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Don & David McAlvany 2006 Conference:


The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

September 12, 2018

“Now we’re witnessing a divergence, a de-coupling, where the emerging markets are falling apart first. And you know what is amazing to me is that only in the West do we somehow think that we are immune. What this suggests to me is that 2008-2009 was not the last time that pride and hubris preceded the fall.”

– David McAlvany

Kevin:David, this is a profound week. There are several things in the last 17 years that have happened in this country on this particular week that have changed, really, life in America.

David:As I look at Barron’sthe Wall Street Journal, and the Economist, there were so many articles that brought those two realities together, of 9-11, almost two decades ago, and the end of Lehman Brothers, which was just seven years after that, and now a decade in the rear view.

Kevin:It is the same week in September, just different years. It was September 11, 2001, of course, and we all know what happened there. And then Lehman was the week of September 11th, as well, when they closed the doors.

David:And for me it is a reminder of how quick time passes. A day passes and you think nothing of it. You have months, and even years, that can slip by almost without notice, and sometimes without account. A decade seems to almost pass unimaginably fast, and frankly, I don’t think of it except for when there are significant events, and maybe it is the two that we mentioned, or maybe it is a child’s birthday or an anniversary, but these are the things that mark time. In grade school what marked time was going back to school in the fall. And you had the summer months, but it was always punctuated by going back to school. Now as an adult it is a little different.

Kevin:Speaking of going to school, my greatest education, Dave, honestly, has been the last ten years of doing this Weekly Commentary with you. The guests we have had on – it’s hard to believe, isn’t it, that it has been a decade, that the Lehman crisis hadn’t even occurred when we started this Commentary.

David:That’s right. Lehman, if I’m not mistaken, was in the seventh month of the McAlvany Weekly Commentary, and now it is over a decade ago. Time passes, and it is a reminder to me of what matters most in life, as you look at how quickly events occur, relationships are the core of our human experience, the most important thing that we involve ourselves in. So, there is the macabre side of me which is that time also is a reminder of our mortality.

Back to relationships, I have been married for nearly 20 years. My parents are getting ready to celebrate their 50thyear anniversary together. The company, just a few more seasons will pass and we will pass that five-decade mark, as well.

Kevin:I was talking to my wife the other day. We had just gone to a party. I was saying goodbye to friends of ours that have been in town for 25 years and they are moving now. We looked at the people at this particular going away party, and none of us really even had to talk to each other, Dave. We were all like family. We have had the ups, we have had the downs together, and we realized the only thing that really does matter is the relationship.

We really have this here at this company. That is something that we really value. The company has been around 47 years. A lot of the guys here have been here three, some four, decades. We have watched each other grow up, but we have also watched – this is a good example – Lehman. Lehman had not happened when we started the Commentary. We got to, week, by week, by week see it coming, and then talk about it in the rear view mirror.

I think about the first year that I was here, 1987, that was the year when nothing could go wrong for the stock market. I remember reading Fortunemagazine, I have said this on the Commentary before, but Fortunemagazine that summer said, “Our stock is too high.” And they said, mockingly, “You know, there are new ways of valuing the stock market. It is going to go on forever.”

David:And you have the same language today.

Kevin:And Bob Prechter said the exact opposite. Your dad and Bob Prechter were saying, “No, no, no. This fall we could have the greatest crash that we have had since 1929.” And guess what happened?

David:They nailed it. Well, I spoke to Bob this week and he has been working in and around the markets for over four decades, working with technical analysis and drawing on what he calls socionomics. But if you look at it, he is certainly drawing on his degree in psychology from Yale. And I have a number of thoughts that relate to the market and the technicals and his team.

But before we get there, there is a conversation that I had this week at the breakfast table, and it was about critical decision-making under pressure. We looked at a phrase from the book of Isaiah toward the end of Chapter 40, where it describes even a young man’s strength failing. Of course, we have that contrast, if you’re thinking of life’s continuum, of wisdom in the more advanced stage, and youth and strength and energy and all of that when you are younger.

Kevin:And of course you were talking to your four kids and your wife at this point.

David:Yes, my point to them was to recognize that there are times when your emotional, your intellectual and your physical strength will fail. And I wanted to encourage them that those are not the periods of time that you want to make critical decisions. We know that failure is a part of life and that pressures emerge and they will make us very uncomfortable and we are not always going to, in those moments, offer up our very best resources or make the best decisions.

I think it is just important to recognize that. We can endeavor to figure out what our responses will be to various pressures, and while we have full access to our faculties and strengths then make decisions in that kind of a timeframe and that kind of a space. Like my little brother likes to say, “You fight like you train.”

