The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: David, last week we had a show that was posted hours before this huge swap line infusion of currency over in Europe saved the day, but the reports came out afterward saying that banks were going to fail, literally, hours after we recorded that program, had that not occurred.
David: Kevin, I have looked all over for an increase in credit default swap spreads with individual institutions and I still can’t figure out which bank it would have been, whether a German or French bank, but the single line item in the Fed balance sheet, which is usually for pocket change, the kind of thing that you would have as a petty cash account in your company, expanded from, literally, a couple of million dollars, to 88 billion dollars. That was a first clue early in the week that somebody needed some kind of cash and they didn’t want to really draw attention to the fact that they were active in the markets, in a bailout scheme.
Kevin: David, that miscellaneous account at the Federal Reserve, is really treated as petty cash. We have talked about it before, it is like having a box with a few hundred dollars in it that you buy pizza with, and 88 billion dollars all of a sudden shows up. We talked about this before, but we are seeing huge amounts of money disappear and no one really wanting to talk about it. Like you said just now: “Was it a French bank? Was it a German bank?” We don’t know who was saved, but we know a lot of money was provided.
David: Just giving you some concept of what it was, within the first 24 hours of these funds being made available by six different central banks, 357 billion euros went someplace in order to keep the gears turning, and to prevent a freeze-up in the banking system within Europe.
Kevin: David, you have pointed out that this is just a temporary solution. This is papering over a problem that we discussed, and for the listener who wants to really understand the problem, they should listen to last week’s program, because you had terror in your voice. You are normally a calm guy, but you had this look on your face as if, unless something was done almost immediately, we were going to see a major failure over on the European side.
David: (laughter) I have mixed feelings, because on the one hand something was done immediately, but I don’t think that it actually is a solution. Here is what is at issue, Kevin: At issue are the European bank debts, and we are talking about commercial institutions. These institutions have over 2 trillion dollars which they need to be rolling over. These are loans that they have outstanding, debts that they have out to other institutions. They have to roll that over between now and the end of the year, and these are denominated in dollars, so U.S. money market funds, as we may have mentioned last week, have been willing to loan money to these banks. Essentially, these banks have been funding themselves with inexpensive money provided to them by U.S. and global money market funds.
Kevin: When you are talking about these banks, you are not talking about the ECB, in particular, you are talking about banks that answer to the ECB.
David: Exactly. That could be Societe Generale, that could be BNP Paribas, that could be Deutsche Bank, that could be Banco Bilbao, whether Spanish or Italian – all of them are funding themselves, to some degree, with short-term money, and a lot of this money has come from the U.S. in the form of money market deposits. U.S. investors place money with their brokerage firms, into a “cash equivalent,” where their assumption is that that can never break the buck. What we saw a few weeks ago was U.S. investors probably making lots and lots of calls to their money market managers, saying, “I hope you don’t have exposure to European paper,” and there was enough of an outcry that – guess what? Those money market funds said, “Okay, we’re done for the time being. We’ll see ya. We’ll be back, but not for now.” That created a rollover crisis for these banks which are reliant on short-term paper, again, in the form of commercial paper or repurchase agreements.
Kevin: The Federal Reserve and five other central banks basically stepped in and filled that void. And I’m part of that, Dave. I mean, let’s look at what this is. We have talked about this before. You continue to print money, you continue to keep interest rates unnaturally low, and what you are basically doing is diluting the buying power of the American public now to bail out Europe. It’s just another form of easy money, is it not?
David: It is a form of easy money, and I think this is what is interesting, because if European banks had to raise that money privately instead of through the central bank, the collateral would be significant. Something would have to be pledged. You would have an interested party on the other side wanting to know if there was a real value that could be assessed to the collateral that you were pledging. This is really the problem. It is why the ECB has to be involved, why the ECB is the conduit for these other central banks, and the liquidity that is being provided, because the ECB is really willing to turn a blind eye to the value of the collateral offered by these banks.
Kevin: It sounds a little bit like here on this shore, when we had the real estate bailout, all of a sudden the collateral didn’t match what the bailout was.
David: That’s exactly right, Kevin. Good recall. Maiden Lane I, Maiden Lane II. That’s where toxic paper went onto the New York Fed balance sheet and Treasuries were issued in response, so kind of a swap transaction. “Okay, you need liquidity, you need something better. What we are doing to do is just an even exchange, if you will. We’ll take the toxic, you take the good. We have time on our side, as the ‘Fed,’ to allow these assets to go back to normal value. You don’t want to sell them in a distressed period of time. We’ll just let them return to full value and we’ll recapture that, and maybe even have a profit at the end of the day.” That’s the stopgap measure we had with Maiden Lane I and Maiden Lane II, and that’s what we have right now – a stopgap issue. It solves liquidity crises in the moment, but it does not solve the debt crises and the solvency issues which remain.
