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The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

If It Walks and Talks Like Recession, Call It “Recovery”
October 30, 2019

“He may be lost in his own matrix of ideas and worldview and textbook knowledge and unable to see the world in any other way except on the basis of the assumptions that he has, but the academic is applying a philosophy of maximal control. The market practitioner, Jim Grant, is applying a philosophy of maximal freedom, and there is the reason I like to spend time with Grant.”

– David McAlvany

Kevin: Well, you’re back, and I always enjoy it when you’ve had a trip to New York and you have had time to spend with Jim Grant and whatever the gang is of economists and experts that he gathers every year, or actually, twice a year, isn’t it, for the Grant’s Conference?

David: This was a unique opportunity, because on the one hand I went for the Grant’s Conference. Jim has been writing the interest rate observer for decades, and my dad read him, I read him, and we continue to learn lots from him and from his guests at the conference. But there was another aspect which was interesting this year. Gratitude and thanks to Bob and to Lily and Michelle and Jeffrey and Derek. I was hosted for a day and got to meet with a couple of different groups there in Manhattan and it was absolutely fantastic.

Kevin: You were treated like royalty from what I understand. From morning to night, it sounds like there was something planned and it was always good.

David: Yes. I was asked to do two different seminars and it was just amazing hospitality. I think I discovered a community of friends quite unexpectedly, so thank you so much for that, Bob, Lily, Jeffrey, Michelle and Derek. Thank you so much.

Kevin: I have to look at this from an aspect of what we learn when you get back because oftentimes – I went to a conference a couple of weeks ago that I am still going back and reviewing – when you go to a conference and you have a high-intensity stream of information coming at you from people who really should know what they are talking about, you can’t gather it all at once. You have to sit down and ask, “What was just now said?” And one of the best things that you can do is talk to someone else who was at the conference. And so what I would like to do, Dave, so that we can maximize this – we should just say right now, this is a conference that is several thousand dollars to go to. If a person who is interested in economics has never been to Grant’s, they ought to go. But if you don’t, or even if you did, make sure that you go through and debrief afterward.

David: He has an online option where you don’t have to go to New York, you don’t have to be at the Plaza Hotel, you can access all of the speaking by video, and I’ve thought of doing that, but honestly, things crop up and so it actually is worth my time and the effort to get there, be there, sit there, takes notes, interact directly with the speakers, have lunch and eat with them, talk with them, and hash through particular issues.

Kevin: And these are decision-makers. Oftentimes we are asked, “Why don’t you just stick with whatever your philosophy is?” Why don’t you just talk more about your philosophy? The problem is the people who are making decisions don’t always agree with your philosophy, and for you to be able to make good decisions you have to know what they are thinking, whether it is a Mario Draghi or an Otmar Issing, or in this case, a Dudley who has been president of the New York Fed, you may not agree with everything he says, but you had better listen to what he is thinking.

David: Jim Grant’s Interest Rate Observer reads more like a human interest story than even just a financial markets analysis. It includes that, but he is looking for the actor behind the scenes.

Kevin: Didn’t he debate Bill Dudley right there at the conference?

David: Yes, exactly, and Jim was earnestly protesting in the debate with Bill Dudley that these are heartbeats, these are people that are impacted.

Kevin: Not just numbers.

David: That’s right. It’s not the artificial manipulation of interest rates which is the only issue, it’s the people behind it. Not merely a figure, it’s a measure of time. These interest rates are a measure of time, they are a calculation of value, they are inputs that end up determining the hopes and dreams of people who have anticipated their income needs at a future date. So the prudent have foreseen a day when they would need a supplement to income, as they age and energy levels slow and they take that bottled up energy, the storing of energy, if you will, through the years, and apply it in a future moment. That is really what savings are for, is being able to reapply your energy and that value stored through the years when you need it most, when frankly stress and strain are not as easily borne.

Kevin: I remember the first macroeconomics class I took. I really had no idea what I was taking. It sounded incredibly boring. I opened up the book and I saw at the beginning of the book, Careers in Economics, and I thought, “Careers in economics? Gosh, I’m only taking this class because I have to.” Now, it was because I was ignorant that economics, the heartbeats, the time, the blood, sweat and tears of the world – that’s economics. Last night when we were talking, it really hit me, Dave, you were a philosophy major because you cared about the way people think, you care about what is going on with this enterprise called human. And economics is philosophy with teeth. It is how energy is stored and translated.

David: Granted, there are different views to economics and different approaches to it, so how you come to the science of economics is unique. The same thing happened with philosophy where there is a reshaping of the philosophical dialogue. Go back to the 1920s and all of a sudden logical positivism became very popular, and all the colleges were trying to bring some form of science and the scientific method into philosophy and it started to reshape, even mal-form, if you will, the world of ideas.

I think the same thing has happened throughout the soft sciences where they have need to legitimize themselves according to some mathematical equation. So today an economist works with DSGE models and is less concerned about human action. That is where you look at Jim’s contribution through the Interest Rate Observer and it really does tie to those issues of humanity and human action, where economics is just a tabulation of a score – who is doing what and why – you are getting into the mind of the individual, which is, again, the point of economics, at least in an earlier iteration.

Kevin: As we go through these speakers I would like our listeners to think that way, because as you debrief me like you did last night, and I would like to hear it again, about what these speakers talked about, realize that even economics – if you go to MIT you are going to learn a certain type of economics. If you go to Berkeley you are going to learn a certain philosophy of economics.

David: (laughs)

Kevin: If you’re Jim Grant, it’s going to be a different philosophy.

David: Right. I like to go to New York City once a year, sometimes it is twice, and it is a mix of individual investors, of institutional investors, seeking to better grasp the investment landscape and how they can more effectively engage it. Typically nine speakers, Jim makes the tenth, and he takes the stage and each of these people share unique perspectives. I ran into people who traveled from every state here in the U.S. and as far as from Australia, Hong Kong, Pakistan, England, Uruguay, Brazil, Japan, Austria and Switzerland – particularly the Swiss, I think it is curious there – those from Switzerland seemed to have a particularly earnest look on their faces.