Kevin:And your little brother does fight like he trains. Not just martial arts, but he was one of the first two guys in after the Banda Aceh tsunami wave. So he has been able to see strength under pressure, making decisions ahead of time. But you are exactly right, you fight like you train. Even with flying, you and I both have passed at flying airplanes. You know that the time that you are going to use, the thing that you just felt like you over-trained for, at that point that you are going to use it is almost always at the point when you wouldn’t be able to do that unless you have trained ahead of time for it.

David:Yes, protocols and training. We went on a hike this weekend and it wasn’t a particularly strenuous hike, maybe five miles round trip. We did put the youngest in front as the designated pathfinder. Thank you for that advice.

Kevin:Oh, yes, that’s right.

David:But the sun came out and as soon as the sun was burning and the pitch on the trail increased, I had little voices which were all joined in one chorus. “Let’s go back, let’s go home.” And it was this little microcosm, the psychology which shifted, and the tone of what I consider trail talk. It went from general cheer to sort of full scale complaining (laughs). “When will it end? When are we going to rest? When can I have some water?” Several things happened prior to that which I think were important, because before we started the hike we had talked, and we looked at the map, and we collectively made up our minds where we were going, and when we would break for lunch.

Kevin:So you had a plan.

David:Yes. Life doesn’t always seem to respect the plan. I get that. But at least we set out in our minds with a plan. And there were minor deviations, but we largely stuck with the plan. When the greatest pressure emerged, it wasn’t that we refused to make choices under pressure, it was that we had already made the choices prior to the emergence of pressure and didn’t allow circumstance to dictate the outcome.

Look, nobody enjoyed the heat of the day. I didn’t either, but I have maybe a little bit more of a social filter than the little ones do. No one reveled, either, in the steepest part of the hike. But the decisions were made in our best state of mind, and in anticipation of the challenges that were ahead. We reached the peak, and when we returned home everybody was grateful to have made it there and back again without giving in to discomfort. I reminded them on the path, “Get used to it, guys, not all of life just feels great, but you do just have to keep on trucking.”

Back to what we do and our perspective on the markets, we anticipate discomfort in the financial markets, and I anticipate it on a scale that may rival or exceed what occurred in 2008 and 2009. I think it is worth making some of your key allocation decisions now while you have access to your best possible thinking and are not operating with a lizard brain.

Kevin:It reminds me of the book that Jon Krakauer wrote called Into Thin Air. He was talking about the Everest expedition that had made the decision on when they would turn around from the top of the mountain. You and I have talked about this even with 14,000-foot peaks here in Colorado. You’re talking about your hike where you stuck it out because you had a plan, but sometimes the plan actually has to know when to give up and when to get out.

I think about your time at Morgan Stanley, Dave. We brought up 9-11, September 11th. I think it would be worth sharing the story of why some of the Morgan Stanley people actually survived the World Trade Center attack. There was somebody there who had taught them when to get out.

David:Yes. There is a certain thing – I don’t know if it is muscle memory, or what, but I know when I do the triathlons, I think about every transition before it happens, and I lay everything out in just the way I am going to put it on. When I get out of the lake or the ocean, what am I going to do with my wetsuit and where do I put my goggles, and what do I do with my shoes, and where are my…? No decisions are made when I’m getting out. It is all laid out and it is all in a sequence, and I go through it dozens and dozens of times because I know that when I walk up to this little pad of space I can’t try to figure it out in that moment.

Kevin:You have already swum 1.2 miles, you’ve biked maybe 56 miles at that point.

David:This is not the time to philosophize or try to figure out how to optimize. All of that is done ahead of time. When you do a fire drill in elementary school, or what have you, I don’t know what that is setting in your noetic structures in your mind, but I was with Morgan Stanley when 9-11 occurred, and the training in New York City was a part of that. So I went back for six weeks and every day went to the World Trade Center, and that was a part of the firm’s program for young recruits.

Kevin:Now, you weren’t there at the time that it happened.

David:No, I wasn’t there when the building came down. The challenges on that particular day were in large part mitigated for Morgan Stanley employees because of the decisions and the training imposed on them by Morgan Stanley security detail. There was one man in particular who had worked as a soldier for hire in Rhodesia, and then as a British citizen volunteered for the U.S. Vietnam conflict, after Vietnam moved to the U.S., lived just outside of New York City, and took on the management of security protocols for Morgan Stanley.