Kevin: I think you have mentioned in the past, it solves the problem maybe for seven days at a time. In other words, we have maybe a seven-day reprieve, and then another seven-day reprieve. We talked last week about the Thirteen Days of Christmas, the critical days in the fate of the European Union, and it has to do with this 2 trillion dollars that you are talking about.
David: Yes, absolutely. Let’s talk about that, because on the one hand, you have private institutions or publicly traded institutions, if you will, but you are talking about commercial enterprises – banks that have to roll over 2 trillion dollars’ worth of short-term loans, and that’s now running in direct competition with the funding needs of central banks throughout Europe, which have close to 100-120 billion dollars, and that’s what we were talking about last week, with the Twelve, or Thirteen (and it’s actually more than that) Days of Christmas. We are talking about a competition in the debt markets for a scarce resource. That scarce resource is money.
Kevin: There is old borrowing and there is new borrowing. What you are talking about is that old borrowing is needing to roll over, and new borrowing needs to still come into the market.
David: That’s exactly right, in order to finance current budgetary requirements by these particular governments. The Financial Times ran an article last week, and one of our guests, Otmar Issing was the author. It was a fantastic piece. He basically said that the ECB’s bond buying is unacceptable. And let’s be clear on this: What happened last week was not ECB bond-buying. That’s not his point of concern. We are now talking about just the unlimited direct purchases of bonds, which the ECB has done already, to the tune of 200 billion euros.
Kevin: But they haven’t officially said that that is what they are going to do. They still say, “Well, we don’t do that.”
David: And what they’ve said, like most central banking measures, is, “This is short-term, and limited in scope.” So the unlimited promise of bond-buying – that’s what Issing is particularly critical of, because it goes back to the classic Walter Bagehot book, Lombard Street, written back in 1897, and he says, “This is the advice that needs to be taken,” sage advice that is not being taken by central bankers today. I will just quote from Bagehot. “First, that these loans should only be made at a very high rate of interest.”
Kevin: Right, to punish.
David: “This will operate as a heavy fine on unreasonable timidity, and will prevent the greatest number of applications by persons who do not require it.” That was the bar set. You had to do it at some sort of a penalty rate. There had to be an interest rate that was unattractive, even though this loan was necessary, otherwise everybody and their brother stands in line for free money.
The second point that Bagehot made was, “Secondly, at this rate, these advances should be made on all good banking securities and as largely as the public asked for them” In other words, we are talking about collateral that is pristine. “We want your best pledge security.”
Kevin, let’s say you want to borrow $100,000 from me and you are willing to put up some collateral, and you could put up…
Kevin: How about a mule and my best blanket?
David: Yeah, well (laughter) that, or some sort of a deed for your house. That gets a little uncomfortable for you because then you have family issues if you should ever have to have a capital call, or a margin call, where I come in and take your house. My personal preference would be, if you are going to borrow $100,000 from me, that you put up $50,000 to $70,000 in gold. That, to me, is pristine collateral. I know exactly what I have, and I am giving you a reasonable loan-to-value ratio and I feel like I am reasonably covered. You have a lot of skin in the game and this is a real asset.
Kevin: Right. What you are basically saying – what Issing is saying – is, “We don’t want to have unsecured debt going out.” That seems to be happening right now.
David: And he would be saying, “We don’t want to see the ECB become the repository for a bunch of crap,” in which it just becomes a dumping field for anyone with garbage paper. That’s a problem. That’s what the Fed did with Maiden Lane I and II, and I think he is very wise to say, “Hey, wait a minute. The ECB is different. The ECB has to be different.” Of course, this exposes his Bundesbank conservatism. He does believe that it should be at a penalty rate, and that the collateral should be pristine. Those two qualifications thus far have not been included, and he is saying it would be an utter disaster – an utter disaster – to continue as we have been, and if you make it an unlimited promise, then you are looking at the end of the ECB’s credibility.
Kevin: Do you think maybe he was writing this article in response to a concern with the new Mario Draghi regime, basically, running the ECB?
David: I think, absolutely, because what he has already seen is the promise of short-term and limited, and those are Draghi’s actual words.
Kevin: Short-term and limited – a little bit like short-term taking us off the gold standard in 1971, or short-term occupation of Spain by the Muslims.
David: Yeah, it only lasted for 700 years, and they were actually invited in! There were major political issues in Spain at the time, and they were invited in to bring stability. A general from North Africa was brought in and he said, “Okay, we’ll come – happy to be here – only be here temporarily.” The first clue should have been that he burned the boats, (laughter) and I feel like all of the world’s central bankers have said, “Okay, short-term, limited.” And we should all be noting that they are burning the boats. They are here to stay.
