a. gary shilling ˇs insight

May 2016 A. Gary Shilling's INSIGHT 1

INSIGHT (ISSN 0899-6393) is published monthly by A. Gary Shilling & Co., Inc., 500 Morris Avenue, Springfield NJ 07081. President: A. Gary ShillingTelephone: 973-467-0070. Fax: 973-467-1943. E-mail: [email protected]. Web: www.agaryshilling.com. Twitter: @agaryshillingEditor and Publisher: Fred T. Rossi. Economic Research Associates: Chris Skyba and Callie Renner.

© 2016 All rights reserved. No part of this publication may be reproduced or redistributed without the written permission of A. Gary Shilling & Co. Materialcontained in this report is based upon information we consider reliable. The accuracy or completeness is not guaranteed and should not be relied upon as such.This is not a solicitation of any order to buy or sell. A. Gary Shilling & Co., Inc., its affiliates or its directors and employees may from time to time have a longor short position in any security, option or futures contract of the issue(s) mentioned in this report.

In This Issue

May 2016

Volume XXXII, Number 5 May 2016

1 $10 to $20 Oil Still Likely The recentfailure of OPEC to freeze oil output andplans by Saudi Arabia to diversify frompetroleum confirm that the OPEC cartel isfading fast. With global productioncontinuing to exceed demand, inventoriesare building toward capacity, and thenunwanted oil will depress prices. So willintensifying financial strains on energyproducers.The oil short-covering rally of recentmonths is probably over, and prices areheaded toward our long-held target of$10 to $20 per barrel. That's the marginalcost that rules in a price war. Laterrecovery to $40 per barrel average costsis still far below the $100 per barrel thatmany earlier energy investmentsanticipated.

13 How To Make Big Money Thereare a number of strategies for making bigmoney. Many, but not all, involveleverage of some sort—technical andfinancial leverage, economies of scale,etc. Others are driven by taking a smallpiece of a very large pie.

1. Government Subsidies2. Inheritance3. Little Equity, Lots of Debt4. Financial Engineering5. Other Leverage6. Great Ideas, But Not NecessarilyThe First Implementers7. Small Slices of Very Big Pies8. Cartels and Monopolies9. Sell the Sizzle, Not the Steak10. Take Advantage of Addictionsand Vanity11. Picks and Shovels12. Get Paid With Money That Isn’t ThePayer’s, Especially If They’re Desperate

28 Investment Themes29 Summing Up

40 Commentary: Aristotle Lives!

We’ve discussed at length in past reports that OPEC is fading fast as an effectivecartel, and American frackers have replaced OPEC as the world’s swingproducers (see “After OPEC,” Feb. 2016 Insight, and “Oil Prices: Look OutBelow!,” April 2016 Insight). Now, even the cartel’s kingpin, Saudi Arabia—ledby the powerful 30-year-old Deputy Crown Prince Mohammed bin Salman(MBS)—is facing up to this reality.

RetreatHe personally trashed a potential output freeze at the meeting of major oilproducers in Doha, Qatar last month after Iran refused to go along. He alsorecently revealed plans to reduce the Saudi Kingdom’s dependence on oil byselling on the public market 5% of state-owned and crown jewel Aramco, whichwould bring in $100 to $150 billion, given the Prince’s estimate of Aramco’s valueat $2 trillion to $3 trillion.

Until it was nationalized four decades ago, “Aramco” stood for ArabianAmerican Oil Co., with major ownership by large U.S. energy companies. TheSaudis have been very secretive about Aramco’s accounts ever since, and thenecessity of revealing key numbers as a public company reveals the pressure onthat oil-dependent economy to report revenue ands and profits as well as thenation’s proven oil reserve, of around 260 billion barrels. Still, MBS said,“Aramco’s listing has many benefits, the most important and before everythingis transparency.” Note, however, that this likely sale of Aramco shares out ofdesperation would about cover the kingdom’s budget deficit for only 2015.

The plan will also create the world’s largest sovereign-wealth fund to finance non-oil investments abroad by transferring Aramco ownership to it. In addition, MBShopes to increase non-oil revenue from activities such as tourism and mining andmake spending more efficient. Saudi allies in the Persian Gulf—the United ArabEmirates, Qatar and Kuwait—have presented similar plans, but implementationhas been slow.

$10 to $20 Per Barrel Oil Is Still Likely*

Economic Research and Investment Strategy

A. Gary Shilling’s INSIGHT

* Based on a speech by A. Gary Shilling, PhD to Oil Price Outlook Conference,sponsored by the Japan Society, New York, N.Y., on April 28, 2016.

2 A. Gary Shilling's INSIGHT May 2016

[email protected] @agaryshilling

"Saudi Vision 2030"Ditto for the Saudis, and the Prince hasdubbed his plan “Saudi Vision 2030,”which also calls for privatization ofareas such as health care and education.Last year, oil provided 73% of staterevenues, and the collapse in oil prices(Chart 1) forced the kingdom to dig intoits foreign-currency reserves to the tuneof 16%, or $116 billion, over the courseof 2015. That reduced the total to $616billion at year’s end and $587 billion asof March 2016 (Chart 2). The Saudisalso borrowed $10 billion frominternational banks, with a five-yearmaturity—the first loans in 25 years.This loan is expected to pave the way foradditional money by tapping internationalbond markets. Qatar and Oman alreadyborrowed in recent months while AbuDhabi is considering an internationalbond offering.

With two-thirds of the population under30 years of age and an unemploymentrate over 11%, Saudi Arabia has majorchallenges, especially with a budget thatrequires $96 oil prices to balance it(Chart 3). Furthermore, the royal familyessentially buys the allegiance of itssubjects with no-show jobs while thephysical work is done by Indians,Pakistanis and other foreigners. Inaddition, the Sunni royal family has toplacate the opposing Shiites that dominatethe northeast oil-producing section ofthe country.

A significant example of the pressure onthe Saudi economy is the recent decisionby Saudi Binladen Group, the PersianGulf’s largest construction company, toslash 50,000 people from its 200,000workforce. Those laid off, mostlyconstruction workers from Asia, havebeen paid their outstandingcompensation, but the firm has alreadydefaulted on a number of debtrepayments and hasn’t paidsubcontractors and suppliers, mainlybecause of the Saudi government’sfailure to pay for completed or ongoingconstruction work.

CHART 1Brent and WTI Crude Oil Prices

Source: Thomson Reuters

Last Points 5/4/16: Brent $44.62; WTI $43.78$ per barrel; nearest futures contracts

Dec-13 May-14 Oct-14 Mar-15 Jul-15 Dec-1520

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CHART 2Saudi Arabia Foreign-Exchange Reserves

Source: Bloomberg and International Monetary Fund

Last Point 3/16: $587.1US$ billion

2001 2002 2004 2006 2007 2009 2011 2012 2014 20160

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CHART 3Oil Breakeven Price for Major Petrostates

Source: Bloomberg and The Wall Street Journal

$ per barrel

$52 $58$68 $70 $76

$89 $93 $96 $98$105

$208

Kuwait

Qatar

U.A.E

. Ira

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Current Brent Crude, $/barrel: $45.83Current Brent crude price: $44.62 per barrel



Other oil producers’ budgets are strainedby the nosedive in prices (Chart 3). TheInternational Monetary Fund estimatesthat Middle East oil-dependenteconomies had $390 billion in lowerrevenues last year and expects anothershortfall of $150 billion this year. Angola,an OPEC member, is seeking financialaid from the IMF as is Azerbaijan,which relies on oil and gas exports for75% of government revenues. Iraq,Nigeria, Ecuador and Venezuela, amongother oil producers, are seekinginternational aid to offset falling oilrevenues. In Kazakhstan, where thegovernment relies on oil for half itsrevenue, the IMF forecasts GDP growthof just 0.1% this year compared to 6%in 2013. Russian officials have been hoping for higher oilprices to lift the country out of recession.

ChickenFurthermore, the Saudis and their Persian Gulf alliescontinue to play their desperate game of chicken with othermajor oil producers. As we’ve discussed repeatedly inInsights since December 2014, cartels exist to keep pricesabove equilibrium, which encourages cheating as cartelmembers exceed their allotted output and other producerstake advantage of inflated prices. So the role of the cartelleader, in this case the Saudis, is to cut their own output toaccommodate the cheaters in order to keep prices fromfalling. But the Saudis have seen their past cutbacks resultin market share losses as other OPEC and non-OPECproducers increase their output. They most certainly hateChart 4, which reveals that OPEC output in the last decadehas been essentially flat while all the growth has beenenjoyed by others such as Russia, American frackers andCanadian oil sands producers.

So the Saudis and the other Persian Gulf producers withsizable financial resources embarked on a game of chickenwith other OPEC members, with Russia, American frackers,etc. They thought they could stand lower prices longer thantheir competitors who will have to back out first. In August2014, the Saudis had $745 billion in foreign-currencyreserves, and despite drawing them down subsequently tofund budget deficits and pay for imports, they still had $587billion in March, as noted earlier (Chart 2).

Bottom PriceWe first discussed over a year ago that the price at whichmajor producers chicken out and slash production isn’tdetermined by the prices needed to balance oil producerbudgets, which are $208 per barrel in Libya, $96 in Saudi

Arabia, $76 in Iraq, $70 in Iran and down to $52 per barrelin Kuwait (Chart 3). Many of these producers thoughtearlier that high oil prices would last indefinitely and pushedup their spending and budget needs when prices exceeded$100 a barrel.

Furthermore, the prices at which some major producerchickens out isn’t the “full cycle” or average cost ofproduction. That includes drilling costs, overhead, pipelines,etc. and now run $40 to $50 per barrel for new U.S. shaleoil production.

In a price war, the chicken-out point is the price that equalsthe marginal cost of producing oil from an established well.It’s the price at which free cash flow vanishes. This gameof chicken is similar to a gasoline price war among servicestations on all four corners of an intersection. One cutsprices to gain market share and the others follow to avoidlosing sales. The final and bottom price isn’t the full costper gallon of running the station, including labor costs, rent,equipment depreciation, etc. It’s the cost of gasolinecoming off the tank truck, plus taxes, the marginal cost.

Marginal Costs—$10 to $20 Per BarrelOnce fracking operations are set up and staffed, leases paidfor, drilling is completed and pipelines laid, the marginalcost of shale oil for efficient producers in Texas’ PermianBasin is about $10 to $20 per barrel. Unlike some otherdrilling locations, producers there can tap numerous layersof oil-bearing rock from a single location, hyping efficiency.Also, decades of drilling in the Permian Basin have spawnedplenty of support businesses that keep drilling costs low.And with new pipelines to carry the crude to trading hubs,bottlenecks there have been eliminated. So Permian Basinoil now sells at a premium at the well head, reversing theearlier discount to oil extracted elsewhere.

CHART 4Total Oil Output for Non-OPEC and OPEC Countries

Source: Energy Information Administration

Last Points 3Q 2015: non-OPEC 58.68; OPEC 37.71millions of barrels per day

1994 1996 1999 2001 2004 2006 2009 2011 201425

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Furthermore, fracking costs continue tofall as productivity leaps. The numberof drilling rigs that are working in theU.S. continues to drop (Chart 5). But therigs taken off line are mostly the oldvertical drillers that drill only one holeper platform while the horizontal rigs,which drill many wells per platform likethe spokes of a wheel, increasinglydominate. So the output per working rigis accelerating (Chart 5).

In addition, many oil companies keepproducing even with losses based onsunk and overhead costs as long asprices exceed marginal costs, and theresulting cash flow is available to servicedebt. Also, Wall Street has treatedenergy shares as growth stocks, so many oil and gascompany CEOs’ bonuses are based on increasing output aswell as growth in their energy reserves. This encouragesinvestment for increasing output, not profits. Furthermore,companies use yet-to-be extracted oil and gas as collateralfor bank loans.

Recently, Houston-based Goodrich Petroleum filed forChapter 11 bankruptcy and converted $400 million in debtto equity with a swap with investors who bought bonds thecompany issued last year. Goodrich is not alone, and debt-for-equity swaps slash interest expenses and allow troubledenergy producers to divert the money to drilling budgets,resulting in increased output.

Still InvestingIt’s also true that investors have been willing to buy newshares issued by beaten-up exploration and productioncompanies this year, apparently convinced that oil priceswon’t drop, but rather rise. This, too, allows problematicoutfits to cushion their balance sheet against lower energyprices and potential bankruptcies while encouraging themto keep producing.

Nevertheless, over 50% of energy loans at U.S. banks are

CHART 5Crude Oil Rotary Rig Count and Average Oil Production Per Rig

Source: Bloomberg and Baker Hughes

Last Points 4/16: rigs 372; oil production 475

2008 2009 2010 2011 2012 2013 20150

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Rig Count - left axis

Average Oil Production Per Rig (barrels/day) - right axis

in danger of default. And in Europe, reserve-based banklending to energy producers has mushroomed in recentyears. These loans, backed by the borrowers’ petroleumreserves and future production, have totaled over $12billion to Europe’s 10 largest non-government-owned oilcompanies, and are vulnerable to falling petroleum prices.

Recently, the Financial Accounting Standards Board, whichsets accounting rules for U.S. companies, moved to requirebanks to record all losses they project over the lifetime ofloans as soon as they’re made. Previously, they could waituntil losses actually occurred. This will eliminate theircurrent approach to troubled energy loans, which is to“extend and pretend” they will revive, “delay and pray” forhigher oil and natural gas prices to bail them out, or—ourfavorite—assume that “a rolling loan gathers no loss.”

The Comptroller of the Currency estimated that for 2013,this provision would have boosted loan-loss provisions by30% to 50% for banks industrywide, and obviously muchmore with the subsequent drop in energy prices (Chart 1).This rule won’t be effective until 2020, but banks may wellmove earlier, adding further pressure to energy companiesand encourage them to produce oil as long as free cash flowis positive.

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Meanwhile, U.S. banks are in the spring redeterminationseason when they must reassess the value of borrowers’collateral. This pressures them to not only write down orcall troubled loans, but also to refuse to renew untappedcredit lines, commitments to make future loans to specificborrowers.

Even The Energy GiantsEven huge international energy companies are feeling theheat. In 2015, the seven largest publicly-traded Westernenergy companies, including Exxon Mobil and Royal DutchShell, replaced only 75% of the oil and gas they producedwith new proven reserves. And recently, Exxon Mobil lostits perfect triple-A credit rating it held since 1930 asStandard & Poor’s downgraded it to double-A-plus, leavingonly Microsoft and Johnson & Johnson at the top. Exxon’sdecision to sell $12 billion in new bonds earlier this year anduse the money to fund capital spending and keep paying outdividends, even in the face of the oil price collapse, haswounded its balance sheet. Its total debt, $39 billion at theend of last year, has tripled since 2012.

Until recently, Exxon and other integrated oil companies aswell as stand-alone refiners have benefited from cheap U.S.shale oil—landlocked due to the ban on exports— whichthey could refine and then export as gasoline and diesel athigh mark-ups. But permission to export U.S. crude hasnarrowed the difference between domestic and foreigncrude prices (Chart 1), and excess inventories abroad of oilproducts are depressing prices. So the refiners’ profitmargin has shrunk from $10.30 per barrel on average lastyear to $6.75 in the first quarter. This shift is severelydepressing the profits of oil-refining businesses.

Marginal costs of production are also $10 to $20 per barrelor lower in the Persian Gulf. Furthermore, a financially-

CHART 6A Successful Cartel

1. Involves a commodity that can otherwise be left in theground, avoiding production and inventory costs until it’sneeded.2. Its product is so much in demand that buyers arerelatively insensitive to price.3. The commodity has few if any close substitutes.4. It includes most of the low-cost suppliers and has fewmeaningful non-cartel competitors.5. It involves relatively few cartel members, therebypromoting discipline.6. It's sponsored by governments and even religiousauthorities that benefit from the cartel and protect it.7. It operates in a period of strong economic growth androbust demand for the product.8. It faces few technological improvements in the industry.

