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The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
FIRE ALL ACCOUNTANTS, MAKING MONEY IS NO LONGER NECESSARY
November 7, 2018
“The idea of everyone having savings that are legitimate that benefit from being on a gold standard – savings and banking don’t have to be in the traditional means anymore. Financial technology has allowed us to very easily own gold and transact, denominating our savings in gold versus greenbacks. So you can establish your house on a firmer foundation, and not the house of cards.”
– David McAlvany
Kevin:We talk about your weekend adventures because you really have them, Dave. You had never run a marathon before. Granted, you had done the half ironman. You had done some of those, but you had never actually run a full marathon. So when you told me that was what you planned on doing, you then told me where it was going to be. The Moab, Utah Marathon, not only with the huge elevation gains and the strange terrain, is just normally full of surprises. I don’t know anybody who makes that their first marathon.
David:(laughs) I made sure to tell the whole family that the first guy who ran the marathon – of course this goes back thousands of years ago – the first guy who ran the marathon died.
Kevin:He ran his 26 miles and then dropped dead.
David:He delivered his message and it was done. And I had no intention of dying, but I said I really don’t know what is going to happen. I’ve never run that far in my life. But I did kind of map things out and I know how fast I can generally run, and I knew there were going to be a few tough spots because some of the hills were really rigorous.
Kevin:And you sort of planned for that because your son was there waiting for you, and you said, “This about the time I think it’s going to take,” and you were generous with the time, but you had planned for the unexpected.
David:Except that one of those hills took a lot longer than I thought. I thought I could run it at a certain pace and it ended up being four to five minutes slower per mile. It was unbelievable, just 1200 feet of vertical. Nobody was taking that at a fast pace.
Kevin:Our guest last week, Ed Easterling, talked about how you really cannot look at the short term, you have to plan for the unexpected, and you can’t really measure investment success unless you are looking at a complete secular cycle. Our guest in a few weeks is also going to bring out that even banking can’t be measured unless you look through a full credit cycle. That can be 30-40 years.
David:I think there is one thing I learned from the marathon is that you can’t go out too fast. There is a lot of enthusiasm the morning of, and you feel fresh the first mile. Actually, you feel fresh the first five, six, or seven miles. But you can’t go out too fast because you’re not running for the first five miles, you’re running for the last three, four, five miles.
Kevin:You have really learned that in triathlon. Talking about the unexpected, we try to deal with finance and politics and geopolitics on this show. Things have been smoothed out so dramatically by the printing of money. In a way, the unexpected has been removed, or surprise seems to have been removed from the market. But in reality, this thing we call quantitative easing is nothing new. This is something that has gone on for hundreds, even thousands of years.
David:In different forms. I think where it was formalized, and where it became a part of the structure and was really managed – John Law did the best job, I think.
Kevin:(laughs) In the beginning. Yes, he managed it well in the beginning.
David:I think he probably came out a little too fast. And how it finished was people wanting him to go to the guillotine, but again, he came out really fast and it was a very impressive showing those first couple of miles. John Law and Richard Cantillon – this is sort of the original QE, formalized, codified within monetary policy, organized and complemented by fiscal policy efforts there in France.
Kevin:That was 300 years ago.
David:Exactly 300 years ago. I think why that is apropos today is that the next round may be 2019. That could be a 2019 event. There is some ambiguity there, though. The ambiguity for market participants is that the Powell administration, the current leadership at the Federal Reserve, brings a lot of uncertainty into the picture because more QE would of course be in response to a rotten stock market. More QE could be good for stocks, could be bad for bonds. It could be good for bonds and bad for stocks. It could be bad for both if it is treated differently in a fresh context.
Kevin:Let me ask you, though, because it is just like any other type of stimulus response. The more you continue to stimulate, the less the response. Do you think that the QE is going to have a numbed down effect compared to what we have seen back early on when people were not expecting it?
David:Yes. And again, I liken that to the race. When I do a race like, I do have some caffeine that is introduced into the system at some point, and it is a jolt.
Kevin:But you don’t want to do it too early
David:No, if you do it too early, you find that you are collapsing at some point in the race. So when do you apply that? Too early and it’s a mistake. Too late and it didn’t do you any good, really. So I think the timing is critical. The key, the scale of what they are doing will be critical. My sense is that the next QE is likely to lack the wow factor, whatever the scale. I think where we will see significant pressure is in the currency markets. So as we begin to see that QE announced, that, I think, is the timeframe that you see a couple of convergences – not only the Dow and the S&P and the NASDAQ selling off, but again, you have policy response to that which triggers weakness in the underlying currency.
I think that is the context where you see Alan Newman’s projection of the Dow at 14,000 and gold creeping toward the $2500 to even $5000 market, in that range, because that gets you back to a ratio of 6-to-1. We had the 6-to-1 ratio in 2011, 2012, and I think we will break through the 6-to-1 ratio this time and land at more of a 3-to-1 ratio. A 3-to-1 ratio is $4900 gold and 14,000 Dow – not a complete failure of the Dow, nothing like what the Prechter folks would see as a cataclysm taking us down 60-80%, but still a very, very, very healthy correction.
