In PodCasts
  • Buffett reassures his investors that they can weather even an extended market closure
  • Buffett’s 3 Secrets, 1) Reinvest Earnings 2) Compound Interest 3) Cash Liquidity
  • Jim Grant looks forward: “Bonds Bad… Gold Good”

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

“You have big surprises ahead, but it’s going to take more careful management, not more auto-pilot investing, to get you through the next decade. And I think a very careful balancing of risk, and an extremely, extremely huge amount of patience in the process if you are adequately reserved. And I fully believe that the next ten years will be some of the most glorious in your investment career.”

– David McAlvany

Kevin: I love the fact, Dave, that our listeners listen carefully. That one actually bit me in the butt this last week because I had brought up the example of giving dimes away – the real silver dimes. But they were not Kennedy dimes. Unfortunately for me, I said Kennedy dimes. I don’t know what I was thinking because we sell Kennedy halves, it just flows over the tongue – Kennedy halves. But Roosevelt is on the dime. I should know that since I was figuring, in the 31 years that I have worked here the company itself has probably bought and sold about 50 million of these Roosevelt dimes.

David: (laughs) That’s right, at least a few. Well, your main point was valid, which is that you can still use the old pre-1964 dimes, and guess what? If you used two of them, you could still get a gallon of gas.

Kevin: Isn’t that amazing? They’re worth about $1.20 apiece, even though they look exactly like the other dimes in your pocket. Speaking of dimes in your pocket, Dave, sometimes we meet with people who are quite wealthy. They may have several million dollars’ worth of real estate, or several million dollars’ worth of stock, bonds, what have you. But they don’t necessarily have liquidity, and I think that is probably a factor that we are seeing in the entire market right now. It is a fully invested market.

David: And that is really what we saw with the mini-crash here a few weeks ago. You can attribute it to VIX and tightness in one particular space, but the reality is, when real sellers come into the marketplace, you find that there is not very many real buyers, because as we have discussed ad nauseam over the last five years, the majority of volume on the New York Stock Exchange today is algorithmic trading. It is computer model trading, and it is sensitive to news feeds, it is sensitive to whatever may be a market trigger in the short run.

And again, you’re not really talking about the old-fashioned market-makers who would be willing to inventory massive amounts of shares, knowing that within minutes, hours or days they would be able to offload those into a retail holding.

Kevin: There was a mutual fund company that I remember talking to in the early 1990s and they were worried because they only had a 5% cash position. This was a bond fund, and they knew that if more than 5% of the people who were investing needed their cash back out they would have no means of getting that unless they sold bonds. I remember in this particular case, they did run out of cash and they actually tapped into the money market of the same mutual fund company to borrow money because they were out of cash.

David: Right. And they would have done that because of the general illiquidity within the holdings of the bond fund, itself.

Kevin: There were stuck.

David: That’s right. So the reality is, a 5% cash cushion on a bond fund is not sufficient because you’re not dealing with an instrument that has a huge two-way market. Of course, if you are talking about short-term U.S. treasuries, or short-term German bonds, you are talking about a very liquid two-way market, but as you move outside of those money-like instruments, all of a sudden there aren’t people standing in line to buy them.

Kevin: Wouldn’t you be worried right now if you were a mutual fund manager and you knew – let’s face it, there is a general consensus by the guys who have been in this market for a while that the market is over-priced, but in a way they are compelled to not only be invested fully but sometimes beyond fully.

David: Yes, I think that’s true. One more thing, just on the bond market and last week’s action, the treasury options last week, which were close to a quarter of a trillion dollars in new-issued treasury bills, bonds, notes – there weren’t as many people in line to buy those, either, which was kind of curious. But you are right, investment managers do know, and are aware, that we are over-priced here in the equity markets.

But as we discussed in recent weeks, no one can risk under-performance, so you find most of these managers are all in. One mutual fund manager I know recently shared with me an insight on cash in the portfolio. I asked him about cash levels and he said the new CEO of the firm made it crystal clear that any allocation to cash was the prerogative of a client, so it was no longer the role of the mutual fund manager to create a cash cushion. If a client wanted cash they needed to position themselves accordingly, asset-allocate themselves, that you were not to mitigate risk in the portfolio. And if you were going to mitigate risk, and be under-allocated, according to your mutual fund mandate, you would find the door with a swift boot to the butt on the way out.

Kevin: So what you’re saying is, that mandate was to be fully invested 100%?