In his free time he wrote poetry and was a playwright, a really fascinating guy. This is a man who was constantly thinking about risk and mitigation. That is what he had trained for the in military and that is what he did in the corporate sector. He had actually anticipated the 1994 World Trade Center bombing. You remember when there was a van driven into the basement and blown up there?

Kevin:Oh yes.

David:And then later as they were looking at that crisis and trying to anticipate the next, he suggested the next attack on the building would be aerial. He was just way ahead of the curve. But he trained everybody from the top executives to secretaries to drill an evacuation plan. And it didn’t matter if they were in pinstripes, and it didn’t matter to him what was on their schedule for the day. Rick was his name, and he ran a tight ship, to which even the CEO was accountable.


David:So the decisions were made and the plans were drawn up critically before the events of 9-11.

Kevin:And that ended up saving lives.

David:It saved lives. The day of the event was not the time to make decisions. It was the time to follow protocols and it was time to take action according to the plan.

Kevin:Let’s look at the other thing that happened in September, but it was a different year. It was when the Lehman Brothers had gotten too far extended. We had seen a number of other firms actually bailed out, Dave, before Lehman Brothers closed their door. But Lehman Brothers, if they could have anticipated a little bit like Morgan Stanley had anticipated because of this guy, Rick, if Lehman Brothers could have anticipated what was going to happen to the credit markets and to the derivatives markets, maybe they would still be in business today.

David:I don’t know if you recall the Bank of America CEO at that time. Here is their version of a plan: “If the music is still playing, you have to get up and dance.”

Kevin:Wow. That’s their plan.

David:That was the plan. To the global financial crisis and Lehman Brothers ten years ago, it was not anticipated, and the risk management professionals involved in those firms were largely put in the basement (laughs) because putting limits and controls on product development meant limits to profit, and an allowance for competitors to gain market share. So as a credit cycle wears on you have risk awareness which is not elevated as it should be. In fact, it is marginalized, because you have compensation and competition which are driving the show.

Kevin:Let’s face it. This is not the first bank crisis we have ever had. They come fairly predictably.

David:No, in fact, it would take us the entire time today if we just wanted to list the litany of bank failures and financial crises which have occurred. Just since 1970, from 1970 to 2007 there have been no less than 124 banking and financial crises around the globe. That is not going to change. Why? Because you have the shortness of memory and the perennial nature of greed which keeps financial crises always in the incubation and development stages. The more time that goes on, the closer you get to the inevitable.

What you are talking about is compromised lending standards, excessive commitments made against the rosiest of expectations. And ultimately, what you have, just like Lehman, one player taking a larger loss than anticipated. And what it reveals is the cracks and fissures throughout the system along with the interconnectedness of all those players.

Kevin:And it definitely was not an unexpected thing. I remember you and your dad, in 2006 before the financial crisis, literally hitting the road and giving presentations on the dangers of all these acronym products that were considered derivative types of products. They were all acronyms, nobody really knew what they meant, but it actually spelled almost a quadrillion dollars’ worth of danger.

David:(laughs) Well, here is how you spell doom loop – CDS, CLO, CDO, CDO/CLO squared. So 2006 and 2007, if you’re interested, we’re going to try to find the old copy of – I think we actually recorded that presentation with our clients.

Kevin:We should put that on the site.

David:(laughs) I’m a little bit embarrassed, it was not my greatest presentation, but the information was interesting.

Kevin:Were you able to grow a beard at that point?

David:Absolutely not.


David:Absolutely not. The reason I’ve kept it is because it is a very novel thing to me.

No, the credit default swaps and all of these derivative products were being hatched by Wall Street to package and re-package debt instruments in that era. Yet very little has changed from then to now, if you’re comparing the past to the present and assuming that things have gotten much better because after all we have Dodd Frank and a whole host of other new oversight measures to keep us safe.

CLOs – these are one of the most popular products on the street today. Here in 2018 you have Wells Fargo estimates this year’s issuance at about 150 billion. Again, it’s the same stuff – the same crap that we were creating in 2005, 2006, and 2007. And this time is different because the proliferation of non-bank loans through private equity firms – what it has mirrored is the other forms of shadow banking and lending that avoid the constraints that have been put on banks in recent years.

We talk about viability during the next crisis, and really what has happened is, money has moved underground. It has moved out of a highly monitored, highly scrutinized banking system. And you have tens of trillions of dollars which have emerged within the shadow banking arena, private equity loans, etc., just one example. But again, it is now in a sphere that is no more accountable than what we had in that period of 2007 and 2008.

Kevin:In 2008, I do remember on the Commentary, when we passed the one quadrillion mark on estimated value of derivatives. Now, I don’t think the derivatives value is up to that level at this point, is it?

