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- Professional money managers caught “fully invested,” when markets crumbled
- U.S. shale oil industry real victim in Saudi – Russian oil war
- When it’s no to stocks, no to bonds, it’s yes to gold
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Calm, Independent Thinking When All The Crowd Is Stampeding
March 11, 2020
“You have the broader context of unstable leveraged finance which has been proliferating, certainly since the global financial crisis, but you can even argue going back to the 1970s and 1980s. We’re building, and building, and building this edifice of debt, and if we can’t make payments, and the bill is coming due, what happens? Actually, a great case in point is what is happening in the oil market today. There is a number of players who will not exist days from now, weeks from now, months from now.”
– David McAlvany
Kevin: Today, Dave, the times that we are in, this is a good time to test just how independent a thinker we really are. Everyone is being tested, with this coronavirus, with the market changes, with what has gone on in oil. What do we do next? I’m watching a lot of people watching a lot of other people trying to take their cues from the crowd. This is the last thing you want to do when you are in a crisis situation, right?
David: We mentioned a few weeks ago that there was an interesting and intriguing psychological and sociological dynamic here where people are concerned and all of a sudden their behavior begins to shift. And actually, you can push and shape and mold human behavior, particularly when people are under pressure. So to be an independent thinker is to do your own homework when it comes to coronavirus. It is to look at the markets and what is driving those market dynamics. And it is to come to some conclusions yourself. Because if you are leaning on the CNBCs of the world, or the CDCs of the world…
Kevin: Or even the Trump tweets. What are we to do? That’s what people are asking, and they are asking friends and family, what have you.
David: And appreciate that everyone has an agenda, so whether it is a political agenda or a stabilization agenda, and it could be a market stabilization agenda or what have you, you do need to make decisions that are realistic and practical for yourself.
Kevin: Listeners to this program, I believe, for the most part, are independent thinkers. Look at the volatility that we have had over the last week. There are a lot of decisions that could be made in the rush that could be wrong in the end.
David: As we have encouraged people to raise cash and own gold in the months leading up to this period of time, I would say luck favors the prepared. I don’t think it is any different when it comes to washing your hands and being cognizant of the very practical things that might improve your immune system or what not, as we consider what this could be in terms of the coronavirus.
As we have talked about it past weeks, this is no big deal if it passes quickly, and it is a very big deal if it doesn’t pass quickly. And it is not so much because of loss of life as it is because of the changes in patterns and behaviors which have a huge economic impact. Of course, our job is not to be doctors and diagnose, ours is to say there are market impacts, and there are asset value impacts to those changed behaviors. So again, short duration, long duration – we’ll tell you how severe it was once it is in the rearview mirror.
Kevin: There is always the black swan that gets the blame, but we have been talking about for months and months and months things that are creeping into the economy. The one thing that we didn’t have until about three to four weeks ago was volatility. Boy, has that changed.
David: (laughs) Yes, time flies, and whether you’re having fun or not, time flies. The stock market peaked February 19th, and in a matter of three weeks we have had sufficient volatility to, as they say, scare the whiskers off a cat. How do you normalize a 1,000-point swing in the Dow, a 3% up day or a 3% down day, moves like that in the S&P and the NASDAQ. I think one of the ways you normalize it is you witness a 7% day (laughs) and then 3% ain’t so bad. Prices seem to always bounce. That is kind of the meme that is repeated over and over again. “Don’t sell. Hold on for the long run.” So you have the CNBC and Wall Street shows which kind of keep the greater fools, many of whom arrived late, in their seats, and they keep them hopeful. Again, it is a time to be an independent thinker.
Kevin: The central banks, of course, don’t want you to think independently. They do want to move the crowd. That is why their words are always perception oriented.
David: You’re right. Macro level management, to some degree, depends on being able to sort of direct the flow of human behavior. Whether that is macro-economic management or social management, this is the reality. What has been normalized here in recent years is the market’s short tantrums, the central bank’s activist words or deeds that come in to comfort, cover the speculators through the nerves of the over-leveraged investor.
That is precisely what we had last week. When that 50-basis point rate cut was announced we had another 3% down day – a little bit of a surprise there. But it was followed throughout the week by a weakness in commodities, the repo market continuing to be under stress and strain, and we saw, this week, the report market move the overnight lending from 100 billion to 150 billion, the 14-day repo arrangement from 20 billion to 45 billion, and then of course we have had growing strain in the credit markets, as well.
So as you have seen spreads increase relative to treasuries there is a re-appraisal of risk in the credit markets. And it is appropriate, I think, and the cost to insure against default has been rising, acutely in some areas, and noticeably in almost all areas. You could argue that this time is different, but this is, again, sort of looking at how we treat viruses. Antibiotics don’t work on viruses. And effectively, cutting rates doesn’t treat the general public’s volitional avoidance of the public square.
That is where the 50-basis point rate cut was a little bit different. It wasn’t the follow-through or impact in the marketplace because, again, it is like antibiotics and a virus. It is the wrong medicine for the wrong disease. So yes, central banks are clever enough to know that, but quantitative easing being the final option, it is not the one that you want to use until you have to. So cut rates first, and then QE next.
Kevin: One of the things that the algorithms and the professional money managers have sort of just gotten to rely on, almost like sailors on a boat who don’t need wind anymore because the know they have the fan always provided by the central banking community. There is always wind in the sails. Central banks have said, “Look, we’ve got your backs,” from the time that Mario Draghi said back in 2011, “We’ll do whatever it takes, to the central banks’ actions even this week. So how prepared were the professional money managers going into the last few weeks, Dave?
David: That’s a good question, but you mention the central banks, and to see the aggregate infusion of capital into the market where essentially we did have QE begin. We had balance sheet expansion by the ECB, the European Central Bank, the Bank of Japan, the Bank of Australia, and the Bank of China and the Fed, combined for 675 billion dollars in 15 days.
Kevin: Wow. More than half a trillion dollars in that many days.
