In PodCasts
  • “Technology is neither good nor bad – nor neutral”
  • U3 unemployment near 50 year lows… If you ignore 95 million people without a job
  • Will self proclaimed ‘socialist candidates’ have an impact in November elections?

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

July 4, 2018

“At the end of the day, you do have, like we talked about last week, the Venezuela function, where people vote, not in light of the numbers, but according to a fear factor. And all of a sudden the money doesn’t matter, the debt doesn’t matter, the numbers don’t matter, it’s just a feeling, and it’s just panic. That is the danger that you have in market panic in an over-leveraged system.”

– David McAlvany

Kevin:David, there were a couple of stories you were telling me last night that I think we should talk about because it involves having enough gas in the tank, or enough power. You and your family have been traveling around when you can in an Airstream so it allows you to travel, do a lot of the business that you do and still be with your family. But you’re pulling that big old Airstream with a Yukon, which should be enough. The towing requirements state that there is plenty. I heard that you sat by the side of the road for two hours waiting for the thing to cool down just a few days ago.


Kevin:Do you have enough gas in the tank, or enough power in the engine, I guess I should say?

David:The specs say that we’re just fine, but I’m curious if, really, the engineering is inadequate, and what we really need is a truck. So at least on paper the Yukon is supposed to be able to pull this thing. But yes, we sort of turned lemons to lemonade as we had a little chocolate tasting and watched a movie and just tried to figure out what we were going to do with two hours on the side of the road.

Kevin:The family thought this was planned, actually. So on Sunday you are again preparing for another half Ironman and that is three weeks out, so you’re having to put the hard long rides in. You had a 70-some odd mild ride on Sunday. But you told me the same type of thing. You rode hard, but you really didn’t feel like you fueled correctly because you didn’t have the power that you wanted.

David:Yes. I know the distances, and I know what it takes to get that done in terms of the training rides, and this was not a distance very much further than the race distance, but yes, not enough fuel in the tank. It is my third for the season, final. I think Mary-Catherine is going to be glad that this season is done and she has a little bit more visibility on Dave on the weekends.

Kevin:Sure. I’m going to tie this in because there are these amazing headlines that have been coming out saying homeowners are sitting on a record amount of cash. That is that liquidity that it takes to fuel the economy, to pull the trailer, to drive the bike. But it’s a little deceptive, isn’t it, when they say 5.8 trillion is just sitting there waiting to be spent.

David:The CNBC headline was a little disingenuous, homeowners sitting on a record amount of cash. To be precise, it didn’t mention that that is home equity, and it’s not exactly the same thing as cash.

Kevin:Too bad it’s not cash.

David:On that basis, if you’re looking at a flow of funds report from the Federal Reserve, corporate America has an extra 10 trillion dollars in liquidity just sitting around.

Kevin:So if you’re willing to mortgage the farm, the farm, itself, is just sitting there as cash. That’s what you’re saying.

David:Exactly, if you could get all of that liquid. That’s not fake news, it’s just not good journalism.

Kevin:Right. Dave, before we jump in on some of the economic numbers, I’d like to address the gold market because what happens every year about this time is that people start to go to sleep. There is this hypnosis. The little bit of news that we’re watching, Supreme Court judge appointments and that type of thing, I think we get distracted from when it is a good time to buy. We do have certain clients right now who are saying, “Gosh, nobody is buying gold. This must be a good time to buy.” Those of you who are listening, and we’ve talked about this this week, it’s hard to do that emotionally, when the emotion isn’t to buy, but the sentiment index, in other words, where people are at, right now is below 10. That’s always been a bottoming period.

David:Right. Feelings, for us, are a big indicator of where you are in the marketplace. So on the one extreme, when it seems like you cannot lose and things are only going up and you begin to extrapolate, and maybe even you keep a pro forma spread sheet of what your investments would be worth at X, and Y, and Z. If you do, just understand that you’re subject to making mistakes in terms of what we would call the error of optimism. Well, the sentiment that drives markets is equally powerful on the other end of the extreme, which would be the error of pessimism. The daily sentiment index, which you mentioned for gold, sits right around 8% and as a contrary indicator, gold is ready to rally. You have the Elliott wave folks, who have drawn some very nice charts that show over a 30-40 year period every time gold gets below 10%, that is, again, dealing with the sentiment indicator and the number of people who are actually interested in buying, that’s a turn in the market. It represents a bottom. You’ve run out of sellers. And hedge funds here recently have taken their positions to the lowest levels since late 2015. December 2015 is when the market turned at 1050 and hedge funds have now taken their exposures down to about that level. That was just prior to a 30% move in gold – that’s a 30% move higher (laughs).