David:No, and I think what it is comparing when you think about notional values is the traded amount of all of those products. So I think we reached 1.2 quadrillion, and that number has shrunk in terms of the total amount that turns over every year. There is a smaller pool of underlying assets which is about 12.7 trillion, according to the BIS, and the notional value is no longer above a quadrillion, it’s at 542 trillion.

But frankly, the 50% shrinkage in notional value, while some will say, “Look, we don’t have to worry about the 542, it’s just the 12.7,” our conversation with, and the writings of, Richard Bookstaber, support the idea that in a crisis it’s not the 12.7 trillion that matters, it’s the 542 trillion that is looking for settlement, that is looking for collateral claims, that is seeking liquidity. And that complicates the game and resembles a free-for-all. So the gross number is absolutely the critical number in the context of crisis. Large volumes that ordinarily don’t seek liquidity are constrained by capacity limits in that particular context.

Kevin:Let’s look at these debt markets because, really, these derivatives are really insurance policies saying, “Look, you’re not going to lose in this area. We’ll pay up if that happens.” In a way, it’s like a Lloyd’s of London insurance policy. People put money into it with the idea that it will probably never be paid out, and there is usually enough there. The problem is, it’s the other side of things with the derivatives market. There is far more money extended out than could ever – well, how much money is there in the world compared to how much money is committed through the derivatives market? It’s probably a 5-to-1 ratio.

David:You’re talking about the debt markets, and that’s very relevant, particularly when you’re talking about CDO, CLO, and CDS derivatives. But there are other forms of derivatives, and that is how we get to the 542. Even in the gold market there are derivatives, where you may have 100 times the paper ownership compared to the underlying physical metal. In other words, me, and 99 other people say, “I own 1000 ounces of gold.” Except there are only 100 ounces available. Now, wait a minute. Me, and 99 other people, own 1000 ounces and yet there is only 100 available. You do the math and you start realizing not all of us can have the only physical gold that is available.

Kevin:And there is your musical chairs analogy.

David:There is your musical chairs. So everybody assumes that they have it, and then when you actually want it you realize that yes, the 542 matters. The larger number matters relative to the underlying asset base. It absolutely matters. The debt markets, going back to these capacity limits, and really, the issue being liquidity, the debt markets are periodically vulnerable to the same issue in terms of capacity limits. What is the primary purpose of a fixed income vehicle?

Kevin:When you’re borrowing money you are looking for working capital.

David:Yes. But on the other side of that you have the creditor who will hold the loan, or if you are an investor you buy the loan, and you collect interest on the loan during the duration of that loan. So there is a bigger audience of present tense fixed income investors, what we will call creditors, than there is a receptacle to sell those holdings into, if more than a few fixed income investors want out. There are liquidity constraints. That’s what we are saying. And as we have mentioned ad nauseam, the ETF market has exaggerated the perception of liquidity in the fixed income products in the context of a shrinking market-maker role.

In other words, you used to have the equivalent of a warehouse that would take in a particular product, both in equities and fixed income, and that “warehouse” which is technically called a market-maker has been marginalized and doesn’t play the same role that they played, even in 2007 and 2008. There has been a structural transformation on Wall Street and it goes very under-recognized and under-appreciated because, ultimately, the fragilities in the derivatives markets, I think, will be revealed and blown up because of these liquidity strains in the real market as people want real liquidity.

Kevin:I want to be sensitive, using this analogy, to those who lost loved ones in the 9-11 tragedy. But you were talking about Rick and his forethought got people out in time. In a way, it’s a little bit like what you’re talking about with liquidity, Dave. If you’re in the building too long, you cannot get out. That was one of the problems with the World Trade Center when it did come down. There were a lot of people who were in there that, had they have left ten minutes earlier, they would have gotten out of the building.

And in a way, we see this same type of thing with the liquidity crisis. Right now there is no problem because we don’t have a crisis. We may have little signs that there are cracks in the walls, but we don’t have a crisis. When that occurs, will the person be able to get out in time?

David:It was fascinating because you had a whole host of firms there in the building, and a number of Wall Street firms and insurance companies told their employees to just go back to their desks. They were trying to figure out what was going on. The fire alarms were going off, so people were moving toward the exits. And they were told to go back to their desks.

Kevin:That was in the second building. They had seen the first building get hit, they were leaving, and then were told to go back.

David:Rick would have nothing of it. He said, against the protest of employees, “March to the doors, get down the stairs. This is game time. Go.”

When you look at the fixed income market, you look at, globally, 217 trillion dollars in debt. Somehow McKenzie comes up with a variant number, 169 trillion.

