In PodCasts
  • Liquidity doesn’t exist today without central bank printing
  • David Rosenberg says prepare for inflation & $3,000-$5,000 gold
  • Inflation is an emotion, being caught off guard is the trigger

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

“The markets don’t necessarily repeat themselves, exactly, but the echo from the recent past may very well rhyme in 2018.  We’re exactly ten years on, and I think it will be fascinating to see – what is the investor behavior?  Is it like a stampede?  Do we have risk hiding in plain sight?  Because not even diversification can save you from losses as a direct result of central bankers’ intervention.  They’ve created the correlation problem.”
 – David McAlvany

Kevin:  We’ve been talking about the dangers, sometimes David, of having a business built on a single large client.  Almost everybody listening can think of people they know who had a thriving business, but it was really based on having a large buyer on the other side.  And I think you even had that in your own family?

David:  Sure.  If I go back 20 years, my wife’s family business had a huge connection with Rockwell automation.  And it was just a known thing, you had to be very sensitive to the relationship with Rockwell because it represented a pretty significant portion of the overall business.  It was diversified into lots of other areas and electrical distribution was not the only thing they did.  They also got into telecommunications and things like that.  But it was just this reality that if something happened to the relationship with Rockwell it was a very, very big deal.

Kevin:  So it’s a double-edged sword.  They enjoyed the benefits of having a large client, but they also had the vulnerability of what happens if they lose it.

David:  There is an implicit vulnerability.

Kevin:  That’s a concern I think we should look at as a world right now.  There has been a guaranteed buyer, a Rockwell, out there – I’ll call it the central bankers, — that has literally been the artificial buyer of last resort of just about everything that is offered in the markets that other people aren’t buying.

David:  And it’s different from a business relationship where you create this mutually beneficial relationship.  In this case, you had the central banks encroaching upon what was a highly competitive and fairly well balanced financial landscape, specifically, in the credit markets.  So we have seen a pretty significant erosion of liquidity in the credit markets. 

Kevin:  But it has been masked because the central bankers have been providing liquidity.

David:  Sure.  So governments of the world via the central banks have been gobbling up the world of credit and expanding the scope of their purchases beyond government bonds, even to corporate bonds.  We feel that that liquidity is ample, or at least adequate, because of the presence of the central bankers when in fact there is something that has changed behind the scenes.  So again, we have the big entity, if you will, who is now very, very important in the equation, and what we don’t realize is that it has completely and utterly caused decay with what was a normal, again competitive, market-driven marketplace prior to.

Kevin:  We can see that in a tourist town.  Being here in Durango there are times that we go through, especially April and November, incredibly dead times.  There is hardly any business.  But if a bus or two shows up at a restaurant, if that was the only time that you saw that restaurant you would think that they were continually crowded.  But it might just be that a bus stopped.  For the last seven or eight years the central banks have been the tourist bus that has shown up.  They’re ordering everything.  When that bus leaves it can be like a ghost town. 

David:  I’ll stretch it to the decade level.  That has been the case for the last decade.  You’ve had balance sheets which have grown, you have central bankers which have inserted themselves abnormally into the flows of bond buying and selling.  As we described those entities, they are the artificial buyers of first resort.  They are not the buyer of last resort because it’s not like they are standing in, they’ve actually stepped in, inserted themselves into the equation as the buyer of first resort and displaced the old buyer.  So they have had the agenda of low rates.  And why?  Because they wanted to create a wealth effect and gin up economic activity and that has put them in a first position as a buyer, not the last position.

Kevin:  Let me ask you this.  Historically, any market needs a market-maker, somebody who not only buys, but sells, or they provide buyer and seller – sort of a middle man.  In other words, let’s say somebody is selling more than the market can take today, the market-maker is going to take that in their inventory and maybe they hold it for a few days, but it actually creates a smoothness in the market. 

David:  That’s why I say there is a liquidity erosion in the credit markets because for the last decade we have seen a radical transformation within the fixed income world and in some ways it is similar to the world of stocks where the market-makers have gone away, for different reasons.  With stocks it was decimalization first – that happened at the turn of the century.  

