018-2020, as rising interest rates, rich valuations, and corporate debt roll-overs all converge as potential triggers for higher stress and volatility. The IMF warned that 22% of U.S. corporations are at risk of default if interest rates rise. Median net debt across S&P 500 firms is close to a historic high at over 1.5x earnings, and interest coverage ratios have fallen sharply.  Between 2018-2019 an estimated $134 billion of high yield debt(16) must to be rolled-over, presenting a catalyst for higher volatility in the form of credit stress.

Reflexivity in the Shadow of Black Monday 1987

Thirty years ago, to the day, financial markets around the world crashed with volatility never seen before or equaled again in history. On October 19th, 1987 the Dow Jones Industrial Average fell more than -22%, doubling the worst day from the 1929 crash. $500 billion in market share vaporized overnight. Entire brokerage firms went bankrupt on margin calls as liquidity vanished. It was not a matter of prices falling, there were no prices. You couldn’t exit a position. Trading desks refused to pick up the phone. Black Monday appeared to come out of nowhere as it occurred in the middle of a multi-year bull market. There was no rational reason for the crash.  In retrospect, financial historians blame portfolio insurance, ignoring the role of interest rates, inflation, and the Federal Reserve. The demon of that day still haunts markets, and 30 years later the crash is still not well understood. Black Monday 1987 was the first post-modern hyper-crash driven by machine feedback loops, but it all started in a very traditional way.

Be careful what you wish for... Today every central bank in the world is trying to engineer inflation, but inflation was the hidden source of the 1987 financial crash. At the start of 1987 inflation was at 1.5%, which is lower than it is today! From 1985 and 1986 the Federal Reserve cut interest rates over 300 basis points to off-set a slowdown in growth. That didn’t last for long. Between January and October 1987 inflation violently rose 300 basis points. Nominal rates jumped even higher, as the 10-year US treasury rose 325 basis points from 6.98% in January 1987 to 10.23% by October 2014. The Fed tried to keep pace by raising rates throughout the year but it was not fast enough. The quick increase in inflation was blamed on the weak dollar, falling current account balance, and rising US debt-to-GDP levels. None of this hurt equity markets, as the stock market rose +37% through August 25th, 1987. Then the wheels fell off.

First the fire, then the blast...

In 1987 portfolio insurance was a popular strategy ($60 billion in assets) that involved selling incrementally greater amounts of index futures based on how far the markets fell (see short gamma risk above). The WSJ ran an article on October 12th that warned portfolio insurance “could snowball into a stunning rout for stocks”. Nobody paid attention.

Although equity markets continued to rise into the summer, the credit markets began to suffer from a liquidity squeeze.

The spread between interbank loans and Treasury Bills spiked 100 basis points in the month of September alone, and then rose another 50 basis points in October leading up to the crash. Corporate yields exploded 100 basis points the month leading up to the Black Monday crash, increasing of over 200 basis points since earlier in the year.  By the late summer the equity markets got the memo. Between August 25th and October 16th, the S&P 500 index fell 16.05%. S&P 100 volatility moved from 15 in August to 36.37 on October 16th.  That was just the beginning. 

On Black Monday the market lost one fifth of its value and volatility jumped to all-time highs of 150 (based on VXO index, predecessor to the VIX index). In total, from August to October 1987 the market lost -33% and volatility exploded an incredible +585%.

Black Monday is best understood as a massive explosion that occurred within a traditional fire. Rising inflation started a liquidity fire in credit, that spread to equities, and reached the nitroglycerin of computerized trading before exploding massively. Central bankers were not able to cut rates at the onset of the crisis to stop the fire due to rising inflation. The same set of drivers exist today, but on steroids. Higher rates combined with $1.5 trillion in selfreflexive investment strategies are a combustable mix. It is important to realize that the 1987 Black Monday crash was comparable to any other market sell-off until it wasn’t. The only difference… in 1987 volatility just kept going higher and markets lower. The chart above shows the movement in volatility leading up to crises in 1987, 1998, 2008, 2011, 2015. The point is that if you are a volatility short seller, how do you know whether you will get a 2015 outcome, when markets rallied, or a 1987 outcome? You don’t! In 1987 inflation started the volatility fire, but program trading amplified that fire into a cataclysmic conflagration. The $1.5 trillion short volatility trade, in all its forms, can play a very similar role now if rising inflation causes tighter credit conditions, but also limits central banks from reacting.

Melt-up Risk

Never underestimate the will of global central banks to risk overvaluation in asset prices to achieve inflation.  For this reason, a speculative melt-up in prices on par with the late 1990s dot-com bubble is possible if policy makers support markets perpetually amid low inflation and growth. In fact, one legitimate argument for raising rates is simply so they can lower them before the business cycle turns. High volatility and high equity returns often coincide in the final phases of a speculative market. Very few investors realize that between 1997 and 1999 the stock market experienced both rising volatility and returns at the same time.

