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The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

300th Anniversary of the South Sea Bubble! Is It Happening Again?
January 15, 2020

“This year we celebrate the 300-year anniversary of the South Sea bubble, which, again, in retrospect, with 20/20 hindsight, I think we’re going to diagnose and critique as crazy behavior. But in the moment, our own version of the bubble, whether it’s Tesla or government bonds, all of this seems very rational, right? So if you’re looking for indications of concern – hey, here we are. There are none. All must be well.”

David McAlvany

Kevin: David, I was thinking about this. I’m going to take you back to 1912. Let’s just think this through. What if you were getting on the Titanic and you had heard that it is the greatest unsinkable ship, the largest – all the stuff about the Titanic? What if you didn’t know that the plan was to go on a more northern route and at a speed much higher than normal? And that if we did encounter icebergs we probably wouldn’t be able to turn out of the way quick enough.

Now, you’re still taking a chance, and it’s 1912, it’s the greatest ride ever. Would you get on that ship if you would know those additional facts, if you would have known that it’s a northern route, there are icebergs in the water, and there is a high chance that you could encounter one and not be able to actually maneuver around it?

David: Kevin, it’s very difficult to separate yourself out from sort of the spirit of the age. So this unstoppable march of progress, if that is a part of the meme of that day, then how do you step outside of that? This is the greatest engineering feat of all time. It’s the biggest boat with the largest number of amenities, so arguably things are different, because you’re working with a different kind of machine. And therefore you should have a different trajectory and kind of imagination of the environment that you may be encountering.

Kevin: Well, and I look at current conditions, talking to clients and just listening to what people are saying. The China deal seems like that is foremost on their mind. I asked a client yesterday, “What do you think about the stock market coming up over the next year or two?” He said, “Well, I guess it all depends on China.” And I just paused. And I thought, “Oh my gosh. He doesn’t hear anything about the icebergs, he doesn’t understand about the northern route. He doesn’t understand that there is no way to maneuver if he is wrong and if China is really not the big issue.” And it just gripped me because I realized he has bought in to the narrative of the age.

David: It’s one of many issues. You look at the Taiwan election here recently, a landslide victory which points toward greater conflict with the mainland. You look at Hong Kong, and you have yet to have resolution there in Hong Kong with the mainland, again. So you have the South China Sea and this region which is full of opportunities if you’re looking for things that could represent triggers for a downside in the market. The China trade deal we have this week, the signing of the first part of it. The trade deal part two, that it is suggested won’t happen until after the election.

It’s not the conclusion of a three-year saga. What it is is a comma in the narrative of dysfunctional international relations, and that story continues on. China is, as of this week, no longer going to be considered a currency manipulator. We have 86 pages of detailed concessions on both sides, which mark up very positive headlines if you’re talking about how the news media presents it. And those headlines have been more positive than less positive over the last couple of months. And I think, of note, is the political mileage that has been gotten out of this.

Kevin: Yes, because it’s not that big of a deal. There are other things. And I want to talk about these as we go through the show, Dave, the other icebergs that are out there – a price earnings ratio that is above 30, you have more share buy-backs right now than any time in world history. Those types of things can catch up as far as maneuverability if something goes wrong.

David: Yes, the market mileage, you’re right, that has gotten squeezed out of this deal with China for the last six months has been nothing short of amazing. And Trump, I think, if we look at the last few months, has played a few very critical cards in the process of getting re-elected. The Iran move helps him, it does not hurt him. The China deal helps him, it does not hurt him. And if the right witnesses are actually brought in by the Senate, even the impeachment might help him versus hurt him in this election process. I’m beginning to wonder if the hairspray he uses isn’t actually some sort of a Teflon coating.

Kevin: It’s not just in America. Yes, everything seems to be a win right now, but if you look at how much money has been added to the stock market since the global financial crisis, it’s huge. We’re seeing trillions and trillions of dollars going – it’s a little like getting on the Titanic. No one is really looking at all of the other reasons why that shouldn’t be happening. The stocks are being gamed.

David: Yes, it’s a source of confidence, and I think the source of confidence, if you’re going back to 1912, was in the engineering, and I think there is an assumption that there is engineering that is just as quality today in the stock market.

Kevin: Unsinkable.

David: It really does not have to do with engineering, as much as it does with liquidity dynamics. The world’s stock markets have added 25 trillion dollars in value over ten years, and that was driven by the same dynamics in the same timeframe that has put 17 trillion dollars – that is what it was at its peak, now it is about 13 trillion – in bond values, to yields with less than zero in terms of their interest rates.

Kevin: And we have gone longer than ever without a recession, so is there a recession imminent or not?

David: The current economic cycle is the longest in U.S. history, and that does not mean a recession is imminent, just that it is unavoidable in the near future. And what makes this period of economic growth equally intriguing and dangerous is what we see from the central banks. They are, in fact, easing into a manic environment, and that is new. That is the opposite of prudent macro prudential market operations as they like to call what they do when they are pulling the levers. Prudent macro prudential market operations do not include easing financial conditions in a manic environment.

So I think history is going to end up being very unkind to the men and women in the central bank community who have preferred to extend this trend of growth rather than discourage excess. And so curving the manic behavior is that role that they should play. Instead, they are increasing leverage in the system. There was a Reuters article which recently pointed out that corporate America has issued over a trillion dollars in debt each year from the last decade. So what began January 1, 2010 to the present, corporate America has added 1 trillion dollars in new debt each year, taking outstanding debt 50% higher just in that corporate debt category.

