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- The Apple (aapl) Falls Far From The T (Trillion Cap)
- 10 Years Of Passive Investments Creates A “No Bid” Market
- Gold Now Shining As Stocks Are Sliding
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
WALL STREET: “BE THE DIP … I MEAN BUY THE DIP”
January 9, 2019
“In the back of every investor’s mind is this question: What didn’t work last time, and why should we think that this time is any different? So, as they announce a two, three, four-trillion dollar intervention via QE, I think you have a different market environment, because sentiment has changed.”
– David McAlvany
Kevin:I finally watched Clint Eastwood’s movie, Escape from Alcatraz. It’s been around for a long time, but honestly, I watched it the other night Dave because you won the lottery and you are going to actually be able to do the Escape from Alcatraz swim and triathlon.
David:Yes, it’s a different kind of lottery, isn’t it (laughs)? Sometimes I wish I had won the other lottery.
Kevin:It’s going to be miserable.
David:There are a lot of folks that want to compete in that race, thousands and thousands each year, more than you can actually have. So yes, it is quite an extravaganza. Training begins very shortly.
Kevin:And you brought that up last night when I drank a glass of Scotch and you had cranberry juice .
David:It was thrilling, actually. I love cranberry juice.
Kevin:(laughs) What we were talking about was that a couple of years ago you got a watt meter for your training bike, and you started looking at comparisons with some of the guys who were doing well in these triathlons and how many watts they are actually pushing. You shared something last night with me that I think is really, really interesting in many aspects, not just for training with triathlon, and that is the value of longevity. The guys who were pushing the large amount of watts, from what you were telling me, have built as much as a ten-year base before actually training up to that next level.
David:And it’s the same in swimming, it’s the same in each of these sports, where it’s not just a matter of choosing to get a pair of running shoes or buying a bike and getting on the bike, but there is muscular development which takes place over a long period of time. And you only get the benefits, you only see the strength and the efficiencies and the gains if you have done it for a long time. So yes, the power measurements for the biking, at my best I’m doing half of what others in the pro circuit would do, and it’s just shocking to me how much power they can push.
Kevin:And what is amazing, you can’t fake out the watt meter. In other words, when I’m watching a race, everybody looks like they’re just biking. You can’t fake out the watt meter. You have guys in the past who can push 300-400 watts on a long, consistent basis – long races, over 100 miles of biking – and you’re pushing, you said, about half of that. That’s not your fault, you’re a strong guy, but you just haven’t had the time to lay the base.
David:And what I think that we have done here with the Commentary, we’re now in our 11thyear, and to me, there is something to be said for doing something for a long period of time. There are benefits that accrue through, not just doing something for a season, but doing something on a longer-term commitment.
Kevin:And this volatility, this is not the first rodeo that this Commentary has been through. Even though the company, starting with your dad, has been through multiple periods of extreme volatility, this Commentary walked us through, you and I were able to walk through, the 2008 crisis.
David:And seeing the gold market, too, from the vantage point of multiple cycles, both up cycles and down cycles, the company has been here for many up cycles and many down cycles. We have been doing the commentary since 2008, which is a good period of time, but that is just one of the up and down cycles, and we will explore a little bit today what we see emerging into the next significant up cycles for the metals.
Kevin:And looking at cycles, it seems there are always two things that always show up. Debt is a problem, and a lack of liquidity or infusing liquidity almost always has the answer to what is going on at that time.
David:This relates to last week’s Commentary as we looked at John Law’s system and Cantillon’s critique of it, and the necessary liquidity that was in the system. As things got out of control, ultimately there were consequences in the area of the currency, the livre, the French currency at the time. So one of the takeaways from last week, and I think it is just as apropos today, is that there is a point where credit expansion and credit excess leads to consequence in the marketplace and in the large economy.
Kevin:What we have seen over the last ten years is that the markets have been artificially fueled in many ways with something called quantitative easing, yet for those listeners who remember listening in October, we started talking about the liquidity being taken away, the spigot being turned off.
David:Right. The ECB started taking away the punchbowl in October. As of January 1st, QE in Europe is done, so that is an era which is past, at least for now. They might do another iteration in the future. But is there any surprise that asset prices suffer when you reduce the liquidity flows which drove those prices above a normal, or sustainable, level.
This summer we thought about that. We looked at the October timeframe. We thought that it would get interesting because they had pre-announced what they were going to do – reductions in October, elimination in January – and we knew that it would be sufficient tightening in that timeframe to get the markets upset.
We didn’t have any announcements from the Fed that there would be increased liquidity. The Bank of Japan was going to continue doing what they were doing. But marginal decreases in liquidity provisions to the market would have an impact. Again, liquidity drives prices higher, and a reduction in liquidity ultimately has the opposite effect.
Kevin:You have mentioned in the past that we rarely ever knew, as a society, names of central bankers, but at this point central banks have really driven just about everything that happens in the market.