For example, during this period the S&P 500 index was up close to +100% but with over five times the volatility we are experiencing today. The recent stock market bubble in China also was an example of high volatility and high returns. Yes, stocks are overvalued, but if rates stay low coupled with dovish monetary policy and supply-side tax reform it could touch a frenzy in speculation. For this reason alone, sitting on the sidelines presents business risk for professional managers.

How does an investor survive the Ouroboros?

The markets are not correctly assessing the probability that volatility reaches new all-time lows in short term (VIX <9 in 2017), and new all-time highs in the long term (VIX > 80 in 2018-2020) 

Reflexivity in both directions is very hard to conceive. Volatility is low and can go lower this year absent any catalyst. Rising interest rates, wage inflation, and credit issuance are very real catalysts in the long-term. Between 2018 and 2020 high yield issuers will re-test markets by rolling over $300 billion in expiring debt.

U.S. average hourly earnings are rising at fastest pace since pre-recession putting pressure on inflation. If these debt-roll overs occur into rising inflation and higher rates this could easily be the fire that sets off the global short volatility explosion. 

If you are going to short volatility, do it with a long-volatility mindset, namely a limited loss profile. Short-dated VIX put options that payoff with the VIX below 10 are currently 5-10 cents. Forward variance out one year is cheap and should be bought into any period of rising interest rates, inflation, or credit stress.

Fixed income volatility is at all-time lows at a time when the Federal Reserve is raising rates

Something must give, inflation or deflation, but you don’t have to be smart enough to know what if you bet on the volatility of fixed income.

Active Long Volatility and Stocks will outperform over the next five years

Long volatility is a bet on change, as opposed to direction. At a time when central banks are removing stimulus, the world has never been more leveraged to the status quo. For this reason, long volatility combined with traditional equity exposure is an effective portfolio for the new regime.  Historically a 50/50 combination of the CBOE Long Volatility Hedge Fund Index and the S&P 500 Index outperformed the average hedge fund by +97% since 2005. The inclusion of long volatility reduced equity drawdowns from -52% to -15% in 2008 while improving risk-adjusted returns. 

The value-add of active long volatility management is to minimize losses in stable markets while making portfolio changing returns in the event of a market crash. The smart long volatility fund can offer protection at a limited or even positive cost of carry.  The combination of active long volatility and equity has historically protected a portfolio from a deflationary crash like 2008, but can also profit if high volatility and high equity returns co-exist in melt-up like 1997-1999.  Long volatility may be your only line of defense if stock and bonds decline together. At this stage in the cycle, you want to position yourself on the other side of the global short volatility trade

*  *  *

Risk cannot be destroyed, it can only be shifted through time and redistributed in form. If you seek total control over risk, you will become its servant.

There is no such thing as control...

there are only probabilities.

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<b>Crude Oil</b> Price Forecast October 23, 2017, Technical Analysis

The WTI Crude Oil market initially gapped higher at the open on Friday, turned around to fall significantly, but then found buyers again as we reached ...

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How Times Have Changed

From the Slope of Hope: One of my favorite little books is called Hey Skinny! Great Advertisements from the Golden Age of Comic Books, which pretty much describes the contents exactly. It is a hodgepodge of cheesy ads from the mid 1940s to late 1950s for all manner of junk, and it's eye-opening to see via these come-ons just how much has changed in merchandising. I thought I'd provide a sampling for your amusement, not edification.

First up is the "Lucky Grab Bag", in which children would send in their precious cash in exchange for a bag of..........stuff. God only knows what stuff would come back, but I suspect it was whatever overstock items happened to be laying around the office........ballpoint pens, sanitary napkins, swizzle sticks. I suspect an entire generation of kids learned the meaning of disappointment from the receipt of these parcels o' crap.


Next up is the most amazing sun watch in the world. The fact it was the only sun watch in the world probably helped. Evidently it was a watch with a triangle sticking out of it (helpful for accidentally cutting yourself) which, if you aimed it precisely right on a sunny day, could give you the time within two hours of accuracy. This allowed you to tell time "the truly scientific way". It wasn't just a watch, though - - this product claimed to have nine functions, including "weather forecaster", which I suppose meant if you couldn't tell what time it was, it was either cloudy or already raining on your dumb ass.


Now we step into the yesterday of political incorrectness with rubber masks. There's Satan, an "Idiot", and......umm........a Minstrel. This advertisement, only partly shown, suggests that wearing one of these masks was a great way to bag the ladies, since they found it terribly amusing. In the parlance of the day, you could "panic a party" (whereas today you could "earn a lawsuit.")


This next one is, for me, the most appalling of all. It seems there was a company back in the 50s whose sole purpose in life was to create photo enlargements. In exchange for giving their sales information to twenty of your friends, they would send you.........brace yourself........a monkey. How they shipped it to you or managed to keep it alive during the shipment (or, indeed, kept it from committing monkey suicide out of terror en route) is beyond me. It's hard for me to believe that the good people of the U.S. had much success with miniature monkeys shrieking and throwing poo around the house across the suburbs of our once-great republic.