Kevin: When we see parents who don’t discipline their kids because the child has a fit and the parent yields, a lot of times what we see is that child getting worse and worse and worse until ultimately there is a crisis. That child may even end up in prison because they were never disciplined. I look at last year, actually going back a year and a few months ago. In 2018 we actually started to see discipline coming back into the markets, the normalization of rates. From September through December of 2018, the stock market was like a little child that threw a fit, absolutely threw a fit, and that is when Powell completely did a 180.

David: And I think history is going to record that 180, early 2019, as a real pivot, and 2019 as a pivotal year, in total. As the central bank community looked into the financial market abyss there in the 4th quarter of 2018, they could not bear the uncertainty of possible outcomes.

Kevin: The fit the child was throwing.

David: Yes. And the outcomes were outside their control. And so easing of financial conditions was an issue once again. So, you have market participants who quickly forget that it was the Powell pivot in January of 2019 which set the context of growth for 2019. It was the catalyst for growth. It was not earnings growth, it was not sales growth, it was not revenues increasing.

Kevin: Well, he knew the growth was unsustainable. At the time he even said that.

David: Right. So prices were high and unsustainable a year ago. And I guess, what does that make them today? As Doug Noland pointed out in one of this week’s portfolio management meetings, behavior at a market peak is rationalized, and it seems perfectly rational to everyone who is involved.

Kevin: Yes, but doesn’t it seem crazy when you look back in the rear view mirror after the crash? You say, “What were we thinking?”

David: Only after, because bubbles are not marked by crazy people acting in a crazy way, but rather normal people, rationally engaging, and justifying behavior, which at the time seems perfectly sane. In retrospect, it may be perfectly crazy. But this is the benefit of hindsight. Here we are – the benefit of 20/20 perspective is that we will see 2019 as a normalization of speculative excess.

Kevin: But where is the inflation, Dave? All we have talked about all of my career here for decades has been, if you print money you’re going to create inflation. Is the inflation just showing up in the stock market? You talked about the machine. Has the machine figured out a way of printing money, funding things that we never have to pay the debt back for, and not having inflation. Sounds like cake and eating it, too.

David: I think it is helpful to look back 300 years on that particular question, because as we talked about, not long ago, with the author of a biography on Richard Cantillon, and he also wrote a biography on John Law, the Cantillon Effect is this idea that a policy is implemented, and only later, like honey oozing from the middle of the plate to the outer edge, you pour a small dollop of honey in the middle of the plate and it oozes toward the edge. And I think the inflationary effects have shown up first and foremost in asset prices. Does that ultimately become an issue in the consumer price arena? Following that model of the Cantillon Effect, I think it very well might.

Why do I mention Cantillon? Because this is the 300-year anniversary, 2020, of the 1720 debacle, the South Sea bubble, which was only a year after the Mississippi bubble, so we’re talking about events and an environment of speculation where actually, one country didn’t learn from the mistakes of the other. They saw the growth potential and wanted to mirror it. So Britain ended up duplicating the kind of bubble dynamics that they had seen in France. Regardless of the potential consequences, they just wanted a bit of that growth.

Kevin: Without going into detail, definitely google both the Mississippi bubble and the South Sea bubble. It’s a great lesson. But really, what it boils down to is just gaming stock prices.

David: We have ultra-low rates, and that has not created inflation in this timeframe, nor did it ramp up economic growth, and I think this is a really key thing to remember, the amount of accommodation that we have had over the last ten years. Yes, we have had a huge increase in corporate debt, we have had a huge increase in government debt.

What have we gotten for the indebtedness, this extraordinary sort of financial engineering? It hasn’t been massive economic growth, not to the degree that reflects the quantity and scale of the indebtedness or the interventions created, if you’re talking about the interventions of the ECB and the Fed and central banks who have been actively monetizing debt and allowing for the creation of that debt without much of a negative consequence, again, I would have to say, at this point.

Kevin: Yes, but if you owned real estate or stocks, asset prices have risen.

David: And they have risen in a very interesting way because typically we think of a balanced portfolio has having all three of those things – stocks, bonds, real estate, gold, cash. There is a variety of buckets that you might pour money into, and the interesting thing is that outside of gold, and even here in the last part of 2019, even gold seems to be correlated. Every asset has been correlated. And yes, real estate, stocks, bonds, have all benefited from this orchestrated compression in the cost of capital by the world’s central banks. They have deliberately taken rates lower and that has, not inadvertently, but deliberately, increased the value of stocks and bonds.

I was reading some notes from a recently released set of notes which have been under wraps from 2014, the Fed minutes, and Jerome Powell was pointing out that they were short volatility. He was just explaining the dynamics of what they were doing to intervene within the markets to control particular perceptions and outcomes. What do we have now, 2020? All of these orchestrated efforts have added to a squeeze in equities to the upside. Again, these are the policy choices made. And then there are the other issues of a shrinking number of investable names. If you look back at the last 25 years, the domestic listed companies here in the United States has fallen from around 7300 companies to right around 3600, so we’ve created a supply issue where there are not as many names to invest in, but at the same time, more capital to push into the investment markets.

Kevin: And if you’re going to game those stocks, if you’re really gaming the market, you also want to reduce the amount of shares outstanding. Smithers talked about that, how corporate boards and corporate executives can increase their bonuses by earnings per share by shrinking the amount of shares outstanding simply by borrowing money or taking cash from the company.

David: That’s a double impact of supply, not only a smaller number of companies, but as you say, corporate boards radically shrinking the number of shares outstanding. That creates a supply constraint, as well. So more capital coming into the markets, more capital created by the world’s central banks feeding into markets which have shrunk in size and scale, both number of names and supply of shares available has created really interesting price dynamics. And it has conveniently – this is the part that is galling, in my opinion – allowed management to extract the largest monetary haul of all time.

