Are You Fundamentally Unsound

Maria Johnson
• Wednesday, 02 December, 2020
• 16 min read

There is a common misconception that scuba divers inflate and deflate some sort of attached air sack to move up and down. This training proved useful when I decided I didn’t want to die in Vietnam.

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(Source: forum.woodenboat.com)


My possible death there had nothing to do with the war, or the landmines that still remain, or the locals who are friendly to outsiders. You eat something on a weak stomach, you run out of water bottles, or you get heatstroke from the oppressive tropical sun.

If you are far from an IV set, your recently expelled water supply cannot be renewed. I read this in the cab to see the desiccated corpse of Ho Chi Minh in Hanoi, and then the next day I felt the words manifest into reality.

The second paradigm is an improvement in that it tries to eliminate the stigma around mental health treatment, but it is still a limited framework. Instead of splitting the nuance into a ‘sane’ versus ‘insane’ dichotomy, it flattens it into ‘everybody is slightly off’.

But these distortions are minor compared with the much larger piece of the puzzle that is not just wrong in both paradigms but missing entirely. A 21st-century framing of mental health care needs to take into account what we do and think about all day.

Most things that people do are either for survival, or else to balance out a discomfort in their brain, their soul or the Universe. Future psychological investigations need to examine the nondestructive, extreme behaviors that people willingly participate in, and the discomfort they are trying to alleviate by doing so.

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(Source: forum.woodenboat.com)

It turns out that walking outside for hours under direct sun is also surprisingly strenuous. I was at a restaurant with two Americans and a local Vietnamese woman named ANH when my body decided that that sunshine was not something it desired anymore.

It was when my stomach expelled the microscopic sip of water I’d tried to drink that the fog in my brain and the pain in my guts clarified into an ironic smile. We have different names for all these things, from clinical terms and new-age buzzwords to Platonic ideals and Jungian archetypes.

But the entire struggle of our lives is to create sanity in a fundamentally insane predicament. I flew across the world in a burning metal tube to see a woman called ANH.

All Premium Members get to view The Good Men Project with NO ADS. As in all periods of speculation, men sought not to be persuaded by the reality of things but to find excuses for escaping into the new world of fantasy.

There’s so much give in the basics that I can stretch them to meet just about any requirement that I need, any conditions I face. Last week, my wife Terri was reaching for a coffee cup in the kitchen, and noticed a little piece of paper taped to the corner of the wall, near the ceiling.

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(Source: www.telegraph.co.uk)

And if you’re aggressive enough to pay more than $100 today for that future $100 payment, you’ll get a negative return on your investment over the coming decade. Given any set of future cash flows, the higher the price you pay today, the lower the long-term rate of return you can expect on your investment.

The red line shows actual subsequent 12-year returns on this portfolio mix. Last week, our estimate of prospective 12-year returns on a passive investment mix again matched the most negative levels in U.S. history.

Yet across history, similar “errors” have been violently corrected (as they were in 2000-2002), by wiping out the associated returns over the completion of the market cycle. Indeed, the only reason the S&P 500 was able to squeeze out an average nominal total return of even 4.4% annually in the 20-year period since March 2000 is that valuations in late-March 2020 (despite the first-quarter market decline) were still a stone’s throw from the 2000 bubble extremes.

Over the completion of the current market cycle, I expect that the entire S&P 500 total return since 2000 will be wiped out. Given any set of future cash flows, the higher the price you pay today, the lower the long-term rate of return you can expect on your investment.

The sudden spike in the price has compressed your entire long-term expected return into an overnight windfall. Conversely, suppose you buy the piece of paper for $100, and overnight, investors suddenly become willing to pay $46 for it.

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(Source: forum.woodenboat.com)

Well instead of a 0% return occurring over 10 years, as you wait for your $100 payment, you’ll instead experience a huge loss all at once. It’s wholly incorrect to imagine that the repeated bubble periods since the late-1990’s somehow render historically-reliable valuation measures useless.

Because even if we completely restrict our data set to the period since the late-1990’s, we still observe a clear inverse relationship between valuations and subsequent market returns, particularly on a 10-12 year horizon. The chart below shows our measure of nonfinancial market capitalization to corporate gross value-added, including estimated foreign revenues (Market/GVA), versus the actual subsequent 10-year annual total return of the S&P 500, restricted to data since 1997.

Even during the bubble period, there has been no breakdown of the inverse relationship between valuations and long-term market returns. We don’t know what market returns will be over the coming decade, but the arrow shows where present valuations stand.

See The Heart of the Matter for similarly consistent charts relating valuations and subsequent market returns across multiple, non-overlapping subsets of history. Market valuations might very well imply a rather low level of 10-year total returns averaging 4% annually, but if investors are eager to speculate, the market might compress it all into a shorter-term gain of 48%, far outpacing the near-term expectations of investors, but also leaving them with no likely additional return for the rest of the decade.

