The Investor January 2018

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A Wicked Tax Law

Hamstringing South African investors!

By Richard Cluver

With our share market rising exponentially, most experienced investors clearly sense that the end is nigh. My ShareFinder software furthermore predicts that the up-trend could last until February 13 at best.

Meanwhile economists attending the World Economic Forum in Davos were last week warning, in the words of Harvard University professor Kenneth Rogoff “If interest rates go up even modestly, halfway to their normal level, you will see a collapse in the stock market”.

Behind this view is the fact that individuals and corporates have borrowed massively in the current low-interest rate environment and would be unlikely to be able to repay the debt as interest costs rise, particularly in the case of collapsing share, bond and property prices.

The impact is, furthermore, likely to be massively damaging to the world economy because Dollar-denominated debt held by emerging-market economies currently exceeds $5-trillion. The burden of that upon countries like South Africa would seem likely to precipitate a series of recessions across the planet.

My graph below shows how the JSE Overall Index has been rising recently, up 17 percent in the past 12 months and down dramatically yesterday: signs of a market nearing its end!

Clearly it is time for investors worldwide to start taking defensive action. The problem that faces them this time around however, is arguably one of the wickedest pieces of South African tax legislation ever enacted in that it effectively prevents people, who have saved diligently all of their lives so as not to be a burden upon their children and the State, from taking such defensive action by selling their shares ahead of the impending storm.

Unlike the situation in most developed nations where tax does not apply to the gain you have made within an investment portfolio provided the capital so generated is kept intact and paid into another suitable investment, in South Africa any transaction involving such investments is immediately taxed and the process can almost halve the value of an investment portfolio at one stroke.

Sell any shares bought within the past three years and you face Provisional Taxation on the “Profit” at the current marginal rate of 45 percent. If you have held the shares for longer, then if they are held within a family trust, you face a nearly as punitive penalty of 36 percent. Better off is the small investor who holds a few shares in his or her own name and has held them for longer than three years, but the punishment is still 18 percent of the gain.

How this impacts the investor can be well-illustrated if one looks at the performance of the virtual share portfolio that I maintain for readers of my Prospects investment newsletter. The four best performing shares in the portfolio have been Naspers which has risen 941 percent, Capitec which has risen 473 percent, Mr Price 355 percent and Famous Brands 200.7 percent. If these were sold the State would receive nearly half the value of the portfolio in its resultant tax claim.

With most analysts worldwide in agreement that global share markets are very overpriced and expecting that a downward correction might occur anytime soon, investors who follow the Prospects newsletter will obviously be considering selling with the object of being able to buy back again whenever the next correction has completed and share prices are once again at attractive levels. But faced with such a tax burden, most will obviously hesitate. After all, they will surely reason, can I lose as much as that if a market crash happens?

Furthermore, a majority of investors worldwide do not believe a crash is coming. As an example, US Analyst Jake Bernstein has created a daily sentiment image which currently indicates that 97 percent of traders are bullish about US markets. This is the highest figure seen in the past 31 years while a 13-week moving average of bullish positions, at 63.5% is the highest since February 1977. So often before, it has been precisely in such times of overwhelming confidence that market crashes have happened!

So let us consider what the potential loss could be for South African investors if such a crash were to occur? My graph below illustrates what happened to the JSE Overall Index during the 2007 to 2009 crash when the index fell from a peak value of 332 329 on May 22 2008 to a bottom of 171844 representing a loss of 48.29 percent. Here you can see that following the crash the market had not fully recovered until January 2012 though it came within an inch of doing so in February 2011 only to fall back again before trying to do so again a year later.

For individuals who have with equal providence built up an investment portfolio within which, for example, they currently hold Naspers shares bought less than three years ago, taking the example of the Prospects Portfolio which were bought at R357.14 per share and today stand at R3 717.81, the gain on a sale would be R3 360.67 per share and a sale would thus attract tax of R1 512.30 per share.

A large proportion of South African investors have, however, been persuaded over the years that it is prudent to create a family trust within which to house such portfolios because such trusts do not disappear with the death of the founder and so their savings can be preserved for the benefit of their children and grandchildren who, for example, in these difficult times when our education system is rated the worst out of 50 developing nations, might need to be educated in private schools where the fees are relatively high.

Were the Naspers shares to have been bought less than three years ago they would similarly be taxed at 45 percent within the trust. Had they been bought earlier than that, capital gains tax would apply and since in recent years CGT has been raised nearly every successive tax year from 20 percent when it was first introduced in October 2001 to a current 36 percent, one might expect it to become a steadily more limiting problem given the fact that the Government has effectively run out of money. However, taking the current level of CGT on trusts, given a capital gain on a sale of R3 360.67 per share, such a sale would thus attract tax of R1 209.84 per share.

Taking the entire portfolio which grew from an initial investment of R1-million in January 2011 to a current R3 522 216.36, selling would attract tax of R907 997.86.