Kevin: How is it legal when you have so many other things against monopoly, what have you – how is it legal that corporate executives can decrease the amount of shares using company money so that they can increase their earnings per share and increase share price?

David: Honestly, I think it is how we framed this as a corporate governance issue, because what we have tried to do is set up things like total shareholder return and earnings as metrics for performance and compensation. How do you compensate a management team, an executive team for the “performance” that they are putting up? The measures would be total shareholder return in earnings. So those are the two biggest metrics, and honestly, I think history is going to be unkind to remuneration committees that have allowed publicly traded companies to be transformed into massive wealth generators, not for shareholders, but for the management of those companies.

Kevin: It’s no longer about what you produce, it’s no longer about your earnings, it’s actually about just making the share price go up.

David: Right. Again, I say it’s about framing, and the reason why this is not illegal and they can more than get away with it is because if you couch things in terms of total shareholder return it certainly seems like what you are doing is for the benefit of the shareholder. But these are the two primary performance measures off of which compensation to executives has been made in the past decade. There was a Cornell University study – it was a combined effort between Cornell University and Pearl Meyer – and the study shows that a focus on total shareholder return as a metric does not improve the operational performance of a company. So it just doesn’t help. And I would argue, if you go back to Charles Goodhart…

Kevin: He was a guest.

David: Goodhart’s law – when the measure, in this case earnings, becomes a target, which is what executives have basically said, then it ceases to be a good measure of progress. Or stated differently, the measure became something to gain. And so we have this combination of dividend payouts and buy-backs which, again, get categorized as “total shareholder return” but in fact, they serve, if you can hit the bogie on total shareholder return via buy-backs and dividend payouts then all of a sudden you’ve hit the trigger for increased executive and management compensation.

Kevin: Let’s just think about this with an analogy. Let’s say UPS, or the post service, a company that is paid to deliver packages no longer worries about how many packages they deliver, but how many rounds per minute their wheels turn. Well, if you’re paid by rpm’s versus packages delivered, at some point you’re going to realize that the system is not working anymore, but people are all focusing on the wrong thing.

David: Right. So is it any surprise that buy-backs are at all-time highs over the past several years, and dividends, as another means of expressing, again, total shareholder return, are also at record levels. Not in percentage terms. If you’re looking at the average dividend yield of the S&P 500, we’re not talking about record levels there, but in terms of total dollars outflowing from companies, return of shareholder value. And as we have pointed out in the past, we also have executive tenure with companies, which is falling faster and faster. So management has figured out how to tease investors’ interest with the promise of total shareholder return, while unlocking a vast fortune for themselves by gaming those metrics and not improving, necessarily, the future prospects for that company.

Kevin: So they squeeze the turnip and then they get out of Dodge.

David: So we go back to that Reuters article I mentioned earlier. The author asked the question. You have 1 trillion dollars in new debt each year being added to the corporate America balance sheet – 1 trillion dollars. And the question is, what did they do with all that money?

Kevin: They’re buying their own shares?

David: And the answer is they focused on returning capital, not earning capital, and that’s what the article gets to. Returning capital to the shareholder, not earning capital. So in 2010 the buy-back in dividend combination was a number around 60 billion dollars in aggregate for the year. Since then it has grown closer and closer to a trillion dollars each year. So here is the sequence. Boost the share price, unlock compensation. Sell stock as an insider from your stock-based compensation which is typically 50-70% of total compensation. Rinse and repeat. Then retire, or jump to the next gig and do it again.

So I think one of the flaws that we have in the capital markets today is that corporate management has begun to reflect a larger cultural issue which is narcissism and selfishness and short-termism all wrapped up in one. All the while you have the veneer of company performance which looks better and better as measured, or should we say targeted, in the earnings-per-share number. Companies are believed to be more profitable than ever because you’re shrinking the number of shares outstanding. Your earnings divided by a smaller number makes it look like you are doing better each year. That veneer is getting thinner and thinner.

So for our long-term listeners you might recall a really critical conversation we had with Andrew Smithers. He was pointing this out five years ago, that compensation structures and games played through earnings volatility was then a travesty, and it has only gotten worse since then.

Kevin: I’ll never forget that interview, too. There was a harp playing in the background, Dave. You were in Scotland, and you guys were obviously in a lobby when you recorded that interview. But I remember that because Smithers was saying, “Hey, this is going to catch up.” Let me ask you a question, Dave. Who do you think is going to get the blame when this stops working?

David: I thought you were going to ask me what my favorite Scotch was. The bar downstairs from where we sat had 400 different Scotches. Unfortunately, I was not able to taste that many. There are limitations to these things.

Kevin: You know, you would like this. Aaron Rodgers, quarterback for the Green Bay Packers, was interviewed by a gal named Erin, on Sunday after he won the game. She asked what he was going to do next, and he said, “I’m going to go home and I’m going to enjoy a glass of Scotch.” So even top athletes, I guess, are thinking the same thing.

So I’m going to repeat the question to you, though, because when you have something going on that is this distasteful that it actually feels like it should be illegal, at some point it is going to stop working and the mood is going to change, especially when people no longer have money coming in their pocket. Who are they going to blame?

David: Right. So this is where, if you’re adding to your library, the library of mistakes, so to say, then this is one of the things that goes into the governance section. And no, it is not ultimately workable. I point this out because when social mood shifts, there is going to be a broad range of issues that get put under the microscope and a variety of changes instituted via the legislative process. What I’m afraid of is that distinctions are not going to be made between the corporate cultural mistakes, again, as we’re talking about total shareholder return, the focus on that, and earnings as the metrics hit, that trigger increased compensation for executives and actually tilt, or, shall I say, malform the reasons why executives are managing their earnings the way they are.

