The Fed Isn’t Manipulating Mr. Market. Mr. Market is Manipulating the Fed.

I remain amused worried by the persistence of the “Central Banks are manipulating rates!” myth.  Particularly among so many self-identified free market types.  It is a comforting myth.  And yes, the facts point in a deeply discomforting direction.  But FRED* doesn’t lie.  Conclusion first.  Facts follow.

  1. The market is driving rates.  The Fed is dancing to the market’s tune.  Its a Wizard of Oz act.
  2. The market has told us two things.
    1. Short-term rates above 2% are too high.
    2. Short term rates around 1.5% might be OK.
  3. Rough but accurate math:  Long-Term Rate = Economic Growth Rate + Inflation Rate.  Re-arrange that and you get Inflation = Long-Term Rate minus Economic Growth.
    1. The market gives us 30 year (2.23%) and ten year (1.76%) rates.
    2. The San Francisco Fed estimates long-term economic growth of 1.5%-1.75%, based on immutable (and low) population growth and a reasonable guess on productivity growth.
    3. That solves for inflation between zero and o.5% (1.76% – 1.75%  = 0.01%,  2.23% – 1.75%  = 0.48%)

Inflation between 0% and 0.5% is scary as hell.

If you don’t believe me, google “deflation” and its consequences (or wait for a future blog post).  No wonder so many people are sticking to the more comforting narrative that “the Fed is manipulating rates.”    Because deflation is super terrifying.  Even a permanent low rate scenario is pretty terrifying too.

A lot of people are ignoring the above,  But the facts are pretty clear.  The above seemed highly plausible a few months ago.  The recent upward turn in long-term rates makes it even more clear.  The market is marking up future prospects as the the Fed cuts short-term rates, the market started raising its long-term rates.

So we might be OK with short-term rates around 1.5%.  Which is a heck of a lot better than a macho Fed-caused recession from over-high rates.  But it leaves no room for inflation in that long-term growth + inflation equation.  And that is the ugly truth.   

The graph below shows

  1. The Fed’s short-term target interest rate (red line)
  2. The market’s 10 and 30 year bond interest rates starting Jan 1 2018.

[iframe src=”″ scrolling=”no” frameborder=”0″style=”overflow:hidden; width:670px; height:525px;” allowTransparency=”true”>

The Fed nearly doubled its target rate over 2018 – from 1.25% to 2.25%.  The (free) market played along until early  November.  Note that market rates started tanking before the Fed’s last rate increase around December 21.  The S&P500 was tanking too.

The Fed, chasing the market’s lead, started cutting its target rate down to 1.75 today.  Markets kept leading the Fed all the way.  Today, with the Fed’s rate at 1.75 and pretty clear signals of another cut to 1.5%, the market did something different.

Market rates have started going up.    The 10 year and the 30 year are ticking up.  The yield curve has un-inverted itself.

Yield Curve – 10 Year Treasury Minus the 2 Year Treasury

[iframe src=”″ scrolling=”no” frameborder=”0″style=”overflow:hidden; width:670px; height:525px;” allowTransparency=”true”>

* FRED is the St Louis Fed’s excellent and free data charting system.  “Download, graph, and track 590,000 US and international time series from 87 sources.”

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“Trump veered… like a squirrel caught in traffic”

So I’d decided to break my self-imposed politics ban about a week ago.  Election is coming up so politics are actionable and just too salient and…   Then I got a stomach bug.  Then the rest of the family got the stomach bug…  Some posts marinating but the piece below deserves wider distribution.

FYI the guy was General Mattis speechwriter.

“For the remainder of the meeting, Trump veered from topic to topic—Syria, Mexico, a recent Washington Post story he didn’t like—like a squirrel caught in traffic, dashing one way and then another. The issues were complicated, yet all of the president’s answers were simplistic and ad hoc. He was shooting from the hip on issues of global importance. With that, the meeting ended.  I learned an important lesson that would pay off when Trump returned for a briefing the following January: only use slides with pictures … no words.”

In crowd psychology terms, the Trump phenomena is reminding me more and more of a financial market bubble.  Note that in both cases, you are OK in steps 1 and 2.  We all do some of that just to stay sane and make decisions.  The agonizing losses start on the slippery slope into steps 3 and 4.

  1. Develop a thesis.
  2. Over-weight facts that support your thesis, underweight facts that don’t.
  3. As the un-supporting facts pile up, construct a narrative that depends less and less on facts and more and more on some unseen “its different this time” belief.
  4. Narrow your information flow to only confirmatory sources to keep the facts/belief dissonance within tolerable levels.  Choosing the model in your head over observed reality.

The “being wrong” part isn’t so damaging.  The danger lies in the very human instinct to double down on a false belief vs admitting you were wrong. We’ll gladly invent “facts” and twist our initial narrative rather than face up to that truth. Choosing the model in your head over observed reality.

When large groups do this, it can be incredibly powerful and long-lived. The dot-com bubble and the real estate bubble were exactly that phenomena.  All bubbles are.  People who stay home in the face of hurricanes (“I got through the last one“) or stay put in the face of immanent genocide (“they are our neighbors! They’d never do that!“) are also doubling down vs facing up to facts.  It is very human behavior.