David:And if you’re looking at the mining shares, 160-200% move there in 2016, a very strong year. So speaking of seasonality, the guys on Golden Rule Radio, in house covered seasonality, I think, very well last week. Feel free to dip into the archives and see what they’re saying on that. That is our program that deals specifically with the metals on a week-in, week-out basis. But July is quite often the seasonal low. So if you don’t like over-paying, as you were suggesting earlier, then think about allocating, and I would do that soon.

Kevin:And you were talking about, not necessarily fake news, but bad news. I keep thinking about what this U3 is, this thing we call the unemployment. We’re not really counting 95-100 million people who aren’t looking for work anymore, but we’re told that unemployment right now is at a 50-year low. Well, if you don’t understand the other parts of those numbers how can you not be excited that the economy is booming?

David:Yes, so this last week we had the U3 which bumped up, actually, from 3.75, 3.8 – that range – up to 4%. You think, “Well, gosh, then the unemployment number is getting worse. U6 edged up as well. But here’s what happened. You have 601,000 people that started looking for work in June, and I think it’s worth recalling that the employment number has improved considerably as people have quit looking for work. That may not even make sense, but that is the way they count the numbers.

Kevin:Don’t they drop off the list after a year?

David:Yes. And so the opposite of that is, the employment number gets worse when people resume looking for work. So yes, they were still unemployed, but now that they are looking again, they’re counted again. So that “not in the labor force” number which we have harped on for years includes 95.5 million people categorized as not working.

Kevin:That’s a third of America.

David:But they’re not considered unemployed either, until they get back to looking, or if they get a part-time job, or whatever, they can be in that category of “under-employed” and be subsumed into the U6 number. So are you confused yet? I think, honestly, that is as intended, and I just can’t help but think that the current labor shortage – that’s what a lot of the news outlets are talking about right now, that there is a labor shortage – that is directly tied to the 95 million people that are not in the labor force.

Granted, this is a complex issue. You have education involved. You have skills and retraining which may be necessary, but if we truly have a mismatch between job openings – and there are tons of job openings – and we have available labor – unavailable labor, I guess – then wages should be pressing significantly higher. That would be a net result if you’re looking at the supply of labor, the demand for labor. If wages do not increase significantly, and I hope everyone remembers this, then we need to dig deep into the BLS in numbers, which, I think, could arguably be considered duplicitous.

Kevin:That’s unemployment, but I want to jump back into politics because we are in an election year. You and I, last week, talked about playing a thought experiment. If we are a Democrat, what do we do to shift the tide, because right now there is very strong support for Trump. We talked about pulling the rug out on the economy, which is a possibility. The Federal Reserve could still raise rates quickly – maybe not – but talking to people, you don’t have Democrats and you don’t have Republicans anymore. Most of the people who voted for Trump just didn’t want to vote for a politician. I’ve talked to the younger generation and a lot of them would have voted for Bernie Sanders just as easily as they voted for Trump. They just didn’t want a politician.

So what if – let’s play this thought experiment now. Let’s say that they don’t pull the rug out on the economy but instead they just say, “No, we’re not going to run true Democrats anymore. What we’re going to do is, we’re going to run Socialists, or even Communists.” Honestly, socialism, in many cases, is just a euphemism for communism. So doesn’t it look like the Democratic party is starting to turn socialist at this point?

David:Obviously, Bernie Sanders is a politician. He just casts himself as someone who is so non-establishment. He’s the non-establishment Democrat, just like you have a non-establishment Republican. And I think you’re right. Had they been given the choice of non-establishment anything, they would have gravitated, perhaps, more toward Bernie than perhaps some of them did toward Trump.

Kevin:It seems that that is happening right now in some of these races.

David:Right. Bret Stephens, writing for the New York Times, was concerned on a similar point, that the Democratic Party is being taken over by socialists. These are his words, his concerns. “Democratic socialism,” in his opinion, “is running up against constraints. Some of those constraints are just as simple as math constraints. You can’t have, again in his words, “unlimited governmental largesse and unlimited immigration.” Actually, when he was writing that, it reminded me of the old money problem that Margaret Thatcher used to talk about. And I’m shocked, frankly, reading the New York Timesbecause it’s very rare to see anything critical of the Democratic Party or Democratic party politics. But Thatcher used to say that the problem with socialism is you eventually run out of people’s money.

Kevin:Otherpeople’s money.

David:And Stephens is basically saying, “Hey wait a minute, you can’t have open-ended policies where you’re going to spend on everybody and then create an infinite audience for that spending. The math doesn’t work.” You know what I really enjoy about the New York Times? Not always the assumptions that go into the articles, but sometimes you get just facts, which is nice, sometimes. And you also get great obituaries. They write the greatest obituaries of any paper on the planet. So in case you’re wondering why the New York Times, particularly Sunday…

Kevin:What’s Dave turned to? What is it that he is reading there?

