Storm Warning - Brian Kelly

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The End of the Debt Supercycle RisksAnother Crisis

January 10, 2016Brian Kelly

On CNBC’s Fast Money, Thursday January 7, 2016, I was asked what investors shoulddo with stock portfolios given recent weakness. My answer was “go to cash”. Later I

reiterated my view during an appearance on CNBC’s special programming “Markets in

Turmoil”; when asked what percentage of a portfolio should be in cash I answered,

“100%”.

My words have set off a firestorm.

It was not my intention to create controversy, we were having a debate on the state of the

markets; I was asked a question and I gave my honest opinion. I unknowingly hit a

collective nerve. The response via social media, phone calls, and email has beenoverwhelming. As a financial pundit that regularly appears on CNBC I am accustomed

to my views being challenged and often derided – dealing with social media “trolls” is an

occupational hazard.

However, something interesting occurred, the majority of the responses have been

positive and only a small percentage have been derogatory. My detractors have called me

irresponsible and reckless for expressing this view.

At first I was shocked that some people thought recommending extreme caution was

reckless and irresponsible, but then I noticed much of the vitriol came from those who

earn a living by continually recommending full investment regardless of market and

economic conditions.

I understand that my view contradicts conventional wisdom and by doing so it threatens

the livelihood of those paid to solicit new investors. Investors need to understand this

too.

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My friend and fellow Fast Money contributor, Dan Nathan, has written must read piece

on the incentives of pundits. The article can be found here

Morning Word 1/7/16: These Aren't the Pundits You're Looking For

Dan’s point, which I whole-heartedly agree with, is that investors should seek out all theinformation available, but should also be aware of the incentives of those who provide

the information.

To that end you should know my incentives.

I am a money manager who gets paid to make money by going long and short currencies,

commodities, stocks and bonds. If I don’t make money, I don’t get paid.

Throughout my career I have never been paid a salary, I have always been compensated

on the “eat what you kill” method. That is to say I have earned commissions, percentageof trading profits or partnership shares. I never set out to be paid this way, but over the

years I have come to embrace this pay structure as my incentives have been aligned with

my clients.

Additionally, because I am actively involved in the financial markets I am biased by my

views and the subsequent financial market positions that I use to express those views.

Privilege and Responsibility

I feel privileged to have the platform that I do on CNBC. It is because of this privilegethat I get to work with incredibly talented and dedicated people. In fact, in my 20+ years

on Wall Street the last 7 years working with CNBC producers, directors, technicians and

on-air talent have been the most personally fulfilling and intellectually stimulating of my

career.

This privilege comes with a responsibility - a responsibility to be cognizant of the fact

that words have power and words said on television often take on an increased level of

importance, for better or worse.

Since my words have inadvertently set off a firestorm, I feel a responsibility to further

detail my views. In the following pages I will lay out everything that has lead to my view

that now is the time to exercise extreme caution.

This document is not meant to be financial advice nor is it intended to be a sales pitch. I

am not selling anything. Frankly, at this point it is in my best interest to shut my mouth

and shrink back into the punditry shadows. If I am wrong I risk losing the credibility I

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http://www.riskreversal.com/2016/01/07/morningword-1716-these-arent-the-pundits-youre-looking-for/





have built over a 20-year career. But my responsibility and conviction compels me to

present my view, for better or worse.

Let me be clear, I do not have a crystal ball or special powers that allow me to see into

the future. Anyone peddling financial advice that claims to have special insight into the

future is lying. What I do have is experience and over 20 years of studying financialmarkets. This experience has taught me that some things are more important to look at

than others. And In my view the most important economic factor for financial markets is

the expansion and contraction of money and debt. When money and debt contract the

economy shrinks and financial asset prices fall.

My research leads me to the conclusion that we could be on the verge the largest debt

contraction the word has ever experienced.

In the following pages I will present this research and my conclusion. I encourage you to

discuss this research and conclusion with your financial advisor and determine the bestcourse of action for your individual situation.