A bunch of emotionally attached, “traditional Republicans” are sliding down that slippery slope right now.  Doubling down on a fantasy (“He’s fighting Deep State corruption!”) to avoid an uncomfortable truth.

The smarter ones are starting to peel away and acknowledge reality.  That is how bubbles eventually pop.  But the main body is still doubling down on the fantasy – hence Trump’s stable ~40% approval rating.

Meanwhile, the facts keep piling up.  Even the best deep state conspirator couldn’t make up the color and detail of that piece above.  The more reasonable and likely explanation is the simplest one.  He’s telling the truth.  Meaning we all should be much more afraid than we currently are.   

Of that 40% who still approve, I’d guess half are too dumb/ignorant to see it.  Half are “seeing” it, but choosing not to deal.  Hence the increasingly brittle, fantasy-driven narrative coming out of formerly serious people and institutions (e.g. the Wall Street Journal).  My guess is that the smarter half finally peels off.  The bubble collapses as they do.  My greatest fear is I’m over-weighting their intelligence…  🙂


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“Given Treasury Rates, Earnings and Cash Flows Today, Stock Prices Are Not Unduly High”

I don’t often re-post other content, but the piece (link in full below) is worth sharing.  It is a “where are the markets now?” piece that very tidily sums up the main (credible) arguments for over or under-valuation of financial markets.  It is readable, clear enough for a non-expert reader to follow the gist, and balanced.  In other words, something I wish I’d managed to write myself.

I agree with his conclusion with a similar dose of caution.  Equity markets simply aren’t looking all that overvalued although we could collectively frighten ourselves into a sell-off regardless.

A few points that really stood out for me.

  • Interest rates are low, but central bankers have had only a secondary role.Conspiracy theories are always difficult to confront, but at the heart of this one is the belief that central banks set interest rates, not just influence them at the margin. But is that true? To answer that question, I will fall back on a simple measure of what I call an intrinsic risk free rate, constructed by adding the inflation rate to the real growth rate, drawing on the belief that interest rates should reflect expected inflation (rising with inflation) and real interest rates (related directly to real growth).  Looking back over the last decade, it is low inflation and anemic economic growth that have been driving interest rates lower, not a central banking cabal. It is true that at the start of October 2019, the gap between the ten-year treasury bond rate and the intrinsic risk free rate is higher than it has been in a long time, suggesting that either Jerome Powell is a more powerful central banker than his predecessors or, more likely, that the bond market is building in expectations of lower inflation and growth.
  • Stocks are richly priced, relative to history, but not relative to alternative investments today
    If you are convinced by one of the arguments above that stocks are over priced and choose to sell, you face a question of where to invest that cash. After all, within the financial market, if you don’t own stocks, you have to own bonds, and this is where the ground has shifted the most against those using the mean reversion argument with PE ratios. Specifically, if you consider bonds to be your alternative to stocks, the drop in treasury rates over the last decade has made the bond alternative less attractive. In the graph below, I compare earnings yields on US stocks to T.Bond rates, and include dividend and cash yields in my comparison:

    In short, if your complaint is that earnings yields are low, relative to their historic norms, you are right, but they are high relative to treasury rates today.

  • Though I have confessed to being a terrible market timer, the implied ERP [Equity Risk Premium] has become my divining rod for overall market pricing. An unduly low number, like the 2% that I computed at the end of 1999 for the S&P 500, would represent market over-pricing and a really high number, such as the 6.5% that you saw at the start of 2009, would be a sign of market under-pricing. At 5.55%, I am at the high end of the range, not the low end, and that backs up the case that given treasury rates, earnings and cash flows today, stock prices are not unduly high.

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A Global, 20-Year Garage Sale. Ugly for “Safe” Asset Values.

Today’s FT brings a tidy, cogent, Japan-based example of the risks of so-called low risk assets when demographics turn against you.

We Are All Japanese Regional Banks.  We Just Don’t Know it Yet.

The (paper) Financial Times has a great article on page 7 about a Shimane Bank – a regional bank in Japan.  If this were just a Japan problem, this would still be useful forewarning (Page 8’s main article is “US Banks to Warn Investors of Grim Outlook [Driven by Falling Interest Rates]“).  Anyone who’s driven through quaint, semi-abandoned towns in Italy, Spain, or Trump country in America is seeing the same dynamic.  Most of us just haven’t connected the dots.  I’m going to pull some selected quotes/facts to tell a broader story.

In order to return to profit, Shimane Bank plans to ramp up higher-margin lending to “medium risk” companies, which did not meet its financial standards in the past. But in a prefecture where the population is already 25 per cent below its peak, and projected to fall another 15 per cent by 2045, good credit risks are hard to come by

…the problem [may be] more severe than just a declining net interest margin in their home market. He believes past forbearance has left the regional banks stuck with many loans to small companies where the owner is about to retire or the collateral has dubious value.

A Conclusion As Clear As a 2% 30 Year Treasury Rate.

Returns on a lot of “low-risk” asset classes are going to suck.