For nascent crimestoppers, there is the "new toy gun" which, it seems, fires off pieces of potatoes. No big deal. What I find intriguing is the story they lay out in in the ad, in which a couple of young chaps stop a bank robbery cold (and are immediately paid for doing so by Mr. Bank Manager). It takes some serious suspension of disbelief to think hardened bank robbers would be stopped in their tracks by some ten year old holding what appears to be the letter "L" from Sesame Street in his hand, but that's how the story is told. One can only hope the kids of the 50s didn't seek out to emulate this behavior by hanging out in rougher parts of town with their weapon, waiting for their payday.


The ads weren't all just for kids, though. There were ads aimed at adults as well, and judging from the ad, there must have been plenty of desperate, disillusioned dads in America. Allow me to lay out what was being advertised here, as the story is told: (1) a guy pulls up in his driveway in a new car under the gaze of his envious neighbor, who puzzles over how he could afford such a luxury (2) the car owner states he is pulling down the big money by selling shoes door-to-door (3) Instead of laughing hysterically, the neighbor implausibly inquires as to how he can muscle in on this kind of action (4) the neighbor evidently signs up to be a new salesman for Mason Shoes, and he is provided a catalog and, yes, a sample air cushion which is the distinctive edge of Mason that makes them better than other shoes (5) the poor bastard pesters his neighbors, co-workers, and anyone else with feet to buy these shoes, and he does well enough that Mason sends him some sample shoes, sparing him the continue embarrassment of having nothing more than a soft insole as his only selling aid.


We finish our journey with an ad specifically targeted to adult women (why they would be reading Archie comic books is beyond me, but there we are). The ad portrays a town whose women are having their engagement and wedding rings stolen from their homes. Mary has been robbed too, but she's chill. How could this be? After all, the diamonds were worth at least a thousand dollars! That's easy - - because Mary has her actual jewelry locked up in a safe where no one can see or enjoy it. What she's been wearing on her fingers day after day are a set of rings that cost $2.98, and apparently no one could tell the difference. Nice going, Mary. I bet they look fabulous.


Well, that's it for our trip down memory lane. Perhaps you were expecting an article on trading. But ask yourself - - how much value have you received from all the articles you've been reading about trading for the past eight years? Yeah, that's what I thought.

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The Next Generation Of Currency Wars: Private Vs State-backed Crypto

Authored by Tho Bishop via The Mises Institute,

Recently Russia announced that it will be unleashing a CryptoRuble, just a week after Vladimir Putin strongly criticized Bitcoin and other private cryptocurrencies.  When announcing the move, Minister of Communications Nikolay Nikiforov acknowledged that it was in part inspired by the aim of getting ahead of other governments:

I confidently declare that we run CryptoRuble for one simple reason: if we do not, then after two months our neighbors in the EurAsEC will.

In doing so, Russia is following the lead of another country that too has become hostile to private crypto, China. Last July the People’s Bank of China became the first central bank to announce it had developed a crypto-prototype that it plans to offer alongside the traditional renminbi.

That the first forays into state-backed cryptocurrency comes from two countries with a history of restricting a free and open internet is not surprising. While Bitcoin originated as a way to opt out of government control of money supply, increasingly governments see the underlying technology as a way to increase their control of the economy.

As Xiong Yue explained:

For example, if the government plans to subsidize certain farms, say some corn farms, to support this sector of agriculture, they can directly add a certain amount of money to the wallets of some farms, for instance 100 million dollars and program this money to be sent to certain fertilizer merchants at a certain time, and that each can only spend maximum of 10 million dollars per year, and in this way, they can make sure that the farmers won’t squander the windfalls, and that this money won’t flow to other sectors, for instance, the stock market or real estate market.


Even though this kind of monetary policy is bound to fail, from the perspective of government officials, CBDC provides them a better tool. For them, with the help of the CBDC, they can plan and manage the economy better.

Not to be left behind, the IMF – who some analysts, such as Jim Rickards, believe is prepared to step up to replace the US dollar as the next global reserve currency – recently opened the door to issuing their own cryptocurrency in the future. While some crypto-advocates have naively celebrated recent comments by Christine Lagarde on the future potential of digital currency, such praise simply reflects the increasing awareness of technocrats that the finance is changing and they must be prepared for it. Considering central banks around the world have continued to advance their war on cash, it is not surprising to see Lagarde and others come adapt to the concept so quickly.

Exchange Regulation

The usefulness of state-controlled crypto is why we should expect increased scrutiny and regulation on private cryptocurrency exchanges.

It's been reported that the Chinese government, which shutdown private crypto-exchanges in September, is looking into reopening exchanges with increased regulation. Russia, too, is working on exchange regulation, rather than an outright ban.  This apparent change in direction may be the consequence of China’s exchange ban resulting in an increased use of peer-to-peer platforms in the face of the government crackdown. 