So, if the 2007 crash were to be precisely duplicated in the near future, it is clear that the penalty for not selling ahead of the crash was nearly the same as it would have been for someone who sold shares held for under three years or out of a trust fund and been forced to pay capital gains tax on the proceeds.

Over the past 33 years South Africa has in fact experienced quite a number of quite severe corrections though, happily, not all have been as severe at the 2007 one. Here in South Africa we were less affected by the Dot Com bubble that burst in January 2000 but nevertheless the JSE All Share Index turned negative on January 17 2000 at a value of 92 260 and continued down until it bottomed on April 14 at a level of 66 320 for a loss of just 28.12 percent as depicted below. Furthermore, for those who simply held on through this phase, their fortunes had been restored by mid-February 2001

But between May 21 2002 and April 25 2003 South Africa experienced another bear market which took the JSE All Share Index down from 116 530 to a low of 73 612 for a 36.83 percent loss which took until September 2004 before investors saw their capital restored as illustrated in my next graph.

South African investors saw another sharp deterioration between April 20 1998 and September 10 the same year when the All Share Index fell 43.8 percent from a level of 83 580 to 46 940 as illustrated below.

In 1987 the market fell precipitously on October 19. From a peak value of 27 340 the JSE All Share Index fell to 19 590 by November 4 and then, after a brief very modest recovery, fell further to bottom at 15 220 representing an overall loss of 44.3 percent.

So, if you care to work it out, the five biggest crashes of the past 33 years on average cost investors 40.27 percent of their portfolio value. Of course that is no guarantee that the next crash will be as modest but from this it is clear that if the shares in your portfolio have been there for less than three years the probability is that it will cost you more in taxes to sell out in anticipation of a market crash than the crash is likely to cost you.

And it would be almost as costly if your shares have been yours for more than three years had you are invested via a family trust and you fear that a crash might wipe you out, the probability is that selling ahead of it might actually cost you almost as much in Capital Gains Tax as the effects of a crash.

The tax is grossly unfair upon those who opted to go without many of life’s little luxuries in order not to be a burden upon their children or the state in their declining years. Other, more progressive countries, do not levy CGT in such circumstances provided you re-invest the capital in an alternative capital preservation vehicle.

If our government really wanted to attract investment into this country it would modify CGT to bring it in line with other progressive countries. So for a moment let us consider what it would mean to investors if CGT were not to be applied; that you could sell ahead of an anticipated crash and subsequently buy back the same portfolio at a one third discount and see it grow back to its full previous aggregate price in an average of a little more than a year! Happily there are some options that allow you to in effect do just that.

You can insure against such a market catastrophe and protect your portfolio by taking out a “Put” which is the right to put a parcel of shares into the hands of another investor at an agreed price. Here the seller of the Put is gambling that the market correction will NOT happen within the agreed period of the Put (usually about three months) while the person taking out the Put obviously gambles that the correction WILL occur within the agree time. The problem with such an approach is that it is quite costly meaning it is really only a possibility in the case of portfolios worth well over R1-million.

If nothing happens, the person taking out the Put looses the cost of it (generally around ten percent of the value of the portfolio) while the person issuing the Put gains the fee. As an alternative and usually for a somewhat lesser fee our investor might take out a Futures position in which case he will only be called on to ante up money if, instead of falling, the market rises. However, in such a futures position, if the market continues rising rapidly the issuer of the future will repeatedly call for the futures buyer to ante up additional money and this could be potentially devastating for a portfolio.

So, the reality facing South African investors currently is that they KNOW that a correction is almost inevitable but the million dollar question is when? If we could know the answer to that one we would all be billionaires! I have accordingly in my own portfolios opted for the conservative approach and to readers of my Prospects newsletter I have for months been advising them to accumulate cash and to sell off a few relative underperformers where the capital gains penalty was not so severe in order to create a “war chest” of cash with which to buy once the anticipated crash has happened. In this manner we have actually accumulated approximately 26 percent of the portfolio value.

Kylie Jerg who administers overseas portfolios on behalf of some of my clients opted to use a futures position to insure these portfolios and, on the face of it, it was the right decision but taken too soon because the portfolios have lost heavily as she has been forced to liquidate shares to meet margin calls. However, once the market turns down, the opposite will happen and the value of the portfolios should be more than restored. Her mistake was to take out such cover too early. But then hindsight is a perfect science. As I have already emphasised, world authorities like Harvard University professor Kenneth Rogoff who is a former US Federal Reserve board member, last week warned the World Economic forum in Davos that a crash is likely soon, and many other authorities have been warning of a crash since the middle of last year.

Overseas markets are dominated by Wall Street and that market is poised to turn down within the next few weeks. The artificial intelligence system within my ShareFinder computer program has proved itself to be 91.07 percent accurate in the market direction forecasts which we publish each week in my Richard Cluver Predicts column, and it now predicts that the London’s FT 100 Index will turn down on February 1 and fall virtually without respite until the end of September as illustrated by the red projection line in the graph below:

Understanding why such a decline could be imminent one needs only to turn to an indicator known as the Cape Ratio.