  1. There are a whole lot of nominally populated spots on the map that are in terminal decline.
  2. There are a whole lot of still nominally worth-something assets in those areas.
    1. Most obviously the unwanted homes themselves (quaint in Italian/Spanish villages, less quaint in dying US farm towns).
    2. Less obviously the nominally operating businesses in those towns – the car dealer, the grocer, the gas station.
  3. All those assets are still carried at a positive dollar value on someones books.  It might be a bank that’s lent them money.  It might just be the informal books of Grandma and Grandpa.  That is just an accounting detail.  Collectively, we are still pretending these places are worth “something.”
  4. In fact, they are worth nothing or less-than-nothing.  If/when it comes time to sell those assets, you will get pennies on the dollar at best, more likely zero, and at times someone will have to pay to exit (e.g. all those underground gasoline storage tanks won’t un-dig themselves).

Ask Not For Whom the Bell Tolls, It Tolls For Thee.  Garage Sale.

Abandoned towns make dramatic examples, but the less dramatic are also obvious and MUCH larger in scale.  Consider the carrying value vs the real-world re-sale value of the toys and diversions of early retirement.  We are on the cusp of the largest. longest-running garage sale the world has ever seen.

  • Motorcycles (Harley Davidson sales have sucked for years as used bikes flood the market).
  • RV sales dropped 4% from 2018 vs 2017 in the middle of a strong economy.  That may just be a blip, but a lot of used ones will be coming back on the market soon.
  • Second homes.  The Grandkids are grown up and the Kids can’t afford the upkeep given their stagnant incomes.

We aren’t into the mega garage sales when primary homes and their contents start selling.  Downsizing is only starting up.

And it isn’t just toys.  Think of all those rotting strip and enclosed malls that can’t find tenants.   The bridges that need upkeep,  The 1960’s school buildings and town halls that need a re-build.  It isn’t just the boomer’s personal possessions.  It is the whole infrastructure built for the education, upkeep, and entertainment.  Most of it needs substantial renovation and some of it just isn’t needed at all as population shrinks.

As all those individual assets get sold, the mark-to-market reality of carrying cost vs actual “value” is going to be ugly.  Less obvious but more worrying, that “safe” bond debt pile the boomers are buying into (to fund their retirements) is at least partially supported by those same fantasy asset values.  The Japanese regional bank problem writ large.

The Increasingly Desperate Search For “Safe” Assets.  Individually Sensible.  Collectively Self-Destructive.

For this, I’ll go back to that FT article.  The Japanese Regional Bank dynamic in it is worryingly reminiscent of the US Savings and Loan debacle of the early 90’s.  Faced with dead-man-walking loan books, banks rational move it to make otherwise insane bets in the hopes for a one-in-a million reprieve from disaster.  Individually sensible, collectively disastrous.

…In provincial towns across the country, bankers are looking at relentless declines in their income, leaving dozens of teetering institutions with an incentive to gamble on risky property loans or exotic investments overseas.

“Japan has built up the world’s largest net foreign lending position. Japanese financial institutions pump this capital out to the rest of the world: they are the beating heart of international capital flows,” said Shannon McConaghy, an asset manager at Horseman Capital in London, who follows the regional banks.

“The reduction in their return, due to negative rates, has forced the heart to take on more and more risk to keep on beating. The problem arises when this risk stresses the heart so much that capital stops beating out.”

Holding more than $3tn in assets, Japan’s regional lenders are bigger than the Italian banking system, and their excess deposits make them a crucial buyer of everything from collateralised loan obligations in the US to covered mortgage bonds in Denmark.

If this were just a Japanese bank problem, it would be worrying enough.  The S&L crisi was ugly.  But the same zombie asset army is walking in Europe and creeping into the US.  Note the increasing gloom in European banking (Deutsche Bank goes splat) and now US banking (FT’s page 8 article).

What I’m wrestling with is the above doesn’t necessarily mean that so-called “risk” assets are doomed as well.  The trite example is that we are still in the middle of a massive Technology revolution.  There is real value creation there – often via creative destruction of the old.  I know and live that every day.  So how do we reconcile that obvious value accretion with the broader trend of asset value write-downs?  That awaits more thinking and another post.

Also a few caveats/clarifications.

  1. US boomers may be particularly navel-gazing, but they aren’t unique.  The post-war baby boom happened across the developed world.  Europe and Japan hold useful lessons and shouldn’t be ignored.
  2. I’m a cranky Generation X member myself, but the views expressed here are not part of some generational warfare agenda.  I’m just trying to make sense of a time that seems out of joint.
  3. The boomers like to personalize everything.  And yes, this is (still) all about them.  But only to the extent that boomers exist in large numbers, are pushing towards 70, and will collectively shuffle off this mortal coil over the next 20-odd years.  As they trod that path, their scope for collective or individual action becomes increasingly limited and/or irrelevant.
  4. Confronting that increasingly limited scope for personal action at the end of life is a hard thing for any one person to face.  That whole generation’s existential crisis will (negatively) color the cultural zeitgeist/tone of the next 20 years as much as the harder facts below.
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Analysis Paralysis. Baby Steps. What is the What?

I’ve been running myself in circles trying to figure out the whole negative rates/inflation/global outlook thing.  Usually writing it out helps, but not in this case.  But seeing if some baby steps might help break the writers (and thinker’s) block.

I have had one very calming analytical breakthrough in the last week or so.  I’d been burning a lot of cycles trying to figure out why rates are so low globally.  I’d got some ideas, but nothing definitive.  It finally occurred to me that the WHY doesn’t matter.  I can just take the WHAT for granted and move on from there.