David: That’s exactly right. As far as he was concerned, the mandate of the funds in house – and I don’t want to say which mutual fund company – was to be 100% invested, all of the time. The ETFs, of course, never have had the option of moving to cash. There is no cash cushion, which is why there is much greater sensitivity when an investor goes to sell. Boom! You see the impact immediately as opposed to hitting the cash portion first for redemptions. But your index funds are always 100% allocated. We will touch on the craze of ETFs in a minute. But the ability to reduce risk has always been in the hands of the manager.

Kevin: Until now. At this point, how do you reduce risk if you’re 100% invested?

David: You can, but you have executive pressure which is stepping in, and for all intents and purposes, eliminating that option. It is full speed ahead. A very competitive environment on Wall Street. That has never changed. But you have had massive withdrawals from mutual funds from actively managed products into passive funds instead. That is reshaping the investment culture’s approach to risk. And I think it is worthy of note that these kinds of “take a little bit more risk because if you don’t keep up with the Joneses you are not going to be in business. You won’t have a job.” These things are happening, again, an increased risk profile at the top of the cycle.

Kevin: Dave, you have a library here. You have a library at the other office. You have a library at home. We all have various portions of our library devoted to wise investment decisions. I think of somebody who has gotten to be famous over the last 50 years or so. It’s called the Buffet way. The idea behind having a library of investment history, economic history, is because if you learn from history and you have some form of discernment and you can apply that, then you should be able to outperform the market and actually be able to preserve your assets on the downturns.

Now, Buffet has been an interesting case study because he is very much about managing money the right way, and he is a very intelligent guy. But strangely, you don’t want to do what he says, you just want to watch what he does.

David: That’s right. I finished the Berkshire Hathaway annual report around midnight last night and I continue to have a great respect for Buffet and Charlie Munger, and continue to conclude that, in terms of their business, insurance was the most important investment. It is the underpinning for all of their success as asset allocators and as active investors. A few lines stood out from the annual report. He says, “The less the prudence with which others conduct their affairs, the greater the prudence with which we must conduct ours.”

And I resonate with that. He discusses being structured to withstand economic discontinuities and he describes Berkshire Hathaway being so solid that it could even withstand the extremes of extended market closures. I thought that was a sort of noteworthy foreshadowing. Again, it was an odd thing to be in his annual report that they are structured to handle the stock market closing down.

Kevin: That is a strange “if the market were to shut down,” isn’t it?

David: Yes, because at the same time he highlighted their long-term growth rate, said here is what we have done through the years, and then he quoted Kipling’s poem, If, which is a classic. If you don’t know it, I would read it. But curiously, he points out that the big four sell-offs in the stock market during his tenure, 1973-1975 1987, 1998 to the year 2000 – the tech wreck – and then the global financial crisis, 2008-2009. Berkshire Hathaway shares were down roughly between 40% and 60% each time.

Kevin: So isn’t it strange that through his management style he did not see those coming and didn’t manage accordingly.

David: In 53 years they have seen the growth in equities commensurate with the equities bull market, but they have ridden that roller coaster down each time, as well. And I wonder if, in fact, his review of performance, and in the midst of that he has this chastisement of margin borrowing to buy shares. He says, “If this isn’t evidence of why you don’t borrow money to buy shares, even Berkshire Hathaway shares…”

And I just wondered if he wasn’t sort of coaching the audience, almost like the mainstream media newscaster. “Yeah, sure, stocks go down but they always come back up again. Stay the course regardless of what happens tomorrow.” It left me with this impression – granted, it was almost midnight last night – and I was thinking, “What do you think happens tomorrow? What is this foreshadowing in page 12-24 of your letter?”

Kevin: One of the things that we have learned through the years is, you don’t have to suffer the 40-60% drops each time. You balance things out, you watch like the Dow-gold ratio. You do those types of things. Warren Buffet, however, has had supplementary income this entire time. You mentioned the insurance. The insurance is what has given him the ability to suffer those losses and continue to function.

David: Right. It has been a godsend. He also reported on his million-dollar bet with Protégé Partners, and the bet was that an index fund would out-perform active trading by even the very best hedge funds, which in the last ten years was, indeed, the case. That is what happened. But the absurdity in Buffet’s position is this. I just want to quote him directly. “Let me emphasize that there was nothing aberrational about stock market behavior over the ten-year stretch.

