Is gold price an advanced warning beacon for inflationary surprise?
Artificial certainty provided by central bankers shifts to fear & volatility.
Buffett tries to calm investor fear with rhetoric while staying on the sidelines himself in cash
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Corona Virus Causing Supply Chain Disruption “For The Want Of A Nail”
February 26, 2020
“Verbal intervention moves psychology and investor expectations. But those interventions fall on deaf ears when the factors in play are existential in nature. Financial risk is real, but it’s not as worrisome as something like mortality. So money printing, in the end, is not the same as a vaccine, and it’s not a cure for health risks.”
– David McAlvany
Kevin: David, I’ve told you I was a toy store manager, but actually, before that I managed in a hardware store. And I will never forget how sad people were when they came in to do a project, they thought they could buy all the parts and pieces, and we were missing just one piece. I have learned there are an awful lot of projects that can’t be finished at all without every part. And that seems to be what we’re running into with this coronavirus. There are supply chain disruptions that are affecting much larger economies.
David: The new model of developing a product and producing a product is to find the best places to have each part and piece manufactured, and then bring it together. And you may even have Made In America stamped on it, but the parts and pieces are done on a just-in-time basis, delivered to you, so that you’re not having an overstock of inventory. There is nothing like having too much inventory, regardless of the business that you’re in. And so, that’s where we have solved the inventory problem, and the risk of slowing business cycles by increasing the stress put on that sort of, “We need it – we need it now,” that just-in-time inventory delivery.
Kevin: I’ve heard that some of these manufacturing companies are sneaking pieces out of China in luggage. I reminds me of Ben Franklin’s quote – I know you are familiar with it. It’s been stated by a lot of people, but I like the way he said it. “For the want of a nail, the shoe was lost. For the want of a shoe, the horse was lost. For the want of a horse, the rider was lost. For the want of a rider, the battle was lost. And for the want of a battle, the kingdom was lost. And all for the want of a horseshoe nail.”
And in a way, when we’re talking about economics, we’re saying that we may not have seen the economic effect of this – maybe it’s not a pandemic, maybe they’ll solve the problem, but some of the damage has already been done as it works its way down the supply chain.
David: And that’s what we discussed a few weeks ago. This is either a big issue or it’s not a big issue based on duration. The longer it lingers, then the greater the consequence for individual companies, and countries, and even the global economy.
Kevin: Let’s look at the geopolitical then. Looking at it from a worldwide view, there are global concerns right now that this could be a pandemic that will affect economics and the financial markets.
David: I think even beyond the geopolitical, there are these three categories of concern that we have been talking about – uncertainty, what I called a number of weeks ago the uncertainty trifecta, where you have political uncertainty in 2020. We don’t know who gets the Democrat nomination. But the markets can be roiled by, not only the nomination, but the result in 2020. There is geopolitical uncertainty, yes. It is global concerns, up to and including a pandemic, and then financial market uncertainties.
Kevin: Look at the 1,000-point drop on Monday.
David: Yes, we can tumble. How far can we go? 3.5% seems dramatic, but frankly, that is only because the point decline was over 1,000 points. If you imagine back to October of 1987 with over a 20% decline in one day, imagine that in today’s terms. That is a 6,000-point move in a single day.
Kevin: I was there, and it was painful at the time. But you mentioned something last week, that duration is really the key word on this, as far as the coronavirus and the expectations of how it will affect things, the duration of the event is actually the most critical point.
David: Yes, growth expectations are already shifting. At this point, you have South Korea which will shave off 05.% of GDP growth for 2020, bringing it to 2%, and that is if the duration of the coronavirus extends just to March and April. The full year would be more impacted. It would be more severe if it lingers beyond March and April.
Kevin: What are the best estimates? If someone is being optimistic what do they think?
David: Best estimates are that the virus will run its course through the summer, and that if they come up with a drug, the creation, then approval process, might take as much as 6-12 months. So it could take longer than the summer months. I think it is fair to say that the global GDP figures, Gross Domestic Product numbers, the measure of all economic activity, is going to be substantially lower, at least in the first half of 2020 due to deteriorating inputs, certainly from Asia.
Kevin: And we had been mentioning that for the last six months or so, even the last year, we have seen a deterioration economically. We were starting to into what could have been a recessionary syndrome. What I want to know is, can the U.S. avoid recession if the globe goes in?