Kevin: When I went to Switzerland with you I had heard that you could eat off the floors of the airport and train stations, and the trains ran on time. In most of Switzerland, they truly are earnest about those things.

David: Well, in this case, anyone looking for interest rates in the land of the gnomes, is probably more of an archeologist than a market practitioner, investor or economist.

Kevin: Are you referring to the negative rates that you can get for long-term bonds in Switzerland?

David: (laughs) That’s right, subterranean and going out 50 years of maturity. So the conversations are always fascinating at the coffee breaks. They are lively, the presentations are thoughtful. Oftentimes they are challenging, and occasionally there is a perspective shift where something is said, or said a certain way, that plants an idea, or confronts a fallacy, which more than makes up for the price of admission.

Kevin: Well, we have had guests, actually, a number of guests, that you have met at the Grant’s conference, that have ultimately come onto the show. But before you ever even get there, you are training for triathlon, but your habit is to put some running shoes on and hit Central Park.

David: Yes, I start every morning in New York City with a tall glass of water, at your recommendation usually more than one, and my running shoes. Right now you have the leaves changing in Central Park and it is glorious. It extends the autumn season by a few weeks. I’m in week four of a new training cycle, and here in Colorado we have already turned toward the winter months.

Kevin: Yes, we got a little dusting.

David: Seeing a little color on the East Coast is something I love. Running Central park is always entertaining to me. I look at people, I watch people, I ask questions. Who are they? Leaving the brownstone, leaving the flat, leaving the one-bedroom studio, saying goodbye to the night and good morning before the sun is even up. Who has eight dogs in this town? You see somebody walking and it’s just like this mishmash of dogs, and of course, that is a profession in Manhattan, being a dog walker.

Kevin: You know, my daughter lived in Manhattan for several years and getting a chance to go, and you go more often than I do, I think about it, when you look at a map of New York from above, you look at that swath that they call Central Park and you think that real estate would have been very, very, very valuable by now if they would have let them build buildings on it. What foresight hundreds of years ago they had when they planned the city to have that park. Otherwise, can you imagine if it was just a concrete city and that was all you had?

David: There is a temptation for me to eat large when I’m in Manhattan because food is an attraction there. But the only other real attraction for me in Manhattan is that of the open space. If I have free time you will find me at Central Park.

Kevin: But you do transition from Central Park. You actually go back to…

David: Some coffee and a suit and then sitting down to sort of – what we started with were the sobering economic observations of the first speaker at Grants, David Rosenberg. He was at Merrill as their North American Chief Economist forever, and then moved on to Gluskin Sheff, and he concluded that a significant rise in the price of gold in future years would probably have him changing his name from Rosenberg to Goldberg (laughs), but before that he made the case, as we have here on the Commentary, that we are in a long-term economic war. This is not simply trade conflict with the Chinese.

And so even coming to certain conclusions – phase I, phase II, however many phases there end up being – there is a backdrop issue here. He pointed also to the uncertainty index compiled by Haver Analytics. It is at the highest level it has been at since 1997. You have Brexit, you have a weak coalition government in Italy and in Israel and Canada. You have impeachment proceedings here in the U.S. and the trade issues which linger on well past phase I agreements.

Kevin: Yeah, but what about phase I? I mean, we have a trade agreement, do we not?

David: I love Stephen Roach’s comments here in recent weeks saying, basically, you can’t solve a multilateral issue on a bilateral basis. So if China and America do come to an agreement, it misses the point, which is the imbalances from an economic and trade perspective are multilateral. So it is the wrong way to approach it. It just doesn’t even fit the right framework. But Rosenberg also pointed out that the leading economic indicators are currently the lowest since 2009. They are down 20 consecutive months, with the OECD member countries, that is the Organization of Economic Cooperation and Development, those member countries, 20 months in a row of declines, and in the U.S., 16 months of decline in the leading economic indicators.

Kevin: I wonder when that turns into a recession because we are 123 months into what they call an expansion, yet QE has been reintroduced, the repo situation – we don’t have to go there again.

David: He said that, basically, as good as it has gotten, is kind of further evidence of tougher times ahead, the output gap measuring aggregate supply, aggregate demand, in this particular cycle, the gap number closed, and it is the first time in U.S. financial history that the gap has remained open in a recovery cycle.

Kevin: So is it really a recovery cycle?

David: He is saying this time has elements of being different. So in a period of disinflation, which he believes is immediately ahead of us, of course, if the gap never closed and things do get worse, then you have the gap widening further.

Kevin: Didn’t John Maynard Keynes say that you could just always push demand? Isn’t that the idea, just make sure that demand continues to happen?

David: That was a focus of Keynesian economics, is actually sort of the moral obligation to prop up aggregate demand. So that looks at one side of the equation. The gap is made up of two sides. Go back in history, in the 1500s we had a supply side deflation. The 1930s is the one that everyone is afraid of. It was a demand side deflation. And now Mr. Rosenberg believes that we are going to have both, supply and demand side deflation.

Kevin: Okay, so where is inflation right now as far as what he is thinking?

David: Well, again, like the output gap which never closed, that being an oddity in history, this, in terms of the core CPI, Consumer Price Index, the fact that it has peaked at 2.4%, that is the lowest peak in a recovery cycle since the 1930s. So his expectation is that interest rates go negative in nominal terms here in the United States and that inflation, which has been hard for them to boost and get higher, in fact, goes from disinflation to outright deflation. So soft landings – how does he arrive at the conclusion that interest rates are going negative? Because soft landings have always had three interest rates cuts. And if it is worse than a soft landing, if you have a recession, the minimum shrinkage in rates is 2%, 200 basis points.

Kevin: That would take us to zero at this point, wouldn’t it?

