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The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

August 1, 2018

“Sometimes the markets are like the same stream leaving the meadow and just simply heading to a lower elevation. Guess what happens when it just takes the form of gravity? It’s violent. It’s noisy. The cascade and the fall to lower levels is never something that represents the same peace and calm. It’s really not that big of a deal. It is all a part of a longer term cycle which I think we need to be reintroduced to, if only to understand it as the old normal.”

– David McAlvany

Kevin:I’m speaking with you remotely, Dave, and all I can think of is this famous saying, since you’re in Estes Park at the Stanley Hotel – all work and no play makes Jack a dull boy. Tell me about it, Dave. You were trying to get away from the massing crowds. I remember Jack Nicholson trying to do the same thing in the movie, The Shining, at that very hotel.

David:Well, I need a film education. I haven’t seen the movie and I just coincidently found a great spot for wi-fi for a brief time today. I’m at the Stanley. It’s a classic hotel in Estes Park, and, as I mentioned, a good place to find wi-fi, which along with cell reception, is nonexistent inside Rocky Mountain National Park. So I suppose in town I could have gone to my dad’s favorite Starbucks, but quiet corners are hard to find, and the coffee is average, at best. So here I am.

Kevin:So since you haven’t seen the movie I will just tell you that this was about an author trying to get away and get some quiet thinking in, and the story turns very sour. Now, hopefully, you won’t turn into a murderer pursuing his family, thank you very much, and I know that sounds grim, but that Stanley Hotel is the hotel that that movie took place in. So now, after we hang up from this call, I want you to just look around and see if you see any paranormal activity – other than central bank intervention, Dave.

David:(laughs) Ordinarily, if I’m on the road I’d be recording from the mobile office, the airstream, but that’s not an option tucked away as it is between granite peaks. The next couple of days on the agenda in between tundra hikes and campfires and last night quite an extravagant experience – wild turkeys went chasing through the camp. Two birds were making a mad dash right past the fireplace and the kids were wondering why don’t we just grab them and throw them in (laughs). It was as if the birds had double-dog dared each other to sprint past us. But I’m one week out, one week left to run and to ride at altitude, before the Boulder, Colorado Ironman, the last one for me this year.

Kevin:At least you’re getting altitude training like you would here in Durango. If fact, I think you might be at a little higher altitude. So you have some quiet, you have some distance from the 24/7 news, even though you are at the Stanley Hotel. I guess ignorance is bliss.

David:(laughs) I know. Well, that’s kind of what I like about this area, the incessant jabbering of the 24/7 newsreels. I think when you’re in a quiet place it helps crystallize and clarify your thinking. So to me, a quiet hike synthesizes thoughts almost like dreams sort through your subconscious.

Kevin:Dave, I was just reading something last night about procrastination. Sometimes our brain does something opposite than what we would think. One of the recommendations for a procrastinator, actually, was not to go do something, but to sit and rest and wait 20 minutes, and then you’ll be ready to do something. That’s seems counterintuitive, but in a way I agree with you, sometimes you have to slow down to speed up.

David:That is certainly something we’ve talked about for training. Your technique improves considerably if you will just slow down and pay attention to technique, and magically, with the proper form you get better function. You can speed up by slowing down. I was watching a mountain stream bounce down the rocks yesterday morning, and I went for a run up and up and up. And as I ran higher to a meadow far, far above, it brought me back to a conversation I had 20 years ago with a Catholic priest in Ireland.

I met him on a day hike and he befriended me. There are hours worth of reflections there, just a really amazing experience, one of those ones where you begin to think – you a referencing paranormal perhaps in the negative – but there was certainly a spiritual aspect to that whole encounter just outside of Dún Laoghaire, Ireland. One thing we reflected on at the time 20 years ago, looking at a stream, the flow finds its way through weakness, and down it flows through the cracks and crevices. Given enough time it’s inevitable that today’s peace and calm becomes tomorrow’s tumultuous chaos. And it’s okay, because oscillating back and forth, those are normal states, and a normal progression.

I think one of the things that has bothered us in our conversation is the high degree of intervention within the financial markets which has taken away the normal ebbs and flows, the normal moves from peace and calm to chaos and an unwind, and it’s made everything always one thing. And it’s unnatural. As much as we like the current state of affairs – growth in the economy, stable financial asset prices.