For the same reason that government prefers regulated bank accounts to cash and safes, state officials may recognize the benefit to propping up licensed exchanges. Already we have seen numerous cryptoexchanges be willing to collect and hand-over sensitive customer information in exchange for government-issued licenses. Much like banks, these exchanges are increasingly being enlisted as tax collectors for government.

Calm Before the Storm?

While this loss of privacy may outrage Bitcoin’s initial supporters, it’s understandable why many current holders may be perfectly happy with these developments. After all, while much of Bitcoin’s initial appeal was its usefulness in black markets, a major reason for its astronomical rise in value is its increasing appeal among average customers who were never all that concerned with financial services regulation. Not only has it helped its appeal as an investment, but also its daily use. Japan, for example, saw a major surge in retailers accepting Bitcoin once a firm regulatory framework was implemented.

It is worth wondering whether this harmony between government and consumers will continue, however, once state-controlled crypto truly ramps up.

After all, we’ve already seen government rely upon traditional boogeymen of terrorists, drug dealers, and other criminals as justification for their increased control. The increasing use of Bitcoin by hackers and extortionists provides a modern-day twist to these age-old scare tactics. Is it all that difficult to foresee a scenario where governments attempt to freeze all regulated exchanges in the aftermath of some terrorist attack or other scenario? Or go one step further, and legally mandate replacing a privately-held asset for a government-issued currency?

The example of China demonstrates the inherently decentralized nature of Bitcoin will likely always ensure a degree of functionality beyond the reach of government. At the same time however, the increased popular appeal of crypto-currency also means increasing reliance on third-party services, and fewer individuals securing their investments in private wallets.  Since the most popular – and thus most lucrative – exchanges and other services have an inherent incentive to maintain a good relationship with legal authorities, it is easy to see how this easily plays to the benefit of government officials.

Already within the industry debate is raging between those who prioritize “efficiency” and mainstream appeal – even at the expense of crypto's decentralized-origins. Luckily, Bitcoin’s original Austro-libertarian ethos means that we are likely to see major industry influence pushing back on state-control.

A Preemptive Strike for Monetary Freedom 

In the meantime, this is yet another reason why what little political capital libertarians on monetary policy have should not be wasted pursuing moderate reforms such as forcing the Fed to embrace rules-based monetary policy. There is no hope to ever transform the Federal Reserve into a useful – or even non-harmful – institution. That hope does exist, however, in crypto.

As future monetary policy is soon to become a major topic of conversation as President Trump rolls out his Federal Reserve nominations, it would be a major loss for the cause to not see Senator Rand Paul and other Fed-sceptics use the opportunity to push discussion about the need for competition in currencies. Further, the recent surge in states that have legalized the use of gold and silver for the payment of debt means there has never been a stronger political case for the elimination of legal tender laws and the taxes imposed on alternative currencies like Ron Paul proposed when in Congress. Such a move now could help set the stage for America being a true safe haven for private crypto in the future. 

Doing so may give the cryptocurrency industry the freedom to give us a fighting chance to truly end the Fed, and their clones around the world.

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Goldman Expects Trump To Withdraw From NAFTA, Congress Readies For A Fight

With NAFTA negotiations going badly, Goldman Sachs has published a report, “Thoughts on the Potential US Withdrawal from NAFTA”, that concludes that the US is likely to withdraw from the trade agreement next year “At this point, efforts at revising the agreement look likely to be unsuccessful, though a deal is still possible, in our view. If the talks do not result in a revised agreement by early 2018, we believe that the Trump Administration could announce its intent to withdraw from NAFTA.” The NAFTA agreement calls for a six-month notice period before a nation can withdraw and “we believe it would follow a similar pattern to the strategy the White House has used in recent decisions on immigration (the DACA program), Iran, and health subsidies. Each involved a disruption to the status quo pursuant to a campaign pledge, with delayed implementation and an expectation that a new arrangement might be negotiated in the interim.”

Trump has threatened to pull out of the pact several times if “America First” demands are not met. Following an unsuccessful fourth round of discussions, the parties have accepted that end 2017 timeframe for reaching agreement will no longer be achieved and talks will extend into Q1 2018.

According to Goldman, major sticking points in the talks are:

5-year sunset: The US has proposed that NAFTA would be terminated after 5 years unless all three parties agree to keep it in force. As a practical matter, this would result in a prescheduled renegotiation every ?ve years and increase uncertainty while the agreement is in effect, decreasing the bene?ts of the agreement on investment and cross-border trade ?ows.


Chapter 19: NAFTA allows member countries to settle anti-dumping and countervailing duty disputes through binational arbitration, which has been a priority for Canada in particular.  The US has called for Chapter 19 to be non-binding.


Investor-state dispute settlement (ISDS): The US has called for the ISDS program to exist on an opt-in basis. ISDS allows companies to seek recourse against policy changes in NAFTA countries that infringe on property rights, such as expropriation of assets.