-BK

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Table of Contents

.............................................................................................................EXECUTIVE SUMMARY 5

..........................................................................................................THE DEBT SUPERCYCLE 7

DEBT TO GDP R ATIO.......................................................................................................................8ECONOMIC PRINCIPLES...................................................................................................................8WHERE ARE WE NOW ...................................................................................................................? 9CURRENT DEBT TO GDP LEVEL................................................................................................... 11

.....................................................................THE GLOBAL SHADOW BANKING SYSTEM 12

THE $9.5 TRILLION GLOBAL CARRY TRADE................................................................................13THE R OLE OF THE US FEDERAL R ESERVE................................................................................... 14SECOND STAGE OF GLOBAL LIQUIDITY........................................................................................16US R ESIDENTS OWN 33% OF DOLLAR BONDS.............................................................................. 17SAME PROBLEM, DIFFERENT WARNING SIGNS............................................................................18

...........................................................THE BULL MARKET PILLARS ARE CRUMBLING 19THE END OF THE FED “PUT ........................................................................................................” 19R ECESSION WARNING SIGNS.........................................................................................................20BUT WHAT ABOUT THE LOW UNEMPLOYMENT R ATE ...............................................................? 24

..............................................................................THE END OF THE PERPETUAL BUYER 26

THE BABY BOOMERS PREPARE TO R ETIRE.................................................................................. 26

.............................................................................................................................CONCLUSION 27

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Executive Summary

The largest debt super-cycle in modern history is ending and it threatens economic

growth and financial markets. The 2008 Great Financial Crisis was an opportunity for

the world to deleverage, but in the last 7 years global debt to GDP has climbed by over

$57 trillion. The current global debt/GDP ratio is at a historic high of 286%. The global

economic slowdown is the proximate cause for the end of the supercycle. My concern is

that a negative feedback loop has begun where falling global incomes make the servicingand/or refinancing the debt more difficult.

Part and parcel to the debt supercycle is the growth of a global shadow banking system.

The shadow banking system has fostered a carry trade where emerging market

corporations have borrowed cheaply in US dollars and lent at higher rates domestically.

The IMF has estimated this so-called carry trade stands at $9.5 trillion, the largest in

modern history. As emerging market economies stumble this debt will be more difficult

to service.

The mechanics of the carry trade mean that there is a $9.5 trillion short US dollar

position. In other words, as the carry trade unwinds there is the potential for a short

covering rally in the US dollar that will be fueled by $9.5 trillion. This makes the

currency markets the transmission mechanism for contagion. We have already begun to

see the impact of this short covering rally in the form of a broadly stronger US dollar. A

stronger US dollar has reduced US corporate earnings and I expect this trend to continue.

Emerging market corporations are not the only entities that have binged on debt. Since

the Great Financial Crisis, US corporations have issued more debt than any other time in

history. Much of this debt was used to buyback stock and engineer strong earnings in a

low growth environment. Unfortunately very little was used to expand the core business.

While it is true that US corporations have large cash positions, this is simply the result of

a debt binge.

The end of the debt supercycle is occurring at the same time that the structure of the

financial markets is undergoing unprecedented change. There are two developments that

have severely reduced liquidity in markets: regulatory change and Baby Boomer

retirement. One legacy of the Great Financial Crisis has been the forced exit of banks

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from the financial markets. While this may have seemed like a prudent move it has

simply pushed the risk onto the balance sheets of entities that do not have access to

emergency funding during times of crisis. Second, one of the largest drivers of the great

bull markets of the last 30 years has been the Baby Boomers. As the Baby Boomers

prepare for retirement they no longer can be counted on as a perpetual buyer of financial

assets.

Each of these developments separately may not pose a systemic risk to the financial

markets. However, collectively they have the potential to trigger another financial crisis.

This process is just at the beginning and will take time to play out. However in the last

year we have begun to see some cracks. In my view, the end of the debt supercycle

warrants extreme caution.

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The Debt SupercycleAt the most basic level the economy expands and contracts based on how much money is

available to buy goods and services. Money can be defined in many ways and tomes

have been written on what constitutes money. For our purposes we will use the simplest

definition. Money is both “cash” and debt. “Cash” can be viewed as money in your bank

account, stock market portfolio, or under your mattress but the key component of ‘cash’

is that it does not have to be repaid. Debt is also money, but it must be paid back. There

may be money in your bank account that is from a home equity loan or a line credit – you

can still use this to buy goods and services but it must be paid back.

