The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
In today’s show we look at gold, which is up over 6% this year, and we look at the stock market where the price earnings ratio right now is signaling a major downturn. Will it happen? We’ll talk about it.
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“I don’t hear rationality, and I’m listening to burning hatred and discontent. And I don’t see the bright light of reason, as if it would be enough in a period of financial panic to help. This is not an understandable and controllable machine. I think this is a time to be very vigilant. I think it’s a time to hedge your bets, and again, de-risk – de-risk to the greatest degree that you can.”
– David McAlvany
Kevin: Dave, we were just talking. I came in from my run this morning before I come into the office. My wife had ABC, the morning program on, and like every morning, they were going over all the reasons why they hate what Trump said the day before – really, not a lot of rationale. I’m not trying to defend Trump, here, because he sometimes does say things that you can mock, but I realized, I’m really getting weary – weary of just all this chatter, all this news, all these things that are being said that really have no substance. I started getting angry at my wife for having the TV on, and it wasn’t really her fault.
When I went downstairs, because I always change out of my running clothes and change into something else before breakfast, I was thinking to myself, “You know, this is why I like to do the Commentary. Not because I need more news. I’m sick of the news. I need less news, but I need more reasonable analysis.” It’s not just with our Commentary, there are things you can read, things you can listen to, people that you can follow where you can say, “You know what? I’m not going to hear this mindless banter, we’re actually going to be engaging something on a rational level.”
David: I feel like we’ve got to do the work – we’ve got to do the work. When I finished the book on legacy, that was really the issue in play. I look at all of the things that I’m either encouraged or discouraged about at the national level, whether that is politics or I’m looking at the economy, the level of debt that we’ve accumulated, both funded liabilities and unfunded liabilities. All these things are really big picture, and sometimes overwhelming.
And I come back to this issue of, we’ve got to do the work. If we shrink back from the macro to the micro there are conversations that are very meaningful, and I’m as frustrated as you are to see the lack of mercy, the lack of an attempt to understand and engage in dialogue. I think, actually, the news media is whipping this up quite a bit because I’m sure that there are individuals on a case by case basis where there is civil conversation which is occurring and there is an attempt to be humanizing rather than attempt to dehumanize. Yet that’s what you see in the news media today, a complete dehumanization, lack of extension of mercy, no attempt at dialogue and understanding.
Again, I just think this is where we have to do the work. I went home last night and watched some YouTube videos with my kids – 10, 8, 5 and 3 – to say, “This is why you are learning rhetoric. This is why you will practice speeches, and know how to articulate the things which you believe, because what you have here is an expression of anger and frustration.”
Kevin: So you were showing them negative examples of that concept. There is no real, true rhetoric going on. All it is, is just banter.
David: That’s exactly right. But even banter – I like friendly banter. This is just mean-spirited, and it makes me think, “What are the things that we justify in the name of good, however you define good?” And this is the key, because many people will define good in different ways, but it’s as if you can justify anything in the name of good, whether that’s fire-bombing, or protesting. And for some people, you may be a peaceful protestor. For other people, it is literally Molotov cocktails.
Kevin: I’ll give you an example. I was talking to Kirk Elliott yesterday. He was a guest of Jim Dobson’s and they sat in the Mike Pence section of the inauguration. To get to the seats – these are people dressed in suits, walking around Washington, D.C. – there were protestors that weren’t just blocking their way, they were grabbing them and pulling them to the ground, some of the group he was with. They were knocked to the ground, and they tore their clothes – the wife of one of the guests and his daughters that were brought to the ground. That’s not rational discussion.
David: No, and I think, really, this is an old, old, old, old theme. If you go back to Plato’s book, The Republic. The second chapter deals with the Ring of Gyges. The ring of Gyges is this magical ring that gives you the power of invisibility. And ultimately, with the power of invisibility comes the power to do anything that you want, to do what you want on an unaccountable basis. Plato raises the question, what would you do with ultimate power? What would you do with the power? What we have today is a scuffle between people who have the power and people who say, “He’s doing evil with the power he has, and we would do good with it.” In fact, what is interesting and ironic is that some of those people are doing evil in the name of good.
Kevin: That can be on either side.
Kevin: This is not about Democrat or Republican, Liberal or Conservative.