Kevin:Newman has said, himself, that the correction we had back in 2008 that got us down to 6-to-1 was not the completion of that cycle. He is really looking for a 5, 4, 3, 2, or even a 1-to-1 ratio on the Dow. But let me ask you about raising rates in December because the economy right now still seems, from a standard economics perspective, that it is chugging along hard and that Powell, probably, I’m thinking that he has pressure on him to raise rates in December.
David:I think Powell is the lynchpin. I don’t know what he can tolerate in terms of social pressure or political pressure, but as you look at the economic stats on GDP and employment, the official stats do argue for a raising of rates in December. And so if Chairman Powell remains data bound then you have gotten a liquidity tightening which we have witnessed globally – that will be exacerbated. And of course, a lot of the volatility that we have seen this year, and acutely here in October, we definitely have seen a lot of that in the third quarter, as well, in the emerging markets leading into October. That liquidity tightening is going to be exacerbated by the next lifting of interest rates.
Kevin:It is interesting, too, because we are seeing inflation tick up pretty quickly. You mentioned John Law and Cantillon but actually, they are best known – John Law, especially – for hyperinflation, a hyperinflationary collapse at the end.
David:I mentioned John Law and Cantillon because I do expect massive intervention at a certain pain threshold. Later this year we will take a deeper look at Cantillon, in particular. I think he is a neglected name in economics and banking, but I think he offers a very fascinating lens through which we can see John Law, who was infamous as the pre-incarnation of Keynes, and what today is considered normal monetary policy and has been adopted as such the world over. But he implemented the same kinds of things – with his version of QE, created the Mississippi bubble – and I think you really have to appreciate fully what the Mississippi bubble was, fully, as an analog to the contemporary central bank monetary policy-making.
Kevin:Lest we sound like a broken record, but I guess it is okay to, we will recommend the book one more time, Extraordinary Popular Delusions and the Madness of Crowds, by Mackay. That was written in the 1850s, long before the new economics that we supposedly have today, and it tells about the Mississippi bubble. But there are other economists that talk about these surprise occasions that can just shock you. Out of nowhere, there is surprise. We are actually going to have a guest on in a few weeks who talks about why the market is always surprised [at crucial junctures]. Hymen Minsky talked an awful lot about surprise, to the point where we have actually turned a phrase called the Minsky Moment.
David:That’s right, Hymen Minsky argued that it’s good times, it’s great success, these things are the prevenient causes, the causes that come before major market chaos and crisis. That is his financial instability hypothesis.
Kevin:Is that just another way of saying pride comes before the fall? When things are going well, pride starts creeping in and risk-taking goes way beyond what it should.
David:I don’t know if it is pride, but there is certainly a neglect to risk as people are emboldened with success. So, embedded in the thesis, and within the rupture of a Minsky moment, when good quickly turns to bad, is misallocated capital. It is the accumulation of bad loans, and it is unsound investments finally being revealed. So again, you are moving along, everything is going fine and everybody is paying their bills, and then all of a sudden you look and you say, “Wait a minute, I shouldn’t have loaned money to that person, “ or “This business really didn’t have a very good, solid business plan.” And it is as the tide goes out that all of these things begin to be revealed. But you don’t see that until the Minsky Moment.
Kevin:Many people had not even heard of Hyman Minsky until 2008, and then he seemed to get an awful lot of press.
David:His popularity re-emerged in 2008 as a number of his ideas provided a plausible explanation for the chaos in the markets. You have Nouriel Roubini, Paul Krugman, a number of people who have been influenced by his thinking. But again, they gave an explanation. You had Federal Reserve officials, you had White House financial planners and policy advisors who failed to see it coming, and so they started looking for a possible explanation. All they had was good news to report.
How could something so catastrophic emerge from out of the blue? I think Minsky might say it didn’t emerge out of the blue, it emerged out of the green. You have your money flows, and then you have confidence that builds, and then that leads to excessive risk-taking, with there being a final consequential chapter in a boom-to-bust saga.
Kevin:One of the things that I can’t believe we don’t see coming is when companies no long have to make any money. Back in the late 1990s, we would see these dot.com companies come out, and they had absolutely no profit. They maybe had hope for profit five years, ten years down the road, but they were hugely funded with IPOs, and if it had dot.com on it, you bought it. The problem was, there was no need to make money. So when does making money make a difference?
David:I think, actually, that suggests that we are in that final chapter yet again. You roll back the clock to the founding of Amazon, and this is one of those dot.com babies that went bust – not completely bust, but you look at the take-down in share price and it didn’t have to make money in the context of raising money in the late 1990s. It washed out and nearly went bankrupt in the early aughts. And fortunately, it has recovered to become what it is.
But here again, we are repeating this. Could the fact that making money is no longer a prerequisite for companies to go public – does that show us a little of that embedded risk that Minsky was alluding to, where people just stop paying attention to risk? That is actually how, things are so good, times are so good, that you are no longer paying attention to what could cause you to trip or stumble.
Kevin:Looking at the last year, we have had an awful lot of companies come to light. How many of those companies are actually turning a profit right now?
David:And again, maybe I’m stuck on the marathon, but I think there is every step that matters. Particularly on a trail run, you can turn your ankle on every stone and root, and you have to constantly pay attention. It doesn’t matter how you feel. If you are not aware constantly of what can trip you up, you willbe tripped up. And it is actually a very different race than a typical marathon because you can just kind of get into a mode and mindlessly go for it with a regular run.
