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- Economic Gain/Loss is often separate from financial gain/loss
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
EXPIRATION MANIPULATION GIVES FALSE
MARKET-BOOST, THEN VAPORIZATION
October 24, 2018
“Really, if you think about it, what is more crazy than thinking that a nine-and-a-half year rally is still healthy, with vast upside from here? What use are valuations and fundamentals? Ultimately, I think, these valuations do matter. When, precisely, I don’t know, but when they emerge as particularly relevant we are all going to live with regret that we didn’t pay more attention to them.”
– David McAlvany
Kevin:I saw your wife at church on Sunday with your youngest of four, but I didn’t see you, Dave. I heard that you were up hiking with the eldest kids. So, why weren’t you at church?
David:(laughs) I’m being ratted out on the program. Well, we were capturing the last of the nice weather. Beautiful hike. Spent the day before in the car locked up driving from Denver, there and back on the same day.
Kevin:Yes, because you have a new addition to the family.
David:That’s right. We went and picked up a dog that was imported, so we were pretty excited about that. But I needed to stretch my legs a little bit and spend some time outdoors.
Kevin:When you look at the colors here in Durango right now, the trees are all changing, the beautiful yellow leaves on the Aspens and the other types of trees, yet you have the snow-capped mountains, the La Platas, in the background. So, of course, no wonder you took a hike.
David:Well, it’s better than stained glass, I think.
Kevin:Last week we talked about the tactical short call with Doug Noland and those are always fascinating to listen to, and for the person who wants to still listen to that you can go to mwealthm.comand listen to that Tactical Short call. It was very revealing.
David:The audioand the transcriptare available at the website, or you can take the links on this page. If you are interested in understanding the financial system fragility as it is presently revealing itself, I think taking the time to listen in, or if you prefer you can read it. Simply put, Doug is a talented guy with some very important insights. The first 30 minutes, his formal comments, with the remainder being Q&A. So if your time is limited catch that first section, for sure.
Last week was fascinating for many reasons. We had our call, but it was right in the context of lots of market gyrations. Earlier in the week we had expiration manipulation.
Kevin:Explain what that is something that actually brings a predictable outcome, at least for the day.
David:When options are coming to their date of expiration, you are either in the money or out of the money on those options. You can see pretty predictably in the days leading up to the date of expiration, manipulation in the underlying indexes to get those one direction or the other, further into the money or further out of the money. So a lot of destruction of value there last week. Again, manipulation was a big deal. We had early in the week the best day in the market since April. The Dow was up more than 400 points.
Kevin:That was that manipulation that you are talking about.
David:Right. Now, the news media doesn’t talk about manipulation, they pointed to Johnson and Johnson’s earnings, which only beat by two cents. Not exactly the kind of thing that would set the market on fire. But they also had Morgan Stanley, Goldman-Sachs, United Health. Again, none of them had robust enough results to really set the market in motion. This is primarily expiration manipulation. Doug covered it a little bit on the call, where if you have the firepower to do it, you can destroy a lot of value for those put buyers.
Kevin:Well, you just call your buddies. The other things, too, a lot of people, when you are out there and you are manipulating markets, you do sometimes have to call in your markers with buddies and say, “Hey, I’m going to be buying this today. How about you buy the same thing?”
But there is another issue. There are numbers on charts that everybody looks at – the moving averages. Oftentimes it is important to push a number above or below a particular moving average to get it to go the direction you are trying to manipulate it.
David:There are different schools of thought as to what a chart means and how you should interpret it, but boosting the markets above the 200-day moving average has been a key here in the last week or so, and the breakdown in technical support levels will trigger automatic liquidations and a reinforcement of risk-off. Because what happens is, option writers have to then hedge themselves, and the markets become self-reinforced on the downside. So you try to get protection, but in the process of protecting your own portfolio you create more downward pressure in the market.
So you have that battle for the 200-day moving average. It’s not over. It’s getting dicey and I think few investors appreciate just our precarious the markets are becoming. Some would interpret that 200-day moving average as a delineation line between a bull and a bear market. Again, different interpretations, but that certainly is one of them.
Kevin:If I had to look back at last week, I would say, “Mama mia, that’s a lot of turmoil in Italy.”
Kevin:It really is continuing to break down over across the ocean.