I did mention this months ago, when Mary-Catherine and I moved to California where weather is perfect, it began to wear on her because she wanted something different. There had to be something that marks time, and the seasons were gone. You don’t have seasons in Southern California. It’s always sunshiny and always green, and there is never really anything that marks the march of time.

Kevin:Dave, I had sort of tongue-in-cheek mentioned that we had paranormal activity from the central banking community, but when you see this invisible hand that is keeping these markets, interest rates, currencies, equities, the assets, gold – these markets moving unnaturally, it is like paranormal activity, and you have to say, “Wait, something else is intervening.” In November, we will reach to ten-year anniversary – this is incredible! We were told that quantitative easing was a short-term emergency step that they pulled out of the bag, and now in November we’re going to be a full decade into quantitative easing.

David:Yes, the policy that the Federal Reserve introduced and then other central bankers quickly adopted, which has really shaped the financial landscape since. And if you stop and think about the profound nature of QE, or quantitative easing, it can only be compared to one other instance in monetary policy history in terms of its uniqueness, that is, 1979-1980, where Volcker did something never done before, taking interest rates to the moon, as you said last week, Kevin, much to the chagrin of the Reagan administration.

Now we have GDP growth figures, and granted, it is only for one quarter, but they are now back at levels which were the norm prior to the ten years of intervention, and prior to the crisis, which oddly enough, gave us some of the most consistently anemic economic growth that we can recall in U.S. financial market history. That is 2008 to the present, economic growth was very tepid, particularly in contrast to the amount of money that was pumped into the system. But I think it is critical to reflect on what QE has and has not done. As normalization of monetary policy occurs, if we do in fact see that, if it occurs, I think it is important for us to anticipate the changes that creates for the economy, but also for asset markets.

We have Mohamed El-Erian who used to be at PIMCO – he claims that the U.S. is now leaving the new normal. That’s a phrase that he came up with while he was at PIMCO, his parlance, which is to say, a long period of sub-par economic growth. The question seems obvious to me, but can you have asset prices sustained at these elevated levels if quantitative tightening, the opposite of QE, continues into 2019 and 2020?

Kevin:Let me ask you a question, Dave. The quantitative easing, the short-term solution that they told us about ten years ago, was actually supposed to boost economic numbers immediately because it was just printing money out of thin air – trillions and trillions of dollars. Now we’ve had this build-up of ten years of quantitative easing and finally we’re starting to see economic numbers come back to what would be normal if we had a relatively healthy economy. So I guess the question is, like you said, ten years of quantitative easing – there is going to have to be a price, even if you are getting those economic numbers that they predicted back in 2011, 2012.

David:And just to roll the clock back, the first round of QE was highly effective. The second and third rounds, and everything following that, were very ineffective in terms of generating any economic activity. I think it was the first round which represented shock and awe. Nobody had ever seen that done before. So under Bernanke something profound had shifted, and that is, the imagination had to be retooled. We can do anything was the idea and the first round was more effective on that basis.

But again, the actual impact and the actual effect into the economy didn’t go as planned, even in the second and third round of QE. So frankly, it was a disappointment from that standpoint. Yes, it saved us from chaos by putting a bid under all asset prices, but no, it didn’t drive economic growth and economic activity. You have just now had economic activity picking up. You had final sales, which grew 5.1%, just shy of the first quarter of 2006 numbers, so we’re just now returning to those elevated numbers, 2006 and that timeframe which was at 5.7%. Nominal GDP here in the second quarter which we have just here in the last few days came in at 5.4%. So factor in inflation and the number is much smaller.

What are we talking about, really, here? We’re dealing with fake inflation, which if you factor in the CPI, or fake inflation, that gets you to 4.06% GDP growth for the second quarter. Be that as it may, there were some interesting things that are marked there. Inventories, which I’ve been critical of, shrank by 27.9 billion – that’s positive – and that took 1% off of the GDP number.

Kevin:Probably the biggest impact on the latest numbers was personal consumption. People are going out and spending right now. I don’t know whether they are spending their money or borrowed money, but people are spending.