Kevin: Well sure, not if you’re just printing money out of thin air and have zero interest rates. No, there is nothing aberrational at all. When money is free, that is not aberrational.

David: (laughs). That’s right. Nothing aberrational about central bank control of rates, creating artificial pricing through the financial markets globally from 2008 through 2018. Nothing aberrational about trillions in excess liquidity that removed – removed – the basis and validity of value investing wherein the individual merits of the company are weighed against its competitors, and where industries and various asset classes are competing for a scarcity of capital.

Kevin: Isn’t that what capitalism is. You have to be efficient in the market so that you can compete.

David: Well, if there is a scarcity of capital, right. But if there is no scarcity of capital, there is an abundance of capital…

Kevin: Everybody wins.

David: Then there is really no allocation of capital. It is a little bit like money raining from heaven via the central bank helicopters. The rain falls on the good and the evil, as scripture says, then as the deluge swells the quantity of liquidity, guess what happens? All boats rise. But there surely was nothing aberrational about that between 2008 and 2018.

Kevin: For the person who is still not aware of the difference between managed and passive funds, what we are talking about is, if you are in a passive fund, basically, you are just invested in that entire sector. Who cares about the management? It doesn’t matter whether you are in GE or Johnson & Johnson, or frankly, Google. You’re just in an entire sector, and it will either rise or fall together. Now, that is a scary, scary thought, especially when you are hearing from Warren Buffet telling the masses, “This is the better way to invest,” even though Buffet is living proof that using discernment in management is what, in the long run, wins.

David: This is what makes some of those indexes almost laughable. You talk about a craze. We’ve talked about bitcoin, we’ve talked about ethereum, we’ve talked about biotechs, and the popularity of the FANGs in recent years – Facebook, Amazon, Netflix and Google, which is now Alphabet. But here is what is fascinating. The index industry association, which looks at your ETFs and your indexes, there are approximately 43,192 publicly traded companies in the world today. So let’s just say 43,000 to keep it rounded. Do you know how many stock market indexes there are that investors can choose from? 3.14 million stock market indexes.

So what are we talking about here? There are only 43,000 companies in the world that you can own, and yet there are over 3 million ways to invest in some slice of them. It is hooey. But Buffet, in this bet with Protégé Partners, Buffet sides with John Bogle, who started the Vanguard Funds, to claim that management of funds, that is mutual funds and things like this, or hedge funds for that matter, comes at too high a price. But then he completely ignores the management fee of government, which in this last ten-year stretch was enormous. It is far more outrageous in my mind that the most over-priced hedge funds who charge maybe 2% and 20% of all profits, is not comparably put on a scale with the government.

The government charges us 2% or more each year for boosting economic growth. Remember their 2% target rate of inflation? So you have 2% inflation target rate and they have been able to produce for us a paltry sub 3% GDP growth per year over the last decade. Then they tax the daylights out of your personal slice of the economic income stream off of that growth. And what is that? 25-35%? So hedge funds charge you 2% and 20%, but Bogle and Buffet both ignore that the successive automated and autopilot investing via those indexes has occurred in the context of record interventionism via governmental windage.

Kevin: And they are talking even more about that because the Federal Reserve is now talking about intervening in the stock market like Japan did. “If we need to, we’ll just go buy stocks.”

David: That’s right. Now, it is interesting, even as they are talking about quantitative tightening, you have dissonance in voices with the Fed, and for everything that they announce, which suggests we may be tightening here, somebody else steps out – Bullard most recently. I can’t tell you the number of times he has stepped out, but also the New York and Boston folks, Rosengren. It has been amazing, the last week since we have seen some volatility in the stock market, everything that is said by the Fed is immediately countermanded by some other statement so that there is no concern in the marketplace, which is, they’re guarding the gates.

Kevin: They’re managing perception. Bill King says, “Listen to how often they’re talking. They’re nervous.”

David: That’s right. But again, back to Bogle and Buffet. I think they are ignoring the significant issue where government is providing some windage to asset prices. They are not factoring in a 2% inflation rate and a massive haircut in taxes as part and parcel to what makes passive investing work. And if you change those variables, instead of government windage, and now go back to something more basic like analysis, maybe paying 2% management fee, or even 1%, makes sense.

Kevin: It doesn’t make sense until the government management fails. Let’s face it. Over the last ten years passive investing is the better way because the government has already taken care of it for you. They’re just providing a buyer of everything. They’re the buyer of everything.