Kevin: So do you think the blame will come down on capitalism and wealth, even if it had been earned in a different way, in a correct way? I bring this up because if you look during the French Revolution, Dave, you had a general consensus when the social mood changed, that it was the intellectual that was the person who had done this to the people. It wasn’t the King or the Queen, it was the intellectual. And I think about a chemist, Lavoisier. He lost his head. This was a guy who had quite a bit to offer the scientific community.

David: Did you say Courvoisier?

Kevin: You know, you’ve got alcohol on the brain (laughs).

David: (laughs)

Kevin: But famous scientists and intellectuals at the time who really were not necessarily part of the problem lost their heads, as well. And I’m just wondering, we keep thinking Trump probably is going to come back into office but there is going to be a mood shift sometime in America and there are people out there who have not played these games with the stock market, they haven’t rigged their corporate earnings and their corporate share prices. They are also probably going to be the target.

David: And I guess that’s the point. If the distinction is not made between corporate cultural mistakes and malfeasance and the general status of those with wealth, then I think there is some vulnerability between those that have, in essence, fleeced the public, or their investors, and those who have legitimately saved and invested through generations of time.

Kevin: If you want to look back at history, which I know you love to do, there is always a period of time where “squeeze the rich” is the word.

David: Right, so with the French it was Courvoisier, as you just mentioned.

Kevin: (laughs) I love “osier.”

David: (laughs) But Steve Hankey was on a program not long ago and in a recent article he penned he is discussing this sort of progressive conversation around wealth excess, and how, actually, the line of argument is very similar to that of Julius Caesar. So we go back to 49 B.C. and first there is an identification of concentrations of wealth, and then an implementation of a very aggressive “squeeze the rich” strategy in order to pay for everything under the sun for the average Roman. So there were monetary policy mistakes being made that were degrading the gold and silver currencies at the time, but there were also fiscal policy mistakes being made, and that supported his tyrannical rule.

So the theory was, shower the public with freebies as a means of gaining popularity, and then do exactly what Cicero was protesting at the time. You introduce legislation which would take private property, would cancel debts, and would basically plunder the well-to-do. So you have fiscal issues, you have monetary issues. As we’re sitting here, I have something that pops up on Bloomberg that says that Elizabeth Warren wants to bypass Congress to forgive student debt using executive action to offer $50,000 in relief for 95% of borrowers in that category. This is a playbook. First, blame the rich for all the problems of the world, begin the fleecing process, and then establish your voter base as very strong by giving as many freebies as possible.

Kevin: Bread and circuses.

David: Monetary problems, public policy uses and abuses of the law are as routine and common as the cycles of history.

Kevin: If we don’t think it can happen even here in America, think about what it was like flying, Dave, in the 1990s, versus after what happened September 11, 2001. The difference between the freedoms we had back in the 1990s as far as privacy and what have you, and after the Patriot Act, after TSA, I’m not saying those things were wrong, but there was a major shift, a social shift, as far as the expectation of what you can keep private.

David: In the early 1970s, I would say, it was not uncommon for people to travel on an airline with a firearm. Not uncommon at all. I know that in having conversations with my dad. In fact, as he headed off toward his honeymoon, his friends, just on a whim, said – I think it was a .38 or a .357 – “Why don’t you leave that here?” And as it turned out, he got to the airport and there had been a terrorist attack in Europe and security was up and he would have gotten in trouble in that instance because of the circumstances. But generally speaking, people traveled with maybe freedoms that we would today consider … are we even comfortable with? You’re right, things have shifted. The social mood has shifted, the desire for security in that regard has shifted dramatically.

Kevin: Our assumption of private property today may be a very different assumption of the social mood down the road.

David: Right. You mentioned that in all likelihood Trump will get elected. Nothing is guaranteed. So what version of Democrat do you want in office who has already, at least on the campaign trail, and sometimes policy implementation is different, either for the better or for the worse, when people come into office because there is a spiel which you have to tell to gain a voter base. And that voter base for particularly Sanders and Warren, to say it is antithetical to capitalism I think might be friendly. I think that would be a conservative and diplomatic way of saying it.

Kevin: So even if we don’t have a political shift, necessarily, in the presidency, we could have a shift in the mood. And so my question is, this bubble dynamic that has been inflated with artificiality – I’m going to go back to that. Is the free market going to take the blame, or is it going to be policy problems and Fed implementation of manipulation?

David: Right. And that’s the challenge. The challenge in our time is to carefully distinguish the governance missteps of the present, and you can include monetary policy choices and things in that same category, but which have led to the bubble dynamics and higher concentrations of wealth, distinguishing those things from healthy functioning in the free market. And it is not uncommon in the free markets, through the history of free markets, to have concentrations of wealth. That in itself is not problematic. That has always been the case. But the central bank policies which have accelerated those trends, exaggerated those trends, and then created the trade-offs and the timelines of interested parties, whether it is corporate America or elsewhere, that is not really free market, it’s not capitalism.

Kevin: Let me throw a wrench in this, though. We have a guest that comes on that always creates a flurry of comments. Richard Duncan, brilliant guy. He has written about the problem very well and if you want to actually see an analysis of bubble dynamics and how they are formed, Richard Duncan is the guy to read. Here is where it gets uncomfortable. Duncan is basically saying, “Look, we’re too far gone to not continue to do what Powell is doing now.” In other words, “Baby, keep printing money, keep doing what you’re doing, because you’re not going to like the outcome if you stop.”