David:One of the greatest factors in the direction of the market is what the central banks are saying, and whether it is Powell or any iteration over the last 20 years, it has become more the case, as time has marched on, that those names and those pronouncements become very, very important.
We had the October to the present timeframe, the fourth quarter of 2018. That was a timeframe where the pain which equity investors have endured is connected to the central bank community attempting to normalize monetary policy. And this is after, not only just a few years of excess, but decades of credit excess. And they are finding that there is a cost to do that, to normalize monetary policy. So 2019, I think, is going to carry that story forward, and we get to explore what are the real costs, and who is going to pay it.
Kevin:Even with the volatility there is no lack of cheerleading. If you turn on financial TV, mainstream media, I don’t know that they have really caught up to fact that liquidity is not there right now.
David:One of the things that they did key into last week, of course, was the ADP numbers mid-week, and then the non-farm payroll numbers at the end of the week, and that was sort of like the savior of the week. You combine Friday’s Powell comments and the non-farm payroll and you have a massive ramp-up in stock prices. But Thursday the wheels were coming off. Thursday, just one day prior, the wheels were coming off. You had credit default swaps for Goldman-Sachs which were up considerably, flashing a red alert. Frankly, Friday’s Powell comments – those were required comments. They were scripted comments.
Kevin:He read them, didn’t he?
David:They were purposeful. They were effective. And they were intended to move the markets. Now, they have a short squeeze going now in the equity markets, but it’s hard to forget Thursday. You had everything from investment grade bonds, high-yield bonds falling to pieces, you had credit default swaps revealing weakness, and a tremendous amount of uncertainty. European debt, Italian debt, everything on Thursday of last week was circling the drain. The bear thesis was, and still is, being validated, and it was all coming together. So Powell speaks and he piggybacks his comments with the non-farm payroll surprise on the upside, and you have a huge rally in equities.
Kevin:Well, we’ve seen volatility before, Dave, and sometimes it is sort of meaningless to the underlying structure of the economy. But you’ve talked about structural damage in the past and sometimes you actually have structural damage, which means you don’t come back the way you did before. It is a little like a body that starts to get older. It heals slower and slower until at some point it can’t heal anymore.
David:Yes, so we had some encouraging words and a nice data point, but it’s dangerous, it’s very dangerous right now, January 2019, to think that the backdrop issues have been resolved, particularly if you’re just going to ignore late 2018 structural dynamics and sweep them under the rug. Structural market deterioration in December was critical. So again, you have the singular news items which are boosting spirits temporarily, but you have had, in the last 30, 60, 90 days, massive sentiment shifts, technical breaks in the equity markets, and credit market deterioration which is worthy of remembrance lest we forget the real state of affairs.
Kevin:Yes, but the mantra of the market has been, or at least the people who have been buying into these markets has been, “Buy the dip, buy the dip, buy the dip,” every time it drops.
David:You’re seeing that activity, individuals trading in ETFs and options. They’re continuing to buy the dip. I know they are inspired by Jim Cramer, I know they’re inspired by the President. Just look at the advertising. If you listen to CNBC or Bloomberg, as we often do throughout the day, the news networks are laying it on thick, and again, the advertising for “you can do the options trade” and everything else, but they’re there, it’s popular. And I think, after major market sell-offs, this is the message – you have to average in, you have to average in. I’ve thought, at least twice in the last ten days, with what cash reserves are the general public averaging in? Because cash has been considered, at least by mainstream media and the business press, to be a fool’s or a scaredy-cat’s asset class.
Kevin:And buying the dip in a bear market – buying the dip in a bull market is one thing. You make more and more money over time. But buying the dip, if this is truly the beginning of a bear market, is just a way of sucker’s money going in, good money going after bad.
David:Right. You have folks who are trading these markets and they are working in a very treacherous environment, and again, particularly, buying the dips. I grant you, if you are talking about the next ten days, two weeks, three weeks, a move higher from here over a short period of time is likely. We have had a significant sell-off in equities, and for that to continue higher for a little bit, no problem. It makes sense.
Move back to 24½ on the Dow, 24,500, 24,480 on the Dow, S&P just above 2600 or thereabouts. I think that is likely. But I think what you are going to see is that it draws out major selling. Smart money is selling into strength, and that has been the case for several months, and it reached a real peak there at the end of the year where you are seeing, not only large accounts, but now I think you are going to see in the first quarter fast money, to contrast smart money which is the institutional big boys, with fast money, which I would, in this case, be thinking of hedge funds and the like. They are repositioning in the first quarter in light of failing energy on the upside, and in light of technical deterioration on the downside. We talked about this last year, the 50-day moving average crossing the 200-day moving average. It did that to positive effect back in 2016.
Kevin:But you called it the death cross this time.
