The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: David, you’re finally back. Each year you go to a conference, a meeting of the minds in New York, pretty famous minds, I should say, like Bill Gross, Peter Singer, John Bogle, and you always come back, not only with guests for our show for the next year, but you come back with information that I don’t know that I’ve read elsewhere.
David: This year was unique in that I took my son. This was his first opportunity to go to this particular conference, and he marveled at listening to some guys who were worth a couple of billion dollars themselves and manage far more than that in the hedge fund world. And of course, his favorite part was not marveling at that, it was marveling at the African animals in the Museum of Natural History. He absolutely loves going there and we found a few minutes to scoot to the west side and go to the Museum of Natural History.
Kevin: It’s a lot like what your dad used to do. Your dad took you to conferences and meetings of minds 30 some odd years ago, when you were doing the same thing that your son is. I was talking to your son, Dave. He is nine years old, and he is fascinated, and he has been studying Greek and Roman history, and I know you guys went to the Metropolitan Museum and spent a lot of time there.
David: I remember when I was his age my dad would give me books that were way beyond my reading level and there were times that I was just lost in the vocabulary, and did not know what was being said because I didn’t know the words. Right now he is interested in Greek and Roman history and the Metropolitan Museum of Art has an amazing exhibit for both Greek and Roman history and artifacts.
So we went there, and I’ve given him a book, and told him if he can read this book I will give him 20 dollars. Now, this is a book that any adult would struggle through, simply because it is very detailed history. It’s not written for kids. It’s on Spartacus. He loves the story of the slave rebellion and what was happening at the time, and this particular period in Roman history and how it was already sort of past its peak, so to say. And so, it was fun for him to be able to see tangible evidence of this empire which has long been lost.
Kevin: And you’re giving him the experience of New York. My daughter lived there a couple of years, and when we go back it’s just a fascinating place. I don’t think I would like to live there all the time, to be honest with you. I love living out west. But there is something about the excitement. You have the subway, you have the street music, Central Park. You were there in the spring. Central Park is beautiful in the spring.
David: To me, the city is almost like a single malt Scotch. In small amounts, it lasts me a long, long time, and any more than that would just be wasted on me anyway. The subway, the street music, Central Park in spring. It really is a different life than what we have here in Durango and I’m glad he was able to see that. But also, the conference. The conference, itself, stretched his mind, things that we take for granted.
Kevin: Dave, you showed me his notepad. It looks like he was taking notes the whole time. Again, it’s nine years old that we are talking about here. When I was nine I was not talking about inflation, deflation, currency moves. At nine years old I can’t imagine he understood everything that they were saying, but the fact is he was interested, he was connected, he was digging in.
David: I just asked him to write down things that he didn’t understand, and so there were lots of little two and three-word things that he would write down. Emerging markets – what is an emerging market to a nine-year-old? Who knows what an emerging market is? So I drew a map for him of the globe and he started saying, “Dad, that doesn’t look like South America.” I said, “Well, listen, this isn’t art class. But the point is, let me demonstrate for you the difference between a developed and developing market – the older versus the younger, the emerging, that shows promise, and has reason, perhaps, to represent future growth, based on demographics, based on commodity, sales trends based on a whole host of things – technological innovation,” and it just opened up conversation.
And I thought to myself, this is really what we’re doing right now, a site project with a 40-part series dealing with economics, entrepreneurship and finance, investment, for school-aged kids. What I try to do at the dinner table with kids, and sometimes they get it, sometimes they don’t, on a routine basis, is something we have now begun to codify and turn into a curriculum for families to be able to say, yes, I wish that my kids knew the difference between macro and micro-economics, and I don’t know that I could explain the time value of money, but I’m glad that you have, in seven to ten-minute videos with sort of capturing and shrinking the world into something that, quite frankly, is going to be above the head of a nine or ten-year-old, but it will be perfectly suited for a parent to step in and say, “Let’s talk about this. We want you to have an advantage, by the time you’re 20 or 30 years old, to be so familiar with these concepts that making wise decisions in the world of finance is almost second nature because you’ve been thinking about this for a long, long time.
Kevin: And these will be the future leaders who, hopefully, will guide our economy a little bit better than what has been going on. Now, let’s pretend for a second, Dave, that I wasn’t at your dinner table when you and your son came back. Let’s say we were sitting at the dinner table and one of the people at the table says, “Give me an overview of the conference.” If you had to summarize, before we get into the points, I’d like to hear just what the overview would be.
David: Yes, there are quite a few data points that I do want to share, but just in broad brush strokes, the conclusion of everyone there was that equities are stretched. Central banks are committed to their schemes, and it is making value investing almost impossible. It’s a rarity today. There is a one-off investment that may or may not make sense in the fullness of time, but that’s a theme, that everyone is recognizing that value is hard to find.
Another thing that was a common theme echoed amongst the different speakers was that load duration in fixed income is where you need to be heading. What I mean by that is if you are looking at intermediate or long-term bonds you are on the verge of being crucified. On the verge – that’s a term that certainly has a near-term urgency to it, but the reality is, no one knows when, it’s just that everyone knows that it will occur, and that was the [unclear] voice, if you will, of the speakers there, that you want to be in low duration, that is, short-term fixed income, if you are going to be in fixed income at all.