The Cape Ratio was developed by Yale University Professor Robert Shiller. Described as a Cyclically Adjusted Price-Earnings (CAPE) ratio, it initially came into the spotlight in December 1996 after Robert Shiller and John Campbell presented research to the US Federal Reserve that suggested stock prices were running up much faster than earnings. In the winter of 1998, Shiller and Campbell published their groundbreaking article Valuation Ratios and the Long-Run Stock Market Outlook, in which they smoothed earnings for the S&P500 Index by taking an average of real earnings over the past 10 years, going back to 1872.

This ratio was at a record 28 in January 1997, with the only other instance (at that time) of a comparably high ratio occurring in 1929. Shiller and Campbell asserted the ratio was predicting that the real value of the market would be 40% lower in ten years than it was at that time. That forecast proved to be remarkably prescient, as the market crash of 2008 contributed to the S&P 500 plunging 60% from October 2007 to March 2009.

The CAPE ratio for the S&P 500 has climbed steadily for the past nine years as the economic recovery in the U.S. gathered momentum and stock prices reached record levels. This week the CAPE ratio stood at 49.9, compared with its long-term average of 16.80. The fact that the ratio had previously only exceeded 30 in 1929 and 2000 has triggered a raging debate about whether the elevated value of the ratio portends a major market correction.

Critics of the CAPE ratio contend that it is of little use because it is inherently backward-looking, rather than forward-looking. Another issue is that it uses GAAP (generally accepted accounting principles) earnings, which have undergone marked changes in recent years. In June 2016, Jeremy Siegel of the Wharton School published a paper in which he said that forecasts of future equity returns using the CAPE ratio may be overly pessimistic because of changes in the way GAAP earnings are calculated. Siegel said that using consistent earnings data such as operating earnings or NIPA (national income and product account) after-tax corporate profits, rather than GAAP earnings, improves the forecasting ability of the CAPE model and forecasts higher U.S. equity returns.

Argument aside, analysts are generally agreed that share markets are at record highs and that a correction must come sooner rather than later and with the Cape Ratio standing higher than at any time other than the Dot Com bubble era, it is an indicator one cannot ignore. But what steps you take in anticipation of the inevitable crash is up to you.

Each of the options I have outlined are costly thanks to the Receiver of Revenue and the irony of it is that Capital Gains Tax brings in comparatively little revenue for the fiscus. Given the deterrent it imposes upon investment in this country and the fact that South Africa tops the list of emigrants of wealth, one has to question the wisdom of maintaining it. On the face of it, everyone would benefit if it were dropped. The most recently available SARS statistics indicate that CGT yielded revenue of R2.2-billion out of total revenue that exceeds R1.2-trillion; a tiny fraction that causes such pain to South Africa’s elderly and so deters foreigners from investing here.

Back in the Emerging Market fold

By Brian Kantor

The South African economy has recently re-joined the world of emerging markets. The JSE, measured in US dollars, has caught up dramatically after having lagged well behind the surging MSCI Emerging Market Index.

The JSE, in US dollars, and the SA component of the emerging market (EM) Index have gained over 40% since January 2017 as we show below in figure 1.

These EM and JSE gains have come after an extended period of underperformance when compared to the S&P 500. The S&P 500 has been making new highs so consistently over the past year. The EM Index and the JSE, in US dollars, have still to be worth more dollars than in 2011.

This JSE catch-up has come with the burst of rand strength that accompanied the defeat of President Jacob Zuma and his faction at the ANC electoral congress in December 201, a defeat that promised a new direction for the SA economy. The rand had weakened by about 11% compared to our basket of equally weighted other EM currencies by November. It is now about 4% stronger than the basket of EM peers (see figure 2).

Rand and EM currency strength has come with a noticeably weaker US dollar. The US dollar index (DXY) lost about 12% of its exchange value against other developed market currencies since early 2017 while the index of EM currencies has gained about 10% on the dollar, with the rand up by over 15% over the year.

A weak US dollar is good news for EM economies and especially their consumers. It brings currency strength and lower inflation – particularly of imported goods – and lower interest rates. It is very hard to see how the SA Reserve Bank can fail to respond to these trends with lower interest rates in due course.

The renewed hopes for the SA economy have extended to the bond market and to the risk premiums attached to SA government debt. Both inflationary expectations – measured as the spread between a vanilla 10 year RSA bond and its inflation-linked equivalent – have declined sharply, from over 7% in November to about 6% currently.

The spread between the RSA 10 year yield and its US Treasury bond of similar duration, that represents the expected depreciation of the ZAR/USD (the interest carry), has also declined by a similar degree. Yet both spreads remain quite elevated by the standards of the past. The belief in permanently lower inflation or a stronger rand is still lacking (See figure 3).

The cost of insuring RSA US dollar-denominated debt has also responded well to the new dispensation in SA. After many years of trading as junk – ever since Zuma sacked finance minister Nene in December 2015 – RSA debt is now competing again on investment grade yields.