Despite strength in the S&P 500 and Nasdaq indices, we again observe the kind of internal dispersion that is permissive of “trap door” market losses. Needless to say, we evaluate these conditions on a continuous basis, so if we observe fresh improvement, we’ll defer the hard-negative market outlook that we presently hold.

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(Source: www.hangingoffthewire.com)

To be clear: our most reliable market valuation measures presently match the 1929 and 2000 extremes, and our gauge of internal uniformity is also unfavorable. In particular, improvement in the uniformity of market internals would shift us to a neutral or constructive near-term outlook (with a safety net in any event).

One of the more intellectually disappointing claims about valuations is the idea that levels associated with various historical norms are merely arbitrary (“Where do you get that?”). As I’ve noted before, a good valuation measure is simply shorthand for a proper discounted cash flow analysis.

A good valuation measure should compare the current price to a fundamental that’s representative and proportional to the very, very long-term stream of cash flows that the security is likely to deliver to investors over time. While earnings are certainly necessary to generate future cash flows, they tend to be enormously variable over the economic cycle.

That’s why market returns are only weakly correlated with the S&P 500 P/E ratio, and are tightly correlated with valuation ratios based on more representative measures of future cash flows, particularly our margin-adjusted P/E (MADE) and nonfinancial market capitalization to corporate gross value-added (Market/GVA). A nice way to demonstrate that stock prices are related to present discounted cash flows is to examine the actual stream of S&P 500 dividends all the way back to 1900.

A good valuation measure is simply shorthand for a proper discounted cash flow analysis. It’s arbitrary, but it does reflect what investors commonly view as a “typical” long-term stock market return.

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(Source: forum.woodenboat.com)

At points in history when the ratio depicted by the blue line was at 1.0, we can infer that the S&P 500 was priced for a 10% long-term rate of return. Neither perfectly overlaps the blue line, but the relationship is closer than any valuation measure we’ve tested or introduced over time.

Current valuations are essentially triple those that would be consistent with historically run-of-the-mill stock market returns of about 10% annually. Long-run salvation by men of business has never been highly regarded if it means disturbance of orderly life and convenience in the present.

Remember that based on median U.S. income, the Paycheck Protection Program of the CARES Act covers 24 weeks of payroll costs for about 22 million Americans. It’s also notable that once the funds are expended and employment is restored to pre-crisis levels, there is absolutely nothing that restrains companies from laying off the employees again.

So it’s likely that a good portion of job “recovery” in June was for the purpose of temporarily satisfying the requirements of the PPP loans. Frankly, I was not a great advocate of the PPP program, and instead advised in favor of creating a level playing field and tying loan forgiveness to actual economic damage.

The $600 weekly unemployment benefits provided in the CARES Act ends on July 31, and the latest Pulse survey from the Census Bureau reports that 25.9% of households have already missed a rent or mortgage payment, or have little confidence in their ability to make next month’s payment. As I noted in May, the Federal Reserve has performed an amydalotomy on the public, intentionally destroying warning signs and discouraging realistic choices that would otherwise improve economic survival.

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First, we have no intention of adopting or amplifying a bearish market outlook in periods when investors have the speculative bit in their teeth. In the face of zero-interest rate policy and other Fed interventions, historically reliable “overvalued, overbought, over bullish” conditions failed to impose any useful “limit” to investor speculation.

In late-2017, we abandoned our bearish response to those syndromes, except in periods when market internals have explicitly deteriorated. So don’t expect us to “fight” Fed-induced speculation in periods when our measures of market internals become uniformly favorable.

The Fed’s brazen step into illegal actions (more on that below) has certainly encouraged a market rebound from the March lows (during which our own stance has been rather neutral until recently). That would shift us to a neutral or constructive near-term outlook, though with a continued safety net in any case.

Don’t expect us to ‘fight’ Fed-induced speculation in periods when our measures of market internals become uniformly favorable. So even when internals are negative, investors will still be hoping and holding based on the historically uninformed delusion that Fed easing is always enough.

As I observed early in the global financial crisis, you’re going to see a lot of chatter about “cash on the sidelines” in the months and years ahead. The moment the Federal Reserve creates base money (currency and bank reserves) to purchase some asset, the base money it creates must be held by someone in the economy, at every moment in time, until it’s retired.

A dollar of base money is just another type of “security.” A given holder of cash can try to get rid of it by buying other pieces of paper like stock shares or bond certificates, but the seller of the stocks or bonds immediately becomes the new holder of the cash. The problem is that as valuations rise, future return prospects fall, and we’ve now got the worst investment menu for passive investors in the history of the U.S. financial markets.