Kevin: And Dave, everyone wants to know when – we know that you don’t know when – but on something like the bonds, or something like the equity market, it’s a little like having a time bomb in your pocket. You don’t know, necessarily, when it’s going to go off if you can’t see the numbers on it, but when it does go off, it is devastating enough to maybe decide not to put it in your pocket in the first place.
David: And I think that’s one of the things that was also echoed is that there are a number of huge directional bets that are worth considering, but again, the timing and the implementation is something that no one is really sure of. So, everyone looks at the equity markets and says, “Well, you should short them.” You just can’t short them today. “Well, you look at the bond market. You should short it.” You just can’t short it today. Do you want to own it, or do you want to sell it short?
There is really ambiguity in terms of what the action is, but everyone understands the context, and everyone understands that things are very catawampus, given the commitments that the Fed, the ECB, the Bank of Japan, and the Bank of England have made to float the world of assets on a sea of liquidity. So, another theme that they had was lowering risk in a portfolio, getting aggressive about that, and what did that look like? Almost without exception, the asset managers in question were talking about cash allocations of a minimum 20%, and in one instance, [unclear], as high as 62.5%.
The last time I sat with Mitch, Declan and I had a great conversation with him over lunch and he said, “The last time I was this high, in terms of a cash allocation, was 2008-2009, and I bumped my cash allocation to 50% because I was very uncomfortable with what I saw, and it was very hard to find value, so in the context of not being able to find value, I would rather sit in cash.” The fact that he has now gone well beyond the 50% mark, to having two-thirds of his assets under management in cash – one, it speaks to the integrity of his clients to appreciate that as a strategic move, and two, it speaks to the deep level of concern he has for the imbalances in the economy. And as I say, he is not the only one. There was a range of asset managers who thought – 20%, 30%, up to 62.5% in cash.
Kevin: I think it is important to point out, Dave, these are men who have made billions of dollars for clients, and themselves, in equities and in bonds, primarily, and these guys are stepping aside and saying, “No thank you, I don’t want to play with that much money.”
David: And it’s interesting, the guys who are in the hedge fund community seem to have a little bit more flexibility to do that than the guys in the mutual fund world, where being allocated according to your mandate requires almost 100% allocation all the time, minor divergence from that here and there. So there is a little bit more flexibility with a hedge fund structure, in part, because you have financial lock-ups, you don’t have access to your capital all the time, so they can “get away with it.”
Kevin: Well, let’s go ahead and start with someone who everyone has heard about. You see him on TV all the time, we know that he has made billions of dollars for himself and others – Bill Gross. What did Bill have to say? Did he kick things off?
David: You know, very little, actually. He had very little to say. I would say, of all the people that I was listening to, I know he is a man of high intelligence, I’ve enjoyed reading his market commentary for years while he was at PIMCO, and I still enjoy reading it now that he is at Janus, but the reality is, he came with something of a cluttered mind. He came with vague ideas, three or four things that he wanted to talk about, and he just kind of rambled about them. Again, I know he’s a man of high intelligence, but he was not on his game in this particular context.
Kevin: Do you think maybe it’s because he has pretty much designated the period of time that we are in, The New Neutral?
David: Well, to me, when he suggests The New Neutral, what he means by that is a low growth environment where we have so much debt today it’s going to be very difficult to see very much economic growth, or to justify very much growth in assets as a result of that.
But I would suggest, The New Nutty, instead of The New Neutral, because some of the things, the data points we went through, whether it was with David Einhorn, or Peter Singer, or David Abrams, John Bogle, Mitch Cantor, the data points that we discussed – again, this is exceptionally strange, and I think as I go through some of these things this morning, you will see, it is out of line with history.
Frankly, when you look at huge directional bets, and you look at major opportunities to make money, a lot of those come when things are out of line with history, and you have the high probability of mean reversion, in other words, something that is over-valued goes back toward under-valuation – the pendulum swings. And what I mean by mean reversion is getting back to some sort of midpoint of balance, or reasonable value.
Kevin: Right. Let’s just talk about growth then, because Bill Gross is calling it a New Neutral, low growth environment. I would say it’s not just a low growth environment, it’s a shrinking environment, because interest rates – I know that was one of the points you came back with – interest rates have been very aggressively lowered, not just in the United States, but worldwide.
David: Right. A couple of these data points come from a great research piece presented by their chief investment strategist, Michael Hartnett. Since Lehman collapsed, global central banks have cut interest rates 569 times. That is the equivalent of once every three trading days.
Kevin: That doesn’t sound like a healthy growing environment to me, Dave. You’re cutting rates to restart the economy.
David: It’s not normal behavior. To have a rate cut here or there to stimulate growth is one thing, but again, on a global basis, central banks all over the planet, 569 times, which is the equivalent of once every three trading days, that would be described as sort of an incubation period. If you wanted to grow hothouse tomatoes, you know what you do? You increase the odds of success by giving more water, giving more nutrients, giving more sunshine, and you keep it in a hothouse so that the tomatoes grow faster and faster and faster. That is what we have tried to do with these 569 rates cuts. Then, nominal GDP growth. Here in the United States we have had an average growth rate per year, since World War II, of 6.6%, but for the last seven years, it has declined to 3.5%, with last year – of course the first quarter is going to be a little disappointing, but last year, 2014, it was about 2.4%, so we’ve been coming in below.
Kevin: GDP is shrinking, and we’re lowering interest rates 569 times.
