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• Deficit Spending Party! A trillion here, a trillion there…
• Does Passive Investing make you dumber?
• No Bubble Here: Inflows into equity funds hit historic high

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

There are two things that define inflation – the actual inflation number, and people’s expectation of where inflation is, and where it’s going. What we’ve been trained to react to is certain stimuli, and so we have statistics that are thrown at us and we respond to those and say, “It’s well in hand, it’s well-anchored.” That’s the fabulous phrase – “It’s well-anchored – inflation is well-anchored.”

– David McAlvany

Kevin: We talked about navigation last week, and we were just talking to a pilot who was affirming for us that the use of GPS can sort of make you stupid over time. Part of that stupidity comes from no longer being able to critically think and understand the whole system.

David: My second-born son is just learning to navigate with a compass, and so it is opening up a whole new world to him to see that with a map and compass he can figure out where he is, where he is going, and avoid getting lost, literally, in the weeds.

Kevin: You have been bringing up passive investing, Dave. We liken navigation, going from place to place, similar to a lot of other things in life. I would include investing in that. We have gone through at least an eight-year period, not maybe fully ten because we had the crisis back ten years ago – the financial crisis – but we have gone through an eight-year period where we have sort of been running, or navigating, for free because the Federal Reserve and the central banks have created quantitative easing, lowered interest rates, really, pretty much fueled this market. But the question that I had for you last night when we were talking was, are we training a generation of idiots who really don’t know how to invest in markets because they have never seen the value of anything?

David: It’s as if the important and valuable lessons learned from the 1960s about race discrimination have been cross-applied, and how we think we should not discriminate at all – ever. And the reality is, when you get to the financial markets you must discriminate between good/bad and better/worse, and you must discriminate between value propositions. What is objectively at risk, and what is of low risk, because of value compression. Again, it is as if we have a generation that says, on a blanket basis that we should somehow stop the discretionary, intuitional, analytical work of figuring out what the best way forward looks like.

Kevin: A GPS will get you to your destination. We make jokes about it, but actually, it’s quite remarkable. Look at the system of becoming a British cabbie. You and I were talking about that last night. It’s a three-year learning process. They say it’s probably one of the most difficult tests in the world, in all of history. They have to memorize 25,000 streets and be able to verbally tell you how to get anywhere in one of the most confusing street layouts in the world.

David: It’s not laid out on a grid, and so when you get your green badge you are able to basically say, “I’ve mastered the city. I know it inside and out.” Granted, you don’t have to have that if you’re an Uber driver, and that is the conflict. You have a technology which is now challenging the old ways of learning, and a lot of people would say, “But isn’t it just easier to use your GPS to cut costs and not use one of those cute little black cabbies, and just go in any vehicle? Anything will get you from point A to point B.” That really is the idea of passive investing today. Why do we need the old ways? Why do we need to discern value between asset classes or understand and appreciate the difference in timeframe and the proposition that is in front of us?

Kevin: Why would we care? We’re in the 103^rd month of the stock market recovery.

David: (laughs) That’s right.

Kevin: You don’t really have to be discriminating. It’s all going up.

David: It’s one of the longest in history. Last year we were joined by other global markets, remained supported, obviously, by central bank interventions, and that may, in fact, be reversing with quantitative tightening, as they call it – so going from an era of QE, which defined the last 103 months, to a period of QT, which is likely to define the next 24, 36, 48 months. If the economy can stretch another 18 months it will be the longest period of growth without a recession going back to the 1850s. Granted, the growth has been very slow. It has been slow and low, and almost nonexistent, in real terms, since 2009, but it has not been punctuated with panic. There has been no recession in the interim period. So 2017 was memorable, of course, for its lack of volatility.

Kevin: Do you think that has to do somewhat with the high-frequency trading and the algorithmic trading? You have robots right now buying from robots, buying from robots. That is 70% of the market.

David: It makes you wonder, if 70% of volume on the New York Stock Exchange is being managed by algorithms and black box computer trading, are we moving into an era of artificial intelligence and of deep learning, where all of a sudden pricing in the markets is not according to, again, the old ways of buyers and sellers determining, according to the knowledge that they have access to, what the value is of a particular asset in the present with anticipation of the future? Because again, if artificial intelligence and deep learning somehow are able to cut off the value of the human mind, it implies that we can know more and faster.