David:And I guess the defining characteristic, whether it is the Dow or the options markets, or as you talk about Italy, is volatility. We had wild volatility in bonds and in bank shares, and mid-week it was Italy that was in turmoil, you have budget discussions and the Italians refusing to change their budget deficit, which they have proposed to the EU and the EU has said, “No, we won’t accept it.” And so there is back and forth with that.
Wild volatility in Italy. Moody has cut them to the lowest investment grade. That was, again, just last week. So market concerns by the end of the week had come off the boil. Again, the noteworthy characteristic, if you will, is these radical intra-day swings in asset classes. I think it is further evidence of a market topping pattern where the bulls are fighting hard and the bears have a growing amount of evidence to support downside vulnerability.
Kevin:But the bulls fight it. The bulls fight it.
David:Yes. You can look at Tuesday of this week. It’s a case in point. I’m not exactly sure why, but I told my kids, the Dow traded down 500 points, gold was up $15 at one point during the day on Tuesday. And my kids interrupted me and said, “Dad, can you play rage against the machine, bulls on parade?” I stopped for a minute and thought, “What have I done to my kids?”
Kevin:Oh my gosh, they’re a bunch of little Doug Nolands. They make their money on the downside.
David:Right. Is this schadenfreude at such a young age? God forgive me. What have I done?
Kevin:Okay, but let’s face it. We’re not looking for the end of the world, but we would like a return to fundamentals.
David:Right. I think my opening comments on the call centered on that, just a few of the fundamental metrics which we have discussed occasionally on the Commentary. These are not tradable data points in the sense that valuations don’t provide the triggers you would base a buy or a sell on with an expectation of short-term benefit.
Kevin:But they are the context. They are the map.
David:I totally agree. Fundamental valuations provide that context and they allow an insight into where you are in a particular cycle and how the present moment, the present position, with a particular asset and price structure, compares with the past in terms of markets oscillating between very cheap on the one hand, to very expensive on the other. That has a huge bearing – where you are, whether you have bought cheap or bought expensive has a huge bearing on future returns on investment. So where you start dictates what you have over a specific period of time in terms of rate of return.
Kevin:Look at people who bought real estate back in 2006. They may still be working at breaking even versus our client who came out of real estate in 2006 based on the recommendation of your dad. He went back in in 2009-2010 and he is at triple where he started.
David:And not just in terms of gains, but in terms of actual doors. He tripled the number of doors that he owns. And that’s the thing, when you look at these cycles there is a time to be engaged and a time to step back and maybe be more protective.
Kevin:So buy and hold does not always work. It is to buy at a particular time and hold.
David:Yes, so if you are holding, it is with support of that backdrop and with the context being supportive. If you bought a bargain your returns are far more likely to be above average. But again, any time you over-pay for an asset, you can take whatever the historical average has been for that particular asset – throw it out. Throw it out. It doesn’t matter. If you have over-paid on the front end your returns as an investor are going to be below average. And vice-versa – the other side of the equation applies, too.
So the average in any investment is rarely relevant because it is not the way markets work. There is a constant volatility in price. And if you look at the numbers, we talk on the Tactical Short side of our team about capturing the 40%. Well, just over 50% of the time, nearly 60%, prices are moving higher. Just under 50%, we call it 40%, prices are moving lower. So we want to be able to capture some benefit on the downside. But bearing in mind, where you enter in a given cycle, if you’ve entered at the wrong time you can be sitting there for a very, very long time with no benefit whatsoever.
Kevin:This is one of the arguments I have against financial planning computer programs that sit the person down and say, “What do you think your bills will be when you are retired?” Then they show them on the screen the average return, let’s say, for the stock market – what has that been, 5-7% through the years?
David:Jeremy Siegel likes to argue for a number that is just above 7%. In his book, Stocks for the Long Run, he makes the claim that a 7% rate of return in equities is the average over time.
Kevin:But that is meaningless if you buy high.
David:Well, next week’s guest makes the case that markets are far more volatile than the average, where you have returns that occasionally are well above the average number, or even considerably below. Ed Easterling is from Crestmont Research – that is his organization – and he looks at the primary driver of secular stock market cycles and I think he makes a very compelling case that you have to know where you are before you can know where you are going, if that makes any sense. So, if you pay attention to the macro picture and the drivers of these long-term trends, then again, like Doug Noland described in last week’s call, it’s easier to know when to hold ’em, when to fold ’em, when to walk away, when to run.
