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  • Did the 2.95 Trillion in stimulus solve Europe’s core problems?
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The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

December 12, 2018

“People are actually putting it together, and what Keynes said would be hidden from almost everyone in the general public is no longer hidden to the French. They’ve figured it out. Why? Because, yes, inflationism is something we exported years ago. Yes, central bank hooliganism and gerrymandering is something that we popularized, perfected, and then handed off to the rest of the world’s central banks to then use and abuse their public with. This is a very, very big thing.”

– David McAlvany

Kevin:You know, sometimes Dave, because we are on a well at home – we have five acres and we’re on a well – sometimes the well runs dry, and it’s a helpless feeling when the thing shuts off and nothing comes out of the spigots, because we’re just used to it being there all the time. Now, I’m referencing Europe right now because Europe has been like the well that doesn’t run dry. They have been the liquidity spigot for the markets there in Europe. Now they are basically saying, “Wait. We’re not going to do that anymore. We’re turning the well off.

David:That’s what marks a very momentous occasion this week, this Thursday. The ECB turns off the QE tap after four years of monetizing corporate and government debt. So you’ve had the artificial buyer of first and last resort, and they have said that they are going to be leaving the room. I just wonder if the impact of that could be a shift in prices and in the yields of bonds there in the eurozone. We discussed this last week with Doug Noland. Is tightening of the corporate bond and government credit markets in Europe sufficient to impact the bond markets globally, and specifically here in the United States. I think the answer then, last week, and today, and this week, as we watch the ECB finally turn off the tap – probably.

Kevin:I measure the flow in gallons from my well. They measure it in trillions from what they have added as stimulus over the last four years.

David:That’s right, 2.95 trillion dollars of stimulus, and the question is, has that solved any of Europe’s core dysfunctional issues? Or did it merely buy time and bring the markets off the boil? You have the ECB’s next chapter, and if you go back to your childhood and those choose-your-own-adventure stories, now you can say, “All right, central bank there in Europe gets to turn to page 13.”

In this case, you could turn to page six of the last Interest Rate Observer – this is by Jim Grant. Jim notes that the economists at the Swedish Trade Union Confederation – nine of them – are protesting loudly about the associated risks of the Riksbank – that’s the Swedish Central Bank, the oldest central bank in the world – raising rates by a quarter of a point. Now, this is a big deal. We know the impact of raising rates here in the United States. We know the potential implications of raising rates and they are, as a unanimous voice, concerned about the raising of interest rates in Sweden.

Kevin:Up 25 basis points. They’ve been in the news quite a bit here recently because Sweden – no wonder they want to go to a cashless system. That way they can keep negative rates forever.

David:And that’s the point. They’re talking about raising interest rates from negative 50 basis points to only negative 25, and this could have serious implications for the labor markets in Sweden. And you have to ask yourself the question, what kind of a twilight zone have we created with all this central bank largesse of the last ten years or so?

Kevin:I can hear Carmen Reinhart right now echoing, “We have to create a captive audience, we have to create a captive audience.”

David:How about a mindless audience?

Kevin:Well, you know, 4,000 of the Swedes have already taken an implant in their hands for buying and selling. They’re perfectly fine with it. That was in Bloomberg – all the major news sources said, “A cashless system is very, very palatable to the Swedes.”

Let me ask you something. When we have had recession in the past there has been something that has triggered that recession, or at least has been a sign of the recession, and that is, when short term interest rates actually exceed the yield of long term rates.

David:This doesn’t guarantee that you go into recession, but the last three recessions that we have had, there has been an inversion which occurred some months prior, as many as 26 months prior, according to Bespoke Investments. And it was Reuters last week that was reminding the public that indebtedness has shifted to corporations. It was fascinating, I listened to a CNBC interview the other day, and there was one man who was kind of marked as the curmudgeon, marked as the guy kind of out of touch.

And then they had these two very well dressed younger people who were saying, “Look, you just don’t understand. We have not seen a huge increase in debt over the last ten years. Look at households.” And the guy was scratching his head. He, unfortunately, was not fast enough on his feet. But the trillions of dollars that we have seen in liquidity expansion and debt liabilities, both on central bank balance sheets and corporations, is absolutely staggering. And I was sitting there at the Wealth Management office wanting to rip the television off the wall, just saying, “Come on, come on.” And actually, it was left alone, and settled, according to the public’s view of things. “It’s okay, we don’t have too much leverage in the system.”

