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The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

“What should you look for as you head further into 2018? With a rise in interest rates, you are going to see not only a decline in the value of bonds, but also a decline in the value of equities. So just let that sink in – 2018 and 2019, a growing correlation between stocks and bonds, losses for both investors. At least that’s our opinion.”

– David McAlvany

Kevin:David, we’re just returning again from a conference that we were at last year in Austin. I’ll tell you, I learn so much when we go to the conference. I know they invite you so that they can learn, but actually, I learn from every person that I talk to there.

David:The trip to Austin was fascinating, in some respects challenging and inspiring. We arrived at a Paleo conference…

Kevin:Paleo diet – eating conference.

David:Ready to discuss our version of non-GMO currency, which would be the old-fashioned gold. There is a natural expression for money, a decentralized expression for money, and it has been with us a long time – 5,000 years we have been using gold and silver, elements on the periodic table, and we apprise them as money. Today we have the modern iteration of that, bitcoin, that expresses, really, what we find throughout history, and that is, the search for a solution to a problem. And it is to have money that is outside of a system, outside of a system of centralized control and micro-management.

Kevin:Something that I noticed as people would come and talk to us, the older generation could remember that their grandparents had real gold and silver, and a lot of them, when I would hand them a dime and I would say, “What makes this dime different,” because the dime that they were holding was from before 1964, they would say, “Well, this dime has silver in it.” That’s the older generation. But the ones that were younger, I would say anything below the age of 40, a lot of them didn’t even know that we had gold and silver in our currency before, and they were seeking after something, the same thing that drives us to gold and silver. They were seeking after something that was outside the system, and that would be the cryptocurrencies. And that was your topic. That’s why you were invited talk.

David:Right, and I’ve been grateful for the constructive feedback provided by some of our Commentary listeners following last week’s Commentary – several book references which have been very helpful, and I’ve looked at those resources. I just want to thank you for that. I’m always interested in seeing topics from as many perspectives as possible.

To me, it’s a little bit like appreciating the facets of a diamond. I don’t know if you have ever bought a diamond but you hold it to the light and you turn it around and around to see how the light dances differently from a different perspective through the many facets of the stone. I think when you’re looking at any topic … long-term listeners know that on the McAlvany Weekly Commentary, we have strong opinions, but we never assume to have the final word on anything.

Kevin:We learn from our listeners oftentimes, those who choose to be constructive. Now, there are people out on the Internet who really just enjoy venting. That’s one thing. But when someone gives real constructive criticism and says, “Hey, have you considered this?” It is of great value.

David:It is super-helpful. We’re always in pursuit of truth and we’re always encouraged to find others who are on that same path. And it doesn’t matter to us if they are ahead of us or behind us, it is just encouraging to know that we are kind of on the same track. I think that is one of the things that we liked about this Paleo conference. There are a lot of people who have their eyes wide open, and their ears wide open, and they don’t presume to know everything, they’re there to learn. And what a fascinating environment to be in.

Kevin:One of the things that I’ve found, because we had a booth there after you talked, and person by person who would come over and we would hand them the dime and we would talk about why it’s worth more than a dollar, and we had some fascinating conversations. But I found from last year that every person who came to talk to us was there for a reason. This is a conference that costs hundreds of dollars to come to, and sometimes it costs thousands to get to because people were from all over the world. But I would ask them, person by person, tell me your story. Everybody has a story who was there. What I found last year, and especially this year since I deliberately asked the question, is that people get caught in a vicious loop of assumption. They assume that what they are eating has nutrition until they start getting sick. And then they go to the doctors. They assume the doctors can help them – until they can’t.

There is a point – and this is the type of person who goes to a conference like this – there is a point where they break out of that vicious loop and they say, “I have to do something on my own. The system is not telling me the truth.” That is one of the things that I love about the conference. But Dave, your family has tried to reveal the truth. Your dad started this company back in 1972 because he knew people needed real money at that time when we went off the gold standard. But we were staying at your aunt’s house. She was kind enough to let us stay. And I got to be present for a McAlvany family revelation, and it just gives me chills bringing it up. Would you share the story?

David:Yes, a little family secret. My great-grandfather had one daughter, and he was a silent movie actor. He starred in a dozen films or more. We were visiting my aunt in Austin and discovered that he had taken the time to fill several pipes with silver coins, and he put this together for his daughter, with the express purpose of providing a reserve for her just in case she should ever need it.

Kevin:These were pipes that were sealed at the end with screw-on caps.