David: And this is where you realize that everyone believes that if they had the power they would do what is good. And what they don’t know – not a single one of us – is what we would do with the power (laughs). So the conversation that I have at home really comes back to, if you’re going to engage with people, how do you engage with them in a humanizing way? How do you extend mercy? How do you attempt to understand the position of someone else, even if you disagree with them? If you understand what they are saying, then perhaps you can engage in a conversation and point out, “These are the reasons why I disagree.” Not just a matter of, “Your opinion – you have it – and I have my opinion, but there may be good reasons for you to change your opinion, and this is what I offer you as consideration.”
Kevin: As long as you’re talking about the issue and not the person. And that’s what seems to be going on right now. It’s just sort of trashing a person, making comments, and that does go both ways.
David: This is where I feel like the ad hominem attack is the cheapest attack on the planet because if you have a problem with someone, or if you have a problem with someone’s policies, then address those issues. But I’ll be honest, I have a very good friend, one of the brightest people I know. As an art student, as a teacher, this is one of the people that I have a tremendous amount of respect for. And when I heard her use the word “racist” as it applied to Donald Trump I thought to myself, “She’s far too intelligent to be downgrading the conversation and the dialogue to a mere ad hominem attack. Address the issue, and address the man, but don’t try to undress the man with an attack against him.”
Kevin: That includes for Donald Trump. I was disappointed that he made the comment during the prayer breakfast about Arnold Schwarzenegger’s low ratings.
David: It’s not necessary.
Kevin: That’s meaningless. But let’s go ahead and get to some analysis, then, because what is occurring right now, other than a lack of rational discussion, is a return of something that, Dave, you and I have lamented losing, back over the last five years. And that is, the beauty of uncertainty in the marketplace. I love the beauty of uncertainty because certainty has to be bought at a price, and it was bought with a lot of debt, a lot of derivative-building, and a lot of Band-Aids put on by the central banking community. But since Donald Trump has come in, let’s just look at gold for a second. Gold is up over 6%, almost 7% year-to-date. Why is that?
David: I think, when you talk about certainty in the marketplace and the price that is paid for that, you’re talking about the perception of certainty, because there is no such thing as a certain or predetermined outcome in the market (laughs).
Kevin: Right, well, we had 700 days plus of the stock market stuck in a sideways trading range.
David: Absolutely. So Monday of this week we have bonds moving in a direction that would indicate people want to buy a safe haven. You have gold moving in a direction that would indicate that people want to buy a safe haven. And you have the U.S. dollar moving in a direction that would indicate that people want to buy a safe haven. And usually when those three asset classes are moving positively in the same direction, it is in the context of global crisis.
So what happened on Monday, just as a preview of coming attractions, where there are a certain number of investors who don’t necessarily trust what they’re being told from the mainstream media. You’re right, gold is up 6.6% year-to-date. That’s not a bad start, has a similar feel to 2016 where the metal moved from January to the July peak of 27.7%, almost 30% at the peak for the year. Last year we noted the significant building of bears and bearish sentiment in the gold camp, and the virtual extinction of bulls. There was virtually no one who thought the gold price could go up. In fact, prognosticators were saying, “Okay, it’s $250, it’s $400, it’s $700 on the horizon.
Whatever it was, it was a complete breakdown from those prices. Again, an extinction of bulls in gold camp. There was more disproportionate sentiment in recent months than even at those 2015 lows. We were at $1065 back then, and there was even more negative sentiment as we got to the end of 2016 relative to 2015.
Kevin: You’ve talked about this before, but we had a beautiful thing happen in December of 2015, if you look at the chart. And I’d like you to just relay what you just relayed to the guys when we were talking at the meeting. The 65-week moving average, which is a very slow moving average – we’re talking looking at prices for over a year – it turned up. Now, we had had it dropping from 2012 until 2015, and into 2016 we saw the bottoming of that market. But you used a great example from the hobbit, and I liked that. It’s not the day-to-day trading that we need to watch, it’s what you called “Ent” time.
David: For any of you who are Lord of the Rings fans, you have the Ents, which are the tree people, and they move very slowly.
Kevin: Very slowly.
David: And they don’t understand why people are in such a hurry. And it really is that way, when you look at a weekly or monthly moving average relative to the daily price action of a given stock, bond or commodity, you have this frenetic pace of up-down, up-down, up-down on a daily basis, but it is these longer-term moving averages which give you an indication of direction.
Kevin: It’s the picture. It’s like going to the Louvre and putting your nose right up against the Mona Lisa. It’s just sort of a blurred-out colorful something. But you step 12 feet back and you can actually see the picture. That’s what a 65-week moving average is doing. And that has been on the rise now for over a year.
