The 'Man of System' Isn't Being Honest With You

The 'man of system' isn't being honest with you... Translating Jerome Powell's latest speech... 'The result can be worse economic outcomes'... Inspiring a new generation of speculators... It's funny until it all becomes sad(der than right now)... You know my mantra – what's yours?...

The 'man of system' is getting desperate...

This man is scared that the U.S. economy will remain too depressed for too long... And even worse, he's running out of ideas for how to fix it. He's starting to abandon his plans.

The mysterious phrase comes from economist Adam Smith's classic book, The Theory of Moral Sentiments, which was first published back in the 18th century. As Smith wrote...

The man of system... seems to imagine that he can arrange the different members of a great society with as much ease as the hand arranges the different pieces upon a chess-board. He does not consider... that, in the great chess-board of human society, every single piece has a principle of motion of its own, altogether different from that which the legislature might chuse [sic] to impress upon it.

Just substitute "central bank" for "legislature" to bring the topic from the 1750s to today.

Putting it plainly, the modern-day world is filled with ambitious, overeducated, politically well-connected men and women. These folks are the "man of system," thinking they know how to control whole economies by pulling the levers of monetary and fiscal policy.

And they really go bananas when faced with an economic crisis...

In 21st century America, the quintessential man of system is Federal Reserve Chair Jerome Powell...

As Digest editor Corey McLaughlin noted yesterday, Powell just "moved the goalposts" on the world.

Said another way... during his speech at the Kansas City Fed's Economic Policy Symposium – an event normally held for an exclusive audience in Jackson Hole, Wyoming – Powell displayed his desperation for the whole world to see through the virtual broadcast.

Corey did an excellent job of giving you the facts of the situation... He laid out the Fed's departure from past policy and explained what it could mean for your investments.

But in today's Digest, I (Dan Ferris) feel the need to help translate Powell's message. As Porter loves to say, it's what I would want you to do for me if our roles were reversed...

As a reminder, the Fed has a congressional mandate of creating monetary policy that fosters maximum employment and "price stability"... which means to control inflation.

However, the Fed now has decided to change all that. As Powell said yesterday...

Going forward, employment can run at or above real-time estimates of its maximum level without causing concern, unless accompanied by signs of unwanted increases in inflation or the emergence of other risks that could impede the attainment of our goals.

From now on, the Fed will focus more on trying to create higher inflation...

The central bank introduced a 2% inflation target back in January 2012. And for the most part, inflation has stayed consistently below that target in the eight-plus years since then.

So now, the Fed will target average inflation of 2% over some unnamed period of time... meaning it will allow – and even try to push – inflation to rise above its previous target of 2% for stretches in the near future. From the Financial Times...

The centerpiece of the Fed's new approach is the move to an average inflation target, which will allow it to overshoot the U.S. central bank's 2% target to compensate for persistently low inflation, which has been weighing on the U.S. and other economies in recent years.

"Following periods when inflation has been running below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time," Mr. Powell said.

Allow me to translate for Powell...

"Screw unemployment. I'm tired of hearing about it. If you bring it up in a meeting, I'll see to it that you're making less than $100,000 a year by the end of the week. I don't care if everybody in this country is employed, and there are still 100,000 jobs to fill.

"We said we were going to hit 2% inflation, and we're enraged that we can't do it. It's almost like the Fed can't just create inflation whenever it wants to or something... and that can't possibly be true. I will create 2% or higher inflation if it's the last thing I ever do!"

If Powell really wanted to be honest, the translation would continue like this...

"Let me spell it out for you, since you numbskulls seem a little slow on the uptake. You're supposed to own assets, not dollars. Anything but dollars.

"Buy a house with the biggest loan those idiots at the bank will give you. And if you haven't refinanced your current home by now, what the hell are you waiting for?

"Don't have a credit card? Get one and buy whatever you want. Don't have a brand-new car? GET ONE.

"Buy, buy, buy. Buy stocks, bonds, real estate, whatever you want. Just spend the money... That's what it's for, you twit.

"Because if you idiots don't start spending more money, I'm going to get a case of Red Bull, head over to the basement of the Bureau of Engraving and Printing, and run the money-printing machines until every square inch of this country looks like the season finale of Hoarders.

"I bet you'll get rid your dollars then, won't you? I bet that'll stimulate some economic activity. You think I'm kidding? I'm not. I swear to God, I will blow the U.S. dollar to hell and gone to prove that I'm the best central banker who ever lived...