David:And now to negative effect late 2018 there in the October-November timeframe, and I think that is going to drive the major trend for some time. So any relief rallies you have, you have the smart money and the fast money repositioning, leaving the dumb money sitting there to hold the bag.
Kevin:That’s exactly right. You have to pass the bag. But the leaders – we talked about how small the market really was this last year where you had leaders that were pulling the entire market up. Those leaders are not looking good now.
David:That’s right. And those were the leaders of 2017, those were the leaders of early 2018, and they’re falling fast. And many of those leaders are now revealing that they have revenue and sales weakness looking into 2019, so look at the supply chains for all of those companies and you see further weakness still.
Kevin:But I’m a skeptic. I’ve played the skeptic before. What if the markets are just continually, perpetually controlled? We get that question from our clients sometimes.
David:I remember a conversation last January with a gentleman utterly convinced that the market was permanently rigged and moving higher. Again, “the powers that be” are going to keep things perpetually moving higher – that view looks pretty silly right now. I have had the same question asked in a different way – aren’t they just going to knock the price of gold down? Yes, because they can control that market, too, as they did from $350 to $1900. That looks like a manipulation of the market lower.
I hear some silver bugs, which I think is absolutely insane – they view silver as an entirely manipulated market. Really? From $3.75 to $48 it was a manipulated market? It has to play both ways. Are you saying that they stepped out of the way? There are limits to manipulation, that’s my bottom line. The bottom line is, yes, you can influence the direction of the market in the short run, but ultimately the trends will reveal themselves. If we are, in fact, in a bear market in equities, that trend will reveal itself, and it doesn’t matter what kind of baling wire and chewing gum the Fed pulls out of the back pocket or toolbox. It’s not going to get the job done.
Kevin:For those who have bet on the manipulation, let’s grant them this – they have made money. It pushed Apple above a trillion dollars in capitalization.
David:Okay, let’s use that as Exhibit A. Exhibit A – Apple, 1.1 trillion dollar market cap at its peak. Okay, a 675-billion dollar market cap today. In three months, a 39% drop in one of the most popular-to-own stocks of 2017 and 2018. When it goes, it doesn’t ask permission, it doesn’t wait for you to reconsider your asset allocation. And if you thought you were going to be, again, that small group of smart traders to get out just in time, you’re sitting there. You’re the bag-holder. You thought you were the smart money and the fast money. No, it turns out you’re the dumb money. This is what people have as a curse in investing. They don’t understand that to not be a little bit early means that it is very painful to be late. And then you just have to conjure hope to substitute for reality and the re-measuring of your portfolio size.
Kevin:In just the last eight or ten weeks we have been talking about share buy-backs again, about Apple buying in the $200s per share. Isn’t it interesting looking back, hindsight, these share buybacks really left Apple and the shareholders holding the bag.
David:And how is that working for Warren Buffet? I do consider him smart money. But come on, you think that you buy companies that are buying back their shares, and that’s a way of protecting yourself, because they’re returning “shareholder value?” He is focused on IBM, he is focused on Apple – these are the companies that he is buying up hand-over-fist, and he is losing his butt.
Kevin:Yes, almost 40% on Apple.
David:And the justification has been, they’re buying back their shares, they’re continuing to return shareholder value. I sat on a chairlift a week ago with an Apple employee from Austin. We were skiing and he just happened to be sitting there and I introduced myself. He said he loves working for the company. He just couldn’t believe what a discount the shares were. He was happy owning them at $233, and now at $170 they were such a bargain, he just wanted to own more. In less than ten days, Kevin, it had gone from $170 to $140, off the peak of $233. Prices are moving up, that’s all well and good, but I have wondered if shareholders are forgiving when it comes to the losses accrued from the share buy-back schemes of the last several years.
Imagine this. If you immediately realized a loss of between 10 and 20 billion dollars on an acquisition, do you think the shareholders would have a justifiable reason to put management under the microscope and put pressure on them? “What were you thinkingbuying a company that created an instant loss of 10-20 billion dollars?” Apple has done just that. Yet, when prices are rising nobody asks about the actual value-add. The actual return of shareholder value – is it really there?
Kevin:Dave, we have a mutual client and friend who brought something up this week. He had listened to last week’s show about John Law and Cantillon twice, and he called me up, and he said, “You know, let me just get this right. So the debt that France had back a few hundred years ago was turned by John Law into equity, basically handing over the bag, and then it collapsed. You know what? That’s exactly what share buy-backs are for companies.” So thanks, Pete, for that insight. That’s exactly what Apple just did.
David:(laughs) And they are willing to even create new debt to buy the equity. And that is, in many cases, because of repatriation and tax benefits and things like this. Major companies and multi-national corporations have added to their debt to reduce their equity, and now the equity is shrinking, but the debt remains.