CHART 7Unfavorable Climate for OPEC

1. Alternatives to oil, especially natural gas but alsogovernment-subsidized renewables, are growing.2. Non-OPEC supplies are leaping, notably from Russiaand especially American frackers.3. Infighting among OPEC members has destroyeddiscipline.4. Global economic growth is weak, and the ongoing shiftfrom goods production to services in China and elsewhereis curbing oil demand.5. Conservation is limiting oil demand.6. Rapid technological advances in fracking, horizontaldrilling, deep-water and Arctic drilling, etc. aremushrooming non-OPEC supplies at low and decliningcosts.

troubled country like Russia that desperately needs therevenue from oil exports to service foreign debts and payfor imports might well produce and export oil at pricesbelow marginal costs. So these marginal costs of oilproduction were the basis of our forecast in early 2015 thatprices could well drop to $10 to $20 per barrel.

Chicken Out PriceAs we discussed at length in our February 2016 Insight,which traced cartels going back to ancient Greek times, theoil cartel earlier had all the elements needed to be successful(Chart 6). Oil is a commodity that otherwise can be left inthe ground, avoiding production and inventory costs untilit’s produced. Earlier, oil was so much in demand that userswere relatively insensitive to price, and it had few substitutes.OPEC included most of the low-cost suppliers with feweffective non-OPEC competitors. There were few OPECmembers, which promoted cooperation and discipline inconstraining output to support prices. In all cases, theOPEC members were supported by governments and,indeed, were the governments themselves. Earlier, robusteconomic growth supplied robust demand for crude oil.And there were few technological improvements in energyproduction to spawn non-OPEC competition.

In part because of its very actions to restrict and control oilproduction, OPEC now faces a very unfavorable climateand it’s probably finished as an effective cartel (Chart 7).Today, alternatives to oil, especially liquefied natural gas,are growing as well as government-sponsored renewableenergy such as solar and wind. Non-OPEC oil suppliershave leaped, notably from Russia and Canadian oil sands,but especially American frackers. Infighting among OPECmembers has destroyed cooperation and discipline, withthe Saudis and Iranians fighting proxy wars in Syria andYemen while financially-weak OPEC members such as



Nigeria and Venezuela resist any talk ofproduction cuts—at least not by them.

Global economic growth and thereforedemand for oil is weak. Meanwhile, thenormal course of economic growthfavors services over goods consumption(Chart 8). Furthermore, China, thatgiant consumer of oil and othercommodities, is shifting frommanufacturing and infrastructurespending to consumption outlays andservices (Chart 9). Energy conservationmeasures in the West, initiated by the1973 Arab oil embargo, are limiting oildemand. And rapid technologicaladvances in fracking, horizontal drilling,deep-water and Arctic drilling, etc. aremushrooming non-OPEC supplies atlow and declining costs. Non-OPECoutput is estimated to rise from 58.1million barrels per day in 2015 to 58.6million this year.

Disintegration Of DisciplineThe disintegration of OPEC’s disciplineover its members’ oil output over thelast several years is stark. Earlier,individual members had specific quotas,but the lack of adherence resulted in anOPEC total limit of 30 million barrelsper day until late 2014. Then, when thecartel decided not to reduce output inlate November of that year, all limits onoutput were abandoned in the hope thatflooding the market with crude wouldforce major non-OPEC producers tochicken out and slash their output.

Subsequently, OPEC output climbed to33.2 million barrels per day in April, itshighest level in recent history (Chart 10),and the cartel still has 3.1 million barrelsper day in excess capacity. Saudi outputclimbed from 9.5 million barrels a day inDecember 2014, right after the Nov. 27OPEC decision, to 10.3 million barrels aday last month, and the kingdom still has1.2 million barrels a day in excess capacity(Chart 11, opposite page).

No FreezeIn another important development earlythis year, Saudi Arabia tried to get other

CHART 8Personal Consumption of Goods and Services

Source: Bureau of Economic Analysis

Last Points 1Q 2016: goods 31.7%; services 68.3%as a % of personal consumption expenditures (PCE)

1947-I 1959-III 1972-I 1984-III 1997-I 2009-III30%

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CHART 10OPEC Crude Oil Production

Source: Bloomberg

Last Point 4/16: 33.22millions of barrels per day

1970 1984 1991 1995 1998 2002 2005 2009 201210

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CHART 9Chinese Value-Added by Industry

Primary: Agriculture, forestry and fishery; Secondary: manufacturing, energy, constructionand mining; Tertiary: Services Source: Chinese National Bureau of Statistics

Last Points 3Q 2015: primary 9.0%; secondary 40.3%; teriary 50.9%as a % of nominal GDP

1992 1994 1997 1999 2002 2004 2007 2009 2012 20145%

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OPEC members as well as Russia tofreeze output at January’s levels. Thiswas an obvious sign of cartel weaknessbecause it would have left OPEC withthe same basic problem that led it tostart playing chicken back in November2014—flat OPEC output while thegrowth in global demand and marketshare would go to others, especiallyAmerican frackers (Chart 4).

The freeze plan, of course, failed afterPrince MBS overruled the Saudi oilminister, Ali al-Naimi, and scotched thedeal since Iran refused to participate.Besides, nobody involved trusts anyoneelse. The Russians continued to pumpflat out to support their recessionaryeconomy as the collapse in oil pricesdevastated government revenues andexport earnings of that energy-dominatedeconomy. In April, Russian output at10.8 million barrels a day was close toher post-Soviet era record (Chart 12).Back in 2001 and 2008, Russia promisedto curb output but instead increased itwhile the Saudis cut back.

Meanwhile, in war-torn Libya, thegovernment that controls the easternhalf of the country reported last monththat its oil company loaded its first cargoof 650,000 barrels of crude. This wasover the objections of the Tripoli-basedunity government that dominates westernLibya, but adds significantly to Libya’srecent limited output (Chart 13).

IranLibya did not agree to a productionfreeze, hoping to recover from thedisruptions of civil war. Similarly, Iranrefused and insisted to regaining its oilexport level that was devastated byWestern sanctions because of thatnation’s nuclear program. With sanctionslifted, Iran’s output has already jumpedby 700,000 barrels a day, from 2.8million barrels a day in January to 3.5million barrels daily in April (Chart 14,page 8), and she plans to boost output to6 million barrels a day in 2020. Thatwould make Iran the second-largestOPEC producer behind Saudi Arabia

CHART 13OPEC Oil Output by Country

Source: Thomson Reuters

Last Point: 4/16millions of barrels per day

10.3

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CHART 11Saudi Arabia Oil Production and Estimated Production Capacity

Source: Bloomberg

Last Points 4/16: oil production 10.3; capacity 11.5millions of barrels per day

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CHART 12Russian Oil Production

Source: Bloomberg

Last Point 4/16: 10.8millions of barrels per day

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(Chart 13). Note that in 1978, Iranproduced 5.8 million barrels a day.

Earlier, many doubted that Iran wouldincrease output so quickly because ofdeterioration of oil production facilitiesduring the sanctions, and would needimmense infusions of Westerntechnology and equipment to recover.Nevertheless, not only has the 700,000barrels per day surge this year exceededthe original 400,000 barrels estimates,but output in February topped capacityby 200,000 barrels a day and 300,000barrels a day in March. Note thatcapacity has leaped from 2.9 millionbarrels a day since then to 4.0 millionbarrels a day. With oil revenues covering25% of her government budget, Iran iszealously undercutting Saudi and Russianprices to sell oil in Europe and Asia.

Ironically, that is inducing producersranging from Angola, Albania and theU.K. to Saudi Arabia to export morecrude oil to the U.S. Countries such asVenezuela and Iraq are also selling oil atdiscounts just to keep pumping.

Excess SupplyEarlier, the International Energy Agencypredicted that even if U.S. frackers cutproduction 600,000 barrels a day thisyear and a further 200,000 barrels perday in 2017, and the now-dead freeze onoutput worked, excess supply will run at1.5 million barrels a day until 2017.That’s a continuation of the recent 1 to2 million barrels a day excess (Chart 15).

At the same time, energy demand in theOECD developed countries has beenessentially flat in recent years (Chart 16)due to weak economic growth,conservation and the tendency ofconsumers to save and not spend theirwindfalls from lower energy costs (Chart17, opposite page). So the growth indemand in the last decade has comefrom developing countries, but that istapering off as economic gains in Chinaand other emerging countries drop dueto slow demand for their exports fromNorth America and Europe and declining

CHART 14Iranian Oil Production and Estimated Production Capacity

Source: Bloomberg

Last Points 4/16: oil production 3.5; capacity 4.0millions of barrels per day

2000 2001 2002 2004 2005 2006 2008 2009 2010 2012 2013 20142.0

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CHART 15World Crude Oil Supply and Demand

Source: Bloomberg and International Energy Agency

Last Points 4Q 2015: excess supply 2.3; demand 94.8; supply 97.1millions of barrels per day

2001 2002 2003 2004 2006 2007 2008 2009 2011 2012 2013 2014-2.0

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CHART 16Annual Average Oil Demand for OECD and Non-OECD Countries

Source: The Wall Street Journal and Bloomberg

Last Points 2015: OECD 46.39; non-OECD 48.28millions of barrels per day

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volumes and prices for the commodityexports on which many of them depend.Those lands now account for over halfof total global demand (Chart 16).

InventoriesIn past Insights, we’ve drawn attention tothe crucial role of inventories indetermining future oil prices. After all,with global output exceeding demand byone-to-two million barrels per day (Chart15) and that surplus likely to persist, theextra oil must go into storage (Chart 18).And when the storage facilities are full,the surplus will be dumped on the marketto the detriment of prices.

Cushing, Oklahoma, which is essentiallyone huge tank farm, is the delivery pointfor determining the price of West TexasIntermediate, the U.S. benchmark. Atpresent, 90.5% of working capacity thereis utilized and the rate is jumping (Chart19). In the week ending April 29,Cushing inventories jumped by 821,969barrels. U.S. total inventories—thehighest in 80 years—are three timesbigger than in 1978 while consumptionhas risen only 3%.

In Europe, the Amsterdam-Rotterdam-Antwerp region, basically the mouth ofthe Rhine and, therefore, the waterentrance to the Continent, is the key oilstorage area. There, too, petroleuminventories are leaping and are within10% of full capacity (Chart 20, page 10).At 62 million barrels, inventories are atthe highest level since data started inFebruary 2013 and up 29% since then.As of early March, oil storage facilitieswere 70% full, close to the 71% recordlast June. Globally, crude oil inventorieshave jumped to record levels with a leapof 370 million barrels since January2014.

China is running out of capacity for hercommercial and strategic reserves. Lastyear, oil imports hit a record high of 6.7million barrels per day, running aheadof consumption and adding 260 millionbarrels to stockpiles. This year, another230 million barrels are expected to be

CHART 19Crude Oil Storage Capacity Utilization


Last Points 4/29/16: shell 75.6%; working 90.8%Cushing, Oklahoma

Mar-11 Oct-11 May-12Dec-12 Jul-13 Feb-14 Sep-14 Apr-15 Nov-1520%

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CHART 17Cumulative Actual Savings vs. Fixed Saving Rate and Gasoline Windfall

Source: Energy Information Administration and Bureau of Economic Analysis

Last Points 3/16: addit. saving $96.9; gas windfall $124.1since December 2014; US$ billion

Dec-1

4

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15

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15

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5

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160

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Cumulative Actual Consumer Savings vs. Fixed 4.6% Saving Rate

Cumulative Savings from Declining Gas Prices

CHART 18Commercial Crude Oil Inventory


Last Points 4/29/16: inventory 543.4; yr./yr. 10.9%weekly U.S. ending stocks

Jan-14 Apr-14 Aug-14 Dec-14 Mar-15 Jul-15 Nov-15200

250

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-5%

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Crude Oil Inventory (million barrels) - left axis

Year/Year Percent Change - right axis



added to reserves, leaving only about100 million barrels in space storagecapacity in China. With oil storagefacilities abroad reaching full capacity,oil is being imported into the U.S., whereabout two-thirds of capacity are filled,leaving room for another 100 millionbarrels.

Flotation And Rolling StorageSurplus oil is also being stored in ships—”floating storage”—even though it costs$1.13 per barrel per month compared to40 cents in Cushing and 25 cents permonth in underground salt caverns, likethose used for the U.S. StrategicPetroleum Reserve. Furthermore, aslow oil prices have made shipping it bytrain unprofitable, rail tank cars—”rollingstorage”—are being utilized. Their costis about 50 cents per barrel per month.

An additional driver of oil storage is theattractiveness of buying oil now andputting it in storage while selling futurescontracts against that physical oil. Thenthat oil will be delivered later to fulfillthose contracts. The futures marketcalls for prices to be much higher in latermonths and years than now, anticipatingthat current prices are temporarily low(Chart 21). This is called a contango andthis rising price curve allows speculatorsto lock in attractive profits, after storageand financing costs.

So, this process adds to demand for oilstorage now but will increase oil on the market when thatoil is delivered out of storage later. Indeed, the recent risein oil prices (Chart 1) has made it attractive to close outsome futures positions established earlier by deliveringphysical oil to the contract buyers.

There’s also lots of oil stored in the ground in drilled butuntapped wells (DUCs) that can easily be brought intoproduction if financially-stressed energy companies aredesperate for revenue. They, joining speculators, can alsosell oil from DUCs in the futures market and then produceand deliver it later. Futures prices for 2017 and 2018 above$45 per barrel have encouraged producers to lock in pricesand drill more wells. There are about 1.8 million DUCs inU.S. shale oil fields, and estimates are that putting 660 ofthem on stream in Texas alone would increase output by300,000 barrels a day.

Wary ProducersFurthermore, after the rise and then collapse of oil pricesa year ago (Chart 1), a number of wary oil producers areusing futures markets to hedge their later production atprices they thought were far too low only several monthsago. Many shale oil producers have no choice, given theeffects of the earlier nosedive in crude prices on theirbudgets and prospects for bankruptcy. The example ofContinental Resources, one of the biggest shale drillers, isvivid. It famously closed out most of its oil hedges in late2014 when oil first dropped below $80 per barrel, figuringthat prices would revive quickly. Instead, they collapsed toa low of $26 per barrel in January and have only recoveredto $43 per barrel. Still, for 2016, only about 36% of U.S.producers have hedged their expected output comparedwith half of production in earlier years.

CHART 20Total Crude Oil Stock in Amsterdam-Rotterdam-Antwerp Region

Source: Bloomberg

Last Point 4/29/16: 59.4millions of barrels

Feb-13 Jun-13 Oct-13 Feb-14 Jun-14 Oct-14 Jan-15 May-15 Sep-15 Jan-1640

45

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CHART 21WTI Crude Oil Futures Curve

Source: Bloomberg

May 2, 2016 close prices; $ per barrel

Jun-16 Feb-18 Oct-19 Jun-21 Feb-23 Oct-2442

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46

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52

54

56

42

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Furthermore, any further oil price risecould be capped by oil in DUCs becomingattractive to produce. Also, China, amongthe world’s five largest oil producers at4.3 million barrels a day last year, hasbeen relying more on imported oil whilecutting more expensive domesticproduction. China ’s significantunderground oil would no doubt beexploited if prices rise. The margin costof even China’s most expensive oil fields,about $40 per barrel, is lower than thecurrent Brent reference price of $46 perbarrel (Chart 1).

Short-Covering Rally?On balance, we still believe that oil pricesare headed for much lower levels,probably to our long-held forecast targetof $10 to $20 per barrel. In this context,the recent rise in prices has been a short-covering rally, very much like whatoccurred early last year (Chart 1), butwith much more speculation. SinceJanuary, net long futures positions ofWTI by speculators have risen from163,000 contracts to 334,000, or by105% (Chart 22).

Interestingly, speculators in oil futurescontracts have not been especiallyclairvoyant in predicting prices. Usingweekly data since January 2015, thehigher correlation between WTI pricesand the number of speculative futurescontracts was for coincident weeks (Chart23). In other words, speculators werethe most bullish at price highs and themost bearish at lows. Nevertheless, thecorrelations do rise as the lags betweenfutures and spot prices shorten. Thissuggests some correct anticipation ofactual crude prices by speculators.