David: You’re right. And I want to make that clear. Bogle and Buffet win the argument on this if you’re looking at a ten-year period.

Kevin: What about the next ten years? Do you think it will work again?

David: I think, what about the previous ten, and the next ten after that?

Kevin: Because this is the first time in history that this has worked.

David: This is a ten-year period which is conveniently telling a particular story and supporting a particular narrative.

Kevin: Let me ask a question, because the person who is retired who says, “You know what? I can’t buy into this. I can’t go risk my money in the stock market, but I can’t earn an income in the bank.” It was really zero rates that got this going the way we are talking about.

David: This is one thing that was also aberrational, going back to this bet between Protégé Partners and Buffet, which is, will passive investing win the argument or will active management of funds win the argument in terms of who adds more value. This was clearly aberrational, and I think this gets to the heart of the matter that Mr. Buffet mentions in the annual report that each side of the bet was going to be funded with zero coupon bonds. And you buy a zero coupon bond at less than its maturity price, and it doesn’t pay you interest, it accumulates interest through time, and it should get you to par. So you buy it at a discount – that’s the nature of a zero coupon bond – and it pays off at par.

The problem was that the implicit income on the bonds was dropping like a stone so much in this ten-year period that both parties couldn’t reach their accumulated asset goal which was a million dollars for the bet – half million on each of them, that is what they were putting into the pot. And both parties, in the middle of this ten-year period, decided to shift the escrowed assets out of the bond market into stocks instead, specifically Berkshire Hathaway shares. But it is very curious that for the first time in 53 years of managing Berkshire Hathaway, Buffet and company are facing the same plight as the average retiree or person depending on fixed incomes. Where did the expected income go? Where did the magic 5% go?

So all of a sudden we see that the variable which is supporting his thesis that non-managed money is the best way to go, passive investing is the best way to go, is actually under-cutting the very means of financing his bet in the first place, because we’re talking about extraordinary circumstances, something that he has never seen in his lifetime, and yet he is willing to say is normal.

Kevin: So what you are saying is, these guys had to change the rules in the middle of the game just to make the bet work, just to try to win.

David: Yes, and there is no comment on this in the annual letter, on the role of financial repression, the role that financial repression played in thieving the expected income from their funding. So that would have disturbed the narrative of the bet. But his shift out of bonds and into stocks was not aberrational.

Kevin: Which is exactly what the retired person has been having to do. They have been having to shift out of any interest-bearing investment because they are not getting any interest.

David: Right. So you have an increase in risk to reach his bogey – this is Warren Buffet – and that is not aberrational? Yes, the performance numbers in equities played to Buffet’s favor on the bet with Protégé Partners, but the final engineering that greased the gears for that decade-long period were left out of the narrative. So just to wrap it up, again, in the annual report Buffet says, “I just want to give you a report. This is to summarize what we have been tracking for the last ten years. Protégé Partners made me a bet that they could find the best, best, very best hedge funds, and that they would beat an index fund like the S&P 500. They failed. Hedge funds in the last ten years have failed. You just buy the S&P 500 and you out-perform. My point exactly, and Protégé Partners was wrong. So, we’re ponying up. But that was the bet in play.”

Kevin: But we have not had a major significant downturn yet. How do you test this when we actually have a 2008?

David: Right. I can promise you the next significant downturn in equities will reveal the out-performance of managed assets over indexed assets and it is directly related to a return of fundamental analysis and risk management. Buffet made the bet, yet still, he is essentially a funds manager just wrapped inside a different cloak. So he is arguing for passive investing, but he is anything but a passive investor. The oracle of Omaha, at his core, is a buy and hold value investor. But you have to understand what he does. The returns that he has are superior to many on the street due to the structure of his investment vehicle which uniquely allows for long-term compounding to occur. And the long-term compounding is absolutely critical. Fifty-three years is a period that begins to reveal the benefits of basis, of cost basis. When cost basis is low and you’re not forced to sell or trade for short-term results, the magic of compounding is revealed. Yes, I completely agree, he chose great companies. But that, in itself, flies in the face of his bet on index investing as a superior path to personal financial gain. He, himself, is not on autopilot. Berkshire Hathaway showed discretion in the companies that they chose, and the vast number. Look, if he has two dozen companies in his portfolio, that’s two dozen out of 43,000 companies that he could have owned. He said no to them, yes to 12-15 – you see what I’m getting at?