David: No, he does a very good job diagnosing this morphing of the capital markets where you used to save capital, invest capital, and grow capital. So a part of the dynamic was excess income, living within your means, gives you savings, savings gives you capital, capital is what you invest, and that is how you continue to grow and see new change and innovation within a company.

Kevin: Duncan would love to be a capitalist, he just doesn’t believe it exists anymore.

David: Right. So that is what he chronicles, is this shift toward debtism where replacing savings has been the free creation of debt and financial instruments to stand in for savings. And so the system that replaced free market capitalism some time ago continues to exacerbate financial market excesses today. This is what Duncan describes as debtism and this system of debtism is precisely what Jerome Powell is defending. And I think this is a very pragmatic move, but we go back to January 2019 – he hasn’t created a philosophical defense of this. You go back to the minutes of things he was sharing with the Federal Reserve in earlier years – 2016, 2015, 2014, even looking at some of his private comments into 2011 and 2010, you have a guy who has a problem with expanding the Fed balance sheet, theoretically. And then there is this practical pivot. What happened that Jerome Powell is now defending a system of debtism? The January 2019 financial abyss which he stared into is the debtism end game which we can hope to forestall. And that is where Duncan would say, “We have to forestall because you don’t want to – you can’t handle the truth. You can’t take the pain. You don’t want to know what happens next.”

Kevin: And he may be right. It may be the end of the system if we actually stopped doing this.

David: Right. We don’t know, but that insecurity of the unknown is what is driving Fed monetary policy today, to continue to buy more time. This is not just a preference for unending prosperity. The current monetary and soon to be fiscal policy backdrop, this is one of desperation, desperation to hold at bay the consequences of too much debt. And also, to address the changed behaviors which are encouraged through access to the debt creation machine.

Kevin: As you know, we both live in a place where forest fires are the norm. You talk to the average top notch fire fighter and he actually would tell you that management of the forests would really be to let them burn and then let them recreate themselves. But the very nature of what they do for a living is to stop that process from happening because we build houses in those same forests.

David: Right. So we have a 21st century problem, and it is based on bad policies of the 20th century, which is, let’s manage for whatever we want, whether it is being able to settle where we want, or if it’s just we like the environment and we want these forests to be healthy and so we define healthy as let it grow, when for the firefighter you are saying, “Yes, but you’re giving potentially too much fuel to any flames that may flicker.”

Kevin: So, I’m just going to put you in a position. Let’s say that you all of a sudden are asked to be the Federal Reserve Chairman. Here you go. What do you do, Dave? You see all the problems, you understand it, you’ve talked about it every week for 11 years on the Commentary. And now, you are in charge of keeping the system from failing. I guess anybody would be in a position, almost, to have to kick the can further down the road.

David: I would like to say that I would stick to my guns, idealistically, and allow some of the hard medicine to – essentially what William McChesney Martin talked about. You just take away the punchbowl. That’s your obligation, to take away the punchbowl before the party gets started. Here we are three-quarters of the way through the party, and I remember Greenspan stepped in as an idealist gold bug. Next thing you know, he’s not much of a gold bug, he’s not much of an idealist, in fact, he is a financial markets pragmatist. And I don’t know, did he come in in the first part of the party, the second part of the party? At some point does he just say, “Look, the party is going.”

Kevin: That’s what Duncan says.

David: “I don’t want to be the party pooper.”

Kevin: And that’s what all these Fed chairmen, whatever their philosophies are before they get into the Fed. It seems to not matter once they get there.

David: Yes, because the punchbowl is about removal before it gets going. What if you’re halfway through? You just let it run its course? And then treat it with the hair of the dog thereafter so that you really don’t feel the full impact? Here we are back on this alcohol – what is going on today?

Kevin: I don’t know, but I do know this, Dave. We are not Fed chairmen, which means we’re not caught in this system. We are investors. We’re talking to people who can make decisions for their own money.

David: That’s right. And frankly, I don’t want to be a policymaker. I don’t want to be any part of that. What I want to continue to do and be is someone who is trying to figure out what happens next. So you’re right, talking about the over-management of forests – that includes the curtailment of natural fires, and we end up with disasters, big disasters, that cannot be contained because the management policies and the view to what it meant to steward that resource meant that you were disturbing the natural ebb and flow of the resource. And then you ended up with something where you just have too much fuel. Excess fuel for the flames. I’m not saying all management is bad, but you can have too much of a good thing, and I think that’s where you argue against the Fed at all, its existence, but it is what it is. It exists. And it’s not going anywhere.

Kevin: If you’re caught in the system as a Fed chairman, it doesn’t matter if you’re an investor. I just think about your house, Dave. I remember going and clearing fuel from your father’s house when a fire was threatening. We went and cleared fuel. You can do the same thing. You don’t have to build your house in a thick mass of trees, you can clear the fuel out yourself. I’m going to apply that to the stock market. Do you buy the stock market right now when its PE ratio is over 30? The Fed wants you to.

David: Right. The fuel has grown up around us.

Kevin: Do you feel like you have to go do that?

David: When we spoke with Ed Easterling, I think it was October of 2018. He does Crestmont research. We discussed the equity market valuations at the time. He used a similar metric to Andrew Smithers and Robert Shiller. We call it the Shiller PE or he calls it the Crestmont PE. He has a slight deviation from Robert Shiller from Yale. Basically, what it is is a less volatile measure of price-to-earnings, that ratio. That PE measure now is at 34.5, and is 135%, above its average, and now is at the 100th percentile.