Government procurement: The Trump Administration is seeking “dollar for dollar government procurement, which would mean that Mexican or Canadian companies could bid on US government contracts equal only to the amount of Mexican or Canadian contracts open to US companies. This would reduce the amount of US government contracts open to NAFTA partners to a fraction of the current amount.


Rules of origin: NAFTA currently requires auto imports to include at least 62.5%n regional content, i.e., parts from NAFTA countries. The Trump Administration has proposed raising this threshold to 85%, and requiring 50% US content.  These levels seem unattainable, in our view, since the US applies only a 2.5% tariff on cars imported from outside NAFTA, and with such high content requirements auto companies would be better off paying the tariff instead.

While Goldman acknowledges that some of the demands might be merely part of a negotiating strategy, it cautions that some of them are of a binary nature, with little room for compromise versus the current agreement.

It sees three reasons for expecting the talks to fail:

First, the recent proposals suggest that the Trump Administration is not concerned about the possibility of a failure to revise the agreement.


Second, an announcement to withdraw from NAFTA would be in keeping with the strategy the White House has recently followed on other issues.  The Administration’s recent decisions regarding the Iran agreement, the DACA program, and ACA subsidies have followed the same pattern: The White House has announced that it will end the status quo, against expectations, but that it will allow for an interim period where a new arrangement could be negotiated.  In these examples, the White House has left Congress with the responsibility for establishing a replacement.


Third, it is far from clear that there would be suf?cient support in Congress to pass a revised NAFTA agreement at this point.  We believe most trade-skeptic lawmakers might not want to be associated with even a revised version of the agreement, and most pro-trade lawmakers might prefer the status quo, although they might be more supportive of a revised agreement if the US has already announced a withdrawal from NAFTA.

On that basis, it expects the White House to give notice of US withdrawal.

Meanwhile, the risk of a US withdrawal is galvanising efforts by Congress and the business sector to thwart Trump if he does, indeed, serve notice. A legal challenge is thought to be certain from both sides of the House and the auto industry. As the WSJ notes  “Congressional trade lawyers and attorneys from private firms in Washington have begun meeting informally to come up with ways to challenge any decision by President Donald Trump to pull out of the North American Free Trade Agreement.”

While contingency planning is in its early stages, the WSJ acknowledges that it has thrown up a critical question“ How much authority does the president actually have to scuttle an existing trade agreement? ‘This is sort of uncharted territory where no one really knows,’ said Warren Maruyama, a former trade official in the Reagan and two Bush administrations…Mr. Maruyama agreed that the president probably has the power to cancel or gut Nafta, but he expects challenges—with a chance of success—if Mr. Trump attempts to kill the deal unilaterally. “There are people who are desperately scouring [key provisions of trade law] on Capitol Hill and law firms and at the U.S. Chamber of Commerce right now to try to create some kind of argument that Trump can’t do this,” said Mr. Maruyama, now partner at Hogan Lovells LLP in Washington.”

The potential avenues for challenging a withdrawal appear to be twofold, either on the basis that it is unconstitutional, or that a President can’t reverse laws which were passed by Congress with regard to its implementation. Should Trump serve notice, any parties, such as lawmakers or businesses, with standing could seek an injunction in a Federal court. If that fails, the WSJ reports that Congress could still take further measures to exercise leverage over the White House “The Congressional Research Service said in a 2016 report that a final notice of withdrawal from the president ‘appears sufficient’ to release the U.S. from its international obligations under Nafta, but that Congress might wield a variety of powers to dissuade a president from canceling the deal, including through its control over the budget. Congress in theory could also pass a law reinstating Nafta or a similar agreement, but lawmakers are divided on the issue and unlikely to advance legislation protecting a trade agreement, especially if they don’t have a veto-proof majority.

For a moment, let’s assume that the US leaves NAFTA, what would it mean in economic terms?

Goldman explains that besides short-term uncertainty if the US does withdraw from NAFTA, Goldman predicts that the economic fallout will likely be relatively modest.

A NAFTA withdrawal announcement would create near-term uncertainty but would likely have relatively modest economic effects, as the US-Canada trade would be likely to be covered under a prior free trade agreement, and exports to Mexico constitute only 1.2% of GDP. Most estimates of the trade gains from NAFTA suggest that it raised the level of US GDP by less than 0.2%, and some of these gains might have occurred anyway as Mexico has substantially lowered tariffs for non-NAFTA countries since the deal was implemented. That said, tariffs would rise, non-tariff barriers would increase, and some industries could face more substantial disruption. The auto sector would be most affected, as tariffs on some vehicles are still quite high outside of trade agreements and supply chains have been integrated across borders.  Agricultural trade, while not as large, would face important constraints given high protective tariffs on certain products.”

