Authored by Mark Yusko of Morgan Creek Capital Management,
Some of my first memories of television are of a series called The Rocky and Bullwinkle Show, which was a witty combination of animated cartoons about the exploits of the title characters, Rocket "Rocky" J. Squirrel and Bullwinkle J. Moose and their nemeses, two Pottsylvanian nogoodniks spies, Boris Badenov and Natasha Fatale. The show was filled with current event commentary, political and social satire, and featured an embedded variety show including a number of repeating shows-within-a-show that "reinterpreted" fairy tales and history lessons. The show originally aired in Prime Time from 1959-1964, but ran for many years in syndication (remember, no internet and no on-demand) in the coveted after-school timeslot (to capture all the sugary cereal buying power of grade-schoolers like me). The intro for the show was often Rocky flying (yes, he was a flying squirrel, think 1960s jet propulsion here) around the stage while Bullwinkle implored, "Would you like to see me pull a rabbit out of my hat?"
The top picture above shows that Bullwinkle's prowess as a magician was suspect and he pulled just about every¬thing out of his hat, except the proverbial rabbit. The show was conceived during the height of the Cold War and had a recurring theme of the spies, Boris and Natasha, following dastardly plans created by their boss, Mr. Big (or Fearless Leader), to defeat our lovable heroes from Frostbite Falls, MN. The show was also filled with commentary on economic and market conditions that resonated with the parents watching the show while the kids focused on the cartoons. Each show ended with the narrator describing the current cliffhanger with a pair of related titles, usually with a bad pun intended. So let's adapt some of my favorite Rocky and Bullwinkle episode titles to modern day; we might see that there are some political and economic challenges that are timeless, as it appears we have been doing the same thing over and over for decades and expecting different results.
"A Fault in the Vault or Banks a Million."There was an interesting storyline about the idea that the worlds economy had become so dependent on box top refunds (you send in cereal box tops to the show's sponsor and get prizes) that Boris and Natasha were able to cause worldwide sabotage via counterfeiting (since box tops are just paper and ink...). It appears that there is nothing new in the world, substitute QE for box top refunds and many commentators might say that printing fiat currency without limit is a form of counterfeiting and that global Central Bankers are nogoodniks just like Boris and Natasha. Clearly we have to make a "small" inflation adjustment to the title and substitute Trillion for Million (and actually Quadrillion in Japan...) and, given the size of the numbers, we may find out soon that there is indeed a fault in the vault.
"Boris Goes for Broke or A Fiend in Need Is a Fiend.. .Indeed."When the fiends (Boris and Natasha) get desperate, a situation can go from bad to worse and this theme could describe the European situation perfectly today. As the Recession rages on, unemployment skyrockets, capital flees the banking system and confidence in the entire Euro experiment wavers, the neediest of the Peripheral countries will become increasingly desperate; and when you find yourself in serious need, you may resort to fiendish behaviors. We are beginning to see the unravel¬ing of the social fabric in places like Greece and Cyprus (where people have lost everything and are becoming more desperate by the day) and Spain and Italy appear to be teetering near the edge. Let's all hope that they don't go for broke all at the same time, as a broke Europe will be expensive for the U.S. given all the loans to the European banks from Mr. Big himself (Ben the Banker) which might suddenly go missing.
"A Creep in the Deep or Will Success Spoil Boris Badenov?" Perhaps one of the biggest problems of the proliferation of Austerity and QE programs around the world is the developing notion that they are actually working. Now, if one were to measure success based on economic growth, job creation, government debt reduction or social stability, these programs would get failing grades; however, if one were to judge success by rising equity market prices, then our Central Bankers might consider themselves big winners. The question is will that perceived success make them continue these programs too long (or worse, escalate them into an all-out global currency war) and lead to less than desirable outcomes in the long-term.
"The Road to Ruin or Mine Over Matter."Bullwinkle inherits an Upsidaisium mine on Mount Flatten (which actually floats in the sky because it is made of the anti-gravity metal) with such value that Boris and Natasha's over¬lord, Mister Big, personally attempts to steal the mountain and then the government's storehouse of ore. Wait a minute, an anti-gravity metal that the government covets and stores? Sounds like fiat currency to me. Remember that this show was running in the years right before the abandonment of the Gold Standard and was likely social commentary on the potential challenges of unsound money. Today we have governments all around the world locked in furious "mining" of Upsidaisium to try and keep the markets afloat and try and maintain their portion of a global economic pie that is growing increasingly more slowly under the burden of the massive global debts. One significant problem is that servicing these volumes of debt shifts productive resources from growth and development to interest expense.