David: Yes. So we have the repo markets, which are part of that, and we have expanded balance sheet stuff all over the world. And there were a few central banks that joined in with lowering rates, as well. Professional money managers coming into the last few weeks – great study by Bank of America, a survey which showed that call option buying was at crazy levels. This goes back to February 18.
Kevin: That’s going long on the market for those who don’t know what a call is. That’s going long for the upside.
David: That’s right. If you want to buy stocks because you think prices are going to go up, then the way to really juice returns would be not to buy stock, but to buy options which give you almost a leveraged play on the upside, specifically if they are in call options, put options are on the down side.
Kevin: A put is on the short side. You’re shorting the market, basically. So what is short interest? Let’s look back a few weeks. How were these guys prepared for a downturn?
David: On the survey the short interest was at its lowest level since 2007. The put/call ratio was at a ten-year low. You had cash levels – again, this was a day before the market peaked – at a seven-year low, and money managers were, even on February 18th, boosting their stock holdings up to the point where the market puts in its peak February 19th.
Kevin: Hindsight is 20/20, but that’s how it always works, Dave.
David: You are tempted to think the efficient markets are all-knowing, and that algorithms today are there to fill every arbitrage gap. Think again. You are talking about a very historic exhibition. What is on display is sort of the uninformed collective judgment. This is not the wisdom of the markets, this is the uninformed collective ignorance, if you will, judging that this is a great time to be putting money to work.
Kevin: Follow the crowd.
David: So call it hopium, call it betting with the Fed and not against it, but I have to say, in the last few days – again, this is not some sort of schadenfreude, I take no pleasure from the market’s decline, but if anything stands out to me as encouraging in this episode of financial market chaos it is that the markets are in control. It is that the Fed is not. Even when you have Bullard proclaiming, “Nothing is off the table,” as he was on Bloomberg saying, using his version of “we’ll do whatever it takes,” the free market is alive, the top-down social engineers are a bit confused, a little bit struggling to make sense of it. Because from our vantage point, math is once again a verity. It makes sense. You can rely on it. You are not crazy for thinking that too much debt will get you into trouble. And so I think what we have over the next three years is that there is actually hope that zombies will finally be put in the grave.
Kevin: Let’s explain that, because really, free markets are zombie-killers, and that is a wonderful thing, actually, for the healthy person, because a zombie is something that should be dead that is alive. The free markets kill the zombies, but the central banks will keep them alive, and it actually turns into a cancer on the system.
David: Free markets are self-regenerative in the sense that a bad idea comes along and it fails. And there is a harsh reality to the free markets, whereas when you infuse capital, cheap credit, unlimited access to it, you can take a bad idea and you can extend the life of that bad idea well beyond its normal cycle. And so you are right, the free markets are like zombie-killers. So when you think of the money manager community, I would suggest that to a large degree you are talking about the blind leading the blind. That is not to say that they don’t read the Wall Street Journal or have the jargon down, can’t speak to earnings, and get sort of wrapped up in that world. That’s great. But I think over the next one to five years, I hope you as a listener remember the B of A survey, and I hope it leaves the same impression as City Group’s CEO. Remember Chuck Prince? He said back in 2007, “As long as the music’s playing, you’ve got to get up and dance.”
Kevin: And most of the time that’s true. When you’re talking momentum and you are a professional that could lose your job if you’re not doing what everybody else does, guess what you do? You do what everybody else does – until you get crushed.
David: Which is why when I was at the real estate conference a few weeks ago I asked the question, “What happens when liquidity stops? How does your business plan operate? There was a debate between you should be buying more real estate right now or you should be selling real estate right now, and the folks who believe you should be buying whole hog right now. I was asking everyone, “How does your business operate in an environment with no access to liquidity?” And nobody had an answer, because liquidity is something that you take for granted. And that actually was a part of Chuck Prince’s commentary. He said, “When the music stops, in terms of liquidity, things will be complicated.” And then you remember the rest. “But as long as the music is playing, you have to get up and dance.”
Kevin: A lot of times these guys don’t have skin in the game. Let’s face it, the banks were bailed out this last time. Executive salaries did not go down when most people’s 410ks did back in 2008. But investment professionals are humans, Dave. Like anyone else, they see what they want to see, and they are also seeing what other people are doing. Again, using that example with the coronavirus, I have to admit, I’m looking around to see what other people’s reactions are, and then I have to say, “Well, is that going to be mine?”
David: And the investment community, quite frankly, is very unforgiving when it comes to under-performance. If you are less than the benchmark, you’re fired. As a consequence, we see investment professionals clinging to job security, and that means playing momentum up until the point where momentum shifts and they are wrong. So you’re right until you’re wrong. And that’s okay if you’re wrong as long as everyone is wrong around you because then you can’t be judged. That’s a fascinating dynamic in terms of preservation of professional viability. You can’t afford to be wrong. What we have always said is that eventually you’re going to be wrong. It is more painful from a monetary perspective, to overextend the stay and let the market claw back from you, 30%, 40%, 50%, 60% in a market decline.
Kevin: And those who were prepared underperformed before. That’s just part of the price you pay to be prepared.
David: And so, can you live with being wrong and missing some of the upside? In an ideal world you would say, 80/20, miss the bottom ten, missed the top ten, and stay solidly in the middle. And maybe more realistically, it is more like 15 or 20 on the low side, 15 or 20 on the upside, and you have to be comfortable with more like the middle 60, middle 70. But that means that the market will continue to move away from you. And there are periods of time when you are going to be wrong.
This is the importance of independent thinking because if you haven’t come to conclusions on your own and understand the assumptions upon which you based your decisions, all of a sudden it is a free-for-all for who has the best idea. Is it Jim Cramer? Is it somebody else on CNBC? What it a quote from a guy at Goldman? Do I get the McKinsey Report and they tell me what I should do next? There are so many things that an investor in a panic doesn’t know how to process.
What I am saying is if you just engage the process you’re going to find that, actually, you are more effective than even the investment professional, which is what you were mentioning earlier. We have the investment professionals, which are all too human. They are like anyone else. They see what they want to see. And generally speaking, they believe what makes them feel good. No one wants to dream of apocalypse, whether that is with zombies or without zombies (laughs). But I think there are enough cycle studies – those are plentiful enough to be sober-minded in particular seasons.