Kevin:One of the things I liked about Ed, selfishly, you know I like celestial navigation, whether it is on sailboats or just studying the Apollo program. This new movie out, First Man, they’re going to be talking about how we got to the moon. There was a sextant, Dave, both on the lunar module and the command module, where the astronauts would sight known stars and then program that into their very rudimentary 1960s computer, and it would tell them where they are. Unless they knew where they were, there was no possible way to set the course for where they were going. They would not have made it to the moon had they not have known where they were on the way to the moon.
Ed talks about celestial navigation and the progress of that in his book as he looks at the map of financial survival. He even builds a map – it is an amazing map, Dave, that you could sit and study over and over and over, that has price earnings ratios, and what have you, on it, that shows you inflation in the picture, GDP. You can look at the map and say, “Okay, where are we in the cycle, and what should I buy right now for the long haul?”
David:It is fairly complex, but it is very worth the time investment to understand that stock market matrix that he has designed. There is a problem with cycles, as I see it, even though he does a very good job of explaining it, and it is a practical issue. The problem with cycles is that most people don’t take the time, don’t have the patience to benefit from them.
Kevin:Sometimes you just need the money to do something else.
David:Well, that’s it. To be generous, it’s too easy, it’s quite normal, to have things arise where you need liquidity in a timeframe that doesn’t match the moves of the market. So maybe it’s buying a house or paying for a car, college tuition, a wedding, or putting on a new roof.
Kevin:That sounds like my life, Dave.
David:(laughs) The list is long, but things that interrupt the ideal course for the cyclical movement of investments through various asset classes in time. The way Ed looks at long-term trends – I remember the first time I read his book which he wrote back in 2004 – long-term trends, what does he mean by that, because everybody has a different definition of long-term? If you’re in a tremendous amount of pain, long-term is about ten seconds. So what is long-term? 50-75 years is long-term, with intermediate trends spanning anywhere from 4-20 years, and 20 years is a generation. Typically, that is what people would view if you are talking to the average investor, 20 years islong-term.
Kevin:One of the ways that you have taught people to realign their thinking – I’ve watched you, Dave, you and your Dad, but especially you since you’ve written the book Legacy, you have taught people to realign their thinking to these longer-term trends and start thinking about their kids and their grandkids, not just today.
David:Our emphasis on legacy and inter-generational family wealth ties to what can be accomplished when you are compounding through many generations versus only one.
Kevin:It is astounding, the difference.
David:The math of compounding over a very long period of time speaks for itself. You could equally talk about the compounding of intangibles and maybe that’s too much of a bunny trail today, but the compounding of generosity, and of trustworthiness, and of solidarity, and of these things as they are mirrored and modeled by one generation to the next, you realize that your children as they grow and mature have so much more potential growing and maturing in those areas at an earlier age than you might have. What they can then pass along in terms of intangible wealth to the next generation is equally profound.
So yes, you have the math of compounding, which I do think speaks for itself, but time is not a sufficient condition for satisfactory returns. Particular asset classes behave in particular ways under particular circumstances. This goes back to that idea of context, and context matters. So when are you beginning the process? Jeremy Siegel, very unfairly, I think, if you look at where he starts, he starts at the very beginning of a bull market to start counting his time forward. And so he skews all of his numbers.
Kevin:That changes his average and it skews the numbers.
David:Exactly. Exactly. So stocks for the long run is a brilliant idea, particularly if you start at just the right time.
Kevin:Just about eleven years ago we started talking on this program, even though the company had been around since 1972. This became a format for us to really evaluate context, Dave. I have been amazed at how much I have learned. It has been like four college educations since we have started because of the people that we have interviewed.
David:We have discussed context from a socio-cultural perspective with Strauss and Howe using their book The Fourth Turningas a tool (laughs). Funny you mention that. We talked with Joseph Tainter to explore historical and social, even archeological, shifts through the millennia. He is reflecting on particular data points in his work The Collapse of Complex Societies.
Kevin:Even technical analysis, just a couple of weeks ago, the guys from Bob Prechter.
David:That’s a different way of looking at market trends and cycles, you are right, bringing in Bob Prechter’s team, looking at technical analysis, looking for different signs and signals that precede a shift in a market trend.