Kevin:Let me ask you this. Things have changed over this last 10 or 11 years in that we don’t have people actually looking at buying Apple. It’s passive allocation. It’s large indexes that are holding Apple. Are people really making the decision as to what individual stocks they own?
David:There is a major concern we have. If you look on the horizon, the next wave of selling – we think 2019 and 2020 are going to be pretty rough in the equity markets. But the major concern we have is here – one of the great transformations in market structure since the global financial crisis has been the move to passive allocations and index exposure. What that means is that far more people own an index than they do the underlying stock. It has meant that the deformation and the gradual removal of market-makers has occurred without many considering what the lasting consequences are or what that means under a different set of circumstances instead of a buying frenzy where everything is moving higher. What about a selling frenzy where everything is moving lower?
Kevin:Well, what difference does it make? If you’re making money, what difference does it make whether it is passive or intellectually stimulating, either way, if you’re making money? That’s what people are thinking right now.
David:Market’s up, it hardly matters, right? But the new structure of the markets forces people invested to play the game. It’s the momentum game. It’s one giant trend. And that game is followed with trillions of dollars. It’s a bet on the market direction moving higher. It’s no longer a bet on the merits of individual companies, it’s no longer ownership in individual companies, it’s sector exposure, it’s index exposure. It’s no longer investing at all, it’s a directional speculation.
That’s what it is. It’s a directional speculation, and it’s trend-following with a huge derivative overlay, so it’s kind of like trend-following squared, or to the second degree. The past decade has not been about investing, it has been about gathering mice to follow the pied piper. So when you combine ETF trade settlement, when you look at and combine hedge fund directional bets and algorithms which feed off of these one-line summaries and tweets, sometimes actually created by a computer themselves, so it’s a computer reacting to a computer, there is a void of depth. There is a void of understanding. It’s merely knee-jerk according to the interpretation of a few words.
Again, then you bring in the derivatives – you have the futures markets, the options trading – to exaggerate the volatility in the market, because you have with these options and futures trading, the underlying assets which end up being bought and sold in light of the options trades. It’s a very, very tenuous market structure. And it is one reason why, if you look back at the last 90 days, you have had volatility on a grand scale, days where we have swings of 800-1,000 points, single up-moves of 600 points up or down. It’s not natural.
Kevin:One of the things that I think people forget is that any time you want to sell something you need a buyer. And if you don’t have a buyer out in the hinterland, it used to be that you had a market-maker. The market-maker would come in and say, “You know what? To bring stability to this market I’m going to buy that stock and then sell it to somebody,” not necessarily have a buyer at that time.
David:Yes, and another way of removing risk, if you’re not going to just sell it outright, is to hedge that position.
Kevin:Okay, but where have the market-makers gone? If everybody is sitting in an index, you don’t really need a market-maker until you need to sell something.
David:That’s right. So now you’re talking about a broad category of off-loading risk, and it’s difficult to do it. The market-makers are scarcer, and if you’re going to be hedging your risk, someone has to be willing to take on that risk, and they are going to operate in the market so that they can create the hedge and not have full exposure themselves. Again, this is one of the primary devolutions since the global financial crisis as there are less and less financial entities to off-load risk to. Where there is an inability to adequately reduce exposure, or reliably hedge a position, you are going to gradually see a shift in behavior. And you’re going to see a shift in the way market participants engage.
So the net impact is that in a real liquidation phase, which I think we’ve just had a foreshadowing of here in the last month or two, the Fed and the Treasury – this is where this is going. If I pull out my crystal ball, I can’t tell you the price of the S&P or the Dow or the price of gold three months from now, but I can tell you what the Fed and the Treasury are going to have to do. The Fed and the Treasury will be forced to coordinate purchases of equities and index ETFs, just as the Bank of Japan already has experimented with.
Kevin:They become the buyer of first resort, not last resort.
David:Yes. What I’m saying is, the next round of QE is closer than you might think. And what we saw in terms of 2018’s reduction in the Fed’s balance sheet – roughly 8% of their balance sheet was run off this last year – by the next election we are probably talking about a Fed balance sheet of 6 trillion, and maybe even eventually marching toward 8 or 10 trillion dollars. Shorter term, if you’re talking a 12-18 month timeframe, we have all the talk of a robust economy. That likely will have faded, and I think you will see the financial market frailties on full display, creating a lack of confidence.
And that lack of confidence then recycles negatively into the real economy. So actually, the issue today is not a weak economy, it is a weak and frail financial structure, and with those financial market frailties being revealed, it recycles negative feedback loop into the real economy, ultimately putting us in the place where we are likely to have recession.
Kevin:And it’s not just the United States, we’re talking about the globe at this point.