David:Yes, that’s right. This was her fallback position. She had the artistic bent of both of her parents and became a ballet dancer with one of the earliest American dance companies out of Chicago, the [unclear] Dance Company.

Kevin:So your great-grandfather was a silent film star and then his daughter was a ballet star early on.

David:That’s right. One of the first years that Mary-Catherine and I were married we went to the Hollywood Bowl. We were living in Southern California. It was amazing to sit there and watch a dance performance and imagine what it was like because my grandmother performed as the swan in Swan Lake there at the Hollywood Bowl.

Kevin:Wow! Oh my.

David:So anyway, these tubes were meticulously prepared with coins wrapped in paper and the first paper that I took off had a date on it of 1921.

Kevin:Yes, you asked your aunt, “1921?” But really, that makes sense that it would go back to that time period.

David:Reflecting on this, with Legacy, sometimes it’s the thought that counts. He was not leaving her a vast fortune. It was a reserve. And in this case you’re talking about saving a few dollars in silver. Of course, with the erosion of value in our currency, it has lifted what was worth maybe hundreds of dollars to being worth thousands of dollars. But more important to me was this time capsule of consideration for a future generation. And it really was to address circumstances that were unforeseen, and in his mind, could only be imagined. Here is a father’s, it could be a mother’s love, reaching beyond the grave, in a form that is very thoughtful and supportive.

Hopefully a message like that, in a capsule like that, is appreciated for what it is. The gift has now stood the test of time and what was intended for my grandmother now rests as a reserve for my aunt. My grandmother never wasted it on something frivolous. She knew that her father’s wisdom and forethought was worth preserving. That is something you can do for future generations. I told my kids about this when I got home and their first question was – they immediately asked me – “Are you going to do the same thing for us?”

Kevin:Well of course. But see, they get it. And as we were doing that, and as you opened that up, your great-grandfather had taken the time to not just do it, but he did it right. He put felt on the end, and he left that for whoever of his inheritors would ultimately need it. But I don’t think your dad, who is the brother of your aunt that we stayed with, probably even knows about this tube of coins. I think it’s going to be worth bringing that up. But the Plan B mentality does stretch to your family, the McAlvany family, and your aunt was a McAlvany before she got married.

David:And it stretches beyond my father, which is what I thought was fascinating. That’s a fun discovery in itself.

Kevin:And I got to be there. It was so fun.

David:What impressed me most was the wrappings and the trappings and the thoughtful care that went into – you mentioned the felt lining – all these other details that a man 80 years ago considered as he created a time capsule of value. He could have done lots of things. Had he put paper dollars into a box or into a coffee can, they wouldn’t buy you a cup of coffee today. But here you have an encoded message of care and concern and it has endured, just as the value of the silver has through time.

Kevin:I totally agree with what you are talking about. If he had rolled up a bunch of dollar bills and rolled that into the tube, which he could have very well done because at the time the dollar was backed by precious metals, but he had the forethought to actually put something precious metals oriented into a tube long before we went off of the gold and silver standard. But that talks to conventional wisdom. We have a tendency to think that whatever is being used right now is conventional wisdom and it is the normalcy. But conventional wisdom is only as good as the assumptions it is based on.

David:Something from Doug Noland’s weekend piece – he manages our Tactical Short Fund – that got stuck in my head, that notion of conventional wisdom often being proven wrong. What is the root issue in most instances? I quote: “Responsibility lies foremost in flawed analytical frameworks. As I have thought about our financial system with its addiction to growth via an ever-expanding quantity of debt, and the recurrence of the boom and bust, in spite of the notion, in spite of the idea that the business cycle can be managed with financial tools, ranging from interest rate control to direct monetization of debt, to sometimes something as simple as verbal manipulations, our modern day version of a market placebo. But the work of a central banker is not that much different than the work of the run-of-the-mill medical practitioner.”

Kevin:It’s strange, looking at the system. We have talked to people who are central bankers, which is a system that we feel, ultimately, when misused has ruined, or will ruin, the economy. The people we talk to, by a person, Dave – these are good people who, as individuals, make their own decisions that oftentimes are very different than the system as a whole. Let’s take the medical establishment as an example of that. There was a doctor who came to this conference. His wife was sick.

David:With rheumatoid arthritis.