Kevin:And Easterling, who is coming up, he is going to bring the fundamentals side.
David:Yes. And Jeremy Siegel, we have mentioned before on the program, and it is not with utter disrespect. He is a smart man. It is just interesting some of the assumptions that he makes in the midst of saying that stocks are, kind of axiomatic, a winner, because they can be a winner, but there are caveats for that to be a more accurate appraisal. You have to think of demography and productivity. You have to think of inflation. You have to think of GDP growth and what is happening in a particular period of time as a catalyst for economic growth, with inflation being pretty critical in that equation, too.
And then, of course, the starting point for your calculations, all of that makes either a case for stocks as a growth asset. Perhaps it is axiomatic but I tend to think there is a big part in there where it depends – it depends on inflation, it depends on productivity. It depends (laughs). It can be a winner if you’re sensitive to the drivers of growth, and these drivers or key elements of growth, of course, run in cycles.
Kevin:It amazes me how many times I can talk to a person who has an investment portfolio who can tell me where the stock market is relative to dollars. They can say, “Oh, well, it is at $26,000 right now.” Yet, if you ask them what the price-to-earnings, the PE is, oftentimes most people don’t even really realize where that is. And that is probably one of the key indicators as to whether you are over-paying or under-paying for the stock market.
David:I love the way the goalposts are often moved by the mainstream media. When valuations start to get rich they move from talking about reported earnings to expected earnings. So now it is not what we brought in, it is what we hope to bring in, or have some belief that we will bring in, in the future, which all of a sudden can bring down the PE considerably. Now, it is earnings which haven’t yet occurred on sales which haven’t yet been booked, on a timeframe which has yet to exist, right? But that’s okay for the mainstream media to be reporting those future-oriented earnings.
Kevin:In a way it is like marking-to-the-imaginary, like we talked about last week.
David:Yes, valuations serve as a signal for where you are in a cycle. And you are right, some people ask, “Why does PE matter? Why do price-to-sales ratios matter? Why does the Buffet indicator matter? (That is, market cap divided by GDP.) Why does Tobin’s Q matter, or the Shiller PE? (The kind of expanded version of PE.)” And the Crestmont folks actually take the Shiller PE and expand on it. I think they add an extra ten years for smoothing out to a 20-year timeframe. We will get a chance to visit with him as to what his rationale for the Crestmont PE is. It is a variation on that same longer-term theme.
Kevin:But there is a why you didn’t ask, and I’m going to ask you this because every listener who has been paying attention over the last eight years would say, “Why should we care about such things? We’re in an area that is influenced by central bank control. Why should we care about PE, Tobin’s Q, Shiller, Easterling’s, Crestmont Research? Fundamentals don’t matter anymore. We can print money and just paper over things. Why should we care?”
David:That, combined with the fact that valuations don’t give you anything actionable, so it’s not like you can go out and say, “On that basis, I’m going to buy this or sell that.” Should we care about such things in an era which is so greatly influenced by central bank interventionism? This is not the first time we have had central bank interventionism, it is just the first time we have used these euphemisms. We have had monetization before, we just never called it QE. I don’t know that we have done hardly anything new, we have just called it different, and we have done it on a bigger scale.
Kevin:We had artificial interest rates back in World War II.
David:Yes, so there are controlling elements. We may have refined the processes of control. That is a legitimate question. Has the role of the market, as normal pricing dynamics, weakened in the last eight to ten years irreparably in favor of a more directed outcome? That is a good question for someone who does secular stock market cycle analysis because (laughs), well, this time may be different. What would be the variable that has changed? Maybe it is technological sophistication or algorithms or black box trading that allows for managed outcomes and increased – if you think about the market today it is kind of a unidirectional result in the market.
Although, think about this. Over in China – this is from the Financial Timeslast week. “A wave of protests by Chinese homeowners against falling property prices in several cities has raised fears of a downturn in the country’s real estate market.” Can you imagine? This is an epiphany to them that prices can go two directions. They are taking to the streets in protest because real estate prices are dropping. “Oh, is that the nature of a market?”