Kevin: Well, it’s a paradox, and an irony, and a contradiction, actually, if you want to look at it, because Buffet is a manager, and he is saying, “You don’t really need one.”

David: Charlie Munger, his partner, and Buffet duo – they would never buy an index fund and call it good, but that is precisely the inconsistent and contradictory conclusion that he suggests in his annual letter. The hoi polloi – should they ride the waves of the market up and down? Should they pay for nothing? Should they go via the autopilot investing to a John Bogle and invest in Vanguard funds? He says, “Yes, let the market be your friend. Own the index.” I think this is hooey, and he knows it.

Kevin: There is another source coming in, not just the government creating liquidity, but he has had this insurance business this entire time that funds his little hobby.

David: So cross-referencing Berkshire’s insurance business – a primary reason he came out smelling like a rose through this 53-year tenure from those significant downturns – remember the four big significant sell-offs – in the 1970s, 1973-1975, the catastrophe in 1987, 1998-2000, the tech wreck, and 2008-2009, the global financial crisis, Berkshire shares were down 40-60%. In every one of those instances, again, how does he come out smelling like a rose? Here is the key. It was due to the growing premium volumes that he had in his insurance business which gave him the float of other people’s money.

Having that float – just go back in time. In the mid to late 1970s his insurance company is throwing off 100 million dollars annually in float, but he gets to invest however he wants. Each year, mind you, by the year 2000 it is just shy of 28 billion dollars a year which he gets to go out and invest – this float that he has available to him. It doubles to 60 billion by the time we roll around to the global financial crisis and it currently sits around 114 billion. If I’m not mistaken his cash and treasury holdings are right around 116. That is 116 billion. That is a lot of dry powder to have as a market is selling off.

So what he has been able to do is step in and buy assets when they are cheap, establish an incredibly low cost basis, and then hold them forever, and nobody is pressuring him to sell, nobody is pressuring him to trade, nobody is saying, “Why aren’t you more active in your portfolio management?” But he absolutely is a portfolio manager.

Kevin: It reminds me of clients that we have, Dave, that are debt free that are bringing in substantial income from, say, real estate properties. So they have that flow coming in. They can go take their money and invest it almost any way they want because they already have a stream of income coming in from an outside source.

David: And they will do the same thing next year.

Kevin: Yes, which is a great strategy.

David: So again, it’s the insurance business. Everything else he owns offers negligible cash flow benefits relative to the annual premium volumes and the float of cash that that gives him to step into the market. Ray Dalio, just a few weeks ago, just before the mini-crash, was suggesting that cash would be an embarrassment to have.

Kevin: Yes, isn’t it funny how they changed their story?

David: (laughs) I think his literal words were, “If you’re holding cash you’re going to feel pretty stupid.” Well, Buffet’s sitting on 116 billion dollars in cash and coaching his shareholders via a Kipling pep talk to stay the course through the next market snap, the next market snafu, the next full blown category 5 financial storm.

Kevin: But remember, watch what he does, not what he says. Look at 2017. Did they really purchase anything while everybody else was rushing into the stock market?

David: Nothing. You have the general public stepping in and saying, “We ought to buy stocks right now with reckless abandon, and the index funds are the best way to do it.” Meanwhile, Buffet is accumulating cash, one of the largest cash hoards Berkshire Hathaway has ever had, and his comment is, “There is really nothing that isn’t way over-priced at this point.”

Kevin: And this is the same guy who said, “By design, we can even whether the worst of things, including a market shutdown.” So he sees something. Any time you start to accumulate a lot of cash, you’re seeing an opportunity in the future.

David: I get it. So the man-in-the-street is moving in with his last nickel and Warren Buffet at Berkshire Hathaway in 2017 makes no purchases and is stacking away cash. Why the near-record cash hoard? I think it is easy to surmise. The Protégé Partners bet was really to underscore Warren Buffet’s value relative to the best and the brightest on Wall Street. He outperforms them all and makes the indexes look like a joke, too. So he says, “No, you shouldn’t give your money to a hedge fund manager. You should give your money to a blind monkey, they’ll do a better job. Oh, but by the way…”

Kevin: “Unless it’s me.”

David: “Unless it’s me.”

Kevin: “And I have glasses, I’m not a monkey.”