In early 2015, many forecasters andinvestors believed that relatively short-cycle fracked oil would soon be exhausted,slashing supply and hyping prices. Soinvestors poured a record $18 billioninto energy share offerings last year. Butfrackers proved very efficient and U.S.oil production fell only modestly afterbeing propelled to record highs byfrackers (Chart 24). So, as of late

CHART 24U.S. Crude Oil Production


Last Point 4/29/16: 8.83millions of barrels per day

2000 2001 2002 2004 2005 2006 2008 2009 2010 2012 2013 20140

1

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CHART 22NYME Crude Oil Futures Positions and WTI Crude Oil Price

Source: Bloomberg and Commodity Futures Trading Commission

Last Points 4/26/16: positions 334.3; WTI price $43.73

Jan-15 Mar-15 Apr-15 Jun-15 Aug-15 Oct-15 Dec-15 Feb-16100

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Crude Oil Net Non-Commercial Futures Positions (thousands) - left axis

WTI Crude Oil Price ($/barrel) - right axis

CHART 23Correlation Coefficient for WTI Crude Oil Price and

Net Non-Commercial Futures Positions

Note: WTI crude oil price as a function it leads or lags crude oil net non-commercial futurespositions, measured weekly Source: Bloomberg and A. Gary Shilling & Co.

-10 -9 -8 -7 -6 -5 -4 -3 -2 -1 1 2 3 4 5 6 7 8 9 10

Lags (-) Leads (+)

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February, those 2015 offerings were down an average ofmore than 20% from their original prices.

How To Lie With StatisticsThe recent rally pushed oil prices from their January low of$26 per barrel to the high of $46 in late April, a jump of 77%before the more recent retreat to $43. But that 77% climbfollowed the 76% drop from the June 2014 top of $107 perbarrel (Chart 1). Sounds like a complete recovery? Not sosince only 25% of the swoon has been retraced to date.Consequently, it still feels horrible to those who invested inoil when it was over $100 per barrel. So much for this shortcourse on How to Lie with Statistics!

The oil price recovery, which now may well be over, alsowas driven by hopes, not based on any fundamental changein the excess of petroleum supply over demand, theprimary cause of the price collapse. So another big legdown in oil prices seems likely, triggered by several probabledevelopments that will reinforce each other. First is thefilling of oil storage facilities that will then force ongoingexcess production to be dumped on the market, therebydepressing prices. Second, pressure from lenders, backedby bank examiners, on financially-weak borrowers that willforce them to produce as much oil and gas as possible togain the revenue to service their debts. Finally, the likelycontinuing rise in the safe-haven dollar against the currenciesof weak developing economies will hype their cost ofimported oil—which is universally priced in U.S. dollars—and thereby curb demand.

Recession ProspectsIf prices drop to our $10 to $20 per barrel target, thefinancial disruption to the highly-leveraged oil industry willcontinue to outweigh the benefits to energy consumers andprecipitate a global recession. That's no doubt why fallingoil prices depressed stocks earlier this year and vice versa.

Already, the earlier slump in oil prices is resulting infinancial strains among consumers in oil-producing areas.Laid-off energy workers are stressed and so too are people

employed in the bars, restaurants, hotels and stores theyearlier frequented. Since September 2014, 119,600 oil andgas jobs nationwide have been eliminated, 22% of the total.Schlumberger, the largest oil-field servicer in the world, laidoff another 2,000 employees in the first quarter. Thatbrings the cuts since November 2014 to 36,000, or 28% ofits workforce.

Auto loan and credit card delinquencies are jumping on oil-dependent Oklahoma, Texas, Wyoming, Louisiana, NorthDakota and other states. Furthermore, tax revenues arealso affected, with 70% of Wyoming’s state revenuescoming from oil, natural gas and minerals. The last thingmost families want to risk is their abodes, but housemortgage payment delinquencies are also rising.

An oil price drop to the $10 to $20 per barrel range wouldbe a shock reminiscent of the dot com collapse in the late1990s that precipitated the 2001 recession, and the subprimemortgage debacle in the mid-2000s that touched off the2007-2009 Great Recession, the deepest since the 1930s.

Later Price ReboundOil prices would not stay in the $10 to $20 barrel rangeindefinitely, however. In the aftermath of a global recessionand after excess energy production was squeezed out—painfully, no doubt—price rises would be expected. In thelonger run, petroleum prices would likely increase to theaverage cost of new production— not just marginal costsbut also including overhead cost and reasonable profitmargins.

Still, with the strong possibility of chronic deflation beinginitiated by a worldwide downturn and the depressingeffects on labor and other costs, the equilibrium prices ofoil might be surprisingly low, in the $40 per barrel range.That would be far below what is needed to justify much ofthe squeezed-out supply that was initiated when prices werecloser to $100 per barrel. Writedowns of uneconomicenergy investments and bankruptcies could be widespread.



How To Make Big Money:12 Time-Tested Strategies

The prime driver of the political populism that is now rampant in North America and Europe is the lack of real incomegrowth for over a decade (Chart 1). As we discussed at length in our March 2015 report, “The Next Big Thing,” and insubsequent Insights, voters no longer believe mainstream politicians can deliver acceptable purchasing power growth, sothey’ve turned to the fringes.

Fringe PoliticiansWitness the far-right National Front inFrance, led by Marine Le Pen, whichwants to cut off immigration and enactprotectionist measures. Extreme rightand left parties have significant followingsin Spain, Italy and even normally-staidGermany. Leftist Jeremy Corbyn nowleads the U.K. Labor Party that earlierwasn’t that far from Margaret Thatcher’sConservatives.

In Austria’s recent first round of thepresidential election, a populist and anti-immigration candidate emerged as thefrontrunner, the Greens Party leaderwas second and the mainstreamcandidates, whose parties have ruled thecountry since World War II, didn’t evenmake it into the runoff.

In Canada last year, left-leaning JustinTrudeau replaced Conservative StephenHarper as Prime Minister. And in theU.S., Bernie Sanders on the far left hasa significant following in the Democraticprimaries while populist Donald Trumplooks to be the Republican presidentialcandidate.

Many of these populists promote theprotectionist belief that foreigners arestealing jobs from the natives—Turks,North Africans and Syrian fromEuropeans, Mexicans from Americansand Chinese workers from the West ingeneral.

They also promote the concept that the rich are robbing the poor. Now, it’s clear that the top 20% of households havebeen gaining income share in the U.S. while the other four quintiles’ shares have declined since the government data startedin 1966 (Chart 2). Nevertheless, losing income share was acceptable to many Americans in earlier years because theirpurchasing power was rising at the same time. But declining income share and real incomes has put people in the mood ofHoward Beale in the old movie, “Network,” when he rises from his anchorman’s chair, walks to the window, opens it andyells, “I’m mad as hell, and I’m not going to take it anymore!”

CHART 1Real Weekly Wages and Household Incomes

Source: Bureau of Labor Statistics and Census Bureau

Last Points 2014: income -1.5%; wages 1.0%year/year % change

1980 1985 1990 1995 2000 2005 2010-6%

-5%

-4%

-3%

-2%

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Avg. Real Weekly Wages of Production and Supervisory Employees

Real Median Household Income

CHART 2Share of Aggregate Income

Source: Census Bureau

Last Points: 2014by income quintile

1967197119751979198319871991199519992003200720110%

2%

4%

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west

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1st Quintile (lowest)

2nd Quintile

3rd Quintile

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5th Quintile (highest)



CHART 3S&P 500 Index

Source: Yahoo Finance

Last Point 5/5/16: 2,050

Jan-80 Jul-89 Mar-99 Jun-07 Jun-09 Jun-11 Jun-13 Jun-150

500

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0

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CHART 4Case-Shiller 10-City House Price Index

Source: Standard & Poor's

Last Point 2/16: 200.96seasonally-adjusted

Jan-87 Mar-91 May-95 Jul-99 Sep-03 Nov-07 Jan-1260

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CHART 5U.S. Personal Saving Rate and Household Debt (consumer + mortgage)

Source: Bureau of Economic Analysis and Federal Reserve

Last Points 4Q 2015: saving rate 5.4%; household debt 104.7%as a % of disposable personal income

Jan-59 Jan-65 Jan-71 Jan-77 Jan-83 Jan-89 Jan-95 Jan-01 Jan-07 Jan-132%

4%

6%

8%

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14%

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50%

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80%

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Saving Rate (SAAR) - left axis

Household Debt as a % of Disposable Personal Income - right axis

Other Spending SourcesFurthermore, in the 1980s and 1990s,many were less concerned about theirincome growth because they believedthat ever-rising stock prices (Chart 3)would fund their kids’ education, theirown early retirement and a few ‘round-the-world trips in between. Ditto for therising value of houses (Chart 4), a muchmore significant part of net worth formost Americans than equities, which areprimarily owned by high-incomehouseholds. Households also increasedtheir spending about a half-percentagepoint per year faster than their after-taxincomes from the early 1980s until2005, a move that reduced their savingrate from 12% to 2% (Chart 5). The flipside was the increase in total householddebt in relation to after-tax income fromits 65% norm to a peak of 130% beforethe more recent decline (Chart 5).

But faith in equity portfolios wasdevastated by the collapse in the late1990s when the dot com bubble brokeand again during the 2007-2009 GreatRecession (Chart 3). Those were two ofonly five stock market declines of over40% since 1900 (Chart 6, opposite page).Similarly, the subprime mortgage collapseand housing debacle (Chart 4) in 2007-2009 destroyed the belief of many thatthey could make a fortune speculating inhousing without even putting a nickeldown. Meanwhile, the pressure to save,especially by the spendthrift postwarbabies now facing retirement, is pushingthe saving rate up as spending and debtrates fall (Chart 5).

Populist PlansSo, many Americans are now susceptibleto populist plans to transfer massiveamounts of income and assets fromthose who they regard as the crooks atthe top to their supposedly hard-workingbut depressed constituents. BernieSanders wants free health care and collegetuition for all, with the costs of morethan $18 trillion over 10 years coveredby $19.6 trillion in tax increases (Chart 7,opposite page).



Hillary Clinton’s tax andspending plans are lessexuberant but still substantial.She would raise $1 trillion inhigher taxes over the nextdecade, with the top 1%earners paying 77% of thetotal, or $78,284 more in taxeson average in 2017, accordingto an analysis by the Tax PolicyCenter. The top 0.1%, withincomes over $3.8 million, would pay over half of the tab.

She proposes to cap deductions for high-income households,raise taxes on private equity managers’ carried interest andincrease capital gains tax rates on assets held between oneand six years. The minimum tax rate on incomes over $2million would be 30% with a 4% surcharge on incomesexceeding $5 million. She also wants an increase in theestate tax rate from 40% to 45%. She’d use the money tobenefit lower-income households with spending oneducation, energy and family leave.

CrooksTo be sure, some of those with massive incomes and assetsare full-fledged crooks such as Bernie Madoff. He ran theworld’s largest Ponzi scheme that sucked in about $65billion from investors who truly believed he could producedouble-digit returns year after year with virtually no volatilityor risks. The government estimates their net losses at $13billion, and since Madoff never invested a dime andtherefore had no losses, his business and personal expenseswere grandiose, to say the least. In 2009, Madoff, age 71,was sentenced to 150 years in the slammer but could get out

CHART 6S&P 500 Declines Over 40%

Peak DateSeptember 1929February 1937

January 11, 1973March 24, 2000October 9, 2007

Peak Level31.3018.11

120.241,527.461,565.15

Trough DateJune 1932April 1942

October 3, 1974October 9, 2002March 9, 2009

Trough Level4.777.84

62.28776.76676.53

% Decline84.8%56.7%48.2%49.1%56.8%

CHART 7Sanders' Spending And Tax Proposals

Source: The Wall Street Journal

Medicare for allSocial SecurityInfrastructureCollege affordabilityCreate paid-leave fundBolster private pension fundsYouth jobs initiativeChild care/Pre-K

$15 trillion$1.2 trillion$1.0 trillion$750 billion$319 billion$29 billion$55 billion

not available

Business healthcare premium taxEnding tax-free status for employer health insur.Wall Street speculation taxIndividual healthcare premium taxSocial Security tax hikeRaising marginal income-tax ratesCorporate offshore income taxCapital gains tax hikePayroll tax hikeDeath tax hikeEnding tax deductionsEnergy taxCarried interest tax

$6.3 trillion$3.1 trillion$3 trillion

$2.1 trillion$1.2 trillion$1.1 trillion$1 trillion

$920 billion$319 billion$243 billion$150 billion$135 billion$15.6 billion

TOTAL: $18.3 trillion+ TOTAL: $19.6 trillion

New Federal Spending Federal Tax Increases

in 2136 after 127 years for good behavior. Don't hold yourbreath!

More recently, the powerful former Speaker of the NewYork State Assembly, Sheldon Silver, was sentenced to 12years behind bars, ordered to pay a fine of $1.75 million andtold to forfeit $5.3 million he gained from criminal schemes.He received millions of dollars in kickbacks and bribesfrom outsiders he aided in obtaining state contracts, accordingto prosecutors who labeled his schemes “multifaceted andnefarious.”

Nevertheless, there are a number of strategies for makingbig money that are entirely legitimate. We’ve assembled alist of 12 that have stood the test of time. Many, but notall, involve leverage of some sort—technical and financialleverage, economies of scale, etc. Others are driven bytaking a small piece of a very large pie.

Before examining each, however, we must point out thatluck is often paramount, regardless of how sound or flawedthe game plan. Being in the right place at the right time hasmade fortunes for idiots. Think of the dot com speculator



CHART 8Miles of Railroad in Operation in the U.S.

Source: Historical Statistics of the United States

1850-1950; thousands of miles

1850 1875 1900 1925 19500

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CHART 9U.S. Corn Production

* Projected Source: Bloomberg and U.S. Department of Agriculture

Last Point 2016*: 13.65billions of bushels

20002001

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20142015

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who only sold out in late 1999 becausehe was buying a McMansion for his newwife, and that house then doubled invalue over the next five years. Conversely,“the best laid schemes o’ Mice an’ Men,Gang aft agley, An’ lea’e us nought butgrief an’ pain, For promis’d joy!” asRobert Burns put it. Bad luck can turn asurefire strategy into a disaster. ElishaGray had the misfortune to arrive at theU.S. Patent Office to patent the telephonea mere hour after Alexander GrahamBell.

1. Government SubsidiesPerhaps the most time-honored andsurest way to make big money is the oldfashioned way—skill, brains, luck,clairvoyance, hard work—and so much government supportyou can’t miss! Records show that contractors who suppliedfood to Roman soldiers made fortunes, even when theyprovided full fare and not short rations. Recall that in themovie, “Schindler’s List,” Schindler’s successful businessof manufacturing pots and pans for the German Armymade it possible for him to rescue many Jews from theNazis. Similarly, American defense contractors todayprosper when the Pentagon weapons budget rises.

Benefiting directly from government spending is obvious.What’s more subtle and therefore more interesting are thevast government cash and tax subsidies. Again, this isnothing new. The Homestead Act in 1862 gave freeWestern land to homesteaders both to relieve crowdedEastern cities and to populate the Continent before Europeanpowers encroached on the U.S. The building of thetranscontinental railroads in the late 1800s was subsidizedby free land in one square mile pieces onalternate sides of the right of way incheckerboard fashion (Chart 8). Morelater on the tycoons involved.

EnergyPetroleum remains heavily subsidizedby tax measures such as the depletionallowance, accelerated depreciation andexpensing of intangibles—and they'vemade fortunes for oil tycoons for decades.Windmill farms would not exist withoutheavy government subsidies of 2.2 centsper kilowatt hour currently. Ditto forsolar energy, which accounts for only0.6% of U.S.-produced electricity.Homeowners get a federal tax credit of30% of the cost of a solar power system.

And states add more. New Jersey rebates 50% of the costof a system and for every 1,000 kilowatts generated, thehomeowner gets a mandated $2,400 from his electric utilityto help fulfill its requirement to produce renewable-sourcepower. Ethanol is subsidized with a $0.45 per gallon taxcredit.