"Wait a minute... That sounded different inside my head."

With my translating help, Powell might have some more specific messages for various groups in the economy. For example...

To people who save money, "I told you to spend, not save. As long as I'm in charge, you'll never earn a thing on your savings. The beatings will continue until morale improves."

To people who borrow money, "Dude, we just made another huge beer-and-weed run, and my parents won't be home until Sunday. Call everybody you know. Crank up some Beastie Boys. Let's get nuts."

To people with money in the stock market, "There is no alternative. You want to buy gold and silver, like some kind of weird little Harry Potter goblin? OK, but try buying a house with it. It's my job to make sure you can't do that."

Now, to be fair, during his actual speech, Powell also said, "The Fed has less scope to support the economy during an economic downturn by simply cutting the federal-funds rate." (We'll discuss this quote further in a minute, by the way.)

But let's not be too fair...

After all, it's not like Powell is decent enough to resign or anything...

The man of system will stay in office as long as he can. He'll just keep pulling on economic levers, looking like an even more cartoonish Wizard of Oz in a Brooks Brothers suit.

That's because Powell still believes he controls the U.S. economy... despite his failure to ever meet his inflation target. It's clear when he makes actual statements like this one...

Inflation forecasts are typically predicated on estimates of the natural rate of unemployment, or "u-star," and of how much upward pressure on inflation arises when the unemployment rate falls relative to u-star.

There is no natural rate of employment. They make this garbage up to justify their actions after the fact... not because they have any clue of what they're targeting in the first place.

The worst thing the Fed does is pursue a policy it knows full well will generate bad outcomes. Here's more from Powell's actual speech yesterday (with my bold emphasis)...

Many find it counterintuitive that the Fed would want to push up inflation.

After all, low and stable inflation is essential for a well-functioning economy. And we are certainly mindful that higher prices for essential items, such as food, gasoline, and shelter, add to the burdens faced by many families, especially those struggling with lost jobs and incomes.

However, inflation that is persistently too low can pose serious risks to the economy. Inflation that runs below its desired level can lead to an unwelcome fall in longer-term inflation expectations, which, in turn, can pull actual inflation even lower, resulting in an adverse cycle of ever-lower inflation and inflation expectations.

OK, we need another translation. I can't let you try to make sense of that baloney on your own...

"We know low inflation is good for everybody and higher inflation is bad, especially for people who are already not making much money. But we don't care about them.

"If inflation gets too low, asset prices might fall, making it really hard for me to get a hedge-fund job like former Fed Chair Ben Bernanke, who now works for Citadel, a $25 billion fund."

Still not convinced Powell and his cronies aren't fully aware that they're sticking it to lower-income households because it'll be great for asset prices? Then, try to explain this part from Powell's speech yesterday (with my bold emphasis added again)...

With interest rates generally running closer to their effective lower bound even in good times, the Fed has less scope to support the economy during an economic downturn by simply cutting the federal-funds rate.

The result can be worse economic outcomes in terms of both employment and price stability, with the costs of such outcomes likely falling hardest on those least able to bear them.

My translation for you...

"Am I stuttering? Are you deaf or stupid? Am I speaking a language you don't understand?

"I know the Fed's policies are bad for low-income households. And... I. Don't. Care.

"I work for well-connected, rich people. I go to parties at Jeff Bezos' house, for goodness' sake. If I don't make everything more expensive, he'll have a harder time putting all his competition out of business by making everything cheaper... And he'll never invite me back."

(You can read Powell's full speech right here. Send in your own translations of your favorite parts. I'd love to read them all. As you'll see, I've barely scratched the surface today.)

Maybe you think I'm just trying to make you laugh with the translations in today's Digest...

First of all, I hope it's working... I laughed out loud when I wrote my translated versions of Powell's comments last night. But it's only funny until it all becomes tragically sad(der than right now) for millions of people one day...

The Fed's machinations – along with the federal government's COVID-19 lockdowns – have inspired a new generation of speculators. By that, I mean the people trading options on Robinhood while wearing their pajamas and sitting in their (parents') basements all day.

They're happy to do what everyone else is doing... until it doesn't work anymore.

The record put-option buying from a few months ago has given way to record call-option buying today. You can see them in your mind's eye...

They're like passengers gathered on the deck of a great ship... running to one side, then to the other, and then back again. And each time, the ship is listing farther and farther.

Is there any hope that they won't all end up in the water when it's all over? None.