Kevin:Yes, for many, many years. I would say he was in his mid-60s. He did not look like the picture of health even himself. But I asked him, “What’s your story? Why are you here?” He said, “Let me tell you why I’m here. Do you realize I’m a doctor? I’ve been trained in the best of medical science. I’ve done everything I can for my wife, and do you understand how hard it is to not be able to heal even your own wife? I finally have given in. I used to think this stuff was crazy. I used to think that eating healthy and these diets and these types of things were crazy. But he came back and he said: I’m here because this is the only thing that works.”

David:The normal analytical framework, whether you are a central banker or a medical practitioner is that everything can be treated on a large scale and you don’t have to really pay attention to the individual constituent parts. So you’re working off of statistical analysis which tells you that everyone should do X, Y, or Z. The majority of people fit the mid-section of the Bell curve or the Gaussian curve. What this allows for is a streamlining, sort of generic one size fits all solution. But the real deep similarity between our economic central planners and the modern medical establishment rests on textbooks.

Kevin:Right, it’s not personal experience, it’s textbooks, it’s theories, it’s how to work it every time.

David:According to the textbook knowledge, there is no reality, there is no reasonable perspective outside the economics or medical textbooks, which was why the doctor was so frustrated. He had the answers and yet there was this reality which couldn’t be addressed by the answers that he had.

Kevin:“My wife is still sick.” That was the reality.

David:Yes. So we have the voodoo economics – that exists, just like quackery in the medical realm. I’m not picking on voodoo economics, it’s a turn of phrase, but for these communities that are hard-coded by the textbooks that they have read, anything outside the standardized text fits that description of quackery.

Kevin:Right, voodoo economics. In fact, I’m going to say, at this conference you had probably 80% of the people who were displaying and talking there really had something to say. And then you had the small percentage of people who have machines that do this, that or the other that you can say, “Okay, well, maybe, but for $15,000 I think I’m just going to eat healthy, thank you.”

David:“I need to understand the science, and if you can’t explain it to me, then I’m not sure there’s much.”

Kevin:Yes, so all conventional is not necessarily bad, but just being different to be different isn’t always the good thing to do. But there are things that are outside of the conventional wisdom that need to be checked.

David:Right. Conventional thinking is soundly taught, it is practiced in conventional ways, and there is the pursuit of the most scientific outcomes. There is nothing wrong with any of that. What happens if, in the midst of pursuing your scientific outcome you’re using a flawed analytical framework? Or an insufficient analytical framework? Bad things can happen in spite of the professionalism, in spite of the generous intent of the Ph.D. economist or the M.D.

The framework in play doesn’t do well with complexity, with particularity, or frankly, with a maintenance regimen. If you look at our health crises today and the chronic conditions that are vexing the medical field, many of them stem from the food we eat. Quantity is one issue, quality is another, but again, the medical framework doesn’t deal well with health maintenance. It is really the interventionist mode where they operate best, very similar to our economists today.

Kevin:Sometimes we have to ask, “What are our goals? What are we being paid for? Are we being paid for quality as we grow food and eat food, or are we being paid for quantity?” Now, as people approached the booth I would explain to them why we were there because everybody else is food-related at this conference, and here is this money guy and he is handing people free dimes from 1964. And I would ask them, “Do you know why this dime is worth more than a dollar, and why the paper dollar in your pocket is worth less than today’s dime?” Some of them could answer, but here’s the thing. A Big Mac looks like a burger, but it doesn’t have much nutrition in it, not the nutrition that a burger had maybe 50-60 years ago. So we have been rewarding the industries that produce for quantity produced, not quality.

David:If you look at the State of Virginia, they decided that tobacco could be used as legal tender, as money. And a part of that was self-serving economic advantage. They had lots of it.

Kevin:So tobacco went from a useful product at that time to a monetary product.

David:Currency, right. Do you know what happened? Farmer’s instantly planted the highest yielding, lowest quality crops. There was a misalignment in incentive because basically, you were being compensated for the poundage, the weight, and the quality didn’t matter anymore. And our food system is the same today. There is a young man who worked for many years here at our company. He was invited back to work on the family farm, thousands of acres of farmland. It is farmed with precision. It is farmed for maximum yield, and for the minimum input cost. And it’s managed for efficiency using the highest tech you can imagine.

Kevin:Yes, he was telling me about his GPS system on the various tractors that they use. He said it is far more precise even than the GPS that we use in cars to navigate. He knows what every inch is yielding, really, all the way through the year.