David: And typically it is 5%, or 500 basis points of cuts. So yes, where does that take us to? The new class in interest rates is going to be called Interest Rates for Archeologists.

Kevin: Yes, negative – under the ground.

David: Subterranean, and for the historical only. So you have negative nominal yields, which he believes are coming here in the United States. That is us catching down to the rest of the world, and he observed that the transportation average, not the Dow-Jones Industrial Index, but the Dow-Jones Transportation Average, it peaked in September of 2018.

Kevin: That’s the worry, you’re past that peak.

David: Yes, the Small Cap Russell 2000 peaked in August of 2018, and there was an interesting article which I am sure folks saw in the Wall Street Journal not long ago – just last week – James Macintosh wrote “The Stealthy Bear Stalking the Dow.” And he, too, makes the point that we are probably going to backdate the recession and the bear market to – we’re already there. And he makes the case – I know this sounds counterintuitive, how can we already be in a bear market, we’re not down 20% in the indexes. And again, look at MacIntosh and the Wall Street Journal, “The Stealthy Bear Stalking the Dow.” It’s an interesting article.

Kevin: Another signal that we have talked about for recession is an inverted yield curve and we have talked about how the Fed has influenced that yield curve in a way where they are controlling it to take that signal away.

David: And as recently as 12 months ago the San Francisco Fed was doing research and affirming the predictability of the yield curve, the usefulness of the yield curve as an indicator in terms of recession ahead. So what I am saying is that when it inverts, you are already on the cusp of recession, and he reminded the audience that when you see Fed activity like we saw in 2018, the 4th quarter in particular, with Powell tightening and raising rates, 10 of the last 13 tightening cycles ended in recession. Not immediately. It’s not like he raised rates one time too many, so here we are in recession. It is generally with a 10-18 month lag.

Kevin: So we’re looking at election year – 2020.

David: But do the math – 10 of 13 means that, basically, the odds of a 2020 recession are 80%, and we’re in that lag phase where no one is concerned and the current rate cuts people are excited by – today’s actions – we have rates being announced by the Fed today, forgetting what is already baked into the cake because of the tightening cycle, which is now almost a year ago.

Kevin: So a flat yield curve is different than when we have steep angles. There are opportunities built in. If you’re a money manager, you’re going to look at the angle of the yield curve.

David: That’s right. So with a flat yield curve you essentially have return-free risk, is what Paul Isaacs – I got to sit next to Paul and we had some interesting conversations.

Kevin: So you are getting no return, but you are taking risk. And that is what we have been trying to convince our listeners we are in right now.

David: Right. So when you have – and he also reflected on the yield curve signaling of maximum opportunity, so you have, basically, zero opportunity but lots of risk with a flat yield curve. You start to steepen the yield curve and when it reaches its maximum steepness, that is the time and place where you want to be adding risk to your portfolio, you want to be buying everything you possibly can, because now you do have great potential for returns.

Kevin: And that is when nobody wants to buy something like that.

David: Correct. So the opposite is true today, we should be de-risking. He likes government bonds, he likes volatility, he likes dividends, he likes cash, he likes gold.

Kevin: What do you mean by volatility? Government bonds, volatility. You said dividends, cash, and of course, gold.

David: If you wanted to pick on one thing you could look at the VIX and say that the VIX, as a measure of volatility, is now under 13, to be able to play that volatility while it’s low, you begin to see volatility in the stock market and that 13 can move to 50 in about two seconds.

Kevin: So it’s betting on the volatility increasing when it gets real, real low.

David: That’s right. And he would say it is the calm before the storm. It’s as good as it gets. In fact, one of the funny things that he said, it was kind of a joke between the optimist and the pessimist. The optimist says, “Things can’t possibly get any better.” And the pessimist says, “I think you’re right.” And that really is what captures Rosenberg’s commentary and comments for his presentation. I think you’re right, it’s not going to get any better.

So it reminded me, looking at the allocations, he was really focused on reliable cash flows, and we are now in earning season, the thick of it. Lila Murphy on our Wealth Management Team is listening to countless earnings calls, and she is a great addition to our Wealth Management Team. One of our favorite companies that we follow and she looks at in detail, increased its dividend again. It is the 25th year in a row of dividend increases.

Kevin: How often can you get safe income these days? Safer – there is nothing completely safe, but safer income.

David: Right. There is risk in everything that you do, but I took from Rosie’s presentation – that is what he is affectionately known as – Rosenberg. I took from his presentation – and soon to be Goldie instead of Rosie, I suppose – that safe income is very scarce. Safe income is very scarce and you should own as much of it as you can, and that happens to be the core emphasis of our most popular account style at MWM. Reliable cash flows translating into well-protected dividends. So anyway, the Rosenberg comments were interesting. They had a particular tone, kind of a deflationist tone.

The next presentation was Ann Dias. She used to be a Soros fund portfolio manager. Now she runs her own shop. Here are a few key takeaways – first, that inflation is structurally lower, and the official central bank targets are not being hit, in part, due to what she describes as the 4th Industrial Revolution.

Kevin: I remember talking to you about that last night. And that is so profound. If you really look at the 20th century, Dave, and going into the 21st century, we should all be on top of the world as far as us making bills and the ease or the cost of everything, because transportation – everything – is affected by technology. Artificial intelligence and the Internet. But if you really look at what has gone on, people are having a harder and harder time making their bills. That money is being funneled somewhere. We are not getting the deflation that we should all have enjoyed of the 20th and the 21st century.

David: Yes, and there are aspects of Ann’s presentation that I really liked and found helpful, and there are some missing gaps, too. The Cloud, the Internet of things, machine learning, big data, AI and digital money and the sharing economy – all of those are themes that are expressed by her succinctly as the Tech Revolution, or the 4th Industrial Revolution. So what came before it was steam, number one, electricity, number two, computing, number three – these are your revolutions – and now tech, which is leading to a better match between supply and demand, less waste, and less excess production. And for the consumer, more bang for the buck. And so she referenced the current reading of the Billion Prices project.