Kevin:As I get older, Dave, a lot of these guys in suits get younger, obviously, and I’ve noticed from crisis to crisis to crisis, a lot of the guys who were giving expert opinions were not in the industry at the last crisis.

David:In fact, 50% of current investment advisors were not in the markets during the last bear market.

Kevin:Let me ask you, if corporations are carrying this much debt, this is sort of a bad time to have high debt, isn’t it? Remember what Pollock said a few weeks ago? He said, “Your assets can fall, but the liabilities stay the same.” Now, the liabilities actually are increasing, because interest rates are.

David:Corporates are at all-time highs in terms of their total debt load. And that does come at a very inconvenient time as rates threaten to move higher. And for me, this serves as a reminder of there being decades in which equities do not offer up any growth to investors. We’re talking about debt, right? But it’s the problem of having too much debt, and having to pay interest on it, that ends up prohibiting the growth or the use of assets toward productive ends within a corporate environment.

So again, the primary driver of growth in assets, specifically stocks, is liquidity. It has always been liquidity. Number one, you have central banks which have created a bunch of that stuff – liquidity – and by and large they are saying they won’t continue to, at least for now. I think that’s a key caveat. But number two, you have rates which are increasing which is like the slow restriction of flow, like a clogged artery, or a collapsed artery. The need for flow doesn’t change, but the restriction of flow becomes consequential with prices in the market beginning to reflect that strain. It’s like a systemic strain.

Kevin:So, did I hear wrong? You talked about equities not always offering up growth. Now, our generation has grown up hearing that if you just buy and hold stocks you will make a given return.

David:(laughs) That’s right. Well, that’s Professor Siegel – not the bird at the beach, it’s the bird who wrote Stocks for the Long Run. It is interesting because we have noted his time series start about when the Ibbotson time series start, which is in the 1920s, but not before. And he leaves these huge swaths of data untouched, which actually are pretty relevant to understanding long-term market returns in stocks.

1852-1932, virtually the entire return in stocks, if you were an investor, came from the dividend. There was very limited upside, when all was said and done, in equities over that particular 80-year period. In the latter part of the 20thcentury, of course, we have had the stock bull market in 1982 to the year 2000, and that helped pull the averages for this century considerably higher.

And so they do, usually, go back to 1926 to include the Great Depression, but they don’t include any of the lumpiness – the lumpy periods, the loser periods – before that, which actually were pretty significant. It was one episode, this period of 1982 to the year 2000, with a few non-repeatable inputs, that have shifted everyone’s mentality and thinking to this idea that stocks are always a good bet.

Kevin:Well, and how much of that rise came from the printing of money? If you go back to the years when they weren’t able to print money, inflation was not as much of an issue.

David:Yes, and granted, there are periods of time when innovation and demographics boost the markets, and that certainly was a part of the 1982 to 2000 boom, but periods of pure growth are more limited than the classic Ibbotson performance charts would infer. And frankly, a lot of growth in the 20thcentury, in nominal terms, comes from inflation.

Kevin:Right, the printing of money.

David:Yes. And the biggest numbers – of course, again, we’re coming back to that timeframe where we have seen massive growth – complemented by a post Bretton Woods fiat period. So again, what did we do in that 1982 to 2000 period as we are beginning to see, and particularly after the fall of the Berlin Wall, and as democracy begins to take root in lots of different parts of the world, one of the things that we exported was the idea of inflationism and the way to run a monetary system. So that has begun to take hold throughout the world.

Kevin:Just a quick memory, I was in Berlin five years after the Berlin Wall fell down and we stayed in a hotel that, just on the west side, you could see where the wall was because of those gigantic cranes building. Of course, Eastern Germany had not been built up, but all the new money that was going to be made with the unification of Germany, there was a new wall. If you can imagine – you know those real tall cranes that are a couple of hundred feet tall that build buildings?


Kevin:You could see – I don’t know, I might exaggerate by saying hundreds – but you could see tens and tens and tens and tens of them right along where the wall was. You could tell that that was going to be a one-time economic boom, and people were taking advantage of it. So what you are saying – look at that time period that you are quoting, 1982 to 2000, there were some major changes that turned into economic productivity.

David:Again, I think this is something we can’t forget. We don’t have the end of communism coming this century such that we have an unleashing of global growth forces complemented by fiat currency, monetary policies, in a post Bretton Woods period. You have all those things swirling in the 1982 to 2000 period. Why do I mention that? Because if you have an expectation of growth in the stock market which looks remotely like this recent period in our past up to the year 2000, you have to realize this is a period which is an anomaly, an expansion in credit, and we were able to expand credit dramatically because there were no limits to the amount that we could expand money and credit, plus we get the end of communism dividend which was absolutely massive. I want to look at a few stats, not just from the 20thcentury, but also the 21stcentury, which I think are instructive – maybe more on that in a little bit.