David:We’re talking about GPS system subscriptions like $20,000 to $30,000 a year to be able to plant to within ¼ inch of the property line. It’s amazing, but yes, it’s all GMO. No, there is no thought or consideration for the health implications which might be connected to plant stimulus and growth accelerants. You have weed killers – the quantity of toxic chemicals applied to that crop every year is staggering. And the quality of the modern commercial farm – guess what? It’s frightening. The analytical framework requires unanimity management.

What I mean by that is, if you diverge from the consensus of other commercial farmers you’re not going to keep up, and you’re going to be out of the farming business. Virginia tobacco was no different. It became a quantity race, and quality was absolutely sacrificed. We have food, we have modern medicine, we have contemporary economics – all have issues tied to the analytical frameworks they employ. We’re not saying that good science isn’t done, it’s just that there are some negative and bad results that happen because maybe some of the implicit goals are flawed.

Kevin:You and I have this conversation often because sometimes we go out and run together, you prepare for these triathlons by swimming and biking. But running, especially, is a good example of this. I ask you sometimes while we’re running, “Is your goal speed, or is it longevity?” Because if your goal is speed, you are going to be able to compete probably for five or ten years more without blowing out your knees or your hips.

If your goal is longevity you’re going to have to run differently, and it’s going to be a slower type of run, but you’ll be able to do triathlons into your 80s. So we have this talk, and I think it is important for us to look in our lives, “What are we trying to accomplish?” The first order question is what I’m getting at. What is your first order question before you get to the second order question?

David:That takes me back to my Philosophy of Science class with J.P. Moreland. The scientific practitioner functions mainly with second order questions. You’re solving problems usually at that level, like what happens when you mix these two chemicals together? That is a second order question. First order questions are the presuppositional questions that should precede the work in the lab, or when you’re out in the field, or if you’re an economist, a Ph.D. working at the Fed, before you show up at the Mariner Eccles building in New York. If you’re that Ph.D. economist, what is the value of what we do? They might ask that question. First order questions: What are we seeking to prove? What are the implications of the work we are about to engage in? Nobody really has time for the philosophical questions that should precede the second order questions.

Kevin:Lest we sound like we’re taking shots at people who help us every day – farmers, medical professionals – we were talking last night when we got together to think about what we were going to talk about today, and we really have amazing discussions. You had brought up something that I love. Doctors are really very, very good at acute medicine. In other words, if I were to fall and break my leg today, I need a doctor. But the chronic types of things, the things that add up over time that are systemic, they may not have all the answers.

David:Thanks to one of our listeners, Eric, who was at the conference, for the contrast between acute and chronic, and also for some of his explanation on “cancering” versus healing. Those were great conversations. But to give credit where credit is due, our medical field is populated with some of the brightest and most talented minds in the world. And the schooling that they have and that they are given is exceptional. The focus is quite often, as you mention, on acute illness and problem solving in cases where a dramatic intervention is required.

There is this fascinating parallel here to our modern economist – well-trained, bright, well-intentioned, from the best schools, and educated in the Keynesian model of interventionism in times of crisis. The problem is, the system doesn’t need this kind of intervention on a routine basis. It is my belief that the human body, like the market economy, is largely self-healing. It doesn’t need the outside intervention. Outside resources can be helpful in an emergency and that is the difference between dealing with chronic illness and acute care, and modern medicine does very well with acute care, in particular.

But outside resources can be helpful in an emergency. Many of those resources, if you look at them, can be toxic, can even be dangerous, if they are applied as some sort of a daily nutritional maintenance regimen. If you have cancer, I’m not suggesting that the best way to cure cancer is using radiation or chemotherapy. But on the other hand, it may be necessary. I know that when my wife had cancer, radiation was a part of the regimen – surgery and radiation. And I’m glad that we had those available to us. But I wouldn’t suggest radiation as a part of a normal health routine. It is a one-time intervention – boom – done – like a smart bomb.

Kevin:One of the things that was empowering about this conference, and I remember now from last year, you can look at these things like what is going on with our food, or what is going on with our money, and you can become very, very depressed. You can become fearful, and start acting out of fear or depression. These people are not this way. I called my wife from the airport as we were flying out and I said, “You know, Sweetie, think of the healthiest person we know, and now add 30% to that.”

The average person who had been on the eating whole foods – and a lot of them had eliminated grains, but I don’t know that you always have to eliminate everything, but a lot of them had eliminated the things that they knew where chronically hurting them. But these people were not acting out of fear anymore. They were empowered, and they wanted to find out the next thing they needed to do. It’s like they had seen the light – “Wait a second. I broke out of one system. I need to find out what is true in other places.”