What is the What?  Risk Free Returns Will Suck.

Returns on low-risk assets are going to suck for a long long time.

The current 30 year treasury yield as of September 04, 2019 is 1.97%.  Risk-free (and a lot of risky) bond rates across most of Europe are outright negative.  For all the loud protestations about Central Bank manipulation, those are largely market-driven rates.

A bond investor buying today will probably lose a little ground to inflation year after year.  Even outright deflation probably won’t save fixed income investors.  They might break even on their bond investments, but all their other assets (Real Estate) would lose value.

Bonfire of the (Boomers) Vanities.

Its worth remembering that Sherman McCoy, Bonfire of the Vanities 80’s Master of the Universe, would be a cranky 70-year old man today.  Looking for a safe return to fund his twilight years.

That incoherent howling heard from so many quarters is the Baby Boomers (or their financial advisors) trying to twist their way out of an inescapable, market driven, read-it-in-the-paper-every-day truth.   Because they are (or were) counting on those bond yields to finance their retirement.

If we shout loud enough, Daddy will give us back those 4%-6% treasury rates we see as our birthright.  We’re OK tanking the economy and impoverishing our grandkids to save our own skins.  After all, self-absorbed pursuit of our selfish best interests (conveniently re-narrated as the “common interest” because that was true for most of our lives) is just our nature…

I say incoherent because the boomers themselves are the authors of their own troubles.  The engine driving rates ever lower is their collective, global urge to move into lower-risk assets as end of life nears.  It is a self-destructive, self-reinforcing cycle.

Risky Asset Returns May Suck.

One way or another, you are going to have climb a long way out on the risk curve to make a decent return.

Pushing back on the other side of the economic equation are the non-Boomer, still-working-age generations.  That is one reason why the (relatively young) US has positive rates why (relatively old) Europe and Japan don’t.

Ummm, Grandpa?  I gotta buy a house and pay the mortgage and we haven’t seen decent wage gains in like forever so….

Yes there is a lot else going on (hopefully this post sparks further thinking).  But under it all its just demographics and an ugly tug of war between an aging generation and everyone else.  At least in the developed world.  Japan went into that demographic spiral first.  Europe is following.  The US is touch and go (higher birthrate and net immigration).

The question remains,.  What the heck to do about all of this?  Hoping this baseline gives me the mental closure to move forward.

Any and all feedback would be deeply appreciated.

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The 737 Max, DSL Networks, and the Creeping Rot in Our Current Model of Shareholder Capitalism

Our current economic model does a lot of things well, but it reliably fails with long-lived assets.  That sounds like a pretty bloodless comment, but the consequences are – literally – murderous in some cases.  

In telecom, we are watching the slow-motion equivalent of the Boeing 737 MAX debacle.  The cancer is incremental investment in an asset (the 737 airframe, copper-based networks) that have hit the end of its useful operating life.  When the truth becomes impossible to ignore and the bill comes due, all that incremental spend gets written off with the obsolete asset.  Leaving you strapped for funds and time to replace it.  The sunk cost fallacy leading on to its logical,  self-destructive end.

Its a bit depressing if you are trying to maintain faith in shareholder capitalism.  About 20 years of pretending a totally obvious problem and need wasn’t there.  Until the creeping crisis accelerates to ramming speed.  It makes me think of the Hemingway quote: “How did you go bankrupt?” Bill asked. “Two ways,” Mike said. “Gradually and then suddenly.”

I kept going back to accounting 101 for asset-heavy businesses.  Incremental capital investment doesn’t magically generate (or demand) incremental revenues.  The whole point of asset lives and depreciation expense is to estimate how long until you need to replace that asset. At the end of that life, you must re-invest to maintain the existing revenue stream.  There is ZERO incremental return on that investment.  Just the privilege of staying in business.

  • The 737 was past its sell-by-date. Boeing knew it. But they tried to get out one more turn of the crank by slapping on new engines and using software to cancel out the resulting balance problems. Hundreds of people have died from that greedy calculus.
  • The copper network has been past its sell by date for decades now. The Telcos invested in increasingly fancy and expensive DSL gear to get a few more turns of the crank out of it. 20-30 years that could have been spent rolling out fiber at equivalent or lower total cost. Now that bill is coming due. People haven’t necessarily dies as a result, but rural and less-affluent areas lacking decent broadband are struggling to keep or attract businesses and jobs. Helping to feed the anger that is tearing away at our national fabric.
  • How many public infrastructure assets – roads, bridges, airports, subways – are creaking under endless layers of fresh paint  instead of being replaced wholesale? 

The 737 and Telecom examples aren’t the only ones. This seems to be a recurring problem with our current economic model. Managers charged with stewarding an asset loot it instead.  Shareholders cheer them on. The logic is “we’ll get all the cash flows and the next guy will be left holding the bag.” The negative externalities of that under-investment – rural blight and hundreds of people killed – are never factored into that calculus.

What follows is a more telco-specific rant. It’s what inspired this post but its a bit inside baseball.

After reading the CenturyLink and other telco transcripts. A durable, 10-20 year trend is getting underway.