David:It’s the obituaries, first and foremost. Malcolm McClennan was a guy that I used to work with at Morgan Stanley, and he was very keen – he would the obituaries in every paper, every day. And at the time, in my early 20s, I thought, “That is a strange habit.” And then I started looking at them and I thought, “These are really interesting people who have lived really interesting lives.” Now, honestly, if you’re talking about a small town paper that might not be the case, but the New York Timesfeatures…

Kevin:There’s a difference. When you live in a small town you’re reading obituaries for a completely different reason. I know we’re chasing a rabbit here, but before I canceled my Economistmagazine, I found out that, really, the first thing I was doing was reading the back page, the obituaries. I hear what you’re saying, there are a lot of interesting people. It’s too bad we really find out how interesting after they die.

David:I’m sorry, I derailed the conversation on the obituaries.

Kevin:Okay, back to socialism, our favorite subject.

David:I just wonder if maybe Bret Stephens isn’t watching the trends, and you have the DNC chair saying that the New York primary race winner – you may recall this from a couple of weeks ago – Alexandria Ocasio-Cortez – represents “the future of our party.” This is a gal who has basically said, the specific words, “Yes, I’m a Democratic Socialist,” not in the Democratic Party, per se, but she wants to break the definitions and the identity and move more toward – I’ve seen quotes from her that actually reference communism as a preferred political philosophy.

The fascinating thing about the upset in that primary was that the incumbent Democrat, Joseph Crowley, was fourth ranked in the House. This is a guy who has been in politics for a couple of decades. There was talk that he might replace Nancy Pelosi as the House Speaker. Now, he’s out on his ear because somebody steps in and starts promising everything for free and basically the creation of lynch mobs for the rich. And it’s fascinating that that did have appeal. We know that 2016 was volatile and an expression of populist angst, but we said at the time, it doesn’t matter that it is conservative in its expression here because you have the Five Star movement in other places around the world that are expressing the same kind of frustration, but it is on the other end of the political spectrum.

Kevin:Yes, you’d better be careful what you’re voting for when you’re voting populist because you can certainly get something that you don’t want.

David:Kevin, we’ve been doing the Commentary for over ten years now every week. So it was years ago that you were in New York visiting your daughter and went by the park where the Occupy Wall Street folks were.

Kevin:I spent hours talking to the Occupy people.

David:The fascinating thing is, there is a connection point here between both conservatives and liberals as it references the critique of the establishment, and it’s the funding mechanism for the establishment as we know it. And central to that is their central bank. Central to that is the Federal Reserve willing to create infinite amounts of credit, infinite amounts of money, and it fuels the problems that the Occupy Wall Street folks saw, and it also fuels just about every other iteration if you’re talking about fiscal or monetary largesse. So there is a common ground. And you may say the spectrum left and right are so far, how can they have anything in common? On this point they’re right next to each other.

Kevin:A good example of that – I just thought of this when you said that – there was a man that I talked to at Occupy Wall Street. They were very upset. They had no idea what they were upset about, but they were very upset. And he had two documents in his pocket. He pulled out the U.S. Constitution. And he then pulled out the Communist Manifesto. He had both.


Kevin:And as far as he was concerned, there was no problem there. This is why we have to understand, what is the foundation of what we’re asking for when we vote?

David:So, the Washington Times– this was fantastic. They’re reporting on a community newspaper – Beaumont, Texas – if you don’t know Beaumont, you don’t need to know Beaumont, honestly, and I say that because I’ve got family who were born and raised in La Porte, not far from Beaumont, south of Houston. It’s the only part of the Houston area that has never grown and developed, and it never will. I’m just telling you, there is a reason why no one goes there, and there has been nothing changed since the 1950s and 1960s. But the newspaper there in Beaumont starts posting excerpts – this is all featured in the Washington Timesthis last week, by the way – July 4ththe Washington Timesis talking about this.

A newspaper in south Texas posts excerpts of the Declaration of Independence on its Facebook page. It’s an educational process. By the way, we read it out loud last week as a family, and given our family’s penchant toward drama – a couple of my kids are in musical theater and Mary-Catherine is, too – they enjoy very robust readings (laughs). It needs to be delivered as if it was by the founders. But anyway, the Timesreported. They put up nine of these excerpts. They put up the tenth and it didn’t post. And Facebook gives them an automated response explaining that the post “goes against our standards on hate speech.”

Kevin:So the algorithm for hate speech basically cut out words from the Declaration of Independence.

David:The Declaration of Independence, according to Facebook, is in the category of hate speech, at least this particular section of it. Listen, as a family guy, I hold curating to be part and parcel of intentionality, and of a life well lived, but here is an example of curatorial work. Facebook’s thought police should not, in my opinion, be the arbiters of what we know from history, of how we reflect on the modern era. I don’t know that the Facebook editorial committee – maybe it’s not the editorial committee, maybe it is fair to say it is an algorithm – but that they should be doing the curatorial work for what we, as a society, see as hate speech or appropriate language. This is one of our founding documents!