When you think about command-and-control dynamics and you think about what the Fed can and can’t do, who has more control, the Fed or the PBOC? Where there is no voting machine and you really can lock down – you already have exchange controls in place, capital controls in place – (laughs) the market is moving lower. I don’t know if you have checked the Shanghai Exchange – the Shanghai Exchange is down 30% this year. The powers that be – you don’t think they could prop that up if they wanted to? That is the point. They may want to, but they are not able to ultimately – ultimately– control the direction of the market. In a short period of time? Sure.
Kevin:This is where being around for a long, long time starts to really help. Are these the types of questions that are always asked before the secular cycle changes? I will go back to 1987. I brought this up because the first year that I started working here I got Fortunemagazine in the summer and it said, “Are stocks too high? New methods of valuation say that we are not going to have a crash.” Well, we had the largest crash since 1929 that October.
In 1999 I got Wired magazine, the technological magazine. It was doing the same thing with tech stocks. It said, “Are stocks too high? Could these possibly ever crash?” They said, “No. If you look at the potential of the Internet and the potential of the dot.coms, there is no way that this thing will crash.” And of course, we saw almost the complete evaporation of the NASDAQ within months of that article. So, is the same question being asked with the central bank in this case saying, “Why should we care about fundamentals? We now have a new technology that can manage these things.”
David:Markets and fundamentals are interesting if you think about the life and trajectory of RCA.
Kevin:The dog listening to the big phonograph.
David:That’s right. So you go back to the 1920s and 1930s, you begin to see market penetration in that timeframe.
Kevin:It was radio, wasn’t it?
David:It was radio. First, there are 100,000 homes that have radios in their homes, and then there are 500,000 homes the very next year. And you see this growth in trend, and they weren’t defunct until 1986 when GE bought them. But there was a long period of time where, not only did they get crushed in the Great Depression, but then they also had to go through that period of price controls where the government was in charge of capital, and the pricing of capital, in the interest rate market, all through the 1940s.
So technology has a great story. There is no doubt, betting on the tomorrow, whatever the tomorrow may have, whether that is AI, or cloud computing, there is no question that these are technologies in their infancy, but that does not change the market.
Kevin:And you want to bet when the price is low. That is your whole point in this program. You want to bet when the price is low, not after the rise.
David:But I agree with you, there are points in a secular cycle where a generation has come to make certain assumptions about the price of money, about the average annual returns of particular asset classes. And it is the kind of questions that you begin to hear – I think they are fairly common – at the end of a cycle, and it is based on all that you know to be true, all of your experience in a generation as an investor. You think, “How old do you have to be to be an investor that remembers interest rates above 7%, 8%, 9%, 10%? You’re talking about not one generation of investors, but two generations ago, if you’re counting a generation in 20 years. You’re talking about nearly two generations ago when someone appreciates that you could have interest rates above 10% instead of here near the zero bound.
Kevin:One of the things I think we take for granted, Dave, is the written word. We live in an area where we had ancient native American cultures here, down in southwest Colorado, Utah, northern New Mexico, Arizona. Spending time in those places, you can tell, these were not dumb people. They understood what they were doing. A lot of times they built buildings in alignment with moon cycles, or solar cycles. They didn’t write things down, however, and so the only thing they could really capture were small generational types of things. Everything was really living for the day.
One of the things I am looking forward to with Ed Easterling coming on is his market matrix, this map that we were talking about, because you can look at that and say, “Okay, let’s go back to the year 1900. What do we want to know? What was the price earnings ratio in 1929? What if we were to have bought a stock in 1926 and sold it in 1934? You can really ask of that map, that matrix, almost any question and get answers that even Easterling may not know because the map, itself, tells the story.
David:Right. We talked about the problem of having these assumptions which are informed by what has become status quo – performance of a particular asset class, directional trend, and things like that. History is larger, history is longer, than a generation, even multiple generations.
Kevin:And it allows you to live many lives if you just go back and read it.
David:Yes. Trends, as it turns out, don’t bend to the whim or fancy of our expectations, our desires, our timeframe to retirement, our immediate needs. These things are happening, and you either observe them and take advantage of them, or don’t observe them and be abused by them. Those are the options in the asset market.
Months ago on the Weekly Commentary I made an observation. This was an observation borrowed from this matrix you are talking about – page 28 and 29 of Ed Easterling’s book Unexpected Returns– that is where you find the stock market matrix.
Kevin:It’s worth the price of the book.