  1. CTL’s prepared comments started with fiber Fiber FIBER! everywhere.  You would’ve thought it was Zayo’s call.  OR a re-run from 2000.  Most shocking was the whole “we’re going after SMB out of region” comment made in the Q&A.  Wow.   I haven’t heard a telco talk that much about building out new fiber plant since, well, last week’s Verizon call.  And the Vodafone call.  And most other recent telco calls.  Except AT&T – which only confirms the trend as T is always the dumb money.  Seriously, the shift in tone and focus was remarkable.
  2. If VZ and AT&T’s wireline business held a stand-alone call, they would sound exactly like CTL.  The voice revenue gravy train is finally grinding to a halt.  Consumer yes, but more so SMB.  The stats on the CTL call were pretty horrifying.  It’s not the revenues they need to replace, it’s the 99% gross margin profits.  Being telcos, they are reacting to the obvious at least 5-10 years too late, but they are most definitely reacting.
  3. The only hope is high-speed data delivered over a fundamentally lower cost network.  Which is what Verizon is actually doing under the cover of this 5G build.  Building out fiber for 4G backhaul and to sell real high-speed data services to businesses all the way down to SMB.  Like CTL, Verizon can see the rot in its own business.  So it might as well exploit that take-away opportunity out of region while shoring up its own.
  4. It all sums up to a wave of local network investment we haven’t seen in decades.  If they don’t invest, we have the Frontier call to remind you where things are headed.  That is worth a look.  Cutting EBITDA guidance in half because revenues are falling faster than they can cut costs.  There is no bottom to that pain on their current course.  Their path out is replacing those voice revenues with broadband.  That needs 1 GB speeds to be viable long-term. And that capex spend can’t be covered by existing (falling) cash flows.  So they’ll go bankrupts, wipe out the debt, and spend frantically to make up for 10 years of lost time.  Expect the same from Windstream.
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Calix – If You Sh*t in Your Own Backyard Often Enough…

I figured I’d publish my post-quarter Calix update here.  As someone noted to me, I probably won’t be getting a Christmas card from them.  🙂  But if the emperor is prancing around in new clothes made of nothing more than delusion, I’m not obliged to play along with the charade.

See below for the post-call note I sent to Calix’s CEO and Chairman of the Board.  See link below for a PDF of my more detailed article on Seeking Alpha.


In an alternate universe, there’s a Calix with appropriately lowered expectations, a detailed investor deck, and intact credibility.  It is currently rallying from $6 to $7.50 on the quarter’s results.  People who bought ahead of the quarter are starting to relax and settle in for the ride.  New investors are reading a clear, detailed shareholder letter that focuses on 2020 prospects.  Doing their own math and thinking about buying in.  The deep value folks who’ve supported CALX, feeling good about a job well done, are maybe marking up the price where they’ll start selling off to the growth crowd.

All is well in that alternate universe.

In our reality, we are wallowing in the swells. Engine off.  A windmilling rudder.  Cash is low. Praying a storm doesn’t hit before we get headway again.  The easy excuse is “What can we do if Frontier and Windstream shifted plans on us?”  The answer is You can do plenty right now.

  1. Significantly improve the depth and detail of your disclosures.  What does Calix 2.0 look like?  I have no idea.  Maybe you’ve hinted at it in conference 1-on-1’s.  That sort of selective disclosure isn’t going to work for a $400m cap left-for-dead stock.  Put it on paper and get it out there.
  2. Fix your forecasting and guidance process.  Quarter after quarter we see a reliable skew towards insupportable optimism.  Put on some corrective lenses that aren’t quite so rose colored.  Forecasting is tough, but most companies get it more right than Calix does.  OR at least get it wrong in both directions.
  3. Change your tone.  I wasn’t at the Cowen conference and I have no idea what was said, but [Cowen Analyst] didn’t hang himself with that table-pounding note [ahead of the quarter that drove CALX up to $7.50] unless someone handed him a whole lot of rope.  One more person with singed fingers.
  4. Promote or hire someone with intact investor credibility to add weight to a more sober message.  A credible message still needs a credible messenger.

The above won’t get Windstream and Frontier back to buying, but it would eliminate a massive uncertainty discount.  The weight of that uncertainty depresses the valuation.  It also depresses trading volumes.  The quarter-by-quarter stream of self-inflicted whipsaws only drives people away.

If you shit in your own backyard long enough, people stop coming over.  Other people start writing up the truth for all to see.  Its not a lot of fun for anyone.  So do something to change the situation.

Key messages From The Seeking Alpha Article (link to PDF below or link to website here.)

Calix_ Drifting At The Mercy Of Market Tides – Calix, Inc. (NYSE_CALX) _ Seeking Alpha

My best guess is CALX will drift with the market until we get to the 3Q19 report – probably in mid-October. A decisive turn in the numbers may not come until 2020.

Today’s market reaction just takes CALX back to mid-June 2019 levels. With the stock holding above $6 today, the pre-quarter run up and subsequent drop could be seen as just a blip in an improving trend. But there is damage done.

Calix has singed the fingers of yet another crop of recent buyers who might have been convinced to become long-term holders of the company. Questions left un-answered by management on the 2Q19 call (see below) will also make it that much harder to find new buyers. Investors tend to be wary about crediting improvements in advance after a stock has burned them so frequently and recently. In the meantime, that leaves Calix and its current owners at the mercy of market tides.