Kevin:Dave, I think it was an algorithm. These algorithms have been written for political correctness. They’ve been written to identify anything that would possibly upset the system as it has been deemed appropriate. What is happening to society right now – the social networking is really changing the way we think.

David:Debate is a skill set. You don’t get to be a good debater without practice, and that’s no longer a part of an educational process. Kids don’t go to school and figure out how to take both sides of an argument. They are taught one side, and taught to defend one side, as if that is the only thing that exists, the only data point and the only perspective that is legitimate. And there is a basic lack of respect for humanity when you teach kids to not engage in conversation and debate. And I think that’s what we’re ending up with. If you want to see a trend toward hate speech, it is that people have an inability to communicate between themselves and to dialogue over issues, even over issues that they disagree on.

Kevin:You have been bothered, and wondered what itch is scratched with social networking. When you dig deeper, we’re all human. We’re driven by very much the same drives, they just change on the surface as to how they manifest. What is it, Dave, that social networking scratches that people are so into it at this point?

David:I think it deals with identity. I think it deals with who we are, who we are becoming, how we perceive ourselves. I am engrossed in a book right now by a psychotherapist from the U.K., a regular commentator on BBC Radio. This book looks at the impact of social networking sites like Facebook and Twitter on individual development. I guess I’ll share a little bit more on that as I get closer to finishing it. But there is growing evidence – this is other research, not necessarily in this book – that social networking sites, over time, begin to rewire brain functioning. Obviously, there is some concern about kids, and the formative years, but this author starts with a quote that I think is a great way of framing our engagement with technology from Melvin Kranzberg, who is a historian from the Georgia Institute of Technology. He said, “Technology is neither good nor bad, nor is it neutral.” When I reflect on Facebook’s curatorial work on the Declaration of Independence, they put a brand new twist on the “nor is it neutral” part. So, as we look at 2016, as we look at 2017, obviously, we have peaks in terms of the valuations for Amazon, and for Facebook, and for Google, and for Tesla. And I wonder if, to some degree, we might not be putting in a peak in terms of the value and influence of social networking. You look at the critique that you have had from some of the Facebook executives who have left the company, sort of a mea culpa for disturbing the fabric of society.

Kevin:Right, the apology commercials. Is that what you’re addressing at this point?

David:Well, that’s different. Those commercials are, “We told you one thing about what we were doing with your data. Oops, we lied.”

Kevin:But now trust us.

David:But there is a whole new Facebook. And there is a whole new Wells Fargo. So they are on a PR campaign. No, I’m thinking of the guy who gave a speech at Stanford and said, basically, we’ve created tools that have ripped apart the social fabric of how society works, and what he was critical of is this constant, dopamine-driven feedback, where people are concerned about how they are perceived, what their standing is, how many “friends” they have. This goes back to the idea of what I would consider the perfect environment for hate speech. This is not a place where there is conversation. And this was his point in his presentation to the Stanford Graduate School of Business. He said there is no civil discourse, there is no cooperation, it is to some degree misinformation, mistruth, and it’s not an American problem, this is not about Russian ads. He said this is a global problem.

The book I’m reading is not actually a critique of social networking sites, but it does ask, I think, some very important questions about the consequences of engagement, and those can be good consequences or bad consequence. But you’re right, it’s fascinating right now to watch in the mainstream media, Facebook and Wells Fargo do this ethics makeover dance in prime time.

Kevin:Something I think we have to keep in mind, Dave. You’re in your 40s, I’m in my 50s. A lot of people who are running the government right now are in their 60s and 70s. The true leaders that are coming in – we sometimes talk about this fourth turning that we talked to Neil Howe about. If we’re in a fourth turning, that means there is a first turning, a new start, coming in the next decade or two. And if that is the case, it is not really our generation, and it is not the generation that is in power right now that needs to be engaged with the proper things, it’s the people in their teens, 20s and 30s right now. We have to look at them as the future leaders, and if they are the ones right now who are being changed by social networking we have to look at what the ramifications of that would be.

David:I don’t know if that is a reason for optimism or pessimism because, as is the case with Alexandria Ocasio-Cortez, she is 28 years old, a radical socialist who is, according to the DNC, redefining what – she is the future of the party. Yes, past tense, we have a reflection of people who contributed at a very young age. James Monroe, 18, in 1776. Aaron Burr was 20. Alexander Hamilton, of course, of greater popular fame today because of Broadway. He was 21 years old July 4th, 1776. James Madison was 25. Thomas Jefferson was 33. So is this a reason for optimism or a reason for pessimism? A first turning event is an opportunity, but to me it’s like watching the football – it’s been kicked, it’s in the air, and we really don’t know which way it is going to bounce. This could help us greatly, or it could hurt us badly. And it kind of depends on which direction the ball bounces.

Kevin:You look at the ages of those guys – that’s just amazing, I’ve never thought of that. I always think of them as old guys in powdered wigs.