David:Yes, and I think that is worth noting, the question of borrowed money. I saw an interesting Reuter’s article on that. But the personal consumption expenditure was by far the largest contributor to GDP growth. It came in at 2.69% of the 4.06 real growth. So PCE – what is that? Basically, it is goods and services. So you should be rolling your eyes when we’re talking about real growth and the assumption that we can still even pretend that the inflation figure is a realistic number. I almost think to myself, “Father, forgive them, for they remember not the B.S. they shovel.” Our statisticians have forgotten just how knee deep they are in the stuff. But whether it is nominal or real GDP numbers, they were strong, and they’re getting stronger. I think, importantly, the equity markets seem to have ignored that.

Kevin:I’m just wondering, and I know we’ve talked about this the last few weeks, but the Democrats have got to be completely frustrated. Think about the economic prognosticators who came out and said that Trump was going to be a complete disaster for the economy. With this mid-term election coming, how does Paul Krugman feel about these numbers coming out?

David:I think he is probably on a couch somewhere, either in anger management or processing his worst nightmares as they become reality, as an economic minion to the Democrats. I don’t think any of them ever dreamed 3% growth was possible under Trump. But I think the main take-away is this. I’m not grandstanding for Trump here, it’s that the higher rates and that issue becomes a front and center concern. If we’re seeing economic growth, again, whether you’re counting nominal or real terms, what you have the Fed thinking is, and this is how I see the setup.

Number one, growth begets higher inflation. Number two, higher inflation begets higher rates. And then, as higher rates begin to have an impact, that begets the pin that pops the over-inflated financial sector. So you’re talking about an asset bubble which has been built through the leveraging of markets and I think ultimately it comes unglued as you see that step sequence – growth betting inflation, inflation begetting higher rates, and higher rates being the pin that pops the bubble.

Kevin:As you will remember, Dave, a couple of years ago we had, from the Government Accountability Office, David Walker, who has made it a point to let everyone know that you don’t just need moderate to strong growth to work our way through this debt situation, you have to have decade after decade of – what was it? Greater than 10% growth?

David:Right. He said to get in front of our debt problems would by necessity have to come in at double digits GDP growth year-in, year-out, for five decades. The amount of leverage in the system cannot, I believe, handle the migration of rates to higher levels without short-circuiting a large number of corporate and governmental interests around the world. And there is no mystery. I don’t think it’s that complicated. But you’re dealing with inadequate cash flows. That makes for liquidity pressures, and liquidity pressures have, in many instances, led the way to solvency pressures.

Again, we are talking the impact of higher interest costs, whether it’s for a corporation or for a government. Now you have the ten-year, which is knocking on 3%, and yes, that is a level that matters because of the cost of debt rising. A greater number of dollars have to be funneled into debt payment. That’s a natural drag on economic growth. And here’s the intersection ten years after the initiation of QE between these two factors, economic growth on the one hand, and stable asset prices on the other. And it appears that the central bank community may be forced to choose between one or the other.

Kevin:I think it is important, also, what Stephen Roach has to say about the increase of the balance sheet of the Federal Reserve. The hand has to be forced at some point because we’re talking almost four trillion dollars that was added to the balance sheet.

David:I have always enjoyed talking to Stephen Roach. He is a very clear thinker. He is a very precise man, and very concise in his words. He is a Ph.D. economist, but more than that, he has been a practitioner on Wall Street for decades and decades and decades. And only now in his latter years after jumping from place to place around the world, millions of miles a year for Morgan Stanley, only now is he an academic. That’s the kind of person I would want to study under. But he had this to say recently: “September 2008 to November 2014 successive QE programs added 3.6 trillion dollars to the Fed’s balance sheet, nearly 25% more than the 2.9 trillion expansion in nominal GDP over the same period.”

So for all the debt that got put into the system we didn’t get a commensurate amount of economic growth. We got far less economic growth. So that’s disappointing to say the least. But I think now you’re in an environment where on the one hand you have elevated stock and bond prices, and on the other you have the real economy which is beginning to slip into a higher gear. Again, just to underscore that question, can they have it both ways?

Because it was QE and the artificial footprint of the market, central bankers, that has given us the asset price structure that we have today, now in sort of bubblicious territory, and I think to some degree has been an artificial support – or at least a psychological prop, let’s put it that way – to economic activity. It has emboldened a few. Can you have both? And we are likely to see the Fed begin to control their monetary policy more conservatively. If that has an impact into the financial markets I think there may be a knock-on effect back into the economy. We’ll have to see.