David: We were talking about Stephen Roach’s comments a few weeks ago about the global concerns and slipping below a 2.5% growth line, which would officially put us in a global recession. And with the Asian contribution, or lack thereof, it appears that that is a most likely outcome for 2020, and maybe that is what we end up talking about in the 3rd quarter is sort of the global recession as it has emerged as growth rates have continued to slip. Again, this is a prognosis based on duration. We don’t know the duration, but we do know that solutions have not been brought to the fore as of yet.
In terms of the U.S., I don’t know, can the U.S. avoid a recession if the rest of the world goes into one? Ordinarily, you could make the case for it through a combination of different-shaded consumer dynamics, and the willingness of the Fed to deliver lower rates and/or more quantitative easing, asset purchases. But the virus is a unique factor because it is not dealing with lack of liquidity in the banking system where perhaps lowering reserve requirements or various things could increase the amount of activity.
Kevin: You can’t just throw money at everything, and this one might be something that throwing money at doesn’t solve the problem.
David: That’s the question because a virus is a unique factor. You’re talking about behavior modifications and shifts in consumption away from public spaces. That puts retail, everything at risk. So if coronavirus concerns do proliferate here in the U.S., then consumption here in the U.S. is unlikely to remain the same. Even if you throw QE into the mix, even if you lower rates, monetary policy as a cure-all, I guess what I’m saying is it is less effective when the disease is nonfinancial.
Kevin: Remember your Keynesian economics, though. You have two tools. You have the monetary tools, which can be interest rates or printing money, but you also have the possibility of the government kicking a lot of money toward fiscal issues.
David: And I think, certainly, because of the ineffective nature of monetary policy with something like coronavirus, I think fiscal policy may be the more effective for keeping the U.S. out of recession. I’m not saying I’m keen on that. We already have a trillion-dollar deficit, and as we have talked about before the CBO, Congressional Budget Office, pencils out 1.3 trillion per year over every year for the next decade.
Kevin: And if you do that, don’t you trigger, possibly, inflation, something that we’re not used to talking about?
David: Yes, I think that’s where we have to be careful because there is more of an inflationary impact, a feedback loop, that you see impacting the rising living costs, particularly for the middle class. And so, with fiscal policy comes, I think, a little bit of a heightened risk. We are already at full employment, we already have rising wages. We had the producer price index that surprised on the high side last week, and you have a stimulus void, which fiscal policy spending may have to fill.
Kevin: Is gold signaling something then? Could it be signaling inflation for the first time in a long time?
David: It is an advance warning beacon for something. And it could very well be an inflationary surprise. But it could also be looking forward to a disruption in the financial markets where people have to have a financial asset, but they don’t want it encumbered, they don’t want to deal with counter-party problems. We’ll have to see if it’s the inflationary surprise or just financial market stability that it is the advance warning beacon for this time.
Kevin: Let’s look at two things then, because we also know this last couple of years we have import restrictions. We have a lot of trade sanctions and that type of thing coming up. So let’s look at that and for want of a nail, what we talked about before, the supply chain constraints. Those two things probably are going to have to be addressed.
David: I think it adds to those pressures. The only thing that balances out the inflationary argument, and again, I think the supply chain constraints end up bringing in the equivalent of a supply shock where we don’t have enough supply of products coming in, and imports coming in, and so prices adjust upward. The only thing that balances that out, again, the inflationary argument, is a steep decline in commodity prices, and we’re seeing that with fuel, certainly more than we are with food. But with fuel costs coming down, oil coming down, natural gas coming down, this is a really interesting period of time.
Recessions, quite often, are preceded by an increase in energy costs, sometimes a doubling of energy costs is the natural step sequence to there being a recession. It is not always the case that an increase in energy costs causes a recession, but almost all recessions have that as a contributing factor. It might be strange to have a domestic recession here in the U.S. where energy wasn’t a causal factor, but with other price inputs being impacted by the flow of trade, it is still possible.
Kevin: Even without energy, like we said, there has been a slowdown that started in China. Look at quarter four for China. The slowdown had already begun before we heard about coronavirus.