David:But the old guys wearing powdered wigs were John Adams at age 40 in 1776 and George Washington at age 44. Those are the old guys.

Kevin:These were the heroes that wrote the independence that we live today, that Facebook just filtered out as hate speech.

David:Amazing. Amazing. So arguably, our education standards are not precisely what they used to be, but I think it is worth keeping in mind that change typically comes from youth. And we’re getting close to that, you’re right. Neil Howe’s book, The Fourth Turning, if you’re a listener and you have not read that book, I think it is a very interesting historical overlay to give you some perspective on the social and cultural changes that happen on a periodic basis, 600 years of British-American history. What you see, at least coming into a period of crisis, and on the other side of that renewal is, you can have something that looks very different.

Look at the summer of 1968. The summer of 1968 was violent if you were in Paris. We had Bobby Kennedy assassinated. We had all kinds of crazy things happening in the United States, and it was youth-driven largely. The winter of 1776 you have these guys who aren’t sure they can hold on by their fingernails, but I think it was youthful tenacity and grit that got them through. They were losing the battle. December 25th, 1776 all hope was lost. And yet, youth, I think, held on for something greater. It really remains to be seen which way the ball bounces.

Kevin:I look back at the last 60 years. As we go through that first turning after World War II and the second turning, you were talking about the 1960s and the 1970s, the third turning, and now we’re in the fourth turning, using Neil Howe’s model. But here’s the difference. We went through our first turning as the largest creditor nation in the world. We had money. We were on a gold standard when we were coming into the first turning back in the 1950s. At this point we’re in a fourth turning, and we have run on credit now for at least 40 years. We have run on unpayable credit. Is it the credit crunch that will ultimately lead, when this system fails – this system of just borrowing more than you know you can pay back, and living like you can – when that fails, which we know it will, will that be the entrance into this next turning?

David:You look at the calculus of excess, and the normal timeframes that we have looking back in time where you would expect to see things begin to deteriorate or unwind, I wonder if timeframes aren’t, in fact, stretched because of the interventionism and the tools that are being used by central banks. But Bloomberg points out, Stephen Major, who is with HSBC, a renowned bond analyst with them. He says that we already have a credit crunch. It is taking hold, but it is in slow motion. It is being ignored because it is happening at a snail’s pace. But he is looking at all these signs and symptoms and saying, “It’s real. The stock market sell-offs, the volatility blow-ups, the collapsing cryptocurrencies. They are all symptoms of an unfolding global credit squeeze.”

And yes, I do think that does tie to the fourth turning. I don’t think it’s an accident that we’re here at the end of 30-40 years of credit excess, experimenting with new tools in order to extend time that has never been on the clock. So if you look at past periods of credit crisis, we haven’t had the extra time because we didn’t have the tools. It doesn’t change the fact that we have massive credit excess and we are at the edges of an unwind.

Kevin:And that’s the point. When you can borrow money, you can mask the volatility, you can mask the signals. Now, Gundlach has been speaking about this and saying, “Watch out, guys. If you’re out there risking money right now, you might have your timing wrong.”

David:And a part of it is looking at two things – high stock valuations and high bond valuations. He has been keen – he does communicate via Twitter, and yes, we do keep in touch (laughs) – while we’re interested in a critique of the social networking sites, we also use them, and we are not Luddites sticking our heads in the sand and saying technology will drive us over a cliff.

Kevin:It’s not good or bad, and it’s not neutral.

David:And it’s notneutral. Right. So the yield curve, he says, is nearly flat between the two-year and the ten-year. You have the Fed, which is tightening. We have tariffs. We have high stock and bond valuations. We have exploding deficit. And that equals risk, not Goldilocks. And that was his recent Twitter send. But let’s look at the yield curve, because from the two-year to the 30-year, nearly flat is an understatement. You have three-month treasury bills at 1.9%. Keep these numbers in mind – 1.9. Your two-year is at 2.5. Your five-year is at 2.7. Your ten-year is at 2.8. Your 30-year is at 2.9. Maybe it’s 2.72, 2.82, and 2.32. But we’re talking ten basis points difference for decades’ worth of duration risk, credit risk, inflation risk (laughs). Right?

Kevin:That’s the masking right there.

David:Yes, the only thing more disconcerting is the idea of interest rate normalization in a place like Europe, right? Because Draghi has discussed the slowing of the pace of purchases there. He has talked about ending the purchases there as he gets toward December and handing the baton off to somebody else to manage the European Central Bank. But these are rates that we just mentioned for the United States. As a reminder, rates are not telling you anything about credit, credit quality, inflation risk. And you really get this point when you look at the Greek ten-year at 3.93 – under 4%.

Kevin:Right. This is a country that is almost guaranteed to fail on the payment of those bonds.