David: That’s right. So, it’s no surprise that there is sort of a mismatch. For instance, U.S. equity market capitalization has grown 122% in that same timeframe, while GDP, in aggregate, has grown 18%. Now, think about the mismatch there because the economy is growing, in aggregate, during that period of time, 18% total, but the stock market, in aggregate, market capitalization, up 122.
Kevin: That sounds like a bubble.
David: What it means is that for all the monetary mechanisms in place, it’s not translating into the real world economy. It’s translating into the asset economy, if you will, or the financial economy. Now, you have central banks, on a broader scale, including the United States – central bank assets have grown to 22.5 trillion dollars. That’s greater than the combined economies of the United States and Japan – 22.5 trillion dollars in central bank assets.
Kevin: They had to go in and buy those assets, otherwise those assets would have faced default. In other words, they are going in and intervening.
David: That creates an artificial price for those assets, because they are, in essence, an artificial buyer. They are not the normal buyer, in terms of markets where you see buyers and sellers in queue. These are extraordinary actions taken to create stabilization, but it is also something that is very difficult to unwind. Once a central bank owns 22.5 trillion dollars in assets, it is going to sit on them forever, or is it going to liquidate them. And the odds are, they are stuck with them, because to liquidate any part of 22 trillion dollars in assets, you are talking about hammering the markets, driving them considerably lower.
Kevin: These markets, they are shrinking already. A lot of these interest rates that have been lowered, they’re not just lowered to zero, they’re negative.
David: Right. And the total is staggering – 4.1 trillion dollars in global debt which has a negative yield. Negative yield – in other words, you pay to own it, versus being paid. You thought the way interest rates worked, you give someone a loan, so to say, and they return your principle with interest. In this case, you are paying for the privilege to loan money, which is a little bit odd, but that is the state of affairs – 4.1 trillion dollars in global debt which has a negative yield, and you get 52% of all government bonds globally, which yield 1% or less.
Again, if interest rates are an indication of risk, interest rates should be somewhere between 2% and 5%, maybe even 2% and 7%, depending on what country we are talking about, and here we are with half the world’s government debt at 1% or less. Something is awry, and there is a correlation, there is a relationship between government bond yields and central bank assets. They have driven those prices down artificially. But it has also created a number of other mismatches we will talk about.
Kevin: You talked about the stock market, but let’s face it, over the years that we are talking about, has it been worth the risk being in the stock market.
David: I think that comes down to, at least, at this juncture, knowing how much longer a bull market could last, and how much farther, in percentage terms, it could run, and in terms of duration, and in terms of the total return in this current bull market in equities, the conclusion at the conference was, looking at those numbers it does not suggest significant upside. And that is a quote. That is a polite way of saying it isn’t worth the downside risk to step into the stock market today.
Kevin: And all of these guys were players back during the tech stock boom. I remember, IPOs, these initial public offerings, were the biggest – it didn’t matter what the company was back in ’98 or ’99, it could have been a sock puppet company, which, there was one – these companies didn’t have any profits, but the IPO would skyrocket.
David: You find that when you get into manic stages in any asset class. For instance, in the 1970s and 1980s, when gold was going from $35 to $875, a 25-fold move, you had companies with the name “gold” in them, although they were not in the gold business. In fact, one of them was a bread company. You had their shares tripling and quadrupling in value because people were buying blindly. Again, it is an indication of manic behavior. It is an indication of what is ultimately unsustainable, but in the immediate, carries and creates its own momentum. Like in 1999, 80% of current IPOs, that is, initial public offerings, are coming to market as unprofitable companies.
Again, a parallel between now and the market peak of ’99, these are companies that are being represented with a great future, but they are not time-tested, and they are not actually even paying their bills. So, what you see with companies like that is, they go through rounds of funding, and raise 5 million dollars, which gets the company started. But they are not making any money, so they raise 50 million dollars, and they keep the company going a little bit longer and create a new business and bigger, better plan for success into the future. And then they raise 300 million dollars. And then they go public, because some day they are going to make money, and when they make money, you are going to want to own this company.
IPOs of this sort are typically – not always, but typically – a way of fleecing the general public of their savings, and redirecting capital from entrepreneurs with creative ideas which don’t always work from savers’ assets which they have worked – blood, sweat, and tears – to set aside. To me, it’s a tragedy. And there is nothing wrong with IPOs, right? Kraft came public many years ago, and here recently was merged with Heinz. There are reasons to own IPOs.
Kevin: But let’s face it. We do eat macaroni and cheese, and Heinz sells ketchup. They had profits.
David: You’re talking about real products, real profits, real cash flow, and a repeatable business model – 80% of current IPOs coming out are unprofitable. Again, it’s just a sign of the times.
Kevin: We’ve talked about government bonds, we’ve talked about equities. How about corporate bonds? Corporate bond issuance right now has been very, very high.
David: Yes. And if you look back and compare the 2006-2007 period, corporate bond issuance was aggressive then, hitting new highs of 700 billion in that stretch of time, and 28% of that debt was rated a very weak B rating, so the minority of it was B rated. Now you fast forward to 2013 and 2014, and we’ve bested those numbers. You have 1.1 trillion dollars in corporate debt issuance, and 71% of the total is now rated at lowly B status.
Kevin: Almost three-quarters of the debt is B rated or lower?