Kevin: You’re talking about humans. What about all the algorithms that have been trading. What is it, about 70% to 80% of the trading is HFT and algorithmic trading?
David: Right. High-frequency trading and algo trading. The trend in recent years has been away from professionals, as in human beings, and toward machines – less emotional, and the argument is, frankly, more reliable. So enter the robo-advisor. The robo-advising alternatives have proliferated and are very popular.
Kevin: Or how about the free brokerage services where you pay no commission whatsoever, like Robin Hood? Look what happened to Robin Hood on Monday.
David: Sometimes you get what you pay for, robo-advising alternatives like Robin Hood. Again, this is where algorithms are opening the way for low-cost investing, “smarter” investing, and perhaps even a low-volatility journey to Elysian dreams. If you are thinking of retirement and just a world of beauty and relaxation, and oops – Robin Hood had a few problems.
Kevin: Robin Hood turns into Terminator.
David: Exactly. So you have the robo and auto, which have a lot in common with the pilot that augers into the ground. It seems that three times in the last few weeks, with Robin Hood in particular, you have the algorithms which were overwhelmed and they shut down. I just can’t help but make this connection. When the algorithm is overwhelmed and shuts down, does that not actually reflect the humanity of the program? It can’t handle stress well? Do you know what I’m saying?
Kevin: Isn’t it amazing that they shut down, however, only when people want to sell. It seems that the algorithms really work well when you want to buy.
David: So the platform collapses in disarray when people want to sell instead of buy. You’re right. But since the global financial crisis, there has been this massive increase in the number of financial products that promote traffic flow in, and that traffic flow in is like a six-lane freeway.
Kevin: Oh yeah, “Here you come. Come on in.”
David: But you try to get out and it’s a little bit more like a goat trail in a ravine (laughs).
Kevin: Hotel California.
David: You’re trying to get out. It’s a little bit of a bottleneck. So we have often referenced the overvaluation metrics, and those are not necessarily a great timing tool for trading the market, but they are, I think, a very timely reminder of what will influence your average returns over the next decade. So when we say average, we mean average. Some years are going to be great, some quite ugly, but on average, over the next decade, what are you going to get? What we get to factor into the next decade, and this is one of the reasons why we have been talking about overvaluation. You get to factor in 20% moves lower like we have seen in the last two to three weeks.
If you think about it, this is very common in the context of a recession to see a 30%, 40%, 50% decline in equities. And in a severe recession or depression to see 50%, 60%, maybe even more than that percentage declines. So just saying, okay, look, we saw that typical recessionary trend that impacts the stock market because earnings decline, etc., and you have a repricing of assets. Okay, well, you could see a move lower in the Dow to 14,000 or 15,000. And again, we’re talking about average returns. Where does that put you over the next decade if you spent the first part of the decade stacking in negative numbers – pretty big negative numbers?
Kevin: For the person who has made their call to their financial advisor and said, “What do I do?” And he says, “Just hold on for the long run.” I can tell you, in 1987 the stock market crashed. People lost 30-40%. Then they worked their way back up, maybe broke even by 2000. Same thing – they lost 30-40% depending on where they were. Then they worked their way back up, maybe a little past break even, and then in 2008 – boom – lost 30-40%. Now we have the same type of thing going on. And so there is an illusion that if you just hold your stocks long enough you’re going to do fine. So in the long run, yes, holding stocks does help. But it’s not just as simple as holding everything just the same. This professional management – let’s look at the long history of equity markets and actually see the truth in that.
David: The only thing I would back up on that is to say the 1974 recession was a pretty nasty one. 1987 was more of an anomaly and it wasn’t your typical 30-40% decline, it was 20% in a day and we recovered pretty quickly thereafter. But that didn’t have the structural dynamics that you had in the 1970s, or certainly what you had at the end of the bull run.
Kevin: That wasn’t the crash, was it? In the 1970s that was actually just a slow degradation of the markets.
David: If you lost 30-40% in the market, you lost an extra 20-30% on top of that because of negative compounding as a consequence of inflation. So your real rate of return was even more deeply negative because inflation was helping you auger in. So how do we get to lower levels? I think this is something that takes months to years. The road ahead is not an easy one. If you’re talking to your financial advisor, first and foremost I would say, do your thinking for yourself. There are attitudinal dispositions. You can see this with coronavirus. There are people who are going to panic, there are people who are super paranoid, there are people who are super careless.
Kevin: And some will take a cruise.
David: Yes, because it’s cheaper right now. So what you have is an expression of personalities. Typically, the personalities that are attracted most to the financial advisory business, which is different than asset management, these are people who are positive-thinking, very well-spoken, somebody who can glad-hand and work the cocktail party, great to talk with on the golf course, super personal, just very emotionally engaged. So keep in mind, you are dealing with somebody who wants to see the best in every circumstance, typically, in the financial advisory business.
You probably need to think for yourself, and there are times that you can see the best, because realistically that is what you have to look at, and other times where a realistic appraisal is something quite different. So what I would suggest is that you sell the rallies. We will see some rallies in here, but I think what we have determined by looking at the credit markets is that something very, very odd has just occurred.
Go back to 2008 and 2009. When you had significant selling pressure all through late 2008 and through March of 2009, where did the ten-year treasury get to? You’re talking about panic buying. People wanted the security of the treasury market where they knew they had a liquid asset. They were not going to be concerned about inflation, even though you had a major ramp-up in commodity prices and more of a visceral concern, or an obvious concern about what could have been inflation. Look at commodity prices back then. We’re talking $100-130 a barrel just coming into the financial crisis. Where we saw the ten-year treasury, it got to a low of 2%. Monday we saw the ten-year treasury get to 31 basis points.