Further support for the rand and EM currencies has come from higher commodity and metal prices. As we show below, industrial metal prices have performed better than commodity prices indices (that includes a heavy 27% weighting in oil). The London Metal Exchange Index is up 30% in US dollars since early 2017 (see figure 5). A stronger global economy combined with a weaker US dollar is helpful to EM economies including SA with their dependence on exporting minerals and metals.

The politics as well as the economics of SA are now in a much healthier state as the market place confirms. And the global economy is offering much more encouragement for SA exporters. But as indicated in our figures, there is room for further improvement. Inflation and interest rates can recede and the exchange rate and sovereign risk spreads have room to narrow further. The opportunity presented to SA is to stop the rot (developments to date have been well appreciated in the market place) and then to follow through with wealth creating and poverty reduction initiatives. 

A very bleak outlook

By John Mauldin

In their fourth-quarter 2017 review and outlook, Lacy and partner Van Hoisington take a 

definitely contrarian stance on the coming year.
Where most analysts – and the Federal Reserve itself – are expecting robust US economic growth, stable inflation, and modest interest rate increases in 2018, Lacy and Van foresee disappointing growth, lower inflation, and ultimately lower long-term interest rates.

Lacy and Van focus their argument on the US consumer. Although consumer spending expanded by 2.7% in the past year, in line with its average growth of 2.5% over the past eight years, personal income rose by only 1.9%. Thus, the authors note,

It was only the ability to borrow that supported the spending increase. In economic terms, borrowing is a form of dissaving. The saving rate for consumers dropped from 3.7% a year ago to 2.9% in November, a 10-year low.

The only period in which the US saving rate was lower than it is today was 1929–1931! And historically, a low saving rate portends a slower rate of economic growth. Personal income should slow even further this year as employment growth continues to tail off, and the Fed’s 125bp increase in the federal funds rate should put a dent in consumer borrowing, too.

When Lacy veers away from the consensus view, I have learned to pay attention. 2018–2019 shapes up as another watershed period for the US and world economies

The crash of the Nifty 500

By Jared Dillian

Jared DillianThere was a big bull market in the early 1970s, led by a group of fifty large cap stocks known as… drum roll… the “Nifty Fifty.”

There is actually a Wikipedia entry for the old Nifty Fifty—click on it and you will see that while a lot of these companies are gonzo, the rest of them very much resemble today’s Dow.

Of course, I was not around to remember the Nifty Fifty—I was born in 1974, truly a child of the bear market. Stocks were down 45%. There is also a Wikipedia page for that bear market—they even call it a “crash.”

The two, of course, are related. A bubble, accompanied by an obsession or a preoccupation with a stock or group of stocks, followed by a great big dirtnap.

You look around today and wonder, is there anything like a Nifty Fifty? Well, there is FANG, but FANG is only four stocks. Besides, I don’t get the impression that any of those stocks on their own has anything like a cultish following.

And it’s not like people are bananas about tech stocks, or energy stocks, or homebuilders. People aren’t really bananas about stocks.

People are bananas about the stock market.

Yes, We’re Beating up Indexing Again

Indexing, which was a curiosity in the 1980s, has become a religion. You invest in an S&P 500 index fund. Why? So you are diversified. You own 500 stocks, which is the ultimate in diversification.

Except—you are not diversified when 30 million people own the same 500 stocks as you, because what happens if everyone wants to sell their 500 stocks all at once?

It actually is a bit like the Nifty Fifty—it’s just the Nifty 500!

“Is it different this time?” you ask the veteran of two ridiculously horrible bear markets.

Well, you always have to entertain the idea that it could be. After all, indexation only makes up a small percentage of total investable assets. And it continues to grow, partly because its growth is encouraged by regulatory changes like the Fiduciary Rule. So there is a lot of momentum.

But you have look at all these inflows into indexes, and ask what would happen if the flows went the opposite direction and they turned into redemptions.

Vanguard gets $2 billion in new investor money a day. What if it lost $2 billion a day?

Not saying it will happen, just being the “what if” guy.

There is no trend in finance that is not capable of running in both directions.


How do you protect yourself? I mean, the S&P 500 makes up most of the investable market cap.

You could do small cap or mid cap, but there are indices for those, too.

In fact, there are way more indices than stocks, so it’s hard to find a stock that is not in an index.

But it can be done.

One of the things I focus on is not getting inside too many crowded theatres with tiny exits. If you are an institutional trader for any length of time, you learn to be paranoid like this. You are constantly asking the question, “How am I going to get screwed?”

Nobody trades stocks these days—they trade index mutual funds and ETFs. So you do the best you can to stay away from big, popular indices.

There actually are a handful of stocks, about 100 or so, that are not in any index. I did some work on this about a year ago. These stocks will not participate in the Nifty 500 on the way up…

…but then again, they won’t participate in the Nifty 500 on the way down.

If I were a research analyst at a large hedge fund with some time to kill, I would go through every stock in the Wilshire universe. I’d figure out how many indices it is in, and the AUM that tracks those indices. Then zig, while everyone else zags.