David:This is not sort of diet-hungry body-worshippers at the venue. They relate, as you said earlier, to their personal story, and it is a story where they have had to struggle and probably gone through a point of despair, in some cases where they were near death. And to see health regained and recovered, and to see individual decisions need to be made as a result of the research they had done.

Kevin:This wasn’t just about weight loss. I would say, more often than not, it was about coming out of an illness that they thought they were going to die with.

David:Right, adopting an approach to health that was outside the textbooks. They had to solve their own problems, they had to do their own homework, they had to iterate. By trial and error they had to figure out what worked for them. Again, this is going beyond medical statistics and standardized protocols. What brings effective results, either in solving a chronic disease or achieving a different level of health? That is the mode that they were in. Again, I think this is how I started my first comment, what made each person that we met fascinating, challenging, and to some degree inspiring.

Kevin:There is a simplicity to what they were talking about because, really, most of them had just changed their eating habits, something we could all do. This isn’t some sort of magic formula where you have to spend tens of thousands of dollars. They just simply changed their eating habits.

David:And it could be as simple as quality over quantity.

Kevin:Let’s talk about quality over quantity. Let’s say that you do have – and I’m going to liken the analogy, because we have it in the mix here now, to the medical establishment. Let’s say a body is dying and the medical establishment can connect them to various life support and various drugs that sort of mask the issue. We all know that there are drugs that can mask chronic issues that actually need to be addressed in another way.

I’m thinking about when we went through the financial crisis. That was a health crisis for our economy, and instead what we did was, we masked. The government came in and bought the Freddie Macs and Ginnie Maes, and they intervened in a market that needed, really, to come out of its vicious cycle.

David:This is one of the things that is so galling about the response to the global financial crisis. Yes, it is helpful that the whole system did not collapse and fall to pieces. On the one hand, I’m grateful that we have the world that we have today and not some other world.

Kevin:My level of comfort wasn’t really disturbed even though it was huge.

David:And I don’t dream of Mad Max Beyond Thunder Dome. That’s not an ideal scenario for me. But theFinancial Timeslast week noted that Freddie Mac and Fannie Mae have morphed since the global financial crisis, and not in a good way. They went from being the purveyor of home mortgages, now to having this huge portfolio of commercial mortgages, as well. They hold a portfolio of nearly 500 billion dollars in commercial paper, which is 38% of the total outstanding in the United States. So now the U.S. government is implicitly standing behind commercial real estate bets, not just the household aspiration of home ownership.

Because remember, Fannie Mae and Freddie Mac existed to provide mortgages so that the American Dream could be pursued. There is a difference between the American Dream and a personal business speculation on commercial real estate. So they are far larger entities today than they were before they went into the global financial crisis, and the taxpayer liability now stretches even further than it did before, compliments of the salve which was put on the market, that is, a massive amount of liquidity came into the market and allowed for, instead of a fixing, a hard stop and a fixing of the system for the bad to just be perpetuated, as you said, this chronic problem to be continued on and covered over.

Kevin:And the chronic problem is the government, itself, becoming the buyer of last resort. Because really, if you look at the Case-Schiller Index of homes right now, real estate is rising at this point. Now, you still have a whole bunch of real estate that has been buyer of last resorted right on over to the Fed that still hasn’t come onto the market. And so, if they weren’t buying we would see lower prices, granted, but those lower prices would be opportunities for buyers. Instead, what we’re seeing is inflation in home prices as these properties are still off the market.

David:The Case-Schiller 20 home price index is up 6.8% in February, according to Bloomberg, and this is with the lowest level of previously owned homes in 19 years. The inventory tightness is a major factor which continues to pressure those prices higher. And if you think of the affordability index in the context of prices going up 6%, 7%, inventory being down about 7% relative to where it was a year ago, and rates continuing to move higher – now I think they are just shy of 4.6% on the 30-year fixed-rate mortgage, 4.58 – the affordability index has gone from bad to worse, and this is in the context of rates continuing to rise.

Kevin:But if you’re a builder, this is a good time.

David:Because of the supply constraints. Sure. And you have building permits that are at the highest levels since 2007.

Kevin:Well, now, stop on that. 2007 – does anybody recognize that date mixed with real estate?

David:Right, so we’re at the high water mark again. I don’t know if that is good news or bad news, but February new home sales are also at levels not seen since the highs in 2007. Good news or bad news? I don’t know. Mortgage purchase applications were 11% higher than they were a year ago at this time. I had a fascinating conversation with a friend of mine over the weekend, a good friend, who was telling me about a condo that he purchased in 2007 (laughs).