David: That’s the thing here. He outperforms them all, he makes them look like a joke, there is virtually no turnover of assets, and again, these are his long-term holdings. He has stuck to some very basic principles which have propelled his success. And yes, his success has exceeded the indexes. And those three basic principles are pretty straightforward – reinvest his earnings, number one. Number two, he compounds his interest. He allows compound interest to work its magic, not over years, but over decades, and therefore through multiple business cycles.

Most investors do not allow for even the minimum of, say, 10 or 20 years, for outstanding or out-performing returns. He is looking at this from a multi-generational or multi-decade standpoint. Again, so what is he doing in the interim? He is controlling management’s ability to siphon off funds from the business. Notice, this is one of the differences between Warren Buffet’s control of an entity, and going out and buying a publicly traded company. You have management, who has been delegated the responsibility of running a business, and how do CEOs run their businesses today? For their personal benefit. I could list at least six or seven CEOs who, this year, in the first quarter, will make 25 million dollars – 25 million dollars in the first quarter. Are they worth that? I’m not sure. I’m not sure, but again, corporations being run for the benefit of the managers?

When Buffet and Munger get in and control a business, they make sure that any of the extra cash flow does not get siphoned off for personal uses, does not get wasted through extraneous acquisitions, but gets invested well, because they believe that they are the best asset allocators. There is a mind involved. This is not an algorithm, this is not leaving investment to chance, this is not saying the indexes will take care of me. This is saying, “We believe that we can offer value in the marketplace.” So the third piece – never underestimate the value of a cash hoard put to good use in a market selloff which allows for a far more competitive cost basis to be established in your portfolio holdings. So in the end, he is the object of the bet.

Kevin: He wasn’t trying to prove that passive investing would win, he was trying to prove that he would win.

David: That there is actually nothing better in the universe than Warren Buffet and Berkshire Hathaway.

Kevin: And he sort of did.

David: And I’m okay with that, because actually, in the timeframe, the last 53 years, unless you are buying Apple when it’s a nobody nothing company, or buying Google when it is a nobody nothing company, there are very few ways that you could have beaten Warren Buffet. But again, yes, there is stock selection involved, but I want you to keep in mind this point number three. You have re-invested earnings, compound interest working for you over decades – decades – and having cash hoards that allow you to buy shares at market lows.

Kevin: Liquidity, liquidity, liquidity.

David: Right. In the end, as I said before, he is the object of the bet. Implicit to this 2017 annual report is a critique of Wall Street, and it is a scale of excellence which places Berkshire at the top of the heap. He is an index on steroids. Better than that, he is an actively managed index fund.

Kevin: Right, not passive.

David: So you have to admit that brains and macro-analysis do, ultimately, outperform the autopilot approach. He just wants to be the guy who is flying the plane. He wants to be El Capitan.

Kevin: He is proof of what you have been trying to teach in this commentary for the last ten years, and what your family has been trying to teach for the last 46 years, and that is, you have to have a disciplined approach with a long-term goal.

David: And a disciplined approach may mean that you are upside-down for a year, two years, three years, just as Warren Buffet was between 1973 and 1975. Four times in his life he has lost half of his fortune, and lost half the fortune of his investors. Warren Buffet, four times in 53 years, has lost half the fortune of his investors. Isn’t that interesting?

Of course, owning Berkshire over the last 50 years has been a winning bet. He is principled, he is disciplined. He is a disciplined allocator of capital, and there are times when he sits on a boatload of cash in order to be able to establish a low basis, which will be held for decades – those shares which he buys at a low level and he intends to hold for life. That is a winning strategy.

It’s not just what Bogle or the 5 trillion dollars in index fund investors are doing. That is not what is happening. Buffet will talk about what the kitchen is cooking up for everyone else, and he talks excitedly about index investing, but in reality, he doesn’t eat what comes from the kitchen, he only eats his own cooking.

Kevin: I think we want to eat the same kind of cooking because if his cooking cooked up just cash reserves last year, what he is doing, basically, is saying, “I’m only going to have the filet mignon burger.” He has a reputation of eating burgers for lunch.

David: What he is going to say is, “I’m going to wait for Tuesday because Tuesday because Tuesday after two o’clock I get the filet mignon burger half off.”

Kevin: (laughs) Okay.

David: So maybe I eat at an odd hour, but you know what? I’m not willing to pay retail.