The Bullish Argument Is Most Compelling on the Highs

Unfortunately, I did not make the Inside ETFs conference this year, but I spied a photo from the conference on Twitter:
Source: @ckelly1980

The slide is making the point that ETFs only make up 2% of investable assets, a figure that will certainly grow.

And it will probably continue to grow for some time, because the ETF structure has some clear advantages over the open-end mutual fund.

Remember, I’m the “what if” or “yeah, but” guy. I’m just observing that people are more bullish on indexing than at any point in history, concurrently with some other sentiment and technical indicators that are unbelievably stretched.

If the bull market is because of indexing, a bear market will probably be because of an unwind of indexing.

Assuming you view the market as a supply-demand equation, the only way you dump supply on the market is if you get index fund redemptions. And how does that happen?

Beats the hell out of me.

How Inflation Might Hit Bitcoin

By Patrick Watson

You know that awful feeling when you think you lost your wallet? Now imagine you had $75 million in it. What would that feel like?

Fortunately, I don’t know, but some unlucky people do. They’ve lost access to the digital wallets that hold their bitcoins—and without it, their cryptocurrency windfall is gone forever.

Or is it?

This is a deeper mystery than it may seem, with some unexpected conclusions I’ll describe below.

Cash in the Trash

Somewhere in the Newport, Wales garbage dump is a computer hard drive that local resident James Howells discarded in 2013. He had spilled lemonade on it and thought it wasn’t worth fixing.

Howells forgot that the hard drive contained the codes to access some bitcoins he had “mined” beginning back in 2009. He had about 7,500 bitcoins, worth $75 million assuming a $10,000 bitcoin price.

Howells naturally wants to recover the lost device. He’s offered the Newport council 10% of the proceeds if it will let him dig into the landfill. So far the answer is “no.”

Stories like Howells’ are popping up everywhere. People who mined or purchased bitcoins, sometimes years ago, can’t access it.

The reasons vary: some forgot the password, others lost the memory stick, or their hard drive with the codes on it crashed. Some people died unexpectedly and took their passwords to the grave.

Whatever happened, a lot of value is missing as bitcoin’s price zooms higher.

Some of the desperate would-be millionaires have even tried hypnotism to recover forgotten passwords. Others are hiring hackers (honest ones, hopefully) to rifle through their files for clues.

And these individual owners are only the first level. The accumulated pile of inaccessible bitcoins could lead to systemic consequences.

Phantom Bitcoin

Bitcoin’s anonymous inventor(s), Satoshi Nakamoto, designed the program to allow mining of only 21 million bitcoins by the year 2140. Miners have dug up about 17 million bitcoins in total so far.

A study last year by digital forensics firm Chainalysis estimated that somewhere between 2.78 million and 3.79 million bitcoins are lost.

That means as much as 22% of the existing bitcoin supply might as well not exist. For all practical purposes, it’s gone.

The real bitcoin supply that is available for transactions isn’t 17 million—it’s 17 million minus those lost millions. So maybe as little as 13.21 million, using the higher Chainalysis estimate.

Does that affect the bitcoin price? It should.

Imagine if these were shares of stock, and the company bought back two or three million of 17 million outstanding shares. The price would rise because supply dropped.

But are the lost bitcoins really lost? For some of them, we can’t be sure.

Satoshi’s Million

“Satoshi” mined some 1 million initial bitcoins. They’re on the blockchain ledger, so we know Satoshi hasn’t touched them. We don’t know who Satoshi is, whether he/she is still alive, or whether he/she still has access to those one million bitcoins, or may have given access to others. Satoshi might even be a group of people.

In any case, Satoshi’s stash represents 5.9% of existing bitcoin supply. Their existence affects the value of all bitcoins… but maybe it shouldn’t, if a bus hit Satoshi and they are effectively gone.

But Satoshi is/was pretty clever. Maybe some time-delay mechanism will distribute the one million bitcoins to Satoshi’s favourite people on a designated date. Or maybe Satoshi will retire and finally liquidate them next year. We can’t assume they are permanently gone.

Similarly, many of those other “lost” bitcoins may not remain so. Maybe that council in Wales will let Howells dig for his hard drive, and he’ll find it. If so, the total bitcoin supply won’t change, but the available supply will rise.

Or maybe scientists will invent brain-computer interfaces that let people recover forgotten passwords. Available bitcoin supply will then grow some more.

The law of supply and demand applies everywhere, even to bitcoin. More bitcoins in circulation means more bitcoins available when someone tries to buy bitcoins with dollars, yen, gold, or whatever.

In theory, at least, that should have a bearish influence on the bitcoin price.

Sound familiar? It’s what we would call “inflation” in a fiat currency. The value of each dollar drops as more dollars enter circulation.

Bitcoin’s Float

So bitcoin is vulnerable to a kind of inflation.

Granted, it’s less vulnerable than a fiat currency, thanks to that hard supply limit of 21 million. Central banks have no such limits. They can debase their currencies to nothing, as is happening in Venezuela right now.