Kevin:Do you remember in the book Born to Run, which is about that kind of trail running, he said, “When you are out there, and you have to make a decision as to whether to take one step or two, take three.”
David:That’s right. You’re slowing down, you’re not stretching things out, you are actually bringing more caution in. If it could be done in two, take three. These companies that have gone public this year, 83% of companies that have gone public this year, obviously to great fanfare or they wouldn’t be going to the public to raise capital, but 83% of them have had negative earnings over the last 12 months. They’re not making any money.
David:That appears to be a market profile of investors clinging to hope of seeing that it is ideas, it is not return on investment, that matters anymore. Maybe every company will be the next Amazon and make no money for a decade before making a profit.
Kevin:But is this just your issue, Dave? I’m glad that you like to make money because I work for a company that really needs to turn a profit to pay their people. Is it just your issue?
David:No, Jay Ritter, Robert Prechter, Mark Faber – they certainly think this is an issue. I remember back to when we were doing an interview with the CEO of Overstock.com. I looked at their numbers and I thought, “How is this possible? The guy is making a couple million bucks a year. The company doesn’t make any money, but everyone is making money off of the company, and it really relies on investors throwing capital at this thing hoping that it someday works. But it isworking. It’s working for everyone in the company, it’s the investors that are getting shined.
That’s really what is happening, and you have to really drum up some enthusiasm for investors to think, “Hey, I don’t care about return on capital, not for a long, long time. I’m in it for the long haul.” Like we mentioned a couple of weeks ago, everybody is a long-term investor until something bad happens. What is long-term? Long-term is ten seconds if you’re experiencing excruciating pain.
Kevin:Dave, we have all known people like that in our own circles, where you have this guy who is always driving a Mercedes, BMW, whatever it is, and he is always raising funds for the next project. But you never see any of those projects actually come to fruition. It is just continually raising funds, raising capital.
David:Snap was a similar case in point two years ago. It went public in March of 2017, launched from an IPO price of 17, went to 29. It didn’t have profits then, it still doesn’t have profits today, and as time has worn on that has become a concern. I think it is a part of that little micro-saga. You have 80% decline here recently in the price of those shares. It is just curious, a good-looking IPO is like a good-looking date. There has to be more substance to ultimately go the distance in a lasting relationship. It can’t just be, “Wow, this is really interesting, so beautiful, quite handsome.” There are Minsky relational moments – Minsky would probably scold me for abusing this idea…
Kevin:(laughs) Now you’re on dating. You’re going to talk to your kids about this.
David:I know – we try to think laterally. I think there are Minsky relational moments for those that don’t holistically manage a balance sheet of intangible assets. And there is, of course, nothing detrimental about good times so long as you have built reserves for the days of challenge and distress. That is where you take advantage of having a successful business to be able to reserve.
What is the bottom line here? We should not be surprised by volatility we saw in October 2018, 2019 being a continuation. We saw, both in early February this year, as well as the replay in October, volatility has re-emerged as so many popular bets in the market are grinding through cash without profit to show for the effort.
Kevin:The thing is, look at these companies that may be facing something that they absolutely have no control over. Take Uber, for example. They have been just hiring people as contractors. Now they face the possibility of going out of business if they have to actually call them employees.
David:I use Uber just about everywhere I travel to. It is very convenient. But Uber as a business model…
Kevin:And they don’t pay medical – I don’t know what they pay, but it’s not like having an employee.
David:Right. It’s very scalable. But they do face some legislative challenges – if you want to call it legislative challenges. But they are a big percentage of the ride hail market, close to 70% compared to Lyft and some of the other popular apps that allow you to get a car on short notice. But look at their margins. Think about this – they have improved from a negative 31%, so this is even at margin.
Kevin:So they were losing 30 cents for every dollar that they brought in?
David:Yes, 31½ cents. Now they’re only losing about 16 cents. So it’s negative 16% margins compared to negative 31%, so that is an improvement. But at the same time, as a company they are seeing deceleration. You mentioned a showdown, that’s the big deal. The big issue moving forward is the legal classification of the drivers. Are all those drivers employees or are they contractors? To this point they have been treated as contractors. If the conclusion is that they are employees, that company is toast. And we’re talking about a company that is supposed to come public at an IPO of 120 billion-dollar market cap? That is pending, that is imminent. But if they are employees, what do you have to do? They lost, in the first half of this year, excluding a one-time gain, 1.3 billion dollars.
Kevin:And that is still calling their employees contractors.
David:That’s right. That does not include the expenses that they would have to shoulder under an employee classification – federal tax withholding, medical insurance, worker’s comp insurance, any other benefit costs that an HR department normally manages. So you have the drivers who are not happy. They have roughly 25% annual driver attrition according to a survey done by the New York City Taxi and Limousine Commission. I don’t know if that is objective or not.
Kevin:Probably not, but it’s probably close enough.
David:That’s right, yes. And a decline in monthly pay – I talk to every Uber driver that I am engaged with and I have some fascinating conversations.
Kevin:There are some amazingly smart Uber drivers, knowing where to be at the right time.
David:The best conversation I had of late with an Uber driver was in Atlanta. This gal was from Venezuela. She told me the story about how she remitted about $150-200 a month to her mom in Venezuela. Her mom lives like a queen on $200 a month in Venezuela.
Kevin:Because everybody else is starving right now.