David: So, good progress there. The same numbers – I want to go back to the sentiment numbers that we were talking about relating to gold and silver. The same numbers and analysis for stocks – this is from Alan Newman in his letter CrossCurrents – show stock market bulls, those who believe the stock price is going to go higher yet, well above 60%, and the bears are in the high teens. You get to these extremes regardless of the asset class, and a reversal in price is fairly predictable.
Stock prices are stretched. By that, I mean, they’re getting a little expensive. You have Shiller’s PE, which is ten-year rolling average of price earnings multiples. It strips out corporate executives’ intentional compensation-driven earnings volatility, and that is now above 28. It’s average is closer to 16. And it’s the highest since the tech bubble.
Kevin: Can I go back and just give a little history on that, because my first year here – your dad hired me back in 1987 – and this PE ratio, this price earnings ratio was too high, and he told us that. And he actually wrote in his August newsletter, when the stock market was just flying – I remember Fortune Magazine that month said, “Are stocks too high? No. There are new ways of valuing. It’s a whole new world.” He predicted in his August letter that there would be a crash in October. Everybody claims this, but I was there when Don did that. That PE dropped. Any time the price earnings ratio goes above 20, you’re going to go back to 16, or 14, or something rational.
David: (laughs) And then we had Barron’s last week say, “Is 20,000 too high? No. Next up, 30,000.”
Kevin: Right, but they’re ignoring the PE ratio. And you know, that PE ratio, any time it has broken 20, Dave – it happened in 1999, it happened in 2007 – each time we’ve had a stock market correction of almost 40% after that.
David: The conversation we had with Andrew Smithers was very important two years ago where he said, “Look, there is an intentional volatility in the price earnings multiple, where the compensation of executives – if they can improve earnings off of a certain base, their compensation and specifically via stock options, their benefits to being the leader at the helm are considerably higher if they can improve earnings off of a certain level.
Kevin: So they just buy their own shares back, reduce the amount of shares out there and it increases their earnings.
David: It also explains why they’re more than happy to see volatility on the downside so they can jack it right back up, and periodically increase their compensation in a major way. That’s why I like the Shiller PE. That’s why I like what is called CAPE, the Cyclically-Adjusted Price Earnings ratio, because it takes out that volatility, the gaming by corporate executives, and allows you to see a clear picture of what earnings are relative to price.
Kevin: And it is highest since the bubble. Remember the tech bubble.
David: That’s right. John Hussman is a gentleman I like to read. He’s like our own in-house Doug Nolan, in that they look at a mosaic of indicators – both of them do – to determine the probabilities of a move lower in equities. Of course, that is the other way of making money in the market. When everyone else is not, prices are going down and you can make money when the prices are going down. So you get the combination of factors which have the U.S. equity market at what Hussman would call an extreme of over-valued, over-bought, and over-bulled.
Kevin: The three O’s, yes.
David: And I quote him, as he says, “At present, the most reliable valuation measures across history rival the extremes observed in 2000, and range between 125% and 150% above” – that is, 2.25 to 2.5 times historical norms. “No market cycle in history,” he goes on to say, “Has been completed without taking these measures at least 40-50% below present levels.”
Kevin: This is a regularly repeating pattern, Dave.
David: And this is his prediction. He says, “Our actual expectation is a market retreat on the order of 50-60% over the completion of the current cycle.” Hussman goes on, and I think he reiterates exactly what Smithers has said in the past. Stocks, on a 12-year horizon, give you a nominal total return of about 1.6% annually. So again, when you look at buying stocks, one of his iron laws of investing is valuation. He says, when you buy a stock, you’re buying future cash flows.
Kevin: But you’re not talking about 1.6 per year, right?
David: No, I’m talking about 1.6%…
Kevin: But what I’m saying is, it’s not like a CD where you have your principle insured the whole time you’re getting the 1.6.
David: Oh, no, you could have an interim draw-down of 50-60%.
David: So we’re talking about over the next 12-year period, because valuations are so high now, you can expect a 1.6% return on average, and that may include two to three years where the stock market does exceptionally well, but also includes, on average, a 50-60% drawn-down. So what I’m saying is, when you’re buying a stock, you’re buying future cash flows for that business, and you’re deciding that it’s okay to pay X amount of money.
And maybe it’s too much money for all the future cash flows of that business. And on that basis, Hussman would say you’ve paid too much, and the most you can expect as a return on your investment is about 1.6% per year – fairly, fairly paltry. I know this will sound familiar, but this is precisely why holding cash, holding gold, hedging an equity portfolio – why that makes sense.