The ‘expiration date’ on debt is what creates economic expansions and contractions.

These economic expansions and contractions are commonly referred to as the business

cycle. The business cycle is really a short-term debt cycle that typically lasts less than 10

years. An easy way to think about it is to use personal experience; outside of one’s

mortgage most debt must be paid back within10 years. That home equity line that you

used for the vacation in Cancun acted just like cash but it needs to be paid back within 10

years. The cash you received from a car loan was money when it bought the new car, but

it still needs to be paid back (usually in less than 5 years). This ebb and flow of debt

acting like money is what creates economic expansions and contractions. This is the

short-term debt cycle.

There is a longer-term debt/economic cycle that plays out over a long period of time.

This debt buildup continues as long as each unit of debt accumulated results in more thanone-unit earned. This cycle tends to last for multiple decades and reflects the buildup of

debt over generations. This cycle is most often associated with a sovereign nation that

accumulates debt over decades and then suddenly finds itself in a situation where it can

no longer service the debt.

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This long term expansion and subsequent crisis was the highlight of the best selling book

“This Time is Different: Eight Centuries of Financial Folly” by Reinhart and Rogoff. In

this book, the authors conclude that once a country reaches a debt to GDP ratio of 90% it

ends up in a financial crisis. For those who want a more detailed explanation I highly

recommend reading the book. Spoiler Alert : It’s never different this time.

Debt to GDP Ratio

To understand how a debt to GDP ratio above 90% can influence the economy I find it

easiest to invert the ratio. That is to say, look at it as the ratio of GDP created by adding

one more unit of debt. For example if the Debt/GDP ratio is 50% this means that for

every unit of debt 2 units of GDP are created. Of course everyone would take this deal,

more debt not only equals more GDP but it means exponentially more GDP. However

there is a catch, once the ratio reaches 100% the next unit of debt no longer adds to GDP,

it subtracts. The following table illustrates this law of diminishing returns.

Debt to GDP Ratio One Unit of Debt Creates “x” Units of GDP

20% 5.00

30% 3.33

50% 2.00

70% 1.42

90% 1.11

100% 1.00

120% 0.83

140% 0.71

200% 0.50

250% 0.40

286% 0.34

Once you reach 100% debt to GDP, the impact becomes detrimental. For example at

140% Debt/GDP only 0.71 units of GDP are created – which means 0.29 units of GDP

are going to service debt and not create economic expansion.

Economic PrinciplesRay Dalio of Bridgewater Associates has done much of the groundbreaking work on debt

cycles. In the following video, Dalio explains how the economic machine works.

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http://www.amazon.com/This-Time-Different-Centuries-Financial/dp/0691152640

http://www.amazon.com/This-Time-Different-Centuries-Financial/dp/0691152640



http://www.economicprinciples.org

If you do nothing other than take 30 minutes out of your day to watch video you will be a

better investor for it.

Where Are We Now?

It’s obvious that the best opportunities for investors are during periods of economicexpansions. More specifically, investors want to own financial assets at the beginning of

an economic expansion. Therefore it behooves investors to know what is the current state

of the debt cycle. We want to be investing during periods that debt is expanding from 0%

of GDP to 90% of GDP – this is the sweet spot.

Now you may have noticed that in the previous section when I calculated the impact of

different debt/GDP ratios the table ended with a weird number, 286%. This is not a typo

or an error; I used this number for a very specific reason that will become clear very

shortly.

In the mean time, one would be forgiven to think that since the Great Financial Crisis of

2008-2009 that the global Debt/GDP ratio had fallen. After all, we hear daily how the

consumer has deleveraged and corporations have stockpiles of cash. Pundits routinely

state that XYZ Corp is a good investment because of its “fortress-like” balance sheet.

This is simply not true.

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http://www.economicprinciples.org/

http://www.economicprinciples.org/



In order to get these “fortress-like” balance sheets corporations have issued record

amounts of debt. The following chart illustrates the massive increase in corporate debt

outstanding - notice the marked increase since 2008

First the US Non-financial Corporate Debt Outstanding

Then the Rest of the World:

It’s pretty clear that there has not been a deleveraging. In fact the world has been on a

debt binge that is the largest in history of the data series.