I continue to hold the stock. I’ve done enough digging to see through to those improving fundamentals. Per the below, there is still 50%-100% upside on 2020 numbers with more potential in 2021. The question is how long it will take until numbers turn up decisively enough and/or disclosures improve significantly enough for the market to price that in.


At some future date, the numbers will win out. The market will duly price them in. A more forthcoming approach to disclosure would bring that date forward by several quarters. It is mystifying and frustrating that Calix management (and its Board) doesn’t seem to grasp that truth.

Calix produced a 7 page investor letter on July 23. They held a 36 minute call on July 24. Yet they failed to answer some very simple questions that would seem central to analyzing and understanding the stock. I present them below. Their call transcript is here.

Questions Left Un-Answered on the Call.

Calix 1.0 to 2.0 Transition/Trajectory: Calix management it pitching a “Calix 1.0 to Calix 2.0” transition to a higher gross margin, more software-based, more profitable business model. But they have given no detail. What is a reasonable range of margin expectations for Calix 2.0 at maturity? How long to get there? How big are Calix 2.0 products and service as a percent of total revenues today? When will it become a majority of Calix’s revenues? The only comment given on the call was a highly un-specific “our [new] platforms are growing very rapidly, but still off of, let’s say, minority numbers. Our traditional and supporting products or our legacy products are still the large majority of the business.

Composition of the Customer Base That is Actually Growing? Calix did (finally) disclose that CenturyLink, Windstream, and Frontier are down from over ¾ of revenues to “less than ¼.” CenturyLink was 17% of 2Q19 revenues, leaving bankrupt WindStream and struggling Frontier at around 7% combined. So we know who is shrinking. But we know very little about who is growing. Calix gives no detail on the composition of the other 76%+ of its revenues. We know that Verizon and CityFibre are relatively big and growing fast, but we don’t know how big or how fast. We are wholly in the dark on the rest of their customer base. This is particularly frustrating as one of Calix’s great strengths should be its relatively wide customer base among rural telcos, cable companies, electric cooperatives, and new over builders. That diversity could be perceived as a strength if we had some numbers to back it up. The only detail given on the call was “Headwinds from our publicly traded ILEC customers will continue through the third quarter and into the fourth quarter. We are confident that these headwinds will no longer be a meaningful factor in the business entering 2020. It is worth noting that not many years ago, this narrow category of customers represented more than 3/4 of our business. Today, that same set of customers delivers less than 1/4 of our business. The flip side of this story is the robust nature of the future Calix business model. We continue to add new customers at a rate greater than 100 per year. That is remarkable. And as the headwinds from our legacy business subside, this new business will continue to shine.”

Outlook for Verizon and CityFibre? Engagement With Other Potential Marquee Customers? Calix management did provide a significantly more detailed update on marquee customers Verizon and CityFibre (see quote below). It is not clear if they will continue to deliver that much-needed context. Moreover, they continue to provide no insight into engagement with other large potential customers. It is never advisable to count chickens before they are hatched. But it would help to have some rough color on how many eggs are left in the nest that might hatch.

Cash Flow Outlook? As a rule of thumb, telcos like to see about one quarter’s worth of cash (or more) on their supplier’s books as a cushion in the event of a downturn. For Calix, this would amount to about $100-$150m. Net cash at present is about $10m. Calix does seem likely to turn cash positive in 3Q19. It appears to have the continuing support of its lender Silicon Valley Bank (the source of the $25m revolving debt shown on the balance sheet). Calix also has roughly $15-$20m of excess inventory that should convert to cash as its contract manufacturer recovers from its 1H19 production problems. But it doesn’t appear that Calix will be comfortably liquid until well into 2021. Will they be able to finance growth in the meantime? When will shareholders see a cash return on their invested capital?

Internal Management Changes to Address Persistent Forecasting Errors and Operational Failures. In the past three years, Calix has experienced two major operational failures – poorly negotiated, negative margin services contracts that dragged down results for all of 2017 and the more recent disruptive manufacturing shift out of China in 2018-2019. Calix has also persistently failed to set and communicate realistic forecasts and guidance to investors – as evidenced by the jagged path of the stock price. It would seem to behoove the company to 1). Make structural management changes to improve execution going forward. 2). Discuss and disclose those changes so investors might have more confidence in that future execution. As it stands, it is not clear if Calix management even sees a need for structural improvement.

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A Chilling Reminder To Take the Madness of Trump (and Trumpism) More Seriously… Plus a Meuller Coda.

Back to the Fed and other matters next week.  I’ve been away from a real keyboard and a bit busy lately.  But had to share this bit.

I’ve been reading a phenomenal (both writing and content) book titled “Defying Hitler.”  Key to its fascination is that it was written in 1939 (unpublished until 2000).  The author goes about dissecting the Hitler phenomena – writing before the full horrors of WW2 and Nazism came to be.  I’m about halfway through it and can’t put it down.  It is brilliantly written – more a memoir than a polemic.  The author is also so poignantly likable and obviously prescient.  I highly recommend it.

He largely ignores Hitler the person to inquire into Hitler as a product of his times.  The question he struggles with is “How did the tides of society and politics and economics conspire to push this manifestly horrible little man into power?”  What phenomena of societal/economic/political conditions enabled Hitler’s rise?  How did reasonable, respectable, establishment Germans (like himself) let something so unreasonable happen?