Kevin: Isn’t the average about 14 or 15? Isn’t that what we should be at?

David: If you’re talking regular PE, I think it stands at 16, but again, this is this the Shiller PE, the cyclically adjusted PE, or the Crestmont PE? They all share a lot in common, they’re almost the same thing. We’re now in the 100thpercentile going back 14 decades – 14 decades. Where do you go from the 100th percentile in terms of valuations? So the current period is comparable to the levels reached during the tech bubble in 1929. That’s it! That’s it! So as an investor, again, we can second guess what Powell is doing, why he’s doing it, and I think he did look into a financial abyss, and his U-turn is absolutely, “We can’t go there because we don’t know how bad it gets, and how fast it gets to a very, very bad place.”

So I’m not criticizing him. What I’m saying is, there is this truism worth keeping in mind as an investor. We have to make decisions. This comes down to the brass tacks of how do we allocate assets? And you have to keep this in mind. Long-term investors know that there are periods of over-valuation which precede periods of under-valuation. And so you get these periods of out-performance, again, this truism – if you have a period of out-performance, it comes before a period of under-performance.

Kevin: Yes, but the costs basis matters. So if you buy something when it is overvalued, you are going to be a long time in breaking even, if you ever do.

David: And believe it or not, there are a lot of people getting started today. The process of allocation. Year-to-date you have had 8 billion dollars go into investment grade debt, 1.4 billion into high-yield – this is junk paper – 15 billion in fresh dollars, fresh investment allocations in the equity indexes. New money is just getting started. And again, you’re right, cost basis matters. You’re at a huge disadvantage starting at an all-time high. Cost basis, arguably, if you’re at an all-time high, cost basis has never been worse.

Kevin: And that’s why it was so interesting listening to Ed Easterling, reading his book, because what he said was, “There is nothing wrong with the stock market. There are only wrong times to buy.”

David: That’s right. So it’s a tough starting point for long-term investment returns. So flip that on its head. And this is where, again, you don’t have to be a perma-bull or a perma-bear, you just have to figure out where you are in that cycle. There is nothing wrong with the markets. Now, we could argue that there have been some artificial inputs that have exaggerated this trend and sustained it longer than is sustainable.

Kevin: Wait a second. I asked you to go back to 1912 with the Titanic example. Give me your favorite dates that you would have actually liked to have come into the stock market. Let’s say you could go back for the last 100 years, when would have been the times to actually go in and buy?

David: That’s one of the reasons why I love this market today because when you can define a market peak you’re awfully close to getting to…

Kevin: Your dream date, which is the date you can buy for cheap.

David: Which is a market trough. So by contrast to what we have today, if you started the process in 1921 – we had a recession in 1921. You remember Jim Grant’s book, The Forgotten Depression?

Kevin: A depression, but it was only 18 months long.

David: That’s right. They came in and cut the budget by 50%, and we came roaring back in terms of economic growth. So 1921 would have been a great placed to start.

Kevin: 1929 would have been a good time to get out. 1921 to 1929 – 1929 was the peak. When was the next time to come back in?

David: 1932 would have been a great time to be coming into the markets. And then you go through this period of depression, actually, 400% returns between 1932 and 1937, great gains.

Kevin: But didn’t they give that back?

David: This is the thing. Most people were just getting back to breaking even by 1953 because they had to play stocks for the long run game. They weren’t willing to take anything off the table, so they went through the market crash. And again, from 1929 they didn’t break even until 1953. Meanwhile, anyone who had dry powder and stepped into the market in 1932, by 1937 you’re up 400%. If you’re in mining stocks, Homestake, Dome Mines – they’re up 500-600%. They outperformed the recovering stock market by 100-200%.

So here is an argument to be made. 1944, you could argue that that is a time to come into the market. I would argue 1949 is an even better time, and that 1949 growth period up to 1968. 1949 because the government finally got out of the business of pricing assets. There were massive price controls through World War II, and so you really didn’t have a free market during World War II. Finally, government got out of the marketplace and you were able to see capital allocation happen on a truly risk/reward, normal basis. And then 1949 to 1968 was a great run.

  1. In 1968 you began to see things peter out, the consequences of the guns and butter policies. We talked about Cantillon earlier, you had fiscal and monetary mistakes being made through the 1960s which didn’t show up until 1973-1974. There was a delayed basis. Everybody with their head screwed on straight would have said, and did say, “I don’t think this is going to turn out right. We should be seeing inflation.” Didn’t see it, didn’t see it, didn’t see it. 1% became 2%, 2% became 4%, 4% became 8%, and that’s the nature of inflation – it doesn’t exist and then it does. And it gets there very quickly because a part of what you’re dealing with is a self-reinforcing cycle of expectations. When people expect it they reposition. It’s almost like a self-fulfilling prophecy.

Kevin: Don’t you wish you had heard some of these dates when you were younger, though, Dave? I’m looking at 1982. I graduated high school in 1981.

David: If you could have gotten a paper route, gotten a job, anything – live with your parents, stay in the basement for three years, from 1982 to 1985 and put 100% of your income into the stock market, you’re talking about the Dow-Jones Industrial Average being at about 1000 points. You do the math on that to $28,000 to $29,000.

Kevin: But that day is coming again. See, this is the important part of this commentary, don’t buy high when you know it’s high. Wait until it’s low and then buy.

David: I think that is a misunderstood element between what we do with Tactical Short, which by the way, Thursday the 23rd we have the next quarterly review. Doug and I will be talking about how the results were for the 4th quarter 2019 for Tactical Short. That is Thursday the 23rd and you can register at, and it’s at 4 pm Eastern. But don’t assume that we’re bearish. Yes, we have reason to be bearish at this moment in time, and when you look at the credit dynamics over the last 20-30 years you can see financial market excess that justifies a bearish position. But there are periods of time when it makes sense to engage on the long side.