Kevin: One of the men you follow very, very closely is Jim Grant. I know you go up to New York to his conferences on a regular basis. Jim Grant is somebody who watches interest rates and has remarked that the last 35-40 years most of the investment movement that we have had, for the stock market, what have you, has been based on falling interest rates. We talked about that last week – 35 years of falling interest rates. Now, what is Grant saying about what the dynamic will look like as we are now in a rising interest rate market? It wasn’t just Grant that said that interest rates have bottomed out and are rising. And we also see the same thing with Bill Gross.

David: Grant, in his most recent Interest Rate Observer, remarks that the 21st century central bankers are many things, but they are not original. And he kind of takes a walk down memory lane, takes you to Paris, 1716. John Law offered ways of creatively financing deficits, creating asset bubbles to the benefit of equity investors, the economy boomed as a result.

Kevin: Everybody wins – again.

David: And that was sort of scene one, act one. But after the bursting of the Mississippi bubble, just four years later, 1720, Law was reduced to a penniless state, was exiled from France, after having been the richest man in Europe. Again, all of that happened, that whole cycle, within the span of 48 months. There is a former business partner with Law who ultimately extricated himself from the bubble and just said, “This is ridiculous.” Richard Cantillon. He saw consumer prices ultimately rising, and a massive inflation waiting in the wings as a lagging consequence of financial asset price inflation.

Kevin: So he saw that you can’t just print money out of thin air and it will still be valuable in the long run.

David: I think it has been probably five years since you and I have discussed what we call the Cantillon effect. It’s like this – pouring honey onto the center of a plate only to watch it ebb outward toward the edge. Liquidity hits different parts of the market and the economy on a delayed basis as it oozes out, just as the honey migrates slowly. You have Jim Grant connecting a few dots here, bringing in the historical analogy into the future, concluding that you have two things. Bonds have a tough road ahead of them. So if bonds have a tough road ahead of them that implies that interest rates are going higher, bond prices are going lower.

Let’s look at the Warren Buffet portfolio under that sort of precondition, where you have an increasing cost of capital instead of a decreasing cost of capital. How does his portfolio, vis-à-vis the rest of the stock market, perform? And I think you’re talking about an environment that moves back into a period of time where, yes, even Warren Buffet can lose 40-60% of the value of Berkshire, along with the S&P 500 Dow, Dow transports, and what not.

Kevin: Do you think that is why he is accumulating cash, because he can sense this?

David: Oh, absolutely. He could have bought things in 2017 along with the general public and he refused to because things were over-priced. But they are not so over-priced that he would not recommend that individuals go invest in the stock market.

Kevin: “Oh, you guys go buy. And make sure it’s indexed. Make sure that it’s not managed.”

David: Again, I have a great deal of respect for the man, but there are some contradictions in his message. And I think, as Jim Grant suggests, bonds do have a tough road ahead of them. The holders of bonds have hell to pay, not just over the next two, four, six months. There is short-term volatility which may actually be some relief for the people who have experienced major losses in bonds over the last six, 12, 18 months. But the reality is, we’re talking about a secular trend. We’re talking about a secular bear market in bonds. We’re talking about something that can last five, ten, 15, 20, 30 years, with some relief along the way.

Kevin: You’re talking about Buffet going to cash, but we saw dollar cash lose 11% of its buying power worldwide last year. So gold would have to play into that liquidity picture.

David: I think it does, and Grant points that out, that it is, so avoid bonds, and gold is looking more attractive all the time, is from Grant’s perspective, a key take-away from the historical analogy and the major run-up of central bankers creating artificial asset booms leading to a full-blown asset bust. Grant is admittedly in the gold bug camp, but I think for good reasons.

Kevin: Dave, we have run out of time. So often, I feel like we cover so much here on the commentary, but there is so much that we leave out that we talk about, say, on the Monday night before we record this program. So Doug Noland’s comments – we have brought them up over the last couple of weeks, but anyone can read them for free these days on the Credit Bubble Bulletin. Noland’s comments this week on China definitely need to be read.

David: We could spend an entire commentary talking about them, and so I will refrain from that, or at least extending this commentary too long, but I highly recommend you read the weekend post at, our wealth management site. Look for CBB, Credit Bubble Bulletin.

Kevin: It’s right at the top. You can just click on CBB.

David: And of note is the seizure of control of one of China’s largest insurance companies. This is really worth reading and thinking about. You have the former chairman, who disappeared in June – disappeared in June. Now, that’s the way things are done. Here in the United States you may be detained, you may go to jail, everyone knows where you are.