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Current Debt to GDP Level

This brings me to the 286% that I used the previous table – this number comes from a

McKinsey report published in February 2015 and is the total debt/GDP ratio for the entire

world. The full report can be found here

http://www.mckinsey.com/insights/economic_studies/debt_and_not_much_deleveraging

In my view, the most important highlight is the following data and conclusion:

Using Bank of International Settlements, Haver Analytics and IMF Data, the report

concludes that global debt to GDP has increased since the Great Financial Crisis and

stands at roughly 286%. This is completely contrary to what you may hear from most

analysts touting perpetual investment.

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McKinsey also concludes that this level of debt/GDP could be detrimental to economic

growth. Moreover, 286% is well above the crisis warning level of 90% that Reinhart and

Rogoff found by examining 800 years of financial data.

The following chart uses the data from the Non-Financial Credit Market Instruments andI have added a long-term average (or mean). Reversion to the mean is an extremely

powerful force in economics and financial markets.

Using this data, we can expect a reversion to the mean at some point in the future and this

reversion would imply a 25% reduction in money. Stated another way this implies 25%

reduction in the ability to buy goods and services.

I began this presentation with an explanation of the debt cycle so that this chart makes

sense. If debt is money, and money is used to buy things, then a 25% reduction in the

ability to buy “things” will have a tremendous impact on the economy and financialmarkets.

The Global Shadow Banking System

The ‘search for yield’ fueled by easy monetary policy has created the largest shadow

banking system the world has even seen… and it could be in trouble.

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According to the Bank for International Settlements (BIS), since 2010 the amount of US

Dollar denominated debt issued by foreign companies has grown by 50% from $6 trillion

to $9 trillion. The proximate cause of this debt buildup was the impact of US Federal

Reserve quantitative easing on bond yields –as the FED bought bonds, yields were

pushed lower and investors were forced to search globally for higher yielding financialinstruments. This demand for yield fueled a credit binge of unprecedented scale.

The epicenter of this pro-cyclical expansion of credit was the fast growing emerging

markets. Investors perceived that investing in countries like China, Brazil and Turkey was

worth the risk, especially if emerging market companies were offering higher yields.

Some of the credit extended to emerging market companies was used for real economic

projects, but a BIS report released on Thursday August 27, 2015 concludes that most of

the money was simply invested in higher yielding shadow banking instruments. This is

the so-called global carry trade.

The $9.5 Trillion Global Carry Trade

The global carry trade works like this: an emerging market company issues bonds

denominated in US dollars – critically the yield on these bonds is above the yield of US

corporate bonds but BELOW the yield on shadow banking instruments within the

emerging markets. The relatively higher yielding bonds attract investors searching for

yield; at the same time the emerging market company can invest the proceeds of the bond

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sale into higher yielding instruments.

The emerging market company earns the difference between its low yielding US dollar

bonds and its high yield emerging market investments. This is financial engineering by

another name.

The global carry trade works especially well under three conditions:

1. There is a large interest rate differential between the US and the emerging

country.

2. The emerging country’s currency is rising.

3. Currency volatility is very low.

All three of these conditions have been present since 2010 and have been fuel for this

massive build in debt. However the economic slowdown in China coupled with the US

Federal Reserve ending quantitative easing has resulted in a strong US dollar (weakemerging market currencies) and tremendous currency volatility – thereby significantly

reducing the attractiveness of the carry trade.

The credit expansion of the carry trade resulted in emerging market money supply growth

that was the basis for economic growth. In fact, it was the virtuous spiral of credit/money

growth fueling economic growth that produced investor demand for emerging market

bonds. Now, I fear, that process is beginning to reverse.

The Role of the US Federal Reserve

The primary driver of any bubble is the availability of cheap financing that is lent with

little due diligence. We need not look any further back than the US housing bubble to find

an example of a credit fueled bubble. In the aftermath of the tech bubble the US Federal

Reserve left interest rates too low for too long and created the housing bubble – it popped

when incomes could no longer support the debt payments.