Kevin:2007, there you go.

David:Not the besttime. But again, he based it on a ten-year history of prices. He came into the area, looked at a ten-year history of prices and thought, “We’re never going to be able to afford if we don’t buy now. I don’t know that we’ll ever be able to afford.” Because you had this ceaseless rise in price, and it was a little bit like standing outside the game, watching musical chairs from the sidelines – watching, and watching, and watching, and watching.

And then jumping in right as the music stops because your confidence was getting higher and higher and higher as you watched from the sidelines, that the music was never going to stop because it hasn’t stopped yet, so your confidence is building. The problem is, confidence is typically, the highest, the best, when risk is at the worst.

Kevin:Right, and you don’t really feel it but we keep hearing about this interest rate creep. I would imagine that the yields on ten-year treasuries, as they continue to go up, are going to ultimately affect the affordability of – you’re talking about the music stopping.

David:Exactly. You do have some pent-up demand, home prices are rising in large part due to a lack of supply, and the yield on the ten-year treasury will ultimately temper the real estate market’s enthusiasm. Cost of borrowed capital is central to the trajectory of prices, ultimately. In the short run, yes, supply and demand is the bigger factor. But as the current context makes clear, interest rates, as important as they are, are not the primary driver. It is a lack of supply, and that allows people to continue to jack prices higher.

Kevin:Back in the 1970s real estate was rising quickly, but interest rates were rising quickly, as well, and inflation was double-digit. What do you think about inflation, CPI?

David:Between wage growth and inflation in a variety of sectors, the CPI needle is going to move this year, I think, more than anticipated. Does anyone like ice cream? Baskin-Robbins just put together a special committee to try to find out why all of their commodities are going up. “Hey, why is milk more expensive than it was last year? Hey, why is sugar more expensive than it was last year? Hey, why are eggs…?” I could tell them, but Baskin-Robbins put together a committee to figure out why the cost of commodities is going up, because a part of the issue is, intelligent people who read the Wall Street Journal, intelligent people who read Kiplinger’s, know that there is no inflation.

Kevin:Right, they’ve been told.

David:And yet, if you’re managing a business, you’re thinking, “I don’t know what’s going on here, this is a little bit crazy.” So yes, I think the CPI needle it going to move this year more than anticipated, higher than expected rates with interest rates rising. I think rates are going to rise even higher than expected. Again, inflation and higher interest rates are going to be the defining factors for the equity markets as we head into year-end.

Anything can happen between now and then, but as we head into year-end, if the Fed is consistent and follows through on what they’ve said, raising rates another three or four times between now and the end of the year, you’re going to see a real bite into the equity markets because of higher inflation rates and higher interest rates.

Kevin:When you were talking about that committee with Baskin-Robbins, I thought of something that really struck me when we read Adam Fergusson’s book, When Money Dies. It was about the German hyperinflation. After the Germans had lost everything, they had gone through this incredible – trillions of percent – hyperinflation, where you could pay a mortgage off with a chicken. It was that bad. It just destroyed it. But at the end of it, he said the people still didn’t know why prices had risen. They didn’t understand that it had been the hyperinflation and the printing of money by their central bank that had created the inflation.

There is a disconnect, and it is amazing, this Baskin-Robbins thing is just another example of the disconnect of, “Well, there must be no inflation, but why are commodities going up?” Not only inflation, talking about interest rates rising and inflation, but there is something that we can watch that sort of gives us an indication of when we are about to go into a recession, an economic slowdown. To explain, when we talk about a yield curve, a healthy yield curve is if you’re borrowing in the short term, you’re getting low rates, and if you’re extending that out 10, 20, 30 years, you’re getting a much higher rate. That is a normal yield curve, as I understand it.

David:From low to high.

Kevin:An inverted yield curve every once in a while happens where short rates are very high.

David:Higher than the long-term rates.

Kevin:Yes. But what we have is a flat yield curve right now and that usually is an indicator of recession.

David:Yes, I would say 80% of the time a flat yield curve is what precedes a recession in the economy. So you have the three-month treasury bill yielding 1.77%, you have the 30-year yielding 3.13.

Kevin:Less than a 1.5% difference.