David:So if it is still a future tense issue, in terms of compromised economic growth here in the United States, you’re right, it’s already a global phenomenon. We’re the exception to the rule. You have Asia, you have Europe, you have Chinese numbers, you have some folks in China right now who are getting in trouble for saying, “Hey, wait a minute, we could actually be – we know how they keep two sets of books, and instead of it being 6%, roughly, GDP growth, it’s probably closer to 2%.” Well, I can tell you, there is a big difference between 6 and 2.
Nevertheless, Asia is seeing the deterioration in global growth. Europe is seeing it. You’re seeing it in the manufacturing numbers coming out of Germany. We already know it’s a mess in the banking system throughout Europe. How long can we, in the United States, hold up as the global economy grinds down?
Kevin:Part of the perception management is the Fed and the Treasury coming in and being the buyer of first resort. But I think since we are looking a little bit in the rear view mirror at the last 10 or 11 years, we can look at the Fed, which grew its balance sheet to over 4 trillion dollars – that was supposed to be temporary. We can look at a Fed that lowered interest rates to almost negative rates – that was supposed to be temporary. We can look at quantitative easing – there were multiple rounds of something that we were told was going to be temporary and you’re talking about it coming back again.
There is a point where you have the government owning and controlling everything, but there is really no market left. I would like to go back, Dave, and look at the impact of this market change that you’re talking about where the market-makers are no longer incentivized to be in the market – in other words, nobody to sell to.
David:Yes, I think this is a key point on the financial markets. You can contrast every bear market of the past with this one now unfolding. If you’re looking at it past tense, the incentives and the profits of managing a bid-and-ask spread – the difference between the price that you buy at and sell at for an individual share – that difference, and managing that bid-ask spread, invited financial firms to buy up liquidated shares, to take a position, to hold them temporarily, to warehouse them, and then ultimately to resell them and capture something of the game. It brought stability to the market. It brought liquidity, as well, to those who wanted an exit.
And this is what I’m saying – the economics have changed. The incentives and the profits have shifted. You have passive investing via the indexes which now dwarfs the ownership of individual shares, with the consequence being a crushing of wholesale market margins, and the elimination of incentives to be the buyer of last resort. So add to this, electronic trading, a migration away from the exchanges toward dark pools, and these things have all helped exaggerate this trend.
Kevin:It reminds me a little bit of what Amazon has done to retail. Yes, the price is lower and we get things a little bit quicker, but all the competition is being eliminated, completely, and we have the same type of thing, that market-makers really can’t be in business anymore.
David:Right. So, it’s positive if you frame it in a certain way. If you frame it in light of progress, we have more efficiency, we have cost effectiveness. You have a world of a digital electronic matching of buys and sells, nanosecond paring of interests. But what if buyers are absent the market? What if it is only sellers? What if only sellers are present and the electronic match-maker can’t make the match? We have given birth to what we might call the unruly bit (laughs). This is when you go to sell something, you click your mouse, and maybe you’ve done this before, you’ve placed a trade and found that the market price was lower than what you expected. The bid was softer than you anticipated.
We have a crushing confluence of ETF across-the-board selling. It is indiscriminate buys on the way up. They buy, and it’s just buying everything in the basket. It is also indiscriminate selling on the way down. You have hedge fund momentum exaggeration in the market, you have algorithmic models which base all of their activity on assumptions, and those trade dynamics put investors today, I think, in a very precarious place.
Kevin:What happens when that assumption turns out to be a misconception that there is always a buyer? I’m thinking, Dave, about a conversation that you and I had about three or four years ago when the government announced that they were opening an office in Chicago for high-frequency trading plunge protection team type of work. We’ve talked about the plunge protection team coming in and intervening on the market. That is when they become a buyer, themselves. But HFT is 70-80% of the market at this point. They probably knew that this day was coming when there may not be a buyer.
David:Part of the success of our tactical short offering in the 2018 timeframe and going forward relates to this financial structure devolution. By creating efficiency and shrinking cost for the consumer, the consumer has been left with a compromised market, and doesn’t know it, because it doesn’t reveal itself in an uptrend. It reveals itself only in a downtrend. So it is a market now that cannot adequately meet the needs of the market in liquidation mode.
So the short-term answer has been, and I think will continue to be – and this goes back to what you’re saying – derivative market manipulation. You have the S&P futures market which is where you see it on full display, sometimes on a daily basis. So again, it brings calm to the market temporarily, you can boost coming into expiration, you can boost on the beginning of the month to set the tone for the month, you can buy for the first couple of days of the year, you can – lots of things that happen in ESH trading, the S&P futures market trading. It’s a little bit like a nip of whiskey.
Kevin:It takes the pain away temporarily.
David:In a moment of duress, a nip of whiskey takes off the edge. But does it actually solve anything? No, all it does is change perceptions temporarily. I really love the interview we did with Richard Bookstaber. If you are unfamiliar with Richard Bookstaber, visit the Commentary archives. Go back to our conversation with him following his time in D.C. where he was helping to construct Dodd-Frank.