And we are. On the MAPS portfolio strategies, we are, we just prefer real things because we do see the unintended consequences of policies that have been put in motion, and the fiscal policies which are going to be unfurled, not only by the Republicans if they win, but certainly by the Democrats if they win, maybe even in a more exaggerated fashion. If the Democrats win we see inflation on the horizon, and so owning hard assets makes a lot, a lot, a lot of sense to us.

So let me just circle back again to Ed Easterling and his comments because, again, long-term returns are unbeatable if you’re putting money to work – 1921, 1932, 1944, or if you wanted to argue, 1949 is even more ideal, or 1982 – the long-term returns are unbeatable. But if you’re coming in at market peaks, your long-term returns are going to be beat by everyone. That’s the easiest prediction ever. You are a guaranteed loser putting money to work at market peaks.

And so we just transitioned from December 2019. Here we are early January 2020. If you look back in time you have the tech bubble and this current rally in stocks, both of those have taken the Crestmont PE above 25, the cyclically adjusted price earnings ratio above 30. The only other periods that, whether you’re talking Crestmont, CAPE, Shiller, that have been this high are August and September of 1929. This is only the second time, ever, that we have gotten to a third standard deviation from the mean.

Kevin: But what I have found, Dave, is talking to people, they’ve seen this artificial stimulation working so long that they are thinking, “You know what? There is a transfer of wealth happening and I want to be on the winning side.” It’s gotten to the point where people will say, “Yes, you’re right. I don’t know when it will happen though, so I want to play.”

David: Exactly. And as I’ve spoken with investment professionals on both coasts, there is an expectation this year for a correction, 10-15%, big deal. A 10-15% correction, and then they expect to finish the year strong. So a strong 2020 finish for stocks, with an interim correction. Maybe that’s because of the trade deal.

Kevin: Are they playing to their employers, though? That is sometimes what I wonder. Their employer is the person giving them money to invest. If they said anything different they’re not going to give them money.

David: I think it is an implicit admission that they don’t have a clue. But it’s going to go down, and then it will go up. Just tell me what part of a crystal ball, if we’re talking about market pricing, that captures. Kevin, prices will go down, and prices will go up. I promise you, I will be correct.

Kevin: I’m not worried. You shouldn’t be worried. But they will go up, and they will go down.

David: Their hedging a reputational bet. That’s what’s happening, in my opinion, and they’re leaving the vast majority of committed money there on the table. They are in the market, right? When we think of bad market environments – we’re not talking about the textbook 20% correction that is categorized as a bull market. That is worrisome. But it is also a healthy part of the capital market’s ebb and flow. The big crashes have had extra accelerant added to the upside, and accelerant comes in several forms with the net result being increased incentives to speculate and ultimately ignore the long-term, focus on the here and now only, and not what could be negative consequences down the line.

Kevin: You brought up 1929. I think most people think of crashes like we’ve seen over the last 50 years, which is between 30-50%. Now, that’s painful, but 1929 was different, talking about an accelerant added to the upside and then an accelerant added to the downside.

David: I think it is important to remember that that accelerant, to the degree that it adds to the upside, that is a part of what precipitates further damage on the downside. So in the 1920s it was leverage. Leverage in the roaring 20s became an 80-90% market crash.

Kevin: Now think that through, you 401k owners, like me (laughs) – 80-90%.

David: You can live with less if you’re comfortable with ramen noodles.

Kevin: Dave, just ask the average person – I was talking to my ophthalmologist yesterday, a great guy and he’s studying right now, PE ratios, he’s looking at all of this – and he also understands that the market is real high. He was asking me questions about investing and I just told him, “You know, it’s good that you’re learning this because the average person you talk to, I’m sure most of the people whose retinas you are checking, are probably going to tell you, ‘Yes, I have a 401k, yes I think I’m in the market, it’s a fund called 2032 fund or something over at Fidelity, or Vanguard.’” Most people have no idea their vulnerability. That’s what I was telling my ophthalmologist, “You know what? There is nobody to buy this stuff. If anybody ever panics and actually starts to sell their 2032 fund, there is nobody to buy it, because what the heck is it?” They really don’t know just how exposed they are in the market.

David: Right. So, 1920s the accelerant was leverage. In the 1970s, getting past that 1949 to 1968 bull market, as things started to roll over, you had fiscal and monetary policy accelerant to the 1960s, both of those things, fiscal and monetary policy accelerant, gave you sort of the blow-off phase through 1968, and then ultimately, the nastiness of the bear revealed itself in 1973. Your market decline was about 50%, not as bad as the 80-90% in the 1929-1932 period, but 50% nonetheless. The new paradigm technology revolution brought us a bubble in tech which was also followed by an average decline of about 50%. There was more, in many instances, 80-90%.

But that was followed by the most recent bull market/bubble which was mortgage driven, which was government sponsored entity subsidized, that is, a debt-subsidized bubble leading to 2007, and on the other side of that we had 50-60% declines. This time is different. Again, as I have talked to money managers across the country, the only way to not get fired is to buy the favorite stocks, ride the bull, because under-performance relative to an index is not tolerated. That’s how you get fired.

Kevin: And the favorite stocks don’t necessarily deserve to be favorites. Look at cars. Look at Tesla.