Kevin:Speaking of ten years of quantitative easing, one of the things that we know about quantitative easing now is that it makes the rich very rich – much, much richer – and the poor poorer. Now, we’re seeing economic activity – we talked about personal consumption – but that personal consumption seems to be coming with a credit card, not necessarily more dollars in people’s pockets.

David:Yes, I agree, I think it’s the Federal Reserve, the central bank community, that has had a lot to do with exaggerating that trend between haves and have-nots, rich and poor. I’m not a Marxist. This isn’t a Marxist critique, it’s just a mere observation. If you look at this on a global scale, I think this has led to the global political tipping point that we have, with populist votes being the most common expression of protest. People don’t like being left behind.

Stephen Roach dug this up from the Congressional Budget Office, who recently said that virtually all of the growth in pre-tax household income over the QE period, that is, 2009 through 2014, occurred – again this is household income – in the upper decile of U.S. income distribution. At the same time you have the distribution of assets, whether you are talking stocks, bonds, real estate, we already know that is disproportional. So who benefitted from QE? It wasn’t the poor, it wasn’t the lower middle class.

Kevin:So if the poor are now spending, or let’s say it’s the lower 90%, or 98% of the people, like I brought up earlier, are they doing it with money in their pocket or are they doing it with a credit card?

David:Well, that’s what made me think of the Reuter’s article from last week. Jonathan Spicer said, “By almost every measure the U.S. economy is booming. But a look behind the headlines of roaring job growth and consumer spending reveals the boom continues in large part because the poorer half of Americans are fleecing their savings and piling up debt.” He referred to a Reuter’s analysis of U.S. household data, which showed that the bottom 60% of income earners accounted for most of the rise in spending over the past two years, even as their finances were deteriorating.

So I think that is worth keeping in mind, again, as you look at the personal consumption expenditure, as you look at that being the largest growing component in GDP, goods purchased, durable and nondurable, and services. Again, this is a break from an older trend where it used to be the top 40% which fueled consumption growth, and now you’re talking about the bottom 60% doing it with money they don’t have. I think that ties out really well to the GDP figures where the PCE was considerably higher than in the first quarter, and by far was the largest contributor to GDP growth. If you look at government spending and private investment, the PCE was huge by comparison.

Kevin:Oftentimes, Dave, you have pointed out that the economy doesn’t necessarily have to be dictated by the stock market and vice-versa. The stock market right now is really ignoring these GDP numbers. Is it because it is already elevated at these high levels? I’m going to do this as a double question because last week we talked about the FAANG stocks, those stocks representing the majority of the market’s move. This week there was quite a bit of a downturn. Can you comment on that?

David:(laughs) Yes, still, the major part of a market move, just moving in the opposite direction, as we anticipated. But you’re right, on the GDP numbers, the stock market is appearing to ignore, and I think this is something you need to keep in mind, when you’re at a market top, or at a market bottom, there is an interesting reaction within the market to news headlines. Markets reach a bottom when in spite of the continuation of bad news, the bad news ends up getting ignored, and you see price action improve.

Again, it doesn’t matter what the headlines are. So, too, when you have good news rolling at the top of a market, markets can ignore good news and start heading lower, as well. So whether it is data points or headlines, underlying and imperceptible shifts occur and it is usually the exact opposite of what you are seeing on the news feeds, so I would say this – watch for more good news. And I don’t know if we’ve reached that junction yet or not, but the news is one thing. How it is digested is another. And I think that relates to Keynes’ observation of the market being like a beauty contest. You don’t try to figure out who is the most beautiful contestant, you try to figure out how the judging is going to occur.

Kevin:It’s funny, Dave, Trump is being blamed for an awful lot of stuff that probably preceded him. I’m thinking about Coca-Cola right now. They’re missing some of their numbers and they’re saying, “Oh, it’s the Trump tariffs.” But gosh, they’ve been missing numbers for a while.

David:It’s interesting, you look at Coca-Cola, you look at GM – there are a number of executives that get to blame earnings shortfalls on the Trump tariffs, and they’re saying, of course, that it relates to rising input costs. That would be true in the fullness of time if you had rising input costs, but if you look closely at the industrial commodities, the move in price has been lower for your industrial commodities, not higher, as you would assume if you merely listened to those executives. So I think they’re shifting some blame, and conveniently playing political.