David: Yes. So, you have 50% more debt, a much higher percentage of it is at lower credit quality. This is massively problematic. Of course, a low interest rate environment enables this kind of activity. It is sowing the seeds for the next and greatest financial crisis. In the same 2006-2007 period, you will recall there was a lightening up of expectations. At one point you just had to fog a mirror to get a loan. Well, 20% of the debt issued in that period of time, 2006 and 2007, was issued what they call “covenant light.” In other words, with very little skin in the game, with very little ramifications, and with very little call for assets in the case of liquidation.
That was then, prior to the crack-up of the global financial crisis. Now, you have 60% which is covenant light. And don’t forget that nearly 600 billion of the new debt was used to buy back stock at extremely high prices. To add to that, you have corporate debt globally, which is growing at about four times the previous rate. So, if you look at 2000-2007, at what rate are they accumulating debt?
Well, from 2008 to the present, it is increasing at about four times the pace. Is that because interest rates are low and they are doing a smart financial thing to take advantage of low rates? Maybe. But taking on that stock of debt, you have to pay it back at some point. And it is one thing to move it and increase your cash position, to be able to grow and expand your business, but to take it and sink it into an asset that has volatility, like your own shares, and to be paying near the all-time highs for those shares, seems the epitome of foolhardiness.
Kevin: But we do have a precedent for debt like this, Dave. We have just passed through a century where there were two devastating wars, World War I, World War II, and you do, in an emergency, see countries go into debt to the degree, I believe, that we are seeing right now. We don’t have war-like scenarios. What we are seeing right now is just trying to bail out an economy that wants to sink into a depression worldwide. But what would you say about that? Where are we level-wise? This feels like war-time kinds of debt.
David: That’s why I would describe this as nutty – The New Nutty – because this is without global conflagration in the picture, and we have debts in the developed world the equivalent of what we had in World War I and World War II, relative to GDP, in most of your developed economies. And why do I call that nutty? Because we needed to – we needed to – borrow the money to finance the war efforts. But now we’re doing it because we want to, because we can – because we can. And that is, frankly, the kind of bad judgment that comes into play when rates are dropped to nothing. The cost of capital, when you lower it to zero, encourages all kinds of nuttiness. And it is no surprise, whether it is corporations or governments, they are all doing the same thing.
Kevin: It is very ironic, Dave, that we’re going into war-time type of debt, and we’re actually seeing, we’ve talked about this before, an increase in what we would consider the war cycle, a return of the war cycle. Yet, our armed forces are being dropped to pre-World War II levels. So, isn’t it strange that we are decreasing our military at the same time that the risks are increasing?
David: It is axiomatic that when you have weaker global economic growth, you are going to have increases in tensions and geopolitical risk and conflict. Why is that? Again, this is dealing with human nature in the way that politicians deal with social pressures and political pressures. But as you begin to see a deterioration of the economy, there is a series of blame-shifting events which occur, and some of those include looking across the border to your neighbor and saying, “Well, it’s their fault.”
So, the French may blame the Flemish, the Austrians may blame the Germans, the Germans may blame the Spanish, the Italians may blame the Germans, the United States may blame the Canadians or the Mexicans. There is a blame-shifting which occurs, and politicians are only too keen to preserve their own political legacies at the fiscal expense of a nation, and that is tragedy, but is it also human nature, if you see that very few people take ownership of mistakes that they have made, and are certainly willing to kick the can down the road.
So, you are right, the funny thing is, we are at pre-World War II levels, in terms of our U.S. armed forces, so at the same time there is a greater potential for geopolitical conflict, we are shrinking our armed forces considerably.
Kevin: I’m sure part of the reason for that is that the federal budget goes elsewhere. The federal budget is huge, you can see why some people would believe we do need to cut back the armed forces.
David: Right. Well, the problem is, you will find new things to spend it on, unnecessarily. There is never a dollar created the government didn’t want to spend. In fact, they will spend three or four that they don’t have, knowing that they can print it, or just finance it cheaply. The 2015 budget pencils out at 3.7 trillion dollars, and that is government spending, which is greater than the entire German GDP. It is on such a massive scale, you say, “Well, we could certainly find some things to cut.”
Sure. You know what? I think that we should have means testing for social security. In other words, if I make $150,000 a year, why should I be collecting social security? Why? If I make a million dollars a year, why should I be collecting social security? You realize all we’re doing is enslaving the next generation which has a demographic deficit to begin with. There are not enough people, working age, to support the retiring class. The graying age, if you will, the graying generation, 11,000 people per day moving into retirement, there is a whole bunch of those people that won’t like to hear this, but the reality is, we have dramatically shifted emphasis.
If you think about the number of tax dollars that are spent on an aging generation versus what we spend on a younger generation, even for education, our education budget pales in significance to our Social Security budget. I appreciate Social Security, I appreciate what it represents as a safeguard, as a safety net, but understand that this is a major problem.
Kevin: The net has holes in it that everybody just tries to ignore. They say someday those holes will show up. Dave, I don’t want to distract. Let’s go back to some of the points that you brought from New York.
David: Again, it’s just example after example of nuttiness. This is not normal, and we shouldn’t accept it as normal. As an investor, you should know that this is not only unprecedented, but unsustainable. In the Bank of England’s 300-year history, the base interest rate has never been lower than it is today. And of course, again, connecting the dots, perhaps that relates to London real estate having quadrupled in the last 15 years. You lower rates to zero and people do what with free money? They go bonkers with it.