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“The Police Just F**ked My Life” – Alabamians Outraged As Civil Asset Forfeitures Soar

The morning of June 29, 2010, began much like any other day for Frank Ranelli, the owner of FAR Computers in Ensley, Alabama. Ranelli, who had owned his computer repair business just outside of Birmingham for more than two decades, was doing some paperwork in his windowless office when he heard loud banging on the front door.  Within a matter of moments Ranelli was placed under arrest and all of the computer equipment in his store, much of which belonged to customers, had been confiscated by Alabama police never to be returned.  Per AL.com:

Within moments, a Homewood police sergeant had declared a room full of customers' computers, merchandise and other items "stolen goods," Ranelli recalled. He ordered his officers to "arrest them all," according to Ranelli, who was cuffed and taken to the Homewood jail along with two of his shop employees.


The police proceeded to confiscate more than 130 computers - most of which were customers' units waiting to be repaired, though some were for sale - as well as the company's business servers and workstations and even receipts and checkbooks.


"Here I was, a man, owned this business, been coming to work every day like a good old guy for 23 years, and I show up at work that morning - I was in here doing my books from the day before - and the police just f***ed my life," he said.

Nothing ever came of the case. The single charge levied against Renelli of receiving stolen goods was dismissed after he demonstrated that he had followed proper protocol in purchasing the sole laptop computer he was accused of receiving illegally. That said, despite no official charges and no jury trial, Ranelli has been trying, to no avail, for nearly 7 years now to recover the items the officers took from his business.


Rick Hightower had a similar experience with Alabama police when he was a student at the University of Alabama at Birmingham.  After being arrested for "lewd behavior" at a college party in 2008, Hightower says police raided his apartment and confiscated as much as $200,000 worth of musical instruments and other property.  Despite never being charged with stealing the property, Hightower says police have refused to return any of the confiscated items. 

On April 13, 2008, he was arrested and initially charged with lewd behavior after police said he was caught exposing himself at Samford University in Birmingham, according to court filings. Hightower, who has a fairly extensive rap sheet, was ultimately convicted of indecent exposure and resisting arrest in connection with that incident.


Five days after his arrest, officers with the Homewood and UAB police departments raided Hightower's apartment, executing a warrant to search for files, cameras and any other evidence related to the incident at Samford.


They also decided to seize "a large amount of property believed to be stolen," including "musical instruments, electronics and other items," according to a UAB Police Department report on the search.


As such, Hightower was charged with receiving stolen property. He was never charged with stealing any of the other items that were seized from his apartment, and was not convicted of stealing the English horn, as he provided a receipt that showed that he had purchased the item from a thrift store.


And yet the Homewood Police Department - which stored and ostensibly continues to store the items seized in the raid - did not return the horn or any other items to Hightower. More than nine years later, he has yet to even lay eyes on any of the possessions that were taken from him.

Unfortunately, the raids on Ranelli's business and Hightower's apartment are not isolated incidents. They are just a couple of many similar cases that have taken place in Alabama and across the U.S. in recent years, according to Joseph Tully, a California criminal lawyer with expertise in civil asset forfeitures.

Long used in major criminal busts as a means to confiscate money and possessions obtained by illegal means, civil asset forfeiture impacts thousands of Americans each year and has become the subject of intense national and local scrutiny over the past decade.


The ability of law enforcement agencies to use such tactics to take people's assets and property almost at will "lends itself to abuse," Tully, who describes cases like Ranelli's as "theft," said.


"It's really hard to fight the system. If it was a private citizen who stole your things, you could go get your things, or in the olden days you could get your shotgun and pay the thief a visit and say, 'give me my stuff back.' But you can't do that in this case because it's the police."


In fiscal year 2016, law enforcement agencies in Alabama seized more than $2.2 million worth of "assets that represent the proceeds of, or were used to facilitate federal crimes," according to its annual report to Congress. In fiscal 2014, the total value of such assets seized by law enforcement in the state was more than $4.9 million.

That recent drop is the local manifestation of a nationwide reduction in the use of civil asset forfeiture as public awareness and outcry over its widespread use has grown in recent years, according to experts. The tactic is still regularly deployed, impacting dozens of Alabamians each year. But the tide is turning. Fourteen states, from New Mexico to Connecticut, have passed laws in recent years to stop police from seizing property absent a criminal conviction.

"The pendulum is starting to swing but I wouldn't say that it has been swinging back the other way for too long," Tully said. "State and local governments are starting to act ... Law enforcement officers are coming around a bit and there's a little bit of a curb in police doing whatever they want."


And on Tuesday, U.S. Attorney General Jeff Sessions issued a memo directing a deputy to establish a unit aimed at ensuring there are no abuses of a federal policy reinstated by Sessions in July to help state and local law enforcement agencies seize accused criminals' property.


Alabama's laws, however, still provide the state's citizens with few protections from the practices, earning the state a "D- for its civil asset forfeiture laws" in a November 2015 report by the Institute for Justice, a Virginia nonprofit advocacy law firm.