David: You have to bear that in mind. It was already there, and you could see it, not only in the auto sales and real estate activity, but global auto sales, as well, were already suffering. So I don’t think we should attribute all weakness to the coronavirus, nor should be expect a comprehensive economic recovery if a cure is found. However, in the context of consumer caution in China, and that certainly is on display, you do have a major hit to the auto industry there. Bloomberg reports auto sales in China – not only were they declining in the 4th quarter and all of last year, but then here in January and February, February acutely, a decline of 92% during the first two weeks of February.
Kevin: Wow! 92%.
David: Yes, they were talking about all of China, an average of 881 units sold per day. Again, these are so small when you think of the kind of demand that you typically see. So combine that with the January figures and total auto sales will be at least 40% lower here in the first two months according to the China Passenger Car Association.
Think about this. Again, what are the knock-on effects? These are consumers but who are the producers? Yes, there are Chinese manufactured vehicles, but the largest markets for both U.S. and European auto makers are China today. So U.S. and European manufacturers are going to feel this one.
Kevin: You had mentioned that possibly the lack of supply of what people need actually will push prices up. So is this time different than other recessions that we have seen more recently?
David: When we think about recession and oil, this time may be different, because ordinarily we would look for energy prices to be higher as a causal factor leading to recession, whether that is domestic or international. Typically, rising prices precede recessionary periods. And it is telling that we are very near a global recession. Think about this. Let this sink in. We are very near a global recession and oil has had no role in it – quite the opposite. Energy prices, if anything, have been sort of a boost to the consumer, tempered inflation concerns. Of course, there have been other places, pick your other categories, where inflation statistics have been significantly higher. But could we have a unique type of economic slowdown where inflation is a contributing factor but more from the disruption in the flow of goods than from the increase in energy as a cost input?
Kevin: We’ve asked this question in the past. How long can they throw money, or print money, at everything? We’ve seen negative rates, because really, it costs no money to borrow money anymore. And we have seen the artificial lowering of interest rates, even purposely, by the various central banks. It seems that Japan has been a model recently of how the central bankers worldwide think they are going to get through a recession or a depression. Let’s look at Japan. Is the printing of money and some of those methods starting to fail?
David: I spoke at a financial conference recently, and Japan was Exhibit A. “Look, rates can go low, we have nothing to worry about, real estate will go up forever.” And Japan was the perfect example. I think what people don’t realize is that this is like a slow motion train wreck. Japan’s economy has been shrinking. A part of this is demographically driven. A part of it is because they carry so much debt relative to GDP. They cannot get out from underneath that burden of debt. And so, the 4th quarter of last year Japan’s economy shrank by 6.3%. They’re not alone. Germany showed zero growth at the end of last year.
Again, these are things that are prior to the coronavirus. What do Japan and Germany look like in the context here, Q1, where coronavirus is more of an issue. There was significant slowing across Europe in 2019. Industrial output in the 4th quarter fell in Germany by 3.5%. In France it fell by 2.6%. And it has only slightly improved by the reintroduction of quantitative easing and a more generous monetary policy combination from the ECB. Christine Lagarde is running with the baton that Mario Draghi passed to her, carried for nearly a decade. Again, only temporary relief. This is different than returning to growth. That – returning to growth in Europe and Japan – has yet to occur at all.
Kevin: Let’s look at other countries. You mentioned Japan, but Taiwan, Vietnam, Korea – even us. What is the percentage of imports coming from China?
David: When you look at Europe and imports going from China to Europe, it is less than 10%, closer to 3-5% on average if you’re looking at Italy, Spain, and Germany. But when you’re talking about Japan, Malaysia, Taiwan, Vietnam, Korea, India, the Philippines, even the U.S., we are importing a lot from China. 15-30% of total imports for that whole list of countries is coming from China.
Kevin: And we’re not talking T-shirts. What we’re talking about is actual things we have to have.
David: Sure, like pharmaceuticals or parts that are necessary for the manufactured goods that are assembled in each other’s respective countries. So right now, an interesting point written about this week in the news – 150 different drugs, including antibiotics, which we source in the U.S. from China. In fact, it was GOP Senator Josh Hawley who was kind of up in arms about this. How have we let our antibiotics and other vital drugs and the supply chains for these vital drugs become so dependent on China? Well (laughs), look, don’t we all love cheaper prices? And where you can manufacture things cheaper, isn’t that nice where you don’t have to pay as much?
But there are two sides of the coin there. And the numbers start to get very interesting when you see the supply chain dependencies throughout Asia and to the U.S. China is a significant source. So, again, duration is a reminder. This is absolutely the critical element. How long does the global supply chain stay restricted? The virus ends up affecting every interconnected economy.