"All That Glitters or Baby, Its Gold Outside."In a not so subtle way, the writers insert their view on the purest form of money. Direct commentary on gold is not new in entertainment, as The Wizard of Oz took on the Gold Standard in the imagery of the Yellow Brick Road leading to the Emerald City (representing the Greenback Dollar that only appears to have wealth) and the Great Oz (President McKinley, who was not so affectionately called the Wizard). During the time the show aired, gold prices were fixed at $35, but after the closing of the Gold Window in 1971, it was five times higher by 1974. The true store of wealth for thousands of years has been gold and with all the Badenov's cranking up their Upsidaisium production, it would appear that gold has a bright future (the last few months notwithstanding). Another interesting development has been the complete drubbing of the gold mining stocks since last summer. Many of the stocks are down more than 60% and sell at the lowest valuations relative to the price of gold in decades. Even if the 1970s melt-up in gold prices doesn't happen, there could be some real glitter in the miners if prices stabilize and valuations return to anything approaching normal.
"Below Zero Heroes or I Only Have Ice for You." In the early 1960s there was talk of Deflation and CPI hovered close to zero, just like today. Many economic commentators talk about Fire and Ice and with many cycle watchers saying we are mired in a Kondratieff Winter, the risks to Deflation are still very real. Our "below zero heroes" of negative real interest rates have been staving off negative CPI since the Financial Crisis, and during January and February of this year, it appeared that the Upsidaisium was working and interest rates started to shoot upwards and the pundits were calling an end to the 30-year bond bull market. Then in March, the Cyprus fiasco occurred and suddenly global investors saw that bank deposits were not as safe as they appeared, interest rates plunged again and fears of debt-induced deflation reared their ugly head again. With the Badenov Boys around the world printing money, everyone believes that the big risk is inflation, but the variant perception is that the Iceman cometh.
"Squeeze Play or Invitation to the Trance."The lowest trading volumes in the equity markets since 2008 should give us some reason to question the veracity of the claims that the global economic challenges are fixed and that the Great Rotation from bonds to stocks has begun (if it had begun, would we not see higher trading volumes as all that money went into the markets?). One thing that has resulted from lower volumes is the frequency and severity of short squeezes, which has contributed greatly to the nearly straight-line appreciation of equity indices during the periods of QE. When the Fed is doing Open Market Transactions of $85 Billion a month, it is a "short at your own risk" kind of market environment and the daily levitation is very "trance-like."History has shown us time and time again that when large numbers of investors (particularly investors on margin, which just hit new highs like in 2007) chase recent returns, meaningful corrections have occurred. Like lemmings following the herd, they walk right over the edge, no questions asked. The one factor that might extend the trance is that the Hypnotist in Chief in the U.S. may get some help shortly from his assistant at the Bank of Japan ("BOJ") and this chapter could go on longer than expected. Investment logic would dictate that the new liquidity from Japan would seek the lowest valued equities in Emerging Markets, Europe and Japan rather than the U.S., but it is likely that the Global Titans in the U.S. will get increasing amounts of flows and just like in the years right after the show ended, we could see a new Nifty Fifty of companies that sell at truly silly valuations (and then fall a LOT, but that didn't happen until 1972 when those companies fell 65% on average vs. 45% for the market, curiously at the same time gold went up 5X from the $35 fix during the two year correction).
"Hello, Orient or That's Some Dandy-Looking China You Have There." Even in the early 1960s the promise of the Orient found its way into pop culture. There was an episode about an Indian Raj losing a jewel-encrusted boat that Rocky and Bullwinkle found, and there were myriad references to the tremendous changes that were pending in China, as the Cultural Revolution was about to unfold. In many episodes the Chinese Launderette was where Boris and Natasha "cleansed" their illicit activities, as Red China (think bad guys) was still the prevailing sentiment during the Cold War era. Yet, there were hints that there was something "dandy" in China and 50 years hence, we have seen the explosion of development and maturation of the economy to become the second largest economic power in the world. As we look at investment opportunities today, we continue to see vast numbers of places to deploy capital in China and earn outstanding returns. Many of those opportunities continue to be in the private markets where you can gain a significant edge in private equity and real estate if you have local knowledge and relationships. We are fortunate to have a strong team on the ground in China, and we continue to find some dandy opportunities in those private markets, but we also have tremendous relationships in the public markets where we work with a number of hedge fund managers who have been able to navigate the volatility of the past few years to generate strong returns despite the index returns being muted. Recently, a very famous market technician, Tom DeMark (who all the big U.S. managers pay huge sums to get his buy/sell signals) made a monster Buy call on March 19th saying that the China A-Share index would be 48% higher within six months! We agree with the directionality (but even we are not quite that bullish) and we have begun to increase our China exposure in the portfolios.