Kevin:Still sounds like a lot of money to me.

David:Well, 56 trillion of the total if emerging market debt. About 1.9 trillion of those bonds come due this year according to the Institute for International Finance. Our perception is how we look at things. It is the lens through which we see things. What I am saying is that today we are fine. We have lots of debt in the system, but it doesn’t really matter. People are happy to own it. Add a little bit of incline, let the sun shine, let it get a little hot, like my kids were experiencing this weekend, and perception begins to change. You go from happy to being miserable.

And I tell you what, as soon as we had cloud cover, their attitudes changed again and they were just as happy as could be. These external variables which you are not in control of can completely shift your perception. The problem is, we have a market that has certain frailties built into it because of its size. Again, when you’re at the outer limits of credit expansion that’s when this becomes a real big deal.

Kevin:In 1987 when I started working here, Dave, I was 24 years old, so that I could catch up, even though I was taking Economics in school and doing all these other things so that I could catch up, I devoured the Wall Street Journalevery morning. I couldn’t wait to get into it. I remember reading about this guy, Robert Prechter, who had predicted the 1987 crash, and he really, I have to say, that is where he gained his fame was in 1987 because he was a lone voice, and the Wall Street Journal said that. He made quite a bit of money for himself and his investors. But the reason I bring him up again, because we have been talking about Prechter, you just got off the phone with Prechter, and he is looking at today’s situation, very similar to 1987.

David:I invited his team to join us in the Commentary, which I think they will do in the next week or so, to explore some of these things because I think we’re at a critical turn in the market. He made a critical call in 1987 and it was one of the best market calls he made. Not that he has gotten all of his calls right, but the ones that he has nailed, the big ones, I think this may be on his list of big calls.

Kevin:And you know it was in 1987 that Richard Bookstaber was trying to piece things together for keeping the crisis from happening.


Kevin:So it would be great to have Prechter here because you have two aspects of the same thing.

David:Yes, Prechter and his team today convincingly argue that we hit the peak for the equity markets in January of this year. Looking at the broadest market composite, the New York Stock Exchange Composite Index, it has recovered roughly 70% of the decline from that point in January, but it has failed to rise to new highs. You have the other indexes at new highs and they have done so on very narrow leadership. There are only a few big names that have been pulling the index higher.

And through the summer months, if you look at the last seven months since the beginning of the year, particularly the summer months, on diminishing volumes, a rally through the summer months on diminishing volumes, Bill King has said over and over again, those were the key ingredients coming into every major market decline, including the post Labor Day peak which was put in September 1929.

So you have the New York Stock Exchange Composite which peaks in January. You have a number of the other leading indexes which have pressed higher. And one thing that is worth noting is that utilities, the Dow-Jones Utilities Index, actually peaked in November of 2017, and it, just like the New York Stock Exchange Composite, has failed to make new highs.

Kevin:So you’re getting non-confirmations. That’s what it’s called in the market where you have certain indexes hitting new highs but other indexes either struggling or not at all.

David:Yes. So the significance of non-confirmations of weak volume statistics, and broad market non-participation is that rather than having a market which is signaling significant rises from here as imminent, you have a set of mixed signals. You have new highs that are suggestive of a possible upside to come, and bulls would fully support that. But you have a short list, which we just mentioned, which also suggests that something in the internal gearing of the market is off.

Kevin:Then let me ask you a question. Are we on the edge of collapse, or are we on the edge of radical expansion?


Kevin:If you read Trump’s pre-election tweets, we’re on the edge of a radical expansion.

David:The fascinating thing is, prior to 2016, and 7500 points ago in the Dow-Jones Industrial Average, he called the stock market a big, fat bubble. That’s almost 8,000 points ago we were in a big, fat bubble, but today he says, no, we’re going higher, because obviously, look at what he has been able to do to engineer the economy toward greater expansion and success.

Kevin:Let’s just look at Apple and Amazon. Something that has never happened in any of our lifetimes, we now have companies in which the capitalization of the company is over a trillion dollars.

David:Right. The Elliott Wave Team describes the Apple and Amazon market caps at a trillion dollars or more as the tombstones for the NASDAQ index.

Kevin:Something we will look back and remember as markers.

David:Yes. This last week, reading Fred Hickey’s most recent research, I would have to agree, particularly with Apple, where he points out that the expansion – there’s an argument for expansion of service revenues, but the fact remains, this is a company that sells Smartphones. And they have gone from having a 23% share of the market to having a 13% share of the market.

Kevin:That’s amazing! I was appalled when I read that statistics. They’re down to 13%.