Kevin: Which is just the opposite of the beauty of globalization. The beauty of globalization is efficiency, but the problem is, if you have a break in that, then you have a breakdown in the whole system.
David: That’s right. The dark side is sourcing dependency. So there is something nice about efficiencies with production delivery, specialization, lowering costs. Those are all the benefits of globalization, but the dark side is sourcing dependency, and if you have something break down, when you farm out a step in any sequence – this goes back to your nail – when you farm out a step in any sequence, under certain circumstances you can lose control of the whole process. And this is kind of the cliché about the chain and its weakest link. That is what the global economy has on display at present.
Kevin: These science projects, these Rube Goldberg machines, can be an analogy for this, as well, because if every part isn’t working exactly right, that ball doesn’t get to the end of the trail. But let’s say that you start realizing that there are parts that don’t work. You go in and you start changing things. So are there longer-term implications? Because people who were manufacturing things, these parts that are critical, that is going to get farmed out depending on duration, right?
David: It is, and I think that is the key variable again, because there are longer-term implications for corporations. They may reconsider supply chain vulnerabilities in the fresh light of current events, and does that cause them to shift production or move employment from one part of the globe to the other? Again, if it is not that big of a risk because this passes over fairly quickly, then they are not going to change their business model. Just-in-time deliveries are probably going to stay just the same. But if they start counting a very high cost, this becomes a risk factor that they are probably going to have to do something about.
So where do they change their models? Do they have redundancies which are introduced? Is this also a reflection of a larger and longer-term deglobalization trend? Perhaps this passes off the radar very quickly. Again, that’s the duration piece. If it is off the radar quickly, nothing changes. No one will institute draconian change if we get past it quickly. But if it lingers, the economic pain intensifies, then the range of options, remediation options, increase too.
Kevin: Going back to Rube Goldberg. Let’s just define what pieces could be affected in this. If you had to break it down, what are the pieces involved with the supply chain?
David: It’s not just the supply chain because we’re talking about both domestic and global economic impact. We’re talking about, basically, four categories of impact from the coronavirus – people flow, supply chains, trade volumes, and commodity prices, and those fairly well capture the economic impact. The people flow we already see, and I think it is well illustrated by what we see in France. I will comment more on that in a minute. But people flow, supply chains, which we have already talked about, trade volumes, which get stymied – you end up seeing a lot of boats floating outside of your major ports, empty and not going anywhere to pick up or deliver anything. And commodity prices. We already see that reflected in oil, copper, iron ore, what have you.
But the supply chain dependencies are growing obvious as the duration of the coronavirus extends, but resolution is still in that questionable category. The World Health Organization sees a growing likelihood of global pandemic. Three weeks ago we were discussing Apple, actually two weeks, before Tim Cook even acknowledged the supply chain issues and the geographic sales declines for the first quarter, because it was just kind of obvious to us. Look, if you’ve got this connection to Foxconn you’re going to have some issues. Nobody has come back from holiday yet, and most of the Apple stores in China are closed. So yes, it’s going to impact sales, and yes, it is going to impact the product that you can ultimately deliver globally.
Kevin: And Durango is a tourist town. We’re a long way away from China. But I was talking to one of our clients who has a beautiful ranch that people come and stay at and tourism is a big part of what they do. He said, “With this coronavirus, I just don’t know how many people will be traveling.” This people flow issue. You talked about that as being one of the components. It could affect places a long distance from China.
David: It’s a domestic issue for us. You ask the question, what is vital travel? I’m asking that question. And international travel. You have 200,000 flights already canceled. How many more get canceled? Again, down to duration. That has an impact on airline revenue, but it also has an impact on where those people are going, and where they would have spent money.
Kevin: You talked about China not affecting Europe that much.
David: No, it does, because people flow is, I think, this obvious factor. France illustrates this very well because you have tourist traffic which is down 30-40% so far. If that continues you have 10% of the French economy which is on the ropes because it is tied to tourism. And then you relate it even further, and that is like the first layer of impact. Employment related to tourism is about 11% across the country. You go to someplace like Paris, one of the tourist destinations in the world, 20% of employment relates to tourism. So restaurants, hotels, what not – Business Management 101 – if you can, where you can, cut costs. And sometimes that includes even employment.