Every dollar created by the Federal Reserve must be backed by a) gold; b) a government-backed IOU, typically Treasury securities, but also including securities guaranteed by foreign governments, or c) obligations arising out of commercial transactions or Section 13 emergency lending, both which must be explicitly backed by collateral “sufficient to protect taxpayers from losses.” It’s notable that when the Federal Reserve Act used the word “discount,” it was intended for things like checks (notes, drafts) and commercial invoices backed by collateral (bills of exchange).

In other words, the Fed was only supposed to provide liquidity needed to clear transactions. The Fed was never intended to buy collateralized corporate debt securities or junk bonds, or take those obligations onto the public books.

In addition, Section 13(2) attempts to clarify the nature of the collateral required in return for discounting of commercial obligations: “such definition shall not include notes, drafts, or bills covering merely investments or issued or drawn for the purpose of carrying or trading in stocks, bonds, or other investment securities, except bonds and notes of the government of the United States.” Section 4003 of CARES does allow the Fed to use a portion of the $500 billion allocated to states, municipalities, and corporations for the purpose of buying their securities on the secondary markets (i.e. directly from investors rather than lending to those entities directly).

Now, on the one hand, 4003(b)(4)(B) allows part of the $500 billion to be used for secondary market purchases of corporate bonds, but 4003©(3)(B) requires collateral sufficient to avoid public loss. By the way, the special purpose vehicle (SPV) that the Fed is using to buy the bonds isn’t a loophole, it’s an end-run.

Creating money to buy unpacked securities crosses an illegal Rubicon, even for the Fed. Unchecked, the Fed could arbitrarily issue (i.e. print) and allocate purchasing power to anyone scribbling an IOU.

Oh, and by the way, when the Fed went into the market to buy high-yield junk bond exchange traded funds (INK and HOG), the largest holding of both was the French wireless company Alice. Now the Fed is buying individual bonds, its largest holdings are the U.S. financing arms of Toyota, Volkswagen, and Daimler (wholly owned subsidiaries of those foreign corporations).

It may or may not make you feel better that the 20 largest corporate bond holdings of the Fed, bought with money intended to support U.S. “states, municipalities, and eligible corporations” through this epidemic, also include the bonds of Apple, Microsoft, Oracle, Walmart, Verizon, and AT&T, along with wholly owned subsidiaries of BMW, British Petroleum (BP) and the Belgian company InBev. I’ll also note that Section 13(3), which applies to any Federal Reserve facility under the CARES Act, also requires that “before discounting any such note, draft, or bill of exchange, the Federal Reserve bank shall obtain evidence that such participant in any program or facility with broad-based eligibility is unable to secure adequate credit accommodations from other banking institutions.” So even with respect to funds approved by Congress and directly allocated to the Fed by Congress, the Fed’s bond purchases are illegal unless Apple, Microsoft, Oracle, Walmart, Verizon, and AT&T have suddenly found themselves unable to secure bank credit.

Read it and sign it, or better yet, print it out along with this section of commentary and send it to your representatives in Congress. The Fed has announced the intention to “leverage” the funds approved by Congress with additional money creation, in an amount ranging between 3-10 times what Congress actually allocated, in order to buy unsecured corporate bonds from private investors.

Aside from the violations of law involved here, and the shift of private risk onto the public balance sheet, it’s important to understand is that the financial effect is to amplify speculation and the issuance of low-grade debt. As the Fed dropped short-term interest rates to 1% following the collapse of the tech bubble, investors desperate for higher yields chased mortgage securities, which had never experienced widespread credit issues.

Worse, once the financial system collapsed, the Fed responded by magnifying the same policies that created the problem. The crisis ended with the stroke of a pen in the second week of March 2009, when the Financial Accounting Standards Board changed rule FAS-157 and allowed banks to use “discretion” in valuing their assets, rather than marking them to market.

The Fed won’t be marking the value of its corporate bond portfolio to market prices either. You have to understand that propping up low-grade securities vastly increases their issuance to unsuspecting investors (even the SEC had the sense to prohibit Hertz from doing that to take advantage of small speculators).

Recently, Jay Powell argued that Fed policies “absolutely” do not contribute to wealth disparities. The richest 10% of Americans own 88% of the $29 trillion in corporate stock and mutual fund shares, according to data from the Federal Reserve itself.

As a direct result of Fed-induced speculation and the public perception of a Fed “backstop”, the most reliable valuation measures (including market capitalization/GDP) are at the most extreme levels in history, while corporate bond valuations are also at or near historic extremes. Fed-induced overvaluation allows the wealthiest individuals in the U.S. to obtain real goods, services, and capital from others by selling or borrowing against their securities.