David:Between three months and 30 years. And this is not good for net interest margin at the banks. It is actually not good for the stock market, either, because you can probably tell me one, two, five, ten different people – someone that you know – who in recent years has bought equities because they were “cheap relative to bonds.” Or they bought them for the income because of a stable dividend profile, and the stock market has been going up inexorably three, five, seven, ten percent a year, and you’re catching your coupon via the dividend rate. Dividends were the income solution for a zero rate world.

Kevin:Right, you go buy a stock so that you can get a little bit of income if you can’t get it at the bank.

David:But rising rates draw people back into cash again, and into money market funds, to keep the income stream but to ditch the equity market risk and volatility. And on that point, you have equity owners now selling. So this is fascinating – a massive increase in February numbers as they have been tallied, major outflows from your ETFs following that January volatility, actually, the largest outflows from equities, February of 2018, since the volatility that we saw in 2008.

Kevin:The global financial crisis.

David:So you had fear of missing out, which December and January had the lemmings parade piling in. Again, that’s the January massive rush into ETFs. We talked about that on the Commentary at the time, just saying, “This is insane, absolutely insane.” And then, of course, we had the January 26thvolatility in the stock market, and February rolls around and you have seven times the volume jumping ship compared to the January inflow.

Back to the interest rates, I want you to noodle on this. Rising short rates also increase the rollover in interest expense pressures in corporations. So again, if you have a corporation that has borrowed a bunch of money it has to be paid back or rolled over at a certain point in time, and yet, in the short-term debt markets you have rates rising even faster than at the ten-year or 20-year.

Kevin:It’s just like a household. You can borrow now, but you’re still going to get squeezed in the future, especially if you have to pay rising interest rates.

David:And that’s the point. Corporations are going to be faced with that. So again, you have rollover in interest expense pressure on corporations. We’ve talked about three to four more rates by the Federal Reserve. Should they follow through on that, you have corporate earnings which are going to be massively impacted by the rise in rates, and the increase in the interest payments that those corporations have to make.

So what should you look for as you head further into 2018? A growing correlation between stocks and bonds. Most people look at bonds and say, “Oh, well, they’re safer than stocks.” No, actually, with a rise in interest rates you are going to see not only a decline in the value of bonds, but also a decline in the value of equities. So just let that sink in – 2018 and 2019, a growing correlation between stocks and bonds, losses for both investors. At least, that’s our opinion.

Kevin:Before I came into the studio, I had just hung up with a client who said, “You know, I’ve been watching the stock market for quite a while, and I wonder, even though it’s overvalued, if we’re ever going to see a trend change, especially while Trump is in office.” This is a man who has high confidence, especially with some of the foreign types of things that are going on, the strategic types of things with Trump. And I just told him, “Presidents never matter. A president can never make or break a stock market. It has never made any difference.” But let me ask you, because the long-term trend has been up now for a while, but it feels like we may have a trend shift, and that trend shift may have already begun months ago. What is your feeling about the trend?

David:The more time that passes from the January 26thmarket peak, the more likely it is that that was a long-term peak. There is a possibility that we could go up and retest those highs between now and August or September. And I think as we move toward September and October you’re looking at potential carnage, not just an insignificant 5% or 10% correction, but far more than that.

Kevin:But the sentiment has shifted, it feels like it a little bit, since the volatility re-entered the market.

David:That’s right, and you had the trading favorites – the FANGS – whether it is Facebook, or Amazon, or Netflix, or Google, or Tesla. These guys carried momentum beyond the January 26thdate and they actually continued higher into March. They put in a top in March. But the majority of those FANGS are now trading below their 200-day moving average, which I think is significant, and does speak to a directional shift in the market, and a change in sentiment within the marketplace.

Kevin:And sometimes you can’t beat the new shenanigans in the market, and there seems to be something happening right before the close every afternoon. I couldn’t afford to anticipate it.

David:One of the things that Doug Noland and I have talked about is rolling out the Tactical Short not just as a separately managed account as it is today, but either as a mutual fund or as an exchange-traded fund. So as I was researching the exchange-traded fund structure, one of the things that I noticed is that you are forced, managing an ETF, to transact most of your trades in the last 15-20 minutes of trading just before it closes. The Financial Timesnoted this last week that the ETF strategies which have gained in popularity over the last few years have shifted a huge amount of daily volume to the last 30 minutes of the day, which is when they settle their trades for the day. And I don’t particularly like that.