My son asked me the other day, “Dad, what if we invented a machine that allowed us to see the future and to know the future?” I said, “It’s interesting, we’re experimenting on that with something called big data today.” There was a movie made a few years ago where the actor Tom Cruise is anticipating action on behalf of a particular agent, and if someone is thinking about being violent, that is done through probability metrics and you can determine whether or not that person might have, or in all probability would have, committed a murder, and you go ahead and on a pre-crime basis, lock that person up.

That is essentially what we are moving toward in the markets. We think we know that we know everything. It takes us back to an old Mark Twain quote: “It’s not the things that you don’t know that get you into trouble, it’s the things that you know for certain that just ain’t so.” (laughs)

Kevin: That was 100 and some odd years ago that he said that. You’re talking about artificial intelligence – Watson, which is the pride of IBM. I remember watching the human Jeopardy champion of all time being beaten by a computer – Watson. If you have ever watched Jeopardy, the questions that are asked aren’t necessarily typical questions that you would think a computer could answer. But one of the things we know is that computers – and they’re trading with each other right now – don’t critically think. All they do is find correlation.

It’s a little like when I order a book on Amazon and I see the other suggestions there. Well, why did they suggest those books? They have correlated that particular subject matter with my buying patterns. The thing is, they don’t really know me. That correlation came come up and haunt you, and when you’re talking about this kind of overwhelming artificial intelligence that is starting to take over the markets, one of the things that they have found with AI is that the thinking is different than human thinking, to the point where the creators of the AI, after they have run for a while, have stopped recognizing the reasons the AI is making the decisions that it is making. Now, the decisions may be more efficient in the long run, but they are no longer human.

David: So, it might be considered good enough, because again, if you’re talking about correlation, if you’re talking about high probabilities, there is a difference between high probability and certainty. But again, you may have the pragmatic social response to that of, “Look, if we’re in the 90^th percentile of probabilities, isn’t that good enough? How about 99%?” And yet, you’re right, I am not a known factor, you are not a known factor. There are things that are known about us, but we are not known completely. And so, to be judged, and for the markets to operate as if they do know everything, actually presumes a little too much. Again, it goes back to the things that you think you know for certain that just ain’t so – that’s where you get into trouble.

Kevin: That takes us to, we’ve just had our State of the Union address by President Trump, and we do see economic growth picking up the pace. The last three quarters the economic growth is picking up the pace, the markets have possibly discounted that by growing the last few years, but what do you think about the infrastructure plan and the deficit spending that is proposed?

David: I think, first of all, the economic growth that we are seeing has only picked up here recently in the last three quarters, and this last quarter was restated from 3.2 to 2.6, but still, overall, a positive number and a positive trend. Now, again, there has not been a lot of economic growth, even as financial markets were driven higher over the entire 103-month period, again, on the promise of economic growth being delivered. So the markets – I’m talking about the financial markets, stocks in particular – have been significantly out in front of the meaningful economic improvement. That leaves us to consider whether a period might exist for digesting the capital market appreciation while the economy continues to grow in a catch-up mode.

Kevin: So we do have a historic precedent for that where we had economic growth after the stock market had risen. And actually, the stock market, if I remember right, back in the 1960s or early 1970s, had one of the worst periods it has had in history during a period of time where we had high GDP growth.

David: Yes, so I guess if I were to anticipate the last couple of years of the Trump administration, it would be continued economic growth, but fading growth in the financial markets. We mention 1966 to 1981 as a period where stocks and bonds moved out of sync with economic growth where you had 9.6% average GDP expansion every year from 1966 to 1981, while at the same time the stock and bond markets were simultaneously crucified by stagnant price changes in the stock market, in particular, and gradually, suffocating increases in the inflation rate.

And of course, as inflation began to rise, and as rates were rising, as well, the bond market suffered, too, through one of the worst bear markets in U.S. history. So the period contained some of the most severe losses for investors in real terms, again, factoring in the inflation scourge, in history. And yet, we had GDP growth of 9.6% per year during that period. The point I want you to remember is that financial assets do not necessarily move at the same time as the economy.