And so, to have basically scraped the bottom of the barrel in terms of interest rates without going nominal negative, is fascinating, absolutely fascinating. The 30-year treasury slipped less than 1% this week. So again, you say to yourself, “What is different this time?” What is different is palpable fear within the credit markets, within the bond markets. You have fixed income investors – there are almost two groups within the fixed income world, those who are still buying with reckless abandon the investment grade products, not realizing that the vast majority of the product in the investment grade category is sitting at Triple B, just waiting for a downgrade again. It will have to be chucked out of those portfolios, moved to junk portfolios.
Forced liquidations equals fire sale pricing. So you have something “investment grade” which is getting ready to catch fire. There are people who don’t know that, don’t appreciate that, are just looking at higher yield and see the “investment grade” and think that is higher quality and so they are willing to take the risk. The other category of fixed income investor is someone who is treasury only, and they say, “I just don’t like the looks of this environment and I think I need liquidity, and I think I need asset preservation. So to some degree you see a few of those dollars move in the gold direction, but a large percentage of those dollars go toward treasuries. So 31 basis points!
Kevin: Right. Near negative. Jim Deeds has been a guest of ours. For those who haven’t heard him he is going to turn 88 soon, yet he stays so actively engaged. He has been in the stock market since the 1960s. He was a broker for many years. He actually worked here for years. Right before I walked into the studio today he called me up and said, “Kevin! I just have to tell you. The bounce that is occurring today (the stock market was up) is what we call in the market a dead cat bounce. You’re going to see a bunch of these all the way down to 3,000 points.” That’s what he said!
David: He is picking a rather low number, but I think 14,000 to 15,000 on the Dow is more realistic than 3,000. I think the long history of equity markets is a series of moves to higher highs. So over the long term, yes, Jeremy Siegel is right. But the painful punctuation lies in the one step back, which statistically puts the market in regress mode 40% of the time. It is the 60/40 split.
Kevin: We have really forgotten that, haven’t we? We thought it was 100% of the time that you make money, but 40% of the time is regress.
David: On balance it pays to be bullish on stocks for the long run, but it also pays to be engaged in risk management, think for yourself, so that while you keep a long-term bullish attitude, you can stay positive, but over the long term you don’t want to be forced to endure these massive tests of patience in the interim.
Kevin: So we have had 10-12 years of growth, if you figure the 2008 crisis. Let’s call it a decade, maybe nine years of growth. What that means, if you’re saying a third of the time, or what have you, a quarter of the time, we’re talking two, three, four years now, where we could have what you’re calling regression.
David: This is textbook. This is Dow theory. Bear markets typically last one-third the length of the bull market which preceded it, according to Dow theory. This goes back to Charles Dow, Hamilton and Rhea and the most recent iteration would be Richard Russell. But bear markets typically last one-third the length of the bull which preceded it. So we have a 12-year bull market in equities, depending on where you want to count it from.
Kevin: We spoke of the new religion of perpetual growth. The central banks have pretty much written a book on perpetual growth. What you are talking about here doesn’t match that outline.
David: No. The central bank community has crafted this global construct in complacency. This is how we got here. They create complacency. No one needs to exhibit adult-like behavior. No one has to be responsible if you have already chosen the designated driver. That is who we have. Central banks have said, “We’ve got this covered.” So leverage builds, risk-taking becomes commonplace within the financial community until you have the whole financial landscape which is rife with speculative bet upon speculative bet, growth based on unsound finance, not unsound business practice. That is the big contrast is that it is unsound financial engineering as opposed to a really well-executed business plan. So complacency grows. You do see a step back. All of a sudden those risks are socialized. And you end up with greater and greater zombie-like characteristics.
Kevin: So let’s look at these zombies because the zombie companies, actually, a lot of them used to produce something. Look at General Electric. Unfortunately, we are talking about Welch after he passed away, but he really did change the entire culture of how GE works.
David: Right. We discussed GE last week, and again, it’s not because I’m a fan of GE, but it serves as a great example, particularly since it is the only Dow component left after 120 years. But I want you to know, when we talked about the GE-to-gold ratio, we were talking about taking those 100 ounces of gold and putting them into GE and being able to buy 16,000 shares. Well, with this week’s market volatility, you just bumped from 16,000 shares to 20,300.
Kevin: What a great example, then, last week.
David: Again, Jack Welch is the poster boy, not a management genius, but of unsound corporate finance, of reporting chicanery. Under his guidance, GE perfected accounting gimmickry and they set the model for corporate management pillage of the shareholder. That is really what I remember him for. And then he perfected what corporations can now use GE as a model for, which is offshore tax arbitrage. There are so many years in which GE never paid taxes because they had 1,000 accountants managing how to create offsets and create transfers and various in-between entities.
Kevin: Even if that’s not good, wasn’t it just an adaptation to what the central bankers were providing. You were talking about the zombification of companies. A lot of times that is a survival mechanism for companies that would have gone out of business.
David: I’m not talking about them doing anything illegal. This is basically shifts within the capital markets which began in the 1970s and then accelerated in the late 1990s with the end of Glass-Steagall and kind of a reduction in management expectations. I think it was the early 1980s in which they started allowing stock buy-backs, 1984 if I’m not mistaken. And it was fascinating because prior to that, stock buy-backs were considered to be a form of manipulation of the stock.
But then, 1984 to the present, you start remunerating CEOs with huge packages of stock options and things like that. None of us are all good, and none of us are all bad, and Jack Welch fits right there in the middle with us. He certainly had a lot to offer of a positive nature. There were many of his leadership attributes which are to be admired. But my point here is that GE stands out as an example of an entire corporate landscape that has become dangerously leveraged and dependent on financial engineering. One of the contributing factors is, of course, access to cheap money, and the enabling of this, the zombification of corporate America, is, in fact, monetary policy. That is really the key generator of these corporate zombies.
Kevin: The older investor is going to say, “But things change. And when they change, you lose a lot of the people who were standing in the same room with you.”
David: Buffet used to say that you get to see who is swimming naked when the tide goes out, and I think that is the same with credit. When credit tightens you get to see who is the walking dead among you.