David:It’s brilliant. It takes a few minutes to dive into the complexity of those pages, but on that page is a map most invaluable. If you’re a student of history, if you are intrigued by finance, I would suggest the book, if only for those two pages. If you unpack all that is on those two pages and come to understand the relationships reflected there, the relationships between economic variables, between asset classes, etc., your expected returns over one or more cycles are likely to be considerably improved – considerably improved– if you imply well.
Kevin:And the observations and the conclusions can be non-intuitive when you look at the chart. What conclusion did you come away with that you were mentioning that you borrowed?
David:Yes, well, if you study the matrix you see that the economy is not the primary driver of positive rates of return of financial assets.
Kevin:Okay, stop that for a second. The economy is not the primary driver of financial assets. That is so counterintuitive. Most people think, “Well, gosh, things are going well in the economy, I have a job, my son has a job. The stock market is going up.”
David:Right, I agree that may sound odd. If you are a regular Commentary listener, this may sound familiar. The period of 1966 to 1981 was marked by economic growth and that economic growth in that period of time outstrips even the Chinese run rate of the last decade or more. So who has been the largest GDP contributor globally in the last ten years, and still is today? The Chinese.
Go back to this 1966 to 1981 period. The U.S. was dominant – a 9.6% average growth rate in the U.S. economy in that timeframe.
David:A 9.6% average.
David:And yet, it was not accompanied by growth in equities. Not accompanied by growth in equities. To the contrary, one of the best periods of economic growth in U.S. history was awfulfor equity investors. Awful, right?
Kevin:And with the flavor that we have right now, we talk to a lot of people who think, “Trump is changing the economy, and the stock market has to go up.”
David:That’s great, that’s wonderful. I’m enthusiastic as a supporter for economic growth, but it doesn’t necessarily translate into higher financial asset prices, and that is the point we have been trying to make. You may be enthusiastic about the Trump bump, or whatever you want to call it – the Trump economic miracle. I don’t know that it has anything to do with him. Certainly, lowering tax rates is helpful in some quarters.
But what is the White House after? The White House is after growth in nominal GDP. They don’t care about inflation. That is an agenda item – growth in nominal GDP. But investors are assuming that that means increased profits for corporate America and a booming stock market, ergo, you should go out and buy stocks before the train leaves the station, and you get sitting there on the stage, left out of this next growth phase.
Kevin:Even though the PE right now is above 30.
David:Yes, my point is that economic growth and financial asset prices can behave independently of each other for a considerable amount of time, even for a generation. More recently – this occurred from 2009 to 2016 – you had anemic economic growth. That is a generous description relative to the monetary stimulus put into the system from the world central bank community. Growth in this period, 2009 to 2016, was the weakest on record for a “recovery period.” Yet, equities and bond prices rose in spite of – in spite of– the subpar economic metrics. It was not the economy driving the stock market. The stock market was doing its own thing and the economy was languishing.
Now the economy is picking up a head of steam and it cannot be assumed that the stock market and the financial markets in general, including fixed income, are necessarily going to be moving higher in that context. So we have increased economic growth. It remains to be seen if equities can maintain that sort of astral trajectory from the 2016 post-election lift-off.
Kevin:Something that Ed Easterling brings up, too, and I really can’t wait to hear what he has to say on this, but I have to dust off a word that I don’t think anybody believes in anymore. It’s called inflation. Dust it off. Inflation used to be an issue. Easterling says inflation always is an issue when it comes to determining value in the market. And inflation is coming back.
David:He makes the case that inflation trends are a, if they are not the, determining factor in valuation metrics, and ultimately, the direction of prices in the stock market. And of course, inflation has a major impact on the bond market, as well. So in a period of relative price stability, guess what? As you might expect, in a period of relative price stability, asset prices do exceptionally well. You see growth in stocks, you see growth in bonds. But in periods of either rapidly developing deflation or inflation, either shift away from price stability equals a decline in financial asset values.
Kevin:Yes, his chart shows that. It is fascinating and it doesn’t just mean inflation, it is like what you said. Deflation will also do it. To have rising stock prices and continue to have that healthy, you really can’t have either inflation or deflation.