Kevin:He was worried about the very thing that he had helped create.
David:Which was an echo from the words of his first book, which is, “I think I might be responsible for this.” (laughs)
Kevin:He has tried to manage danger all of his life and he realizes, he then writes a book later about his managed danger, the management of danger actually leads to more crisis.
David:That’s right. He admits that the solutions that they sought to the last crisis, again, drafting Dodd-Frank, the solutions that they were seeking will inevitably cause the next crisis. And we could, and we did, describe the global financial crisis as a liquidity crisis, and it did morph into a solvency crisis thereafter. But what we are talking about when we are talking about the compromise of market liquidity and the change in dynamics when someone goes to exit an index and it blanket liquidates across companies through no fault of their own who are caught up in the basket, the liquidity crisis of the next phase is a more exaggerated buyer strike – a much more exaggerated buyer strike – with no one but Trump and the folks at the Treasury and the Fed to step in and restore calm.
This is the challenge, though, because if you say, “Well, they’ll do it again. Remember shock and awe, the last go-round? We’ve had this before. They announced their policies. It was the big bang of the financial world. We’ll buy it all.” Well, it’s got to be the bigger bang, or the biggest bang, because if it’s anything less than the last 4 trillion, it really doesn’t measure up. It’s not that impressive. And in the back of every investor’s mind is this question – what didn’t work last time, and why should we think that this time is any different? So as they announce a 2, 3, 4 trillion dollar intervention via QE, I think you have a different market environment because sentiment has changed.
Kevin:I yearn sometimes for some of the guys that we have read that are now gone, that were not alive during the time of this commentary, like Jacques Rueff. I would love to have you interview Jacques Rueff right now. He was writing in the 1970s about a time similar to this when he was looking at the dollar, which at the time was backed by gold. But he saw the excesses and the things that were going to be needed for liquidity. And he told de Gaulle, “Start trading your dollars in for gold now because it won’t always last.” There are currency implications to the Federal Reserve coming in and just being the buyer of everything.
David:I think that is where, whether you take the side of the deflation argument, or the inflation argument, there was stronger demand for the dollar in the 2008-2009 timeframe. I think we are at the juncture where there is a significant currency market implication. We talk about the liquidity crisis being more exaggerated in this phase and the buyer of last resort being the Trump, Treasury and Fed folks combined. This is where the currency market implications start to reveal themselves.
The next round of QE should mark that definitive point in time, and it’s not unlike the late 1960s when the U.S. dollar’s reliability is questioned, when its safety and stability is second-guessed, and we witness currency volatility on the heels of financial market chaos. There is the inevitable direct asset purchases which the Fed will have to employ at some point, and I think that the consequence, if you’re looking at the FX market, the foreign exchange market, is where you are going to see the pressures revealed as, “Wait a minute, we’re not tolerating this.”
Kevin:Do you think, just like in the 1960s, it was gold that people moved into?
David:The de facto winner is gold. Look at the timeframe here. In the October to present timeframe, gold’s strength has been the inverse to equity market weakness. It was that way from 2000 to 2012, if you’re look at that broad swath of time, one of the worst decades in U.S. stock market history, and gold went from under $300 to over $1900 in that timeframe. I would be buying gold and silver on any weakness in price over the next 30-60 days because the regime change is in full swing. You have gold and silver performance, which will surprise on the upside.
I want you to consider its relative strength in the context of the past equity market sell-offs. The 1973-1974 bear market, gold was up 133%. The 1987 stock market crash, gold was up 30%. Take that larger swath of time we mentioned earlier, 2000-2012, break it into two segments. 2001-2005 NASDAQ faltered – gold is up 100%. Repeat again, rinse and repeat, 2007-2009 it doubles – gold double from $650 to $1200, even as the stock market suffers. In most of the equity sell-offs in recent weeks we have had gold and silver miners which have bucked the trend, which is also sending a pretty clear message.
We have advised all last year that you should be raising cash and raising your metals exposure. For those of you who have cash, you can put some of it to work right now. For more speculative dollars, that idea of the precious metals miners is a good place to go in 2019. Metals purchases, I think, make sense. Yes, keeping large amounts of liquidity does make sense. Yes, we do see a currency event, so having that balance between metals and cash provides something of a cushion.
Kevin:Isn’t it strange, though, that the rest of the world doesn’t really see the currency event? They don’t really think two or three steps down the road?
David:Because ironically, you have the long dollar trade, which is huge. If you look at the statistics for how many people – investors, commercial interests – are long the dollar, there is lots of faith in the dollar today. Let’s see what happens if that faith is tested.
Kevin:I did this a couple of weeks ago with you and I’m going to do it again. Make your case for a bear market right now. Pretend we are in an elevator on the 80thfloor and we’re coming down fast. I want you to make your case for a bear market before we finish the program because a lot of people right now are not necessarily seeing it.