A better comparison might be shares of stock. Companies know exactly how many shares they’ve issued and retired, so they can always tell you the number “outstanding.”

There’s also something called “float,” which is the outstanding shares minus restricted shares that owners can’t yet sell. Float is the tradable inventory.

Then there’s a “fully diluted” share quantity: outstanding shares plus the new shares the company would have to issue if all option holders—typically employees or early investors—exercise them.

We can map those same concepts to bitcoin.

  • Outstanding bitcoin is the number that have been mined, around 17 million.
  • Bitcoin’s float is 17 million minus Satoshi’s million and all those “lost” bitcoins—maybe as little as 12.2 million.
  • Fully diluted bitcoin is 21 million, which can’t happen until the year 2140.

The bitcoin float could unexpectedly increase if Satoshi sells his/her million or owners recover significant quantities of “lost” bitcoins.

This would look much like the share dilution when a company issues new equity. Usually, the share price drops.

That may never happen to bitcoin, but it’s not impossible. That means bitcoin buyers and sellers should consider it in their valuation.

The broader point: Bitcoin has a kind of inflation risk.

Just like monetary inflation, this risk grows with time. The longer people search for lost bitcoins, the more likely they’ll find some. Technology will be giving them better tools as time passes too.

Bitcoin has many risks, so this is a relatively minor one. It’s small, but above zero.

Small risks add up when trading stocks, bonds, or currencies. The traders who survive are the ones who watch for them.

Bitcoin traders should take note.

Gross Domestic Problems

By John Mauldin

Fictitious Wall Street villain Gordon Gekko famously declared, “Greed is good.” I think actual Wall Street titans would mostly disagree. They would change one word. Instead of “greed,” they would say, “Growth is good.” That is Wall Street’s real mantra. Growth is the magic elixir we all need.

The question, if we define growth as good, is how do we measure it? Presently we use gross domestic product, or GDP. But GDP is showing its age in the 21st century. The measure was actually invented in the late 1930s when President Roosevelt needed some way to prove that his policies were working. And at 85 years old, the old formula may be nearing time for retirement.

The only way for Roosevelt to show that his policies were working was to put government spending inside the GDP number. There was vicious fighting among economists over whether he should be allowed to do so. Many economists even argued that military spending should not be included in GDP because it didn’t produce anything. And it’s true that overreliance on GDP has often sent policymakers and business owners in wrong directions. We need a better yardstick.

First, we must next decide what, specifically, a newly formulated GDP should measure and how – and that’s a thornier question than you might think. Today we’ll wrestle with that question and with some of the implications of changing how we measure growth.

These are exactly the types of pressing questions we will be attempting to answer at my upcoming Strategic Investment Conference. By “we,” I mean the hand-selected, A-list cast of economic, investment, and geopolitical powerhouses who will speak, and the audience that will respond to them. And for SIC 2018 we really do have an all-star group, including “bond king” Jeffrey Gundlach, hedge fund titan John Burbank, renowned historian Niall Ferguson, and some 20 more brilliant minds. At SIC you will get their latest and best thinking. Better yet, SIC is small enough that you can usually find the speakers in the hallway or after hours and interact with them.

In addition, there are a couple of hundred “core” SIC attendees who come every year. They represent a remarkable range of talent, experience, and wisdom. Some of them really ought to be on the stage. Instead, they’ll be sitting with you, and you’ll find them friendly and ready to swap ideas. We’ve seen countless business relationships form at SIC, and many more will happen this year. I hope you’ll join us, March 6–9, in San Diego.

Now, let’s see how we can fix the GDP problem, starting with where we are right now.

The Plow Horse Speeds Up

Brian Wesbury, chief economist at First Trust Advisors, has been calling our present recovery phase a “plow horse economy” for several years. It’s not fast or impressive, but it’s not stopping, either. He’s been mostly right, too.

Last week Brian said that the horse is now breaking free.

We’ve called the slow, plodding economic recovery from mid-2009 through early 2017 a Plow Horse. It wasn’t a thoroughbred, but it wasn’t going to keel over and die either. Growth trudged along at a sluggish – but steady – 2.1% average annual rate.

Thanks to improved policy out of Washington, the Plow Horse has picked up its gait. Under new management, real GDP grew at a 3.1% annualized rate in the second quarter of 2017 and 3.2% in the third quarter. There were two straight quarters of 3%+ growth in 2013 and 2014, but then growth petered out. Now, it looks like Q4 clocked in at a 3.3% annual rate, which would make it the first time we’ve had three straight quarters of 3%+ growth since 2004-5.

That was Monday. On Friday the Commerce Department released its first 4Q GDP estimate at 2.6%. The estimate will likely change, but for now it looks like Brian was a tad bit optimistic about Q4. But you should read his outlook anyway, because he breaks his estimate down to the components of GDP to show how he arrived at 3.3%.

The GDP formula is C + G + I + NX, where

C = Consumer spending
G = Government spending
I = Private investment
NX = Net exports.

Net exports, is exports minus imports, so it’s a negative number for a country like the US that runs a trade deficit.