What is a market-maker?  It is somebody that is willing to connect sellers with buyers, and vice-versa.  There are interim periods, you mentioned, on the shorter end of that spectrum.  Maybe it’s minutes, maybe it’s weeks or months, in which if there is not a buyer and seller to match up, the inventory accumulates.  That unsold product has to be held, and it is held off the market so that a bid is supported.  So the role of the market-maker is to hold the product and allow for the functioning of the market to remain normal, for pricing to not be erratic.  

Again, that is, in essence, supporting the bid.  But as we have had U.S. corporate bonds outstanding, if you look at the trajectory of growth, how much debt is in that marketplace?  Going back to, say, 2005, the market was about a 2.6 trillion dollar market, and today it is over 5.3.

Kevin:  So it has doubled in this last ten years.

David:  A significant increase in the quantity of corporate bonds on the market, and yet, the primary dealers’ holdings of corporate bonds has continued to shrink.  So again, if you go back to 2005-2007, those dealers held roughly 250 billion dollars’ worth of inventory.  They are buying it, holding it, waiting for the next buyer.

Kevin:  That’s the market-maker function.

David:  That’s right.  Today, they only hold balances of about 33 billion.  So what you don’t realize on a day in, day out basis, is that the dealers are not providing liquidity.  And here we are in the context of a relatively stable bond market, but in recent years the market-makers have been receding from the marketplace, even as central banks have been imposing themselves on the market.  What are the pricing dynamics of a full-fledged bear market in bonds?  We don’t know, in part because we haven’t tested that out, a new market dynamic where the market-makers are not there.  Who is providing liquidity?  Today we know who it is.  Tomorrow, we don’t really know.  

Is it imaginable, after the central banks have taken over the space, that market-maker function, in terms of volume and becoming the whale gobbling up everything available, that there are not big waves in the bond market caused by an organized retreat of the central bankers?  This is what normalization means.  So if central banks are going to be selling assets, normalizing interest rates, there are implications, and what I think many people in the financial universe are forgetting is the role of market-makers, and that they are largely absent from the market today, both in stocks and bonds.  So as we go into the potential of a full-fledged bear market  in both asset classes, what does it look like, bear markets in those asset classes, when historically you had someone to make a market, and today you don’t?

Kevin:  In a way we’re asking, what happens when the bus with all the tourists leaves?  What actually happens to the market at that point.

David:  Yes, because first there is the issue of artificial demand.  So what we have seen is elevated prices because of the economic footprint of the European Central Bank, the Bank of Japan, the Federal Reserve, and their balance sheets have become a dumping ground for credit.  So you have central bank buying that is artificial.  That’s the first issue, an excess amount of demand that doesn’t really belong there and may not remain.  Then there is the consequence of an ever-expanding debt market.  You have the private, you have the corporate, you have the governmental markets, and the scale is now considerably larger than it was ten years ago.  So supplies are greater – far greater – but that is not apparent in the pricing of debt today because you have had this artificial buyer.

Kevin:  And that is what has kept interest rates so artificially low.  We continue to harp on this.  If these bonds and this credit were actually going out and chasing a market, they would have to pay higher interest rates.

David:  That’s right.  So if the central bankers decide to liquidate or reduce their holdings – this is the normalization we were talking about – in the fixed income assets that they own today, that swells the available product in the market, in a timeframe where the market-makers have either gone dormant – maybe they come back – or they have disappeared.  So who assists in the orderly buying and selling of an excess amount of bonds in that environment?  

Kevin:  This brings me to the question, can the central bankers actually normalize?

David:  It is going to become apparent, and I think very soon, that having killed off the market-maker function the central bank community now must remain squarely in the middle of the bond market.  There has almost been a devolution of the marketplace.  It used to be a competitive market environment where many people were making the market, and by creating inefficiencies, by creating a misallocation of capital, essentially what they have done is they have harmed the structure of the market, and the normal functioning with market-makers.  