The funny thing is, the Federal Reserve has failed in that regard, too...

Earlier this week, I read a report from Michael Green and Wayne Himelsein of Logica Capital Advisers...

The report argues that there's less liquidity in the futures, options, and equity markets today than earlier this year. And it's certainly less liquidity than a few years ago, not more... like the man of system would have you believe.

For example, S&P 500 futures-contract volumes have returned to their levels from earlier this year – at half the order book depth. That means half the number of offers to buy and sell at each price level... or in other words, half the liquidity.

Fed interest-rate easing and bond-buying is supposed to increase liquidity, not reduce it.

But clearly, the market doesn't work the way the Fed thinks it does – the way the Fed needs it to work if its policies have a prayer of ever achieving anything like their desired effects.

Logica believes the reduced liquidity is as likely to result in spikes upward in market prices as spikes downward... It simply points to a rougher ride, no matter which direction we're headed. That kind of action is brutal on know-nothings wearing their PJs in the basement – demonstrating yet another way that Fed policy hurts the folks of modest means.

Once again, the man of system – along with his legion of helpers at the Fed – is too confident in his ability to rearrange the economy from the top down. He creates more and bigger intended consequences while failing to get anywhere near his intended targets.

But of course, the man of system must never acknowledge his failure... even though, as you've hopefully seen from today's Digest, it's hard to miss it if you know where to look.

Green and Himelsein at Logica conclude their report on an upbeat note...

Fortunately, the story does not have to end badly for those who are prepared. While markets have certainly exceeded even our optimistic forecasts from March, the colossal retreat of index volatility has created an opportunity for those who are willing to consider a narrative other than "Fed printer goes Brrr!"

Repeat that first sentence and let it sink in...

Fortunately, the story does not have to end badly for those who are prepared.

The Logica guys are super sophisticated, so they likely have a complex portfolio full of options and other sophisticated stuff that'll do well whether those price spikes go up or down. For the rest of us...

Super sophistication is optional. Preparation is mandatory...

Now is the time to bring up the diversified portfolio that I find a way to mention in almost every Friday Digest.

It's my answer to adequate preparation for potentially extreme action in markets that don't quite operate the way the Fed, the pajama-clad crowd, or just about everybody else believes they do. As you likely know by now, it goes like this...

Hold stocks because the world finds a way to get out of bed every morning and get things done.

Hold cash because the markets have become volatile, and the lack of liquidity suggests more volatility lies ahead. Cash cushions losses. And when it's employed during downturns, it acts as a no-cost, never-expiring call option on future opportunity.

Hold gold and silver because they've been money for at least 6,000 years and can't be printed by the Fed or the U.S. Treasury. Macro investor Luke Gromen, contemplating the prospect of years of low-interest-rate Fed policy, recently theorized on Twitter...

The Fed is giving creditors of the world (sovereign & private) a choice of storing their hard-earned surpluses in: a) 0%-yielding bonds of finite duration & infinite issuance [U.S. Treasurys], or b) 0%-yielding bonds of infinite duration and finite issuance (gold & [bitcoin]). Choose wisely.

In brief, the Fed can print as many dollars as it wants. But it can't print gold or bitcoin.

Hold bitcoin because of that, too. Plus, there's a chance it could still become a 50- or 100- bagger – or maybe even more – from its current price of around $11,500. Bitcoin is already accepted as currency all around the world. A tiny 1% or 2% position will suffice.

I told my editor last week that I felt like I was running out of good ideas for my Friday Digests. But after thinking about it, maybe I was just being too hard on myself.

In crazy times, like what we're living through today, there's value in repeating a sane mantra. By now, if you've been reading the Digest every Friday, you know mine...

Watch the macro scene like a hawk. And make sure you're practicing true portfolio diversification... represented by a core portfolio of stocks bought at reasonable prices, cash, gold, and bitcoin.

What's yours?

New 52-week highs (as of 8/27/20): Booz Allen Hamilton (BAH), Innovative Industrial Properties (IIPR), Microsoft (MSFT), Victoria Gold (VITFF), Belo Sun Mining (VNNHF), and Vanguard S&P 500 Fund (VOO).

The mailbag is quiet today. We'd love to hear about your "sane mantra" in today's crazy times. What are you doing to make sure your portfolio is properly diversified? As always, you can send your comments and questions to feedback@stansberryresearch.com.

Good investing,

Dan Ferris
Vancouver, Washington
August 28, 2020