So with income uncertainty, cash flow uncertainty, you end up having employment concerns, and to see that rise in a place like Paris – business curtails the hours, they get defensive. What does that translate into? You end up with social stress as a factor. And I mean, at an extreme, you have something like the summer of ’68 in Paris, where again, social stress is on display. And the answer here, we come back to the cure-all – if it’s not monetary policy, then it’s fiscal spending. Fiscal spending is a predictable next step for Macron in light of a decline in tourism, and a direct impact to the French economy.
Kevin: The question that has been in my mind, actually, for decades now, Dave, is what happens when deficit spending – you talk about fiscal spending, but they’re actually spending money they don’t have. You have to borrow for fiscal spending. So what happens when deficit spending and printing money and lower interest rates just plain stops working?
David: This is where I do think we’re lost without any real bearing. When you’re in a world of free-floating currencies, and there is no singular plumb line to tell you what is what and how things have value, or what their value relates to, it is easy to get mixed up and confused. And this is the problem with mass currency devaluations. You can have the euro depreciating, you could have the Korean won depreciating. You can have the yen depreciating. You can have the RMB depreciating. And if they are all depreciating at the same rate, then nobody really knows except vis-à-vis something like gold.
So if we follow that sequence in Germany and France, the euro remains under pressure. You’re talking about fiscal deficit spending. So deficit spending and currency pressures remain, not only in Europe but throughout Asia, and that is for the foreseeable future. Europeans and Asians are already investing defensively in gold. They have been for the last two years, and I think that should continue with added currency volatility.
Kevin: They have been ahead of the Americans on that, because the Americans are not buying gold.
David: Absolutely. But that brings an interesting point to the U.S. dollar because to the degree that you have these pressure points globally and it shows up in terms of monetary and fiscal pressures on the underlying currency, this makes the U.S. dollar very interesting. Dollar strength has been there. Relative to other currencies, the dollar has been on the increase.
Kevin: Yes, but gold is going up. How often do we think that gold only goes up when the dollar goes down, but gold has been going up, and the dollar has been going up.
David: Exactly, so the gold market has completely ignored strength in the dollar market, and the dollar, as it has risen, you are right, has offered zero headwinds for gold. And so, if you’re typically looking at a relationship about 85% of the time the relationship that you described would be true, where if the dollar is strong, gold is going to be weak. We’re in that 15% of the time where the two, gold and the dollar, disconnect. We saw the same thing happen in 1976. The dollar had been in decline through the late 1960s and early 1970s, began to stabilize and move sideways from 1976 to 1979, and that did not represent the demise of gold. In fact, some of the biggest moves in gold were between 1976 and 1979 where the dollar was not a factor.
This week is so fascinating, so many fascinating connections and interactions economically and financially. Listen, I’m certainly not downplaying the human tragedy in this health concern because it is very real, and loss of any life is tragic. And to not have our arms around that can be scary. But as a market practitioner, watching asset class behavior has been fascinating, has been instructional, to say the least.
Kevin: Part of that is because we have had an artificial certainty that has been applied by the printing of money, and the printing of money has brought almost a hypnotic state to the markets where everyone knows the central banks have their backs, and so no matter what happens, as long as they can print money, lower interest rates, even if a government can come in and fiscally spend, we can solve the problem. Again, I will restate – this could be a problem that no amount of money can fix.
David: Right. Artificial certainty is one thing. But we’re talking about three factors that impact uncertainty, and people’s view of the future that ends up changing behavior. You’re right. Monetary policy accommodation doesn’t help supply chain issues, not the way it might ease other business cycle concerns. So the interventions, if they come from monetary policy, will have to be more targeted to be effective. Maybe it’s bailing out a particular institution, or creating a subsidy for a particular segment within the economy. But a comment here or there from central bank leaders is going to be far less effective in this environment because of the impact of the four categories mentioned – people flow, supply chains, trade volumes, commodity prices.
Verbal intervention is a critical tool. Verbal intervention moves psychology and investor expectations, but those interventions fall on deaf ears when the factors in play are existential in nature. A pandemic evokes a different behavioral path than something like market panic. Financial risk is real, but it is not as worrisome as something like mortality. So money printing, in the end, is not the same as a vaccine, and it is not a cure for health risks.