To get GDP, you just estimate the change in each component, weight it by the appropriate amount, and add the components together.

That’s easy enough, but the calculation ignores whether those are the right components and how to define them. The result is a lot of potential distortion. For example, very little happens to GDP if you do your own housekeeping. You consume some cleaning products, but your labour doesn’t count, no matter how long you scrub. But the labour does count toward GDP if you hire someone and pay that person to do the exact same work while you take a nap. The hired labour “produced” something of value, and you did not.

To an economist, a barrel of oil selling for $100 has the exact same effect on GDP as two barrels of oil selling at $50. Silly, but that’s the way the accounting works.

Libraries and Typewriters

Looking deeper, we realize that GDP is a historical artefact from an industrial economy that doesn’t really exist anymore, at least in the US. GDP worked well in the post-World War II era when the US economy thrived by making material goods: trucks, cars, machinery, appliances, airplanes, houses, and skyscrapers, etc. Output is easy to measure for such goods, as are the kinds of inputs required to produce them, mainly large factories and raw materials.

Today’s economy isn’t like that. Technically, manufacturing is still 35% of GDP, but fewer than 9% of US workers are actually involved in that manufacturing. We are producing more stuff than ever, but we are doing it with far fewer people. And now we produce huge quantities of largely intangible goods: computer software, movies, music, and so on. Those products are easy to copy and hard to track. The productive capacity often exists inside some smart human’s brain. How do you measure that?

Think also of how much more productive technology has made us. That’s hard to measure, too. Imagine it’s 1975 and you want to know what GDP growth was in 1972. Unless you happen to be an economist who keeps such figures handy, you get in your car and drive to the library. You consult a card catalogue, note the Dewey Decimal classifications of many promising volumes, then set off to search the shelves for them. When you chance on something, you thumb back and forth through it to find the statistic you want. Then you head back home and resume typing your research paper on a typewriter – perhaps you even have an IBM Selectric!

To get that number now, of course, you whip out your Smartphone, type “us gdp 1972” into a search window and voila! I just did this, and it literally took me less than five seconds.

Or consider travel. Remember the spiral-bound map books that covered major cities? In Dallas the company that made them was called Mapsco. If your job involved going to unfamiliar places, you had to have one, and they were expensive. And you had to buy a new one at least every few years. Now your phone can get you anywhere you want to go, not just in your hometown but the world over.

We could list thousands of little tasks that used to take hours but now require only seconds. Add up all that time saved, then scale it over hundreds of millions of workers. The impact on productivity is mind-boggling. Does it show up in GDP? Not really. It may even reduce GDP, since we no longer consume as much fuel, printing, and library space, etc. I grew up in the printing business, and I would often print prospectuses. They were incredibly expensive and time-consuming to produce. Today a prospectus is a PDF file. Going back to the old ways might improve the economic numbers, but would it help the economy? No way. Yet we measure economic growth as if it would. That’s a problem.

Our antiquated methods matter to employment, too. I saw in a recent Wall Street Journal report the reduction in labour needed to operate a power plant as we move from nuclear or coal to natural gas or wind or solar. One company that is shutting down its coal plant and laying off 430 workers will be opening a solar plant in West Texas that will be one of the largest solar facilities in the country, operated by two workers, who may actually be part-time. Put that in your future-of-work pipe and smoke it.

 Coal power accounted for 39% of US electricity production in 2014, 33% in 2015, and 30.4% in 2016. There are 1308 coal-powered plants in the US. Assume 125 workers per plant. That’s 163,500 workers. Now cut that number by at least 80% if the plants all shift to natural gas, which they will over time. That’s a loss of 130,800 workers. And that’s assuming that they all go to natural gas and don’t go to wind or solar. This is going to happen in the next 10 to 15 years. My math could be off here or there, but not by an order of magnitude.

We are now producing vastly more energy with far fewer workers than we did in GDP’s heyday. That’s a labour problem for sure, but it’s also a growth measurement problem. We desperately need a better method.

Better Mousetraps

I could go on at length about the problems with GDP, but I’ve done that before. Read “GDP: A Brief But Affectionate History” and “Weapons of Economic Misdirection” for the gory details.

A key question: Is GDP completely outmoded, or does it just miss some things? If the latter, then maybe it just needs some tweaking instead of total replacement. The wickedly brilliant Diane Coyle, a University of Manchester economist, has been working on this issue for years. She proposed in a recent paper with Benjamin Mitra-Kahn a series of incremental changes that should help: better measurement of intangible goods, an adjustment based on income distribution, and some other relatively simple changes.

Distribution effects are a problem whenever we look at GDP per capita, as we commonly do when we compare nations. Almost everywhere, income is far more concentrated at the top than it used to be, but the effect varies a lot depending on where you are. It is entirely possible, indeed it is likely in some places, for per capita GDP to rise sharply while most of the population sees no change in its living standards or economic health. An adjustment to compensate for this inequity is an excellent idea.