If we borrow from Rogoff and Reinhart, history shows that debt defaults start to rise initially, and then that is followed by inflation. And looking at where we are in terms of the trends since at least 1900, yes, defaults are expected to rise globally, if you want to look at Venezuela, certainly Russia, Ukraine, there are half a dozen to a dozen different countries that are moving into high-probability default, maybe even Greece this week, next week, by the end of April. We have these tensions and pressures, and it is typically, according to Reinhart and Rogoff, symptomatic. Defaults precede inflation.
Just as an aside, U.S. equities, another point from the conference. In real terms, that is, when you net out inflation, the U.S. equity markets are still 4% below the peak we put in in the year 2000.
Kevin: That’s if you factor in inflation that the government tells you is inflation, which is already understated.
David: And so, what’s fascinating is, if you go back to 1871 – again, this is from Michael Hartnett – going back to 1871, looking at the S&P 500, the largest 500 companies in the country, it has had a negative real price return nearly one out of every two years. About 50% of the time you’re losing money, in real terms, because again, inflation is a huge factor in terms of what you’re getting. So people feel like, “Well, 18,000 on the Dow, this is fantastic, we’re in recovery mode.” Just understand that, not only has the majority of growth in the last century been attributable to inflation, but the majority of the growth since the year 2000 has also been attributable to inflation. The better part of a century’s price gains were not organic growth.
Kevin: They were actually paying back government debt through inflations. That is the bottom line. You have an inflation so that your debt becomes cheaper over time. You were talking about the stock market, though, Dave. You were talking about equities, people excited that they have reached $18,000, but the amount of money actually in equities – it has not even reached 2000 levels, has it?
David: We’re right here, in terms of world equity market cap, that is, all of the world stock markets combined – 70 trillion is about what you have in global equity markets, which is right about where you were in 2007. Now, it has been a disproportionate gain for the developed world because emerging markets are still roughly 26% below their 2007 levels. Again, the dominant theme has been developed world recovery. That’s where our central banks have been printing the most. Now you have, in lockstep with that, a rise in the dollar, which is tightening a noose on emerging market economies, as you draw liquidity out of those economies and financial systems into the U.S.
Kevin: It’s intriguing to me, Dave, that we are already at very low interest rates here in the United States, yet the dollar has been continually rising against these other currencies. And ultimately, that causes great tension in the rest of the world. It can create inflation outside of our own country.
David: It’s a little bit like water displacement. If you take a solid object and push it into a cup of water, what happens to the level of that water? It rises because of the displacement. When the euro goes down, the dollar goes up. Is that a strength story for the dollar, or is it really commentary on something being depressed in value and naturally creating a buoying effect, if you will, a rising level, just like you would in the liquid? The U.S. ten-year treasury hit a 220-year low of 145 basis points. That is 1.45% in July of 2012.
Part of the reason money is coming back to the United States is because you can go elsewhere and pay to have your money with someone else. In other words, if you are in Denmark, you are paying money to sit in Danish bonds. You’re not receiving money to sit in Danish bonds. Or you can go to a ten-year treasury in the United States and actually make 1.5% to 2%. Believe it or not, as low as our rates are, having hit a low July of a couple of years ago, a 220-year low, we still are significantly higher.
Kevin: How can Yellen raise rates, then? Let’s face it, we’re lowering rates and the dollar is still going up.
David: It will attract a lot of money and it will end up driving the dollar higher on that basis. But the question is, can she do that? And that remains to be seen.
Kevin: I guess we could always invest in the Italian bond market. That’s just a bastion of safety, historically.
David: Well, goodness gracious. Italian bonds, French bonds, they call the ten-year French bond the “oats,” and I just imagine this donkey, this ass, with his head in a bag. They call it a nose bag. I can’t help but think of the ass in a nose bag when I think of French bonds. Sorry. And maybe that is the person who is going to French or Italian bonds today, the ass with their nose in a grain bag. It just doesn’t make sense that you would look at Italian ten-year bonds and receive 1.5% because that’s what they are today, and assume that that is normal, healthy, or safe. Because, look, it is QE, it’s coming from the European Central Bank that drives yields that low.
This is, I think, where people are very, very short-term in their thinking. You are not appraising risk. You are looking at yield only, and again, I guess 1.5% is better than zero. But at what risk? Literally, in a three-day period, you can walk away from three years’ worth of income in an Italian bond. The volatility in those kinds of bonds, you have no idea. You assume liquidity. You assume that you can sell. Good luck with that. There are so many times in the marketplace where you have zero liquidity. I could go on and on, just observations that, quite frankly, I found refreshing in the context of some of the smartest money managers in the world, and granted, they’re managing small pockets of funds, they’re not managing things that are generally available to the public.
As a qualified institutional investor, sure, a number of these guys manage funds that they closed down years ago because they don’t want to raise any more capital, they don’t want to raise any more money. Why? Because it is difficult to operate in the market effectively if you have a larger and larger footprint. So, that’s operating with integrity, I appreciate that.
Certainly, one of the big questions was, how does an era of excess liquidity come to a close? Because look at this. Everything that we have just been discussing, every one of these data points, is at an extreme because of the excess liquidity in this particular era. You can say, okay, it’s all going to go the other direction. Maybe, but at what political cost? How do you reshape the world in terms of policy and politics and geopolitical relationships in the context of mean reverting? We’re talking about equity markets that in 2008 and 2009 went from about 70 trillion to less than 35. They got cut in half.
Kevin: And now we’re back up to about 70?