Kevin: So when the family comes over for Thanksgiving, and then stays until Christmas, and then stays until Easter, maybe that’s no longer temporary (laughter), and Draghi is basically saying, “Oh, yeah, we’re just going to do this temporarily.”
David: I want to quote from the Issing article in The Financial Times. They did a great job putting that in there. Issing says, “You’re transferring an obligation of public finance into a monetary phenomenon. Then he goes on to say, “Stressing the role of the central bank as the ultimate buyer of public debt should be seen as an indication of the pathological state of public finances, not as a sign of strength. Again, it is this issue of, when the ECB makes an infinite promise, you should not see that as stabilizing, you should see that as a sign of pathology. Boy, he’s got that nailed.
Kevin: And David, for people who are not familiar with European central banker-speak, Issing is very eloquent and careful in what he says. What he is actually talking about is that they are transferring this problem, this crap public debt, into pure inflation. I’m just trying to cut to the chase, because that is what it would be, if it’s not temporary. They are going to print the money, they are going to lower the interest rates. It is going to turn into exactly what the Germans said they never, ever wanted again.
David: This is the point that he is very sensitive to. He realizes that a central bank, creating money, is doing that dependent on one variable: Credibility. Credibility is key. If your actions, at any time, create, even on an unintended basis, the consequence of a loss of credibility, then you, as a central banker, are out of a job, and can’t fulfill a function that, by a central banker’s own admission, is absolutely necessary. We would say, maybe not necessary, but again, if credibility is the key, then don’t do stupid things to eliminate that credibility.
Kevin: David, let’s go back and see if what they did, at least temporarily, worked. We talked last week about Spanish bonds and Italian bonds, especially the Italian bond auction, needing to succeed. Well, it did.
David: You are talking about the coordinated effort last week by five to six different central banks, funding money through the ECB to the banking industry.
Kevin: Yes, but the Spanish got to sell their bonds. The Italians got to sell their bonds.
David: Exactly. The yields came back under 7%. French paper was fully subscribed at reasonable rates, as well. The Spanish bond rates, immediately thereafter, were the highest they have been, but the bonds were over-subscribed, so the demand for those bonds was twice the paper on offer. Again, it had a “stabilizing” impact, in the immediate.
Kevin: Let’s face it, Dave. If you knew you were going to get paid on those Spanish bonds and they were offering 7%, or Italian bonds, or what have you – forget the fact that they are from Spain, or Italy, or bankrupt countries. What we are basically saying is that it has the full faith and credit of the United States government behind it, at this point.
David: (laughter) When you have six central banks backing up the ECB, well, five I guess, and then the ECB as well, so six total in the mix, that’s a lot of credibility. Now, guess what? That’s also a lot of credibility to lose if this begins to fade. We see that the actions did, in fact, relieve the immediate funding pressure. It provided liquidity from these foreign central banks to the ECB for further disbursement to the European banks, but, at the end of the day, it’s just a stopgap measure. And yes, it was needed, as the private sources of short-term funding were drying up, but money market managers here in the U.S., for the first time in a long time, were finally engaged with these issues. We explored some of the money market funds that we are familiar with, and have used, and fortunately, the ones that we have used were engaged with this process 18 months ago.
Kevin: So they had already stepped away.
David: Yes, not 18 days ago, when there was an uproar from the crowd, saying, “I think this is going to be a problem,” but they were thinking ahead of it, and they have been eliminating exposure to European banks all along.
Kevin: Talking about thinking ahead, one of the things that we have criticized over the last few years is S&P, and Moody’s, and Fitch, and these guys who are looking at problems, and ignoring them, because of old models. S&P downgraded last week, a number of institutions, did they not, saying that it is now time to look at risk in a different way?
David: Right. Now they are looking at country-specific elements, and funding-specific elements within specific countries, if that makes sense, that would impact the funding of these large financial institutions. These are very relevant risk factors, and on that basis, they downgraded 37 of the world’s largest financial institutions in a single week. Last week, we were talking fireworks. This is fantastic. As a student of financial history, it’s not going to get any more interesting than what we had in real time last week, perhaps until next week (laughter).
Kevin: (laughter) David, we talk about countries. We even talk about large blocks of countries, like the European Union. And then we talk about states and we have talked about municipal bonds. We don’t get, too often, into the individual category, though. Let’s say that the S&P was actually looking at the finances of someone who is in their teens, or in their 20s, these young households right now here in America. What kind of credit rating would they get?