Now all of a sudden, as that role has deteriorated, it has left a gap that only the central banks can fill.  They have basically written a script in which they have to play a dominant role moving forward.  So the Federal Reserve moves in.  What are they trying to do?  What are they claiming that they are going to do by the end of this year?  Put 600 billion dollars’ worth of bonds back onto the market.

Kevin:  You need a buyer to buy those, though.

David:  Yes, probabilities are high that they will have to reverse course and restore order to the bond market.

Kevin:  You have brought up the ten-year treasury, that it is a critical moment when ten-year treasuries pass 3%.  We’ve been hanging in that area here recently and we are above that today.

David:  Yes.  So 3% is where we are hanging out.  Jamie Dimon at J.P. Morgan says get ready for 4% ten-year treasury rates.  What are the thresholds that begin to reprice asset classes, where people say to themselves, “The cost of capital is rising.  What does that mean?”  Discounted cash flow models – when are the equity analysts going to start looking at stocks differently because they have new hurdle rates to keep in mind, because the cost of capital has increased and now they have to look at things differently?  They are going to look, from a fundamental perspective, at equities in a different light, and they haven’t begun to rethink their math in light of higher rates.  That is a dangerous place to be.

Kevin:  So let’s talk about this mechanism.  So the Fed liquidates what they have been naturally buying.  Rates are going to have to rise because you have to attract a buyer.

David:  And that has an impact.  That has a corresponding impact, not only for the bond-holder, but also for the owner of equities.  The bond-holder is looking at an erosion of capital as interest rates rise, again, a disappearance of face value for their bonds, with rising rates.  The Fed liquidates, rates are rising, then that begets the general public liquidating as they see losses in their bond portfolios, which causes rates to rise more.  What we are really talking about is the dynamic opposite from what we have had for the last ten years.  Buying over the last ten years has beget buying.  That has been on display.

Kevin:  They call that the wealth effect, in a way, don’t they? They are assuming buying will beget buying and it will ultimately restart the economy.  But what happens when people start selling?

David:  Selling begets selling.  That is beginning to happen at the edges of the market, and could easily migrate to the market core.  Two weeks ago we discussed the increased correlation of stocks and bonds in the cycle. 

Kevin:  In other words, they are moving up and down together. 

David:  It is an important point.  In many instances, bonds move in the opposite direction of stocks, and they do better than stocks as stocks are falling.  But in a rising rate environment both can slide the same direction.  

I got off a plane a month back, flying with my family, and directly in front of us were two adults that had been drinking the entire flight.  And it did not matter that they had each other to hold onto.  We had lots of family conversations about it.

Kevin:  This was in front of the kids.

David:  Oh, immediately in front of us.  Me, and then these two people in front of us – two grown adults.  Both of them collapsed in a heap on the jet bridge.

Kevin:  Slobbering drunk.

David:  And they couldn’t pull themselves up.  My kids got to witness what happens when the liquidity flows.  And everyone wants to say, “But this is a normal market functioning, what we’ve had over the last ten years.”  No, this has been a grand party on the basis of the liquidity flowing.

Kevin:  So you’re saying liquidity from the Fed is like an alcoholic beverage.  It reminds me of how they have likened it to a punchbowl. 

David:  That’s right, William McChesney Martin’s famous injunction for the Fed to take away the punchbowl before the party gets started.  And we’ve just walked through the opposite.  Jim Grant reminds us, quoting from the Federal Open Market Committee, the FOMC meeting December 11, 2012.  “Janet Yellen said this:  Keep filling the punchbowl until the guests have arrived, and don’t remove it prematurely before the party is well under way.”  That is very different than William McChesney Martin, the head of the Federal Reserve, and the first paid Chairman of the New York Stock Exchange going back to the 1950s and 1960s.  He was one of the best Fed Chairmen we ever had.

Kevin:  Right, because he was conservative.  He pulled the punchbowl back in time.

David:  He understood that Federal Reserve policy could not afford to be pro-cyclical.  In other words, you don’t want to put additional wind in the sails.  In fact, you want to do everything that you can to moderate the market’s tendency to get ahead of itself.  What we have done is become very pro-cyclical, which is to say, if the boat is going in one direction, five knots is not enough, we want 25, and we’ll do everything to get it to top, top, top speed.  