David:Yes. Her brother sends another $100. They are there to study. They are there to get degrees, and they really don’t have a desire to go back, not at this point.
Kevin:And she’s a driver. That’s how she pays for this.
David:Yes, that’s exactly right. I asked her, “So what has changed?” And she hasn’t been driving long enough to give me a contrast, but J.P. Morgan did a study and monthly pay for the Uber drivers has come down 53% since 2013. So what was a great deal a few years ago has been the only means by which Uber hasn’t shown horrific numbers. They have shown bad numbers quarter after quarter after quarter, but they haven’t been horrific because they have squeezed the drivers.
Kevin:So good ideas don’t necessarily make money.
David:Think about this. For the listener out there, is Ford a substantive company? Do they make products? Is GM a substantive company? Do they make products? Of course, Chrysler almost went broke and was bought out by Fiat, and now you have Fiat-Chrysler. Combine the market caps of Ford, GM and Fiat-Chrysler and the Uber IPO will make them look like a nothing/nobody upstart. The market caps of those three companies are smaller than the expected IPO of Uber. And it doesn’t make any money. It’s losing several billion dollars a year. What is this?
Kevin:Again, just like a replay back in the old dot.com days, back in the late 1990s, we live in an age where finance, creative finance, especially, is more important than actual accounting.
David:We saw that uncovered with Enron, we saw that uncovered with Worldcom, we saw that uncovered with Arthur Anderson. And this is an accounting firm. But it’s creative finance, and it’s structured finance that allows for a lot of things that – again, it’s just new thinking.
On that same point, Harvard Business Review, the article I would recommend reading, “Why We Need To Update Financial Reporting for the Digital Era.”
Kevin:Why this time is different (laughs)
David:The author interviews a bunch of tech company CFOs, and he tries to enter the mind of the tech company CFO. Some of the telling conclusions from your chief executive officer, your chief financial officer – all of your C suite folks, and this was brought to my attention by Jim Grant – investors are paying more attention to ideas and options, rather than earnings. That is one conclusion, that CFOs today care about ideas, not earnings. Another conclusion was that accounting is no longer considered a value-added function.
Kevin:(laughs) Why count? If the money keeps flowing in, you don’t need to count.
David:Right. And I guess if you’re talking about capital raising, it doesn’t really matter what is in your piggy bank today.
Kevin:Oh, I didn’t mean profits coming in. I meant capital coming in.
David:Right, right. The calculation of GAAP, the General Accepted Accounting Principles, the calculation of GAAP-based profitability – this is a conclusion of the CFOs in Techlandia – it is a hindrance and a distraction to their internal resource allocation decisions.
Kevin:Wow, this almost sounds snowflaky. I’m sorry (laughs).
David:Harvard Business Review – this is a fascinating article. One CFO commented that they now avoid inviting company accountants to their strategy meetings. And another said that a CPA designation, a CPA certification, is considered a disqualification for a top finance position.
Kevin:Wow. That does sound so much like the top. You remember, Dave, any crash that we have been through that is predictable ahead of time is always triggered by something that people say, “Gosh, we never saw it coming.” It reminds me a little bit of Chaos Theory, where they say, if a butterfly flaps its wings in Mississippi, months later there is a cyclone or a hurricane somewhere else in the world. We can go back and say, “Gosh, we knew that there would be a cyclone but we had no idea it was the butterfly. We talked about Uber. That may or may not go their direction, but they are going to have to start making money at some point.
David:This is one of the things I like about the Prechter folks. I don’t agree with all their conclusions, but I do appreciate their analysis on mood and culture and some of those shifts.
Kevin:They’re looking for signals.
David:Yes, because honestly, when you start talking about a CPA certification being a disqualification to be in finance in a tech company, you are talking about a cultural decision. You’re suggesting that there is a mood that we need to be a little more aggressive.
Kevin:“Dude, stop counting.”
David:GAAP versus non-GAAP accounting. GAAP versus non-GAAP is the difference between putting the pedal to the metal and managing a business conservatively for the next 100 years, not the next 100 days. And when you’re talking about capital burn rates, you need to worry about the next 100 days, and the capital raise, and the next round of funding, etc. Silicon Valley CFOs, on this point of the butterfly effect – it flaps its wings in one part of the world, there is a causal chain of events, unforeseeable consequences closer to home – one of the largest sources of funding of liquidity in the tech space in recent years has been Saudi Arabia.
Kevin:Boy, they’ve been in the news a lot, haven’t they?
David:So, connect these dots and see how this sits for, not only your unicorns, these young, upstart companies that are worth now a billion dollars or more. That’s what they call a unicorn, if you have, in a very short period of time, a billion-dollar market cap or more – in their infancy they have gone very quickly. What happened here a few weeks ago in Turkey with Khashoggi, the journalist? He was murdered by the Saudi government, and you have Silicon Valley start-ups which have taken so much money from the Saudi Arabian government. Again, you are talking about a significant PR problem straight out of the gates, because who are you partnering with? It becomes very awkward, moving forward, to receive funds. Richard Branson is looking at a billion-dollar fund-raising deal with Saudi Arabia – or was, until the Khashoggi event. And now he is thinking, “I can’t do this. This is not going to work.” Why? Because he understands the PR nightmare that that is – first of all a PR problem, second of all a funding problem. And for some of these young companies that is very significant.