David:Yes, they’re falling off fast. Samsung, now, is number one, with their Chinese competitors likely to displace Apple from the number two spot next year.

Kevin:So they probably have shelves of unsold phones right now.

David:Well, as you know from your earlier days, inventories communicate something, and inventories at Apple, year-on-year, are increased by 89%. If you look at their two primary suppliers of parts and the manufacturers for those parts, their inventories are also up, I think on the order of 30-60%.

So in a bear market – fast forward – if we’re right, and we enter into a bear market here shortly, you have the global consumer facing economic constraints. These emerge, and now what happens to Apple and Amazon? When you get to these kinds of cyclical peaks, you can expect 40-60% declines, and it is not uncommon to see as much as 80-90% declines in many instances.

Kevin:I wonder, Dave, if you were to take out – I think of, say, 12 batteries, you’re working something that is powered – when you test the batteries to see if they’re still good you find out that only two of them were really good and the rest of them were very, very weak and pulling everything else down. I wonder if we were to pull Amazon, Apple, some of the FAANGS stocks, out of the S&P 500, how is it doing without those few batteries?

David:Right. So the S&P 500, without the FAANGS stocks included, just like the New York Stock Exchange Composite, has recovered about 62% of the market decline since January to the present.

Kevin:So it’s far behind if you pull the FAANGS stocks out.

David:Right. So we’re looking at new highs, and that is very impressive, but if you take out just those few that have done all the heavy lifting, in fact, there are only ten stocks which are responsible for more than the entire move in the S&P 500 since the beginning of the year. That is a narrow channeling of investment dollars into a few names. That is the hallmark of a top. That is what we saw in 1999 and 2000. The reality of narrow investor interest in the momentum players – fascinating if you look at individual investors buying mutual funds and hedge fund holdings today. They are virtually identical in terms of the clustering of what they own. They are all around those names – Amazon, Microsoft, Apple, Netflix – they are the biggest contributors to growth.

Kevin:So who do you sell it to when you want to sell it, if everybody is clustered into it already?

David:And your market makers have largely left the room? Prechter and his team have agreed to join the Commentary in a few weeks and want to explore the idea that this is the end of an era. The list of stocks already in bear market territory – this is fascinating, because again, we’re very used to seeing the indexes at highs. But again, I think this is very important. You have U.S. Steel which is down 38% this year, you have Avis down 37%, General Electric down 34%, Symantec down 32%, American Airlines down 32%, Ford down 28%.

Kevin:These are the blues. These are the old blues.

David:You think of a bear market as when you’re 20% down or more. So we have a number of these companies that are not along for the ride. They have not made it to all-time highs, they are underperforming considerably. Kraft/Heinz down 28%, MGM down 25%, General Mills down 25%, Tesla down 22%, General Motors down 20%, Facebook down 19%, AT&T down 19%, Jet Blue down 17%.

So what is this? What is this? What it is suggesting to us is that we are putting in a secondary top, and that the New York Stock Exchange Composite is sending a very important message. We have had seven months of recovery but we have not had new highs in the New York Stock Exchange Composite.

Kevin:Well, and the volume is falling, isn’t it?

David:The progress, particularly if you are looking at NASDAQ, where we have had new highs put in, number one, it is attributable to a few big names, and number two, it is on declining volume! Look at your volume statistics for NASDAQ over the last three or four months, and the only huge volume days have been liquidation days! It does not bode well. It does not bode well. You have year-end 2018, we mentioned Gave/Cal last week and the week before, they call for a global recession by March of 2019. The question is, when will the equity markets digest that?

Kevin:Well, if we’ve learned anything from the past, it’s not until after it’s over. Remember the tech stock bubble back in the 1990s? As the momentum guys were buying all these incredible stocks, and a lot of those companies don’t even exist anymore, those are the ones that crashed the hardest. It’s what the momentum buyers bought that disappeared after the crash.

David:Right. This is from Fred Hickey’s most recent comments. He says, “The crowding into a relatively small number of names is even more extreme in September of 2000 on that pre-Labor Day rally, the favorites among the momentum investors poured into them included Intel which plunged 82% from its peak to the October 2002 trough, Cisco Systems, the third-highest valued stock in the world, which plummeted 90%. Number ten in terms of stock market capitalization was Nortel, a 99% decline.”

Kevin:These were the Amazons and the Apples of the day, Dave.

David:“Nokia down 79%, Sun Microsystems down 94%, EMC down 96%, respectively the 17th, 18thand 19thhighest valued stocks in the world at the time. The collapse of these market favorites in what was supposed to be a new era for stocks ushered in what became the worst decade for stocks in 110 years.”