It really boils down to this – if Coca-Cola is saying, “Look, we’re going to pass on higher aluminum prices because of the trade tariffs,” it’s important to know what aluminum is doing. And lo and behold, aluminum is down 8% year-to-date. So what are they talking about? In the case of GM it’s far more likely that the downtrend in auto sales since 2016 – that’s the culprit for why they are missing their numbers. Coca-Cola? I don’t know, they have such a global business, I suspect you have some unhedged currency swings which may have played a more significant role, which is down to mismanagement and bad timing, and missing some macro plays with your currencies.

But it’s the same idea with the recent farm interviews. You’ve had some farmers trotted onto the mainstream media news outlets and they’re talking about declining soybean prices and how Trump shouldn’t be messing with the farmers by using tariffs, and whatever else. Look, if you take a chart of soybeans and look at a longer-term picture, that argument simply doesn’t hold. Prices in soybeans have been declining since 2012, and that obviously predates tariffs and everything else.

Kevin:You had mentioned that it might be currency fluctuations or other items, and that is something that has really changed over the years since I’ve worked here, Dave. We really now have to look at the Bank of Japan or the People’s Bank of China. We have to look at these other central banks, as well, to see what the impact is. We talk about ten years of quantitative easing, but if the Federal Reserve, and even if the European Central Bank, were to stop today and let interest rates rise, or stop quantitative easing, we still have two major central banking entities that could fuel this market for a while, or at least provide unlimited liquidity.

David:It is fascinating to me that if you did look at things ten years ago you might have been able to reflect and say that the Japanese serve as a wonderful lesson to us. Let us all remember that balance sheet recessions are not something that you want to find yourself stuck in. And so, we would have used the illustration of the Japanese to avoid the same outcomes, and yet more and more, monetary policy, radical interventionism, and the permanence of those radical interventionist measures seem to be modeled after the Japanese.

Last week we had the Bank of Japan intervening twice in a big way. On Friday they were offering to buy unlimited quantities of JGBs, Japanese Government Bonds, to hold the line in the interest rate market. You now have an entire generation of speculators that have come to believe that they can go to the Japanese, borrow free money, and speculate with it in the financial markets. We call it the carry trade. But it has become an enduring aspect of the last 20 years. You have investors who don’t recall a period of time when you paid handsomely for money, and because of that you had to measure, you had to weigh your risks accordingly.

Now, the margin for error is arguably wider because the cost of money is lower. And the question is, is it going to stay that way? How much longer will you have that extra margin for error with free money? You have the yen, you have the RMB, you have the dollar, you have the euro – these are really interesting things to be watching and paying attention to. The currencies show you where you have, first and foremost, a sentiment shift. And secondly, they indicate where you are beginning to see regime change or destabilization. And it is fascinating – it is in this order that you nearly always see price moves as an indicator of changing financial market realities.

So if you’re looking for instability, if you’re looking for cracks, look at the volatility within currencies. Currencies show it first. Interest rate driven assets, bonds, show it second. And last of all, you have equities, which begin to show real weakness. So the stock market is typically the last to roll over, or if stocks are going up, they typically are the last. You see positive moves in the currency and the fixed income market, stabilization there first. So, we’re watching now an expansion of the list of emerging market currencies that are under pressure. You can add three or four more Asian currencies to the mix as of the last two weeks. And ultimately, I think that may mean a longer list of securities market, that is, equity market woes, as well.

Kevin:David, I was thinking about this the other day and it is really startling, but the interest rate cycle going back hundreds of years is roughly 30 years up, rising interest rates, 30 years down, sometimes that extends out to 33, 34, 35 years. We’re at 35 years now, I believe. But if you put that in perspective, a person, let’s say they don’t even realize what interest rates are doing until they are in their early 20s. I think of that being me back in the 1980s. If a person was in their early 20s the last time that interest rates rose, not falling, because we’ve had 35 years of falling interest rates, that person would have to be 55 – my age, or older – to remember a rising interest rate market.