But Janet Yellen’s quote about keeping the punchbowl out and don’t take it away prematurely is the exact opposite kind of philosophy that William McChesney Martin had 50 years ago.  So we have the bond and stock markets being properly smashed, absolutely drunk, like the couple that was on the jet bridge, with very little to keep them from toppling over.  They exist in an inebriated state today.  I think we live in fascinating times, but the real question is, as stock-owners go to liquidate and diversify into some other asset, it is normally bonds, and bonds may, in fact, be moving down at the same time.  What does it look like for this lovely couple, the stock and bond couple, to fall down on the jet bridge?

Kevin:  Sometimes interest rates are the most important piece of information you can possibly get about other things.  You’re talking about interest rates not just affecting bonds, but stocks.  It’s not just the longer rates, either.  One of the indicators for a downturn in the stock market can be the two-year treasury. 

David:  Right, on the front end of the curve.  The long end of the curve is the long rate, the front end of the curve is your two-month, two-year timeframe which is immediately in front of us.  David Rosenberg, who is in Toronto with Gluskin Sheff, is a great analyst.  I’ve read him for probably the last 20 years.  He has been in a couple of different firms, and I like reading him wherever he happens to be.  He comments on the two-year treasury, and he says it is the leading indicator for all risk asset classes.  The front end of the yield curve – I would draw that two-year chart before every single bear market historically.  He says this:  “It is a great leading indicator, the front end of the curve, because it is a great leading indicator of market liquidity.”

Kevin:  That’s what we’re talking about here.  This market liquidity has been so necessary for the price appreciation that we have seen.  The price appreciation has come because we have had a continual buyer in these markets.  If you don’t have excess liquidity, what happens to price appreciation?

David:  And with two-year yield rising, it is telling you that liquidity is leaving the market.  Excess liquidity is one of the necessary ingredients for asset price appreciation, and deficient levels of liquidity are responsible for a fall in prices.  There is no natural mean.  There is no mean or midpoint.  There is no virtuous level for liquidity, thinking of Aristotle’s definition of virtue, the mean between excess and deficiency.  The history of the markets goes from excess to deficiency and back again.  They are constantly searching for the middle point and they never find it.  We know that we have had excess liquidity in the marketplace and we have seen that with rock bottom zero interest rate yields.  Now we have the two-year beginning to rise.  What that suggests is that, yes, we’re moving toward a deficiency of liquidity, the pendulum swinging back the other way.  And it doesn’t take much imagination to see the next phase unfold.  What are the implications of rising rates?  What it is telling you, just as Rosenberg said – this is an indicator of market liquidity, lack of market liquidity.

Kevin:  What does he think when the wind comes out of the sails of the equity market, this wind that has artificially been applied, how much does he think it could go down?

David:  I was one of the guests at Jim Grant’s recent conference in New York.  He says that this excess liquidity from central banks has added probably 1000 points to the S&P 500. 

Kevin:  We’re not talking about 1000 points to the Dow, but to the S&P, which is a much smaller index as far as points go.

David:  This is really worth grasping.  He is basically saying, fundamentals took stock market prices to a certain level, and then central bank liquidity, excess liquidity, have taken them from that level to the level that we have today.  The difference is about 1000 points, or in percentage terms, roughly 35% difference.  In support of his point, he looks at every other period of time when the U.S. saw an increase in the stock market – a big increase in the stock market.  And he notes that when stocks have seen this kind of annualized growth – 10%, 15%, even 17% – that there was a macro-economic backdrop which was very supportive, typically, 7% nominal GDP growth.

Kevin:  Where are we now with GDP?  We’re nowhere near 7%.

David:  Just to reiterate, you have strong economic expansion serving as the foundation.  In this cycle, the contrast post 2008 is that economic growth has been less than half the historical metric, with the upside in the pricing of stocks still being on par with the highest historic growth level.  So yes, we have seen growth in stocks, but we have not had the same complimentary economic growth driving it, which is where he gets to his bottom line conclusion – 1000 points of excess in the S&P 500.  What does that really imply? (laughs) There is an air pocket in equities of roughly 35% on the downside just to return to levels reflective of the actual fundamental economic backdrop.  Stocks got ahead of themselves.  