To be sure, I am not standing on a soapbox making a political statement about central

banks; I am simply looking at data that suggests both during the early 2000’s and today

the Federal Reserve left rates too low for too long. By way of illustrating my point the

following chart shows the Federal Funds rate (set by the FED) vs. the rate suggested by

the Taylor Rule.

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The Taylor Rule is an objective yardstick for the level that the FED should set of interest

rates given the economic backdrop. In this chart the blue line represents the Taylor Rule

and the actual rate set by the Fed (Fed Funds) is the red line.

Notice that beginning in 2003, when the US economy was emerging from recession the

Taylor Rule suggested the FED should be increasing rates – but the FED actuallyDECREASED rates. Moreover, when the economic backdrop began to slow in 2006 the

Taylor Rule suggested the FED should be lowering rates – but the FED was actually

RAISING rates.

If we look at the chart from 2009 to present, we can see that once again the Taylor Rule

suggested the FED should be increasing rates in 2010 and that they should now be

LOWERING those rates.

Once again the FED has left rates too low for too long and at the exact moment it should

be easing monetary policy it has tightened monetary policy.

A quick aside on the Taylor Rule – as with any economic indicator there are criticisms

and by using the Taylor Rule I am not necessarily endorsing it. However, what is

indisputable is that an objective rules based method of setting monetary policy indicates

that during the last two bubbles the FED has made a serious error.

While we all share the blame for over indebtedness, the FED played a central role in

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creating the conditions fertile for a debt fueled housing bubble… and they have done it

again, but this time it is on a global scale.

Second Stage of Global Liquidity

Economist Hyon Song Shin has dubbed the global credit bubble the “Second Stage of

Global Liquidity”. In a 2013 speech, Shin presented the following charts using BIS data

that show a marked acceleration of debt issuance by leading emerging market economies

since 2010.

This trend has been verified by the BIS itself in two reports that concluded the amount of

global debt has increase by 50% since 2010 from $6 trillion to $9 trillion.

The credit bubble that preceded the Great Financial Crisis featured global banks at the

center of the lending frenzy, but this time it’s different. Regulatory changes and capitalrequirements have essentially sidelined banks from this bubble, while asset managers

have assumed the lead role of shadow bank intermediary.

Let’s look again at the chart presented previously that shows the large buildup of debt

since the financial crisis – but this time don’t focus on the colored portion, focus on the

black line.

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The black line is the percentage of debt that is comprised of bank loans – notice it has

fallen dramatically since the Great Financial Crisis. This time the asset managers sit at the

center of the system responding to an insatiable investor desire for yield.

While the regulators have all the fire trucks parked outside of the banks, the flames are

raging in the asset management sector. Despite being the intermediary of the global

shadow banking system, none of the asset managers are deemed to be systematically

important financial institutions. This means during times of crisis asset managers cannot

receive emergency funding from the Federal Reserve. The fact that there is no safety nethas created an incredibly unstable market structure.

US Residents own 33% of Dollar bonds

At this point one might dismiss this global shadow banking system as something that US

investors need not worry about – after all during the Asian and Russian financial crises

the US markets rebounded strongly. Moreover, if US banks are not a major holder of this

foreign credit then a primary crisis transmission channel is no longer operating – this is a

good thing.

However, with the help asset management ‘spread products’ like the iShares Emerging

Market Bond ETF (EMB), US investors have increased holdings of global debt from 10%

in 2009 to over 33% on 2014. The implication is that a crisis will be transmitted directly

to US investors via the portfolio channel rather than via reduced lending at banks.

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Same Problem, Different Warning Signs

The ebb and flow of leverage is not a new problem, as I have shown the changing amount

of leverage (debt) in the financial system is a primary driver of the business cycle.

Previously most of this debt originated with banks and investors could look at the

interbank market for warning signs of an impending crisis. However, with the banks a bit

player in the global shadow banking system it is unlikely that signs of trouble will be

seen in the traditional interbank markets. Instead investors need to watch three key

market based indicators:

• Yield on emerging market debt via iShares Emerging Market Debt ETF (EMB) – a

declining price of the ETF is a warning sign.

• Emerging market currency – weak currencies contribute to the instability of the globalshadow banking system

• Currency volatility – higher volatility can be a sign of trouble.