Agriculture and Real EstateU.S. agriculture has been heavily subsidized since the1930s, and even more so in Europe. In this country, theprices of grains, wheat, corn, cotton, tobacco and evenhoney are supported one way or another and provide 23%of farm income. Import quotas on sugar do double duty bykeeping domestic prices well above world levels to thebenefit of producers in Louisiana, Hawaii and elsewherewhile favoring foreign producers the federal governmentlikes—a list that obviously doesn’t include Cuba, but may



CHART 11Steel Price

Source: Bloomberg

Last Point 5/5/16: $560.0US$ per short ton

Oct-08 Jul-09May-10Feb-11Nov-11Aug-12May-13Mar-14Dec-14Sep-15300

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soon now that the U.S. has re-establisheddiplomatic relations with the island nation.

U.S. corn production has been high withgood weather in recent years (Chart 9,opposite page) and as Midwest farmersexpanded to satisfy biofuel demand andexports to growing developingeconomies. But the world followed suitwith Brazil, the No. 2 grower behind theU.S., and Argentina producing huge cropsthat they’re selling at discounts in theU.S., aided by the strong dollar in recentyears. The collapse in ocean shippingrates is also reducing corn import costs.Don’t be surprised if Congress againcomes to the rescue of American farmerswith more corn subsidies. Despite thetiny and dwindling percentage of thenation’s workers in agriculture (Chart10), sizable farm subsidies will persist aslong as there are two Senators fromevery state.

Real EstateReal estate is another large beneficiaryof government largess. Commercial realestate investors enjoy tax-free exchangesthat allow them to defer taxes by promptlybuying a second property after selling asimilar appreciated holding. Full-timereal estate professionals, who spend morethan half their working hours and morethan 750 hours a year on that business,can deduct depreciation, interest costsand property taxes from their income.Individuals can deduct mortgage interestfor federal income tax purposes, and realize up to $500,000of appreciation per married couple on their primaryresidence every two years.

The earlier real estate bubble (Chart 4) was significantlyfueled by cheap mortgage money and low lending standardsby government-controlled Fannie Mae, Freddie Mac andthe Federal Housing Administration. Also instrumentalwas the widespread conviction in Congress and successiveAdministrations that everyone deserved to own their ownhouse. And when real estate gets into trouble, taxpayersfoot the bill, as was seen by the federal bailout of the banksand other big mortgage lenders in 2008. Earlier, thecollapse of the S&Ls in the late 1980s, due to unsound realestate loans, resulted in a $130 billion federal bailout. Manysavvy investors profited handsomely by taking over loans

and whole financial institutions that the Resolution TrustCorp. was almost giving away. Full disclosure: We wereamong them.

The U.S. steel industry is, in effect, perennially subsidizedby anti-dumping and other tariffs on imports, especiallyfrom China as U.S. prices fell by a third last year (Chart 11).Chinese steel shipments to the EU have doubled in the lasttwo years as prices collapse. U.K. crude steel productionis down 18% in the last decade. Tata Steel, an Indianconglomerate that is Europe’s second-largest steel producerand owner of a majority of U.K. steel factories, has decidedto sell its British plants due to “deteriorating financeperformance.” This puts tremendous pressure on the U.S.government for aid to the industry.

CHART 10Agricultural Employment as a Share of Total Employment


Last Point 2014: 1.0%

1948 1958 1968 1978 1988 1998 20080.5%

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Health CareThe government, of course, hugelysubsidizes the mushrooming health carebill (Chart 12) and currently pays 45% ofthe total through Medicare, Medicaidand other programs (Chart 13). Thatshare is forecast to reach 50% in 10years—to the immense profitability ofmany. Look around your community.We bet that many of the newer, biggerbuildings are health care-related as arethe high-paid professionals working inthem.

Nevertheless, Obamacare, by violatingthe basic insurance principle of higherpremiums for the biggest risks, has forcedmajor health insurer United HealthGroup, after deepening losses, towithdraw from almost all the 34 states inwhich it offered exchange plans. Humanais losing money and most health insurersseek huge rate increases from regulators.

With the aging of the postwar babies(Chart 14), government support forhealth care will mushroom (Chart 12).It’s curious that despite the leaping healthcare costs, government doesn’t seemmuch interested in increasing supply andthen letting competition control prices.In fact, some local governments limitthe expansion of hospitals in local areasfor fear that overcapacity will encourageoveruse, increase costs per bed andrequire more government subsidy.

We’re not aware of any significantattempts to expand the number of medicalschools and MDs trained—despite thefact that a growing number of physicians,including residents in teaching hospitals,are trained in India or other countries.Then there are those medical schools inthe Caribbean for Americans for whomthere is no room in U.S. institutions.

Feet In The TroughOver decades, we’ve examined thebreadth and depth of governmentinvolvement in the economy to determinethe percentage of the population thatdepends on government in a major way—enough so that they’d squawk if their

CHART 14U.S. Population Age 65 and Over

Source: Census Bureau

Last Point 2015: 14.9%as a % of total population

1945 1970 1995 2020 20456%

8%

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Actual

Projected

CHART 12National Health Spending

* Projected Source: Centers for Medicare and Medicaid Services

Last Point 2014*: 19.6%as a % of GDP

1960 1970 1980 1990 2000 2010 20214%

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CHART 13Government Health Care Expenditures

Source: Office of Management and Budget

Last Point 2014: 43.5%as a % of total national health care expenditures

1960 1970 1980 1990 2000 20100%

5%

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45%

0%

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Medicare Coverage Starts



Government Employees with dependentswithout dependents

Federal MilitaryCivilian

State & Local StateLocal

Dependents

Transfers & Pensions with additional dependentswithout additional dependents

Fed Gov. RetirementState & Local Gov. retirementVeterans’ Pension & CompWelfare, etc.Unemployment InsuranceSocial Security, OAI (retirees)Social Security, SI (survivors)Social Security, DI (disability)

Additional Dependents

Other Recipients ofGov. Benefits with addit. dependents

without addit. dependents

Food Stamps minus welfareLow-Rent HousingSupplemental Education Grants

Additional Dependents

Private Employmentdue to Government with dependents

without dependents

Due to Government SpendingDue to Agricultural ProgramsDue to Regulation and Protection

Dependents

Non-Beneficiaries

Private Employment not due to GovernmentDependents

Direct Gov. BeneficiariesPrivate WorkersTotal

Dependents of Direct Gov. BeneficiariesDependents of Private WorkersTotal

Total Gov. BeneficiariesTotal Non-Beneficiaries

Total Population

195010.45.01.01.30.72.05.4

8.27.20.10.32.01.41.01.70.60.0

1.1

0.00.0

0.00.00.0

0.0

10.04.8

3.81.60.1

5.2

71.3

34.237.1

17.034.251.1

11.737.148.9

28.771.3

152.3

196014.66.01.41.30.82.58.6

15.413.90.30.52.21.71.15.72.00.4

1.5

0.00.0

0.00.00.0

0.0

12.55.1

4.00.90.2

7.3

57.5

23.733.8

25.123.748.8

17.433.851.2

42.557.5

180.7

197018.47.71.51.41.33.510.7

22.621.30.50.62.34.10.98.33.21.3

1.3

0.40.4

0.00.00.4

0.0

11.04.6

3.80.50.2

6.4

47.6

19.827.8

33.919.853.8

18.427.846.2

52.447.6

205.1

198017.78.10.91.31.64.39.6

27.625.80.71.12.04.71.510.33.32.1

1.8

5.65.6

4.60.01.0

0.0

10.44.8

4.00.40.4

5.6

38.8

17.821.0

44.317.862.1

16.921.037.9

61.238.8

227.2

199015.38.20.81.31.74.47.1

26.425.60.91.61.44.71.011.42.91.7

0.9

4.44.4

3.30.01.1

0.0

9.55.1

4.50.30.2

4.4

44.4

23.820.6

43.323.867.1

12.320.632.9

55.644.4

249.5

200014.87.90.51.01.74.76.9

23.923.20.82.21.12.10.711.32.52.4

0.7

6.96.2

4.00.71.5

0.7

8.24.3

3.90.20.2

3.8

46.3

24.621.7

41.624.666.3

12.121.733.7

53.746.3

281.4

200414.57.80.50.91.74.76.7

24.023.10.82.31.21.61.011.22.32.7

0.8

9.58.9

6.50.81.6

0.7

8.54.6

4.20.20.2

3.9

43.5

23.520.0

44.423.567.9

12.120.032.1

56.543.5

293.7

200714.47.80.50.91.74.86.6

23.823.10.82.41.21.40.811.32.22.9

0.7

10.69.8

7.40.91.6

0.7

9.45.1

4.60.30.2

4.3

41.8

22.719.1

45.922.768.5

12.319.131.5

58.241.8

301.3

CHART 15Government Beneficiaries and Non-Beneficiaries

% of total population



government goodies were removed. Weignored minor items like lunch subsidiesfor school children. But when we addedup government employees and theirdependents, suppliers of governmentpurchases and their dependents,recipients of Social Security, welfare,Medicare, Medicaid, student loans, farmsubsidies, etc., we found that thepercentage of the American populationinvolved climbed from 28.7% in 1950to 61.2% in 1980 (Chart 15, page 19).

That figure then receded to 53.7% in2000 due to strength in the privatesector while anti-government sentimentslashed the number of welfare recipients.But the percentage climbed back to56.5% in 2004 and 58.2% in 2007, andis headed for 60% in the decades aheadas the postwar babies tap Social Security,Medicare and Medicaid (Chart 16).

Since over half of Americans have theirfeet firmly planted in the governmentfeeding trough, it’s highly unlikely thatgovernment subsidies will disappear oreven be cut substantially. In fact, theamazing reality is that the percentagehasn’t risen more than it has since withover half of Americans already receivingsubstantial financial support fromgovernment, they could simply vote formore. As noted earlier, Bernie Sandersand Hillary Clinton both want to move inthis direction.

Government subsidies, then, are often a great way to makebig money. But there are drawbacks because he who paysthe piper calls the tune. Because of soaring medical costs,the federal government is more and more controlling thefees it pays to hospitals and other medical service providers.This is clear from the fee structures imposed by Obamacare.

2. InheritanceYou can always make big money by picking rich parentswho die young after you encourage them to save the moneyfor you. Then there are wealthy and feeble uncles with noother heirs.

Another approach is to knock off all your relatives whostand between you and the money, as shown in thewonderful old Alec Guinness comedy movie, “Kind Hearthsand Coronets.” The daughter of a 19th century English

CHART 17

duke takes off with an Italian tenor. When she dies, her sonwants to honor her request to be buried at the family estate,but the present duke regards the late mother and son asdespicable foreigners. So the son systematically kills offabout 10 men and women who stand between him and thedukedom, all played by Alec Guinness. They include asuffragette shot in a hot air balloon while celebrating herrelease from prison, an aging Anglican rector, an incompetentadmiral, a stuffy general, a closet alcoholic and, finally, theduke himself. The son’s goal, however, wasn’t money asmuch as revenge and the prestige of being an English duke.

For most, however, inheritance is not the route to riches,as we’ve reported in past Insights. In 1993, two academiciansestimated that the postwar babies, who have saved little fortheir retirement, would inherit more than $10 trillion in1990 dollars from their parents ($19 trillion in today’s

CHART 16Social Security, Medicare and Medicaid

Source: Congressional Budget Office and Social Security Administration

as a % of GDP

1970 1990 2010 2030 2050 20702%

4%

6%

8%

10%

12%

14%

16%

18%

20%

22%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

22%

Social Security

Medicare

Medicaid + CHIP + Exchange Subsidies

Labor Force Participation Rate for Ages 65+

Source: Bureau of Labor Statistics

Last Point 4/16: 19.6%

Jan-48 Jan-57 Jan-66 Jan-75 Jan-84 Jan-93 Jan-02 Jan-1110%

15%

20%

25%

30%

10%

15%

20%

25%

30%



money). Not to be outdone, otherresearchers in 1999 concluded that atleast $41 trillion would be passed on overthe following 60 years. Wow! If you're atypical postwar baby, quit your day joband get ready for a life of leisure!

Reality Sets InBut those same researchers concludedthat the boomers would get a mere $7trillion after estate taxes. Subsequentwork by AARP slashed the total forinheritances of all people then alive to$12 trillion in 2005 dollars. Most of it,$9.2 trillion, would go to pre-boomersborn before 1946, only $2.1 trillion tothe postwar babies born between 1946and 1964, and a mere $0.7 trillion to thepost-boomers.

The reality, however, is that parents are living longer andincurring more medical expenses before they die. A 65-year-old man can expect to reach 84 and a similarly-agedwoman is likely to live to 87. That’s almost two decadesbeyond normal retirement, and by then, high and soaringhealth care costs may well dissipate wealth substantially.About 40% of those 65 and older will probably spend sometime in a nursing home, and costs there can run over$100,000 per year.

Also, many well-to-do older Americans are selling their bigmoney-pit houses in suburbs and moving into retirementcommunities, some of which shift them from independentliving facilities to assisted care and finally to nursingquarters as they age. We refer to them as “happy acres” andsome of their names about as euphemistic. In many ofthese, however, the new residents pay sizable up-front fees,enough to buy a comfortable house, but they don’t actuallyown anything. So there’s no inheritance for their offspringwhen they die as ownership is retained by the developer.

The Rich Get RicherThe AARP survey also found that families with high networth receive bigger inheritances than those with less. Well,what would you expect? Rich kids often have wealthyparents. So, most of the money is not going to those withfew assets but to those who are already well off.

All this evidence is borne out by the current zeal of thepostwar babies to save aggressively for what they earlierhoped would be carefree retirements, as noted earlier(Chart 5). They’re also working longer, as shown by therising labor participation rate for those over 65 (Chart 17,opposite page). Sure, many are still in good health and want

CHART 18Real Quality-Adjusted House Price Index

Source: Robert Shiller

Last Point 2015: 155.60index 1890=100

1890 1910 1930 1950 1970 1990 201060

80

100

120

140

160

180

200

60

80

100

120

140

160

180

200

to stay active, but many have so few assets, includinginheritance, that they’ll need to work until they die or enternursing homes.

You can’t pick your parents, but you can pick your spouse,and marrying for money is an age-old strategy for acquiringmajor assets. Nevertheless, our great and unfortunatelylate friend, Robert M. Dunn Jr.—our colleague at Stanford’sPhD program and then a professor at George WashingtonUniversity in Washington, D.C.—loved to quote his motheras saying, “Son, if you marry for money, you’ll earn everynickel of it!”

3. Little Equity, Lots of DebtYou can make lots of money by investing with little equityand huge borrowing—as long as you’re right on theinvestment’s price direction! Real estate is obviously in thisarena. Earlier, 20% downpayments on houses were thenorm, but during the late 1990s-early 2000s housing bubble(Chart 4), they shrank to zero or even negative numberswith “piggyback” loans, second mortgages on top of theusual 80% first mortgages, which took the total loan tomore than 100% of a house’s value.

Those loans were especially attractive to subprime borrowerswith little demonstrable income or assets, and lenders wereonly too happy to accommodate them. Many thought thathouse prices would leap indefinitely and were totallyunaware that, adjusted for inflation and size, house priceshistorically have been constant—and despite the 2006-2009 collapse, still remain well above that norm (Chart 18).

Let’s look at a simple example of why this was so attractive.If a house buyer puts down 20% and the price rises 10%,he makes 50% on his investment—excluding, of course,



brokerage commissions and other closingcosts, taxes, maintenance, utilities,mortgage interest, interest foregone onhis downpayment, etc. But with 3%down and the same 10% appreciation,the gain on his investment is 333%, andwith zero down, the gain is infinitepercent.

Then, of course, there is the matter ofsize. A house that costs twice as muchpromises twice the dollars of profit. So,many bought the most expensive housesthey can finance, using second mortgagesto secure bigger properties with thesame equity, and then relying on interest-only and option adjustable-rate mortgageswith low initial teaser interest rates tohold down their monthly payments. Butthis math works both ways. Those withlittle or nothing down were highlysusceptible to delinquencies and defaultswhen falling prices pushed their homeequity in negative territory. This becamepainfully clear when house pricescollapsed in 2006-2009 (Chart 4).Leverage is very much used in bothcommercial and residential real estate.

Hedge Funds and Private EquityHedge funds, of course, employtremendous borrowing, which is neededto achieve the superior returns neededto justify high fees for investors, often2% annual management fees plus 20%of the gains. With declining and lowinterest rates in recent years (Chart 19),pension funds and other institutionalinvestors as well as individuals havepoured money into hedge funds andrelated products, pushing their assetsfrom $1.5 trillion in 2008 to almost $3trillion last year (Chart 20).