David: They wouldn’t get a very good rating, and this is not just on the basis of not having any exposure to the credit markets, no record to base it on, a track record, so to say. Kevin, let’s look forward to what happens in the stock market over the next two, three, four years – what happens with earnings, what happens to profit margins with individual companies within the United States, and around the globe, on a couple of demographic variables, and that’s really what you were raising, the issue of a young, up-and-coming generation that is not going to have the same wherewithal that previous generations had, and that wherewithal comes from several sources. As we have talked about in last year’s DVD, there was the element of a decrease in savings. There was an average of about 10-12% annual savings in the U.S. between 1966 and 1982, and what fueled the equity bull market from 1982 to 2000 was two primary variables: One was a decrease in savings from that 10-12%, on average, to zero, so you are spending instead of setting aside, and in fact, you are spending through your savings, as well – going back and dipping into the bank account to go ahead and enjoy the here and now.
In addition to that, you had an increase in credit, so people were actually going into debt to consume yet even more. That was the cycle where interest rates were falling all the way through that period of time. You have brought out the fact that it has been about a 30-year dropping interest rate cycle. There is a vast difference between the household wealth of the over-65 set versus someone under 35, and this is really critical. We talked about this several weeks ago, contrasting the over-65 set and the under-35 set, just in terms of net worth. The net worth used to be, back in the 1980s, about a ten-times differential. And you would expect that. Somebody is 30 years on in their professional career. They have been able to buy assets and see them expand in value, and they have paid off some of their debt, so in terms of a total net worth statement, assets minus liabilities equals net worth, they should be about ten times ahead.
Kevin: But that was quadrupled.
David: 47 times! Almost quintupled. That is amazing. The additional statistic we would throw in this week is that 37% of young households have either zero, or negative, net worth.
Kevin: That’s a hard way to start. Right when you get out of college, or right when you get married, you have a negative net worth to start with.
David: And again, you are just taking your assets minus liabilities and that is your net worth. Yes, that is exactly right. College debt, and in some instances, even mortgage debt, are strapping this younger generation with a burden that many older generations never knew.
Kevin: David, that is also a period of time, looking back – there were eras when debt was not as cheap and as accessible as it has been over the last decade or so. Right now, you could get any debt for anything at almost any price.
David: I think the other thing is that the older set went to college when tuition, relative to the average income at the time, was not as inflated. That’s the issue. You have an inflation in education, thus an increase in the total stock of debt that a young couple is carrying, one, or two times, if they are both college-educated, and a first-time home purchase which was not done in nosebleed territory in terms of pricing. That has been the experience of anyone buying a house in the last ten years. These have been the peak prices, so you have paid very high prices, which have not appreciated, plus you are sitting on an outstanding stock of debt that was supposed to propel you forward professionally and give you greater opportunities. And yet, you can’t get past that negative net worth number.
Kevin: And getting past a negative net worth number can happen if you have a job, but unemployment right now is a huge, huge problem with the youth, as well. Teenage unemployment is at the highest level since the Great Depression. It is slightly better than it was in 2009 when it peaked at about 27%, and of course, the employment prospects remain better for the college-educated set. But listen, that doesn’t mean that it is easy, and it doesn’t mean that when you get a job it’s at the number that you thought it would be. I remember interviewing a young man out in Southern California about five years ago. He was a graduating senior at a private institution and he just looked at me very calmly, with a bit of swagger in his voice, and said, “Oh, I would expect $125,000 to start, and who knows what the bonus would be on top of that.” And I’m thinking to myself, “Who are you? What world do you exist in? I’ve looked at your resume, you have zero experience, and the fact that you are just now graduating with a four-year college degree. Someone has spent far too much time patting you on the back, and considering you to be the privileged and the best and the brightest. I am seeing an interesting resume, but not one that is compelling to the tune of $125,000 a year as starting salary. Excuse me.”
Kevin: That kind of salary, actually, would pay back college debt pretty quick. Most of these guys graduate with a pretty strong average debt, don’t they?
David: At least $22,000 to $28,000 is sitting there, and to be honest with you, I’m not sure where that statistic comes from, because everyone that I know carries a debt of $45,000 to $60,000. If they’ve gotten Master’s degrees, or have gone to college and specialized in something post graduate, yes, now you are talking $100,000, $200,000, or $250,000. I know many people in their 40s who still have $120,000 or $130,000 in debt, because they did a professional career advancement course of study beyond undergraduate.
Kevin: David, do you think because this money has been so easily available for that kind of thing, that is why tuition has risen so quickly? Tuition is the one thing that if you were to measure from an inflation index, would scare you to death.
David: Tuition is up 440% over the last 25 years. Kevin, college and university study has become big business, and it’s not so much the quality of education, as it is the quantity of students through the door. How many bucks can we put in the seat? That’s the revenue that we are going to generate on a per-year basis.
Kevin: But are they improving their critical thinking skills? Are they able to actually change direction when they need to, or are they just coming out in that one field?
David: Marc Faber, in a recent report, was pointing to a study done by New York University and the University of Virginia. What they came up with is that while there are more people getting degrees, they were finding at least one-third of all college students graduating had no improvement in critical thinking skills, no improvement in analytical reasoning, and no improvement in writing and communication skills. Kevin, what’s the point? This is like the song lyric, “Sixteen tons and what do you get?”