David:This is a very critical point. If you recall last week we discussed the Fed’s shift toward an inflation focus, as Bianco did his word search, and through an algorithm, looked at how often they are talking about it in concerned language. So as the CPI gradually rises, the Consumer Price Index, as velocity gradually increases, which it is, ever so gradually, the question is on the table – where do asset prices go in the context of rising inflation and rising interest rates?
This is where, again, Jim Bianco argues, we are headed toward a renewed investor concern on inflation. Even if we don’t have radical inflation, itself, we have a renewed investor concern on inflation, which he is convinced brings the correlation of stock and bond performance into alignment. “Where do you hide?” That’s how Bianco frames the issue. Where do you hide?
Kevin:Even though the stock market has come off from its highs that we had a month ago, it is still only 5-6% below its high, so nobody is asking that question right now.
David:You are right, the investing public is not asking the question: Where do you hide? Because we are only a stone’s throw away from a record level. So Ed argues that as rates in inflation rise, investors demand higher compensation for the risk in the market. So again, follow that through. Interest rates and inflation are on the rise, investors demand higher compensation for the risk in the market, and asset prices, as a result, get discounted to open up a future of higher returns.
Kevin:In other words, you need lower prices to be able to gain higher returns later.
David:Yes. The high does not go from high, higher, highest, and then just infinitely keep on rising.
Kevin:You want to go from low to high.
David:That’s right. Prices have to go down for the possibility of higher-than-average returns to emerge, and I think that is often lost on investors. Higher returns are predicated on lower prices, and lower returns into the future are determined by higher prices. Investors don’t want to do that. They want to go after red-hot markets. They want to go after things that are priced expensively because they are performing well in that moment, not looking ahead and saying, with some predictive capacity, high prices don’t become high, higher, highest. High prices ultimately become low prices, and that is how you end up with subpar returns. Why they won’t touch bargains is beyond me, but in both cases, the issue here is that extrapolation leads an investor to make a mistake, that of either buying high or selling low. These are the classic errors of optimism and pessimism.
Kevin:Weren’t you in the Bahamas one time and met Sir John Templeton? His classic phrase was to buy bargains.
David:Buy bargains. What set Templeton apart is that he would look for bargains in any part of the world. So being an international investor in a period when international was not common really gave him a leg up. But what was he doing? Whether it was domestic or international, buying bargains was the ticket. And it is not as easy as it sounds because it takes a combination of conviction on the one hand, and patience on the other, because cycles have to play themselves out. This is not something that happens in a moment, in a day, in a week, or even in a year.
If you want long-term out-performance in growth, conviction and patience are there. Patience implies time as a resource that you are working with. We talked about this earlier. You have life events that sometimes mitigate against long-term investment success by shortening time horizons to the point that cycles can’t be used to your advantage.
Kevin:One of the ways that you watch cycles, as well, is through a friend of yours, Alan Newman, who writes a great report. We have had him on the program. Actually, these numbers are not on the matrix that we are talking about, but they should be, which is margin debt. How much are people borrowing to actually buy stocks? And right now margin debt numbers are at all-time highs.
David:We have put that in the category of a sentiment indicator. How enthusiastic are investors about owning stocks today. Now that the number is north of 3.2% of GDP…
Kevin:It has never been that high.
David:And it has grown 3.3 times in this phase of growth in equities. Margin debt has grown by 3.3 times since 2008-2009, that timeframe.
Kevin:Yes, and if you could look at the chart, which we can’t audibly do with your listeners, you would actually see that every time it gets up into this range, or even just near it, we have a major repricing of the stock market.
David:Because you have an overhang of liquidations. It is not as if these are strong hands. This is borrowed money on borrowed time.
Kevin:Right. They are forced out of those stocks when it goes down a certain percentage.
David:Yes, so you have the threatening there of a catalyst, large forced liquidations in equities with that 650 billion dollars, 669 was the peak in May, of borrowed money in the equity markets, 3.3 times what it was just a few years ago. Now, factor this in. With rising inflation, with rising interest rates on that margin debt, you have an adjustment yet to take place in the category of investors and their expected returns. And as you see an expectation of high returns, as you see that dimmed or diminished, all of a sudden you see the allocation shifts occurs. And many of the allocation shifts will be knee-jerked out of the stocks and the bonds. Unfortunately, in a period of correlation, moving from the frying pan into the fire is not going to be of that much help.