Kevin:Let me ask you something, though, because we are not only talking about economic inputs that may never repeat, let’s say that you’re just a retirement planner right now, a financial planner. All the models that a financial planner is going to use – you’ve been using this 1982 to 2000 period. Let’s just take it from 1982 until now, every one of those retirement planning models is built on falling interest rates, not rising interest rates.

David:It’s not just your run-of-the-mill retirement plan, it’s your endowment manager, it’s your pension fund investment committee which has counted on average expected returns, and over the last several decades have shifted an unhealthy percentage in the direction of equities and away from debt. And the point is, they are assuming that they are going to capture the risk premium in equities. And what they may capture instead is just the risk end of the stick.

Kevin:Probably the greatest change that I have seen in the 31 years that I have done this – the last ten years, especially – is the role of central banks. The central banks now play almost the primary role in market moves.

David:Right. What you saw was central bank experimentation following the end of Bretton Woods which started with some baby steps. And frankly, the story goes back, obviously, to the Great Depression, when our central bank, the Fed, really didn’t understand how to operate in the context of crisis. They had only been around since 1913, so they were in the 1930s, they hadn’t really been given the keys to the kingdom, and it was only in the context of crisis that they asked for them, and ultimately were given them. But since then they have gone from baby steps to the strides that you see from someone like Usain Bolt, the fastest sprinter in the world. These are the guys that not only now have the reputation and the rock star status, but have begun to get very experimental.

Just one bit of central bank trivia here, just to end this thought, and I want to give you kind of an example of a negative feedback loop. Where was inflation targeting by a central bank first experimented with?

Kevin:I don’t know. We were talking about John Maynard Keynes was nothing new. Three hundred years ago they were experimenting with things like that. So does it go a ways back?

David:Inflation targeting is the idea that if you are designing a system to create inflation you will, at the same time, create economic activity and growth because of that targeted inflation.

Kevin:If you print it, they will come (laughs).

David:Right, and now we actually have a range of inflation rates that considered acceptable, and in fact, optimal for promoting economic growth. Ours is a 2% target. We have a few global examples of 4%, and of 6%, and there is even a central bank out there today which has a targeted inflation rate of 13%. So who got the party started? Not the fiat party – that was us. That was us here in the United States. But the idea that we should whitewash and sell as something that is beautiful and pristine, what throughout history has more consistently destroyed and redistributed wealth than any other financial factor – that one factor, inflation. I know it’s on the tip of your tongue. Inflation targeting is the thing that you think about, and I know if you’re playing in the game show with the game show host you would say, “Yes, I’ll take inflation targeting for 200.”


David:New Zealand.

Kevin:New Zealand?

David:New Zealand, 1989.

Kevin:So we got our inflation targeting cue from New Zealand.

David:The fun fact of the week comes from Robert Shiller at Yale. He wrote a fascinating article in Project Syndicatethis last week, and he is asking the question, “Guys, are we playing with fire here? We’re creating inflation, and by the way, there are perhaps some unintended consequences. He is a consummate diplomat. He doesn’t want to scare anyone with inflation, but he is asking all the right questions. So there we have it – New Zealand, 1989, the original experimenters with inflation targeting.

Kevin:For the person who doesn’t quite understand what inflation targeting is, that basically is theft targeting, because it is saying the buying power of your money will be worth 2% less per year. It’s like buying a bucket. When you go down to Home Depot and you buy those big orange buckets, what if you had the bucket that had a 2% hole? And a bucket that had a 4, or a 6, or New Zealand – what was that?

David:(laughs) And this is the fiction that we all live with. If you talk to your grandparents and you say, “Listen, when I built our first house I paid less than $10,000 for it, and this is the house that I have in retirement today and I’m selling it for $250,000.” And you think to yourself, “Wow, the house price has really gone up.” The reality is, the greatest factor in that appreciation was not supply and demand of the real estate market, it was the central bank creating more money so it takes more of those same dollars to buy the same sticks, bricks and mortar.

Kevin:But if everything is working perfectly right – let’s say the last ten years – go ahead and let them print because the markets are going to give it back to you. But it seems, at this point, since October, we have had a lot of damage done in the markets.