Kevin: Grandpa, where did my husband go?

David: Gone. Gone. Thank God for due process. You can critique the U.S. system, but there still is a version of the rule of law.

Kevin: Right. Innocent until proven guilty. That’s not the case when Grandpa is running the country, and I bring up Grandpa for a reason.

David: Well, right, because this man was charged with fraud and embezzlement, and I think what is really interesting here is, not only is this one of the largest insurance companies in China, but here is the curious really important fact. He was married to the grand-daughter of Deng Xiaoping.

Kevin: He is married to her.

David: He is married. I’m sorry, he is married to the grand-daughter of Deng Xiaoping. And what you realize is that under Xi Jinping there is no political connection which he cannot or will not take down or disempower. The story points to the heart of destabilizing credit conditions. The story here points to the complete consolidation of power by Xi Jinping.

Kevin: And if you’re not related to Xi Jinping, that had to make the hair stand up on your arm.

David: Which is the majority of people in China, right? So this is not in Doug’s notes, but there is a theme that runs in a parallel track, which is the one belt/one road project which serves as a positive outlet for mass discontent, as more people protest the pressure that they are being put under by the Chinese superstate, and this is happening. It has exceeded what used to be the routine 70,000 street scuffles and protests on an annual basis in China.

But again, the one belt/one road project ends up being a great release valve for all this pressure. It is a great source for national pride, it is a great source to go spend a couple of trillion dollars, it’s a great source to employ people. It is something that you can really, in terms of a PR campaign, get behind as the world gradually shifts from a dollar and petro dollar standard toward a less unipolar world, and the U.S. is not front and center.

Kevin: China knows that they cannot be reliant on the dollar as the world’s reserve currency, to continue to move this direction. In fact, we were talking just yesterday about oil futures and different types of oil trade now being denominated in yuan. It’s not on a large scale, but it is testing the waters to move away from the petrodollar.

David: Consolidation of political power in China is no accident. And it is coming in a time just before a very significant credit crisis in that country. How they are able to channel the flows of negative energy in that country is going to absolutely be critical. And yes, we have an erosion of dollar dominance, a migration toward a more leveled playing field with the rest of the world players, whether that is Turkey or Russia or the BRICS countries flocking together and becoming more unified. Again, we could spend an entire commentary talking about that.

But you have some macro-level things which argue that the success of the last 20, 30, 40, 50 years is not readily duplicatable. And while I would love to go back to those three basic things, and reinvest earnings, and allow for compounding of interest, and keeping a cash hoard to invest at key strategic times, I think there are going to be other mitigating factors that make that project even harder. When Munger and Buffet are gone, which being in their 80s it is not as if they’re going to last forever unless they cryogenically freeze their brains and tap into them just for the shareholder meetings…

Kevin: Well, they don’t need to anymore because indexed passive investing does it better.

David: (laughs) The reality is, the managers at Berkshire have an uphill battle and it is not because Buffet and Munger will someday be gone, it is because the prevailing winds which were so helpful over the last several decades are going to be shifting and moving the opposite direction. If you underestimate the cost of capital and its contribution to what the stock market has done over the last 20 and 30 years, let alone the last ten, you have big surprises ahead – big surprises.

I like those three principles, but it is going to take more careful management, not more autopilot investing, to get you through the next decade. And I think a very careful balancing of risk and an extremely, extremely, huge amount of patience in the process, as you store away cash, balance that with metals, and look for opportunities in equities and real estate and other asset prices.

As you said earlier, Kevin, you should look at what Buffet does, not necessarily just what he says – stepping away from the markets, holding back cash. Read Kipling’s poem, If, in its entirety. “If you can keep your head when all about are losing theirs, if you can wait and not be tired by waiting, if you can think and not make thoughts your aim, if you can trust yourself when all men doubt you, yours is the earth and everything in it.” There is Warren Buffet saying, “There is a reason why I have 116 billion, and I’m not concerned about losing 40-60% in the short term because we’re playing the long game. We’re playing the long game.”

If you don’t have reserves – this was the point of the article that I wrote for the March MIA – if you don’t have sufficient reserves, the road ahead for you will be very, very difficult. If you’re adequately reserved, then I fully believe that the next ten years will be some of the most glorious in your investment career.

Recommended Posts

Start typing and press Enter to search

mcalvany weekly commentary