This quote rang chillingly true for me.  Remind you of anyone?

“Hitler himself, his past, his character, and his speeches were still rather a handicap for the movement that gathered around him. In 1930o, he was still widely regarded as a somewhat embarrassing figure… And then there were the contents of those speeches: the delight in threats and in cruelty, the bloodthirsty execution fantasies. Most of those who began to acclaim Hitler at the Sportpalast* in 1930 would probably have avoided asking him for a light if they had met him in the street. That was the strange thing: their fascination with the boggy, dripping cesspool he represented, repulsiveness taken to extremes. No one would have been surprised if a policeman had taken him by the scruff of the neck in the middle of his first speech and removed him to some place from which he would never have emerged again, and where he doubtless belonged. As nothing of the sort happened and, on the contrary, the man surpassed himself, becoming ever more deranged and monstrous, and also per more notorious, more impossible to ignore, the effect was reversed. It was then that the real mystery of the Hitler phenomenon began to show itself: the strange befuddlement and numbness of his opponents, who could not cope with his behavior and found themselves transfixed by the gaze of the basilisk, unable to see that it was hell personified that challenged them.”

To be clear, I am not equating Trump with the real-world Hitler (see Godwin’s law below).  I AM equating the Trump phenomena with the Hitler phenomena as the books’ author understands it (in 1939, before the full arc of Hitler’s monstrosity played out).  A populist vulgarian whose transgressiveness is key to both his appeal and apparent invulnerability.  Characteristic of an entire parade of horribles today – Boris Johnson?  Viktor Orban?  Le Pen?  Nigel Farage?  Etc…

The chilling part of the book is how the author narrates the inch-by-inch surrender of “reasonable people” to a madman’s unreasonable demands.  “Everyone” comforts themselves that some higher authority – the law, social norms, big business, labor – will somehow rein in or temper the madness.

It rings uncomfortably true with Democrats denial before the election (people won’t actually vote for him, will they?) and Republican’s denial after the election (he’ll surround himself with competent people! sotto voice and we’ll still get that fat tax cut and my team is winning…).

It also echoes with the “well, the country might go to hell but my team will win the next election and that’s what matters” reasoning that seems to be motivating the UK’s conservatives as well as the Senate’s Mitch McConnell.  Everyone bends a little bit – assuming someone else will step in before all is lost.

It hits dead on on the inchoate, hesitant, hypnotized impotence of reasonable people to come to grips with Trump.  that “befuddlement and numbness of his opponents, who could not cope with his behavior and found themselves transfixed by the gaze of the basilisk.

The quote above is a sad coda for Mueller’s non-performance at this week’s congressional hearings.  We had an older, respected, Republican-voting man in the twilight of his career with 7 hours on the national stage.  Put aside what his report said or didn’t say.  Sometimes the facts matter less than the truth.  As a patriot, Meuller should have lied through his teeth in the most colorful, sound-bite friendly language he could muster.  Torching his reputation for careful establishment probity to ring the alarm.  Shaking “reasonable people” out of their torpor in front of that “basilisk stare.”  Sometimes the path of true patriotism lies with shading (or ignoring) the truth…

Anyway.  I’m not despairing yet.  I don’t think Trump is all that dangerous.  Hitler was a madman.  Trump is simply self-serving.  Trump is (thankfully) proving to be a paper tiger in many matters.  But that doesn’t excuse reasonable people from confronting the un-reasoning forces propelling him.  The damage done by overt racism, jingoism, and devil-may-care spending will take a long time to repair.  In many cases, things will simply remain broken.  Especially as regards the USA’s overseas credibility, which matters more to me than maybe it should.

Anyway.  Do read the book.  You’ll better understand the chains that bind today’s reasonable people (which I assume is most readers here) in the face of the unreasonable.   And it is brilliantly written.

A book summary and “Godwin’s law” below.

Godwin’s law (or Godwin’s rule of Hitler analogies)[1][2] is an Internet adage asserting that “As an online discussion grows longer, the probability of a comparison involving Nazis or Hitler approaches 1”;[2][3] that is, if an online discussion (regardless of topic or scope) goes on long enough, sooner or later someone will compare someone or something to Adolf Hitler or his deeds, the point at which effectively the discussion or thread often ends.

Book summary.

Written in 1939 and unpublished until 2000, Sebastian Haffner’s memoir of the rise of Nazism in Germany offers a unique portrait of the lives of ordinary German citizens between the wars. Covering 1907 to 1933, his eyewitness account provides a portrait of a country in constant flux: from the rise of the First Corps, the right-wing voluntary military force set up in 1918 to suppress Communism and precursor to the Nazi storm troopers, to the Hitler Youth movement; from the apocalyptic year of 1923 when inflation crippled the country to Hitler’s rise to power. This fascinating personal history elucidates how the average German grappled with a rapidly changing society, while chronicling day-to-day changes in attitudes, beliefs, politics, and prejudices.

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The Scariest Chart In The World Part 1

I am re-posting this as the charts didn’t show in the prior version for some reason.  I’ve pasted them in a different format.  Please view the post in your browser if need be.

All that money the Fed has been printing?  It’s not actually circulating.  The faster the Fed prints it, the slower it seems to go.  Money went from flowing like water in the 90’s to maple syrup in the 2000’s to molasses in 2010’s. 

