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2024-03-03 09:10 by Karl Denninger
in Market Musings , 865 references Ignore this thread
Falling Chainsaws *
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If you've read this column for any length of time you know I'm not in any way bullish on the intermediate and longer-term path our government and fiscal policy are on.  In fact the problems go back for at least 20 years and arguably 40 in that every challenge has been met with more and more government credit emission.

Now a certain amount of this might be tolerable -- roughly that which is covered by the improvement in productivity.  In my book Leverage I argued (and still do) that even at this level its theft, because productivity doesn't improve because government improves (that is, it would be "theirs" to dole out) it improves because people improve things.

Since we cause it we should get the benefit, not some glad-handed decision coming from a state or federal legislature or, as is currently the case, not even through legislative process such as NY deciding to hand out EBT cards with huge amounts of money on them to persons who are neither citizens or who entered the US lawfully.

As you also may recall back well before I started penning this column I have pointed out that the medical system specifically, which was about 3% of GDP when Medicare was passed and about 4% when Medicaid became common, now consists of 20% of the economy and about one third of federal spending yet the tax remains right near 3% -- meaning that as the expense as grown as a piece of the whole the tax revenue has not.  The entire problem with our budget, on a simple fiscal analysis, lies here -- not in Social Security or anywhere else.  Politicians and other analysts always conflate these and its intentional; anyone can read the MTS, effectively the Federal Government's "by category" transaction summation (commonly called a "cash flow statement") and see these facts.

It is also a fact that as "medical employment" has grown virtually none of it, on a per-capita basis, has been in doctors and nurses.  In other words none of it has anything to do with actually providing medical care to human beings; the entire expansion is elsewhere.  We should not have permitted this but we have and once again nobody on either side of the aisle will do anything about this as evidenced by the last 20+ years of it.

The over-extension of asset prices of all sorts has followed from these policies.  This is not sustainable and it will break.  It has broken many times before, and it will again.  We can argue over timing, but not outcome.

Here's the important point I want to impress with this article:

When it does, and I believe it is imminent (meaning weeks or months, perhaps a year or so but I will take the under on that) it will be very tempting to try to call bottoms in the belief that the same cycle that has played out since 2000 will occur again and thus you should use the financial leverage you can obtain because you'll get wealthy if you do.

It is my considered opinion that you're foolish to take that risk because if you're wrong you will be bankrupted or worse.

Further you don't need to do that to make out ok.  That is, if you buy a house once prices collapse you don't need to take on leverage, buy five, and try to be a landlord and make a ton of money on the "appreciation" you expect to come.  Buying one where you want to live, and living in it, treating it as a consumer durable good, leaves you way ahead of the game than if you buy one now and wind up sitting on a 50% or more loss hoping prices come back up.

If you can buy business equipment for a nickel on the dollar even a modest amount of money purchases something that makes a profit because your cost of operations is cheaper than the other guy's cost.  If you take leverage and the asset does not go back up in value the other guy who doesn't do that will destroy you because the leverage costs money and he doesn't have to spend it.

Living beyond your cash earnings power is dangerous.  It has paid off for the last 20 years with the only requirement being that you be able to withstand short-term, usually less than a year or two, drawdowns.

This time the drawdown and flat-line is likely to be a decade or more -- similar to the Long Depression of the late 1800s.  If it is, and you have leverage on, you will be ruined because your earnings power will decrease but the leverage costs money and that expense is fixed for the term when you take it.

During both the Long Depression and Great Depression those who had not taken on such leverage were ultimately able to buy assets for a nickel on the dollar but that strategy only works if you do not take on leverage.  If you do and either miss the bottom or the exit from the condition does not come quickly enough you lose everything because leverage multiples the losses exactly as it does the gains and worse, if you lose half you now need a double to get back to even.

In the 1990s I was able to take advantage of a relatively minor economic downturn with cash and obtain both high-quality office space on lease and other assets.  This was a tremendous advantage.  Had I employed leverage I could have, of course, gotten much more but the risk in that was a complete wipe-out if I timed the exit wrong or had to hold through the 2000 wreck and was too far out over my skis.  I had seen that movie before as a customer of mine before MCSNet was an Internet firm who had leverage on with a quite-profitable small business out in the suburbs had his operating line get called by the bank.  He could not replace it on terms that he could meet and was immediately and entirely destroyed.

I'll point out that we had roughly 100 competitors in our local market and I knew many others in the business in other regions and areas.  Of the local competitors I know a couple of who sold out as I did at various valuations and one who stayed in, navigated the 2000 crash and now has a lot more money than I do.  Most of the rest were literally destroyed.  In 2008 I knew several people who had put on a bunch of leverage and were entirely ruined including losing their primary residence.

Do not make this mistake by believing that asset prices, when they dive, will come back in a reasonable period of time.  They might not come back in your remaining lifespan but even if they do you need to assume that the timeline will be over one to three decades, not years and your income over that period of time may decline to a material degree so even fixed-rate debt is likely to destroy you if you use it to purchase them.