Kevin: You’ve talked about that before.

David: Exactly, on the show, we have. And at times in the past it has read much higher than either the PCE or the CPI, two measures of inflation, but the Billion Prices Project currently reads at -1% for your offline aggregated prices, and because so many things have moved online into the digital platforms, they now have two measures, the offline aggregated prices and the online. The online is -3% for online prices. She is making the case that it is these technological shifts that are making central bank inflation objectives impossible to reach. And I might add, my personal opinion, that is not the whole banana there. This is deflationary effects of having too much debt in the system. That is also a very, very big deal. I would argue maybe even the bigger of the two, but it was still a very helpful insight to consider this sort of 4th Technological Industrial Revolution. I agree with her that the next policy choice will be to implement fiscal initiatives.

Kevin: Right. In other words, reasons to spend money. Building projects is what you are talking about.

David: Yes, and that will be another attempt to bump up to that 2% inflation target. She also observed that central banks are likely to shift the target higher, and that is just so that they can hit the old target. You aim for 4 in order to hit 2. If you have aimed for 2 and you can’t get there, then you start targeting a much higher inflation level. And of course, I’m sitting there waiting for the exchange with Bill Dudley and Jim Grant, for them to take the stage, and I want to hear him reconcile the Fed mandate of price stability at the Fed, which is one of the stated reasons for their existence. How do you reconcile price stability, currency stability, with any form of inflation target? But I’ll get to Dudley in a minute.

I can’t possibly get to all nine presentations in a podcast today, so what I’m going to do is mention at least a quip or a quote or a key takeaway from the rest of them, just to give you an idea of some of the things that stood out. Seth Klarman is from Baupost Group, and he takes the stage with Jim – he is a hedge fund guy.

Kevin: So he is a practitioner

David: Oh very much so, 37 years.

Kevin: Not just an academic.

David: Jim starts by saying, “There are A students who become professors, there are B students who become lawyers, and the C students end up endowing the buildings.”

Kevin: (laughs)

David: I would like to introduce you to our favorite C student, Seth Klarman, who built a rather large building there on the Harvard campus.

Kevin: So he got a C, but he built the building.

David: And he probably got As, to be honest, but whatever. So yes, the Baupost Group with its 2% annual fee and 20% performance fee bonus, that model over 37 years has built a very significant personal fortune. And one of the first things to come up in conversation is, “Is there a bubble, and is it an everything bubble?”

Kevin: Well, the Economist magazine called it the Everything Bubble nine months ago.

David: And Seth said no. He said not everything is a bubble, but everything is now correlated.

Kevin: Everything that goes up will go down at the same time.

David: And so everything is moving up at the same time, and everything is moving down, theoretically would, at the same time, if that correlation holds. And as he describes the Baupost mode of operation, in some sense it reminded me of what we do on our wealth management team. He says he worries from the top down, and invests from the bottom up, and that is exactly the structure we have with sort of a macro-economic overlay with Doug Noland.

Kevin: Doug and you, and then Lila from the bottom up.

David: Exactly. So marrying macro-economic insights to micro company-specific analysis, you get to find the needle-in-the-haystack opportunity, and still maintain that healthy risk awareness. So one of the observations that Klarman was making was, not my opinion, not particularly rocket science, but 12-17 trillion dollars in negative nominal yields in the bond market – that’s got to be a credit bubble. And I agree.

Kevin: Right. You brought up debt earlier. The deflation that we’re experiencing isn’t just technology driving prices down.

David: Right. So there is not an everything bubble but there definitely is a credit bubble. And here is where I would back up and say, “Yes, Seth, but if you have a credit bubble, don’t you end up having a nearly everything bubble?” So what is cheap? If you are a value investor and looking for something that is undervalued, how many things are undervalued? And then maybe we go back to Rosenberg’s comments. Maybe volatility is undervalued. Maybe there are things that are cheap, but you’re not thinking about them from an operating perspective, a business that you could own and it’s priced well. It’s just a speculation that is overlooked and ignored. So maybe in that sense there is not an everything bubble.

But Jim Grant asked him about all the money that is supposed to be on the sidelines ready to come into the markets and off of the private equity sidelines, money that has just been piling up in cash and is going to go into mergers and acquisitions.

Kevin: Okay, but the last three to four weeks we have been talking about a lack of liquidity, the repo markets having to flood billions into the market. Now we have QE again, 60 billion dollars a month. So where is all this money that is piling up on the sidelines?

David: It is investor liquidity looking for an opportunity, and his point was, so you count 2 trillion dollars which may be on the sidelines. Do you understand the nature of liquidity? It’s there one minute, and it’s gone the next. Just because it is on the sidelines does not mean that it has to necessarily go into the markets. It can just as easily scatter to the winds. So don’t count on dry powder in that sense. Investors can make it disappear instantly under stressful circumstances. So he had a great observation on the TIPS market, Treasury Inflation Protected Securities. This is something that you might expect from a hedge fund guy. Why would you ever buy something where you know who is on the other side of the trade, and they are not trustworthy?

Kevin: And so the Treasury not only tells you what inflation is, and what they are going to pay you on those TIPS, but they are guys who benefit by lower inflation.

David: (laughs) Yes, so who is on the other side of the trade? A, they are not trustworthy, B, they get to count the inflation stats, so why would you ever do that?

Kevin: It’s like retirement, with Social Security. The government is basically telling you, “No inflation this year.” And maybe that plays out, but cost of living continued to go up.

David: Skinny cost of living adjustment. So what Seth Klarman was suggesting is kind of the opposite of Rosenberg. So again, I liked the back and forth between the presenters. Don’t be surprised by a sudden up-tick in inflation, and a break in the credit markets, where rates that here recently might have been 1% or 2% – that’s what they are presently – can overnight be at 4%. And again, these are things that you might expect from a macro-oriented hedge fund manager.