Kevin: I was just talking to somebody this morning and they were saying, “Wow, what a difference two or three weeks makes.” There was such optimism. Two weeks ago we were talking about the supply chain disruption with Covid-19. Now we have had other factors. The Bible talks about birth pangs coming closer and closer together. In a weird way, we have had that. We talked about Covid-19, then supply chain disruptions. Then all of a sudden we had the stock market really reacting. And then we had the OPEC crash. It really does feel like it’s coming more and more rapid, doesn’t it?
David: (laughs) Well, it’s not unlike 2008 when we were starting the podcast 13 years ago, where it was rapid-fire from the get-go. Every week was like drinking from a fire hose. But, yes we have a short mental break here from those supply chain disruptions. We have the changed consumer behavior because of Covid-19. And I would say this week, very key, watch the sentiment numbers that are out this Friday. It will be fascinating to see what three weeks in the volatility meat grinder has done for the average investor, the average consumer. How do they feel? So we have transitioned from that to the fireworks that were lit in Austria this last Friday. The OPEC Plus meeting where Russia was involved, not a member of OPEC.
Kevin: Let’s look at that, because that is not exactly what we see on the surface news. You just interviewed George Friedman not too long ago. One of the things I love about George is he gives you a perspective as if the world is chessboard. And it seems this OPEC meeting isn’t necessarily what it seems. There is something underlying that.
David: Yes, there is a lot in play here because you have two countries which require higher oil prices to pay their bills. We talk about guns and butter policies. These are countries that do have both, and particularly, the butter policies where they are taking care of their constituents. They have social programs which they are obligated to. Both Russia and Saudi Arabia generate a lot of their revenue from oil. They are major contributors in the oil market.
Kevin: Replay that sequence then. What actually occurred?
David: In a nutshell, Saudi Arabia suggested at the OPEC meeting on Friday – it ended on Friday – that there would be cuts in oil production to support the price in light of Covid-19, this coronavirus, and it is the impact that it is having on global oil demand. So they are suggesting proactive price management by turning down the tap, not turning it off, but just turning it down. Since 2016, Russia has played a key cooperative role in aiding the Saudis and the rest of OPEC with managing the global supply of oil ex the United States.
The 2014-2016 period was brutal in the oil markets, and Russian cooperation from 2016 forward has helped set the tone for the oil markets, stabilizing them since then. So prices stabilized, prices moved higher, and U.S shale was given a whole new lease on life (pun intended). Fresh drill techniques – they were working off of those. They had prolific acreage. And here in the U.S. the shale patches – they were developing only the best wells. Even in a low price environment they had been kind of forced to refine and just focus where they could see best return on capital with each dollar spent.
And so the refining process was there, which was helpful toward bringing their cost structure down, and then you had the supply side being managed by the Russians and Saudis and the OPEC group. And so gradually what we saw over the course of time was the U.S. moved from 8.5 million barrels of day of production to over 12 million barrels.
Kevin: So in a way, the higher prices that were helping Saudi Arabia and Russia in the short run were actually creating and building their greatest competition, which is U.S. shale.
David: Yes, they helped build their U.S. shale competition. So the cost of cooperation with OPEC has for several years set the stage for giving U.S. shale a larger and larger share of the global oil market. So that issue of market share is a huge factor here. Last week’s Vienna meetings proposed basically more of the same. In order to stabilize crude oil prices, the proposal was going to be to reduce supplies to meet the lower levels of demand as a consequence of coronavirus.
Kevin: That’s where Russia walked out. Russia just said no way.
David: Right. The surprise was – they had been playing ball – Russia refused on the basis that stabilization costs, if they were going to stabilize the price of oil, it was coming out of their hide and leaving the door wide open for the U.S. shale producers to march right on toward 13 million barrels a day and beyond, taking even more market share from OPEC. In essence, they are gutting the earlier international geopolitical order and oil pecking order. So this is where they want to make sure that they can take back some market share and make sure that the international geopolitical landscape where power is wielded by the largest global oil producers, that they are completely written out of the script.
Kevin: This is what is delicate, though. Saudi Arabia needs U.S. protection, they need U.S. favor, and so how in the world do you crush U.S. shale without having some sort of distraction between them and Russia. Is that what you’re saying?
David: Yes, and you have to play this with a strong poker face because on the one hand both the Russians and the Saudis are willing to crush the price by non-cooperation and then setting the prices at a lower level in tandem, but Lila, who does a lot of research for us on individual companies within the energy space, would say $45 a barrel is required, bare minimum, for Russians to pay their bills, keep the lights on. And the Saudis have made so many social promises and are paying out so many things in terms of benefits to the Saudi citizenry. They need $80 just to break even. Of course, that is not to say the oil production costs are that high. They are more like $3, $4, $5, under $5 a barrel coming out of Guar and those large fields. It’s like giant pools of oil…
Kevin: Yes, they have committed those funds to the degree that they need $80 per barrel oil.
David: To fiscally break even as a country, right. So the Saudis reacted to the Russians, and as they declared war on each other, conveniently, the U.S. shale industry is positioned right in the middle, taking fire from both sides. I think diplomatically it is brilliant because the cast is the Saudis against the Russians, the Russians weren’t playing ball, the Saudis were playing hardball with the Russians. But both of them are hoping to chop the U.S. oil production capacity down to size.
Kevin: Yes, Shakespeare said all the world is a stage. This was a stage.
David: (laughs) Absolutely. Recall that the U.S. is still using sanctions against Russian energy companies. Rosneft comes to mind. They are trying to pressure Russia on the Nord Stream 2 pipeline. That is a pipeline that is to deliver Russian gas directly to Europe. When you start thinking of energy as a tool, not just for something that keeps the lights on or fuels this or that, it is a geopolitical tool, and it can be either be used as a carrot or a stick. So what you have with the Nord Stream 2 pipeline is basically the stripping out of U.S. influence into Germany and France by getting reliable sources of gas directly to – and if you can create a dependent relationship, then all of a sudden you start defining the nature of international relations going forward.