Kevin: You talked about hedging last week. There is a way, actually, that you can make money as the stock market drops. You have to be careful that way, but if someone manages it correctly, if you think it’s coming, you probably should have a hedge on it.
David: We have two different versions of that in our managed accounts. One is a large cap risk-managed account with market hedges next to your large cap equities, and that takes most of the market bite out, allowing for sort of old-fashioned stock picking to bring in the occasional out-performance. The other version is an outright short, like our tactical short. It is unique in the industry. You can be short when it makes sense to be short (laughs), sitting in treasuries or cash, or cash equivalents, the rest of the time.
Again, if you don’t like complexity, and there is complexity in the financial markets – if you don’t like complexity, then cash and gold, and for a growth flare, maybe a few mining shares, that will suffice over the next few years. But this is a pretty good time to be thinking about hedging any long stock positions.
Kevin: Speaking of complexity, the markets, themselves, take on complexity. I read a great book, A Demon of Our Own Design, that was written by Richard Bookstaber. We’ve had him on several times. It is brilliant in that he says that the market adapts itself to whatever regulations are in play, or the current environment, but it starts, actually, bowing down to that model. That model doesn’t necessarily always represent reality. When reality hits, the occasional black swan, the crash is much more resounding.
David: I think the opening lines for A Demon of Our Own Design were some of the best opening lines of any book I’ve ever read. I love it. He was an operator with Smith Barney. He was head of risk management at Salomon Smith Barney, and I also recall our guest William White, who was a different kind of operator.
Kevin: He was a central banker.
David: With not only the Central Bank of Canada, then the Bank of England, then working in a consulting position as an economist with the Bank of International Settlements in Basel, Switzerland, and then also in a consulting role with the organization for economic cooperation and development, the OECD in Paris. William White recently said, “The fundamental analytical mistake has been to model the economy as an understandable and controllable machine, rather than a complex, adaptive system.
Kevin: Bookstaber talked about the same thing, looking at a complex system breaking down. He used the shuttle. He looked at Challenger. That was a very complex system, to the point where Chuck Yeager, who had broken the sound barrier 40 years before, said that as a pilot he used to know every nut and bolt in the plane, and he could take it apart and put it back together again. You can’t do that with a complex system where there are a million parts like the shuttle. The derivatives market, in a way, is like the space shuttle of the current world, Dave. Derivatives are built to hedge various risk in this, that, or the other direction.
David: Right, and when Bookstaber describes knowing what takes place as the world melts down financially, and says, I was there, might have even been responsible to a degree…
Kevin: It was a little bit of an apology, in a way.
David: (laughs) Well, he was talking about derivatives, which had been growing at an unbelievable rate ever since their popularization in the 1980s, and that was where we had the first significant blowup, hiccup – it depends on how you view it. But they were calling derivatives, in that era, portfolio insurance. And yes, there have been a few hiccups along the way as portfolio insurance proved to be the wrong description. What they should have called it was sort of a daisy-chain of financial chaos and pain. Buffet, a few years ago, eloquently called them WFD, or weapons of financial destruction, kind of playing off the WMD and the Bush-era mistakes.
Kevin: Any person who has ever taken a macro-economics class, which is every business major out there, learned about something that was to keep that under control that was put in place after the Depression, or during the Depression, of the 1930s. It was the Glass-Steagall Act that was kept in place until the late 1990s.
David: Right. The Clinton team really triggered an explosion in the derivatives market. That is when the derivatives market went crazy. When they eliminated Glass-Steagall, 1999, again under Rubin and the Clinton team, that took the derivatives market and gave it a life of its own. It has grown to many multiples of size relative to the underlying markets which they are supposed to represent. I think that single act of deregulation is more of a contributing factor to the instability of global finance than any other thing so far in the 21st century.
Kevin: It allowed banks to go back in and almost do anything in the markets. Banks are a little different than what we think. The central bankers are the ones who can create the money and hand it to the banks. So you can create money and then do anything that you want. You give that kind of allowance to the banking system and it will take over.
David: We often reference the record levels of debt here in the United States, at really every level – private, corporate, governmental. Private sector debts have shrunk in several categories after the imposition of Dodd-Frank. But again, the explosion in size of the debt markets – maybe that’s the biggest thing that has happened in the 20th and 21st century? But no, it’s the multiplier effect in the arcane world of structured finance and derivatives that takes our debt numbers and creates cross-company obligations known as counter-party risk, and brings the numbers into the hundreds of trillions, rather than the tens of trillions in that more simplified world of banking credits and debits. So yes, we have a debt problem, but the derivatives market basically takes the debt problem, which is almost unfathomable because of its size, and multiplies it (laughs) – it’s big.