Just the last point, one of the things he pointed out, too, is that managing money, today it is becoming very in-vogue to use quantitative analysis, and so big data factors in. And he said, still, the success in investing ties to big judgment, not big data.

Kevin: In other words, you still need the human. You mentioned something a little bit earlier, and I think it would be worth explaining. There is a massive amount of money going into something called private equity, and they are actually bundling up private equity a little bit like bad mortgages back in the mid 2000s. Explain private equity and what is going on.

David: Yes, we look at the public markets, which are stocks and bonds that you can buy with the click of a mouse, at your broker, online, whatever. And so there is buying and selling in the public markets all day long using CUSIPS and ticker symbols. The private markets are where you have smaller businesses. These would be markets that fit the micro-cap or small-cap categories, under 400 million, under 180 million. So in that sense, smaller business is relative to a company that may be worth billions or tens of billions of dollars.

Kevin: You gave an example to me a little bit like the dental field. At this point you have dentist offices being purchased up all around America.

David: Yes.

Kevin: And being turned into more of a franchise than a particular home run business.

David: Exactly. So these moms and pops are being all rolled up, and that is a theme of private equity, to just basically aggregate an entire industry. And they are taking investor dollars and basically saying, “Look, we’re bankers. We can do a better job than a business operator because we’re sophisticated and we have an MBA and we know how to engineer things. What they are really saying is that they are good at engineering leverage, and they are good at taking an asset that has a return and adding leverage to it, and then trying to extract extra value for themselves from that.

So Dan Rasmussen talked about private equity, and to sum it up, he laid out a compelling case that institutional investors are moving en masse to private equity at the worst possible time, and based on a set of assumptions about returns and inherent risks that are just wrong. They’re wrong. So a study by Cambridge Associates shows PE, that is private equity, outperforming the markets by 6% a year. And everybody is like, “Well, sign me up, that’s what I want.” Swenson at Yale – this is why he is such a proponent for having endowment assets and something that is a little less liquid, but a lot greater returns.

Kevin: So they outperformed by 6%, but what was the time period that they were looking at?

David: That was from 1980 to 2006.

Kevin: So that was past tense.

David: The same Cambridge Associates study shows that post 2006 that category, private equities, has been primarily a loser, almost consistently every year. That is, in part, because you have 50 times more private equity firms – literally, 50 times more private equity firms today trying to do deals than there were 15 years ago. The hedge fund industry has suffered from the same kind of dilutive effect, because you go back to the 1980s and you had roughly 500 hedge funds. Today you have just shy of 10,000. Call it 8500 roughly. So again, it is a lot more people trying to chase something unique and different in the marketplace. And returns suffer.

So, also, this is, I think, a significant point, that bankers do believe that they can run businesses better than business operators. I would put that as one of the primary fallacies within the private equity area. Just because you know how to count beans doesn’t mean you know how to make a product, or run logistics, or do R&D, or even organize people, and get those people to do what they do best.

Kevin: One of the things that bankers also do is, once they have a business they know how to leverage it because they can, at that point, go multiples of what the business is actually worth.

David: And that is where they really are talented. Bankers do apply leverage to balance sheets to increase internal rates of return, and Dan Rasmussen’s conclusion, critically, was that these are very highly leveraged. At this point private equity is highly leveraged, very expensive, the credit quality has slipped, it is at the lowest rung, it is very illiquid, and you are dealing with opaque investments that are popular, due primarily to that legacy performance, 1980-2006, and now you have institutional investors that are ignoring the risks, and will continue to do so because the pricing of the assets in the models used don’t have to be marked to market.

Kevin: Do you remember ten years ago we started hearing that? Market price was something that we all just assumed until about ten years ago, but then we started hearing mark-to-model.

David: Let’s say I run a portfolio and I want 10%, or 20%, of the portfolio in private equity. This becomes a 10-20% black hole, where, essentially, I’m not going to get any market pricing for it, so I’m going to have to come up, for the sake of my statement.

Kevin: We’ll just call it this price.

David: We’re going to call it our cost, or we’re going to call it – yes, let’s assume that it is appreciated by 7% a year. There are going to be assumptions in the modeling of the valuation, but there is no market price for privately traded companies on a monthly basis, weekly basis, real-time basis. And so there is a lot of room for – (laughs) positive thinking?

Kevin: And the problem with that, too, is how liquid is that asset?

David: Not very. And so you have with a lot of these structures, the holding periods for the companies that they are buying, restructuring, trying to roll out and resell or even take public again to extract more value, the holding periods are now longer than ever, you have bad investments that are not being acknowledged, in many cases the bad investments get restructured into a new product offering.

Kevin: Boy, does that sound familiar. Yes, you restructure. This is one thing bankers can do, too. It’s like, “Oh, there are some bad investments here.”

David: Let’s move that from portfolio A to portfolio B. Report on portfolio A, which shows impeccable performance. So as I listened to Dan, I had every one of my concerns about private equity confirmed. And he could have been talking about Enron, frankly, because here you have private equity which is a Wall Street favorite today, and you go back to that period where Enron was a Wall Street favorite and it was the master at presenting phony happiness, and that is what Dan describes as this endemic feeling. Everybody wants private equity because it presents this sort of phony happiness. Your returns are above the market, at least as we mark to model, not mark to market.

But when he is talking to pensions, when he is talking to endowments, family offices, and a host of other institutional investors, they will universally tell him that their private equity managers are in the top quartile. So everybody believes they have the top quartile performers, so there are some people this applies to, yes, they are doing some crazy stuff, and it is way overleveraged and it is really low-quality credit. But not ours. We’re dealing with the top quartile managers. 100% of people believe they are working with the top 25%. How does that work exactly?

Kevin: Yes, 70% of the time it works every time.

David: Yes, but they also believe, in addition to the top quartile, that they don’t have liquidity issues because these are very sellable companies and there are no credit concerns within these structures. So everybody believes they are picking a winner. And this is how he did this mass survey. 94% of the institutional investors that he surveyed believed that they would outperform equities, that their private equity holdings would outperform equities. 94% believed that. 76% believed that the credits they were investing in were double B or better.