David:Absolutely, and I think the markets are in a very vulnerable place. Technical damage was done last week in the equity markets, even as we were talking with Doug Noland. What I mean by technical damage is, the prices have gone below certain levels and have triggered what some consider to be a long-term sell signal. Bill King, in his note from last Friday, says that an estimated six sell programs hit stocks on Thursday before the European close.

Kevin:Somebody knows something.

David:He says, “This indicates that large institutions are liquidating more aggressively. Charts and market action from October clearly show that large entities had begun to sell equities. This week’s actions” – again, this was quoted from last week, Friday, the King Report – “suggest that downward momentum is begetting more selling urgency, which produces the dreaded self-reinforcing negative psychology.” That’s the end of the quote.

As we mentioned last week, and again, drawing from Grant’s interest rate observer, Deutsche Bank, looking at performance of asset classes through mid-November, has 90% of dollar-denominated asset classes – 90% of all dollar-denominated asset classes that they track are negative for the year. So this is the highest share of losers since 1901. The important aspect here is the correlation increase. The majority of categories of assets, it doesn’t matter, they are not supposed to be moving in lockstep. Stocks and bonds are not supposed to be doing the same thing at the same time. But the majority of categories are in the losing side of the equation all at once. It doesn’t matter if you balance between stocks and bonds when both are in the red.

Kevin:Three or four weeks ago we talked about the 50-day moving average moving below the 200-day moving average. That looks like it’s happening.

David:Right – as we speak – and it’s what they call a death cross. The translation of the 50-day moving below the 200-day is this – the short to intermediate trend has been down long enough that it may now influence the long-term trend similarly to the downside.

Kevin:What does that mean, though? Does that mean for sure that the market is going to be falling?

David:It’s not a perfect predictor. We had the last “death cross” in the first quarter of 2016 and we managed to raise the dead thereafter. But nevertheless, it’s a warning that should be noted. And the ten-year bull appears to be capitulating. And of course, what is tricky is that even though psychology is shifting, you have news feeds, you have algorithms, you have the Twitter surprises from the president – whether it is on trade or some other topic – that can create a violent upsurge, countertrend – upsurge in price.

Kevin:If you were wise beyond your years, and you somehow could look into the future, you really would only have to buy the market if you were in a bear market, a down market, you would really only have to buy if you knew what days it would rally, you could just buy the rallies, because those rallies can be incredibly violent.

David:That’s right. And I think what you see in a bull market – this is true, the violence of a market always marks the countertrend. Let me say that more conservatively. It typicallymarks the countertrend move. So in a bull market where progress is steady to the upside – very slow and steady, making gains – you have violent moves, countertrend moves, to the downside. In a bear market, the opposite is true. There is a steady erosion in price.

I have described it once as the bowling ball falling slowly, and then rolling down and falling and hitting the next set of stairs. But the word picture fails, frankly, because it doesn’t capture the violent countertrend moves to the upside. You can have these massive spikes higher in price, and when violent moves in the market are present, they generally represent countertrend moves. Last week we had the combined pressure of trade relations deteriorating, and a weaker than expected nonfarms payroll report on Friday, which are continuing to pressure the market lower. Guess what? We had the violent spike upwards the week before and then again, it begins to fall apart again last week.

Kevin:Well, then what about geopolitics, because America’s legal reach seems to be a little bit larger than just the United States. That affected the markets last week when we’re nabbing executives.

David:It’s tough to think of functional trade relations with the Chinese when the U.S. is taking their executives from foreign soil, while those executives are in transit.

Kevin:That was in Canada that she was picked up.

David:It makes you think about jurisdiction. It makes you think about who we are in the world and how our laws extend into what boundaries they go to. Break our laws in our country – I get it. How would I like to be prosecuted for breaking a law in Turkey right now? Or let’s say, for instance, I was defaming Muhammad? Should I be subject to Iranian laws? At what point do Iranian laws not apply in the United States, or Syrian laws apply in the United States?

Is there anything in terms of jurisdiction that we should appreciate here? This is confusing to me, because again, if you break our laws as a non-citizen, and you’re in our country, yes, you are subject to them. But break our laws as a non-citizen in another jurisdiction – how is it that we get to hunt you down? There are interesting presumptions in that.

Kevin:Is it because we have the reserve currency? And is it because we have the carrier fleet and the military?

David:There you go. I think it’s the carrier fleets. I think it’s the long-range bombers. I don’t know that having the reserve currency gives us the ability to extend the long arm of the law, I think it’s the long range of the bombers that allows us to extend the long arm of the law.