And that is what Nord Stream 2 is all about. Obviously, it is revenue and it is selling product and all of that, but there is more to the story. There is a geopolitical component. And here Russia has found a way to retaliate by basically going after U.S. oil. And in their view, hopefully shift the pressure. You talked about the chessboard earlier. They are shifting the pressure on the energy chessboard, and so now you have scores of U.S. energy companies which are pricing in bankruptcy this week.
Kevin: So we will see a contraction in the shale industry, but what you are also saying – I think the Germans were dependent, you’ve said this in the past – about 50% of their oil dependency is on Russian oil, and the Russians are stepping that up. It is going to cost them. They have to take lower oil prices for a while, but you crush the shale oil industry in the United States and you pay the price for it initially, but ultimately gain power.
David: Yes, so the severity of this particular issue for the U.S. shale player, and the ultimate consequences, which could be both liquidity and solvency-related, ties just like the coronavirus does to duration. Again, we’re playing a little bit of poker, while we talk about chess. How long can you stay at the table because, like for the Russians, if $45 is your number, we’re well below that. If $80 is your number in terms of money per barrel that you need to pay your bills, how much margin do you have? How much do you have in reserves such that you can play this game, because to really damage U.S. oil you have to extend that – three months, six months, twelve months. The longer the duration, the greater and deeper the pain, the more companies are gone.
So the Saudis drop the oil price, and these are amongst the largest clients in history. This was a surprise move, caught the oil complex off balance. So it raises some questions. Today, who is driving the OPEC bus? You have Russia, who, when we say OPEC Plus we’re talking about – not like plus sizes for Saudis – we’re talking about Russia. They are the extra in the mix. So is Saudi now kind of calling the shots for OPEC vicariously by their non-participation? Who just turned the oil patch inside out? Saudi had a play in it, of course. Russia had a play in it, of course. And again, I think it was masterfully, masterfully played, diplomatically played, where they get to be shooting at each other and it just happens to be U.S. shale right in the middle.
Kevin: So what we just saw this weekend really set the tone for that first 2,000-point decline that we saw.
David: Absolutely, because last Friday set the tone for the credit markets, and it set the tone for the energy markets. Oil was off, kind of underappreciated was the crude decline, roughly 10% on Friday. And that led into sort of over-subscription of repo markets early this week, declining treasury rates this week, a healthy gold price. Both of these are sort of extended trends from last week into this week, but the oil market debacle, as Lila liked to call it, dumpster fire, really got things started and churning for the market open on Monday. Well, for the overnight futures, as well. But I think what develops over the next few months is likely to reshape shale, and thus, you are talking about a different U.S. production profile going forward.
Kevin: So how is this different? We had a blip in the markets back in 2014-2015. Is this different this time?
David: Yes, I think it is going to be a far worse crisis for shale, and through that period, even coming through 2015 to 2016. Cheap credit at that point enabled a whole lot of drilling. That was then. I think credit dynamics are going to change. Even though credit is cheap according to the ten-year treasury, the two-year treasury, the 30-year treasury. Availability may be a different issue. Bank lending likely to be constrained there into the oil patch. I think shale producers at that point in that period of time were able to cut costs. If you think about it, compared to a hard rock miner, if you know you have a rich vein to the right, and a really skinny vein to the left, and you’re under financial pressure, you go to the rich vein because it is going to be more cost-effective to do that. That is exactly what the oil producers did. They went to their land which was the best, the most prolific acreage. They were selective in their drilling, and they were very effective by doing that. Also got the support from Wall Street. Private equities started coming in and doing acreage plays there, as well, and that provided a huge financial backstop for shale in that 2014-2016 period.
Kevin: But no encore performance this time?
David: No. I don’t think we have an encore performance. So we already have, out of the beltway, this talk of a national oil company. Consolidate the zombies of Marcellus and Eagle Ford and Permian and Barnett and Bakken and all the rest. It is an interesting idea. It kind of reminds me of an SPV – special purpose vehicle – like we had in 2008 and 2009 where pressure starts to build, credit starts to deteriorate, and things get ready to blow up, create a bad bank. In this case, it is like a bad oil company. Not bad, as in moral bad, but where you take all of the zombies to sort of congregate. And if that occurs, what do you end up with? You do stabilize the oil market from freefall and you probably stabilize the credit markets, at least as you look at the high-yield market’s exposure to oil, but what you are doing is institutionalizing. You are preserving the zombies for another day (laughs).
Kevin: I’m going to shift to gold here, because a lot of the listeners – hopefully, all of the listeners to this program – have some gold. One of the arguments that people have against gold is that they say, “Well, it doesn’t offer any interest,” or “It doesn’t produce a dividend.” And that true. So there is an opportunity cost, really, with any investment, but gold, especially. Let’s say that you can really make a lot of money in the stock market safely, or you can really make a lot of money in the credit markets safely, then gold is less necessary. But let’s talk opportunity cost.
David: When you look at wealth from a long-term perspective, if you think of this in terms of a multi-generational project, there are ways in which you generate riches. That may be employment. That may be speculation. It may be starting a business and selling a business. But there is a difference between riches and real wealth, and real wealth is, whether it is stuff like farmland, fine art, gold ounces, it is stuff that has a permanence to it which is different than a business which may have a very short life cycle, or a product which is popular today, not popular tomorrow. You can create riches with those kinds of things, but your job, if you’re creating something that is going to last through the generations, is to figure out what this balance is between riches creation and wealth preservation.
We’re kind of at the periphery of what we talked about last week with the Dow-gold ratio, with GE, where if you are building ounces over time, you’re expanding a financial footprint. The dollar value doesn’t matter to me. What I do care about is acres, ounces, and if you are able to ultimately expand that financial footprint. We did this last week. It didn’t look like gold did much, but in fact, looking at the Dow-gold ratio, we moved from 15 and change, back toward 14.3. On a percentage basis, you expanded your financial footprint. The gold market did what it was supposed to do in this value exchange equation.
The opportunity cost – this is the big bugaboo when it comes to gold. Why would you own it when you can get paid to own anything else, whether it is a dividend yield or income in a savings account, or what have you? Golden opportunity cost. What we have seen over the last two decades, actually, is that the opportunity cost of holding gold has declined. Think about this. Rates have moved lower and lower, so that is one factor. Interest rates compared to gold, your reason to have money in the bank versus money in ounces has just diminished.