Kevin:Doug Noland has pointed out that this time the bubble that we have, which is clearly a bubble, will probably collapse from the periphery in. And the Shanghai Composite, you mentioned earlier, is down 30%. When does that start to catch up, actually, to home markets?
David:Bloomberg noted the extra pressure in the Chinese market, Shanghai – you are right – 30% down since January, at its worst. I see this week it has picked up a little bit. Officials pledged support and the markets are reversing to the upside, 4% in the day. As the U.S. stock market was selling off 2-3% on Tuesday, you had the Chinese, again, stepping in to prop up, the equivalent of their plunge protection team active in the markets.
Kevin:Yes, but how many stocks are actually being purchased relative to the declining stocks, decline versus gains?
David:Right. If you are looking at last week’s trend in the Shanghai, 13 times the amount of liquidations to purchases, 13 companies being sold for every one purchase. That is fascinating for the overseas markets. Bringing it home here, bespoke investments highlighted a similar trend here in the U.S. last week. We had 266 new 52-week lows in the S&P 500, only 16 new 52-weeks highs. So what is this telling you about deterioration? Weakness is certainly there in China, but here in the U.S. you have a few big name gainers which are covering over what is broad-based weakness here in the U.S. markets?
Kevin:So have we created our own problem? I asked you a question midway through the program – do we really care about fundamentals because of central bank intervention? But even Trump recently has been saying that his greatest threat is the Federal Reserve. They are having to raise rates. The rates are coming up anyway, worldwide. So does it still come back to the central bank, and have we created a problem that is going to now play out?
David:It reminds me of the days of Arthur Burns, where you see pressure from the oval office, and compliance – very little independence and separation between the executive branch and the Federal Reserve being exhibited under that particular timeframe. You listen to Trump and his interview with Trish Regan this last week. Fascinating. It is worth thinking about the tough spot the Fed is in. This is what Trump said: “My biggest threat is the Fed,” he said this in the interview, “because the Fed is raising rates too fast and it is too independent.”
Kevin:Is he setting up a straw man, also, for what he thinks is probably going to happen?
David:(laughs) There is nothing surprising here. He knows that higher rates will derail the economic growth narrative, if nothing else, by taking the enthusiasm out of stocks and bonds, and that having a negative feedback loop within the economy. But let that sink in. This is every politician’s dream – control of the money supply. It is very tempting. This is like Gollum and the ring, or if you go back to Gyges in book two of Plato’s Republic.
What would you do if you had total control? And that’s all he wants is what a president should have – total control of everything, right? Particularly if it is over gold, money, and all that stuff. So the Fed is too independent, he says. What would our monetary policy look like today if it was an extension of the executive branch, where he said earlier, real GDP growth is not his objective.
Kevin:I think we would see Venezuela is what we would see, with any administration.
David:Because when you prioritize nominal GDP growth and don’t pay attention to real GDP growth, which factors in inflation – if you’re just looking for a headline number to say, “Hey, look, I’m the new hero, I’m the new knight on a white horse. I’m the new guy in town. I’ve done things that no one ever imagined doing,” Well, so has the president of Venezuela, if you’re talking about nominal values. This is spectacular. We’re talking about success in the trillions. Now, it doesn’t really matter that much when it comes to buying groceries or a cup of coffee or toilet paper.
Kevin:In bolivars (laughs).
David:But, nevertheless, we have a White House that would focus on nominal growth over real GDP growth. Inflation be damned, he’s going to make America great again. What is fascinating to me is, Trump is saying the Fed is going crazy. The Fed is doing what they said they were going to do – gradually raise rates. The challenge is, that does have an impact. It is the equivalent of taking away the punchbowl. And no standing president, no standing political party, is interested in the punchbowl being taken away because it will affect the economy, it will affect the financial markets, and there will be, whether it is legitimate or not, a blame game played. There will be fingers pointed, and political ramifications.
Kevin:So he’s saying, “They’re going crazy.”
David:(laughs) Really, if you think about it, what is more crazy than thinking that a 9½-year rally is still healthy, with vast upside from here? Again, what use are valuations and fundamentals? It may be they are just the wallpaper that is in the background and they provide some context, but nobody really cares what is hanging on the wall. Ultimately I think these valuations do matter. When, precisely, I don’t know, but when they emerge as particularly relevant, we are all going to live with regret that we didn’t pay more attention to them.