David:The Portuguese are financing their ten-year debt at 1.8 and we’re at 2.8. What does that tell you? The Italians are financing their ten-year paper at 2.7, and our ten-year is at 2.8. What is it telling you? What it is telling you is that you have a central bank footprint in the market which has completely distorted the signaling from the numbers. We could talk about the Germans at 29 basis points, and the French at 64 basis points, or the U.K. which still has to go through its whole Brexit process. And they’re financing their paper at 50% less than we are. Ten-year of the gilts are at 1.27%.

What it says to me, Kevin, is that 2019-2020 is going to be very painful if you’re a fixed income investor and you have exposure to Europe. Of course, the kiwi could be redoubled and you could see the ECB go back in and start buying tens of billions of dollars every month. We could see that. But I think the point here is that interest rates are ridiculously low, bond prices are ridiculously high, getting back to Jeff Gundlach’s Twitter feed, and we’re at this point where, if you’re looking at the Stock Trader’s Almanac, it is saying you’re moving into the wrong season of the year. “Markets subject to elevated volatility after July 4th,” reads the Stock Trader’s Almanac. “July begins NASDAQ’s worst four months.” That’s from the Stock Trader’s Almanac.

Kevin:Let me ask you, when we’re talking about the stock market, a lot of times we think, “Oh, this is the broad market. This is everything. It’s either rising or falling.” You really have just a few stocks that are driving the whole market right now.

David:You could say five stocks, most of them technology shares, are driving the S&P and the NASDAQ bonkers, and there is a divergence between those indexes and the Dow. The Dow is actually lower for the year while the S&P and the NASDAQ have maintained positive territory. But I think it’s worth keeping in mind, that just as we talked earlier about there being a seasonal low for gold – guess what? It’s not without coincidence that you put in a seasonal high and stocks begin to trade off after the July 4thweekend, or week.

Kevin:Until about October, right?

David:Through October typically you can see a little bit of a revival in stocks as you move toward the end of the year, but up through October you have a couple of nasty months. So again, the Dow is 2500 points off of its January all-time high peak. You have the Wall Street Journalsaying that merger and acquisition activity is on pace to beat 2007 this year, again, what are the signs and symptoms of where we are in the cycle? Does MNA activity mean anything to you? In 2007 we did 4.3 trillion dollars’ worth of mergers and acquisitions. And if we keep on track at the current pace, we’ll have 4.8 this year. Does 2007 mean anything to you? We were also putting in peaks in the stock market. 2007 real estate was booming and all was well. 2007 was like this picture perfect year, right? Except that when anything is picture perfect, usually you’re not looking close enough.

Kevin:If you think back, Dave, it was January of 2008 that we started this show. In 2007, you’re right, we were putting in perfect peaks and people really didn’t want to know what was happening because it was going to happen for forever. By 2008 we had to have a medium where we could talk to a lot of people every week because everyone wanted to know what the heck just happened.

David:And what the heck just happened was really interesting in 2008.

Kevin:Okay, so liquidity. I want to go back to how we started the show, because your legs ran out of liquidity on Sunday.

David:(laughs) I had a friend ask me, “Why did you go on a 70+ mile ride with two water bottles?” I said, “That’s a good question.”

Kevin:But when you run out of steam and you’re on a long ride, and there is the expectation that you’re going to do just as well without the liquidity, you have a surprise coming. One of the ways that we see this liquidity, other than the weird new story about how much money people have in equity in their homes and that is just cash waiting to be spent, credit spreads usually tell us how much liquidity we have to expect as we move forward.

David:We have had some folks from the Bank of International Settlements check in with us. William White was a guest on the program not long ago. He also moonlights with the OECB in Paris. The folks who put together the BIS annual report said this very interestingly, on illiquidity in the markets and credit spreads. “Credit spreads have been unusually compressed, often are even below pre global financial crisis levels, and the corresponding markets appear to have become increasingly illiquid.

That comment from the BIS – that’s their annual report just out here in the last week or so – I think is worth keeping in mind because we think that there is plenty of liquidity in the system, and they are seeing that actually there is not a lot of liquidity there. It’s a worthy quote to keep in mind because should a significant market decline emerge as we head into the fall, the liquidity backdrop is not as robust as pricing would indicate, if you’re look at the stock market or the bond market. I know we mentioned this in passing last week, but I think it bears repeating. Part one of the liquidity mirage in the stock market is that corporate buy-backs and corporate buying of shares is very, very robust.

Kevin:Right. That’s not the public coming in and buying, it’s the companies buying back shares actually at highs.

David:So there is less real liquidity in the market if you take out corporate buy-backs. But part two of the liquidity mirage in the stock market is that margin buying is back toward those highs. We mentioned last week, 669 billion dollars, according to FINRA, and it’s just one of many signals that you need to hold onto your hat.

Kevin:We’ve talked about the tech stocks, but some of these stocks are actually not catching back up. I’m thinking about the financials, the industrials. Unless they start doing what some of these small count of tech stocks are doing we don’t really have a rally.