Kevin:But we’re losing the love of the countries outside of the United States.

David:Listen, I don’t have to be Chinese to feel awkward in this moment. I don’t feel warm and friendly about the idea. Just try this on – see if the shoe fits, theoretically. Let’s say that Russia asks China to capture and extradite one of our top executives. Let’s say that Mark Zuckerberg is traveling through Beijing and he is detained by the Chinese and is going to be extradited to Russia to be tried because he has, through his social media posts, allowed for defamation of the state of the Great Bear. Can you imagine? Can you imagine them going after him and using the Chinese as a puppet to get what they want?

Kevin:What would be our reaction?

David:What is our sense of things as a country? Can we fit this into the category of do unto others as you would have them do unto you? I’m very uncomfortable with this. This goes back to a philosophical argument that Alasdair MacIntyre raised in his book, Whose Justice? Which Rationality?Alasdair is 89 years old. To me, he is like the second version of the Scottish enlightenment in terms of what he brought to philosophy as a Catholic philosopher.

But you see these competing interpretations in his book, Whose Justice? Which Rationality?– interpretations of those ideas – justice and rationality – according to different theoretical starting points, whether it is Aristotle, or Aquinas, or Augustine, or Hume. There are more competing views in the world than just these, but the conversation, through time, on the topics of justice, on the idea of rationality, has these names in the dialogue. What we are really talking about is ourjustice, and ourrationality.

Kevin:From the United States’ point of view.

David:Whatever the basis we have for it, and it’s not universally agreed upon. So when we construct an argument justifying a certain action according to a certain interpretation of ourlaw, we should not be surprised when other state actors sit there, scratch their heads, and wonder, “How the hell do we think we are justified in our actions extending beyond our borders?” Again, how to win friends and influence people – I don’t think this is how you get it done.

Kevin:You know, for the last 11 years, almost, on this program we have talked about the financial going to the economic, the economic going to the political, and then ultimately, the geopolitical. The geopolitical is a little bit different. It starts to get bloody. Right now, the relationships that we are trying to negotiate with these trade negotiations are starting to look more like they are warlike negotiations.

David:Well, yes, because our actions are inflammatory and they don’t necessarily help dialogue. The markets figured that out instantly last week, when you saw the announcement – actually it started happening a little bit before. Someone else knew ahead of time and knew what the implications would be, but you began to see a sell-off in the markets directly related to the nabbing of this telecom executive from China. So the volatility increased. It increased before Friday, and then you layer in the nonfarm payroll disappointment. We had 155,000 jobs when 198,000 were expected. And again, Bill King notes this week, “Real sellers are now regularly overwhelming traders and pattern trades. This trend which began in October suggests that the long bull market has ended.” That was his quote.

Kevin:That answers a question that we have been asking now at least for five years, maybe more. When will the real market return? And it seems that what King is saying is that real sellers are overwhelming the algorithms.

David:It feels like The Gods of the Copybook Headingsall over again, where the market actually does return. You have the posturing of the president on trade negotiations, and this is one for the history books. These are the strongest trade negotiating tactics ever. I don’t think that you will ever see anything more radical than his…

Kevin:Do you think that is good for the United States?

David:I don’t know, but I know that he is not a diplomat, he’s not a politician, and he’s driving policy. Technically, he’s a politician, but he doesn’t have a history of being a professional politician. That’s what I’m saying. And he is driving policy. And it could move the needle favorably for the U.S. And I think, so far, it has. But this is the danger point. It may be moving the needle for us, economically, but it could also move fingers to buttons. And there is a risk, even if we hold the perfect poker hand, that number one, China can either fold or, as we can recall from the days of poker matches in the old west, the second alternative is that accusations can fly, guns can be drawn, and it makes the royal flush we hold completely irrelevant.

Kevin:(laughs) Yes, the cards no longer matter. It’s now bullets.

David:Someone is dead, lying on the street, and it didn’t matter if you had the perfect hand.

Kevin:I had mentioned what it feels like when the well runs dry, because you just assume every single time you want to get a drink of water it’s going to be there. I have to say, I’m a little sad, Dave. Alan Newman, somebody that I love getting the latest charts from – he’s been doing this for longer than I’ve been alive, I think, almost – he is retiring. He is a regular guest of ours. I hope that he will continue to do guest appearances on the show. But aren’t you sad that you’re not going to be getting your Crosscurrentson a regular basis?