Nevertheless, hedge funds in recentyears have vastly underperformed thestock market and investors are retreating.Industry leader California PublicEmployees Retirement System, with $279billion in total assets, decided inSeptember 2014 to eliminate entirely its$4 billion hedge fund portfolio. Othersfollowed and in the first quarter of thisyear, the net withdrawals were over $14billion.

CHART 20Global Hedge Funds: Assets Under Management

Source: BarclayHedge

Last Point 2015: $2,796US$ billion

'97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '150

500

1000

1500

2000

2500

3000

0

500

1000

1500

2000

2500

3000

CHART 21Apollo Global Management and KKR & Co. Stock Prices

Source: Bloomberg

Last Points 5/5/16: Apollo $16.64; KKR $13

Jan-14 May-14 Oct-14 Feb-15 Jul-15 Dec-15 Apr-1610

15

20

25

30

35

40

10

15

20

25

30

35

40

Apollo Global Management

KKR & Co.

CHART 1910- and 30-Year Treasury Yields

Source: Federal Reserve

Last Points 5/5/16: 10-yr. 1.75%; 30-yr. 2.60%

Jan-07 Dec-08 Dec-10 Dec-12 Dec-141.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

5.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

5.5%

10-Year Treasury Note Yield

30-Year Treasury Bond Yield



Private EquityPrivate equity funds, another earlier WallStreet darling, also use heavy borrowing.Typically, they load the corporationsthey take private with heavy debt anduse the proceeds to pay dividends totheir investors. This can reduce their netinvestment to very low levels, givingthem tremendous financial leverage.Then the private equity outfits attemptto cut costs and otherwise improve cashflow to justify those huge interestexpenses, and eventually take the cleaned-up companies public.

But shaky security markets in recentyears have dampened this bailout strategyand depressed the stocks of privateequity firms. So major player Apollo,whose stock was down 53% from itsJanuary 2014 peak, plans to buy back upto $250 million of its shares. Similarly,industry veteran KKR, with its stock off49% in the past year, will buy $500million of its equity (Chart 21, oppositepage).

Futures contracts don’t exactly involveborrowed money, but it amounts to thesame thing. To buy or sell a futurescontract on $164,000 of 30-year Treasurybonds requires a speculator to have$3,650 with his commodities broker. Ifbond prices rise 1%, he makes $1,640,or 22%, on his money, excludingcommissions. But, of course, futureswork both ways. A 1% price declinewould cut his capital in half.

Bank CapitalBanks typically borrow 10 times their capital or morethrough deposits and other means, which gives themimmense financial leverage. Much of this borrowing is usedto finance long-term and relatively safe business andconsumer loans, but investments in subprime mortgagesproved to be lethal in 2008 when their value collapsed(Chart 22). Also, the reliance on short-term funds sankLehman in 2008 when scared lenders refused to renewthose overnight loans.

Many lenders, especially the big banks, earlier emphasizedhighly profitable proprietary trading, private equityinvestments and all manner of derivatives activity. Giventhe small size of the banks’ equity relative to the assets they

CHART 22ABX BBB-

Source: Markit

06-1 tranche

Jan-06 Nov-06 Aug-07 Jun-08 Mar-09 Jan-100

10

20

30

40

50

60

70

80

90

100

110

0

10

20

30

40

50

60

70

80

90

100

110

02/01/2007

controlled, the profits on these activities were tremendouswhen their bets worked out—but so were the losses whenhousing collapsed. Our favorite example is Citigroup,whose equity price collapse of 98% from a peak of $564per share in December 2006 was so embarrassing that thebank resorted to a 10-for-1 reverse stock split. That raisedit from what would have been $4.40 per share today to thecurrent $44 price (Chart 23)

After Washington and international lenders bailed outvirtually all of the major banks worldwide in 2008, theywere pressured to enhance their capital tremendously(Chart 24, page 24). Also, the big banks have been bereavedof proprietary trading and other highly profitable activitiesand pushed back toward traditional commercial banking—taking deposits and then lending them out—as well as assetmanagement.

CHART 23Citigroup Stock Price

Source: Yahoo Finance and Bloomberg

Last Point 5/4/16: $44.66

Jan-06 Dec-07 Dec-09 Dec-11 Dec-13 Dec-150

100

200

300

400

500

600

0

100

200

300

400

500

60005/9/2011

1 for 10 Reverse Stock Split



4. Financial EngineeringA recent subset of financial leverage isfinancial engineering. This involvesdeliberate measures to produce big profitsand high income through asset purchases,taking advantage of price leaps to sellmore stock, multiple layers of companies,careful tax planning, etc.

Note that the average S&P 500 companyhasn’t used debt increases to fund sharebuybacks (Chart 25) aimed at increasingprofits per share. The biggest 1,500nonfinancial companies increased theirnet debt by $409 billion in the yearending March and used almost all of it,$388 billion, to repurchase their ownshares, net of new issues. The debt andequity of the median U.S. nonfinancialcompany is 11 times operating cashflow, higher than in 2007 and at the peakof the late 1990s dot com bubble.Obviously, those funds are not beingused for capital investments that willproduce future profits.

Still, this financial engineering has beencarried to extremes by companies likeValeant and SunEdison. Valeant doesn’tdevelop new drugs but rather buyscompanies with already-approvedpharmaceuticals and then hypes theirprices. Last year, the firm skyrocketedthe prices on two cardiac drugs by 525%and 212%. The company maintains thatit’s just brining their prices up tocompetitive levels. Valeant earlier usedcheap financing provided by its high-priced stock andbonds to make ever-bigger acquisitions in the classic “rollup” strategy. In effect, its growth was through accountingand valuation multiples rather than economies of scale ornew products.

Ponzi Scheme?A number of major hedge funds owned Valeant stock, butthis Ponzi-like scheme worked only a long as the companykept doing new deals. But investigations into Valeant’spractices by the SEC, the U.S. Attorney’s Offices inMassachusetts and New York, the State of Texas, theNorth Carolina Department of Justice, the U.S. Senate’sSpecial Committee on Aging and the House Committee onOversight and Reform as well as requests for documentsfrom regulators in New York and Canada, where Valeant

is based, ended the party. Its stock has lost 86% of its valuefrom the August 2015 peak to present (Chart 26, oppositepage), or $78 billion.

In a similar vein, solar-power company SunEdison filed forbankruptcy in late April after its market capitalizationplunged 99% from its $10 billion value last summer (Chart26). SunEdison spent over $18 billion on acquisitions andraised $24 billion in debt and equity between 2013 and thisyear. It grew through deal-making and tax planning, andbought up renewable power projects around the worldbefore the market soured last summer. Its subsidiaries,known as yieldcos, raised cash from investors and thenbought operating projects from SunEdison. They then paidout the cash flow in the form of high dividends to theirshareholders, tax-free.

CHART 25S&P 500 Stock Buybacks and Net Debt


Last Points 1Q 2016: net debt $402.5; 4Q 2015 buybacks $145.9US$ billion

2008 2009 2010 2011 2012 2013 2014 20150

20

40

60

80

100

120

140

160

180

150

200

250

300

350

400

450

Stock Buybacks - left axis

Net Debt - right axis

CHART 24Tier 1 Risk-Based Bank Capital Ratio

Source: Bloomberg and Federal Deposit Insurance Corp.

Last Point 4Q 2015: 12.4%measured as core equity capital to total risk-weighted assets

Mar-00 Sep-02 Mar-05 Sep-07 Mar-10 Sep-12 Mar-158.0%

8.5%

9.0%

9.5%

10.0%

10.5%

11.0%

11.5%

12.0%

12.5%

13.0%

8.0%

8.5%

9.0%

9.5%

10.0%

10.5%

11.0%

11.5%

12.0%

12.5%

13.0%



Income-starved investors jumped in asdid investors seeking green companies.But then came changes in state taxbreaks for those projects and the collapsein oil and natural gas prices. And theSEC and Justice Department areinvestigating the company’s possibleoverstatements of its financial condition,concerns also expressed by seniorSunEdison executives who fretted overa vast overstatement of the firm’s cashflow and profits. Like Valeant, SunEdisonlooks like a Ponzi scheme that requiresa constant inflow of new money to keepfrom collapsing. Maybe they both studiedBernie Madoff's technique!

5. Other LeverageOur third strategy, little equity with lots of debt, of course,amounts to huge financial leverage. But leverage as a wayto make big money extends well beyond the use of debt toother forms of finance. Think about movies vs. stageproductions. A play can only reach an audience of severalhundred and must be repeated night after night by the sameactors to generate much revenue. Many of them tire of therepetition and leave the cast before the end of the successfulrun of a play or musical. Sure, road companies of popularmusicals are the norm and provide some leverage forowners of the show. And popular musicians perform inhuge football stadiums, complete with giant video screens,to reach much larger audiences.

But none of these enhancements rival the leverage ofmovies, which are presented to unlimited audiencesworldwide and, if they have legs, for decades to come (Chart27). The same leverage and opportunity for big moneyexists for entertainment transmitted viaCDs, DVDs, radio, TV and the Internet.Obviously, the big squabble over piratingCDs and DVDs involves originatorswho want to receive the full financialbenefit of that leverage.

At the same time, mass distribution ofentertainment does have its drawbacks.In the old days of vaudeville, anentertainment group would perfect anact in New York City, then shuffle off toBuffalo—that's where the termoriginated—and on to Cleveland, Detroitand points West and South. After hittingall the major, and many minor, cities inthe country, they’d return to New Yorktwo or three years later to develop

another act. While on the road, however, they never neededto change the script, except to put the name of the town inwhich they were playing in their jokes. But today when acomedian tells a joke on national TV, they need a huge teamof writers to come up with new material for the next show.

AthleticsLeverage is the lifeblood for professional and, to a certainextent, college athletics. Decades ago, professional athletesweren’t especially highly paid except for a few superstars.But then came TV broadcasts of games. Today, negotiationsover $20 to $25 million contracts for professional footballand baseball players are simple decisions on how the TVrevenues will be split up (Chart 28, page 26). Then there arethe fees for endorsements by stars, equipment and sportswearlines, etc.

Years ago, I met Billie Ray Smith, then a securities salesman

CHART 26Valeant Pharmaceuticals and SunEdison Stock Prices

Source: Bloomberg

Last Points 5/5/16: Valeant $34.49; SunEdison $0.20

Jan-15 Mar-15 May-15 Jul-15 Oct-15 Dec-15 Feb-160

50

100

150

200

250

300

0

5

10

15

20

25

30

35

Valeant Pharm. - left axis

SunEdison - right axis

CHART 27U.S. Movie Box-Office Gross

Source: Motion Picture Association of America and Box Office Mojo

Last Point 2015: $11,127.6US$ million

1985 1988 1991 1994 1997 2000 2003 2006 2009 20120

2000

4000

6000

8000

10000

12000

0

2000

4000

6000

8000

10000

12000



in Dallas for White, Weld, where I wasChief Economist. We became greathunting and fishing buddies. He had awonderful personality and was well-known in his earlier career as an all-American football player, so much sothat he regularly entertained Americantroops in Vietnam during that war.

Through Billie Ray, I learned about heroworship. One day when we were walkingdown the street in Dallas, he said, “Gary,I want to go into this tobacco store to getme some cee-gars (cigars).” While hewas picking out his stogies in the walk-inhumidor that resembled a bank vault, ayoung man behind the counter engagedme in conversation. I knew that he toowas a football player because his physiquehad a straight drop from his ears to hisgigantic shoulders, with no neckindentations.

He asked me, “Is that Billie Ray Smith?I saw his Super Bowl ring.” Actually,Billie Ray Smith had two Super Bowlrings from his playing days with theBaltimore Colts, but I earlier assumedthat he’d gotten that huge ring with ahorseshoe on top from a gumballmachine. When Billie Ray returned withhis cigars, the young man vigorouslyshook his hand, said what a privilege itwas to meet him and how his Daddy hadmet him on the football field.

Billie Ray was a national sports hero, buthis playing days ended before nationwide TV broadcasts of pro football games propelled player incomes. He told me hishighest annual income was $35,000, even though he had a longer-than-normal playing career, stretching into his 30s.

Sports TV revenues, of course, are provided by advertisers who hope their messages will be effectively and profitablyleveraged many, many times to viewers. Ditto for radio,newspapers and magazines as well as the Internet ads that areincreasingly replacing those in print media.

We say “hope” because it’s difficult in most cases to measurethe effect of advertising on sales. And even though online adshave many more viewers than those in print, the net revenuesare much lower. Note the miserable failure of major newspapersto replace hard copy ads with electronic versions. The resultis poor profits, ongoing consolidation and lousy stockperformance (Chart 29) for the industry as a whole. Note thatnewspapers and magazines combined now account for only13% of total media advertising (Chart 30).

CHART 30Advertising by Medium

Source: Bloomberg and Magnaglobal

2015; US$ billion

Television (national and local)InternetMobileRadioNewspapersMagazinesTotal

$63.3$59.1$19.8$14.5$14.4

$9.6$180.8

35.0%32.7%11.0%8.0%8.0%5.3%

CHART 29S&P 500 Publishing and Printing Index

Source: Bloomberg

Last Point 5/5/16: 270.02

1990 1993 1997 2001 2005 2009 201250

100

150

200

250

300

350

400

50

100

150

200

250

300

350

400

CHART 28NFL Salaries and Television Revenues

Source: NFL Players Association and SB Nation

Last Points: 2014

1970 1976 1982 1988 1991 1994 1997 2000 2003 2006 2009 20120

1000

2000

3000

4000

5000

6000

7000

8000

0

500

1000

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2000

2500

NFL TV Revenues; million USD - left axis

Average NFL Salary; thousand USD - right axis



Lawyers And Mass ProductionThe nonfinancial leverage we’re thinking about also appliesto lawyers. Large law firms don’t make their big moneyfrom billing partners’ time, even at $1,000 per hour. It’s thetime of all those associates who may be paid $150,000 peryear or $75 per hour, but are billed out at $350 per hour.That’s why legal bills that involve three hours in partnertime but also 20 associate hours aren’t uncommon.

Then there are all those mass-produced items. Producingthe first one of a new car model costs billions of dollars, butmass production drops the unit cost drastically—andpumps profits. The same is true for Apple. The cost ofdeveloping a new smart phone is high, but cheap per unitwhen millions are being manufactured by low-cost labor inthe Far East.

Building cars still requires lots of steel and other materials.To the extent that a mass-produced product contains fewerraw materials and more intellectual content, the leverage isgreater. Consider Microsoft. Once a new software programis developed, it costs next to nothing to transmit it via theInternet to a customer. Years ago, our Insights were all inhard copy form, which entailed considerable printing andmailing costs. Now, with most readers preferring onlineversions, those costs are largely eliminated—but we hopethe content still makes our monthly reports a bargain!

6. Great Ideas, But Not NecessarilyThe First ImplementersRalph Waldo Emerson supposedly said, “If a man can writea better book, preach a better sermon, or make a bettermousetrap than his neighbor, though he builds his house inthe woods the world will make a beaten path to his door.”Recall that Emerson holed up in a cabin on Walden Pond,but his wife did bring him a hot lunch every day.

History doesn’t record a beaten path to Emerson’s cabindoor, but what he said has been true in some instances. Aswe noted in our 1998 book, Deflation: Why it’s coming, whetherit’s good or bad, and how it will affect your investments, business andpersonal affairs, Henry Ford virtually created the mass-produced automobile industry. His application ofinterchangeable parts and introduction of the movingassembly line increased the production of cars by the wholeindustry from 65,000 in 1908 to 1 million in 1915.

Between 1913 and 1914, the labor time required to puttogether a Model T chassis dropped from 2 hours and 38minutes (down from an original 12 hours and 28 minutes)to 1 hour and 33 minutes. Consequently, the price of theModel T runabout dropped from $500 on August 1, 1913to $260 on December 2, 1924. Henry Ford paid hisworkers an unprecedented $5 per day. He reasoned that if

they couldn’t afford to buy the cars they were assembling,he wouldn’t sell many. At $5 per day, 300 days a year (theyworked Saturdays back then), the assembler made $1,500and paid few taxes. A Model T at $260 was definitelyaffordable!