David:Right. If you’re financials and industrials either get on board – that is one scenario, that they start playing catch-up to the tech sector – or else, frankly, there is not much room on the upside. Again, as the almanac suggests, and of course, that is just speaking in generalities, it doesn’t say absolutely every year at this time, but in general, on July 4thyou begin to see NASDAQ sell off.

Kevin:Even within the techs, though, you have to look at what kind of technology you’re talking about because not all technology is rallying.

David:Fred Hickey is spot on in this point. The semi-conductors have been the weakest within the tech sector, and as he pounds the table constantly, you might recall he was one of the contributors in the Barron’s Roundtable, and he always has good things to say on tech, or insightful things to say on tech. Semi-conductors are a very good leading indicator, and they are already off by 15-30%. So they’ve already sold off. Financials have sold off, industrials have sold off. They’re not participating in the S&P 500 and NASDAQ rallies. And the curious investor will want to ask why the SOX, which is the Philadelphia Semiconductor Index – just pull a chart on that – and again, as a leading indicator, it is suggesting that we’re at the end of a tech cycle.

Kevin:Is it a lot like copper is with commodities in the economy? A lot of times they call copper Dr. Copper. Could we call this Dr. Semiconductor?

David:If copper is not participating as the economy is ramping up then something is not right. And so, Dr. Copper, the prices of lumber, the sell-off which has already occurred if you’re looking at homebuilder stocks, robust economic activity is typically accompanied by all of those elements rising rapidly at the same time, right? But I think it is very important to look at Toll Brothers, it is very important to look at some of the other home builders and say, “Why aren’t they moving higher? If housing starts are what the news says they are?”

Copper prices began selling off in January, and they are now in a renewed spirited decline here over the last 30 days. Lumber, if you’re looking at the last year or two doubled off its lows in 2017 and it has given back only about 10% now. But it has given back 10%. So I think you want to look at some of these things coupled with Philadelphia Semi-conductors index and just ask yourself the question – which is likely to mean-revert? The NASDAQ to a lower level, or the financials and the industrials? Are they going to confirm a move higher in equities to the upside?

Kevin:The last 40-50 years have pretty much been run on credit. I would imagine as these guys are sitting down looking at their expenses running these companies they would have to say, “What happens if interest rates do continue to rise, like Powell has promised?”

David:That’s right, because rates are a very relevant factor in terms of economic growth, and particularly when the kind of economic growth that we have had is so dependent on an expansion of debt. When rates begin to rise and you have been dependent on an expanded base of debt, now the interest component becomes very, very critical. Watch the interest expense rise for corporations. Watch the interest expense for governments. Watch the interest expense for individuals. This is a domestic issue, it is an international issue. I think this is going to be a major factor over the next 18 months as shorter-term liabilities and debt instruments have to be rolled over.

Kevin:And it translates to you and I. The corporations are going to have higher expenses but it is passed down to you and I.

David:Yes, just to illustrate, and again, this is not just a U.S. issue, but it is for the common man anywhere in the world. Jim Grant points to the impact on individuals in his recent missive highlighting the high number of interest-only loans in Australia. Debt as a percentage of disposable income in that country has been steadily rising. It is now 188%, debt compared to disposable income. Households have taken advantage of interest only loans, in large part because the cost of housing has skyrocketed in recent years. And now as rates rise, many of those homeowners are on the front edge of interest only expiry. So you have the Assistant Governor for the Reserve Bank of Australia, Christopher Kent, who is looking down the pike and saying, “Not good. This is not good.” At a speech in Sydney here in just the last week or so, he said, “You have 120 billion dollars in interest-only loans…”

Kevin:And I should say that is no-equity loans. This is interest only. You’re paying only interest at that point.

David:You’re not paying any principle. You’re not paying down the debt, you’re just keeping the interest meter going.

Kevin:It’s like renting from the bank (laughs).

David:Well, that’s right. But you have 120 billion in interest-only loans, which will convert to principle and interest loans each year – 120 billion each year for the next three years. That will require a payment increase of between 30% and 40%.


David:Now, you tell me how that would impact your budget if your rent check to the bank increased by 30-40%. And what is fascinating to me – I don’t even understand this – but the conjecture on Christopher Kent’s part is that the majority of people who have interest-only loans don’t realize that they are only interest, and have no idea that their mortgage payment is getting ready to go up by 30-40%. So you’re dealing with a country just like the United States where real incomes have been stagnant for 20 years.

Kevin:Right. So they don’t have new money coming in that is going to cover this 30-40% jump.

David:Right. Governments are really in the same position. Globally, as we track the increase in U.S. interest rates, debt burdens are moving higher as a percentage of tax receipts, not only here, but in other places, too. The U.S. – I think we have time on our side, but not a whole lot of time. The Fed Funds Rate is between 1.75 and 2%. To really consider that normalized you have to be back in the 4-5% range, and that seems far off.