That’s one of the reasons why I like the Vaulted program. I think we may be entering a period where we have orchestrated lower, or even negative, interest rates, in which case you recalibrate the way you think about your savings in the bank, and I wanted Vaulted to be a savings alternative in that regard. Opportunity cost gone? You’re not getting any income? Well, then what would you rather have? Greenbacks, where there is now a debt relationship, your money is actually being lent out and speculated with? Or do you want just the real thing. Think about Hetty Green. If she wants cash in the account, what is it? It’s gold ounces.
Kevin: And you know what you’re talking about, Dave. You have brought this to my attention, and the listeners’ attention. There was a thesis that was written back in the 1970s by Larry Summers, and Barsky. Remember that? The Summers-Barsky thesis. It talked about that. As opportunity cost diminishes in gold, in other words, as people get less in the way of interest or less in the way of capital returns in the stock market, they are going to move toward gold. But there is not a lot there.
David: This was one of our earlier shows going back ten years ago or more – Gibson’s Paradox and the Summers-Barsky thesis was the paper. I don’t remember if it was the late 1970s or early 1980s.
Kevin: I think Gibson’s was, wasn’t it?
David: The Summers-Barsky thesis was, I think, 1980s. And so, the long-term aficionados of the Summers-Barsky thesis, the final ingredient, shifting investors who might be interested in stocks and bonds, shifting investor traffic toward gold. We’re talking about a relatively static supply of gold. It’s not like we’re quadrupling the supply of gold every year. The stock is relatively limited. It’s the stock market selling off.
Again, the basics of the thesis are this. In the absence of competitive returns, gold becomes more attractive. Just leave it at that. In the absence of competitive returns, gold becomes more attractive. So we’re either talking about an income play where you have a savings account or a bond yield which is more attractive, why would you own gold? You would not. But now in a low-to-negative interest rate environment it makes more sense. Again, the basics of the thesis are that in the absence of competitive returns, gold becomes more attractive.
Kevin: A child would understand that.
David: And what people don’t appreciate is the limited supply of above-ground gold. What we often reference as supply inelasticity – again you can’t double or triple up on the amount, you can’t run extra shifts to increase the supply. There is a very finite universe of above-ground gold that is available for investors. That makes for dramatic pricing of the asset when the alternative investment choices lose attractiveness.
So brush off the Summers-Barsky thesis and recognize that between lower interest rates and pressure within the financial markets, where stocks don’t offer unlimited and one direction upside – okay, here we go. Remember from the Quarterly Journal of Economics, an article titled Durable Exhaustible Resources, it said, “The willingness to hold the stock of gold depends on the rate of return available on alternative assets. We assume the alternative assets are physical capital and bonds.”
Kevin: Right, where you can just come up with as much as you need.
David: If you haven’t read the Summers-Barsky thesis, it is a strong argument for gold’s role, not only as a portfolio diversifier, which it is, and gives a thorough explanation of gold’s negative correlation to market returns, and you can pencil it out somewhere between 75% and 88% negatively correlated to stocks.
Kevin: Explain that. What you’re saying is, it goes up and stocks go down.
David: Let’s say it is between 75% and 88% of the time, they will move in the opposite direction, so there is some room in there where on a given day let’s say stocks go up, gold goes up. Oh, wait a minute, I though you said they were non-correlated. Why aren’t they moving?
Kevin: This is longer-term.
David: And it’s not a one-to-one correlation. It’s between 75% and 88% non-correlated. So the summary – I think this is a sufficient way of looking at it. When stocks and bonds are doing well, gold doesn’t have much of an audience. I think that is pretty straightforward. But when those traditional assets are not performing, that’s when you see the audience for gold increase, you have the limitations of supply which makes for very compelling returns.
Kevin: Like you had said, the stock market actually just recently, it took 20 ounces of gold to buy the stock market. Now it only takes about 14 ounces of gold to buy the stock market. That’s a pretty quick change.
David: That is a pretty quick change. And I think, what we talked about here last week is that we ultimately get to 5-to-1, maybe even 3, 2 or 1-to 1, on that ratio, and that is a pretty dramatic expansion of your financial footprint, because price is one thing. The ratio gives a clearer message on long-term expansion of wealth. If you say, “There are ways in which I have made my riches. I had a great job, I saved a lot, I have speculated on this or that venture.”
What do you do to then secure your riches? You translate them into real forms of wealth that do not go to zero. That is where expanding purchasing power is really critical, putting it in terms of a ratio where you are, over a course of time, expanding – maybe it’s shares, maybe it’s acres, maybe it’s square feet. I think that tells a truer tale than if you’re just looking at a dollar figure on a page which is priced in some random fiat currency.
Kevin: It might answer the confusion. Oftentimes people will call in and say, “Gosh, the stock market is down today. Why isn’t gold up? But it is, really, in the long run, the wrong way to measure in the first place, but the negative correlation does not kick in on a daily basis anyway.
David: No, and I think it is, again, it is on balance negatively correlated. On balance is the qualifier there. 88% is a good number to tie into there. Why did gold not go up as the Dow collapsed on Monday? Again, I think we’re talking about nominal terms versus Dow-gold terms. It reminds me of something that Richard Russell said over and over again about bear markets. The person who wins is the one who loses the least. So in gold terms, you may actually expand your financial footprint.
So yes, I think what we have in the weeks ahead are the surprises from the Federal Reserve. Bullard, on Bloomberg TV, was just saying, “Everything is on the table. We are willing to do whatever it takes to get through this. He is talking about the coronavirus, he is talking about market accommodation, and yes, I think everything means everything. And so, when you see the floodgates open, whether it is liquidity – we mentioned 675 billion dollars between – and this is balance sheet expansion from five different global central banks in a 15-day period. Everything is on the table.