So Mr. Rasmussen takes that whole portfolio and has it looked at by Moody’s. Moody’s reviews the same private equity credits, and, remember, the institutional investor said 76% believe we’re BB or above. Moody’s says 98% of the paper you just put in front of us is BB or below. So we’re dealing with junk credit, and you don’t know how to read your credit risk, is what they are saying to the institutional investors. So underestimation of risk – is that a recipe for success, or is that a recipe for disaster?

Kevin: Then you had mentioned that right now everything is correlated. If that is really true, everything that is rising right now will fall at the same time. People don’t buy when things are falling. Where is the liquidity?

David: Yes, so back to Klarman’s observation about correlation. The greatest correlated belief for the last 25 years is that private equity is the best place to be. Again, you have Swenson at Yale, that endowment, and he has made the case that it is a better form of capitalism. And that might have been the case of the early adopters. Again, go back to 1980. If that is when you got started, [unclear] the 1990s, great. But what about now?

Kevin: Yes, remember, it was either last week or the week before we were talking about your past brokerage experience where when Wall Street wants to sell something, they are going to make it sound like it’s the greatest thing.

David: Right. So you have a sizzling Wall Street sales pitch, and I think that is largely why institutional investors, endowments and pensions are moving toward private equity. Let me ask you a question. Would Wall Street promote a loser if the fees were well above average? Let’s say, for instance, you are all in, fees were 6% a year – per year.

Kevin: No, they wouldn’t do that. No, they’re always looking out for the client.

David: Would you be interested in promoting a loser if it paid you 6% a year? Now, it’s 3% if you’re not including carried interest, so between 3% and 6% depending on how you calculate carried interest. You tell me. So here is where you have disaster embedded in the private equity markets. It is tied to a consensus view which is the best place to be, leverage, which continues to ratchet higher with basically small-cap companies, and illiquidity. You have a structure which doesn’t allow for people to get out.

And at the end of the day, what do you do if you need to liquidate an asset within your private equity holdings? Who buys it? Premiums or discounts? Because the exit strategy for most private equity guys is to take it, repackage it back to the public markets and sell it to the public market sucker at a premium, based on numbers they won’t understand, dependent entirely on the boost from leverage, not realizing that it is not sustainable, and actually, you are going to end up having to pay for that debt accumulation, and may actually sacrifice the business, itself.

Kevin: Every once in a while you’ll see something and you’ll think, “You know, that should be a bumper sticker. I need to remember this for the rest of my life.” And actually, you just said it, Dave. There are three things that a person needs to write down. If they are driving, memorize this. But when you have consensus, leverage and illiquidity, the very next thing that comes at some point is the crash.

David: Oops.

Kevin: Yes.

David: Well, only two more, I promise. I can’t possibly go through all nine. But Chiappinelli was from GMO – that is Jeremy Grantham’s group – and it was fantastic. His whole presentation was on bond indexes. That may not sound like a very interesting lead-in, but it was arguably the most important presentation, because first, his target for critique was the Barclay’s Aggregate Bond Index. There are a number of other indices for bonds, but this is one of the big ones. And what is the importance here? In an age of passive investing, this gives you, I think, a very clear picture of how malinvestment and continuations of that theme of malinvestment, is on auto-pilot because of the structure of the indexes and the way these things work.

Kevin: And we’ve talked about this. Passive investing is part of this consensus that we talked about before. Consensus, leverage and illiquidity. When you have passive investing where everyone is going just into indexes because everybody else is going into indexes, you don’t realize there is the other side of the market that never appears until the repricing.

David: At least with this you have two of the three. Consensus which is definitely you want to be in indexes because it is a cheaper way to invest, and the third of those three, illiquidity, as I think people will find, the fixed income markets are not quite as liquid on the way out as they seem to be on the way in. So in this context, the Barclay’s Aggregate Index, there are no judgment calls or analysis. Once an asset is listed in the index, the buying of that asset is automatic, and frankly, if we ever see selling, selling is automatic, too.

So you see sort of a radical volume increase driving prices higher, and arguably you could see the flip side of that, as well. The quantities of money coming into these funds are astounding – tens of billions of dollars, some of these indexes even hundreds of billions of dollars. So Peter points to certain assets that keep on seeing flows, for instance, Swiss bonds. You think to yourself, “If a Swiss bond is yielding negative 1%, or negative 95 basis points, nearly 1%, why would you buy it? Oh, did you know that it was in a bond index? And because it is in the bond index, as capital flows into the passive side of the investment universe, which is now the largest growing side of the investment universe, it is an automatic purchase.

Kevin: I was just asked the other day, “Why would I ever buy a negative paying interest rate bond?” Part of the bet is basically saying that the only reason you would own a Swiss bond that is negative rate is to speculate that the interest rate is going to go lower.

David: And there is a fascinating article on that last week in the Financial Times where it talks about bonds trading like stocks, and stocks trading like bonds. You know you are in a mixed up world when people are buying bonds for capital gains and stocks for income. And that is exactly where we live today.

Kevin: And a stock, however, represents a company. A bond represents debt. How good is this debt that is in these funds?

David: This is where, as a student of history, the markets seem irrational for making these purchases of bonds, but the point is that rationality is not in the equation. And this is not new on our commentary to talk about the quantities of debt. The quantities of debt outstanding are pretty high. But the other observation would be about the quality, which is rapidly deteriorating. And this was a point that Peter Chiappinelli from GMO made. Ten years ago one-third of the sector was triple B.

Kevin: Which is junk, right?

David: No, triple B is the last rung of investment-grade. So you’re barely hanging on.

Kevin: Not quite junk.

David: That’s right. So you are investment grade. So triple B credit is not that great, but it is not terrible either. You don’t have to hold your nose. Really, a third of the sector was triple B, that’s the lowest investment grade rating, that was ten years ago. Today triple B is half of the market. So you have an increasing amount clustered on that lower rung. So greater quantities of barely investment-grade paper, and today, because of the compression in interest rates, it is paying the least in interest – ever.