Kevin: I sometimes wonder – the kings of verbal intervention have been the central bankers up to this point, but I wonder if the World Health Organization is now going to become more important than a central banking mouthpiece.
David: A part of that comes down to the same thing that the central banks face every day. Are we credible? How do we remain credible? So seeing the World Health Organization, seeing the CDC kind of pander somewhat to the Chinese propaganda machine, you recognize with the large population that the Chinese have, they have to maintain a certain narrative. I read an excellent article by Minxin Pei, who has been a guest on our program before. He teaches political economy at Claremont Mckenna and has a very interesting insight into the Chinese government and is very critical.
He would say that the coronavirus is just evidence of, really, a failed state. When you can’t allow freedom of speech, and all they were doing for the first four weeks was managing and controlling the dialogue, and basically shutting out any discussion of what coronavirus is. And he says, “Look, when you are more concerned about managing the narrative than you are solving the problem, there you have evidence of a failed state.”
Kevin: We watch these interviews on TV of various very, very wealthy investors. I think about Warren Buffet. Even though there have been books written about his methods, and sometimes he will talk about his methods, the bigger his portfolio gets, the more he has to do verbal intervention and actually sound quite opposite to the Warren Buffet that was building money and didn’t have to do that.
David: I enjoyed the back and forth with Warren Buffet on CNBC on Monday morning.
Kevin: When the stock market was down?
David: Yes, stocks were melting down. He actually was on pre-market, so futures were down 800 points and he looks like he has maybe a little bit of acid burn in the stomach.
Kevin: He has skin in the game, too.
David: Yes, well, he says, “Look, we’re not buying stocks, we’re buying businesses. So frame it that way. It’s not stocks and whether you buy today, sell tomorrow, these are businesses. And so are these assets that you want to own for the next 10-20 years? It was a fascinating conversation, but I did not hear him reference his 2002 favorite valuation metric, which implies what premium you’re playing for that business. If you want to own it for 10-20 years, did you pay a premium to own it? Did you buy it at a discount? Again, we think of Warren as a value investor, but is that the hat that he wears today – the public persona that he has, and are you buying a discount today?
Kevin: That works for stocks, that works for real estate, that works for commodities. Let’s face it, yes, there is nothing wrong with building and buying a business for the next 20 years, but you don’t want to overpay for it.
David: Over the weekend, I spent time with a group of real estate investors and the majority of them agreed that you make money on an investment depending on what you pay for it. So this points to basis. This points to value. This points to being a buyer when you can get the asset at or below replacement value, ideally. In the group there were a few enthusiasts who thought that real estate is everywhere and always the right asset to buy, and at this point are speculating on cap rates being even further compressed. It would be extraordinary to see that, and it actually has echoes of the greater fool theory.
But to be fair to them, there is a case for central banks playing with negative rates, taking them even further, and because there is such a dearth of income in the world, that income scarcity theme is on display to such an extreme that investors are forgoing liquidity, and they are just going for anything that offers them a modicum of cash flow.
Kevin: So let’s remember Will Rogers. He was the king of being able to say something. He said, “I’m not so worried about my return on capital, I just would like to have the return of capital.” I think he used the word principle, but it’s the same thing.
David: Well, we are playing the greater fool theory here with real estate and we may see further cap rate compression, but you’re swapping return of capital for a return on capital. That is precisely what you are doing at this point in the game. And I think we recognize that as the hallmark of the end of a cycle. I was fascinated by some of the grey hairs at this particular conference, been through multiple cycles, and some have been reluctant to chase prices since 2016. So, needless to say, our interest in real estate is not in the private realm, but in the publicly traded realm where we do have some exposure to REITs. But I found their observations helpful. These guys who are very cautious.
Kevin: And if in your business your bottom line is affected by what other people perceive, you are going to have to maintain several narratives. Let’s go back to Buffet. He has an awful lot of skin in the game, but he has also got a lot of cash, waiting for the prices to come down. So there are two narratives, aren’t there? You have what Buffet says on TV, which is like, “Hey, keep buying companies. This is for the next 20 years boys and girls.” But he is sitting in cash.
David: Absolutely. The narrative that drives his revenues is one that – he wants to encourage people to buy See’s Candy and Dexter shoes. And he doesn’t want to say anything that might inhibit the volume of traffic on his rail lines, predominantly moving commodities here and there. So there is an understandable positivism – not the philosophy, but an attitude of positivity as it relates to his various sources of revenue. And perhaps the obvious carve-out is his insurance business, which is less tied to consumer sentiment and whatever. But the second narrative, he is the embodiment for most outside observers of a value investor. So paying the right price does matter.