Kevin: I remember the 1970s because those were my high school years, and I remember the incredibly high inflation. You had to have 9.65 average GDP growth because you had inflation running in the double digits. So every dollar that you made, granted, you had almost a 10% gain in GDP, but we had 12%, 13%, 14% inflation. We had interest rates that were nearing 20%. You could literally lock a CD on, Dave, during that period of time, for 19%. That was incredible.

David: Again, going back to the State of the Union, obviously, there is a lot to be excited about. But if you’re expecting causality between economic growth and stock price increases, there you may be disappointed. We have had 8½ years of anticipation and PR hype about the coming economic improvement, and assets, with the help of record easy money and credit, have already risen. They have already gone to where you would expect if we were moving into the economic recovery zone. Now that we have economic improvement, to some degree the financial markets will have to get jazzed on the basis of something else, because again, the ordinary role of the markets is to discount the future.

Kevin: Sure, you buy the rumor, you sell the news. That is a phrase that works in the markets.

David: Yes. I don’t see the current flurry of activity in the stock funds, year-to-date it has been nothing but impressive, but I think it is a lot like guests arriving at the party after last call, and long after your hors d’oeuvres have been polished off. This is way beyond showing up to the party fashionably late (laughs). You’re too late.

Kevin: But have you ever been to a party where everybody is drunk and it is after the last call?

David: Yes, January 1^st, 2018. We’ve had 17 sessions in the stock market, ending last week with the Dow up 1897 points in those 17 sessions.

Kevin: That’s quite a punchbowl, Dave.

David: (laughs) That’s one for the history books. You’ve got the NASDAQ-100 and the biotechs up 9.8% and 16.7% respectively. And my humble opinion? You should close out your year now with reasonable annual returns in the first month.

Kevin: You’ve talked about the hockey stick look of rate of change. Rate of change is such an important thing to look at when you are looking at the markets. Do I buy when it has already gone hockey stick up, or do I wait?

David: We already have annualized rates. We said that from the time that Trump took office we had the S&P 500 move close to 50%, so in a year’s time, and as our discussions have developed over the idea of a rate of change, you have an annualized gain – annualized, which is to extrapolate from this month’s gain into the future. Continued at this pace you are moving at over 100%, 150%, for the full year 2018. This week prices started to soften up a bit earlier in the week in anticipation of the Fed meeting. We’re saying goodbye to Janet Yellen, the possibility of rises in rates. Maybe the market does need to take a breather from time to time, and this might be it.

Kevin: Let me ask you a question. Pendulums sometimes swing too far to one side, and Obama – I hate to say it – was so bad for business and the American outlook. Do you think the pendulum is swinging the other direction, and maybe a little bit too hard?

David: To clarify that, for those who love Obama, and we have lots of listeners who do (just kidding), the reality is his tendency to regulate was bad for business. So, objectively, you could say the individuals who were running corporate America had to say, “If I’m investing dollars today, what are the odds of success when anything that represents a win may be regulated against, mitigated against, or taxed away?” So there was a real hesitation in terms of capital expenditure and capital investments. The tone has changed from the Obama administration that was a negative impact on business. You had capital investment and corporate executives which were very cautious, and now we are moving to a de-regulatory environment of business optimism under President Trump.

Kevin: Corporate tax rates – how much of an effect do you think they are going to have?

David: For the largest companies, they have already mastered tax arbitrage and have effective tax rates which are well below the 21% on offer. So for the multinationals, I don’t know that it affects them very much except that it may incentivize them to bring some of their business back here. There was this idea of taking your corporate headquarters in Sheboygan, Michigan and relocating to Donegal, Ireland, buying a company there and relocating the headquarters so that your tax domicile was in a new place, and thus the nexus lowered your effective tax rate. I think some of the lowering of taxes will keep that geographic arbitrage from happening in the future, and you do have some incentive to bring back the capital which has been kept as retained earnings overseas by those companies.

Kevin: Going from 35% down to 21% – that’s a relevant thing, though.

David: It is, but it was likely priced into the market a long time ago – not to the specific numbers, but in anticipation of Trump. I think that anyone who knew that Trump was the president, November going forward, could say, “Look, he’s going to change tax policy and he’s going to de-regulate.” Regardless of what de-regulations occurred, and the specific numbers, it was a pretty decent bet that he was going to slash and burn in both areas. And lo and behold, now we have the actual numbers. But again, I think a lot of this was already priced into the market. That is what constitutes your 7,000-8,000 point move since his election.