Kevin:John Taylor would tell you that.

David:Right. These levels seem pretty high, 4-5%, relative to the last five years of near-zero rates, but they are actually in a range, 1.7 to 2%, that was considered low in every other period of history in the United States as we were heading into recession, or needed to lower rates in order to accommodate economic slowdown, we would bring rates down to the current levels of 1.75 or 2%. So factor that in. A rate increase doubling from here to 4% or 5%, what is the impact for a fixed income investor? A minor interest rate increase of 1-2% is going to take 15%, maybe even 20%, of a bite out of a fixed income portfolio, a treasury portfolio.

Kevin:Dave, we talk about how it will impact the individual, but what happens is when corporations can’t pay their interest they cut salaries, they cut people. Talk about the unemployment rate, look at what happens down in South America.

David:Governments are the same. Corporations are the same. I read a report from Costa Rica discussing the need for cuts currently in public salaries and expenses. I have some friends who spend a lot of time in Nicaragua. They are going through a similar cycle where rates are on the increase, budgets are not matching up. Interest rate rises are squeezing the stuff that puts food on the table.

Governments are moving toward austerity and laying people off. In the case of Nicaragua you have had riots and a couple of hundred people killed. In the case of Costa Rica there is no violence except in the upward move of interest expenses. There in the last year you have had a governmental interest expense jump by 48%. That’s in one year. There will be a lot of hype coming back around to corporate America. There is going to be a lot of hyper over the current quarterly earnings numbers. But I wonder at what point the interest expense for corporations ends up putting a massive dent in corporate earnings.

This is my recommendation to you. If you have selective, hand-picked, publicly traded companies in your portfolio, you want to look at the maturity schedules for those companies, and you want to make sure that you don’t have rollover risk which is embedded in your equity positions. Just let that sink in. You don’t think about your stock portfolio having rollover risk. That’s usually for a bond portfolio. But you have highly leveraged U.S. corporations and multinational corporations, and you want to be aware of what their payment plan is like.

Let me give you two examples. IBM has tens of billions of dollars in debt – tens of billions. But that pales in comparison with AT&T. AT&T is coming up on a quarter trillion dollars of debt – a quarter trillion dollars in debt. Now, what’s the payment for it? Do they have to come up with 50 billion dollars next year, roll it over, or pay it off?

Kevin:Think about that. A quarter of a trillion dollars – if it goes up 1% that’s 2½ billion dollars more they are paying just on interest. And we know, a lot of these corporations are taking that debt and buying shares at a stock market high.

David:AT&T is now the 32ndmost leveraged entity on the planet. That is a corporation…

Kevin:Larger than many countries.

David:Oh yeah, I don’t know if they’re right before or right after Indonesia. But they are 32ndon the list of indebted entities. So how much rollover risk do you have in that particular equity position? People don’t think about rollover risk in equities, but you should in a world that is over-leveraged.

Kevin:We need to think about that with our good old debt here in the United States. The United States government is not immune from rollover risk.

David:Right, so 21.2 trillion dollars is the number that we may have to contend with. Pare that back a little bit because 25% of it is intergovernmental loans. So you could argue that 25% doesn’t even matter. It’s the government paying the government, and it’s interest from one entity paid to another arm of the government.

Kevin:Of course. Ask Venezuela. You can just print your way out of anything. So really, if you’re borrowing from yourself, and paying yourself back with your printed money, Venezuela has shown us that that can be done for a while.

David:But it’s still relevant to look at the 75% which is owned by the public whether it is the public in the United States or abroad. You get average maturities on U.S. debt – five years – so if we financed all of our debt – tens of trillions of dollars – more or less short-term, 20% of the total is going to have to be refinanced each year for the next five years.

Kevin:And this is to the buying public, this is not to the government itself.

David:That’s correct, to try to keep that number conservative. My guess is that what happens over the next five years is that we take our interest payments on the national debt from, let’s say, 280-300 billion a year to 600 or even 750 billion. We might even see a trillion dollars a year in interest payments, which would put us somewhere between 15% and 25% of all government revenues going just to pay for the interest component. Does that put a drag on growth? We’re talking about 2018, this year, having a budget deficit of 830 billion dollars – this year. It is really not hard to imagine blowout deficits as we move into 2019, 2020, 2021 – again, just looking at interest rates.

So the area of contest remains the central bank arena. The question remains, how much latitude do they have to control sentiment? Because at the end of the day, you do have, like we talked about last week, the Venezuela function. And what is that, exactly? It is where people vote, not in light of the numbers, but according to a fear factor. And all of a sudden the money doesn’t matter, the debt doesn’t matter, the numbers don’t matter. It’s just a feeling, and it’s just panic.

And again, we’re probably last in line globally, but we’re still in line. And we may change place and cut line if we’re not careful. That’s the danger that you have in market panic in an over-leveraged system.

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