David:I amsad, and yet, I understand it. He said to me, on a personal note, “There are few other things that my wife and I would like to do.” And I get it. The markets have been a 54-year obsession, he has written his millionth word on the market, and the last Crosscurrentsissue is in hand. Of course, he might change his mind and there might be a special issue in February (laughs). He said, “I’m going into retirement! But I might not be fully retired. I’ll have to tell you in 2019, and it will be a surprise event.”

Kevin:Well, would you summarize at least what he is saying since this is the last issue? What is it that he is looking for over the next couple of years?

David:The last sort of swan song issue of Crosscurrentssays that the Dow is heading to 15,000, gold is heading to $3500, maybe even $5000. But the important number is not in nominal terms, it’s really the ratio. He is looking for a 5-to-1 Dow-gold ratio. It’s about 20-to-1 at present, so you’re looking at a four times increase in purchasing power, owning gold relative to stocks. And I personally vary off of that opinion.

I think that geopolitical factors may take the ratio a bit below that – back to the classic 3-to-1, maybe even 2-to-1 or 1-to-1. But again, I think, regardless, even getting to a 5-to-1 ratio – that is good news for gold owners. Give yourself a few years and the picture which you thought would be in view will be. The market does what it is supposed to do, but as Richard Russell used to say, “Not when you want it to.”

Kevin:Someone else that you read on a regular basis is Fred Hickey. His specialty is tech stocks. That’s what he really does his business in. He was on the Barron’s Round Table for years.

David:Absolutely. He agrees that gold over the next few years has great prospects. When Fred is not tearing through the financials of tech companies – he’s one of the best at that, for sure. I should say he has been an advocate of physical metals and of the mining sector. The gist is that tailwinds, that is, that which helps gold emerge even as headwinds for the world’s other financial assets, are also present. So again, as you see pressure in the stock market, gold catches a bit. Anything relating to gold does very well in that context.

We had a decade of that being the dominant story and theme leading up to Barron’s in 2012 throwing in the towel. They’ve always been bearish gold. And there in 2012 they finally said, “Everyone needs to own it!” To their chagrin, their timing was absolutely awful. And I think they will be, again, on the bandwagon saying everyone needs to own it, but it will probably be in that price range of what Alan Newman suggests, $3500 to $5000, before Barron’s again is on the bandwagon.

Kevin:I think of some of the guys that we read regularly, and no longer can, or that we have read and no longer can. We had Richard Russell for years. For five to six decades we were able to read his material. Alan Newman – that’s another one. Fred Hickey is another one with the High-Tech Strategist. But honestly, we’ve talked about how wonderful it is to have this close, but another person that we would have added to that list is Doug Noland with the Credit Bubble Bulletin.His Z.1 Report – he is still very actively writing.

So we no longer have Richard Russell, we no longer have Ian McAvity. Alan Newman is retiring. We still have Hickey. But Noland – we had him on last week. We had great feedback from that conversation. That is something I just want to encourage our listeners, you can read the Credit Bubble Bulletinfor free. Simply go to mwealthm.comand click on the Credit Bubble Bulletintab.

David:2000-2005 were very important years for me. They were the years that I was at Morgan-Stanley, and then made the transition to our family business, Wealth Management and Precious Metals Brokerage company. And in those years, the influential voices in my head were Richard Russell who I read every day without fail, and on a weekly basis, Doug Noland. But I didn’t get to read Noland’s comments daily. What I did get at PrudentBear.comwas a list of articles with shrunk the universe down to a bite-sized portion and allowed me to go to the top Reuters, top Bloomberg, top CNBC, top articles from the Financial Timesand every other news rag in the universe because he had already distilled what was most important and was going to be truly impacting the markets.

Kevin:He was showing you what he was reading.

David:That’s right. That, to me, has always been the key. If you find somebody you enjoy reading, find their bibliography, find who influences them.

Kevin:(laughs) Your life is defined by bibliography. It really is.

David:In many respects. So the Credit Bubble Bulletinthis last week, when I read Doug over the weekend, and that is a ritual I suggest, the review of the Federal Reserve’s Z.1 Report was most helpful. What it made me think is that Richard Koo nailed it 15 years ago. Still an economist, working in Japan, going to be guest on our program in February or March – I think March, actually – and looking forward to our conversation with him. But his explanation of why growth is constrained in an era of over-indebtedness, what he called the Balance Sheet Recession – these are the issues which we are talking about and looking at in the Z.1 Report, and they are very significant. Though there is a slowing in credit growth in some areas, growth in others, Koo popularized that idea of the Balance Sheet Recession. In a nutshell, it is having too much in debt such that much of your productive potential, that is economic potential, is sapped by feeding the interest meter.