Kevin: (laughter) Right, “Another day older and deeper in debt.”
David: Even if you are just getting out of college, it would seem. Youth unemployment continues to increase, but Kevin, this is real interesting. For anyone who knows someone in the 18-25 year old range, there is a new sense of aimlessness, and a new purposelessness. I don’t know if it is the additional burden of debt, I don’t know what it is, exactly, Kevin. I certainly view this graduating class coming out now as graduating as serfs, frankly, forced to deal with, now, a conflicting view of themselves as super-special children of super-special people (laughter), and yet, nobody wants to hire them.
David: Which doesn’t seem to be consistent. “I though I was super-special. Everyone has always patted me on the back and told me that I just need to study something that I enjoy so that I could have a job that I am deeply fulfilled in, and nobody seems to think I’m that special. Nobody is offering me a job.”
Kevin: Dave, I wonder, too – this is a generation that was raised on video games, for example, where you’ve got enough golden rings to go to the next level, and then you did this, and you went to the next level, like a Donkey-Kong generation, where you know that if you just do the correct things, and in this case, let’s say, go to college, get a degree…
David: You get to go to the next level.
Kevin: You get to the next level, yes.
David: We wonder what kind of voter is being created through these circumstances. Is it someone who has a skeptical eye to all authority, because they feel like they were misled somewhere along the way and perhaps the dream of being college-educated and launching, and having a life of “significance” on that basis, isn’t really a dream at all, it’s turning into a nightmare for them? Is it, on the other hand, the type of person who is going to be open to grand governmental solutions, who say, “You know, the market – this is what we were taught in our very left-leaning (laughter) college classes – the market has abused us, and government is the only solution?” We think there is going to be a certain openness amongst this new generation, and we just wonder what is going to fill that void.
Kevin: David, it is amazing, when I talk to people in this college town we live in here. Durango, Colorado is a college town. I often ask at the coffee shops, “What is your major?” It is almost overwhelmingly that it has a green leaning. It is some sort of environmental study, or ecology, and when I think about it, I say to myself, “Golly, I don’t know anybody who actually is studying how to produce something. It is just, really, how to save the earth.”
David: And there is no problem with that. I think that is laudable. except that all the funding for most of those programs comes from government grants, so your assumption in your professional career choice is that the government is going to spend the money to get this project going, and that is probably where the fly is deeply in the ointment.
Kevin: Again, David, this is not an indictment of anybody who is age 18-25, if you are industrious, if you are flexible, if you are educating yourself and interested. They say to be interesting, you need to interested, and there are lot of people out there, listening to the program right now, who are very interested, and they are going to get into the job market, but there is a major concern right now. Even for those who are employed, who are engaged – the wages are lower, David.
David: Kevin, we are certainly interested in social commentary, and trying to figure out what the world looks like from a qualitative standpoint for us. There are some quantitative elements here which we are also interested in because they drive us toward where we think the equity markets may be in coming years, and what may, in fact, be a reasonable investment thesis, not just for the next six months, but for the next six, or sixty, years. Are there significant trends that are taking place that will mark this generation and mark this generation’s investment thematics and investment choices?
Kevin, that brings us back around to this issue of students today, because we think they are going to be less inclined to be the robust consumers of tomorrow. Many of them are, in fact, critical of past generations for being over-consumptive, and as you said, Kevin, they do have a green leaning, and maybe that is coming from an educational bias, but they are seeing lots of people, with lots of stuff, and not a lot of happiness. A part of that is because a lot of that stuff, people don’t actually own outright. They do have it, but only because the loan was there and the money was cheap.
Kevin: So there is a positive twist to this, if a person starts to realize, “Wait a second, the world isn’t all about just buying the next iPod.” It isn’t all about the almighty dollar.
David: Exactly, and that period of 1966 to 1982 was a period where people were saying, “You know, I don’t think I need as much. I’m going to save more. I’m going to be smart about tomorrow. I’m gravely concerned about what I see in the world today, and if I’m going to take care of my own family someday, then I know I need to be making wise choices now.”
Kevin: But David, if I went backward in a time machine, right now, to 1966, and knew what the stock market was going to look like from 1966 to 1982, you can bet I wouldn’t be in the stock market.
David: Right, that’s a major concern for us, Kevin, because we have low wages, we have consumption and the impact of these declining trends on corporate profits. That’s been the story, and will continue to be the story, for the next 5-10 years. Labor compensation, according to Morgan Stanley economist, Gerard Minack, is at its lowest level in 50 years, compared to GDP. Labor compensation is on the decline, while consumption has been on the rise. What has filled the gap, Kevin? Comparing consumer outlays to labor income, the real divergence began back in 1970. We actually did begin to see a shift then, which really got into full gear in 1980-1982.
