Let me decode something that most people won't understand...

Today Mish wrote a post pointing to an interview of famous short seller Doug Kass that was given by Aaron "what happened to my face" Task.  I want to expand upon the two main quotes from Kass that Mish pulled from the interview transcript:

•  “My view is the Fed has made a mockery of fundamentals, that there is no real natural price discovery"

This first part is not so difficult to understand but it is worth underscoring.  How many times I have written that the real fundamentals are unknown and unknowable?  Government and central bank intervention is one of the big reasons why.  The drivel that they feed us in Yahoo finance for "fundamentals" can and will change on a dime.  Kass is completely correct: as long as the Federal Reserve continues to buy assets in order to keep their prices from falling (be they treasuries, stocks or bonds) AND as long as the Fed is printing up money or selling gold (to the Chinese...) in order to generate cash to do these manipulations, we will never know what the true market price of these items is. 

At the same time, the fed is not bigger than the market and both Yellen and Bernanke know that continued asset purchases will eventually result in wealth inequality so great that a pitchfork revolution occurs.  So despite what some people think, no, the con cannot go on forever.  It only seems that way, especially during the end game where all the big detractors of the con are throwing in the towel.

Kass goes on to say:

• "Every asset class in the world is being tied relative to the U.S. 10-year yield..."

Now here is the actual part that I think most people will not understand.  I mean, how can the value of every asset class (which includes hard assets like commodities as well as houses and stocks) be tied to the interest rate on the 10 year treasury?  At first blush it makes no sense! 

Weeeeellllllll, OK, maybe real estate prices make sense in that context, right?  After all, liberals are taught to forget about the price tag and focus on the monthly payment.  If you can make the monthly, you can afford it, right?  Isn't that what we are told?  Isn't that the driving force behind GW Bush's home ownership society?  And the monthly payment on real estate is PITI.  Principle, Interest Taxes and Insurance.  So, the interest rates for real estate, which are closely tied to the interest rate of the 10 year treasury, absolutely does affect the price of real estate because all real estate is only worth what the next greater fool can afford (in terms of PITI) to get a loan on.

OK Doug Kass, I'll give you that one.  Housing prices are indeed tied relative to the US 10 year yield. 

But what about stocks and commodities?  Why does some government bond interest rate affect their value?  I mean, in the case of real estate it was because debt was being used to do the pur-cha-si..... 

Oh, crap.  
 
There you have it.  That's the tie that binds.  Since fractional reserve banking allows basically unlimited amounts of debt to be taken out, that debt is used to buy stuff - stuff from all asset classes - for the purpose of price speculation.  In other words, to buy stuff in the assumption that a greater fool will come along and use even more debt to buy it from you. 

Margin debt has indeed been used to pump up stocks and it is currently at an all time high and the interest rate on margin debt, like real estate debt, is tied to the 10 year treasury interest rate (although the adder might be bigger for margin debt interest rates than for real estate debt interest rates).  With this understanding, everything Kass said so far makes perfect sense.  The following charts are from this link. 

The first chart (below) shows NYSE margin debt in red and the S+P 500 in blue. Note that margin debt is at an all time high.  Gee, what could go wrong with that??   Without the use of margin debt the longs could not buy the shares that they did in fact "buy" and the only way they can keep holding onto them is if the prices keep going up.  Why?  Because otherwise the debt service will eat them alive.  This is why the debt Ponzi cannot plateau.  Debt never sleeps!!  Either stocks go up forever or they will, like a plane running out of gas, begin to descend.  Of course, stocks cannot go up forever because at some point the law of diminishing returns kicks in.  High share prices require even more debt to buy them and that debt requires even more service.  The additional debt increases the money supply thus causing inflation.  So the inflation adjusted returns begin to sink the value of the investment in addition to the debt service.  These are the basic mechanics of why debt based growth only works for those who get in first.  In other words, just like any other pyramid scheme.





Kass says that that the tie of assets to treasury rates...

•  "... It's leading toward malinvestment."

First off, this already makes some sense based on the understanding that debt is being used to purchase all asset classes.  But to go deeper,  Let's first agree on what malinvestment is.  But before that, we have to first understand that investment is not consumption!  Sounds pretty simple but economists all over the world would argue with that statement.  In other words, if you borrow money in order to build a park, that is not an investment. It's a public consumption item.  Real investments pay for themselves. 

The problem is that not every investment works out the way the debtor thought it would.  In these cases, the investment loses money.  In fact it is a self fulfilling prophesy that not all investments will make money. This is because of the law of supply and demand.  The more debt that is used to build production, the more goods there are running around in the economy.  With all that debt fueled supply relative to a fixed demand, prices go down.  Those who are first to use debt in order to build production capacity do so without much competition and so they command big prices for their goods.  But the more copycats go into production using debt, the cheaper things become until you just can't make any money.  So the common use of debt in order to build capacity is guaranteed to make the investment unprofitable over time.

Of course, profitability is the main factor in whether something is an investment or malinvestment.  You might not like a bridge built "to nowhere" in Alaska but if that bridge charges tolls enough to pay for itself (PITI!!) then it is not malinvestment.  Of course, that requires lots of traffic which out of the way places don't have which is why it is pretty much always malinvestment to build a bridge to nowhere.

So how do we know something is malinvestment?  Simply by looking at the inflation adjusted returns.  And so that is what the second chart, below, provides.  It should be pretty clear that margin debt in the stock market has sky rocketed since 2009 yet the inflation adjusted S+P is lagging badly.  So there you are.  The concept of diminishing return in one easy chart. 

Diminishing return is the primary reason why Keynesian-ism is a mathematical scam.



The "IF" part of "if this blows up on us" has already sailed folks.  We are just debating the when part now.