So we’re not just talking about a single generation forgetting about this. We’ve had ten years of quantitative easing that has kept interest rates low. That’s why the Bank of Japan had to intervene because interest rates want to rise. The central banks won’t let them. Think about the age category of the last group of people who saw interest rates rise. They’re nearing retirement, Dave. So the generation before it has no idea how to operate in a rising interest rate market. Now, Mario Draghi, who just completely opened up the floodgates in 2011, is still saying we need more significant monetary policy stimulus if it’s needed.

David:Right. And if you read the most recent ECB comments, not only is he still willing to put that out there, but he is saying that the key European Central Bank rates are going to stay at current levels through the middle of 2019 and for as long as necessary.

Kevin:Aren’t the Chinese saying the same thing?

David:Yes, the Chinese continue to promise ample credit. This is where they have a real challenge. Both of these places have huge challenges. I would encourage all of you to read Doug Noland’s comments from this last weekend on the Target II balances and how just unrealistic it is to see the imbalance between the Italian Central Bank and the German Central Bank, or the ECB. But you have massive imbalances in Europe which are pulling at the stability of that whole monetary union. Meanwhile, you have the Chinese who are trying to rebalance, have been trying to rebalance their economy for over a decade, and yet the idea of rebalancing continues to butt up against the constraints of financial market stability.

The PBOC appears to revert to what they know, which is the export-oriented growth model and continued credit expansion, and it’s almost like an addict. They want to do better, they want to do different, but they can’t help themselves. And I think a part of what is at stake, at least with the Chinese, is the free market capitalism which Trump is something of an advocate for versus the Chinese state-directed quasi-capitalism. Which one of those is going to work?

Kevin:What you are asking about is, does communism or capitalism work? State-directed quasi-capitalism, whenever the pressure is on, you have pointed this out in the past, it turns to communism as long as they need it, and then we start getting the capitalism again.

David:And the Chinese believe that they have developed a better system. All we know now is that it is a system based as ours is today, not historically, but as ours is in the present moment, on huge credit expansion. And also, in their case, and in ours, with very little market signaling due to command and control dynamics driven by, in their case, the PBOC and the Politburo. What is the difference between our systems today?

Maybe it is just this, that the Fed is at least contemplating – at least contemplating – a move back to free market dynamics and that would include letting a balance sheet shrink and play less of a role in pricing assets and allowing for normal supply and demand dynamics to re-emerge. Contemplating – that’s the key word there. They’re considering it. It remains to be seen whether they will walk out that path that they have described and heralded in advance.

Kevin:So as we move forward we really do have to keep China and Japan in mind. As they intervene in their own economies, that affects all of us.

David:Both of those countries are focusing their interventions in order to maintain the status quo and some people are now referring to PBOC initiatives, People’s Bank of China initiatives, as the Beijing put. You remember the Greenspan put years ago where Greenspan would not let the markets fall. And it appears that Beijing – you know, the best form of flattery is imitation. So Beijing is taking the cue from Greenspan. He should be so proud. But these are some interesting wildcards, and when you look at Japan, in particular, even more than China, Japan is the world’s second-largest bond market, and when they are having to step in and buy unlimited amounts of bonds I think every investor should be watching that very, very closely.

Kevin:I was listening to a book on tape last night. I was in the mood to listen to Ray Bradbury. He is an amazing short story author. I just picked one. I didn’t know what it was about. But it turned out it was about a spectator. It was the year 2050. Now, of course, Ray Bradbury was writing this about 100 years before that, back in the 1950s. He is talking about a society that every household was just sitting and watching TV. This was a man who refused to do so. Talk about forward thinking, writing this book in the 1950s, a robot-controlled police car came and picked him up and took him away because he wouldn’t be a spectator like they had demanded of everyone else in the society, for peace.

Now, think about the market. What we have seen in the 31 years that I have been here, the market used to be a very, very interesting thing. People would make interesting decisions based on values, and the price discovery would tell us a story. Some would think things were overvalued, others would think things were undervalued, and that is what created market discovery, or the price of an item.

Now what we have had, really, for this last ten years, especially, is a spectator-based economy, those who really are not making decisions based on value, but are literally just putting money into passive funds. They’ll say, “When do you want to retire?” My daughter just went through this. “When do you want to retire?” “Well, I’ve got 40 years to retirement, or 30 years to retirement.” What they do is they just put them right into a particular mix of investments. There is no judgment whatsoever. It’s just designed to be passive.