The global shadow banking system worked quite well in pulling the global economy out

of the Great Financial Crisis – it provided credit when it was needed. However, as it

unwinds a global deleveraging is occurring that will have the opposite impact on

economic growth.

The determinant of the severity of any crisis will be pace, if the global carry trade is

forced to unwind rapidly then it could create a sudden stop scenario that creates a crisis.

On the other hand, a slow grinding deleveraging may be less traumatic in the short run,

but present a long run drag on the global economy.

The more things change the more they remain the same. Once again the global financial

system is threatened by a massive increase in debt levels. As the fuel of the economic

machine, credit serves an important role on the way up and the way down. While the

shadow banking system may look a little different this time, rest assured it is still fueled

by credit. My concern is that we may have just run out of fuel.

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The Bull Market Pillars Are Crumbling

The unwavering belief that the Chinese economy was a perpetual growth engine became

a pillar of the bull market. The engine stalled this summer. Actually, the Chinese

economy had been sputtering for a while, but it took the devaluation of the currency to

change investor perception.

The second pillar of the bull market is the so-called ‘Fed Put” and its structural integrity

is about to be tested.

For the better part of 2015, the US stock market traded in a historically narrow range as

investors disputed the signal of falling commodity prices. When the bulls charged they

declared that falling commodity prices were a result of oversupply, but when the bears

roared back it was about falling demand from a weak Chinese economy.

On August 11, the Chinese government devalued its currency; four days later the S&P

500 began to crumble, the markets entered a precipitous decline that shaved over $600

billion in market capitalization from US corporations and culminated on August 24 when

the Dow Jones Industrial Average fell over 1,000 points in the first few minutes of

trading. The battle was over. The bears had won.

The End of the FED “Put”

Since the Great Financial Crisis, central bankers have acted like Atlas, holding up the

financial markets on their shoulders with the help of quantitative easing. Investors have

not only benefited from unprecedented monetary policies but also unprecedented

coordination of policies. However, the US Federal Reserve (the biggest, baddest and

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strongest central bank) has declared its intention to take break from holding up the world.

To be fair, the Federal Reserve has been doing most of the work. While the Bank of Japan

has shouldered some of the burden, it took the European Central Bank a long time to

begin its monetary easing. Now that ‘other’ central banks are printing money, the FED

has said it needs a break – but its timing could not be worse.

By almost all measures the global economy is slowing. The slowdown in the global

economy has been most notable in the emerging markets dependent on commodity

exports. Brazil is a prime example of a high growth economy that has been decimated by

low oil and iron ore prices. Adding to Brazil’s misery is a political crisis that is part and

parcel to an economic decline. Now the emerging market economic decline is beginning

to impact the United States.

Recession Warning Signs

Over the last few months I have suggested that the US economy is headed toward

recession in 2016, which has made me out-of-consensus (exactly where I feel most

comfortable).

But instead of taking my word for it, let’s look at the data.

First ISM: ISM Manufacturing has been below 50 for the last 2 months and is at the

lowest levels since 2008.

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Raoul Pal of the Global Macro Investor and RealVision TV has done brilliant work on the

meaning of the ISM Index below 50. His work (and that of Citi’s Willem Buiter) suggests

that the ISM at its current level indicates a 65% probability of a recession.

The good news is that ISM Non-Manufacturing has yet to drop below 50, butunfortunately the trend is lower. The following graph illustrates the rapid deterioration in

the survey over the last few months.

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http://www.realvisiontc.com/

http://www.realvisiontc.com/



Next Let’s look at the US Yield Curve:

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The yield curve as defined by the spread between the 2-year and 10 year rate has broken

below the critical 1.20 % level and is now at the lowest level in 10 years.

This flattening in the yield curve is consistent with the Atlanta FED GDP Now model that

suggests growth of about 0.7%.

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The FED has been wrong for 7 years, yet it continues to ignore reality.

Finally another FED model is suggesting the US economy is heading toward recession –

the Chicago FED National Activity index hints the US economy is a whisker away from

recession.

In this diffusion index a reading below -0.35 suggests recession…in November the index

was at -0.3 – close enough to cause concern.

But What About the Low Unemployment Rate?

The stellar jobs report released on Friday January 8 th, 2016 does not change my view; in

fact it emboldens my conviction.