Jawad Mian is a writer and CFA, certified financial analyst. In his report, “Stray Reflections” he quotes a tech journalist, Kara Swisher – a very influential tech journalist. She is 51 years old, has been around a long time, whether writing for Wiredmagazine or – she has written for everybody, and she has published a couple of books. She says, “Anywhere you look, at any company or investment firms or venture capital, there is either Saudi money, or questionable money everywhere, across the system.” This is her quote, this is where it ends: “And if you remove the Saudis from the worldwide network, everything collapses.”
Kevin:Let me ask you, what is the fingerprint of the Saudi kingdom then? Obviously, the news can take things one direction, but we also see behind the scenes that if there is a lot of money behind something, usually you start to see strange outcomes as far as pursuing people who would kill people – what have you.
David:The Saudi kingdom has invested more, in the last two years in the Silicon Valley, than the Chinese have, for instance, since 2000, every year combined.
Kevin:In the last two years, they have put more in than China has over the last 18 years?
David:Correct. They are the largest single VC investors around. A couple of things that they have done here recently – they flipped 45 billion to SoftBank for their venture capital fund, technology fund, and SoftBank is talking about launching another 100 billion-dollar fund, and the Saudis have said, “We’ll be the first ones in. We want to be half of that fund.” Again, you burst the unicorn bubble and I’m not sure that the NASDAQ 100 isn’t far behind it. You’re implicating big names in a knock-on effect. And yes, you look at the butterfly – the dismembering of NASDAQ comes from what? The same event in Turkey.
Kevin:Isn’t it strange, Dave? We have watched Tesla continue to lose money over and over and over. They’re not making any money. Yet, look at Tesla shares.
David:Right. This goes back to an interesting question that we had on the Third Quarter Tactical Short Conference Call with Doug Noland. Transcripts are at mwealthm.com if you’re interested in looking at those. It is only about the first 30-40 minutes that are formal remarks and then the rest are Q&A. But that is what I wanted to mention. The question that was repeated, not once, but three times, in what was sent to us, and I only mentioned it once for the sake of time – if a company like Tesla continues to burn through billions of investor cash on quarterly basis – burning it up – and the market is setting up for a decline, with particular cruelty meted out for those that don’t operate sustainably, that are perpetually having to go to the market and get investor cash…
Kevin:Like a Tesla.
David:Why not short Tesla?
Kevin:Right. That’s the question that listeners were asking – why wouldn’t you short Tesla?
David:Yes. This seems like a lay-up – let’s just short Tesla. If it’s not sustainable, if they’re not making money, if there is going to be pressure in Techlandia, this is a company that is going to pay the price. They willpay the price. In our in-house strategy sessions, Doug Noland continues to emphasize that, in his experience, it is the wrong time to short individual names. It is not that some aren’t going to be profitable. It works. But the risks in the early stage of market deterioration are too unbalanced.
Kevin:And this is coming from a man who is probably more experienced on the short side of the market than almost anyone.
David:Did you notice Tesla’s share price behavior last week? It was up 38% in one week. And before you get real enthusiastic about, “Hey, wait, I wish I had owned that,” you realize that is short covering. That is shorts that are forced to cover and they fed a buying frenzy, closing out their positions to avoid greater losses. If you are the average investor saying, “I want some of that,” you just missed the point.
Kevin:So I ask, when you see weaknesses in these markets, the first thing you can think of is, “If I see a weakness and nobody else does, why wouldn’t I short something?” But shorting is an art, it is a science, but it is beyond that, isn’t it? It’s a feel. Doug Noland knows things that I don’t because of history – and pain.
David:I might even say this. Let me try that on differently. Maybe it is neither an art nor a science, but just a rigorous analytical process. And what that leads you to is taking a certain number of risks, and these are managed speculations. And if you don’t have principles and rules in place that you are following, which takes a particular mindset, it takes a unique disposition, you can’t do it effectively. And I would say Doug does that effectively. I can’t count his global peer group on one hand. These are folks that understand the market, can operate in that space, and do it effectively. Again, there are very few out there that could even be considered as peers.
Kevin:Oftentimes you have brought out the fact that the direction of a market sometimes is relatively boring, and then all of a sudden very exciting the other direction. That can often tell you where you are going long-term. I’ll give you an example. Last week we saw this huge rally in the stock market. That had characteristics of a bear market rally. In other words, the longer-term trend now is probably a bear, but you have the spikes on the upside. Just like when you are in a bull market and you have those surprises to the downside, they can be much more extreme.
David:That’s right. The counter-trend moves always tend to be much more extreme. So to see a massive rally like we did last week – volatility was off the charts. Goldman-Sachs, most short index, surged 9% last week off the Monday lows. The semi-conductor sector, you saw individual names rise anywhere from 14% to 24% last week off of the lows. Deutsche Bank rose off its lows by 11%. Hong Kong, the financials in Hong Kong, specifically, were off their lows 8.3%. You could go anywhere. Kevin, you could go from Argentina to South Africa and you had massive short covering. Much of it was triggered by a politically savvy announcement from Trump that a deal was being struck with the Chinese.
Kevin:Yes, the timing was pretty good.