"Down to Earth or The Bullwinkle Bounce." One of the original storylines of the show was the accidental discovery that Bullwinkle's cake recipe was an excellent rocket propellant and there are numerous episodes about traveling to the moon, Boris and Natasha trying to steal the secret formula, and visits from some actual alien moon dwellers. Capital markets in the 1960s were notoriously volatile (like today) and just about every other year there was a meaningful drop or a significant bounce. The past four years since the crisis have exhibited huge intra-year volatility, but over the entire period have inexorably risen more than 130% off the bottom in March of 2009. Let's call this the Bullwinkle Bounce since it has clearly been rocket fuel induced in terms of zero interest rates and massive amounts of QE and plenty of market strategists are forecasting that it is time for the U.S. equity markets to return to Earth. In fact, the average forecast for the firms that generate consistent 7-10 year forecasts (GMO, PIMCO, AQR, etc.) are calling for a meager 2% returns for stocks, so more of a leveling off of the glide plane rather than a crash landing. That said, Albert Edwards, the Chief Market Strategist for SocGen, just published a piece last week reiterating his forecast that markets were about to seriously come down to Earth with the S&P 500 falling to 450, ten-year Treasury rates going to sub-1% and gold going to over $10,000. Now that is a bold forecast (also a little unsettling). His thesis is that the Badenov Boys have over-stimulated and that hyperinflation, a collapse in growth, and loss of confidence in policy makers are inevitable. He posits that, like in the 1974 period when stocks collapsed (review Nifty Fifty numbers above), gold originally fell nearly in half (only fell 25% this time) and then went completely vertical, rising 8X over the next few years. So, Albert is calling for both sides of the cliffhanger, for equities to come down to Earth and for Gold to have a really serious Bullwinkle Bounce.
"The Deep Six or It's Tough to Fathom." Given the recent ebullience in the markets and the commitment of the global Central Bankers to "do whatever it takes," it is truly "tough to fathom" that we could be on the verge of a "deep six" kind of dive and that playing defense is important today. Human psychology has a really difficult time with bad outcomes. Human nature is generally positive and optimistic (has to be to survive in a dog-eat-dog world) and we tend to truncate the bad outcomes and exaggerate the potential good outcomes. Today, it may be a good time to force ourselves to imagine what the worst-case scenario really is. I am sure that business owners in Greece never contemplated GDP declining by 25% and Cyprus business owners never imagined they could wake up one morning with 40% less cash in their bank account and no ability to gain access to more than $5,000 per transaction. Things may never get that bad in the Developed Markets, but it is probably prudent to think a little more about tail risks in the current environment.
"Moosylvania Mish Mash or A State of Confusion."There was a storyline about how the bad guys in Pottsylvania had developed a Goof Gas that renders normally intelligent people silly (but has no effect on Bullwinkle) and a series of spoofs about how governments want to convince everyone that all is well (reminds me of the Kevin Bacon character at the end of Animal House imploring everyone to remain calm and he is trampled into the sidewalk). Bullwinkle accidently discovers a new territory, Moosylvania, and Fearless Leader tricks Rocky and Bullwinkle into getting foreign aid from the U.S. (that he intends to have Boris and Natasha steal). We could substitute so many names into this storyline as the willingness of the U.S. government to extend aid to remote corners of the globe has been going on for decades and the current extension of massive amounts of credit to the European banks by the Fed (that the European Central Bank, led by the Germans, have shown a propensity to summarily steal with Cyprus-like tactics) leaves this narrator in a serious state of confusion as to why we want to make their looming bad debt problems our problems. There is confusion when Spanish and Italian non-performing loans ("NPLs") can rise at double digits, yet yields on Spanish and Italian government debt are collapsing. There is confusion when the leverage in the European banking system is still well above 30X and that leverage is on top of Peripheral debt that is supported by the aforementioned NPLs. There is confusion when claims of the European bank/debt crisis being solved don't jive with the complete lack of capital adequacy in the financial system. Perhaps we have all been Goof Gassed and we should just grin and bear it.
"Moosylvania Mish Mash" was the last episode of the Rocky and Bullwinkle Show, and they left us with a cliffhanger and no final pun. The second picture above and the title of this quarter's letter are my attempt to bring the Bullwinkle spirit to the current economic comedy/drama. Ganbaru is a Japanese word that loosely translated means "Good Luck," but since the cultural bias in Japan is that you do not bestow luck on someone else, a better translation would be "Do your best." The Force (of Star Wars fame), according to Jedi Master Obi-Wan Kenobi, is "what gives a Jedi his power. It's an energy field created by all living things. It surrounds us and penetrates us. It binds the galaxy together," so what we are really telling Kuroda-san (the new Bank of Japan Governor) is that we hope he can muster all of his Jedi power to achieve his goal of reflating the Japanese economy, because with global growth slowing, massive debts looming and demographics looking pretty daunting, we really do need him to pull a rabbit out of his hat and get the number three economic engine running again. Achieving a 2% inflation target and defeating the Dark Side of Deflation will be no mean feat, and Japan's re-entry into the global currency wars (dubbed, the race to the bottom) has vast ramifications for economies and markets around the world.
Abenomics is the plan set out by new Prime Minister Abe with three pillars of aggressive monetary easing, fiscal stimulus and a strategy for growth. Abe-san is depending on Kuroda-san to show Jedi-like Yen-saber skills in battling the other currency manipulators in the picture above as he must double the monetary base and weaken the Yen materially for this plan to have the chance to work. To misquote Princess Leia, "Help us Kuroda-san, you're our only hope." If this plan is not executed with precision, there is a high likelihood that the animal appearing from the hat (as a symbolic representation of global capital markets) will resemble the carnivore in Bullwinkle's gloved hand above.