To be clear I am very happy that more Americans are finding jobs, but the jobs report is a

lagging indicator. To illustrate my point look at the following chart; one line is the year

over year percentage change in Payrolls, while the other is the ISM Manufacturing

Employment Sub-index. Can you guess which is which? And can you see which one

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leads?

The astute among you can see the red line is the leading indicator, while the blue line is

just a follower. When we add the labels to the chart something magical happens.

Ok, maybe saying “something magical happens” was a bit of an oversell, BUT the point

is that the ISM employment index leads payrolls AND the ISM employment index is

below 50, suggesting contraction, aka less hiring in the future.

Based on this analysis, I expect the unemployment rate to begin to CLIMB over the next

6-9 months. AND since the stock market is a forward-looking sentiment index, I would

expect investors to begin to sell stocks in anticipation of a rising unemployment rate.

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The End of the Perpetual Buyer

Since the end of the last long bear market there has been a perpetual buyer of financial

assets. During the great bull markets of the 1980’s and 1990’s Baby Boomers were

saving for retirement. Every month they diligently transferred money into financial

markets and created one of the greatest bull markets in modern history – measured by

both time and magnitude.

The Baby Boomers Prepare to Retire

However, this tailwind is projected to end. I have had the following chart on my desktop

for the last several years – it was produced by Citi Research – unfortunately I do not have

the date of publications. Nonetheless, it illustrates that the tailwind created by the

“Savings Age” population is coming to an end.

The red line represents the percentage of the US population in “savings mode”. It is easy

to see that as the Baby Boomers were in savings mode the financial markets benefitted

from this perpetual buyer. In my view, this is the origin of the widely entrenched belief

that financial markets tend to go up over time.

My concern is that as the Baby Boomers retire the percentage of the US population that is

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in “savings age” declines. This means that the perpetual buyer is leaving the market. Of

course, many will point to the Millennial generation as the obvious choice to fill the gap

left behind by the Baby Boomers; however to date, Millennials have shown a propensity

to shun traditional financial markets.

Conclusion

I want to reiterate that I do not have a crystal ball, what I have presented is a scenario that

leads me to believe the most probable path forward for financial markets is lower. The

world has not deleveraged, it has in fact re-leveraged to unprecedented levels. This debt

has been supported by growing economies and incomes, but as global growth slows the

ability to refinance or service the debt will deteriorate. This implies that the amount of

debt in the world needs to decline. I have suggested that a reasonable target would be a

25% decline in the amount of debt. Since debt is money, this means there will be 25%

less money to buy things like cars, drones, mobile phones and financial assets.

This reduction in the amount of money available to buy financial assets comes at the

same time that Baby Boomers are either retiring or preparing to retire. In other words the

perpetual buyer for financial assets that has been present since 1980 is leaving the

building.

Finally, we are currently experiencing one of the greatest monetary policy experiments in

the history of the world, quantitative easing and its termination in the US. The

unprecedented nature of this experiment makes the risks of the unwind unknowable.

However, one trend has become clear – the world has used low rates to go on a historic

debt binge.

I know this has been a tour-de-force and if you have made it this far I congratulate you.

As you do your own research and peel back the onion you will inevitable discover that

there is a lot more to this story than I have presented. However, I wanted to make sure I

hit the most important points without unnecessary complications.

Please feel free to share this document, tear apart my analysis and otherwise form your

own conclusions. My hope is that this document explains why I said those fateful words

that investors should “go to 100% cash”.

Finally, I want to make clear that “go to 100% cash” makes for a great headline and

sound bite, but may not be the best decision for you. There are alternatives like short-term

bonds or using options to protect your portfolio. I am not advocating, recommending or

advising any of these alternatives, this is for you to decide on your own.

The goal of this document was to simply present the basis for my sound bite so that you

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can use it as one part of your analysis. It is my sincere hope that I have accomplished my

goal. Some of what I discussed may take some time to play out, while other parts seem to

already be happening. But this is about risk management. And my view at this point is

that fears of missing out on new market high should take a backseat in investment

positioning to protecting against the chance of a precipitous decline.

Date post:	04-Mar-2016
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Storm Warning - Brian Kelly

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