You don’t need to know anything about monetary policy to read the three charts below (same data series starting from 1959, 1987, and 2007 respectively).  Something has clearly down-shifted drastically since the 2007 bust after starting to slide ahead of the 2000 bust.

That something is “monetary velocity.” Best understood by its folk definition – how fast a dollar bill changes hands as it moves around the economy.  Calculated as the quantity of money floating around at a given level of GDP.  A little money moving quickly = high velocity.  A lot of money moving sluggishly = low velocity.

What makes this double scary is the final chart, which is (roughly calculated) monetary velocity for Japan since 1996.   The Japanese have been printing money like mad, but its circulation has just decelerated.

I’m going to pick this up in a subsequent post, but take a look at these charts.  Take a look at the excellent post cited below.  Let it all rattle around for a bit

Velocity 1959 – Present

Velocity 1989-Present

Velocity 2007-Present

Japan chart (roughly calculated myself as GDP divided by M2 Money)

Rough Calculation of Japanese Monetary Velocity 1996 – Present

A more textbook explanation of Monetary Velocity follows (the linked piece is excellent BTW)

Money velocity, as might be suggested, isn’t necessarily how frequently a certain $1 bill exchanges hands in the economy through financial transactions. Hence the concept of money velocity spuriously suggests that its increase comes as a consequence of economic actors’ increased willingness to spend the same amount of money at a faster pace. But that’s not actually what’s taking place. Rather, money velocity is more accurately a measure of the rate of credit formation.

If the product of the money supply, M, and the velocity of money (i.e., credit formation), V, increases – i.e., M*V – this will either increase prices, P (i.e., inflation), increase real output, Q, or both.  The relationship was first expressed by Irving Fisher back in 1911: M*V = P*Q

P increases through an increase in spending. Q increases if the sum of productivity growth and growth in the number of hours worked in an economy increases.

One common criticism of central banks in recent years has been seemingly profligate monetary printing, or the idea that vast expansions of the money supply are inflationary. This is not correct, given that this money needs to be spent before it can influence prices and therefore inflation.

This is, for example, why Japan is expanding its money supply so rapidly. For demographic and other reasons, Japan has been fighting the ogre of deflation for nearly three decades. If the demand for lending remains low and credit isn’t formed in sufficient enough quantities – i.e., a fall in V – then the Bank of Japan has no other option but to keep expanding the money supply, M, in order to keep M*V above its previous mark.

If M*V falls, deflation sets in. This is bad, given some low level of inflation is necessary to incentivize consumption, which is primarily how developed economies grow.

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Why the Fed “Has” to Cut Rates.

The Fed “has” to cut its short-term rate.  Why?  Because their current lending rate seems to create an arbitrage incentive for banks to NOT LEND.  As currently structured, the Fed’s rate policy appears to be an active drag on the economy.

The chart below shows three interest rates.

  1. The Fed’s (now 2.35%) Interest on Excess Reserves rate: “The IOER is the interest rate paid to banks for the deposits they hold with the Federal Reserve above those required by banking regulation.
  2. Market rates on 1 year (1.8%)  and 2 year (2%) Treasuries.

What if someone could borrow at the 1.8% or 2% treasury rate and put that borrowed cash to work earning that IOER 2.35%  rate?  It is only a  0.35% to 0.55% profit, but it is (literally) risk-free.  Someone can do exactly that.  Federally chartered Banks are the only entities that can make deposits at the Fed and earn that IOER.

I have NO IDEA if this is actually happening out there.  But that dynamic may be one reason why market-driven rates went into free-fall shortly after crossing over the Fed’s 2.35% IOER rate (see chart below).  A whole lot of banks exploiting a free money opportunity.  Regardless, the gap leaves the Fed exposed until they cut the IOER (which means a general rate cut).

The problem with the above is twofold.

  • Earning risk-free money at the Fed is a lot less work than the hard work of lending money to living breathing economic actors.  So the bank’s incentive is to sit back and earn deposit money at the Fed, not stimulate the economy.
  • The arbitrage profit gets BETTER as market-driven rates fall.  The selling pressure of a bank selling (imaginary) treasuries into the market would tend to push rates lower.  So the more banks sell to fund the trade, the more they will earn on the trade.  That is the really dangerous dynamic.

A caveat that this is just my thinking.  I may just be howlingly wrong on some important bit of the mechanics.  But the numbers above are real and there is clearly something broken in there.

There are any number of clever ways to sell Treasuries (that you don’t actually own) which effectively puts you on the hook to pay the interest on those Treasuries – 1 year treasuries (promising to pay 2% to the seller) or 2 year treasuries (promising to pay 1.8%).   So you sell $1b fake treasuries to someone promising to pay 1.85% (a 0.05% premium), they turn around and deposit that $1B at the Fed where it earns 2.35%.   It’s only a $500,000 profit on that $1b, but if you add a few more zeros it adds up…

And in answer to the next question – Yes, that is a hidden subsidy to the banks at the expense of the real economy and your average hard-working man on the street.  So happy you asked.

And in answer to your next question.  No, you can’t just go to the Fed and deposit YOUR money at 2.35%.  Because they don’t let little people (or even really big but non-bank-magic-circle people) step up to that deposit window.

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