I look at these indexes. We have the Dow Jones Industrial Average, we have the Russell 2000, we have the NASDAQ. All of those indexes can be indexed into a passive type of investment. The problem is, there is no value call being made. Some of these stocks that are doing so well right now are in companies that don’t even have a profit.

David:Right. I think, particularly, you have to dig into the Russell 2000 for that, and that’s your smaller companies, your micro-cap companies. And if you look, actually, at the segment which has outperformed in the Russell 2000 it is the segment made up of unprofitable companies. This again, is to your point. When valuation is no virtue, it’s the segment made up of unprofitable companies which year-to-date is up 14.5%. And the entire index is up just over 10%. And the companies that are actually making money out of the Russell 2000, that segment is up just over 9%. So there is almost a 5-point differential between the companies that are making money and not, and it favors companies that are making zero – zip – zilch. They are actually operating at losses.

Do you see anything wrong with that picture? Risk management is part of the equation in asset management. But when risk awareness and management put you behind in terms of peer performance, I think it tells you something about the froth, I think it tells you something about speculative sentiment which is dominant in the market at that time. And again, when valuation is no virtue – it almost sounds like the title of a book – you begin to see things that shouldn’t be, undo themselves.

Last week we talked about the FAANG stocks. We talked about having concentration of ownership and many of our discussions have included those few storied stocks which have now been included in hundreds of ETFs and index funds, many of those funds which are cap weighted. In other words, the largest companies get the largest additions as new money is coming in, which just drives and exaggerates the trend even further for those few companies of real size and scale.

Kevin:So what you’re saying is, the haves get more and the have-nots get less.

David:At least in the corporate structure.

Kevin:If you have, you get more added to this passive investing index fund.

David:Yes, the cap weighting drives me crazy. But if you want to see what a large multi-billion dollar company looks like when there is no bid for the shares, no one wants to buy it, look at Facebook. It was off a quarter of its total value in a matter of days. Twitter? Netflix? You thought that large cap meant liquid. Well, it does – until that moment when it doesn’t. Any market, any company, can be subject to a no bid circumstance, and particularly, when you are talking about over-owned companies. These are companies which grab the interest, they grab the attention of momentum traders, they are the success stories and success leads to even more success.

And there is even more vulnerability to a downdraft when those companies become so over-owned. Now you know what it looks like. Netflix is not exactly soaring at the moment. Twitter – what was it? Off 20% in a day until it was off 90% in one day? These are hugely volatile one-day moves, and I think they’re interesting clues, and they are signals for the risk-aware investor. I think these are things we have to pay attention to.

Kevin:You bring up a no-bid market, and we’ve seen them before. We saw this back in 2008 with the stock market. We saw it back with the tech stock bubble when it popped back in March of 2000. I remember seeing it back in 1987. There was just virtually no bids so the stocks just fell in free-fall. I just got off the phone with your dad a few minutes ago before we got on here, and I didn’t realize your sister, Rebecca, had just lost the home that she was living in in Redding, California. One moment everything was fine and then somebody came in and said, “You’ve got to get out of here, there’s a firestorm coming.” And sure enough, this tornado of a fire came in and it took the house out completely.

We were just talking about the suddenness. She’s okay, as you know, but the suddenness of having to get out of your house, everything was fine, you didn’t even see the fire nearby, and then you’re told that you have to leave. And within minutes, the house had burned up. So I think of that with the market, that analogy where you have the norm, you have the norm, it just keeps going on, the cycle just keeps repeating like the Buddy Rich song, And the Beat Goes On. It just keeps going on, until it doesn’t. And when there is no bid, or when that fire comes to take the house away, you have to be able to adapt.

David:And that’s liquidity. That’s the disappearance of liquidity which causes a cascade in price. Bids drop, and they drop, until someone is willing to put money on the barrel and step in and make a purchase. I think – I don’t know for sure, but I think the next major market decline in equities and bonds is going to be interesting. We’ve often reflected on the old-fashioned market maker. In large part they were responsible for the orderly trading, and providing a bid, and their role in the market has thinned down considerably in recent years.