With the auto industry now mature and on the ropes duringthe 2007-2009 Great Recession, it’s easy to forget howpowerful Henry Ford became. He went into steel, shippingand many other industries related to his auto empire. Hisinfluence was immense. Charles Stewart Rolls and SirFrederick Henry Royce worried about competition fromFord even though they were in England producing luxurycars at the other end of the price spectrum from Model Ts.The leaders in Brave New World, Aldous Huxley’s nightmarishutopia written in 1932, were addressed as “Your Fordship.”

WaitIn many cases, however, entrepreneurs were better offpreaching sermons while waiting to build the second orthird version of the better mousetrap. Alexander Pope said,“Be not the first by whom the new are tried, nor yet the lastto lay the old aside.” He was talking about literary criticism,but his words also apply to entrepreneurs.

Ever hear of Seattle Computer Works? That firm developeda computer operating system in the 1970s that Bill Gatesbought in 1980. IBM was late in realizing the potential ofPCs after Apple led the way, and knew that its engineerswere too tradition-bound to develop an operating systemquickly. So Gates paid $50,000 for Seattle ComputerWorks and licensed MSDOS to IBM for use in every oneof its PCs, making a fortune as a result.

More recently, buying dot com stocks at their IPO pricesin 1999 was not a good deal even with the enormous firstday price jumps on a number of them. Investors werethrowing money at them, begging these startups to burnthrough the money as quickly as possible in order to buildtheir reputations and market shares. Those start-ups didn’tneed many physical facilities to generate revenues and theexpected zillions of website visits were supposed to producehuge earnings and stock prices. But they were easy-entrybusinesses. So, big advertising was considered necessary todevelop brand loyalty and prevent the next entrepreneursfrom stealing business with slightly lower prices.

Lots Of AdsIn early 2000, we counted the editorial and ad space inseveral leading print publications. In five consecutive issuesof The Wall Street Journal, total pages averaged 84, with 51%of the space in ads and of that 62% were Internet-related.

(continued on page 30)



INVESTMENT THEMESOur Investment Themes section reflects the positions that are in or being considered for our managed portfolios. We may add or delete

portfolio positions in the course of the month, but those changes will not be show in Insight until the following report.

In January, many saw the world headed for recession, with the Fed’s plans to raise interest rates this year adding to thegloom. Markets told this story with commodities, especially oil, falling, Chinese economic growth slowing, investorsstampeding out of emerging markets and stocks falling while safe-haven Treasurys and the dollar rallied. Then inFebruary, euphoria replaced despair as the Fed, as usual, backed off and oil producers discussed an output squeeze. Somost markets reversed their January patterns.

Still, we don’t believe the fundamental reality has changed much in the last four months. Commodities continue to bein substantial excess supply—especially oil, which is still likely to fall to our $10 to $20 per barrel target. Export-dependentdeveloping economies’ financial woes persist. The dollar is still favored as a safe haven in a sea of global trouble andas almost every other country tries to devalue against it. Looming deflation and safe-haven status continue to favorTreasury bonds.

So we’re sticking with the investment themes that have been serving us so well for over two years:

1. Short commodities2. Short crude oil and related securities3. Long the dollar vs. euro and yen, commodity currencies and developing economy currencies4. Short emerging-market stocks and bonds5. Short junk bonds6. Long 30-year Treasurys7. Short U.S. stocks



Summing UpStock indices, except for Asia, were up through most ofApril as investors digested corporate earnings reports thatwere not as bad as feared—even though U.S. corporateprofits declined for a third straight quarter—and saw theFederal Reserve as being in no great rush to raise interestrates. Higher oil prices also helped energy stocks andfinancial companies. The Dow Jones Industrials closedabove the 18,000 mark on April 18 for the first time sincelast July while the S&P 500 topped the 2,100 mark a daylater for the first time since December 1.

But markets then reacted negatively to weakness in techstocks as well as to the Bank of Japan’s late-month decisionto not ease further in an effort to spur the economy. Theyen surged against the dollar after the central bank’s move.The greenback was pretty much flat vs. the euro whileyields on 10-year Treasury notes edged up slightly.

Fed policymakers after their late April meeting said againthat they’ll raise short-term interest rates at a “gradual”pace—but that doesn’t mean another quarter-point hikewill be happening any time soon. After bumping up its fedfunds rate by 25 basis points in December, the Fed held itsfire at its January and March meetings, and again lastmonth, and we think the Fed will continue to hold off whileeconomic conditions remain uncertain.

“Labor market conditions have improved further even asgrowth in economic activity appears to have slowed,”policymakers said in a statement. While cautious about theU.S. economy, the Fed sees some improvement in globaleconomic and financial markets, which it promised to“closely monitor,” quite different verbiage from earlierstatements saying that “global economic and financialdevelopments continue to pose risks.”

Continuing the uneven trend of economic growth since2009, the initial estimate of first quarter GDP came in at+0.5%—well below the fourth quarter’s +1.4% and thethird quarter’s +2.0%—but in linewith weak first quarter results in2011, 2014 and 2015. Despitelower gasoline prices and lowinterest rates and the warm winter,consumer spending declined in thefirst quarter as did business spendingdue to weak overseas demand andrestrained consumer spending inthe U.S.

Desperately seeking inflation:Despite a rebound in gasolineprices, consumer prices barelybudged in March, up 0.1% vs.

February and 0.9% over the prior 12 months. Core CPIincreased 0.1% while the 12-month core rate rose 2.2%.Producer prices fell 0.1% in March vs. February and weredown 0.1% year-over-year. Stripping out energy and foodprices, core PPI dropped 0.1% in February and 1.0% ona year-over-year basis. Despite the failure of major oilproducers to agree on a production freeze, crude oil pricesedged up steadily in April, topping the $45 per barrel markfor the first time since November.

Retail sales continue to be weak, falling 0.3% in March afterremaining unchanged in February and falling 0.4% inJanuary. Year-over-year, sales rose 1.7%. March’s weaknumber was due mainly to a 2.1% decline in sales ofvehicles and parts; ex autos, retail sales were up 0.2% inMarch. Sales at gas stations rose 0.9%, due to higher fuelprices.

Nonfarm payrolls rose by 215,000 in March whileFebruary’s gain was revised slightly upward and January’sincrease was revised slightly downward. The unemploymentrate ticked up to 5.0% from 4.9% while the laborparticipation rate inched up again, from 62.9% to 63.0%—its highest in two years. Average hourly earnings were up2.3% from a year earlier. But, with productivity decliningin the fourth and first quarters, it takes more employees toproduce the same output while rising unit labor costsdepress profits.

Housing starts fell 8.8% in March from February but were14.2% higher than a year earlier. Building permit issuancefell 7.7%. New home sales fell 1.5% in March due topronounced weakness in the West. The median price of$288,000 was 1.8% lower than a year earlier. Existinghome sales rose 5.1% in March from February, led by an11.1% jump in the Northeast and a 9.8% rise in theMidwest. The median price of $222,700 was up 5.7% froma year earlier.

Led by gains in Portland, Seattle and Denver, the S&P/Case-Shiller index of home values in 20 cities rose 5.4% in

February from a year earlier, butthe pace of gains has been slowing.The National Association ofHome Builders’ confidence indexremained at 58 in April.

The Conference Board ’sconsumer confidence index fell to94.2 in April from 96.1 in March.The University of Michigan’sconsumer sentiment index fell to89 in April from 91 in March.

Fred T. RossiEditor

THE NUMBERS

Dow Jones IndustrialsS&P 500Nasdaq CompositeNikkei AverageSTOXX Europe 600Shanghai CompositeFTSE 100

*through April 29

April 2016% Change*

Year-to-Date% Change

+0.5%+0.3%-1.9%-2.6%

+1.2%-2.2%

+1.1%

+2.0%+1.1%-4.6%

-14.2%-7.1%

-17.0%n/c

10-yr. Treasury note$=¥€=$West Texas Inter.

3/31/164/29/161.83%106.43

1.15$45.94

1.78%112.55

1.14$38.16



In contrast, in the late 1980s-early 1990s, tech ads were only 20% to 30% of the total and 4% in the late 1960s-early 1970s.In our early 2000 survey, a company called Freedom3 ran a full-page ad with two kids jumping for joy and a brief pitchfor the Corel Linux OS. Venture capital firm EarlyBirdCapital.com used a full-page to inform the world that it can “SeeWhat Others Can’t.”

VA Linux had a 698% first day gain, butit was a whole lot cheaper in 2001 afterthat stock bubble collapsed (Chart 31).Ditto for TheGlobe.com, which jumpedfrom its IPO price of $9 per share to$63.50 the first day of trading, a 606%leap. TheStreet.com was a terrific buy atits IPO price of $19 per share, followedby a first day catapult of 216%. But thepatient investor who waited until October2001 to buy the stock at $0.98 per shareenjoyed a 1,038% rise through February2007.

DumontSome of us are old enough to rememberDumont’s lead in selling TV sets whenthey were new gadgets, but the companylost out to latecomers like RCA and Motorola. Chux was the leading disposable diaper but succumbed to Procter & Gamble’sPampers. Ampex had a commanding position in video recorders and tapes for two decades but then Sony took over. ButSony had its own setbacks. Recall that its Beta format for videotapes was technically superior to the VHS format, but howmany Beta video players exist today outside museums? Then videotape players disappeared in favor of DVDs and BlueRays, which now are giving way to video streaming.

Rheingold Brewery brought out Gablinger’s low-calorie beer in 1967, a cool summer with weak beer sales. So Rheingoldlost interest and Miller Lite later mastered the field. Until the early 1960s, AT&T had a nationwide monopoly on long distancetelephone service. Then Tom Carter invented the Carterphone, a device that allowed owners to rest the telephone receiverearpiece over a microphone and the mouthpiece over a speaker. That way, the telephone was acoustically coupled to anamateur radio transmitter or a mobile radio network. Only 4,000 Carterphones were ever installed, but AT&T saw it as athreat to its long distance monopoly and its ownership of all telephone instruments. Can you remember when every telephonewas owned by the phone company and manufactured by its Western Electric division?

Back then, we bought some telephones in Hong Kong, smuggled them home and (illegally) hooked them up as telephoneextensions in our residence. AT&T claimed that any equipment but its own might cause catastrophic damage to the system.Carterphone and AT&T went to court in 1966, and in 1968 the Supreme Court ruled in favor of Carter Electronics. Sothe FCC ordered the nation’s phone companies to connect their lines to non-Bell devices, as long as they were technicallycompatible with the phone network. Little Carter broke the huge AT&T monopoly, but did that give it a commanding leadin supplying telephone instruments and related gear? Heard much about the firm lately? It voluntarily dissolved in 1969.

Great InventionsGreat inventions are seldom the route to riches without the control of the resulting production leverage as they becomewidely used. Europeans made the initial discoveries in electromagnetics, but it was the Americans who turned that knowledgeinto practical money-making uses. Thomas A. Edison, of course, was the champ, with his development of electric lights,the phonograph and the movie camera. And he made sure he had plenty of patent protection to benefit from his labors.

(continued from page 27)How To Make Big Money

CHART 31VA Linux Stock Price

Source: Yahoo Finance

Last Point 2/28/07: $4.31

Dec-99 Oct-00 Jul-01 May-02 Mar-03 Dec-03 Oct-04 Jul-05 May-06 Feb-070

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1st Day Gain: 698%



His original movie studio is still on display at the EdisonNational Historic Park at Llewellyn Park in West Orange,N.J., but the movie industry soon moved to Los Angeles fortwo reasons. The sunlight was better in the days of veryslow film. But more interestingly, his rivals wanted to be faraway from “Edison men.” Those were thugs Edison hiredto enforce his patents on the movie camera by literallybreaking up violators’ equipment with sledge hammers.Strong message to follow!

7. Small Slices of Very Big PiesFortunes can be made by taking small slices of very big pies,especially if those ultimately granting the slices are makingmoney. Fees of, say, 1% of the transaction’s price don’tsound big, but they add up to big numbers. This is especiallytrue if a merger or IPO or leveraged buyout involves tensof billions. And note that large acquisitions often don’trequire much more work than smaller ones. Even a 1% feeon Aramco’s likely IPO of $100 billion to $150 billionwould be $1 billion to $1.5 billion, enough to make manyinvestment bankers happy.

The term “leveraged buyout” got a bad connotation withthe discrediting of Michael Milken and the collapse of hisfirm, Drexel Burnham in 1990. So they’re now called“private equity deals.” Nevertheless, those involved stilltreat themselves to huge fees in dollar terms, but still minorpercentages of the deal size. Furthermore, buyout outfitsoften charge the investors in their funds 1.5% annually.Again, the percentage may sound small, but the funds arehuge, tens of billions of dollars.

Banks, of course, traditionally profit from the spreadbetween the interest rates they pay on deposits and thehigher rates they charge on loans. As noted earlier, thesespreads of a few percentage points are greatly magnified asa return on bank capital by the relatively small ratio ofcapital-to-assets,. In effect, banks combine our third strategy,invest with huge financial leverage, with our seventh, smallpieces (interest rate spreads) of big pies. Still, the recently-required increases in bank capital are reducing the leverage(Chart 24).

CEO PayThere’s much handwringing over current high and leapingCEO pay levels. But here, too, corporate leaders’compensation is often tiny compared to profits and muchsmaller as a share of revenues. That’s one reason whyshareholders have shown little effective concern—as longas stock prices are rising.

Sure, there are other reasons for outlandish CEO pay.Directors are reluctant to challenge CEO desires for fearof breaking boardroom camaraderie and disrupting thecongeniality needed to get corporate business done, asdiscussed in “Little Room At The Top,” April 2016 InsightCommentary). Directors who object to huge compensationawards find themselves marginalized and merely toleratedwhen executive pay and other matters are discussed. Manyboard members take the attitude that it’s not my money, sowhy not pay up and buy peace? Their linkage to shareholders,whose money it in fact is, is often vague and remote.

Compensation ConsultantsCompensation consultants are increasingly hired bycorporate boards and not top officers, but often with CEOrecommendations. So they want to please seniormanagement by pushing for higher pay levels. We’ve neverseen or even heard of a case in which compensationconsultants say the CEO in question was overpaid. Andalmost every corporate leader wants more money. Somethink they need it to compensate for the probability thattheir tenure may be short. Many reflect the reality thattoday, the way corporate brass keeps score is by the size oftheir pay.

Regulations for public companies now allow for stockholder“say on pay,” non-binding votes on senior officers’compensation. And in an increasing number of cases,shareholders are voting “no” to board compensationcommittee recommendations. Last month, 59% of shareswere voted against BP’s executive compensation for 2015,including a 20% increase for CEO Bob Dudley, after theoil giant lost $5.2 billion last year. About a third of

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Citigroup’s shareholders also votedagainst the pay plan for top executiveslast month. About 64% were in favor,but down from 84% last year.Furthermore, 39 companies in the Russell300 index have lost “say on pay” votes atleast twice between 2011 and last month.Oracle shareholders have said “no” fourtimes.

Companies seldom back downimmediately after losing “say on pay”votes. But they probably are lessaggressive on executive pay in futureyears. Once a company gets into thepenalty box over “say on pay” votes, it’shard to get out.

The small slice of a big pie route to riches isn’t confined tofinance and CEO pay. Fast food franchises make penniesper hamburger and nickels on a soft drink, but it adds upas they sell millions of dollars’ worth. The same is true ofmany other businesses where profits per dollar of revenueare small but volumes are huge. Polls consistently show thatmost Americans believe that profits represent a much,much higher portion of sales than they actually do (Chart32).

8. Cartels and MonopoliesCartels and oligarchies are great ways to make big money—as long as they last. In 1975, we did an exhaustive study oncartels and noted that they are definitely not new. In TheWealth of Nations (1776), Adam Smith made his oft-quotedstatement, “People of the same trade seldom meet together,even for merriment or diversion, but the conversation endsin a conspiracy against the public, or in some contrivanceto raise prices.”

Cartels are formed to promote profits by keeping pricesabove equilibrium through restricting demand. Of course,a cartel only works when demand is so insensitive to pricethat higher prices will actually increase the seller’s totalrevenue, as was earlier the case with OPEC (see Chart 6,page 5).