Kevin: I just want to insert this, David, before you go on, because what happened in 1971, on August 15th, was that the dollar went off of the gold standard, and so monetary discipline went out the window at about the same time that you start to see this increase of public spending.
David: And about ten years later, we saw a massive change in general sentiment, and rapid acceleration in consumer spending, which coincided with a change in interest rates right around 1980. Since then, even as wages have been declining, consumption, as I mentioned, has been on the increase. What has the gap been filled by?
Kevin: It’s debt. It’s just pure debt.
David: Yes, cheaper and cheaper rates, and on easier terms. Kevin, if that has been the story, is it safe for us, as investors, to assume that the drivers of the market of yesterday are necessarily the drivers of the market of tomorrow? And we would contend that, no, we will have different drivers, and in fact, some of the things that have been there to prop up and to fuel the market growth of yesterday simply are absent today.
Kevin: David, this newer generation that is going to be fueling whatever markets are out there is not going to be able to take on debt like we have seen in the past, and they are actually going to be experiencing the de-leveraging of old debt. We talked about old debts having to roll over, and new debts having to be taken out. Well, you can’t have the new debt if the old debt can’t get paid.
David: Yes, and sometimes people forget that de-leveraging is just a big word for paying down debt, and then an increase in savings is likely to occur amongst this generation, gradually beginning to see improvement in the national savings rate, as we speak, and that should be thought of in a future tense where the GDP growth dynamics of the last several decades are not being repeated, because, again, the Keynesian model impresses upon the human consciousness: Spend, spend, spend – thrift is for fools. Thrift and savings are re-emerging, Kevin, and I think long-term that is very positive, but short-term, that does mean a contraction in margins for corporations, it does mean a slow-down in sales, it does mean a shrinkage in earnings, and Kevin, that does mean something very tangible for someone who is investing in equities today.
Kevin: David, this is just the revisiting of the true business cycle. Yes, it’s grand, and it’s larger. These huge 30-year cycles, one direction or another, are caused by Keynesian economics, but you still have the contraction healing the economy. It just takes almost an entire adult lifetime for it to happen.
David: If the consumer is less of a driver of economic growth for years, and perhaps even decades, to come, that begs the question: Will government spending, and will deficit spending, be used to make up the difference in future years, as we have seen it done here in recent years? This is the critical point, because if this is, in fact, the case, Kevin, we will have a date with destiny very similar to that of the European debt crisis last week, the week before, and in coming weeks, in coming months, in Europe. This will be coming to a theater near you.
Kevin: The market basically says it’s unsustainable.
David: The growth was unsustainable – can’t do it – can’t be done on the basis of debt, and there weren’t enough savings to draw down from. The good news is that as the consumer does enter an age of thrift and savings, you are setting up the stockpile for growth and investment and a period of expansion in the business cycle in the future.
Kevin: Right, but that’s a long time in the future. Let me ask you about earnings for companies, David, because if, indeed, consumption is going to drop, and if there is less money available, coming up in this next generation, what happens to corporate profits?
David: That’s where they do get eroded, and I think this goes back to Jeremy Grantham’s comments we mentioned last week, when he said that this is probably the peak in the earnings cycle. And here is the interesting thing that he didn’t say, but that you should connect. If this is the peak in the earnings cycle, then this is probably the peak in the pricing cycle, as far as equities are concerned.
Kevin: Last week, David, you said this next year you really do expect several thousand points to come off of the stock market, barring some unforeseen huge infusion of cash, or what have you, from the government.
David, what we are talking about here sounds pretty dire for the market, but we are talking about the United States market. I know a lot of people right now who have been focusing on the emerging markets, and they have been focusing on China, and the attitude is that the United States and Europe may have their problems, but we also have this mentality that the emerging markets and China are going to be some sort of savior. Is that something that you can see happening?
David: Kevin, I think one of the things that is missing today amongst investors, and amongst people in general, is the patience requisite to be a successful investor, and they want to see something happen now. There is so much opportunity over the next 5-25 years, you just can’t expect to be rewarded in the next five minutes, and yet that is what we are used to, Kevin. We have become, and I don’t know how, but we have become like rats in the cage. If we can just tap the button and get the stimulus, tap the button and get the stimulus, tap the button and get the stimulus…
Kevin: It’s that video game mentality.
David: We’re happy, happy, happy, unless we’re sad, sad, sad, and we don’t have a time frame, we don’t have a patience escape, if you will, that would include what is happening now and its implications over the next 2, 3, 5, 7, or 10 years. If these things are the case, don’t worry. Don’t rush it. If you are rushing issues, you are going to find yourself in an awkward position.