Kevin: Right, because the market valuations, the metrics that you look at, are already at all-time highs.

David: Right. We have covered in depth that the valuation metrics in the market are at, or near, all-time highs. We have discussed how those conditions of over-valuation – what do they set the stage for? They set the stage for a long period of under-performance in the stock market.

Kevin: That would be Andrew Smithers.

David: Exactly.

Kevin: Smithers would say you are going to have under-performance or negative returns now for the next decade.

David: I listened to an intriguing interview with Shiller from Yale earlier this week, and he said the same thing. “Look, we kind of know how the math works.”

Kevin: This is of the Shiller PE, for those listeners who aren’t familiar.

David: Right. If you get to valuations like this you’re looking at 10-12 years of negative returns. That is certainly not on the mind of the average investor coming into the market today. But we have talked about the nature of momentum and that really is what is in motion today, carrying prices farther than you think possible. And then, ultimately, when momentum turns, for no apparent reason, to the downside, in a nanosecond you can give up those gains in about half the time it took to accrue them. So, if you look and say, “Oh, we’ve had a 103 months, you can give up a good percentage of that in more like 50 months.”

Kevin: And that can change the mood of the people. Now, this may not be the end of the bitcoin rage, but I can tell you, the last couple of weeks since bitcoin has gone from 20 down to 10 or 12, there has been a mood change. I’m not really trying to pick bitcoin out because maybe it’s going to go much higher, but it’s interesting to see the mood change. You were talking about how something that may take 10, 12, 15 years to build, the mood can change almost instantaneously where people run for the hills.

David: John Hussman wrote an interesting piece here in the last couple of weeks explaining how – not predicting that, but explaining how – you could very quickly lose 65% of the value of the S&P and the Dow. He says, “Actually, from a historical perspective, this would come as no surprise, whatsoever. Will it happen? Time will tell. But here is how it happens, and here is the perch from which you start, if you are going to see that kind of decline.” And he is basically saying that we have the environment, we have the right environment. This is the kind of cliff that you do your swan dive from. This is what it looks like. We have it today.

Kevin: So, it’s the things you know for certain that just ain’t so. I go back to that artificial intelligence we were talking about. Those computers really have never, ever, had to go through a major financial panic.

David: It would be interesting to see how they process, emotionally, the decline in equities. I wonder if the way a computer processes the emotional stress is just by overheating and blowing up (laughs). Last week we saw the largest in-flows into equity funds in history.

Kevin: In history. That’s amazing, I read that. In history!

David: It’s funny, because I read some comments by Howard Marx, a hedge fund manager, and he said, “Look, I’m not worried. We don’t see anything that looks like a bubble. There’s really nothing here that looks euphoric.” And I’m thinking, “Nothing? Really? What?” I guess you see what you want to see, but that kind of late stage business cycle behavior – again, largest single in-flows into equity funds in history, last week – last week.

We have talked about uniformity in recent weeks where, again, using that language – uniformity – where regardless of geography, regardless of the asset class, prices are moving higher on a tide of indiscriminate confidence and indiscriminate buying. That is late cycle behavior. The only one that got punished last year – you remember we said this a few weeks ago?

Kevin: Pakistan, I think, is the only one that didn’t really perform.

David: That’s right. Every country, otherwise – and you see it still today, there is a uniformity of marching higher across asset classes to varying degrees – up 5%, 7%, 10%, 15% – and we’re talking about the first month of the year.

Kevin: So, we do have our State of the Union now behind us, as far as the first year, and it is distressing to me. Now, I’m happy to see an America-first policy. I like a lot of that. But it’s really distressing to see how many of the deficit hawks, the guys who said we can’t borrow more, it’s unsustainable – they’ve all run for the hills. There is hardly anyone speaking out, saying, “Hey, this tax plan is going to cost 1½ trillion.” This new infrastructure plan – all of these things cost money that we really don’t have.

David: I think I would say it differently. I don’t know that they ran of the hills, it’s just that months ago they said, “We don’t think it’s a good idea to go into debt, this is a bad idea, it’s not responsible. We need to rein in this and that. If you played the YouTube clips, the next YouTube clip is, “We think we need to do this, this is good for the economy, what’s good for America is good for the worker, is good for me.”