David: Exactly. You can see mean reversion very quickly – very quickly. And what are the consequences? Well, the consequences next go-round may be even more severe from a political and social standpoint. Why? Because the central banks have already used all their ammunition.
Kevin: Dave, let’s put this in context for a second, because I think of Declan, your son. When you were Declan’s age, or just a little bit younger than that, the dollar was worth 1/35th of an ounce of gold. Just in your lifetime, Dave, the dollar has gone to 1/1200th of an ounce of gold.
David: I think the real critical thing there is that we are talking about the definition of money. We don’t define money in terms of gold today, but we always have.
Kevin: But that’s the price of money.
David: Just as we are talking about extraordinary data points which reflect complete and total imbalance and an unsustainable course, what are we talking about here? The definition of the dollar was 1/20th of an ounce of gold. And then in ’33 it was devalued to 1/35th, by official dictate, 1/35th of an ounce of gold. And here we are looking at an environment of managing price stability. We now have a 100-year track record of the Fed doing their job, “managing price stability,” and if we define the dollar, as it always has been defined up until the ’70s, how are they doing? We’re now 1/1200th of an ounce of gold. Talk about a radical devaluation of our currency.
Kevin: Let’s face it. We’re on our way, at some point, to 1/1500th of an ounce of gold to 1/2000th of an ounce of gold, on and on, and on, because they continue to print dollars, and that’s the bottom line.
David: They haven’t changed their tune from 1913 forward, but they have ratcheted forward the aggressive nature of their policies in light of crisis, and we think they have basically created a permanent footprint in the financial market. The Fed and the financial markets are today married, and unless there is some sort of a forced divorce, we have a very different world today.
Kevin: Something that you focused on in the last few months, actually, the last year or so, is corporate buy-backs of their own shares. It’s a way of stimulating the stock price, it’s a way of stimulating, actually, the earnings per share, but it doesn’t necessarily show the actual health of the stock market, does it?
David: No, it doesn’t. Interesting Financial Times article this week. We’re on target for 1 trillion dollars, buy-back and dividends, for this year, and it was interesting. An analyst described it this way. Positive description. I quote: “This represents perpetual synthetic growth,” (that is how it was positively described by one analyst) “helping support secondary market demand.”
Now, what is interesting is, in this article, this trend is healthy in their view, and it is supporting demand for equities, but there is another analyst in the same article that says, “If they stop buying back shares, it’s not going to have a negative impact.” So, it will help you if you’re doing it, but it won’t hurt you if you’re not doing it. Does this make sense? This is the kind of talking out of both sides of your mouth that is an exploration of how we justify where the stock market is today, using any and every means.
And yes, it is very clear that buy-backs have gotten us here, but it is very disingenuous to imply that the relationship doesn’t hold moving the other direction. And it does hold. So, we circle back around to that idea of synthetic growth. What is it implying that this is the means by which growth is captured? Any thoughts on the real economy? Does that factor in? Retail sales, credit expansion, ex-government, corporations? We’ve already said that corporate credit expansion was half-directed at swapping debt for equity, and what we are talking about here are the buy-backs.
We don’t have real growth. We have interest rates the world over – we mentioned the Dutch at 500-year lows, the British at 300-year lows, the United States at 220-year lows. We couldn’t be at 500-year lows, or we would be if we could be, but we’re too young a country! You have to go back to Europe to find new records set at half a millennium. Do you think this is odd? Do you think this is unsustainable? Does the pendulum swing the other way?
Just to summarize what we concluded from this conference, whether it was David Einhorn, or David Abrams, Bill Gross, John Bogle showed up, Mitch Cantor, Jim Grant. The conclusion was not if, but when, and it’s difficult to judge when, but when, we are talking about the big kahuna. We’re talking about major moves. And is that six months from now, six days from now, or two years from now? I think there is a growing number of people who are recognizing it’s not different this time. It’s going to end as poorly as it has ever ended. Credit expansion, credit excess, lead to credit bust, and there are implications for that.
So, we have the same kind of declining economic statistics, not only in the United States, but in China, further deterioration of the recent Chinese import and export data – what are the knock-on effects? The Canadian dollar, Australian dollar, New Zealand dollar drop lower. They are now at 2009 levels. The last time we saw these currencies at these levels we were in the worst phase of the global financial crisis.
My question is this: Are the commodities markets, are the currency markets, already telling us what to expect in terms of market volatility? Meaning? Translation? Are we on a similar course, immediately ahead, for the equity and bond markets? And again, how? When? The thing here is, if you’re even partially right, you’re going to be right as rain. Do you see? The decline of the import and export numbers turned China’s expected trade surplus from 43.8 billion into a trade surplus of a mere 3 billion.
Kevin: And that’s such a big difference. We talked to Dr. Malmgren last week. She talked about what she called the perfect circle, how China was able to grow the way they were because we were buying so much of their goods that they created, and then they would loan us the money back, but that perfect circle is not only being broken in that China is starting to work out other ways of getting paid for things other than the U.S. dollar, but also, their growth is slowing. They’re not the perfect circle anymore for us. And we’ve never experienced that. In your and my adult lifetimes, Dave, we have never experienced a slowdown in the engine that was actually fueling our economy.
David: The chart of the week is Chinese GDP growth expectations set next to the Shanghai stock exchange. And Chinese growth expectations, economic growth expectations, are in this nasty little downtrend, moving from the left to the bottom, bottom right of the chart. Meanwhile, the Shanghai Stock Exchange is moving parabolically to the upper right-hand corner of the chart. Explain to me how this actually makes sense. And I’ll tell you, it doesn’t, but you get to ignore the implied hard landing.