There is one last point that Rosenberg brings up.  He is not ordinarily a fan of gold, but he strongly admonishes buying a lot of inflation protection.  He basically says this is an environment where you could see $3000, $4000, $5000 gold. 

Kevin:  It is important to talk about this because a lot of times people will look at the inflation numbers and they will say that gold is not necessarily a very good short-term indicator of inflation.”  It doesn’t move back and forth with inflation.

David:  I think it is fair to note that gold is not a very reliable adjustor for inflation on a day in, day out basis – very fair.  But I think what Rosenberg is talking about is a sentiment shift as it relates to inflation.  With gold repricing to $5000 or $3000 or $4000, or whatever it may be, the market tends to ignore inflation creep in the short run.  And then it only plays catch-up at inflection points in the market.  What do I mean by inflection points in the market?  

Lest we forget, the market is just an aggregation of people.  It is just you and me and a bunch of other people expressing what we think.  Greed and fear show up via our investment and purchasing choices.  And when you have a preponderance of one or the other, greed or fear, markets are moving one direction or the other.  An inflection point in the market is simply when a group of investors finally takes action because something finally becomes apparent to them that wasn’t apparent to them before. 

Kevin:  So expectations and perception and emotions and this Eureka moment – that is really when things chance their price.  It has relatively nothing to do with the everyday numbers that we get from the boards.  

David:  This isn’t the first time we have talked about inflation and drawn the distinction between inflation and inflation expectations, but this, I believe, is why inflation expectations are far more important than the B.S that is reported as government statistics. 

Kevin:  I got a letter yesterday from one of our clients.  This is a man who listens to the Commentary, he reads your dad’s newsletter, but he did want to correct us on something.  He said, “I appreciate what you guys are talking about, but we don’t have 2% inflation.  We have 7%, maybe 8%, inflation.”  He said, “I love it when you have John Williams on the program because John Williams is pointing that out.”  And to be fair, you have continually said that you believe inflation is quite a bit higher than what the government is telling us. 

David:  I would agree, real world inflation averages 7-8% annually, not the 2% that people look at in the CPI.  We’re kind of locked into this double world where there is the world as we know it to be, kind of a “big R” reality, but we still have to play the games in the “small r” reality world, where every other investment analyst says, “We’re not worried about inflation because inflation is 2%.”  

This goes back to Keynes’ idea that there is a beauty contest, and it doesn’t matter objectively who is the most beautiful, it matters what the judges are thinking.   If the judges have bad inputs you still have to care about the judges’ bad inputs because they can determine the direction of the market, regardless of reality.  This is the double world we live in.  Yes, I acknowledge real world inflation averages 7-8%, and no, 2% is the CPI.  What are we talking about again?  The inflection point.  The inflection point for gold as it relates to inflation is when a mass of investors see inflation everywhere they look, and they see the Fed falling behind in a fight to curtail it. 

Kevin:  Let’s call it the inflation emotion.  We don’t have that right now, but when that inflation emotion kicks in it is unstoppable.  Do you remember when Greenspan was with the Treasury?  This was in the mid 1970s.  Greenspan came up with the “Whip Inflation Now” buttons, because they figured if everybody was wearing a button that said “Whip Inflation Now” they no longer would be worried about what they could obviously see happening, which was prices sky-rocketing.

David:  My dad used to say this:  “There is inflation and deflation, and sometimes there is this thing in the middle called stagflation.”  And the difference is, deflation, you clearly drive up to a traffic sign and it’s a red light.  Full stop, red light.  Inflation, green light.  Stagflation is when you come up to the traffic stop and the traffic signal and it’s red and green and yellow, and they’re all flashing at the same time.  Which is it?  Where do you go?  What decisions do you make because you’re getting indications of all of the above?

Kevin:  He even renamed it ecospasm because it is a spasmodic type of reaction.  How do you react at that point?