Alabama laws stack the deck against victims of asset forfeiture by establishing a "low bar to forfeit" and not requiring a conviction to do so; offering "limited protections for innocent third-party property owners"; and letting "100% of forfeiture proceeds go to law enforcement," the report stated.

The irony here, of course, is that we live in a country where the police can show up to any "Regular Joe's" apartment on any given day and legally confiscate all of his stuff but James Comey couldn't even manage to interview a material witness in the Hillary email investigation without first granting them an immunity deal.  Seems fair...

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GE-Dip-Buying-Panic Sends Dow To ‘Most Overbought’ In 62 Years, Yield Curve Collapse Continues



As Bloomberg summarizes, the dollar rose, Treasuries sank and all three broad stock indexes are heading for a record close on bets a budget compromise will bring Washington closer to agreeing on Trump’s promise of tax reform. The dollar touched a three-month high and 10-year Treasury yields approached 2.4% while the Canadian dollar tumbled after inflation and retail sales missed estimates. Some clarity on a budget resolution, a good quarter of earnings and the anticipation of an announcement of the next Fed chair has led to market confidence. One stock clearly bucked the earnings trend; GE posted results before the bell, missing analysts’ estimates significantly and slashing its profit forecast. The stock erased losses after falling 7% in premarket trading.

So - GE did this...

GE now 1% above yesterday's close after abysmal earnings, cutting guidance by 30% and “horrible cash flow”

And The Dow did this...


Which pushes it to the most overbought (based on RSI) since July 1955...


The Dow has not been near 'oversold' since Jan 2015...


Another perfect week (5 up days) for the S&P 500 (making 4 in 2017, compared to 1 in 2016, 2 in '14, 2 in '13, 2 in '12, and 2 in '11)


VIX ended back below 10 (after briefly spiking above 11.6 yesterday)...


and then this happened right at the close...


Homebuilders soared today... due to fun-durr-mentals...


Bank stocks underperformed today - but still have a long way top go to catch down to the crash in the yield curve..


Uglyish week for FANG stocks and AAPL ended red...


TSLA Tanked Today...


Following last night's budget vote, tax-hope picked up again from recent lows...


Yields are higher on the day (and week) with the short-end continuing to underperform...


The yield curve continued to collapse this week - lowest weekly close for 5s30s since Nov 2007


Copper/Gold is at its highest in 3 years suggesting bond yields have a lot further to rise...


The Dollar Index soared today after last night's budget vote - this is the best day for the dollar in 9 months... after bouncing perfectly off the unchanged for the week level...

The Dollar is up 5 of the 6 weeks - highest weekly close in 3 months


Yen and Loonie (retail sales weakness) were the biggest losers this week sending the green back higher...


Dollar strength weighed on precious metals with copper best on the week and WTI managing to limp into the green for the week today...


Finally, Bitcoin soared today (on Zimbabwe panic) above $6000 for the first time ever...


Now bigger than Goldman Sachs...


So who is right?



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Marc Faber Responds To Racism Accusations

Having been forced off the boards of Sprott, NovaGold, and Ivanhoe mines and excommunicated from mainstream business media following his comments earlier in the week, Gloom, Boom, & Doom Report writer Marc Faber responds to his racism allegations...

"I have been labeled by the mainstream media as a racist - I don't think this corresponds at all with reality.


I wrote a report about capitalism and socialism and about private property rights, and I also wrote about the tendency nowadays to want to rewrite history.


In the US they are trying to tear down statues of people who had a different view from other people at the time... they also tried to tear down statues of Columbus..


I think that when you have civilization, when you have culture, you should remember your past.


Our past - the white man - has certainly not been glorious, it's been very cruel with the periods of imperialism and colonialism being very cruel.


But the fact is that the white man and the Europeans brought a lot of skills and knowledge and a work ethic that built a very prosperous society... until very recently.


I think that to try to deny the fact that the western white man made America great is just not right and for that reason I was attacked very badly."

The conversation then continues to discuss cultural clashes, skin color, religion, confederate statues, African repression, capitalism, gold, bitcoin, Hillary Clinton, the swamp, President Trump, and America's military-industrial complex running foreign policy.

We suspect Faber's reponse will do him no favors in this age of ever-increasing virtue-signaling, but he has at least clarified his perspective.

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Fired Tesla Workers Discover They Were Replaced With Cheap Temp Labor

Just last week, amid their Model 3 "production hell," Tesla shocked the auto world with news that they would be firing hundreds of workers.  Of course, firing seasoned production staff is somewhat atypical for a 'growing' company (shrinking cash flow aside) that was already having difficulty meeting their own production schedule.  Of course, the irony was apparently 'lost' on Tesla who tried to dismiss the mass firings as "performance-based terminations."  Per Capital and Main:

Tesla announced the firings, which are reportedly still continuing, last week. Though no official number of terminations would be given, estimates range from 400 to 1,200. The company did not give advance notice under the WARN Act because, it insisted, they were performance-based terminations, not layoffs. “Like all companies, Tesla conducts an annual performance review during which a manager and employee discuss the results that were achieved during the performance period,” said a Tesla spokesperson in an emailed statement. “As with any company, especially one of over 33,000 employees, performance reviews also occasionally result in employee departures.”