This is one of the reasons why ETFs won’t work for us on the Tactical Short – won’t work for us because we have to be able to increase or decrease our positions midday, not just wait until the end of the day and see what you get. That doesn’t work for us. So again, what the Financial Timeswas hitting on is that there is a growing operational risk within the stock market in the late day trade. And I thought to myself, for all those guys who for years have enjoyed two-martini lunches, if you’re a trader who is sort of prone to relax at the end of the day, there has been a structural shift because of the introduction of ETFs and the way they trade.

Kevin:Don’t leave work early.

David:No, because a lot can change when you face a real trading bottleneck in the afternoons.

Kevin:Dave, something that you have taught us all to watch as we look at the stock market is if you’re an insider in a company and you actually have executive power, you actually have to also show what you are buying and selling. It is called insider trading. And the insider trading is giving us an indication right now that, at least in certain categories, the insiders are wanting out.

David:And let me clarify, because insider trading itself is illegal, where you are trading on insider information, and that categorically is what they call insider trading. But what you are talking about is insider buying and selling, where as a routine course of being compensated as an executive you receive stock, or you take your hard-earned cash and buy more of the company shares because you believe in the prospects of the company, and of the economy moving forward.

Kevin:In a way we should call it executive buying and selling.

David:That’s right. So you’ve seen a major increase in insider selling in the industrial and material sector. Let’s go back a couple of weeks, let’s say, three, four weeks ago we were talking about bank stocks. And we were talking about how this is just right at the beginning of earning season. Bank stocks were beating earnings expectations and trading up, but by the end of the next trading day had sold off and were well below where they were before the earnings announcement. So you have that same dynamic which is afoot with Caterpillar, with 3M, with Google, and it’s not healthy behavior.

Caterpillar this last week announced their earnings, share price went up 4.2% on the announcement, and then closed down 4%. So it’s up 4% with enthusiasm on the news, but closes down 4% for the day. That’s not a good indicator. The market is telling you something. The market is in that psychological shift. We spent several years watching accumulation. We may be in an extended distribution phase.

What it is telling you is that smart money is selling into strength. There is this add-on of the insider selling in the industrial and material sector where I don’t think they look at the global economy with a rosy picture on the horizon. I do not think they look at it that way. At least, their self-interested behavior is reflective of, “I’m not betting on a future increase in price, not on this company, not the company that I manage,” and so they’re getting liquid. But smart money elsewhere, again, on the earnings announcement prices go up, and then prices close lower within a day, and that’s telling you that people are using the market strength to sell into, and are getting rid of huge positions.

Kevin:The client that I was talking to that liked what Trump was doing and didn’t think, maybe, that the stock market could correct, that may not be the case across the board then. It sounds like sentiment is changing and the smart buyers are selling into strength.

David:It doesn’t matter if Trump does some things that are constructive for the economy. The economy continued to grow. We have frailties within the financial system. And the financial system is driven by easy money flows, it’s driven by liquidity flows. And if there is an excess of liquidity, financial assets go up. If there is a deficiency of liquidity, financial assets go down. That is a separate issue altogether from the economy. So for someone who is saying, “Hey, he’s doing good things for the economy therefore the stock market won’t fall,” they don’t understand what they are talking about – two different beasts altogether. The economy is not the financial system, and the financial system is not the economy.

Kevin:To give this guy credit, I will say he doesn’t own a single stock. He doesn’t trust the market, it’s just he’s been deflated. He feels like he’s been beaten. But since Trump took office I think a lot of people have assumed that if he gets things right the stock market will go up. And like you said, it’s just wrong to connect those two things.

David:So if you get an updraft with these stock prices, and then constructive interests are dumping stock onto the market and selling into strength, what it’s really telling you is that there is a bunch of people who think that the first quarter tax benefits are really the last hurrah for bullish equity performance, like, “This is it. Thank you very much. Now it’s time to get to the sidelines.”

For the first time since Trump took office, Bloomberg reports that there is a majority of consumers who expect stocks to be lower over the next 12 months – this is from the conference board readings – which is absolutely fascinating to me, because again, we’ve said this over and over again, sentiment shifts and it moves hard and fast. You have bullish sentiment, and Kevin, what changed in the last 90 days?

Kevin:The only thing that has changed is we do have volatility – finally, finally, finally – which we didn’t have for three years.

David:But if you look at the conference board numbers in January, or late in 2017, there was no doubt that we were going to have double-digit returns in stocks coming into 2018 – no doubt whatsoever.

Kevin:Now there’s doubt.

David:Now there’s doubt. And that’s the key. If you want to see a shift in psychology, all you have to have is the introduction of doubt.

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