David:How does that translate? Trade war dynamics should fade as a global concern – maybe that was it. Maybe looking and saying, “Hey, if any of that is resolved, then tensions are off and Republicans are more likely to keep the House.” We’ll be able to tell you at the end of this next week what it means as we watch the market either blow up, implode, or move to the moon. But what we saw last week was absolutely fascinating – all this based on a positive phone conversation with, “Gee, the news created a lot of volatility going into the weekend and it was prior to the election.” Certainly convenient, very political, and we can circle back around to China in a minute.
Kevin:Dave, listening to last week’s interview with Ed Easterling, that was a fascinating interview. We got great comments on it. There is so much to learn from it. But actually, he sounded like he was downplaying share buy-backs, companies buying back their shares. We know that can be a signal for a crash. I’ll just read a quote here. “Big U.S. companies spent more money on buying back shares than they did on capital expenditures in the first half of 2018. The last time that happened for two straight quarters was just before the crisis in 2008, according to the chart from Deutsche Bank.”
So share buy-backs – when companies are actually saying, “You know, I don’t think we’re going to go ahead and expand,” you talked about not needing to make money, thinking, “Well, we don’t really need to have capital expenditures,” which is what a business does. “Let’s just go ahead and buy back our shares,” raising the earnings per share by doing so.
David:Right. I think I’ve been clear on where I stand on the buy-back issue. There is a traditional approach to that and there is an acceptable place for share buy-backs. If you have not wanted to increase your dividend because it’s a long-term outflow and you don’t want to obligate yourself to that, or increase your dividend pay-out ratio. You can say, “Are there other ways that I can return shareholder value?
Kevin:Especially when prices are low. When PE is low – that was Ed Easterling’s main point last week – that is when you do it.
David:But even if you just applied the traditional understanding, regardless of the price of the shares, you could say, “We’re returning shareholder value.” For me, the bigger contrast is what the executives are doing with their own shares versus what they are doing with the company capital, and buying back shares. So I’m not relenting on the gaming of the news cycle because every quarter you have companies that are presenting their quarterly results, and the earnings-per-share – if they shrink the shares outstanding they can play with the earnings-per-share results, and again, game the news cycle, give you the good news that everyone wants to hear so that the share price goes up. And that game gets play all the time.
Kevin:Do what I say, but not what I do, because they are also selling their own shares.
David:Exactly. That’s the contrast that I think is irksome. We look at insider selling and that is the issue, because as share buy-backs have been increasing, insider selling has bumped up simultaneously. It strikes me the wrong way. You have fiduciaries – these are corporate executives, not managing, in most instances, their own businesses, but their fiduciaries for shareholders, and they are willing to spend other people’s money…
David:To buy shares from the market while personally unloading their positions in the same company. It is consistent, in my mind, with a cyclical turn from a bull to a bear. And this is where I think you would look and you would say to yourself, “What is the smart money doing?” There are several categories of smart money. One certainly is the C suite.
So if your Chief Operating Officer, or your Chief Financial Officer, or your Chief Executive Officer are watching sales figures, if they understand margins, either expanding or compressing, if they are anticipating and forecasting and then start to take action with their own shares, either buying or selling, it signifies something significant. Just by contrast, look at the gold mining industry today. There is about a half dozen gold miners that have had healthy insider buying this year.
Kevin:Right. They know something. They are buying their own shares because of that. Or holding – they are holding, at least.
David:I’ll give you one example. What does it mean to you if you read this – and this happened this year – what does it mean to you if a CFO adds to his existing shares with a 25-million dollar cash purchase of the company he is managing? That’s a cash purchase. Does that send a signal?
Kevin:Sign me up (laughs).
David:Right. So now you’re talking about one of the big boys in the gold space because they see a cyclical turn – they see it turning. I would bet on the gold space. Look how compressed it has gotten. The combined market cap is 25 billion dollars. That is every gold mine on the planet today squeezed into 25 billion. You realize your cryptocurrencies’ combined market cap is like 250 billion – almost ten times the entire production capacity of the gold market, which is 4,000 tons per year. It is pretty small in the financial universe.
Gold shares, of course – what do they need? They need a higher gold price. You’re going to see them go from low valuations to high valuations, and I think that is something we are likely to see. I think that is something even the impatient – even the impatient – listener is likely to see.
Kevin:Do you remember – I know you do, actually, that’s a stupid question (laughs) – when Southern California real estate started to turn down? I’m thinking about that 2006 period when things had just been going gangbusters, but 2006, the signals were there. I have a really good friend – actually, we have a mutual friend – who is leaving Durango after 25-26 years and buying California real estate. This person knows the real estate market really well. But it’s different. It’s like a doctor. Doctors, a lot of times, don’t necessarily eat the healthiest meals.
I remember hearing about a convention of heart surgeons and the line at MacDonald’s when they had a break at this convention – oh, that’s not good. This person who is moving to California – you know who I am talking about – has been known as Mr. Real Estate here in Durango. The problem is, I’m wondering if he’s not buying real estate at the top of the California market because we’re starting to see a turn here. If it continues, it could be bad.
David:We subscribe – one of the many pieces of research we look at is a gentleman who publishes analysis on Southern California real estate. He makes the claim, and it has been pretty consistently proven, that what happens in Southern California is the trendsetting for the rest of the nation. So that idea is worth keeping in mind. Southern California leads the housing market. It has led the trends in the national housing market for a number of decades, so it is of greater consequence.