Kevin: You’re not a fan of regulation, necessarily. Glass-Steagall, though, was put on to keep things relatively under control. I’m going to ask you, Dave, because a regulation that came on under the Obama administration that actually was – and I’m sure this has been overused, but it was an abomination. It really looked like it was going to kill the markets. It was Dodd-Frank. What is your thought on taking Dodd-Frank off, if Trump actually gets it done?
David: Here is my take on regulation. If someone is unable to self-regulate, then they must be regulated. And this is the importance of the rule of law. It makes for an even playing field for all participants. So law I am completed fine with. Why do we need law? Reflect on yourself for just a moment, and realize that without proper boundaries you and I may be capable of anything. And we learn self-regulation as we grow up. We learn self-control. And in these areas, these pockets, where vice is allowed to grow and flourish, guess what you must have? You must have law and you must have regulation.
Undoing Dodd-Frank – this is where I’m kind of caught between, on the one hand I’d love to see the reimposition of Glass-Steagall. On the other hand, what does it mean for Dodd-Frank to be sort of disposed of? That’s what Donald Trump has proposed here in the first quarter of 2017, and it’s going to increase private sector debt. Certainly we’ll see growth in that area. Beyond that, I don’t know what we know, because this is a mammoth piece of legislation that was not fully implemented to begin with. Now we have sections being undone. I think it’s very notable that we’ve had price action in the stock market, in particularly the banks and financial firms whose shares have moved up in response to the idea of deregulation. Dodd-Frank goes away, they get more of a free hand to speculate with their own capital. Potentially, that means higher profits for them.
Is that a good idea? Well, in an era where the taxpayer is the ultimate backstop and responsible for the bailout of financial institutions, should they be allowed to speculate and do whatever they want without the comeuppance of insolvency and disappearance? I would say, yes, by all means de-regulate and let them get away with murder, but allow for the consequences of their choices to be felt by them, and not by the general public.
Kevin: Changing the rules midstream goes back to what we were talking about, creating uncertainty and volatility. The market sophistication is going to adapt to whatever regulations are out there. We watched the Super Bowl here this last weekend. What if they were changing the rules of the game all through the game? It would be very, very difficult to maneuver and to understand what the next thing to do would be.
David: Right. Again, I’m a fan of deregulation. However, within the financial system there has been an evolution of market sophistication which has allowed for financial firms to stay way ahead of the rules and the regulators, for at least the last 10-15 years. Ending Glass-Steagall invited the return of cleverness to Wall Street firms, which had really been held in check, to some degree, since the 1930s. Money is not problematic. Money, according to the New Testament, is not inherently evil, but the love of money is a cause of much evil. That’s the way it reads. After Glass-Steagall that loves has turned to an unbridled, passionate obsession, and again, that is really since the turn of the century.
Kevin: And we’re not talking about Main Street here, we’re talking about Wall Street, the powers of Wall Street.
David: That’s right. So while I applaud Mr. Trump’s no nonsense approach to simplifying a world which is bound and held hostage by bureaucratic red tape, he, and I think we, would do well to remember that Gordon Gekko’s credo: “Greed is good.” That has proven a little problematic over the last two decades. Again, I think we just need to be careful how much we hand over the reins to Wall Street to determine what greed looks like and how they get to exercise it.
So markets have become very much like a casino operation. The house always wins, the guests have to be content to be speculators rather than investors. I don’t like that dynamic. I don’t like that Wall Street is playing a game where they win, primarily, and an investor class, again, is forced into that speculator category, rather than being able to make reasonable choices along the way as to what value looks like, and how capital should be put at risk. That game is being changed.
Kevin: You just used the word capital, and one of the concerns that you have Dave, and you’ve expressed it over the last several months, is that Donald Trump may be holding the bag for things that he didn’t actually manufacture in the first place. We talked about a stock market that he inherited that is already overvalued, that needs to correct. But if something happens to the markets over the next, let’s say, two to four years, it could be not Donald Trump that is blamed, but capitalism, itself, and the whiplash on the other side could be devastating.
David: That, I think, is the biggest political danger over the next several years. As we complete four years with Trump, any failures, any financial market volatility that is associated, unfairly, with free markets, rather than with specific policy choices, or favored select corporations or sectors which have been chosen and sort of blessed – that is not free market, in my opinion, but it is an extension of political choice as to who wins and who loses, and who, for the time being, benefits from the special gaze or the uniquely crafted tweet, as it were, opening the door to greater riches for whomever that is, or for whomever is willing to kiss the ring.