That point brings up a thornier problem, though. In whatever way we measure it, is “growth” the right thing to watch? Does it really tell us what we think it does? We look at GDP growth and assume a country that has it is prospering. We think everyone who lives there must be thrilled. Often, they have little reason to be.

The assumption works in the other direction, too. If GDP is flat or falling, we see a recession and react accordingly. That is particularly the case with political leaders and central bankers, who then introduce policies to solve the perceived problem. These policies can be damaging if the problem is less serious than central bankers think it is. This may be happening in the US right now.

We’re asking GDP to do something it can’t. What we want is a benchmark of economic progress. Are a country and its people generally better off economically than they were last year or five years ago? If so, by how much? Then we can start to know which policies might help and which might hinder progress. Business owners would be able to make better decisions, and ultimately everyone should feel the benefits.

The problem is, measuring concepts like income inequality may differently skew the witches’ brew that is GDP. The only part of the economy that is really subject to serious increases in productivity is manufacturing; and, as noted above, manufacturing involves less than 9% of the workforce. It is hard to get increased productivity out of service workers. Now, you can use technology to replace them, but that hardly improves their situation, even if it does increase the production of gross domestic stuff per dollar spent.

People have proposed such measures. In 2013 the Skoll World Forum launched the Social Progress Index, defined as “the capacity of a society to meet the basic human needs of its citizens, establish the building blocks that allow citizens and communities to enhance and sustain the quality of their lives, and create the conditions for all individuals to reach their full potential.”

Some of those indicators could be hard to pin down. I don’t see how you put a number on “religious tolerance,” or “tolerance for homosexuals,” for instance. But the creators of the index are on the right track in that they are attempting to measure well-being. I am not certain how widely accepted such a measure would be, but it’s a start.

Another effort appeared in a 2010 book by economists Joseph Stiglitz, Amartya Sen, and Jean-Paul Fitoussi, called Mismeasuring Our Lives: Why GDP Doesn’t Add Up. Their suggestion is to continue using GDP but add other data points to clarify it. They would use things like life expectancy, debt levels, educational achievement, and other social progress metrics.

The World Economic Forum, which had its annual shindig in Davos last week, took another stab at this problem with its “Inclusive Development Index.” It too supplements GDP with other progress indicators.

The WEF paper says GDP is fine as a top-level measure, but growth is a means to an end, namely better living standards. Only by looking at those living standards can we know if GDP growth is accomplishing what it should.

By WEF standards, the “most inclusive” advanced economies are mostly European. The US and Canada are not in the top 10. The most inclusive emerging economies list is more interesting. Azerbaijan? Really?

Lithuania leads the list, and from what I’ve heard, it probably deserves to do so. (We have employees in Lithuania, and they are excellent and productive workers, as are our Eastern European staff. We are truly a worldwide virtual company.) The other countries on the list look like a strange mix at first but make more sense after some thought. Several live in the shadow of much larger neighbours, so maybe they are more willing to innovate. This list would be a good starting point if you have money to deploy in emerging markets.

That’s a good thought: Countries that are growing in a fair, sustainable way should attract investment. Often they don’t, because investors want quick profits. Look at the move by corporations to increase the number of temporary workers and contract workers so that they are not so much paying for employees as paying money for actual production, without having to cover a lot of the extra benefits that normally go along with traditional employment.

This is a particular complaint that I hear from the friends of my kids, especially the Millennials. They need to hold two part-time jobs in order to make ends meet, and generally those are not jobs that pay a great deal. The gig economy is not all that it’s cracked up to be. The drive by senior management to create short-term profits and to see employees as liabilities rather than as partners in the business process will create a great backlash in coming years.

I’m going to stop here because the next section of the letter would be at least as long as this letter is so far. But let me tease you for next week. I think I’m getting ready to start talking about the probability of a recession before the 2020 election cycle. I see structural problems, monetary policy errors, and a tax cut that is not going to produce the results that the Reagan tax cuts did. M2 money is not even growing at 2%. The savings rate is the lowest it has been for 70 years except for one quarter in 2005; and even though consumer spending was strong last quarter, it came from much-reduced savings and borrowing, much of it on credit cards as a result of the two hurricanes and other disasters and longer-term challenges.

So while on the surface 4.4% nominal GDP growth and 2.6% real growth look pretty good, when you really begin to inspect the engine of growth, you find less under the hood. The velocity of money keeps falling. Our demographics mean that we are not adding workers, and the latest immigration proposal would reduce the number of immigrants and potential workers. And while I am all for allowing the so-called Dreamers to be allowed to stay in this country – the only home country they have known – we do need to be a lot more strategic about allowing potential workers into this country.

After all, GDP is simply the number of workers times productivity. With the number of workers tailing off and with productivity as weak as it has been, the sugar high that the economy has been on is going to wear off. Let me hasten to say, I don’t think nearly enough credit has been given to Trump for changes in the regulatory environment. It’s not merely the reduced number of regulations, it’s the attitude of the regulators that I keep hearing businessmen talk about. Given that I am in highly regulated businesses, I hope to enjoy that new environment sooner rather than later.


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