Aristotle discusses one of the earliest cases on recordinvolving a philosopher, Thales of Miletus, who wasridiculed for being smart but still poor. To prove the valueof his vast knowledge, he used his astronomical observationsto ascertain that there would be a bumper olive crop in acertain year. Long before the harvest, he rented all the olivepresses in the area, which were so cheap in the off seasonthat even his meager funds were sufficient. The huge crop

arrived on schedule, and the demand for olive pressesskyrocketed. Needless to say, Thales made a killing insubletting them and proved that a philosopher, when helikes, can easily become rich—but his “ambition is ofanother sort,” said Aristotle.

Our February report, “Lessons of History for OPEC,”covered our earlier detailed history of cartels, why theywere formed and why they failed. As discussed in our front-page report, and outlined in Chart 7 on page 5, thefavorable conditions for OPEC are over and the oil cartelis fading fast.

SteelThe American steel industry had a powerful cartel thatlasted for over half a century after the founding of US Steelin 1901. Back then, no one could compete with AndrewCarnegie, so J.P. Morgan organized the buyout of hisFederal Steel Co., which was then combined with otherproducers. In Europe after World War II, the EuropeanCoal and Steel Community, the ancestor of the EU, wasformed by governments to limit output and competition.

But foreign competition killed the U.S. steel cartel and itspricing power late in the last century, despite repeatedgovernment attempts to provide protection. Almost allAmerican producers except US Steel went bankrupt underthe weight of noncompetitive labor costs. Wilbur Rossbought and combined bankrupts such as Bethlehem Steelsans excess labor costs to form International Steel Group.The Mittal family that controls Arcelor Mittal went on aglobal steel producer-buying spree and bought ISG. was thefirm trying to create a new global cartel before theonslaught of Chinese steel floods the world? Earlier, wenoted that Mittal is seeking help from the British governmentto avoid closing English steel mills.

CHART 32S&P 500 Operating Profit Margin


Last Point 1Q 2016: 9.02%quarterly operating profits/sales

2000 2002 2005 2007 2010 2012 2015-2%

0%

2%

4%

6%

8%

10%

12%

-2%

0%

2%

4%

6%

8%

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12%



UtilitiesElectric, gas, water and telephone utilitiesused to be treated as natural monopoliesand, therefore, regulated. They madegood, steady returns but weren’tfabulously wealthy since regulatorsusually allowed a set return oninvestment, which encouraged them tospend on plant and equipment whetherthey needed it or not. Seriousderegulation started in 1984 when AT&Twas forced by a federal antitrust suit tospin off the 22 local companies intoseven “Baby Bells.” Deregulation ofnatural gas pipelines and electric utilitiesfollowed and free competition was hailedas the consumer’s friend. But with thecollapse of Enron in 2001 and theskyrocketing of electrical prices in California that Enron’senergy traders aided and abetted, to say nothing of thetroubles at electric utilities that decided to become dotcoms, the deregulation trend came to a grinding halt.

Some electric utilities were essentially re-regulated. Theseven Baby Bells have shrunk to three that include wireless,cell phone and other telecom modes—AT&T, thecombination of AT&T, Ameritech, Southwestern Bell,Pacific Telesis and BellSouth; Verizon, which includes theformer Bell Atlantic and Nynex; and Qwest, formerly USWest. Now the industry is dominated by AT&T andVerizon. Still, competition in telecom remains fierce andconsolidation reflected it more than it heralds a new goldenage of oligarchy profits.

AirlinesUntil 1978, airlines were controlled by the Civil AeronauticsBoard. The CAB controlled airline routes, with specificairlines pretty much dominating specific geographic areas.Delta was strong in the Southeast, United owned Chicago,Eastern flew up and down the East Coast and to theCaribbean. International routes were confined to only twocarriers, TWA flew domestically and abroad, but PanAmonly flew from U.S. cities to foreign destinations.

Fares were also controlled by the CAB, which essentiallyrubber-stamped whatever airlines wanted. Since passengerspaid through the nose, the industry thrived even thoughcosts were high (Chart 33). Airline personnel were well-paid, and pilots were truly the princes of labor. Senior pilotsmade over $200,000 per year—a king’s ransom in the1970s—for working less than 40 hours per month. Thisallowed many of them to live in, say Montana, andcommute at company expense to their flight bases in NewYork and other major cities.

Fares between specific destinations like New York toChicago were identical on all airlines for both first-class aswell as coach. One airline would file a fare change with theCAB and the rest would follow quickly. Still, competitionexisted, at least on routes served by multiple carriers. Onebig TV winter-time ad campaign featured an entertainmentcelebrity sitting by a swimming pool in the bright Floridasunshine. The ad ended with him beckoning at the viewerand proclaiming, “Come on down, the weather’s great!”—on his airline, of course!

Bizarre CompetitionCompetition also took some bizarre forms. At one point onthe lunch-time New York to Chicago flight, the CABapproved regulations that allowed only sandwiches to beserved. So the competitive juices flowed, and airlines viedwith each other to see what can be put between two piecesof bread. We recall that the top of the tree was reachedwhen one carrier stuffed a whole filet mignon between twoslices of rye while other airlines only had a chicken or apheasant. Another weird example by one airline was theripping out of seats and their replacement with piano bars,complete with bartenders and piano players.

Needless to say, the huge revenues and lack of farecompetition meant that airlines did indeed concentrate onpassenger service with unlimited drinks and decent eats.This was all before competition ranked airline food withmilitary intelligence, congressional ethics, tax simplification,vegetarian vampires and postal service on the list of greatoxymora.

Predictable ProblemsUpon airline deregulation in 1978, we foresaw big troublefor the industry because of its economic structure. Fixedcosts are high in the short run and marginal costs are very

CHART 33Real Airline Passenger Revenue per Passenger Mile

Source: BTS and Haver Analytics

Last Point 2015: 4.66CPI-deflated; 1982-84=100

1970 1975 1980 1985 1990 1995 2000 2005 2010 20154

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low. An airline that’s scheduled to fly from Atlanta to LosAngeles has incurred all the overhead costs of management,airplanes, reservations personnel and systems, airport gatecosts, etc. Furthermore, it is locked in to the costs of pilots,flight attendants, ramp workers and gate agents for thatflight. So, the cost of flying an extra passenger is trivial—that passenger’s meal or snack and several gallons of jetfuel. In addition, it soon became clear after deregulationthat the industry is an easy entry business. Sure, planes areexpensive but lenders are eager to finance them—if theairline goes belly up, the lender can easily fly away thecollateral.

As we all know from Economics 101, in this environment,the airline makes money in the marginal short run as longas the passenger who fills an empty seat pays more thanthose tiny marginal costs. So when there’s free farecompetition and excess capacity, fares—at least for the lastpassengers—will be driven almost to zero. We recall in theearly deregulation days being in Chicago and getting a last-minute fare on start-up People Express back to Newark,N.J. for $50 while old line carriers charged over $300.

Territory InvasionsNot only were fares but also routes deregulated in 1978.Consequently, airlines invaded each other’s territories withgay abandon. In one instance, we were in LaGuardiaAirport waiting for an American flight to Dallas. Wehappened to be standing slightly in back of the gate counterand saw a message flashing on the computer screen thatsaid, “Convert Braniff Revenues! Convert BraniffRevenues!” We asked the clerk what that meant and sheexplained that she’d get bonus points if she could convinceBraniff-ticketed passengers to switch to American. Americanwas invading the Dallas market that was critical to Braniff,and had no qualms about pushing Braniff to the ropes.Indeed, that airline filed for bankruptcy shortly thereafter,in May 1982—for the first time.

Old-line carriers have fought deregulation with frequentflyer programs designed to create customer loyalty. Theyalso keep challenging deregulated fares with sophisticatedcomputerized pricing models that separated price insensitivebusiness flyers from cost-conscious leisure flyers. Theover-the-weekend stays required to get the low-ball pricesare only one example.

Couldn’t Buck The Jet StreamThese competition-deflecting strategies by high-cost airlineshad some success in the 1980s and exuberant 1990s, but bythe end of the last decade, the legacy carriers were no longerable to buck the jet stream of competition. With the stockmarket collapse in 2000-2002, the huge gap between

business and tourist airfares induced many businesspeopleto fly steerage. Mushrooming Internet websites made iteasy for passengers to overcome the airlines’ deliberatelyconfusing array of fares and nail down the lowest ticketcosts. Meanwhile, leaping jet fuel costs could not be offsetwith higher fares.

Furthermore, the previously successful hub and spoke airroute system proved too expensive to compete with thepoint-to-point systems of upstarts, specifically Southwest.As the low-cost air carriers more and more dominate, thelegacy airlines, with high labor costs, inflated fuel costs andpressure on fares, suffered huge losses. Also, legacy carriermanagement and labor have been totally unwilling, untilvery recently, to face the reality of deregulation and theresulting competition. This attitude, unfortunately, iscommon in other businesses. Real, or inflation-adjusted,airline revenues per passenger-mile flown have been on asteady drop since the late 1970s deregulation (Chart 33).

In past Insights, we noted that old line companies inindustries like steel, autos and airlines that were shieldedfrom competition by regulation, cartel-like structure,protectionism, etc. almost never adapt successfully whenthose shields are removed. Apparently, management andlabor are so comfortable with the earlier easy life that theycan’t bring themselves to change. Only the startups, withfresh attitudes and structures, are successful in the newenvironment.

A Fresh StartA very important deterrent to consolidation in the airlineindustry is the cost-cutting opportunities of bankruptcy.This makes it possible to cancel labor contracts, if thebankruptcy judge agrees, and even the threat of filing forbankruptcy can wring concessions from unions. Bankruptcyalso allows airlines to drastically reduce or even eliminatedebt to say nothing of essentially wiping out stockholders,as was the case with United’s parent, UAL, Northwest,Delta and US Airways.

Another big advantage of bankruptcy is the opportunity todump defined benefit pension fund obligations on thefederal government’s Pension Benefit Guaranty Corp. Thebankrupt simply has to convince the judge that it can’trestructure without getting out from under that albatross.The PBGC benefits are lower than those promised byairlines to pilots and other high-paid airline employees. So,threatening bankruptcy is another way of pressing unionsfor concessions. A pilot could see his pension cut in half ifhis employer enters bankruptcy and then bails out of itspension plan. With all these advantages, it’s no wonder thatU.S. airlines have entered bankruptcy 279 times since1978.



9. Sell the Sizzle, Not the SteakAn age-old route to riches is to promotehopes and dreams, regardless of how farthey may be from reality. Of course,government regulation has curtailed thewild health claims for snake oil and manyother patent medicines, hair restorers,potency formulas and fountains of youth,but opportunities still abound.

Years ago, we met a couple with athriving business selling pills, lotions,salves, soaps and even toothpaste thatcontained royal jelly. That substance issecreted from glands in workerhoneybees’ heads and is fed to larva thatwill become worker bees. But when theworker bees sense that there is no queenin the hive, they feed extra doses to a number of larva andthey become queens (hence the name royal jelly), which areable to produce female worker bees and male drones. Ofcourse, the first queen to emerge from the cocoon stage (webeekeepers call it sealed brood) immediately stings to deaththose other yet-to-emerge queens. There’s going to be onlyone queen per hive!

The wife of this couple had suffered a near death fromcancer, but recovered completely when a friendrecommended royal jelly. So she became a true believer,and they imported the stuff from China and combined itwith other substances to make their products. The coupleexplained to me carefully that in their marketing literature,they were not permitted by the FDA to make any healthclaims they could not substantiate with scientific tests—andthey had none. But they could print statements of satisfiedcustomers who testified to miraculous cures from royaljelly products. That’s protected by the First ConstitutionalAmendment guaranteeing free speech.

As beekeepers, we're well aware of other medical claimsinvolving bees and honey. Some believe that if they eatlocal honey, they won't get allergies, but there's no scientificevidence of that. Others think that getting stung by honeybees prevents arthritis, and there is a cottage industry ofbeekeepers who incite their bees to sting people on a regularbasis—and for nice fees, of course.

Bee stings do produce reactions that temporarily combatthe pain of arthritis, but again, there's no scientific evidenceof permanent help. And if you don't believe me, just lookat my hands. I get stung 400 to 500 times a year, but mytwisted but still functioning fingers look like those of mymother and some other blood relatives.

Garlic and Penny StocksIn a similar vein, garlic growers have benefited from thebelief that garlic protects against heart attacks. Health foodentrepreneurs have accommodated those who don’t likethe taste or digestive effects with garlic pills, widely advertisedon TV and elsewhere. But a scientific study, complete withdouble blind tests and placebos, found absolutely no effectin reducing cholesterol. Garlic producers, of course,responded that the tests weren’t meaningful. Even morerecently, researchers found that high doses of antioxidantsupplements like beta carotene, vitamin A and vitamin Eactually raise death rates. Those who made money fromvitamin pills are not amused.

Penny stocks of dubious, even nonexistent Canadian goldmining companies were long the staple of the VancouverStock Exchange and appeal to sizzle lovers. So, too, do get-rich-quick schemes. We recall getting a call at home atdinner time, before the do-not-call-rules, from “Ol’ Earldown here in the oil patch.” We listened to his pitch longenough to be sure that the oil investment he offered was toogood to be true, and it probably was. When he said themagic words, “You can’t miss,” we hung up.

Then there are all the get-rich-quick and related self-helpbooks (Chart 34), DVDs, lectures and online courses. Thepurveyors can make good livings and then some sellingtheir strategies as they prey on hopes and dreams. But domany buyers stop to ask, if this guy really knows how to doit, why would he share that priceless knowledge with the restof the world? Why wouldn’t he keep it to himself, build abig fortune and retire at age 29 with his trophy wife on hisown private Caribbean island? But, as P.T. Barnum said,“there’s a sucker born every minute.” Amend that to read,every second.

CHART 34"Get Rich Quick" Books

“How to Get Filthy, Stinking Rich and Still Have Time forGreat Sex! An Entrepreneur’s Guide to Wealth and Happiness”

“Get Rich Quick”“Trump: How to Get Rich”“Do This. Get Rich!”“How to Get Rich on The Internet”“How to Get Rich With A 1-800 Number”“How to Get Rich in Real Estate”“How to Get Rich Selling Insurance and Annuities to Women”“How to Get Rich Selling Cars and Trucks to Women”“How to Get Rich While You Sleep”“How to Get Rich Buying Bankrupt Companies”“The Automatic Millionaire”“The Millionaire Next Door: The Surprising Secrets

of America's Wealthy”



10. Take Advantage ofAddictions and VanityCatering to addictions and vanity hasalways been a big money-maker, evenmore so when they are outlawed. Thinkof sex and prostitution, the world’s oldestprofession. Concubines have alwaysbeen a trapping of political and economicsuccess. The courtesans of Washington,D.C. who frequently embarrasspoliticians, Congress and Administrationofficials are no different from those inLouis XIV’s court. They’re just lesssocially acceptable in America.

Smoking is on the decline as healthawareness and high prices, promoted inpart by high taxes, curtail demand.California just increased the age for cigarette buyers from18 to 21. That follows Hawaii last year, and other statesmay follow while a number of cities including New YorkCity and Boston have 21 age requirements. Since 90% ofsmokers start by age 18, the hope is that higher age limitswill keep people from smoking altogether.

Tobacco exports to England drove the thriving Virginiacolony in its early days, but the business could be hazardous.Sir Walter Raleigh, who is credited with introducing tobaccoto Britain, reportedly enjoyed two pipesful before hisbeheading, for unrelated reasons, under Queen ElizabethI's orders.

But those still hooked on tobacco will pay almost anythingto satisfy their nicotine addictions. That’s why the tobaccoindustry accepted the huge $206 billion settlement withstate attorneys general in 1998. They simply jacked upprices to offset their fines, and with the full approval ofhealth officials who hoped leaping prices would discouragesmoking. The average price of cigarettes today is $5.96 perpack in California. And don’t forget the growing industryof nicotine patches and gums, smoking-cessation clinics,hypnotists and other devices that benefit from smokers’

attempts to kick the habit, despite limited success.