Again, I don’t want things to go wrong, for one reason or another, and for the free markets to be blamed, when favoritism to big business, some form of corporatism, is played out. It is not clear to me at this point, and maybe this will be more clear, and I’m open to having this conversation on an ongoing basis. Does Trump represent capitalism, or does he represent corporatism? So far, most of his measures have been wide open invitations to big business to do well, and on the one hand, that is where a lot of jobs are created, and I understand that agenda, but we look at how corporate national interests are lining up outside the White House – actually, outside Trump Towers.
Kevin: (laughs) That’s the other oval office.
David: That’s right. You have GE, you have Boeing, you have Oracle, and they’re all a part of a coalition to support that border tax. So if we’re importing goods, and a 20% tax is slapped on, there is a bunch of corporate bigwigs who are thinking, “Yeah, good idea.” Let’s see. Why would that be? I wonder. Oh yeah, if we just follow the money, the answer is pretty clear.
Look at GE as an example. In a single company, it’s like owning a U.S. manufacturing mutual fund. GE represents U.S. manufacturing. And even more so today, actually, after they’ve sold off some of their financial interests, because by the year 2000 they had become, basically, a finance firm almost more than a manufacturing firm. Jeff Immelt is faced with a challenge of running a manufacturing business again, and he is all for the end of globalization, as far as I can tell, and for a return of national interests. Again, who is kissing the ring?
Kevin: As we look at some of the things that he is talking about to bring business home, border taxes, actually, really do mean much higher prices. The people who are opposed to border taxes are not the manufacturers necessarily, but the people who will be retailing those products to Americans. They realize it is going to become unaffordable. If we put those taxes on goods coming in, it’s going to translate to the pocket book of the man here on the street.
David: So ultimately, the consumer objects, but he doesn’t know that yet because he hasn’t faced sticker shock. It’s the retailers who, in anticipation, experience the buyer strike as soon as they have to pass through the cost to the consumer. Ultimately, there are two components to a rise in prices stemming from that border tax. Well, the obvious one is the pass-through of the percentage increase in price from the tax, itself.
But the second one, and the bigger one, is that if you bring any products onshore to have them manufactured here in the United States, the estimated increase in cost due to labor differences, is five to seven times.
Kevin: Now, think about that for a moment. We have to stop and ponder that. You go to Walmart and you start paying five to seven times more for this gadget that you need, or whatever it is that you’ve gotten that is manufactured from out of the country that now can’t be afforded because of the border tax. What that does – it seems to cut into what actually has driven our economy for 30-40 years, and that is consumerism. We are told, “Look, you can pay these cheap prices. To be patriotic, we want you to pay those cheap prices.” That’s going away if Trump gets his way, correct?
David: Yes, there are a couple of things, and I want to get to the big one here in a minute. But that is one of the things that goes away. Cheap consumer goods go away if we bring manufacturing back to the United States.
Kevin: Unless there are special privileges granted to that country. Look at the Japanese. They’re lining up outside of Trump Towers to work a deal.
David: In the next couple of weeks they are planning a trade investment tour in the U.S., in which they are suggesting a 450 billion dollar market will be created as a result of the 700,000 jobs they intend to create through investment in the United States. Now, you’re speaking Donald Trump’s love language. “We’re going to deliver to your door 700,000 jobs, and a brand new and bigger economy, as a result.
Again, I don’t think Angela Merkel got that particular memo, but the Japanese are sitting there ready to kiss the ring. And guess what? Will they have special access and privilege? Will we have trade deals on a one-off basis which look more attractive for the Japanese? Again, this is where I think Merkel and others in Europe are missing the point. Everything is up for negotiation, and the folks who are going to get the best deals are the ones who offer us the most.
Kevin: We talked about models changing and how markets will adapt. We’ve had a model that has really required us running a trade deficit with these countries that turn around and re-buy our U.S. treasury bills. Now, under Donald Trump, what he is trying to do is eliminate that trade deficit. I’m not saying that’s a bad thing, but it does change the model.
David: It changes the model, and I don’t know that anyone is ready for a change in model. In future weeks we’re going to talk about a change in model in China. Again, there is a model change that needs to happen, but to get that done, there are some consequences to it, there are some costs to it, and it is going to be very difficult to implement. This change in model is the big, big deal. This is, as Donald might say, the HUGE deal, because Donald’s policies thus far suggest a reduction in the U.S. trade deficit, which spells the end of an era in terms of global credit growth.