Kevin: And he still is. No matter what he says, he is still a value investor.
David: Yes, but I think this narrative becomes very thin. It is like the whisper between friends. You can barely hear it, but the second Berkshire Hathaway narrative is defined by a deliberate choice to hoard cash versus put dry powder to work in this price environment. They did a little buy-back this last year – 2 billion dollars, no big deal. I appreciate that as the market trend has been to buy back shares, basically throwing money, at all-time high prices, into the stock market to retire those shares. Berkshire has bucked that trend. So Berkshire is not playing the game, thankfully, and again, you may think 2 billion dollars is a big share buy-back. No, 128 billion is what sits in cash….
Kevin: That’s chumming the water. Yes, that’s very small.
David: Yes, token. Token amount. 128 billion is the clear message, and it’s not the same as what you hear on CNBC. Buy good businesses, sit back for 20 years to reap the rewards. No. The cash war chest reflects discipline. It reflects a willingness to underperform an index on the belief that quality assets can be owned at a better cost basis.
Kevin: I remember being in Argentina, and we went into a wine store. I’ll be honest with you, I don’t know that much about wine, especially Malbec, which is what came in Argentina. We went into this store, and because I knew you knew more than I did, I just watched. And if you were going to buy something, I would probably be interested in buying it. But if you said, “No, no the price is a little bit too high,” and I remember that happening, I didn’t buy. Buffet is a little bit like that. You have to watch what he does, not what he says. I remember you ending up getting a great deal on that Malbec.
Kevin: (laughs) It was a good lesson. But we watch the experts, don’t we, to see what they are doing. You definitely don’t want to listen to what they are saying if they are multi-billionaires.
David: Yes, and I think this is where you have to do some independent thinking because prices – there is more to the story, whether it is real estate, or gold, or stocks and bonds, you really need to get critical. Do we have an accurate read on asset prices when the Greek ten-year treasury, their debt, yields 91 basis points?
Kevin: Less than 1% for Greek debt. Why in the world would you loan the Greeks money?
David: The U.S. is still … now near all-time lows, but that puts us at 133 basis points, 1.33% versus 0.91% for Greece. The Dutch Finance Minister publicly marveled the other day. He was talking about the ease of raising money. You could almost hear his tone of voice. “We just raised 1.3 billion euros in four minutes with the lowest interest rates a Dutch government bond has ever been auctioned for.”
Kevin: Aren’t they negative?
David: Negative 0.487.
Kevin: They were still able to borrow 1.3 billion dollars and say, “Look, we’re going to give you less than that when maturity comes.
David: That’s right. We used to talk about the PIGS, Portugal, Italy, Greece and Spain – irreverently, of course, but Portugal’s paper today, ten-year paper, 24 basis points. That is less than quarter of a percent. We’re not talking about top quality credit here. But we are talking about price distortions as a result of central bank activity. Italy is a little bit higher, right in line with Greece, about 91 basis points, 0.91%. I mentioned Greece just a second ago, 91 basis points, right on track. Spain, 23 basis points, also less than a quarter of a percent. Jump over to France, 0.2%, 20 basis points. Germany is negative, as well, negative 46 basis points.
And the fixed income market remains completely distorted. By comparison, so does every other asset class. If we haven’t drilled this into our listeners, when you distort the cost of capital, you distort every other asset price because the cost of capital defines where stocks should be, defines where bonds should be, defines where real estate should be. I grant you that supply and demand factor in, but supply and demand are distorted by the cost of capital, too.
Kevin: Don’t you sense that there has been a sea change? Even over the weekend there has been a sea change. I remember when you talked about how you used to keep an investment journal – your wins, your losses, and the things that you learned. I came in on Monday and I was talking to one of the men who has started here in the last two years. We have a lot of guys here who have been here 30-40 years. I happen to be one of them, so there are things that I remember. I was talking to this younger guy. I said, “Remember this day. Try to remember how you felt before and afterwards.” This was when the Dow was down 1,000 points and gold was up. It is good to go back and say, “I remember 1987. I remember the year 2000 when the tech stock bubble popped. I remember 2008.” But see, we may need to remember 2020 because there has been a sea change.