Kevin: I have to ask you. Howard Onstatt said the cycle prevails. What is the cycle as far as credit defaults?

David: This is now the riskiest equation you could possibly have for triple B credit, and Chiappinelli is pointing out that we have had credit events roughly every 4-7 years where you have a deterioration in that lower quality and it gets kicked into the junk category. So mass deterioration moves debt from one category, triple B, to a lower rung, and now you are categorically, again, just one grade lower and that is the difference between investment grade and junk. Many institutions don’t allow junk bonds or high-yield bonds, as they are euphemistically called, into their portfolios.

It is kind of a big deal. But capital keeps on flowing into the space. So what are you getting for the money that you are investing? You are getting a smaller and smaller income stream, you are taking higher and higher risk. Oh, and by the way, duration is being stretched out farther and farther and farther for the same paper. So you are taking myriad risks and not getting any reward for it. Again, back to that issue we were talking about earlier of return-free risk. So quantity is one thing, quality is another. On top of those, Peter looks at the corporate sector debts and he says, “Look, just for a minute set aside quantity because that is only one aspect and you can always be surprised on the upside by how much debt gets added to the balance sheet. Compare it to earnings ratios. Look at debt to EBITDA – Earnings Before Interest, Tax, Depreciation and Amortization. And this number, this ratio, shrinks in an economic recovery.

Kevin: Sure. You borrow less if you are recovering.

David: Well, and as your earnings grow relative to your debt, that ratio ends up looking better. And of course, the number expands in a recession where your earnings are shrinking, but the debt does not go away. In fact, sometimes you have to take on more debt just to survive. His point was this – the ratio of debt to EBITDA is spiking, and we’re not in a recession. Debt growth is exceeding earnings growth significantly.

Kevin: I thought we had been expanding – 123 months.

David: That’s the issue. The longest U.S. financial market expansion, and we are already seeing where there are areas, particularly lower rung of investment grade, where the market is turning. So one of the things that GMO is sort of on the map for – Jeremy Grantham started taking risk off the table in 1999 and in 2000 he lost half of his assets under management. His clients fired him because he reduced risk in the portfolio. And they came back later on.

Kevin: He didn’t like what he saw before the bubble popped.

David: No, and so to do the right thing when you are allocating assets does come with professional risk, and there are very few people on Wall Street who will do the right thing because they fear professional extinction risk.

Kevin: It’s lonely to be right because you talked about – remember the three things – consensus was one of those. If you are not with the consensus, then you’re lonely.

David: When I’m training for triathlon one of the things I remind myself is I either pay now, or I pay later. I tell the kids this all the time – you either pay now or pay later. Are you working hard now, or are you working hard later? You either take the risk on the front end of being wrong on your timing, or you face a far graver risk, which is your enterprise may be gone in the context of a major market sell-off.

Kevin: And Grantham basically paid early and saved all the loss later.

David: And that is what his spokesman was there to say is, “We’ll pay now. We’re taking risk off the table, and you look at the credit markets, and you should be taking risk out of your bond portfolios. You have no idea how it is stacking up, and it is on an automatic basis. You don’t want to do this.”

Kevin: But we’re talking about people’s retirement. We’re talking 401Ks, pensions, what have you.

David: That’s the key because the index buys massive quantities of bonds. Those purchases are not scrutinized by a credit committee. They’re not looked at for credit risk, duration risk, inflation risk. The capital flows into things. Think about this. Does any of the listening audience have a targeted date fund in your 401K? I want to retire in 2035, so I want some mix of stocks and bonds at the 2035 fund. You own the Barclay’s Aggregated Index. You own negative-yielding Swiss bonds. You’re the sucker. You’re the sucker, and you have no idea.

Kevin: This goes back to passive investing. This whole passive investing thing has just basically put a bunch of junk in people’s portfolios, calling it good.

David: Right. So, indiscriminate buying today is indiscriminate selling tomorrow, and everybody feels like they’re doing such a great job managing that risk by saying, “Look, I’m not paying any fees. My feels are so low on these index funds.” Right. So you’re going to save yourself half a point to a point management fee and you are willing to risk 20, 30, 40% of the value of your assets? In an old book – I forget what it is called but I think that is penny wise and pound foolish?

So we have discussed countless times on the commentary sort of the indiscriminate buying today and the potential for that being indiscriminate selling tomorrow. In fixed income this is the issue. There is no market-maker of last resort.

Kevin: But Bill Dudley was right there, and the Federal Reserve has been looked at as the final buyer of everything. If there is a problem, they are the buyer of everything. How do we know that the Fed doesn’t have our back?

David: I’m just going to comment on Dudley and then we wrap up the day, because Dudley, in a part of his debate with Jim Grant, said emphatically, there are things the Fed cannot legally do. We cannot buy stocks, we cannot buy bonds – this is corporate bonds – and so keeping Chiappinelli’s comments fresh, you have to say the Fed won’t buy corporate bonds – until they have to, until the next crisis, until they ask for permission. And then the rules will change and what was illegal in the last crisis will be front and center, because they will have to.

For those of you who don’t know Bill Dudley, he was the tenth president and CEO of the Federal Reserve Bank of New York, like Mario Draghi. Goodbye Mario. 48 hours from now you will be retired from the European Central Bank. We wish you well. Like Mario, Bill Dudley spent a good stent at Goldman-Sachs prior to his role as permanent member of the FOMC and the presidential role, the CEO there.

Kevin: A little more recently, Bill Dudley is the guy who said, “Why wouldn’t the Fed possibly consider getting Trump out of office? I know I am condensing that, but if you remember, about a month ago, he was like, “You know, if Trump is not good for the economy, the Fed could certainly do something about it.”