You might say, “Well, don’t we have too much growth in credit, which is ultimately unsustainable?” To which I would say, “Sure.” But if foreign debtors maintaining U.S. dollar denominated obligations don’t have enough dollar liquidity to pay back those debts, then we end up with creditor solvency issues which emerge in the financial system. So the long and the short of it is, we have major financial market disruptions ahead of us which coincide with, and are exacerbated by, a shift in U.S. monetary policy to higher rates. What is good for America, on the surface of things – let’s improve jobs, let’s increase exports, let’s decrease imports – may in the end be catastrophic.
So you have fiscal policies meeting up with monetary policies – again, that tightening of monetary policy and an increase in rates. What is the net effect? Reducing dollar liquidity to a world that has developed an over-dependence on dollar liquidity, and that sets up many of our trade partners for financial chaos. I have to tell you, what goes around comes around.
Kevin: Well, and financial chaos is different than economic chaos. We’ll probably have both worldwide, but what Trump is proposing – correct me if I’m wrong – is to improve the economy here in the United States, which, Dave, we’re all for. But what has replaced the economy since 2008? It’s the financial system, it’s Wall Street. So what happens to the financial system when, actually, you bring the economy in, but the financial system has been the replacement up to that point?
David: This is such an important distinction. The two kinds of growth, whether it is in the financial system or it is in the economic system, takes us back to our conclusion several weeks ago that economic growth and increased economic activity in the Trump administration – that’s likely, which is good. But it is also likely to have a variety of unintended costs within the financial sector, to which you might say, “Okay, great, so be it. It’s about time. Maybe the pendulum should swing the other way.” But as an investor, you had better be prepared, from a portfolio allocation perspective.
Kevin: Yes, the central bank Band-Aid, which hid everything, is coming off, Dave.
David: So you had better be ready for increased stock and bond market volatility, but also, for more inflation than officials are, at present, accounting for. These are issues which will be driving financial market dynamics. Market dynamics are, importantly, also influenced by the whims of trading algorithms.
Kevin: It’s computers that, actually, are modeling what they’ve seen before.
David: Right, which pretend to understand the significance of news headlines, and of course, now, presidential tweets. We look at volatility increasing and see that volatility increasing, in part, because of increased uncertainty, but also because of the speed of reaction, or over-reaction, which is staggering. Back up and recall that on any given day, 70% or more of the buying or selling which is done today on the New York Stock Exchange is done without reason, without analysis.
Kevin: It’s a robo-trader.
David: There are real-time stock market adjustments to headlines which may, in fact, have little to do with reality. And instead, really, just offer an editorial opportunity. Right? That’s what happens. You improve the likelihood of being read if you write a headline provocatively. Is that not true?
David: We live in a click-bait world. We live in a world where news writers and their employment hang vicariously by the few readers that they can attract. And tell me, going back to our earlier frustration with the kind of dialogue which is happening in the public square today. But tell me that hyperbole isn’t moving from the occasional literary device to being the core content of most mainstream media writings today.
Kevin: Right. And including Trump. He speaks in hyperbole.
David: Sure. He lives by hyperbole. But this is the deal – finding fact in a world flooded with under-qualified opinion – this is a daily treasure hunt. And yet – and this is why I bring up high-frequency trading – high frequency trading is based, primarily, on the assumed relationships between assets that are, in turn, driven by a few key word choices in a headline. Do you see how crazy the U.S. stock market is today?
Kevin: And most of these algorithms have developed since the financial crisis back in 2008. So if you take the Obama administration until now, with the Band-Aid that was put on by the central bankers, with the lack of volatility, the HFT trading, that high-frequency trading, had to be there to make any money because you were just doing these moment-to-moment moves. What happens now that volatility is back?
David: So to return to the earlier part of our conversation today – derivatives, high-frequency trading, and the impact on asset prices due to a few choice words. We have all the essential ingredients of the 1987 market.
Kevin: Going back to 1987.
David: Look at what you have – presumed protection in the world of derivatives, where half of the parties involved have bought what they consider to be insurance, and the other half are providing insurance protection, regardless of their financial ability to deliver (laughs). That’s the amazing thing, you’re talking about such a staggeringly high number – hundreds of trillions offered in insurance policies and there are not hundreds of trillions, in terms of the capital of those companies, to actually deliver on any number of those insurance payments, if you will.