Think of this. The import/export numbers are off. Yes, it tells you something about who the end buyer is and their desire to own Chinese goods, but you are also talking about domestic demand in China which is also weak in terms of the import numbers. Look at this. Stocks are up in Hong Kong and Shanghai, like 12-15% in one month. So, you have the joys of speculation and leverage and monetary policy gone wild, and that is the reason why you can excuse and ignore what appears to be, again, the implied hard landing, the import/export buyers.
Kevin: Let me ask you a question. We saw a couple of months ago a very important peg to the euro get broken – the Swiss. It is very expensive to peg your currency to another’s currency, and you lose control, frankly, of your own monetary policy. Now, with what is happening with China, are we going to see that peg go away with the currency?
David: That’s an interesting point, because again, you’re looking for things that would change the direction of not only one, but many markets. And we’ve talked about the exchange rate mechanism, what happened in 1992 when George Soros was betting against the British pound. The interesting thing is, he was betting against a relationship that couldn’t be sustained. The Germans wanted to manage their fiscal policies in a certain way and monetary policies in a certain way, and they were tied to the British pound, and so you had an increase in rates in Germany which didn’t match up with the same kinds of policies in Great Britain. Ultimately, two parties at odds separate. And they did.
So, you look at what we have. Yes, you’re right, defending the pegs, the Swiss National Bank did it. The Danish now are trying to sustain it, and the question that you are assuming, that you are asking, that you are suggesting is, with the People’s Bank of China, they’ve been tied to the dollar. And, it has been in their interest to be tied to the dollar as long as we are the buyer of last resort for every trinket and bottle on the planet. But there is also a cost. The rising value of the dollar, having the RMB, the renminbi, tied to the U.S. dollar, means that, yes, they may continue to sell to the United States without losing an advantage, but they are now losing a trade advantage to the rest of the world, whether that be Japan or Europe or everywhere else.
Kevin: As the dollar rises, their goods are not any more inexpensive than something made here in America.
David: That’s exactly right. So, they’re compromising their trade competitiveness with the rest of the world by being tied to the U.S. dollar. What are the ramifications of taking that peg away? It is very interesting to consider – as you know, I keep a journal of various trades and investments I’ve made, some of the winners, some of the losers, things that over 15-20 years have made sense, and things that seemed to make sense, and in the end didn’t. And I like reflecting on my mistakes. It’s a good way to learn from them. It adds insight for future decisions. And I’m writing down my assumptions, and I’m writing down the variables that were in the economy, the things that I had to go on at the time. And I’ve looked and said, “Okay, what are the biggest mistakes I have made in recent years?”
Kevin: You know, most money managers won’t talk about that. Most money managers are not going to come out and say, “These are the mistakes that I have made.”
David: I look at the assumptions, always, and here is a list of the possibilities, of the biggest mistakes that I have made. I have assumed that free markets would continue.
Kevin: And especially the last two to three years, we don’t see free markets.
David: Not particularly. But here is the problem with assuming otherwise. You must assume that free markets continue, even if there is a temporary hiatus, we have the extremes of equity market and bond market highs. Yes, they are supported by lingering central bank emergency measures. Yes, there is a general distortion across asset classes via the control of prices, that is, via our central bank community.
So, here is that issue of the free markets. Even in the period of the 1940s, where we went to a complete command and control economy, it was temporary in nature. There hasn’t been a period of time, ever, when the free market quit working. Even if you went to communist Russia, in the Cold War period, there was still a free market operating. Do you know what they called it? They called it the gray market. They called it the black market. People looked at the system and said, it’s just not in our interests to play by the rules because the rules are corrupted, and we have to do something to, A) survive, B) feed our families, C) move forward in life. And so I look at it as something very temporary in nature.
Could it last ten years, could it last fifteen years, could it last 20 years? I don’t see the dynamics being even remotely similar to what we had in communist Russia compared to what we have today in a command and control environment. So that it happens is no surprise. That it could be perpetuated without causing concern is very surprising to me. So this notion of free markets and clamping down on them, I am surprised that no one is concerned about it and everyone has moved to treating it as if it is normal. So, here is an area where one of my assumptions is temporarily completely wrong.
Kevin: Right. And Jim Grant – I just read Jim Grant’s comments on what you are talking about, how long can they perpetuate it? And he said, really, the policies are being put forward, especially by Yellen, right now, as if there will never, ever be another bump in the road. And he said, “Once there is a bump in the road, we’re going to probably see the return of real pricing.”
David: Yes. Doesn’t that harken back to Mike Tyson’s comment? Yes, we’ve got a plan, Yellen has a plan, Tyson has a plan, everybody’s got a plan, until you get punched in the face. Then it’s all out the window.
Another thing that I assumed. This makes the list of possible mistakes. I assumed that the destabilizing effects of debt which we experienced in the 2008-2009 period would suggest to investors that adding more debt to the equation would further destabilize global finance and not fix the mess. I assumed the people would be looking at this and saying, like being exposed to radiation and getting cancer from it, and then voluntarily stepping in line and saying, “But I’ll take a little more dose to see if I can cure the cancer.”