And so you begin to see the reaction of the markets to that kind of dialogue, rates on the ten-year reach a low of 31 basis points, the three-year below 1%. The lowest we have seen on the ten-year – again I can’t believe this – back in the late 2009 crisis, 2%. Fear and panic entered the market in 2008, and then what followed was a series of interventions and QE. Gold went from $700 an ounce to $1900 an ounce. Silver went from 6, to 7, to 8, to 49. And now, I think the only conceivable choices are of QE to infinity.
But here we are at a broader context, and this is where I think the markets are absolutely fascinating. The oil sell-off, credit market risk is now being reappraised, and this is all happening within the last few days, because as we said, the market peaked on February 19th, and yet the market was not appraising risk at all on February 18th, but call ratios ten-year low, cash seven-year low. All of these factors which would suggest that complacency reigned just three weeks ago. We lived in a perfect world. And it is only in the last seven days where we have seen a ramp-up of concern – investment grade, high-yield, emerging market, the financial markets, all of those areas where credit default swaps begin to mark real stress and strain.
Kevin: We’re not in Kansas anymore, Toto. That’s just it. Things have changed.
David: Literally, just a few weeks ago, we were at levels of complacency which were identical to 2007 prior to – and again, this is the perfect world of 2007 – the global financial crisis. And the key turn in the credit default swap market was only in the last week. You can tell this is radical. The leveraged speculators are being put to the wall. We have hedge funds which at the end of the quarter you will see a number of them liquidate and go home – take their marbles and go home. Look at the wildness that has happened. You think 2,000 points on the Dow – 7 percentage points – means anything, we had between a 40% and 50% shift in the ten-year treasury in a 24-hour period. That is radical.
Currency swings? Again, currencies swinging violently, yields swinging violently, as you saw an unwinding of carry trades. These are huge dynamics, and what they suggest, what they have in fact confirmed, is that our thesis is correct. What is the thesis? That there are layers of instability within the financial system, and those layers of instability are revealed at a point in time, and then have to be dealt with.
But the context – well, it’s not coronavirus. Coronavirus is the pin that pricks the bubble. You have the broader context of unstable leveraged finance which has been proliferating, certainly since the global financial crisis, but you can even argue going back to the 1970s and 1980s, we’re building and building and building this edifice of debt, and if we can’t make payments, and the bill is coming due, what happens? Actually, a great case in point is what is happening in the oil market today. There are a number of players who will not exist days from now, weeks from now, months from now.
Kevin: I’m reminiscing here a little bit, Dave, because even though I go back to 1987 here at the company, and you go back even further than that because you were born into the family (laughs). There was a real turning point for us in March of 2008. We’re going into our 13th year now of the Weekly Commentary. But a lot of those years we have been supported as an economy with artificial money, artificial stimulation, quantitative easing, artificially low interest rates, the “whatever it takes” mentality. We’re starting to see that break down.
When we started this program, we were in the middle of the financial crisis. Remember that? 2007 Bearn Stearns tried to sell toxic debt. It was only 400 million dollars’ worth. It was a small amount. And they couldn’t sell it so they pulled it off the market hoping nobody saw. But everybody saw. And it started getting worse and worse and worse. We went through 2008, really until about 2011, and August of 2011 Mario Draghi came out and said “we’ll do whatever it takes.” But here we are, going into 13 years of doing this commentary. Are we now about to repeat, say, a 2008 scenario, and is it worse this time?
David: It feels like rapid-fire is in motion now, and there is something of a repeat of 2008-2009. If we said it was an extension, it wouldn’t be an exaggeration, an extension of the global financial crisis 2008-2009, because the only thing that changed from then to now was a series of promises and the market’s perception of whether or not the central bank community could deliver on those promises. Now, what the relevance of those promises actually was or is, I think, has to still be weighed and measured. What we have seen in a very concrete way is that global debt to GDP is now 322%, and that is just astounding. We have added close to 50 trillion dollars in debt since the global financial crisis. There is no lack of things for us to talk about on the Weekly Commentary, and I think things are about to get wild and wooly.
Kevin: One of the things that has changed – when we started this Weekly Commentary it was just us, and at this point we have been added to a network that we want our listeners to be aware of because there will be like-minded programming on this network.
David: We have been working with a group for 13 years that has done the sound engineering and they do a lot of content production themselves, and so mentioning who they are and what they do, I think, as an added resource, if you’re in the market for doing your own thinking and gathering your own information, we would like for you, the listener, to know about what is essentially a new offering. Our commentary is listed there, SPN podcast network is a free mobile app. Just look for SPN mobile app, and you can find a whole host of podcasts, whether it is on iTunes or Apple podcasts, or Spotify or Google Play.
But the weekly commentary we do is on SPN, and there are a number of other podcasts that you might be interested in, as well, with our partner studio, which they produce. So if you’re interested, search SPN podcast network, and here we are, 13 years on, still doing the podcast every week, and love doing it. I don’t think we called it a podcast then, because I don’t think they actually called it that.
Kevin: It was supposed to be a radio program. Do you remember we were sitting there talking about doing a radio program? I think it was going to be based out of Texas. The suggestion came, why wouldn’t you do a podcast? You realize that is the 21st century answer. And boy, am I glad we did.
David: Radio syndication was the conversation 13 years ago.
Kevin: It was. I remember the meeting.
David: And literally, podcast was not a word. It didn’t exist 13 years ago, but we were doing a show and publishing it to the Internet. And what a bizarre, unhappy world we live in.
I think one of the things that I am very grateful for with the commentary is that over 13 years this discipline on a weekly basis has kept me engaged at a level, and forced a discipline in study and in conversation with people who are better than us, which has made us better. And that, to me, is just an expression of being a lifelong learner. To me, when I think of our listeners, I think of a group of people who are lifelong learners. The reason they are here is they are curious. The reason I am here is because I’m curious.
Kevin: Dave, I go back and listen to podcasts so that I can relearn what I’ve already forgotten. So yes, I was here sitting with you when you said it.
David: Back to that original theme that you brought up of being an independent thinker. No time like the present to be digging deep and to organize resources around how you process what is happening in the world, and what you can be doing about it.