Kevin: It’s called autopilot investing, isn’t it? And that autopilot has learned to fly that particular plane based on an economic environment that was provided for the last eight years.
David: I think, on the one hand, you have the assumptions of normalcy, which allow people to think about, “Look, I’ve bought my insurance, therefore I can go take more risk elsewhere, because this part of my portfolio is insured through derivatives. Again, that’s an assumption. The autopilot investing via passive funds – that, I think, is very curious because it has brought the public into the most mindless asset allocation approach in history.
Kevin: And people are saying right now, “Why should I pay anybody to manage funds? Look, all I have to do is put it into this particular account, and for almost free they’re going to manage it for me.”
David: And the irony is that it is the high-frequency trading which is making macro-investing almost impossible, at least in the short run. And if you look at hedge fund performance since 2011 to the present, it has been abysmal. Why? Look at the growth in high-frequency trading in the same timeframe. People are trading for pennies off of any particular excuse, and they’re not actually investing on any real reason, or basis, as an investor classically would have.
So if a thoughtful process is worth nothing, and we’ve assumed that auto-pilot investing is the way forward, then the only – the only – compelling fact for any investor is, let’s reduce costs, let’s reduce costs, let’s reduce costs, because that will increase my total return over time. So we’ve assumed a lot about the value of auto-pilot investing, but that’s why saving 50 basis points makes such a big deal, and why so many people are moving to the autopilot stance.
Kevin: At exactly the wrong time.
David: It’s dangerous. It’s dangerous. High-frequency trading dominating New York Stock Exchange volumes on a daily basis, and then having a reaction in real time to news, which at every turn can, and perhaps should, be second-guessed? That’s the reality. We don’t even know truth from fiction in the news. And the algorithms that run those volumes on the New York Stock Exchange are designed to change allocations and purchase or sell assets according to asset price relations that are based on rational, or at least, what are considered to be predictable behaviors. This context is absolutely mind-boggling, and into this, the average investor is saying, “Throw caution to the wind, I’m now willing to take the averages because it’s cost, baby, it’s cost. Reduce cost as much as possible. The mind needs to be taken out of the matter, because the market will do all the heavy lifting for us.”
Kevin: Dave, when we’re on autopilot – you know, you’ve flown planes, I’m a private pilot. I have gone back and looked at various crash reports in the past, and what you find is, autopilot crashes oftentimes are attributed to someone not really understanding the environment that they’re in. The environment has changed, yet they have stayed on autopilot.
I think of that horrible crash up in Buffalo, New York not long after Sully had landed the plane in the Hudson – which was a brilliant counter-example of having control. But the pilot and the copilot had been on autopilot the whole time as they were flying up to Buffalo, and when they turned it off they were almost instantly in a stall configuration and they started to do just about everything wrong because their reactions were new to them.
I wonder what is happening in these markets right now. You have an entire marketplace that is actually encouraging – even the laws are starting to come in and encourage – people, “Look, go ahead and just give it to a big, automatic, autopilot kind of program. Don’t pay the fees, we’ve got this. We understand this environment.” Now, when they flip that autopilot off, when a black swan happens, or like with the Sully crash in the Hudson, when the engines go out, you’d better have somebody who has been paying attention to the environment and adapting to it long before the autopilot goes out.
David: That’s the clear take-away for me, Kevin, from the Buffalo event. You have a team which was not engaged, and they were forced to get engaged quick, and they couldn’t adapt fast enough.
Kevin: They were too low to the ground.
David: The events were occurring too quickly. And then all of a sudden they trusted instinct over protocol. So lots of things did go wrong, but they were absent, to some degree, and they were not engaged, to some degree. What is absent today in the market, and this is, perhaps, always the case – predictability – but we’ve assumed a lot more rationality in the way that these markets are functioning and operating.
What I think we’ve seen over the last 90 days, if you’re looking at political theater, is that predictability is completely out the door. From a public policy standpoint, and really, as the markets have to react to the next announcement, predictability is completely out the door, as is rationality. I hear, and I read, rancor. I don’t hear rationality, and I’m listening to burning hatred and discontent. And I don’t see the bright light of reason, as if it would be enough in a period of financial panic to help.
I go back to William White’s comment, who I mentioned earlier. White said, “This is not an understandable and controllable machine.” With that in mind, would you really choose to be on autopilot? I think this is a time to be very vigilant. I think it is a time to hedge your bets. And again, de-risk – de-risk to the greatest degree that you can.