David: Isn’t that funny? Jim Grant’s intro, he included the reference to Bill Dudley’s Berkeley Ph.D. in Economics and he had this sort of hilarious reference to the Irish philosopher, George Berkeley’s, immaterialism. He said, “Yes, Bill is actually here.” I have to admit I was the only one in the audience that laughed out loud. But Jim’s side of the argument was this. The post-crisis monetary policy is a failure. The Fed has not done a good job.

Kevin: (laughs) So he is basically insulting Bill Dudley because Bill Dudley was there for the whole thing.

David: Yes, and so Bill Dudley says, “No, it was an evident success. We have the stock market at all-time highs, bonds are quite stable, everybody is happy.” Jims argues, “For the price mechanism, and the importance of interest rates as a basis of valuation in all assets.” Bill Dudley says, “Look, I was the manager of SOMA [System Open Market Account] during the crisis and rates are a tool. You may consider them to be a signal but we consider them to be a tool for managing the economy.” A very different perspective, right?

Kevin: Huge. That’s night and day. One of our guests called them salt water versus fresh water. Salt water is the guy who says, “No, no, no. This is my tool, I will manage it, you don’t need to be here.” Fresh water would say, “No, no, no. We like free markets. We want the signal.”

David: “I think that was supposed to be interest in my pocket, not a discount to the debt burden you are trying to subsidize.” A difference in perspective. So Bill Dudley admitted the Fed took some liberties when it interpreted the price stability mandate and then adopting that arbitrary 2% inflation target. And I appreciate the fact that he recognized that there was wiggle room on the interpretation. And I would still say it’s a damnable activity, it should not be done, there should not be an inflation target. It runs directly in conflict with and contrary to one of two mandates the Fed has – moving us toward fuller employment, and maintaining price stability. And by the way, price stability is not asset price stability, which is what they have taken on as a third unofficial mandate.

Kevin: Controlling the market,

David: Right. So we can somehow now define price stability and currency stability as, “We’re only picking your pocket 2% a year, but it might be 4% if necessary.”

Kevin: But the reason you read Jim Grant, and the reason you go, is because Jim Grant still favors a free market – market pricing – he had to be. How was he, if he was debating Dudley and Dudley is like, “Everything we’re doing is just fine.”

David: Not only is everything we’re doing just fine, but even to that 2% inflation target, his argument had sort of marinated in this “greater good” fantasy, where it’s like, “Oh, no, no, no. You don’t understand what we’re doing for you, but it is for you.” It’s just the tone was fascinating, and I think what seemed to set Jim Grant off – I truly believe his temperature went up past 98.6 and never came back – was a comment on the adverse impact of negative rates. Dudley said, “Oh, it’s a terrible thing. I really don’t like it, such a tax on banks. We just can’t stand it.” And it was the clearest reminder that a central bank serves banks, and banks serve banks. The saver is, in this equation, the useful idiot putting capital into the system for the intermediation process.

Kevin: They pay the system to do its own thing.

David: But over the last 100 years the transformation or deformation of capital has included the depositor in the bank being disregarded as the most important person in the equation. Why are we here, if you are running a restaurant? To entertain ourselves, or to serve the customer? When you get onto a plane, are you there to see and test the physics of flying at high altitude in an aluminum projectile? Or are you a customer? Are they there to serve you? Bankers serve the individual, but this is, I think, what is lost. The saver has become the useful idiot. What about the tax on savers?

When I look at negative interest rates, I see it impacting the individual. Bill didn’t see it. It was a tax on banks. Negative rates are bad for banks. And listen, pragmatically, I can agree with that. The impact of negative rates, and a flat yield curve for that entire sector – they can’t maintain profitability. You can look at the bank index in Europe and it’s a disaster. So yes, negative interest rates do, clearly, have a negative impact on banks. But the central banker is not asking questions about what is wrong with the equation as it applies to humanity or the individual, it is the banks.

Kevin: This goes back to the philosophy with teeth. Economics is still philosophy. It is liberty or control.

David: That’s where Jim was clear. These are individuals. These are heartbeats. This is a world where money equals work, equals time, equals those heartbeats. So this is where that clear distinction was, Bill Dudley on the one hand and Jim Grant on the other, interest rates are the most important price in the financial system. That is a position statement and a philosophical statement from someone like Jim Grant.

Kevin: And that truly is an expression of philosophy. Like you said, we only all have a certain amount of heartbeats. That is scarce. Money printed by the Federal Reserve is not.

David: Jim, consistent with my own perspective, sees that individuals are valued – individuals are valued. And we can look at our lives as a measurement of time. We can look at our savings as a reflection of the time and work. What we do has a value. Again, this is back to perspective. I’m sure that Bill Dudley is not trying to do wrong, he is trying to do right. We’ll just call him Dudley Do-Right.

Kevin: (laughs)

David: So the system of price controls is not offensive to him. He is looking at the impact that it has on a treasury bill, much more than he is on what it says about the associated value of time, and of work, and of savings. So stable money, market-driven rates – these are things that reflect real-time value of work, that is either stored labor in the form of savings, or labor expended in the present moment. So we have two different worlds, preserving, on the one hand, and seeing this value as needing to be protected. That is inherent monetary or fiscal conservatism versus degrading. And degrading is the practical difference between these two men, where for pragmatic reasons it may make sense to tinker with the numbers.

Kevin: But when they tinker with the numbers, what we are talking about is adjusting the dials of how much savings you are going to lose to the banking system that they are trying to stabilize.

David: Right. So the academic is applying a philosophy of maximal control on the one hand. This is why I go to New York, is to see very clearly how people are coming at things. I want to extend as much of an understanding to Bill Dudley as possible, and recognize that he may be lost in his own matrix of ideas and worldview and textbook knowledge, and unable to see the world in any other way except on the basis of the assumptions that he has. But the academic is applying a philosophy of maximal control. The market practitioner, Jim Grant, is applying a philosophy of maximal freedom.

And there is the reason I like to spend time with Grant.

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