What you just raised, Kevin, is a very interesting issue, in terms of the emerging markets, and the myth that they are going to carry the day. Going back again to Grantham’s comments, you remember the younger generation coming of age – low wages, low credit access – that’s the environment we are in. Many are already loaded with debt and simply unable to contribute to GDP growth as past generations have. In a long enough time frame, the good news is that we are talking about a new era of thrift. Even better news is that this prepares the investment world for fresh capital, non-leveraged, and it allows for a period of capital scarcity which drives marginal businesses out. You will see business failure, and that’s not a bad thing!
Kevin: And David, the whole investment strategy of buying low and selling high – unless things are allowed to fall to the low, you can’t ever get that low, and so the very best business cycles, or the very best investments that have ever played themselves out, were purchased during these periods of time.
David: There is a healthy evolutionary process embedded in the business cycle, where bad ideas fail and good ideas get to continue, so the strong survive. And Kevin, we would like to own the strong companies that have survived. We would like to get through the period of time, most like the 1966 to 1982 period of low growth rates, high levels of savings, and emerge again into an environment where savings which are, and will continue to be, set aside, get deployed into value investments. Again, by the time we get there – is this two years from now, or is this twelve years from now? We don’t know.
Kevin: For now, what do you see in the market? Are you thinking it is just going to be lethargic? You had mentioned that you thought we would see the stock market come down. That’s not set in stone, but you don’t see great gains in equities for at least the near term?
David: No, I don’t see anything fundamentally driving the market higher, so what you have driving the market higher is what we had last week. Tuesday, we had close to a 300-point move, on Wednesday, close to 500 points – 490 points up on the Dow. Kevin, this was liquidity-driven. Somebody had insider information. In case you think you are playing on an even playing field, understand that certain people sleep with other people, or certain people pay other people, or certain people dine with other people, and that may even be Goldman Sachs employees, sleeping, paying, and eating with Fed and Treasury officials. Kevin, this is fascinating – a fascinating period in time. So just wait around for QE-III, IV, V, and guess what you have? A reason for equity values to move higher. Is that something that is ultimately going to be rewarding for the long-term investor? We would argue, no.
I would just want to come back to your issue of the emerging market myth.
Kevin: Yes, Dave, the subject of emerging markets. We joke about it, that your dad likes to play with you on this one, because he really likes China, but are the emerging markets going to pull this one out?
David: Are they going to carry the weight of the world on their shoulders? Kevin, we have real credit growth in China, which is collapsing, we have the real estate market in China, which is imploding. We have banks, although they are state-controlled, which are still in trouble. Being state-controlled just means that they have more control over the information flow, and they can obscure things much more conveniently, so they can go further down the road. But I would say they are going down the road, limping along more and more as they go. The modern central bank panacea, Kevin, of money-printing, may, in fact, keep the gears churning within the emerging markets, but only with weaker currencies. We are really talking about the cost of growth in the emerging markets being seen and felt in the form of higher inflation.
Kevin: Yes, when somebody says weak currency, that’s sort of a euphemism for costing more.
David: Exactly. So lest we forget, rising inflation in developing countries is very de-stabilizing. The choice to print, and print, and print, has a very different and unsettling effect in places of the world where you are sort of on edge in terms of whether or not you can or cannot feed your family to begin with.
Kevin: David, I know a lot of times people say, “Well, I don’t like the U.S. stock market, so I’m going to go to another market because maybe it’s going to perform differently.” I think that may be a misunderstanding, because equities oftentimes correlate with each other very closely, don’t they?
David: Kevin, that’s the issue. There is some degree of correlation and Societe Generale did a great study on this, but there is always some degree of equity market correlation. What is unique is that you can normally expect one standard deviation, either more correlation, or less correlation. Somewhere between 40-60% is normal. Now we are consistently trading with global equity markets, in lockstep, at about an 80-85% correlation.
Kevin: In other words, when the stock market here in the United States, or in Europe, goes down, you can pretty much count on the Asian market, 85% of the time, going down.
David: It is going to be marginally better, or marginally worse, but they are moving in lockstep. 100% correlation would be spot-on, basically the same market. We’re not saying that’s the case. They are different, but you are only talking about a 15% variance, in terms of the actual numbers, so that they are moving, in the same direction, at the same times.
Kevin: David, last week your level of concern for the European markets and our markets was at almost a peak, and then, of course, the 357-billion-euro bailout came in – whatever you want to call it – the swap lines, what have you. It papered over it temporarily, but you’ve mentioned some things to the guys here, talking very personally, not necessarily about clients, but just to these guys, saying, “Look, this is the year. If there is going to be a Christmastime, for instance, when you are with family, friends, what have you, and they are confused, and they are concerned, this is the time to pull the napkin out, draw the triangle, and just show them the simple solution. It’s not like it’s a magic solution, but it definitely is something that can be simply stated, even a child would understand, but most people don’t do.