David:  It’s fascinating, we could have an inflection point that has nothing to do with the markets.  I read an interesting article from The Economist over the weekend citing Bernie Sanders, Elizabeth Warren, Kamal Harris, and a few other co-sponsors of a bill guaranteeing every American a tax-payer financed job.

Kevin:  I’m surprised.  It’s Bernie Sanders, Elizabeth Warren, Kamal Harris – you should have said Karl Marx, Lenin…

David:  I’m surprised (laughs).

Kevin:  Yeah, yeah.

David:  What’s funny is that you have the Scandinavian experiment which UBI, Universal Basic Income, where they have basically said they’re going to pay people for existing, they don’t have to work.  That’s failing.  The Scandinavian project is failing.  The unemployment rate here in the United States sits at 3.9%.  We have African-American and Hispanic unemployment rates at the best they have been in decades.  And yet Democrats still feel it’s necessary to put in place a bill which, according to the Center on Budget and Policy Priorities, a pretty left-leaning group, will cost 543 billion dollars.

Kevin:  Only half a trillion dollars to introduce communism into our system.

David:  That’s one-and-a-half times what the government spent on Medicaid last year.  It would expand the government payroll by 50%.  Why mention this in the context of inflation?  Because sometimes there is a shift in inflation expectations and it doesn’t come from seeing the price of a Snickers bar increase, or sticker shock because of a gallon of milk, or because nobody wants to pay an obscene amount for tuition to go to a junior college or a state school or an Ivy League.

Kevin:  But it’s like what happened to Venezuela and Argentina that we’ve been talking the last few weeks.  It’s seeing socialism introduced into the system, buying votes.  

David:  You can have a political event which shifts a whole mindset.  So this kind of legislation is absurd.  It’s absurd.  And yes, it is a scam to buy votes, you’re right.  But there are a dozen different fiscal alternatives to it which could be sourced from either side of the aisle.  It doesn’t matter if you are Republican or Democrat.  And they can accomplish the same thing.  Because here it is – in the nexus of public policy, of fiscal policy, of market pricing dynamics – in that nexus, it is in the mind of the investor as these issues are synthesized and adjusted for that you see the snap.  The bet on gold and silver, in conclusion, is not a bad one, because ultimately your inflation expectations can move because of the price of a Snickers bar, or a gallon of gasoline.  But it can also be something that comes from left field, left field being somewhere on the East Coast.  

Kevin:  And you sometimes cannot get something out of someone’s mind.  At this point the central banks have numbed us into thinking we don’t have inflation.  You know the old saying, “Don’t think of a pink elephant.”  Sorry, there is no way not to think of a pink elephant once you say that.  You can’t get it out of their minds.  I do remember the 1970s.  When that happened with inflation they couldn’t get it out of their minds.  It took Paul Volcker raising rates and almost killing the Reagan administration.  You remember how Reagan was completely upset with what Volcker was doing because Volcker raised rates a little bit like they have been doing in Argentina until it snapped.

David:  There was a supply-sider we had on our program a couple of years ago.  He did not like Volcker at all.  You could tell – 30-40 years have passed and there was bitterness. 

Kevin:  He was in the Reagan administration when Volcker was raising rates and he said, “Do you not know what you’re doing?”

David:  We’ve been in business for 46 years, and clearly we have a bias – the gold business.  But the bias is really this.  There are periods of time when insurance is necessary – that’s our bias.  And in some circumstances it’s even more necessary.  We are in the circumstances where we believe it’s needed, even more than normal.  You have major inflection points, both in the stock market and the bond market, and these are timeframes, over a short period of time, where liquidity and asset preservation should be prioritized.  You have to underscore that as a priority.  

And there is going to be a mass of people coming out of the stock and bond markets that are seeking those two things – liquidity and asset preservation.  You can either get to where they are going to go before they get there, or you can get right along with them, along with the herd, and pay significantly higher prices.  Our view – and this is where we can assist – is that you want to be early, not late. 