So we’re living in a different period of time where the market-makers are not as robust and they don’t inventory bonds and stocks to the degree that they used to. It makes me think, since we’ve been talking about the Japanese quite a bit this morning, the wave of the future may have been previewed there in Japan, where the new market-maker, whether it is for stocks or for corporate bonds, or what not, it’s not just for government IOUs, but it’s the national central bank stepping in and saying, “We’ll take it. We’ll take it in unlimited quantities.”

Kevin:When we had Richard Bookstaber on, he talked about the new rules that were coming out – the Volcker rule that came out – that probably discouraged the old market makers from becoming the market maker in a crisis. It used to be Wall Street that would step in and become a market maker. Now that is being discouraged because of some of the legislation that came over the last four, five, six years. But the new market maker becoming central banks – is that an unlimited solution since they can print money?

David:Again, all you’re playing with is for time, and for the perception of stability, and so I think it does work for a period of time. And for anyone clued in to what that actually means in terms of the eradication of free markets, it’s a major hit. It’s like a return to the days of FDR where socialism was becoming more prominent and dominant within the financial markets, and I think ultimately that equals capital destruction, not the re-emergence, or even salvation of capital markets. That would take Richard Duncan’s idea of going from capitalism to debtism, and the death of capitalism, to a whole new level. I think that would be the final nail for the free markets.

Kevin:Dave, I was reading Bill King and he was looking at the social media craze and the investment that has gone into social media. He speculated, he just wondered in the back of his mind, was this the peak of social media? Facebook, Twitter – we’re seeing some significant declines.

David:I think, certainly, as you begin to play in the realm of politics, you are going to end up seeing some push-back and maybe even legislation which takes some of the bloom off of the rose. Facebook, by the end of last week, had pared some of its losses and was only down 16.7% for the week. Twitter was only down 21% for the week – 21.4%. And Intel had only lost 8.4%, again, for the week.

Here is what you have to recall. These are the leaders. They are the leaders which are taking a hit. Not all companies have participated proportionally as the indexes have risen. Now you have the leaders which have driven the indexes beginning to take a hit. So here we are at an interesting juncture. What will drive growth in the indexes moving forward?

We either have a radical shift from those growth players to more value-oriented companies – that’s an option, full leadership rotation with a short-term pause in the momentum game. Maybe we go back to momentum and those old names, as well. I mean old as in Facebook, Twitter, whatever. Not exactly old, but the ones who most recently have been driving growth. Maybe that’s happening now.

Or maybe this is the first in a series of risk-off moves. You have money managers which may recalibrate to a whole new financial market backdrop. Again, keep in mind, less accommodative central banks around the world, Main Street and the economy are the winners, at least in this round. And Wall Street may end up being a loser.

Here’s our bet. Our bet is very simple, that late autumn you continue to see interest rates move to higher levels. That finally passes some sort of a subconscious level with money managers, and it does, it precipitates a rotation which your computer models, your algorithms, your black boxes can’t rationally process. It’s not a particular number, it’s just a feeling about a change in the wind, and all of a sudden selling begets selling, just like buying had begotten buying in year 2016 and 2017.

Kevin:When you say selling begets selling, I had mentioned the analogy of the fire because here in Durango we had the 54,000-acre fire, and of course, your sister just went through some of the California fires and thank God she is okay. But what we found is fire begets fire. In fact, some of these fires gets to be so large they create their own dry lightning storms which start other fires.

We have two new fires that just started here, Dave, on Sunday up in the Delores area based on these dry lightning storms that were created by fires, turned into lightning that struck and lit other areas. So I guess the point is, when you talk about selling begetting selling, selling not only begets selling, but when you have a no-bid market, selling can beget a total freefall until you hit a much lower price level.

David:And, you know, this is not the apocalypse. This is not the end of the world. Just like I ran past that stream yesterday morning, sometimes the markets reflect the calm. They reflect the meandering stream, barely visible as it weaves through the meadow, creates its own little oxbows. It’s the low, no-volatility period like we had in 2017. It’s hardly noticeable.

And sometimes the markets are like the same stream leaving the meadow and just simply heading to a lower elevation. Guess what happens when it just takes the form of gravity and is impacted by gravity? It is violent. It is noisy. The cascade and the fall to lower levels is never something that represents the same peace and calm.

It’s really not that big of a deal. It is all a part of a longer-term cycle which I think we need to be reintroduced to, if only to understand it as the old normal.

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