David: When you are with aunts and uncles, when you are with brothers and sisters, when you are with distant relatives, I think this is the time to definitely pull out the napkin, Kevin, and say, “Listen, this is real simple, but it’s one of the reasons why I come into the holiday season without the same stress and strain I’m hearing in your voice, and here’s why.”
Over a glass of eggnog, or mulled wine, just explain it as simply as possible. You have the base of the triangle, you have the sides of the triangle, and their performing mandates. This has to do with the expectations that you have, the requirements that you are putting on the asset base that you have. You take your liquid assets and you say, “Okay, I have to maintain my household, I have to pay bills. I have to continue to look for opportunities, manage a business, in addition to managing a household, in some instances, and therefore that right side of the perspective triangle is given to liquidity.”
Kevin, I was reminded of how important this liquidity function is, spending time with dear friends down in the Houston area for Thanksgiving. This is a company that is thriving. It is doing quite well. But, there is not enough liquidity to even make payroll.
Kevin: They are doing well, but they don’t have enough actual cash to pay the bills?
David: Part of it is because they are doing more and more business, and the terms of settlement on each transaction they have is 60, 90, 120 days – they are having to do all the work on their nickel. Yes, they are happy for more business, but as they have done more business, it has depleted their cash, and they don’t have the liquidity to operate.
This is my point, Kevin. Whether it is a household, or a business, don’t neglect the liquidity side of the perspective triangle. On the left-hand side of the triangle, again, we are talking about the mandates that you give them, not the specific things that you invest in, but the theoretical requirements that you put on them. So liquidity is there just to be available – to be liquid!
Kevin: That’s the right side. Then, the left side is the growth side.
David: Growth, or income, and you are talking about stocks and bonds. Again, I’m not going to give you the specifics, here, but you can have an equities or a securities exposure there, and its mandate is growth and income.
The bottom part of the triangle is insurance.
Kevin: That’s the gold.
David: Someone may have more silver than gold, more gold than silver, more platinum and palladium. I don’t care what’s at the base, as long as you are very clear on the mandates that you are giving your assets.
Kevin: That is physical holding of that particular item, something that you are not really looking for a paper contract saying that you have.
David: No, no, because then you would be introducing other elements of risk, and you wouldn’t want to compromise the strength and the surety of that insurance.
Kevin: With that side, no one has ever gone broke with an ounce of gold.
David: This is why you look at this combination, again, back of the napkin, and you say, “I like the fact that if it is an inflationary outcome, I have the base covered. I like the fact that if it is a deflationary outcome and the debt unwind, the deleveraging which we may see, part or total, here or overseas – I’m covered. I have that liquid portion. And I like the fact that if I am taken by surprise and somehow a rabbit’s pulled out of the hat, and we do find ourselves in the middle of a growth cycle again, I have a third of my assets which are able, like the sail, to collect the wind, and be empowered. I have an opportunity, and I have protection, all in one, by taking this balanced approach.”
The critical part is this, Kevin: Too many people are not engaged. Too many people have trusted their financial advisors to come to the table with all the answers, and I’m sorry, but there are very few financial advisors who are even asking the right questions, let alone having the right answers. What we find, in talking with clients, is that they generally are more curious than their own financial advisors, doing more homework than their own financial advisors, and this is why you are coming up with consternation, concern, bordering on the paranoid, where people are saying, “I just don’t think my bases are covered. I’ve been told over and over and over again, ‘Just don’t buy gold. Do anything else, but don’t buy gold.’” That’s the general stock advice that you get from Wall Street.
Kevin: David, indeed, a person should be able to draw this for anybody and explain this to anybody, and maybe it will, this holiday season, ease some tension, and actually help a person long-term.
David: Kevin, I think when you look at how simple this is, it obviously is not complex enough to include every decision that you make as a financial person, entity, business, family, what have you. But it gives you the simplicity that you need to organize your thoughts, to organize your assets, to organize the mandates, and to be able to categorize, and then move from one to the other, and determine whether or not you are making good decisions for that section of your asset base.
Kevin, it’s that idea of moving from simplicity to complexity, and then back to simplicity, that we find a very healthy way of approaching your finances, and this is the reality: When you sit down with your kids and grandkids, it needs to be boiled down to something that can fit on the back of a napkin, when you are trying to teach a life lesson, and you can say, “Here’s what I’d like for you to keep in mind. This is the way I handle my own finances. Obviously, there is more detail than I can share, but I want you to think in these terms, because there has to be a balanced approach. You have to take humility into account when you’re managing money, and as you are given more responsibility, by your grandmother, for example, as we are passing money intergenerationally, here are some principles I want you to keep in mind, and it begins with what we call our perspective triangle. It’s the way we manage our risk, it’s the way we look forward to opportunity, and it’s the way that we would like you, the next generation, to see that.”