Kevin:  I think back to the last couple of years of shows – 2017 going back to 2016 – the last three years have been characterized by the lowest volatility in history in the markets.  Honestly, it was hard doing shows when the markets were completely stabilized from every direction.  And now, we’re seeing volatility in the market.  You brought out that period of time when it was quiet.  You said what characterizes a period of no volatility is that it changes to massive volatility.

David:  Do you remember the conversation that we had with the gentleman who is an engineer and manages radar frequencies, and is looking for particular signals?  We talked about what we were seeing in terms of lack of volatility.  This was the fall of 2017 when you and I had the conversation with him.  As we described what was happening in the stock market up through 2017 and all through 2014, 2015, 2016 and 2017, where this signal muting had occurred and there was virtually no communication, no real information being gathered from the stock market, he said to us, “I work for the Department of Defense.  This is what I do.  I look for that kind of behavior, and I can tell you, it’s not normal.  That is by design.  That is when the powers that be, whether it is a foreign government, or our own government, are trying to tinker with the communication.”

Kevin:  It can actually show the presence of an enemy.

David:  Right.  The absence of signal shows the presence of an enemy.

Kevin:  And you’re calling volatility a signal.

David:  Volatility is a signal.  Volatility is like the pulse in the marketplace.  As we talked to him about what was happening in the stock market and the bond market…

Kevin:  It was like white noise.  When I sleep I’ve got a little white noise app, Dave, that I put on so that I can’t hear anything that is information-oriented so my brain turns off.  I’ll put that on, or a fan, or what have you.  Some people need to sleep with white noise.  It’s because it does erase information.

David:  The danger is that central banks, if they continue as they have through the last several years, to kill the signal in the marketplace, they are, in fact, killing market capitalism.  They are killing the ability for the market to price risk, and in so doing they are basically nationalizing everything.  They are saying, “It doesn’t matter what the price is, what matters is our presence in the marketplace.”

Kevin:  And they also kill appropriate response, so panic can come out of that.  You turn that white noise off and you find out, “Wait a second, there was a siren behind me.  I needed to pull over.”

David:  Right, so for the listener who says, “Why can’t that happen indefinitely?  It just appears that central banks are controlling it completely.”  Look, we’re on track to see 100 or more days this year with at least 1% moves up or down in the stock market.  So 2018 is a different year than 2017.

Kevin:  It’s a signal year.

David:  It’s a signal year, yes.  So we have discussed topping dynamics in stocks, and part of our thesis was the return of volatility in the markets here in 2018 versus the dead pulse of the markets in 2017.  But here is what you need to know.  The years of almost zero volatility are behind us.  In the past seven decades the kind of volatility that we are seeing now in 2018 has only happened a handful of times – 1974.  After 1974 – 2000, 2001, 2002, 2008 and 2009.  

Kevin:  Those should be familiar dates because those are dates of crashes.

David:  And I’m just telling you, the kind of volatility that we are seeing now – no, the central bankers cannot control the signaling in the marketplace indefinitely.  Did they do it for a period of time?  Yes, they did.  Does that mean that they can do it indefinitely?  No, they can’t.  What is your best evidence?  

Actually, they’ve tried to control it multiple times, from Greenspan through Powell, and they do it periodically with success, and then it’s met with failure.  You had the Greenspan put which was the guaranteed one-way bet in the stock market.  How did that turn out?  We ended up with the declines of 2000, 2001, and 2002.  We had the Bernanke put.  How did that end up?  We ended up with something which was just shy of the great depression which Ben Bernanke was such a specialist in, and he could not keep it from happening.  2008 and 2009, the chaos in the markets there were in spite of the central banks’ best efforts.  

Now we have had another iteration of that, another attempt to mute market signals and create a zero volatility environment, and here in 2018 again we are on track for over 100 days in a calendar year of 1% moves either up or down in the stock market.  1974, 2000, 2001, 2002, 2008 and 2009 – those are all years that have similarities, and you said it, it has to do with the chaos which comes in the market thereafter.  