Overvalued markets can only be protected by destroying future investment prospects and by allocating capital. Of course, if enough holders were to attempt to sell their securities simultaneously, much of the presumptive “wealth” in overvalued market capitalization would vanish into thin air.

In order to prevent the destruction of speculative wealth, the Fed would have to actually buy the overvalued securities, replacing the “speculative” currency held by investors with actual currency created by the Federal Reserve. Congress should not be misguided enough to allow the Fed to create U.S. base money in order to relieve investors of unpacked corporate securities.

The Fed should not be allowed to shift the risk of unpacked corporate securities from private investors to the public. The moment those securities lose value, the Fed will have effectively created money without taking enough legally-required collateral to protect the public from losses.

Without strong containment, the total number of cases would follow an ‘exponential’ growth trajectory more closely. The SARS-CoV-2 virus is primarily spread by suspended particles in shared airspace, preferentially infects respiratory linings and alveolar cells in the lung, and suppresses their front-line defenses (particularly Type III and Type I interferons).

My impression is that while the inactivity of SARS-CoV-2 is likely due to accessory proteins of the virus that knock down respiratory defenses, the lethality of COVID-19 (the resulting disease) is largely due to infiltration and retention of highly inflammatory blood cells into lung tissue, that then degrade, perforate, and cross through the alveolar-capillary barrier. In recent weeks, we’ve seen rapid outbreaks in Florida, Texas, and several other states, largely in the same places where protective measures like distancing and masks were disregarded.

The only surprise is that it has involved entire states, because somehow, well-understood features of epidemiology and cell biology have become subjects of wildly ignorant political debate. Having written on the urgency of containment beginning on February 2, when the U.S. had only 5 cases and zero deaths, watching this predictable, slow motion train wreck has been excruciating.

It is increasingly clear that the primary mode of transmission for SARS-CoV-2 is exhaled air from infected individuals. There’s some evidence that toilet bowls and hospital floors also act as reservoirs for expelled viral particles, but unless you’re regularly sticking your hands into toilet bowls or wiping them on hospital floors, the most likely way to acquire the virus is from expelled air.

A useful way to think about transmission is that, based on what we know about the inactivity of SARS-CoV-2, stabilizing the spread of the virus requires a roughly 63% reduction (=1-1/R0) in “susceptible” contacts. Until we have a vaccine or better therapeutics, stabilizing the epidemic requires either 63% immunity in the population as a whole, or a combination of reduced contacts and shared infective airspace that produces the same effect.

It just requires enough common sense to use a combination of efforts to reduce infective contact by about 62% in order to substitute for immunity. That combination of measures includes setting gatherings outdoors when possible, keeping some social distance, maximizing fresh airflow, limiting group size, and wearing a mask in confined indoor locations like stores, elevators, offices, and shared transportation.

Based on geospatial modeling of virus transmission, we should be particularly careful about areas that act as “hubs” that bring together multiple individuals that were previously separated and would not interact otherwise. It’s no surprise that the cities with major international airports, like New York, Seattle, D.C., Houston, and Chicago have been epicenters of the epidemic.

I’m concerned that this will become a challenging issue as we move into October and November, when people begin to shift activities back indoors and previously isolated groups are brought together. The dismissive early response to the epidemic let the genie out of the bottle, so that by April, what I called the “optimistic” projection already implied 60,000 U.S. fatalities.

What we do in the immediate future will determine whether we follow the orange trajectory (which is now my “optimistic” projection) or the light purple one. One of the current debates is whether the growing number of reported cases are due to an increasing rate of infection or simply better testing.

The red line shows the U.S. case fatality rate, which is currently at 4%, but falling from 6.5% back in April. We also know that viral shedding (inactivity) can begin a couple of days before symptoms emerge.

That’s a challenging situation because it means that without reasonable precautions, lots of people will transmit the virus without even knowing it. They also imply over 2 million U.S. fatalities if we were to abandon containment efforts and just let this thing progress to “herd immunity.” Still, I hope that these estimates are wrong, and that there are far, far more asymptomatic cases than we think.

Equally important (and much of my work at the Human Foundation in recent months) is research toward repurposing already approved pharmaceuticals for a) prophylaxis to increase the defense of respiratory cells against the virus; b) interventions for early to moderate disease, focused on reducing the viral load, suppressing inflammatory signaling, and reducing the expression of certain molecules that recruit and retain inflammatory blood cells at the capillary-alveolar barrier, and; c) acute-stage interventions aimed at disrupting the inflammatory cytokine storm and suppressing lung tissue inflammation. Refusing to wear one is like clicking the seat belts of all of your passengers, and then texting while driving into oncoming traffic.

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