David:The backdrop for a continuing bear market, a nasty bear market, is set. So I think, to the degree that uncertainties emerge in the minds of investors, it is negative stocks, it is positive gold. So I want you to consider the following: You have excessive debt in the corporate sector, by some measurements as much as 72% of GDP, and it is rising rates which are sort of the nasty cocktail for earnings growth.
Kevin:Okay, excess debt.
David:Excess debt in the corporate sector – nasty disappointments for equity investors moving forward. You have a divided government. This is a political comment. You have Democrats who are doing everything that they can to upset the President’s expectations of economic growth, and of course he foolishly, in my opinion, took credit for the bull market in stocks, and now I think they will like to lay blame for the bear market in stocks at his feet.
This is the tricky thing. If you have the operations of the President’s Working Group on Financial Markets – as you called it earlier, it is also known as the plunge protection team – if there are any benefits from market intervention they are likely to be viewed as politically beneficial to Trump. You’re going to see the Democrats in an uproar about that kind of market manipulation.
Kevin:So, Trump basically saying, “Hey, this is my bag,” when the stock market was going up, he is now holding the bag when the stock market is going down.
David:Right. I also think that global banking and financial firms are already indicating gross financial instability, and they are indicating that it is here now. You have the German bank index which is off 52%, you have the Italian banks, which remains under extreme pressure, and you have the U.S. financial and banking firms which were down 2x what the general markets were down in 2018 – not a good indicator.
Looking at the liquidations in the last 90 days, from October to the present, really heightened in December, you have increased volumes with those liquidations. These are real sellers. These are huge blocks of institutional money which are exiting the market.
Kevin:It’s starting to look like a real market, overwhelming the algorithms.
David:Right. So you’re seeing these increased liquidations sell into every rally attempt, so I think the tide has changed. What else would I add to an elevator speech? Hedge funds were largely caught flat-footed in the fourth quarter. They were inadequately hedged and they are now sitting on losses. That’s okay, they keep cool heads, they’re good traders. But I think what you are going to see is, again, they are looking for a rally to reduce longs and go short. So again, people are selling into any rally, and positioning on the short side in advance of what they consider to be a change in time.
Kevin:Okay, elevator is about halfway down. What else?
David:(laughs) The president is zealously watching business news television to monitor stocks. I don’t think that is a part of his job description.
Kevin:I read that! It’s an obsession.
David:Yes, and I wouldn’t include that in his JD. Cheerleading the equity investor via his tweets and news announcements, I think you’re already past the turn. If he is trying to hold things up through some positive commentary, I think it is because he feels it is necessary, and that’s a bad place to be.
Kevin:Presidents should not be cheerleaders for stocks, up or down.
David:But it also tells you where you are, with the market already having turned. All liquidation phases of the past decade have been short-lived, so for those who were thinking that this is going to be just like Greece, or just like Brexit, or just like the problems in Europe, or we’ve got a one-day flash crash, or the volatility blow-up in the first quarter of last year. We have a group of investors today that are conditioned to believe that pain is short-lived and they forget that just about a decade ago we saw sustained liquidations over a multi-year period, declines of 60-90% in the emerging markets, 30-50% as the dust settled in the developed world markets.
No one today is assuming that a 50% haircut is possible in U.S. markets. Last year, from where we started to where we ended, we lost 6%. I realize we were off more than that if you are talking about off-peak numbers, but from the beginning of the year 2018 to the end, we lost 6%, and CNBC is describing it as “utter carnage, and that is why you should be buying right now. Buy the dip. Buy everything that you can, because the market is on sale.”
Kevin:(laughs) We have been trained that every market downturn at this point is just a flesh wound. It’s really going to go away, it’s going to get quite better. The problem is, if you look at history, this decade doesn’t represent history.
David:Every severe bear market begins as a correction, and I think that is what we have seen so far is a healthy correction which has a good reason to go a lot farther. Market manipulation and intervention would be another point. It is becoming more common. But it is not holding as long. So it is required to manage the S&P futures markets, and they are doing so aggressively, but it is only having a 1-3 day impact on those significant interventions.
I think another thing that is different, and people certainly in the know and within the hedge fund community recognize this, Powell is a different guy. Powell is not Yellen. He’s not Bernanke, he’s not Greenspan. Powell doesn’t see QE as the best plan. Go back to some of his commentary from 2012 as they are rolling out QE and he is skeptical. He is skeptical about the trillions they are getting ready to spend, he suggests that if you spent even more than this the market will love it, but it doesn’t necessarily solve any of our problems. He is aware that there is excess in the system, and I don’t know that he necessarily wants to play.
Kevin:Could he possibly be the first hawk since Volcker?