Kevin:And Dave, you were a broker at the time for Morgan Stanley, and if we go back and look at that year, we had a crash. We actually had peaked out in march of 2000. And then the market started to look like it was going to go on up to new highs. That was the prediction, that we had already seen the worst, a little bit like this year where we saw possibly the high of the stock market in January. Now we have seen it recover some and the talk by a lot of people, the bulls, is that the sky is the limit from here. Same thing happened in 2000, and then ultimately these tech stocks rolled over. Like you said, a lot of them lost over 90% of their value.

David:What drives credit market chaos and financial market chaos, ultimately, a credit-driven boom coming into a retrenchment of real significance? It comes from loans that can’t be paid back, and the exposures that are revealed under those circumstances. Lehman was simply that – lots of loans, some of which soured and implicated a number of financial players. And contagion was inevitable. It’s not unlike the splitting of atoms in a nuclear reaction. It only takes one to go from, “My, what a lovely day for a picnic,” to the equivalent of Chernobyl in the financial landscape.

Kevin:And it’s human nature. You would think the concern would naturally grow as the credit bubble grows, but actually, people become more and more comfortable the larger the bubble is.

David:Exactly right. Thinking investors should have a level of concern which is more naturally elevated as credit expands (laughs). It’s not the case. As the quantity of loans proliferates, you have the quality of credit which declines, and you have an increase in enthusiasm in that context. So the opposite is true. Well, it’s not axiomatic. It’s not axiomatic that quality declines as quantity increases. It simply is all too human to gain comfort when you don’t have many defaults and you have an increased number of people who want loans, and the best loans have already been made to the most qualified borrowers, and to continue your business of lending you have to find new bodies.

In order to do that, you have to compromise some of your standards. And after all, you haven’t had many defaults. So again, the looser requirements are there to accommodate a larger gaggle of borrowers, and this happens over and over and over again. You and I have talked about Argentina before. It’s only about a dozen-and-a-half, two dozen different defaults that they have had since the 1870s.

Kevin:They never really pay their debt back.

David:No. But as quickly as they move through a financial crisis they start stacking up debt again and then default on it again, and then stack up the debt again and default on it again. In case investors are thinking to themselves, “Yes, but we’re the United States. We’ve never defaulted on our debt.” What do you call the 1933 debacle? What do you call the FDR event where overnight he devalued the currency by 40%? Are you telling me that is not an implicit default?

Kevin:How about in our lifetime, Dave. From 1971 on, we have lost 90% of the buying power of the dollar. That’s a default.

David:Of sorts, yes.

Kevin:It’s a different type of default.

David:But I would say that overnight devaluation by FDR is evidence that with the stroke of a pen, if the President wants to, on the basis of trade priorities, or a penchant toward keeping the system going, he will do whatever it takes.

Kevin:Right. I remember when that happened to Mexico. It happened to Russia several times in my career here, but I remember it happened to Mexico at Christmastime. They just literally devalued the peso by half at Christmastime. Everybody just lost half their value.

David:(laughs) Merry Christmas. Merry Christmas – ho ho ho. Well, as time wears on, as credit wears on you have the mechanics of lending, which wears out, and precision is no longer critical for the functioning of the credit machine, again, as you move further along into a credit cycle. What happens is you start accepting wider tolerances, and eventually that introduces some slippage, and then eventually what happens after that is you have some unexpected outcomes.

Kevin:Well, nobody likes an unexpected outcome. That’s what causes panic.

David:We all love positive surprise, but if it’s surprise of another sort, if it’s not positive, we don’t like it. But yes, you trigger concern with a downside surprise, and then you enter that realm of the lizard brain – fight or flight.

Kevin:With no plan in mind.

David:So I guess what we learn from history in reflecting back over the last ten years is that financial panics are normal, they are perennial, and we move closer to them occurring even as investor complacency increases.

Kevin:And we’ve talked about just a single indicator. If you want to talk about lizard brain, if you want to be lizard brain about a single indicator, you could actually just watch the PE all the time, and just say, “All right, I’m going to be dumb about every other aspect of the market, but I’m just going to look at what the price of a share is relative to the earnings of a company.” Every single time, over and over and over, when it gets above 20 times its earnings you are going to have a crash.

David:Interestingly, Graham and Dodd – these are the guys who sort of mastered value investing back in the 1920s and 1930s – they looked at some anomalies for PEs, and they said, “The reality is there are periods of time when PE doesn’t capture the information you need. It lags by about a year.” And so what they did to smooth that and to make it a relevant indicator, they said you need to smooth it using a three, five, or seven-year rolling average.”