We can look at the Case-Shiller 20 price composite index, and it was down in the third quarter by 5.5% at the end of the quarter. But far more important, and I think of greater consequence, is that new and existing homes and condo sales were down by greater than 18% in September. That is the slowest September since 2007.
Kevin:That’s what I’m talking about. It is reminiscent.
David:And I don’t know that we have had that much of a price correction, but you are starting to see the volume trends move in the direction that precedes the price trends.
Kevin:Is that interest rates? Is it the cost of borrowing that is causing that?
David:It’s both, right? We’ve talked about rising borrowing costs. We have also talked about rising prices and how that is discouraging first-time homebuyers because affordability becomes a major issue. Affordability is the crux.
Kevin:Young people can’t afford real estate right now, Dave. They are still paying off school loans.
David:That’s a big deal. The housing eco-system requires little fish and big fish. For prices to move across the spectrum you have to have the first-time homebuyer pushing out and pushing upward the previous owner. You are pushing them up into the next higher real estate echelon. So if you take away the entry level, demand across the entire spectrum ultimately is lacking. I have read the argument that it is a lack of supply that is constraining the lower end, and I think it is not a lack of housing supply as much as it is an excess of personal debt. You are talking about student loans, particularly for the group that is feeding that first-time home purchase, and that is constraining the first-time homebuyer.
Pervasive weakness among your homebuilders has been a cause of concern. We have talked for the last six months about copper and the fact that the homebuilders have not participated in this economic growth phase. So as GDP is increasing there are some things that should be moving that are not moving, and it is a bit of a tell. So when you are looking at weakness in the autos, when you are looking at weakness in the homebuilders, when you are looking at a couple of key commodities that are the tells for robustness in economic activity, and you’re not getting them, you have to stop and think.
Kevin:Two or three years ago you started talking – actually, before Trump got into office – about what would have to happen when you start to see these slowdowns where federal deficit spending and a fiscal push by the government. In a way, it is a little like adding QE to the system or lowering interest rates artificially. It gives a stimulus. Granted, it’s not paid for, it is deficit-spent, but if we start to see enough of a slowdown do you think that is going to come out with Trump, federal deficit spending?
David:Sure. If you go back to 2007, 2008, 2009, 2010, 2011, 2012, as you began to see the crisis unfold, the monetary guns were blazing. And they were doing most of the work. And your central bankers were doing a little bit of grousing. They were complaining about the fact that there was no fiscal effort, really, and that it should be meshed with some fiscal effort. So when the monetary expansion largely ended in 2014 here in the United States, we have remained accommodative in terms of rates.
But a lot of the QE programs wound down in 2014. There was a pause, and now we are seeing fiscal policy measures come in. I think a lot of the deficit spending that we are seeing here in 2016, 2017, 2018, in the end I think that is what is driving GDP growth – it is deficit spending – and I think that is going to be responsible for the GDP growth we have maybe next year, too.
Kevin:Without real estate expanding, because that does pull on the GDP, doesn’t it?
David:To some degree, yes. The GDP numbers, if you look at the Commerce Department numbers here in the last week or so, we were at a 4.2% growth rate in the second quarter. We are at a 3.5% growth rate in the third quarter, decelerating and moving toward what is more of a normal range. As Ed suggested last week we should be around 3%. That has been normal, except since the year 2000 it has averaged more like 1.9%.
David Rosenberg at Gluskin Sheff points out that without real estate expanding there is broad-based drag on GDP growth, and I think that is what we are going to see in 2019 because real estate has not participated. It has not been the booster. This is what he says: “The drag on GDP growth is not going to come strictly from the direct impact of a housing slowdown, but also from the fact that the housing market, while it is a small share of GDP, has the most powerful multiplier impact on the rest of the economy. There is going to be a spreading impact to financial services, into legal services, architectural services, and into related forms of construction and land services.”
Fundamentals have deteriorated within the housing market and are showing signs of that even more so as we mentioned with Southern California. A bear market rally – this is what we have seen in the equity markets here in the last few days – they are as severe as they are swift. You have the homebuilders, which have suffered all year long, and they finally had a little bit of relief. Again, bear market rally – they had a short-covering rally. They were up 11% last week before they settled into about a 7.3% gain at the close on Friday.
Kevin:Right, but the long-term trend is down. A bear market rally is severe and rapid to the upside.
David:That’s right. Just like a bull market correction is short and swift to the downside.
Kevin:One of the major new themes since Trump has been in is a trade war. Is that over? Now that we have the potential of talks with China, is the trade war over?
David: (laughs) The potential for talks with China has been there every day since 2016, and it just depends on what rhetoric is favorable for not only the campaign trail, but also the news cycle.
Kevin:But now that the elections are over, is the trade war over? Do we have good news coming from China?
David:I think last week – let’s talk about that for a second because the Friday campaign speech, Trump said – his words – he wants to do it. He’s talking it up.
Kevin:Both sides are making it sound like the other relented.
David:Yes. He wants to do it. He said this, “They want to make a deal.”
Kevin:It’s like Monty Hall. Let’s make a deal.
David:Right. So the Chinese state media was clear. They followed up immediately on Trump’s comments that “they want to make a deal.” They wanted to clarify that the call was originated from Trump.
Kevin:Right. “No, no no – he called me.”