David: Yes, I think you remember what the relationships were between assets and what behavior looked like, and not just what the memes were on the news and what they are pointing to as causal factors. Because again, if we look at the global economic backdrop, it actually is far weaker prior to the coronavirus. Coronavirus is just sort of the cherry on top.
Kevin: Yes, we don’t want to blame the wrong thing for something that was going to happen.
David: I think gold was the lone sanity check last week. We went through options expiration on Wednesday, and so the whole world seemed right. Of course, there is speculation and sort of a drive for call options to be a profitable win as you come through options expiration, and so a tendency toward market manipulation peaked there late Tuesday, early Wednesday, and frankly, the coronavirus was considered contained. And yet, gold was up 59 dollars last week to a 7-year high. Between gold and the 10-year treasury which fell 12 basis points last week, you had safe havens which are, again, suggesting something that the equity markets were still willfully ignorant of.
And I say willfully ignorant because sometimes the truth of a matter can be right in front of us and we just don’t have the eyes to see it. There are categories of uncertainty which should temper market enthusiasm. That had to wait. It had to wait until Monday. So a 1,000-point decline was a slap in the face, and that was, again, the tempering of market enthusiasm. It’s not like those factors of uncertainty weren’t there prior to, but no one wanted to look at them. Let’s not confuse willful ignorance with the “black swan.”
Kevin: A lot of times you can see the confidence in a market by how much cash is actually being kept on the sidelines, like mutual funds. When mutual funds have liquidations they have to either take it out of cash or they have to sell something. And right now cash has been very low.
David: In contrast to what Buffet has done, 128 billion in cash, it is not every day that you get to see the stock market do a swan dive by 1,000 points. It was just last week that Bank of America Merrill Lynch reported to the Wall Street Journal that cash balances were 4% of portfolios. And the comment was that so little cash on the sidelines is often a sign of investor confidence. No kidding. We come into a 1,000-point decline Monday with investor confidence being very high, this issue of willful ignorance – what? Woops.
Kevin: When we talk about willful ignorance, we have gone through a decade, Dave, where a new form of investing has become vogue, and that is, passive investing. Just give it to the indexes, the indexes will do everything for you. The problem is, when you have declines, even if it is a 1,000-point decline, there are differences in funds that are managed by people who have been through this before versus just throwing it at a general index.
David: One of the things that I love, because it is so ridiculous, is this notion of a target date fund, where if you do choose “I want to retire in in 2030,” the assumption that the market gives two flips about you and your timeframe.
Kevin: It is the epitome of pride and hubris to think that.
David: I think it is actually the epitome of ignorance because the market doesn’t accommodate you. The market does what it does, and it has no idea that you’re 22 years old, or you’re 72 years old. It’s either up or down on whatever basis it is up or down, but it doesn’t care about you. So this notion of a target date fund makes certain assumptions about market volatility and what the relationship you have to the markets will be when you need your assets. So I think it is worth looking at market downside and when you see episodic periods of market downside, are you positioned in such a way where you don’t get taken out of the game? Can you win on the upside, but do you have a risk-managed portfolio?
I don’t often do this, but I want to discuss just this one day’s performance. McAlvany Wealth Management performance versus the market Monday of this week. Rough day in the markets, the S&P is down 356 basis points, just under 3.6%. MWM, all accounts, excluding our short funds, lost 22 basis points, less than a quarter of a percent. Were we down? Yes.
Kevin: That reminds me of 2008/2009. Remember how MWM did well while everybody else was getting crushed?
David: We actually made 6% in 2008, so in a down market we did very well. We repositioned our portfolios differently than 2008 to capture some of those same trends, but still to have more of an income focus. But to see daily volatility impact an account, and to see accounts broadly lose 3.5%, and if you had certain technology companies or what not, or financials, it could have been more like 4, 5, or 6% losses for the day in the general markets. And yet, we were down less than a quarter of a point on one of the worst days on record for U.S. stocks. And you are right, it is reminiscent of 2008 – rocky markets. My takeaway is, rocky markets don’t have to be catastrophic.
But going back to this notion of autopilot investing, whether it is the index fund, or the target date fund (laughs), is that really what you want, and is that really the outcome that you desire, just hoping that the market is going to take care of you? I don’t know, I think there is a better way.