David:He is not a Volcker, but he’s not like anyone else in between either. So I think he is his own man, and it will be interesting to see how he plays this. Short interest – two things about just sort of numeric factors – margin debt has come off a little bit but nowhere like you would expect it to in a market sell-off like this, so I think there are still liquidations pending in the borrowed-to-buy category. And then you have short interest, which has not gone up significantly. Back to that comment I made a few minutes ago where hedge funds were caught flat-footed. Short interest is not up significantly. It was actually higher in the early part of 2018 than it was as we closed the end of the year. So I think hedge funds are going to get positioned on the short side as time goes on.
But you assume, if you are listening to CNBC and Bloomberg, because of all the bearishness from commentators, that it’s just awful, and we should be seeing a massive short-covering rally because of all the shorts that are out there. There is less short today than there was at the beginning of 2018, end of the first quarter – March, April, May, that timeframe.
Kevin:Okay, so we’re about three floors up. What are your final reasons here?
David:(laughs) So back to the banks and the financials. The financials have significantly underperformed the market in 2018, and this is just axiomatic. The economy is not moving forward in a healthy manner without the banks and the financials leading. That they under-performed in 2018, I think gives you a pretty good idea of what is around the corner, which to me, suggests that we could have recession tail-end of 2019. I don’t think we make it into 2020 without having a recession. I could be wrong. Maybe we can hold it at bay until then, but again, you have to see a massive turn-around in the financials to the upside to abrogate that move lower.
Kevin:Well, you gave us 10, 11, 12 reasons why we are in a bear market. For the listener who wants to hear the counter to that, all they have to do is turn on mainstream media because they’ll get that counter.
Kevin:But you know, we craved volatility over the last few years.
David:If you remember in 2017 we sat here at this table during the Commentary…
Kevin:Where’s the volatility?
David:And it’s like, do you remember that scene in Master and Commanderwhere there is no wind, and they’re looking for a Jonah, and you can’t sail a ship…
Kevin:With no wind.
David:Without something going on, something has to happen.
Kevin:Well, that day has changed. We have volatility.
David:That’s right. Sharp episodes of panic selling, you have the interventions, verbal and otherwise, lifting prices again. And then what we are seeing now is the constructive, the large interests, liquidating into those rallies. And then a few days later, more sharp drops follow, interventions, rallies. I think it is worth remembering that you get these two to three day massive rallies, and they are not uncommon in a bear market. They are not uncommon in the context of panic selling. You had it in March and April of 2000. You had at least a two-day rally quickly following the 1987 crash. You had a two-day rally which emerged in October of 2008. So again, panic selling, massive ramp-up and a rally, and it doesn’t mean that the worst is behind you.
Kevin:Dave, we have learned that life is not made up of good answers, but actually, the best questions. If you had to ask a question for 2019, what would be the question that you would be asking, and that you would ask the listeners to pay attention to?
David:I guess one of the things that is on my mind is, if we do have a recession next year, because if we do have economic deterioration on top of the financial market frailties which we have talked about, sufficient for a recession, in that case your bear market financial dynamics have a significantly longer timeframe to play out. No recession, and we probably have 12 months, maybe 18 months at most, of bear market dynamics in the financial asset classes we have been discussing.
With a recession, maybe it’s 24, 36, 48 months of pain. So no recession, your declines are limited. No recession, your declines are probably to Dow 20,000. That is a 20-25% correction off the top. With a recession, with a lengthening of time, the damage that does to psychology to the investor in the Dow, the S&P and the NASDAQ, now you’re talking about significantly lower numbers – 13,000 to 14,000 on the Dow.
Put some of this in perspective. The magnitude of the bull market, the ten years leading up to this, off of the absolute lows the NASDAQ has moved higher by 700%. It is off a little over 20% now off its peak. But it is up 700%. In a bear market, you can, it is not unhealthy, it very commonly gives up 50-60% of the gains. So we would still be well above where we were in 2008 and 2009 with a 50-60% give-up of the gains.
Here we are in the United States wondering about what is going to happen next, and if you want to look overseas, I think you can see what is coming down the pike for us. 2018 was far worse for the emerging markets, far worse for China where it got truly ugly, down 25-26% for the year. Returns in the U.S., again, with all the talk about horror and the mainstream media has made it seem like, “Oh, it’s been so tough out there.” 6% loss for the year. “So tough out there.” And certainly it was worse off peak numbers. But the total for the year was not that rough. Emerging markets were twice as bad as the U.S. markets, 12-25%.
I could be wrong, but going back to your question about what question I think needs to be asked – if we do see real deterioration in the economy, for whatever reason, then I think you are locking yourself into a very significant and long-term bear market in equities. Lest you think there is safety in bonds (laughs), I think 2016 launched us into the long-term structural generational bear market in bonds.
So where do you go to hide? I might be wrong. I might be wrong in the ultimate depth and the duration of a bear market. The main take-away is that there is more pain ahead, and I suppose the other take-away would be, there is gain if you are on the right side of the trade.