David:“He called me. Sure, we want to do a deal. But does anyone know what the terms of the deal are? Have they flushed anything out, or is this a phone call that you get to talk about just before the elections? That really is what we are talking about. And I would say, here is what you have to keep in mind. You have to keep in mind the South China Sea, territorial expansion, the steady displacement of other leading nations economically in the G20 in recent years. This is the trend in play for China. The trend would suggest a long game of global presence. The trend would suggest that China is capturing greater financial flows, that they are designing an economy to manufacture higher-end goods, not trinkets and T-shirts for Walmart, but higher-end technology, and distributing that all over the world. So the long-term objectives for the Chinese have not been met, and the long-term objectives of the United States have not been met. I was doing a little review on our relationship between Saudi Arabia and Iran. We have relationships of convenience. If we see our long-term benefit – think about what we did to pull the carpet out from under Mosaddegh in Iran, and we helped get the Shah in place. And then the Shah turned too nationalist and wasn’t doing exactly what we wanted, so our State Department – this is before the Treasury Department really got active in the foreign field – when they were out there…
Kevin:I-ya-toll-ya so, I-ya-toll-ya-so … (laughs).
David:That’s who we put in power. We put in…
David:Ayatollah Khomeini. This was 1979. So from 1953 to 1979 we’re playing power broker in the Middle East. We shift in 1979 to supporting Iraq in the Iran/Iraq war. All of these things we do on the basis of what’s in it for us. And I don’t see that we have settled anything with the Chinese in terms of what’s in it for us. If they are going to continue to march forward in terms of territorial expansion, then what’s in it for us has not been determined.
Kevin:We do a lot of that with our treasuries and SWIFT transfer system. I was just reading something this morning about how Turkey, Iran, Russia, China are all talking to each other about moving away from the dollar. Now, that may be a long-term plan, but can you imagine if the world had another option that wasn’t part of this SWIFT transfer system?
David:What we are doing with Iran is entirely inconvenient for SWIFT and it is entirely inconvenient for the rest of the world, because the U.K. would like to do business with Iran, France would like to do business with Iran, Germany would like to do business with Iran. The Russians are doing business. It is fascinating, when you look at our threats. We threaten everybody. You can’t work with Iran or we’ll bring sanctions against you, and this is the bluff that they have with SWIFT right now. You should not be clearing anything for anyone. There should be no bank transfers in or out of Iran. But do you know there are exceptions to that? Who is at the top of the list of the exceptions? The Chinese. We are willing to push around smaller people and smaller countries, but that is not a hill we would die on.
Kevin:The dollar was a house of bricks when it was based on gold, but the dollar right now is based on 22 trillion dollars’ worth of deficit. It’s a house of cards. This whole thing, I think back to the 1870s, Dave, when Otto von Bismarck was holding all of Europe together with just these agreements with each other. Ultimately, when he died, things just started falling apart until it led to 1914. These guys were shooting at each other and they had absolutely no idea why. They didn’t know what World War I was about, but it was because the house of bricks had turned into a house of cards, and the person who was holding it all together was no longer there.
David:We’ve had a house of cards since 1971 when we moved away from Bretton Woods which was not really a gold standard, the quasi gold standard, the Bretton Woods period. You would have to go back to the real gold standard pre-1923 and the Conference of Genoa for something actually true. But you are right, you have these circumstances relating to China which have not been settled. Not only do we not have a trade agreement, past the midterms we don’t know anything about anything as it relates to the stress and strain of the financial markets caused by trade. Nothing has been settled there.
The bigger picture is, nothing has been settled with Taiwan, nothing has settled regarding the South China Sea, nothing has been settled with Iran. And these are the flashpoints which create real tensions and underlie the actual relationship between us and China. We are in a competitive relationship. We are no longer in a complementary friendship that you could have argued for from the 1970s and 1980s forward where they are moving toward us and we are helping them to modernize, etc. I appreciate that is only one interpretation of those events. But we have flashpoints – Taiwan, the South China Sea, Iran. Until these things are settled, I think the trade war is just the means by which we talk about the conflict which is ongoing.
It’s almost as if we are in an unannounced war, an unofficial war. And the trade war is the way we talk about things, but the real issues are those things that we just talked about – Taiwan, the South China Sea, the Spratly Islands, building out military infrastructure in a place where over a third of all global commerce flows. And that is what they want. The Chinese want to be able to control the toll bridge in global trade.
Kevin:Dave, before we finish up I would just like to bring up the fact that one of the men you work with grew up in Russia. He looked at America, he loves America, but he sees that they are no longer on a gold standard. He saw what happened to other countries over in Europe and Eastern Europe when that was the case, and he pointed out to Jim Grant a way to put yourself on a personal gold standard. I think we have to finish with that because you can leave people hopeless by saying, “Well, we’re not on a gold standard, and this whole thing is going to fall apart.” But we can still legally, here in America, put ourselves and our savings on a gold standard.
David:The idea of everyone having savings that are legitimate – I’m talking to this gal in an Uber car in Atlanta.
Kevin:Her family could have starved.
David:I’m telling her about vaulted.com. Why? Because this is a way that she can save and that her mother can benefit from being on a gold standard.
Savings and banking don’t have to be in traditional means anymore. Financial technology has allowed us to very easily own gold and transact, denominating our savings in gold versus greenbacks. So you can establish your house on a firmer foundation, and not the house of cards.