David: Right. So when you have artificial accelerant, is it reasonable that you see even greater declines on the other side? Tesla is a great case in point, a $290 move per share in only a few months. The company now has a market capitalization of above 96 billion dollars – that capitalization is greater than if you took Ford and GM and combined them into one market cap. In fact, Tesla today rivals, as of this week, past the market capitalization of VW, which is the largest vehicle manufacturer in the world. VW delivered 10.6 million vehicles to the market last year.

Kevin: How many did Tesla deliver?

David: You want to guess?

Kevin: I don’t even know.

David: 367,000.

Kevin: Versus 10 million?

David: 10.6 million vehicles sold.

Kevin: For VW.

David: And they have a 93-billion dollar market cap. You now have Tesla at a 96-billion dollar market cap, and they have delivered 4% of VW’s, actually less than 4% of VW’s production. Part of the move higher has been short interest in Tesla which sees the vulnerabilities of the company, but you get on the wrong side of a short squeeze – there was 40 million shares short, and a good part of the recent move has been that short covering. Massive losses for those who got caught on the wrong side of that trade. The Tesla short interest is now down to 26 million shares, which at $535 a share is a chunk of change. It is almost 14 billion dollars, which is still short the market, which you could argue, “Hey, Tesla continues higher just on the basis of short-covering, because it certainly is not moving higher on the basis of earnings.”

Kevin: Well, Let’s just go to these crashes because we talked about the difference between a 30-40-50% crash, and an 80-90% crash, and most people cringe when they hear the word “statistics.” A lot of people who took business had to take statistics, and of course, you learn about derivations, basically, from the mean. And usually, there is a standard deviation, and then a second level of deviation, and then a third level which is almost impossible, but sometimes is reached. And that is when you get the big crashes. Most of those crashes we have talked about were just one or two levels of deviation away from the mean, right? At this point, are we not into the third level?

David: Yes, exactly. The majority of market peaks in the 20th century, again these were the peaks of the market, two standard deviations above the mean. So whatever the trend is, you are multiples above where that level is. Again, two standard deviations above the mean, to be at three standard deviations means something.

Kevin: The only other time was 1929, right?

David: The only other time was the tech crisis, because actually, 1929 only got to two standard deviations. So it’s a tough market because melt-ups don’t have a real calculus to them. They just go until they don’t. And as they go, they draw in more and more participants along the way, making a mockery of value investing, creating a backdrop which is conducive to even more speculation because nobody wants to be left out of the fun.

Kevin: Last week you talked about taking insurance out. We can usually see the temperature of the people, as far as how worried they are about us being three standard deviations out of the norm right now. Shouldn’t we be buying an awful lot of insurance in case something were to go wrong?

David: No, but see, that’s the spirit of the age, again, where confidence, just like that 1912 comment you were making earlier – nobody wants to buck that trend. Who would second-guess the greatest engineering feat to hit the waters – ever?

Kevin: Why even put enough lifeboats on the boat? Why even bother?

David: That’s right, because this was unsinkable, right? So several weeks ago we commented on credit default swaps, the insurance products that you can have against the default of your company or a decline in an index or a particular bond or what have you. Several weeks ago we looked at that and said, “Yes, we’re hovering at 2007 lows.” Again, the low price of insurance suggests that nobody cares to insure at these levels, no one believes that anything can go wrong. Everything is just perfect. Even Deutsch Bank – think about what a disaster of a company Deutsche Bank is these days. Deutsche Bank’s credit default swaps on five-year senior secured paper, 54 basis points above treasuries. That’s half a percent – half a percent. That basically implies zero risk of default with Deutsche Bank.

Kevin: Unsinkable.

David: Unsinkable. So when Doug Noland argues that people in a market melt-up appear to be perfectly rational it’s because they’re making choices in light of particular inputs that support those choices. If you said, “Where’s the stress and strain in the market, you could look at the credit default swap market and there is no stress and strain in the market. Everything is perfect.

Kevin: So here’s your time machine. I’m going to take you back 300 years, and you’re looking at massive profits in the South Sea bubble.

David: (laughs).

Kevin: It’s beautiful. And the government, itself, it endorsing it. It’s not just happening on the fly. The government, itself, has endorsed them as a monopoly. They’ve said this is how we’re going to pay our debts. Everybody’s playing. All the neighbors on your block are playing their 401k’s – 300 years ago, their 401k’s were the equivalent of these 2032 funds, except for back then, of course, we’re talking the 1732 funds, right?

David: (laughs) Yes, exactly.

Kevin: Whatever the case is, let’s just think this through. Everywhere you look, there is no worry, so why in the world are you listening to a commentary that is warning people? Why would you do that?

David: What I love, if you read the biography of Richard Cantillon, you see a man who engaged with the bubble, recognized it for what it was…

Kevin: And took his profits.

David: Took his profits.

Kevin: He got out of there.

David: And guess where he went? He went straight from the Mississippi bubble straight over to the South Seas bubble, and basically migrated his offices from Paris to London and made a second fortune. Because one thing he knew for sure was that there was going to be foolish behavior in the markets because nobody knows how to say no when they should.

Kevin: Right.

David: All they can say is yes to the prospect of future profits. And this is what is blinding about the world of money.

Kevin: Well, how long do you play that game with a lifetime of savings?

David: I know, I know. So this year we celebrate the 300-year anniversary of the South Sea bubble, which again, a year after the Mississippi bubble, I think, if memory serves me correctly. In retrospect, with 20/20 hindsight, I think we’re going to diagnose and critique crazy behavior. But in the moment, our own version of the bubble, whether it is Tesla or government bonds, all of this seems very rational, right? So if you’re looking for indications of concern – hey, here we are. There are none. All must be well.

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