Well, Robert Shiller comes along and says, “Actually, the ten, statistically, is the best way of running that rolling average.” Now we call it the Shiller PE. But actually Graham and Dodd and the value school have liked this idea of keeping track of PEs for a long time. Again, so that you don’t have the anomalies, you smooth it using a three, five, seven or ten-year rolling average.

Kevin:But using that rolling average, we’re above 30 now.

David:Yes, 32.4, and that’s kind of a big deal. Now, if you go to Ed Easterling and the folks at Crestmont Research, they would put the PE today in the 100thpercentile. Again, historically, looking back over the decades, that is a 14-decade data set – a 14-decade data set. If you look at today’s PE, we are in the 100thpercentile. Where do you go from the 100thpercentile? Do I need to ask that question? Is there an obvious next step?

Kevin:That’s the one that is not smoothed out. Where are we if we take Shiller into account?

David:The Shiller PE lands in the 97thpercentile, and that’s in line with 1929 and the year 2000, also just above the 97thpercentile.

Kevin:Dave, there is another indicator that we have talked about many times. It is the Buffet indicator, and it seems to also be a pretty accurate way of looking at whether the market is over-valued or not.

David:Market cap divided by GDP, or if you take the aggregate value of equities and divide them by GDP. We call it the Buffet indicator, going back to a 2001 Fortunemagazine interview where the Oracle of Omaha said it’s probably the best single measure of where valuations stand at any given time.

Kevin:It’s very simple – market cap over GDP.

David:(laughs) That was 2001. Granted, we’re moving into the middle of a bear market, equities have already sold off, and he is saying, “Yes, this tells us that things are cheap. But if it tells us when things are cheap, doesn’t it also tell us when things are expensive? And this is what is galling to me, because in 2001, at a market low, he is willing to say, and I quote, “It’s probably the best single measure of where valuations stand at any given time.” And now today, it’s the second highest level – the Buffet indicator – the second highest level in U.S. financial market history, yet Buffet somehow proclaims in a CNBC interview this year that the stock market is on the cheap side.

Kevin:Stocks are a little cheap, but how come he has so much cash? If stocks are cheap, why is he keeping his money in cash?

David:This is where you sometimes see the heart of a capitalist. Has he lost his mind, or has he lost his integrity, or something in between? I don’t know. I don’t want to give you the fallacy of a false alternative. But you look at 110 billion dollars in cash…

Kevin:That’s not bargain hunting stocks, that’s cash.

David:That is clearer communication to me than whatever mumbo-jumbo he provides for CNBC and a headline that they can run, which says, “The stock market is on the cheap side, according to Warren Buffet.” Following his favorite indicator, it’s the second most expensive market in all of U.S. financial history.

Kevin:We’ve had Andrew Smithers on the program several times, and you have gone out to see him in Scotland. Smithers uses something called Tobin’s Q – the Q ratio. Now, I’ll be honest, it’s not quite as simple as these other ratios. It’s a little harder to calculate, but it has been very, very accurate. I think the Q ratio right now is getting close to where we have been before a crash, as well. Is that not the case?

David:Yes. In a nutshell, the Tobin’s Q measures the replacement value of a company and where the current market is above or below that replacement value. Tobin, by the way, got the Nobel prize for a related study. What Tobin’s Q looks at is the replacement value of equities, and the premium or discount that they are trading above or below that.

Kevin:So to restart that company, and to build that company up that the stock represents, that’s the replacement value of that company.

David:That’s right. So if it costs you a dollar to build from the ground up, and you can buy it for 50 cents on the dollar, you should buy it. But if it is selling at a $1.50 and you could start from scratch and build it for a buck, you are over-paying. That’s Tobin’s Q in a nutshell. When you start trading at premiums, it may trade at one standard deviation above the average mean, or two standard deviations – it has only traded at three standard deviations once in all of time.

Kevin:Was that during the tech stock bubble?

David:It was. It was. So the Q ratio sits at two standard deviations above the mean today, and that is a level at which all bull markets have collapsed into bear markets, with the exception of the year 2000, whereas, as I mentioned, the number reaches three standard deviations.

What is the context here? Kevin, we have homogenous monetary policies which have boosted global asset prices to records. Now we’re witnessing a divergence, a de-coupling, where the emerging markets are falling apart first. And you know what is amazing to me is, only in the West do we somehow think that we are immune. What this suggests to me is that 2008-2009 was not the last time that pride and hubris preceded the fall.

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