Kevin:That goes back to Pollock’s quote I just brought up earlier. “Your debt doesn’t go away when your assets do.”

David:Right. The only thing that central banks have done for us is artificially capture the rate of interest and hold it down. Central bank QE programs have bought a lower interest rate. We still have to pay for it (laughs), but they financed a lower interest rate, and they have kept those rates at a level that has at least allowed for slow economic growth to be in the picture. Now with rates rising you can begin to see the vulnerability to global and domestic economic growth because yes, debt kills, and if you have more of it, it just happens to kill faster. That’s the nature of leverage when it is working in reverse.

You might be tempted to say that maybe we’re moving toward an era where capitalism has revealed its weaknesses and is moving toward the dustbin of history, and we have in its place autocratic regimes like the Chinese taking the best of capitalism and massaging it into their own framework. It will never matter because they have the ability to control the system. And it is true, they have the commercial banks – those are tools of the state. They have the central bank – that’s available to serve the party’s priorities. Therefore, maybe it’s different. But banking and credit, I would contend, even in a controlled environment, still succumbs to natural laws.

Kevin:That’s the real market. That’s exactly what we were talking about with King. The real market sometimes overwhelms the control, the algorithms, whatever you want to call it.

David:Yes. The only difference is that the losers, when they are assigned the losses, really have no recourse. So in a democracy, if you’re a loser, and you are assigned the losses, you can take it to the polls, and you can make the politician who allowed the dirty system that abused you to get cleaned up or go away. So there is political recourse. In the autocracy, you will still be assigned the loss because there are losses to be assigned, there are consequences to bad debt.

You just don’t have any political choice, you don’t have any political recourse – unless you take a big enough hit, and then maybe you just decide to blow up the system (laughs). Stranger things have happened. If you look at the continuity of regimes through time, show me one autocracy that has lasted more than – I don’t know, 500 years? 1,000 years? None that exist today existed in the 1500s, 1600s, or even 1700s.

Kevin:One of our guests years ago, Barry Eichengreen, talked about the dollar’s reserve status as an exorbitant privilege. We seem to be losing that. The Chinese are looking more and more like they want oil backing the yuan. The reserve status of the dollar was protected mainly by OPEC and its oil trade. Now the world is basically saying, “I think we can buy oil in something else.”

David:And I think this issue that the Chinese are working through is very significant because we have many of the themes in motion – some that people are aware of, some that people are not focusing enough on. Look at Enron. Enron was okay as long as they were able to use special purpose vehicles and able to shuffle off the nasty, bad liabilities, and maintain a perfectly clean balance sheet for Wall Street to look at. And they lied, and they got Arthur Andersen to lie for them.

In an autocracy, you don’t have to have Arthur Andersen lie for you, you can do anything you want. The Chinese today show 1.5% of all their loans as bad, which means, really, that the stinky stuff has already been quarantined. When we talk about the problem with wealth management products and the blow-up of these other assets, in China, they’ve already taken a lot of the garbage and given it to the general public, because the general public can own it, have bought it thinking that they were going to make their millions, and lose.

And really, what is the recourse? You raise a totally different issue on the petro yuan, and it is a very interesting one because we have trade, we have currency conflicts, we have territorial disputes. All of those three things – trade, currency conflicts and territorial disputes – are all taking place with China, between us and China, in the context of the ten-month run since the launch of the yuan-denominated oil futures contracts on the Shanghai International Energy Exchange. So whether you call it yuan or RMB, you have gone now ten months and it has captured the interest of Glencore, its volumes have exceeded a number of other exchanges…

Kevin:It was an experiment to start, wasn’t it? And the experiment seems to be working.

David:Yes, and this is the importance. There are few things which support the development of the Chinese capital markets and bring the RMB into the center of global commodity trading than adding to demand for RMB via the oil markets. The oil markets are ubiquitous. Demand for oil requires a certain degree of commitment to a currency, and if you can settle those currency contracts, those oil contracts, in the currency of your choice versus dollars, doing RMB or some other currency, then that, I think, is a significant trend.

The Governor of the PBoC back in 2009, Zhou Xiaochuan – I apologize, I did not pronounce that correctly – wrote in depth back in 2009 about the inadequacies of the dollar-centered monetary system, and he was a proponent of the RMB’s inclusion into the IMF and the SDR system that is a special drawing rights system which creates a basket of currencies, and the RMB is now a part of that. But he viewed it, the former governor of the PBoC, viewed RMB inclusion in the SDR system as a stepping stone to greater things.