Well, maybe in certain areas of medicine that makes sense, but generally, applied to the world of finance, if you have a debt problem, more debt doesn’t solve it. All it may do, and Bill Gross suggested this at the conference, more debt certainly hasn’t fixed the debt problem, but it perhaps has postponed a day of reckoning. Nevertheless, you have investors who are today voting with confidence that all is well as they are doing the opposite of what they should be doing. They are extending the maturities of fixed income instruments they are buying. They are increasing duration risk. They are lowering their credit quality to get more income. That’s what they need, they need more income. They’ll do it at any cost. And that reach for yield goes back to the quote from Rudyard Kipling: “The burnt, bandaged finger wobbling back to the flame.”
Kevin: Okay, the two assumptions that you made that you can look back in the rear view mirror and say, “This was a mistake.” You assumed that the free market would continue. You assumed that everything that debt had created to create the crisis in 2008 and 2009 would not be recreated to get us out of the crisis. And obviously, we’ve talked about it, the debt is so much higher now. What other assumptions, looking in the rear view mirror would you say, “I would have never known that?”
David: Look at gold. I came to work with our family business in 2003. I left Wall Street, was working at Morgan Stanley, and a big reason I came back was seeing a major directional change in the price of gold. And a major multi-decade change in asset prices. And looking at that, I assumed that gold would, in this context, today, right now, reflect a no confidence vote on central banks. And what we have had is, they have doubled down on their monetary policies, the very policies which created the global financial crisis.
In other words, I came in with an assumption, and it was an assumption about a frail fiscal position, and a very predictable monetary policy course that was going to be taken. And gold, when I first came into the business and invested heavily in it myself at $300 an ounce, has even to this day at $1200 an ounce, done what I thought it would do. Now, it did more than I thought it would do in a shorter period of time, the period of 2010 and 2011. The question is, should I look at that same assumption and undo it, or deny its veracity?
This is what I’m getting at. If the central banks have doubled down on the same monetary policy that got us into the global financial crisis, what makes us think that the outcome is going to be different this time?
So, the extreme measures taken continue to disappoint, as growth metrics trickle in, this is still an allocation for me that is focused on future market reaction and a desire for security. The market is today, instead, ramping up risk – that’s what it is doing at present. People are looking for reward without looking at the intrinsic risks in the investments that they are making.
To me, what do I do? I’m still focused on a future reality, on a cause and an effect, and the cause has already been put in place. The effect is a question of timing. Listen, for 2003 to 2011, right as rain; 2011 to 2015, where has the price of gold gone? Nowhere but sideways to down. So again, I look at that and I say, “Well, has the information changed?” If the information has changed, I may need to change course.
Kevin: But the information hasn’t changed.
David: Lo and behold, the only thing that has happened is that in this narrative you have come along and all you have done is highlighted, underscored, and put an exclamation point behind all the relevant points in the previous narrative, the same things that were done, what brought us to this particular place of instability. Again, all we have done is underscore, highlight, and put an exclamation by it and say, “Well, it worked last time until it didn’t, so we’re going to try it again, just with more juice.”
Kevin: So in other words, the factors that took gold from $300 to $1200, those factors have grown exponentially to take gold from $1200 to wherever it’s going to go, because we’re not talking about gold going anywhere. We’re talking about the dollar and the paper markets going down.
David: Yes. The consequence of fiscal mismanagement, and then the pressure that has been put on the Fed to make up for it in monetary terms and via monetary policy, has put the dollar, basically, on a death march. Does that happen overnight? Does that happen over a longer period of time? It really depends on how long they can perpetuate confidence. And so, to me, I look at the assumption and I’m willing to question it. I’m willing to put it under the microscope, and see if it still holds. And it is a potential mistake, but the information hasn’t changed. The information has not changed.
Kevin: Well, let’s play a game then. Okay, so I’m one of your investors, and I’ve watched gold just languish over the last two or three years. Yes, the information hasn’t changed. I get that. But I’ve watched the people around me making money in the stock market. I’ve watched people seem to prosper in, let’s say, British real estate, what have you. These are bubble markets. But what do you do when someone starts to try to pressure you, an investor who says, “You know what? I’m really tired of just sitting here, I’m tired of losing money. Yes, the information has not changed, I’ve heard this all before.” What do you do, Dave?
David: That’s a good question. Perhaps the biggest mistake was not assuming these things, which I just mentioned, but assuming the time frame in which there would be an effect from the cause. We see what is wrong. When will the consequence be felt? The nature of a confidence game like the one the European Central Bank, the Fed, the Bank of Japan, the Bank of England, like the game that they are playing, is that a shift from confidence to no confidence happens in an instant. Indeed, we have all the ingredients for the next global financial crisis. We only lack a catalyst. Where we are today is in a situation where we are being coerced.
We talked with Pippa Malmgren last week about the nature of interest rates, playing a role of justice between savers and debtors, and they keep things in balance, but what we have today is coercion. In the marketplace we are being coerced to take more risk for a very thin and ephemeral reward. That is not my idea of a good time. So, I continue to opt for cash, I continue to opt for precious metals, and I continue to opt for patience. And quite honestly, it seems that the most difficult asset to hold onto today is the last one on the list – patience. But it is, by far, the most important.
The scale and the scope of these imbalances have my mind racing. There are things that keep me up at night. And as I think about the things that keep me up at night, it is these unresolved relationships. It is these unresolved trends. It is these unsustainable courses. And for anyone who studies history, you know, the market gives, the market takes away, and the market has given all that it can. You know what comes next.