Kevin:  And we’re seeing a reversal in interest rates, and this is so important to understand.  When talking to a client, if they are not familiar with the way bonds work, it’s like a teeter-totter or a see-saw.  If you think of interest rates on one side, and you have the pricing of those bonds on the other, if interest rates fall, which they have been doing for a little more than 30 years, the value of those bonds goes up.  But when interest rates reverse, which is what you are saying is happening, large reversals, the value of those bonds goes down.  So it’s not just stocks.

David:  Right.  So before we completely leave the bond market dynamic behind us, Grant’s Interest Rate Observer, in the May 4th edition, he notes that, “The recent increase in the ten-year treasury yield by 56 basis points,” that’s just a little over half a percent, “has deflated real estate investment trusts by 7%.

Kevin:  You’ve talked about that.  When interest rates start rising, what happens to real estate?

David:  And this is key because it is bonds and bond-like instruments, which are like that see-saw you were describing.  Low rates on the one end of the playground toy equals high prices on the other end, and if rates rise it’s axiomatic that anything with bond-like characteristics will decline in value.  

This is absolutely critical.  Think about this.  In this era of yield-starved investors there are lots of assets which stood in as a bond portfolio substitute for the sake of getting a bit more income.  You have blue chip stocks – they come to mind.  The aforementioned REITs.  You have utility stocks.  There is a lot more rate sensitivity in the markets than normal, as income investors have by necessity, settled for synthetic coupons in the form of dividends, in the form of MLP distributions, etc.  

The financial markets’ interconnectedness has always been an underlying reality.  We saw one version of that in 2008-2009 marked by the dangers of counter-party interconnectedness.  But perhaps the surprise on this particular go-round is in something that we all take for granted – a diversified portfolio.  

Kevin:  Right.  It’s just the standard that we’re all taught.  If you’re diversified then one thing will rise, the other thing will fall, but nothing will rise or fall together.

David:  Is it possible that asset allocation models matter less in a period of central bank intervention.  And following the same line of thought, also, can they be the proximate cause of pain, again, in a normally allocated portfolio, as all assets are driven crazy by the mispricing compliments of the Fed, the ECB, the Bank of Japan.  What are we saying?  We’re saying that there was one cause of them all doing well, and there is one cause – the absence of liquidity, the shrinking of liquidity from the marketplace, the mean reversion in interest rates and the implications that has for any asset class that has become interest rate sensitive.  

The list this time around is a lot longer because of the crowding effect.  The crowding effect is where central banks went out and bought a huge bunch of paper, and that meant that private investors didn’t have access to that paper and they had to go someplace else to get their same income.  So there has been a crowding effect in the financial markets and lots of things have taken on those bond-like characteristics. 

Kevin:  Dave, we live in an area that is known for cattle ranching down here.  This where the movie City Slickers was filmed.  And you’ve been on cattle drives.  You’ve actually gone on a cattle drive.  One of the things that scares people who move cattle is a stampede because there is correlation.  You can be amongst thousands of cattle that are all doing their own thing.  If they’re not panicking, if they’re not all moving the same direction it’s really not a big deal.  But you get them all moving the same direction, you get them all correlated, you’ve got a stampede, and really, there is almost no surviving that. 

David:  I think that is where we are today.  We have risk hiding in plain sight.  Because of this correspondence with equities and bonds, it’s correlation.  A diversified portfolio is of little help when correlations begin to come together and assets move closer and closer together and are moving in lockstep.

Kevin:  They’re moo-ving in lockstep.

David:  (laughs) The most recent period of high correlations was 2008 and 2009 when there was chaos across the board and note, intelligent investors were, indeed, scrambling for safe havens.  There are very few safe havens.  We’re further along in a bond market progression over the last ten years, and arguably, by some of the best minds in the fixed income space, well past the point of turning into a bond bear market.  So does the treasury market represent a safe haven as it did in the last turn down in stocks?  We don’t know.  We’ll have to see.  

The markets don’t necessarily repeat themselves exactly but the echo from the recent past may very well rhyme in 2018.  We’re exactly ten years on, and I think it will be fascinating to see – what is the investor behavior?  Is it like a stampede?  Do we have risk hiding in plain sight?  Because not even diversification can save you from losses as a direct result of central bankers’ intervention.  They’ve created the correlation problem.

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