As it turns out, we're not the only ones who were surprised by Tesla's mass termination event as laid off workers are now coming forward to say the decision was nothing more than an attempt to break up unionization efforts at the company's Fremont, CA plant and replace seasoned employees with cheap, temporary contract labor.

Those are the questions the labor organizing campaign at Tesla is asking, after the company issued a wave of terminations, allegedly linked to performance issues among its 33,000 employees. Several members of the campaign, known as A Fair Future at Tesla, were among those fired, and they all claim to have had excellent performance records. None have been able to obtain the negative reviews that were supposed to be the rationale for their firing.


The terminations struck many as strange. Tesla wants to ramp up production of the highly anticipated Model 3, a more affordable electric vehicle. CEO Elon Musk set a goal of 20,000 completed cars per month by this December. But in the third quarter of 2017 Tesla finished just 260. Musk has cited “production bottlenecks” for the poor output. But firing workers and retraining replacements seems a hindrance to, not an improvement on, this goal. Also, Tesla fashions itself a high-growth company, and mass terminations aren’t something high-growth companies do. Furthermore, fired employees claim they never had the kind of review that would explain the terminations. “I had great performance reviews. I don’t believe I was fired for performance,” said Daniel Grant, a production associate at the plant for three years. Grant claims he was injured on the job on a Friday, and fired the following Monday. “The company didn’t show me or others our most recent reviews when they fired us.”


Other production workers say their performance reviews were stellar but were dismissed after speaking out about "low pay, hazardous working conditions and a culture of intimidation at the Fremont plant."

Only when you understand Tesla’s labor issues does a more plausible explanation emerge. For months, Grant and other Tesla workers have spoken out about low pay, hazardous working conditions and a culture of intimidation at the Fremont plant. They have sought to affiliate with the United Auto Workers to win a voice on the job. While Tesla said that most of the exits were in administrative and sales jobs, at least some of them hit the factory floor. And many of these pro-union workers were among those fired, according to the Fair Future at Tesla campaign. That includes Grant, who said he wore union T-shirts on “Union Shirt Friday,” addressed safety issues in employee meetings and handed out informational fliers to colleagues.


Pro-union workers criticized the Model 3 ramp-up in August, saying that Tesla skipped test runs for the assembly line and predicting the company would likely institute forced overtime to keep on track. Both issues could lead to more injuries, the workers claimed. Grant believes that vocalizing these types of concerns about safety cost him his job.

Meanwhile, local advertisements imply that Tesla is seeking contract laborers who will start at much lower hourly rates and not receive health benefits...you know the benefits that Silicon Valley elites like Elon Musk demand that other companies must provide.

But a number of job fair listings spotted throughout the Bay Area suggest that Tesla will be replacing pro-union voices with contract labor. One such listing, through the temp agency Balanced Staffing, touts “hiring on the spot” for “a manufacture [sic] of electric cars in Fremont!!!” There are no auto facilities in that city other than Tesla. The listing says workers will make $18 to $20 an hour doing “repetitive motion” tasks, and that applicants “must be able to work 12 hour shifts.” The site of the job fair, in Modesto, is at least a two-hour drive from Fremont (the listing promises free shuttle service).


A similar Balanced Staffing listing on Craigslist for an event in Stockton, also a two-hour drive, again offers $18 an hour and says workers “must be open to any shift.” The entry-level wage is lower than what terminated workers with three and four years of service were making at the plant. Contracted work from a third party also likely means no benefits, certainly not the stock options offered Tesla employees. In addition to lower costs, independent contractors would be far less likely to join organizing campaigns.


It certainly appears that Tesla is attempting to increase Model 3 production with a temp labor force, while weeding out longer-tenured employees, at least some of whom were vocal about unionizing the plant.

Finally, the irony is that just as Musk is firing employees in the U.S., he offered 30% raises to workers in Germany...

Soon after Tesla fired hundreds of workers at its plant in Fremont, California, it managed to settle a problem with its German staff that could have been far, far worse. Things got off to a bad start when the boss of Grohmann resigned shortly after the takeover, and workers threatened to strike. They complained that once Tesla was their sole client—they used to supply a variety of automakers—they would face job insecurity. On top of that, they said they were getting paid 30% less than union rates.


Tesla will reportedly ramp up wages by about 30% and safeguard jobs till 2022. The previous offer of $10,000 in Tesla stock has also reportedly been accepted. “We have developed our own remuneration structure in very pragmatic discussions,” Uwe Herzig, the head of the workers’ council at Tesla Grohmann Automation, told Die Welt (link in German).

...a tricky situation which we anticipate might just draw the attention of a frequent tweet stormer in Washington D.C. who loves to speak out about unfair treatment of American workers...

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