And here we have 2018, while we will generally remember for trade conflict with China, the bigger issue is the currency issue. And the currency issue is being driven by the petro yuan. It’s the shot across the bow the Trump administration is not talking about. Marc Faber, in his recent letter, had a quote from Talleyrand in the 1760s, who said, “Speech was given to man to conceal his thoughts.” And I think to myself, as loudly as Trump is trumpeting on the trade issue with China, the trade topic is getting the air time, and there is the actual topic which deserves air time and is being completely obfuscated – obfuscated, hidden– and that is the petro yuan.

Kevin:Talking about speech concealing thoughts, Warren Buffet has been awfully quiet now that the index that he talks so much about when things look like they are going to go up, is now pointing to a down market. Do you think maybe his speech is concealing his thoughts?

David:Absolutely. This is where, again, you look at 2001, you look at the Forbes Magazinearticle where Buffet is basically saying, “This is the greatest measure, if you want to know if a market is overvalued or undervalued.” And as I mentioned in an earlier Commentary this year, just this year, January, he was saying, “No, no, no, it’s not overvalued. The stock market is not overvalued.”

Of course, those comments only make sense if you’re comparing stocks to something that is even more outrageously priced, which in this case would be – bonds. So stocks are cheap relative to – bonds. But both are expensive. And this is where, again, the Buffet indicator at 151%, up from the recent 144%, shows that we are getting into and beyond bubble territory. The all-time high for the Buffet indicator was 161% in the year 2000, and we far exceeded what we had in virtually any other period in time.

Now, that’s using the same Z.1 Report we talked about earlier that Doug Noland was mining information from. Use the Z.1 Report for the total value of corporate equities, and you get your 151%. If you compare, on the other hand, the Wilshire 5000 to GDP, we’re at all-time highs. So again, look at the speculative nature of small caps and the broader market, and what it reveals is the excessive position that the markets are in.

Many of you joined us for the Commentary conversation with Crestmont Research’s Ed Easterling. If you missed it, it’s probably one of the clearest insights into market valuation you will ever get.

Kevin:That was an excellent show, and his chart that we put on that site where you can click on it and you can actually look at economic or stock market history for the last century.

David:If knowing where you are helps you figure out where you are going to end up in this journey of investment returns, I would say it’s a vital conversation to review. I mention it because of a variety of valuation metrics that Ed looks at, and he develops. Similar to the CAPE, he has his own Crestmont PE. CAPE is a Cyclically-Adjusted Price Earnings ratio, the PE-10, otherwise called. These are numbers that get routinely updated and show that, yes, we are at the top of the range.

I mentioned earlier the impact of inflation, we talked about inflation targeting, and I just wanted to share as we close today, the impact of inflation here since the beginning of the millennium, 2000 to the present. We have the Dow, in nominal terms, up 117%. When you factor in inflation, it’s up 47% instead of 117%. The difference between 117 and 47 over the last 18 years is inflation.

Kevin:That’s a leaky bucket.

David:That’s a leaky bucket. The S&P is up 80% in nominal terms, 22% in real terms if you factor in inflation.

Kevin:That’s a leaky bucket.

David:And the NASDAQ is up 45% since the year 2000, except when you factor in inflation it’s down 1.9%.

Kevin:Wow! Almost 20 years of no growth when you factor in inflation on the NASDAQ.

David:Perception versus reality – this is a real thing that people need to be cognizant of. In fact, this is what is the debate in France today, families, working people, and a populist movement, basically saying, “The cost of goods and services are going up. Our income is not going up commensurately. We’re getting squeezed, you’re raising taxes, it’s intolerable, we’re taking to the streets.”

Again, we talked about this crisis moving from the financial to the economic, to the political, to the geopolitical. You’re seeing the political in real time in France. Why? Because people are actually putting it together, and what Keynes said would be hidden from almost everyone in the general public is no longer hidden to the French. They’ve figured it out. Why? Because yes, inflationism is something that we exported years ago. Yes, central bank hooliganism and gerrymandering is something that we popularized, perfected, and then handed off to the rest of the world’s central banks to then use and abuse their public with. This is a very, very big thing.

Kevin:A very famous book says whatever is done in darkness will come to the light, and inflation is something that seems to be done in darkness, until, actually, you can’t pay your bills.

David:And then guess what you see? You see yellow jackets and yellow shirts all over the place.

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