Caffeine And SodaThen there is caffeine addiction, which has created vastfortunes in coffee and tea. It had a lot to do with originallyattracting the British to the Far East. And don’t believe softdrink makers when they say they put caffeine in theirproducts to improve the flavor and pep you up (Chart 35).It’s mainly to make them habit-forming.

With the recent surge in obesity and the related diabetes, anumber of civic leaders and even countries have declaredwar on sugar in soft drinks. India, South Africa and thePhilippines, among others, are debating special taxes onsugar-laced soda. The World Health Organization inJanuary recommended taxes on sugar-added beverages toreduce childhood obesity. Former New York City MayorMichael Bloomberg tried but failed to limit the size ofsugary soda servings to 16 ounces. U.S. soft drink saleshave been falling for the last four years straight, and theswitch to other liquids is expected to continue. Can yourecall when it was humanly possible to get through the daywithout sipping continually from a bottle of spring water?

CHART 35Caffeine Content of Soft Drinks

Source: Mayo Clinic and American Beverage Association

0 50 100 150 200 250

Milligrams

Starbucks Coffee (16 oz.)

Red Bull Energy (8.3 oz.)

Monster Energy (8.3 oz.)

Mountain Dew (12 oz.)

Pepsi (12 oz.)

Coca-Cola (12 oz.)

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But the public is not solidly behind thishealth measure, even though global sodasales volume rose only 0.1% last year.Two years ago, Mexico, with a majorobesity problem, put a one-peso perliter, or 10%, tax on sodas. The taxraised over $2 billion since January 2014,a third more than the governmentexpected, and sales of carbonated softdrinks dropped (Chart 36). Mexico’sNational Institute of Public Healthestimates that per capita consumptionof sugar-sweetened beverages was 8%lower in 2015 than the pre-tax 2007-2013 years, adjusted for populationgrowth and economic activity.

But Mexico’s daily caloric intake onlyfell by six or seven calories, or 0.2%.And carbonated soft drink sales revivedlast year (Chart 36). In the first quarterof 2016, Coca-Cola’s Mexican soda salesrose 5.5% from a year earlier for itslargest bottler and 11% for the secondlargest. And last year, the market sharesof full-calorie Coca-Cola and Pepsi-Colarose slightly to 48% and 11%,respectively, from 2014.

Illegal DrugsIllegal booze, of course, was the lifebloodof the Mafia during Prohibition, and ahigh but bloody life it was. Now, illegaldrugs are huge money makers. So muchso that a major demand for U.S. currencyis for $100 bills used in the illegal drugtrade. Its practitioners have major problems in launderingthe money that is far too much to be employed profitablyin their business and must be recycled into legitimateactivities. The European Central bank just announced thatit will no longer issue €500 bills worth $570 each to reducethe ease of transporting suitcases full of illegal and launderedmoney.

The war-torn economy of Afghanistan has revived due tothe poppy industry, under the careful protection of localwarlords. Several years ago, we met the head of a dock andbulkhead construction firm. He told us his previousoccupation was in the Caribbean, welding steel plates overdrug-filled secret compartments in ships headed for theU.S. He was paid $10,000 per day for his work, but he didn’tneed it to pay hotel bills at his next residence, Attica StatePrison in New York State.

Vanity and Small LuxuriesAppealing to vanity is another lucrative business, andalways has been. In the bazaars of Cairo you can still buyCleopatra’s secret formula lotion. And think of all themoney spent on face creams, hair coloring, botox injections,body slimming gyms, etc. Then there are all the gorgeousclothes to fit on those magnificent bodies. What’s yourguess as to how much was spent by women as well as menon looking good at the recent Academy Awards ceremony?The devil, and his vanity-feeding acolytes, really does wearPrada.

Small luxuries is a category we discovered decades agowhen we noticed that auto and apparel sales are oftenmirror images. When people can’t afford new vehicles, theybuy new clothes as consolation prizes a year or so later(Chart 37). We also learned that in South Africa, before theend of apartheid, socially ambitious blacks carried the fine,

CHART 36Volume of Carbonated Soft Drinks Sold in Mexico

Source: The Wall Street Journal and Canadean

Last Point 2015*: 0.5%year/year % change

2009 2010 2011 2012 2013 2014 2015-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

CHART 37Auto and Apparel Personal Consumption Expenditures


Last Points 1Q 2016: auto 3.5%; apparel 1.3%year/year % change; 3-year moving average

1951 1961 1971 1981 1991 2001 2011-4%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

16%

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

16%

Motor Vehicles - left axis

Apparel, lagged 1 year - right axis



slim and expensive umbrellas found among London’sinvestment bankers. They couldn’t afford much, certainlynot cars or even taxi rides. But they wanted the best of whatthey could.

Hallmark operates on the same principle. Greeting cardsaren’t big expenditures, and for just a buck or two morethan the run-of-the-mill supermarket offering, you can tellthe recipient that you care enough to send the very best.Starbucks operates on the same small luxuries strategy thatmakes people happy to pay over $4.50 for a latte served ina cool atmosphere. Then there is the light blue box fromTiffany's that may only contain a pair of cuff links, butreeks of prestige.

11. Picks and ShovelsSupplying goods and services to a riskybut potentially very profitable venture isa time-honored way to clean up. The oldstory is that few gold miners in the 1849California gold rush got rich, but thoseselling them picks and shovels—andLevi pants—did.

I was a graduate student at Stanford inthe early 1960s, and on a recent returnvisit I toured the Stanford Museum andthe room devoted to the Stanford family.Leland Stanford was one of the FourHorsemen who promoted thetranscontinental railroads in the late1800s, along with Charles Crocker, CollisHuntington and Mark Hopkins. Noneof the railroads made much money andall ended up being reorganized, despiteall the free federal land they were granted,as noted earlier.

But the promoters became immensely wealthy, enough sothat Stanford and his wife, Jane, after he died, were able tofinance an entire university. The museum exhibit pointedout that the Four Horsemen’s technique was to establishrailroad companies that sold stock to the public. Then theyset up separate businesses to supply those companies withrails, timbers and other goods at huge profits. Theyeffectively transferred the railroad investors’ money totheir own pockets—and to those of Stanford students forgenerations to come. Thanks, Senator Stanford!

Recent CasesFast forward to today, and businesses that prosper assuppliers to those who hope to make gigantic profits arelegion. In stock bull markets and especially bubbles, investorshave dreams of fabulous riches and will pay heavily to thosewho serve their needs, aspirations and whims. This includesstockbrokers, as shown by the close correlation between

stock prices and brokerage commissions.

Ditto for investment advisors and mutual fund advisors.Nevertheless, with choppy security markets and low interestreturns in recent years, fees for investment advisors havebeen declining. Some money market firms with trivialinvestment returns slashed their fees to zero or close to it.Hedge fund fees are under pressure with 2% managementfees plus 20% of the profits becoming less standard.

Mutual funds are reducing their fees and some are eliminatingtheir front and back end “load” charges. At the same time,investors are increasingly wondering whether manyconventional asset managers are adding enough value andreturns to justify their fees. The acceleration in assets undermanagement of ultra-low fee and index fund champion

Vanguard is clear evidence (Chart 38).

Fiduciary ResponsibilityThis trend will no doubt be enhanced by new regulationsthat require brokers not just to recommend investmentsthat are suitable for their client but those that are in theirbest interest. This will force brokers to justify and expensefees above rock bottom. This is the expansion to brokersof fiduciary responsibility that already applies to registeredinvestment advisors.

Those that provide back office, custodian and otherservices to stockholders like State Street Boston and Bankof New York Mellon are also in the picks and shovelsbusiness. And note that almost all areas on Wall Streetdepend on stock price action. When stocks are rising,mergers and acquisitions, private equity, investmentmanagement and IPOs are all vibrant. So, houses involvedin all these activities prosper.

CHART 38The Vanguard Group

Source: AdvisoryHQ

Last Point 2015: $3.1assets under management; US$ trillion

1975 1979 1983 1987 1991 1995 1999 2003 2007 20110.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5



Stock market radio and TV shows also get big shares of thegoodies. Enthusiastic viewers remain glued to the tube inexuberant markets, and advertisers are only too happy topay heavily for air time. Don’t think that the joy of theirshows’ anchors over ever-rising stocks is artificial. Theyknow who butters their bread. Of course, when the goldvein plays out, the miners disappear and picks and shovelssales plummet. And the few that are sold fetch lower prices.

The earlier residential real estate bubble (Chart 4) fedarmies of brokers, mortgage lenders, builders, appraisers,construction material suppliers and Wall Street houses thatgenerated all those subprime residential mortgage-backedsecurities and collateralized debt obligations. Mortgagelenders promoted loans to patently unqualified subprimeborrowers because of their lucrative fees. The U.S. JusticeDepartment has for years challenged the anticompetitivefixing of commission rates by real estate brokers, buthomebuyers don’t do much negotiating as long as prices arerising.

12. Get Paid With Money That Isn’t The Payer’s,Especially If They’re DesperateSmall pieces of big pies get bigger and easier to obtain whenthe buyer of the pie wants it badly and considers the servicein question essential to get the deal done. We saw this in ourown firm years ago when an industrial consulting client wasmaking a major acquisition. We were told of it at the lastminute and asked to do a quick study of the fit between theclient and the company to be purchased.

The investment banking, legal and accounting fees, allnecessary for the deal to close, totaled about $1 million, alot of money at the time. The CEO definitely wanted theacquisition and considered our input as no more than ablessing of his decision. So he offered us a mere $5,000 forthe study. We did it even though several of our economistsspent a weekend on it and missed our company outing thatyear, a deep sea fishing trip. We’ve often thought about whogot paid what on that deal as a reflection of their relativeimportance in the CEO’s eyes! Well, on the bright side, ourcolleagues who labored in the office didn’t get seasick as didmost of the rest of us on that rough-seas day.

A Walk Down The HallThis strategy has wide applicability. CEOs are often quitefree with corporate money in paying bonuses to consultantswho may help save their companies, even when thoseoutside experts tell the corporate chiefs what they alreadyknow. A CEO friend talks about high-priced consultants hehired who took what he called “a walk down the hall.” Theyinterviewed all of his senior staff on the issue in questionand then simply regurgitated that information to him—fora sizable fee, of course!

Compensation studies by outside consultants almost always

conclude that the senior brass is undercompensated. Butthose consultants are paid well because they’re considerednecessary to substantiate pay scales. Corporate directorsapprove lavish CEO compensation and severance packagesin part because it isn’t their personal money and they wantto keep the leader happy.

Business-oriented law firms are particularly good at thisstrategy, especially when their clients face significant classaction suits, other substantial legal difficulties or potentiallydebilitating regulatory problems. Corporate officials willspend almost any amount of their firm’s money to stay outof trouble, and lawyers know it. And when their lawyerssympathize with them over how bad the class action lawyersare who oppose them, corporate leaders should rememberthat without those class action suits, their own lawyerswould not have billable hours. And billable hours they canrun up so fast you can’t even see the meter spin. We knowof one case where the defense attorney had to work ninehours a day, seven days a week for two months straight tojustify the time he billed.

Of course, the class action lawyers are also getting paid withother than their clients’ money since they almost alwayswork on contingency bases. It’s the defendant who, ineffect, pays them when the usual settlement is reached. Thelast thing the plaintiffs’ lawyers want is a time-consumingtrial they might lose.

Soft DollarsMutual funds and other managers of others’ money usedto pay for securities trading, outside research, quote machinesand even furniture with brokerage commissions. This wasthe vast “soft dollar” business, which they preferred to harddollars, cash payments that came out of their hides whilesoft dollars were paid from their clients’ assets. The resultwas that some services paid in soft dollars, including lavishentertainment, clearly did not benefit the money manager’sclients.

Abuses led the SEC to restrict soft dollars to outsideresearch and other services that clearly benefit the ownersof the managed funds. In an era of market-determinedcommission rates, anything an institution pays above bare-bones execution of a few pennies a share for a stock tradehas to be justified as a client-benefiting expense. The funhas definitely gone out of the soft dollar business!

What Do You Think?This list of 12 strategies for making big money is probablynot exhaustive. Perhaps this number could be expanded.Still, we hope our list gets you thinking. Maybe some of ourstrategies may suggest highly profitable opportunities toyou. On the other hand, do you have other approaches wehaven’t thought of? Please give us your thoughts.



CommentaryAristotle Lives!Aristotle, Plato and other ancientphilosophers first decided how theworld was ordered, based on intuitiveprinciples, and then looked forsupporting evidence. Hence theirconviction that the universe revolvedaround the earth. But carefulobservations by Copernicus andKepler as well as Galileo’s telescopemade the geocentric conceptincreasingly untenable, and Newton’slaw of gravitation confirmed theheliocentric theory.

Those years saw the birth of thescientific method—looking first andthe letting the evidence dictate theconclusions. But over 300 yearslater, the Aristotelian model of firstdeciding how the world works andthen selecting the data to supportthose preconceived notions stillpersists. Even in the scientificcommunity. Several years ago,investigators of global warming threwout data that did not verify their beliefthat it’s the result of fossil fuels. As aphysics major at Amherst College, Ilearned that true scientists never,never, never discard data, whether itsupports their hypotheses or not. Theoutliers may prove to be the mostimportant observations.

Aristotelian thinking also pervadesgovernment regulation. If specificmeasures fail to produce the desiredresults, the reaction is not to reappraisethe theory but to intensify the actions.Government job training programshave generally failed to prepare peoplefor productive employment, but thestandard response to more of thesame.

Government attempts to redistributeincome from higher to lower incomegroups through tax increases, welfare

spending, Obamacare, etc. have failedto arrest the polarization of incomethat has been underway at least sincethe 1960s. Yet rather than concentrateon enlarging the economic pie, soeveryone gets a bigger slice, the strategyof Bernie Sanders and Hillary Clintonis higher taxes on the rich to betransferred downward.

Conservatives can be just asdoctrinaire as liberals. Years ago, Ispent an afternoon, one on one, withMilton Friedman, who told me therewas no such thing as shortages orsurpluses because prices would alwaysmatch supply and demand. But crudeoil supply continues to exceed demandby one to two million barrels per day.He also said labor rates around theworld would equalize to stem the U.S.inflow of cheap manufacturedproducts but was oblivious to outcriesby American workers after theresulting declines in their real incomes.

This Aristotelian mindset is reinforcedas government programs build strongconstituencies. Charter schools inwhich instructors are free toconcentrate on educating studentshave proved superior to public schoolswhere teacher unions’ interests oftencome first. But union strength hasheld back this expansion.

Ironically, businesses that fightincreased government regulationoften support it after they’ve incurredthe time and expense of adapting.Reverting back to lower carbonemission standards would be verydifficult and costly for the electricity-generating industry.

The Sarbanes-Oxley law, enacted in2002 in response to questionableaccounting at Enron, Worldcom andelsewhere, added huge corporate auditand compliance expenses, andaddressed an era that is long past. Butthe resulting need for substantial

outside auditing services spawned asubstantial constituency.

Similarly, the 2010 Dodd-Frank law,the response to the financial crisis, isso massive and complicated that someaspects are yet to be worked out.That includes the Volcker rule thateliminates proprietary trading bybanks. Yet the financial excesses thatthis after-the-fact legislation addressesare unlikely to be repeated, at leastnot until the current generation ofembarrassed bankers are gone.

Due to the Aristotelian mindset androbust constituencies, governmentregulations are seldom reversedentirely. Almost alone was theelimination in the late 1970s of theCivil Aviation Board, which set airlineroutes and fares. Galileo was formallycondemned by the Pope in 1633 forhis heliocentric theory, but that actionwas only revoked 332 years later in1965.

The Fed and other major centralbanks have been thoroughlyAristotelian in recent years. Theypersist in “forward guidance,” advisingmarkets on future monetary policyeven though their decisions are data-driven and they have consistentlyoverstated economic growth, inflationand interest rates. Our analysisrevealed that stock and bond volatilitywas less before than after the adventof forward guidance.

Still, there may be some hope thatAristotle will be returned to ancientGreece. Several key Fed and TreasuryDepartment officials recentlysuggested that their new regulationsmay have increased market volatilityby reducing liquidity.

a. gary shilling ˇs insight

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