Kevin: (laughs) Okay, so they didn’t run for the hills, they just changed colors.

David: They changed colors completely. So the deficit hawks have determined that the possibility of increased wages and an improved economy is argument enough for them to get over any ideas of fiscal restraint and do their best to do what? Frankly, what most politicians do on a routine basis – gather votes. They’re coming into a midterm election and they don’t mind doing that via an explosive debt binge. With a trillion dollars that we’ll add this year, my guess is that it’s a trillion next year, so a trillion here, a trillion there, eventually you are talking about real money.

Kevin: Dave, it reminds me of a commercial. You might remember this commercial a few years ago about a couple who was getting off of a plane. They had already taken a vacation. They probably had already run up at least one of their credit cards, maybe two. And they look at each other, they’re in the airport, and they have that knowing smile. “We want more vacation.” So they pull their American Express card out, which they never leave home without, and they charge another vacation. That’s what this feels like, administration after administration. I took a shot at Obama earlier as far as the business side of things, but Trump is no different when it comes to spending money, neither was Bush, neither was Clinton, neither was Reagan. We could just continue to go backwards.

David: Before taking public office Trump was more adept at spending other people’s money than any president in the history of the country. So now he is in office and is it any surprise that he is more adept than any president at spending other people’s money?

Kevin: OPM.

David: That’s right. So Bill Dudley, of all people, now moving on from the New York Fed where he served in the past, and still does but is retiring as president of the New York Federal Reserve, cautions that the latest tax legislation will increase the nation’s longer-term debt fiscal burden, which is already facing pressures such as debt service costs and entitlement spending as the baby boom generation retires. Then he goes on to warn that the current fiscal path is unsustainable. “In the long run, ignoring the budget math risks driving up long-term interest rates, crowding out private sector investment, and diminishing the country’s credit worthiness. So, Dudley, in my words, in a nutshell, is saying we have short-term gains from this tax bill, long-term pains. Again, my words, not his, but he does say, “There is no such thing as a free lunch.”

So there will be a price to pay for the benefits that we gain from an economic standpoint, and it is that we are watching a slow moving disaster, fiscally. That is different than the kind of financial stress and panic that we saw in 2007 and 2008 (laughs) but we have a slow moving disaster in terms of the fiscal policies. He sees it, lots of people see it, but nobody really wants to do anything about it because they think it has a very, very long fuse. So to quote another American author, the question was asked of him, “How did you go broke?” Mr. Hemingway said, “Very slowly, and then all at once.”

And the reality is, as I spent time this last year with an ex-Treasury Department guy – I spent seven years with Treasury overseas as an attaché for them – the question in our conversation was, “Does the Treasury Department have any consideration or concern for the dollar losing reserve currency status? Are they watching China? Are they watching Russia? Are they watching the Middle East? And what is happening in terms of deteriorating relationships and a realignment which ultimately will strip out what we have as reserve currency? Are they aware of it?” He said, “Absolutely, they’re aware of it. They just think that it’s a fuse a thousand miles long.” So yes, they are aware of it, but they are not concerned in the least because they think they have from now until kingdom come to deal with it.

Kevin: Here is the difference. From 1966 to 1981 – you talked about the GDP growth – we had a gold standard in 1966, we had a reserve currency based on the Bretton Woods system – the whole world had to buy its oil in U.S. dollars. So yes, we had high inflation. We saw dollar devaluation during that period of time. We saw under-performance in the stock market. Right now, if we have inflation, Dave, without having reserve currency status, we don’t have a foot to stand on.

David: The other issue is, if we have inflation, it is arguably the case that we have rising rates. And so, we’re dealing with a very different math equation. Think about this – Reagan cut taxes, right? But he did it when we had 31% debt-to-GDP. Just keep that number mind, because now we have 106% debt-to-GDP and we want to cut rates, and we’re going to add to the deficit. Are there greater implications when you have passed the 90% threshold, which implies little to no traction, long-term, economically, from those cuts? You’ve crossed the 90% threshold.

Kevin: So we’ve crossed that threshold. We’re also seeing inflation creep up. They’re having to take the things that we use on a daily basis out of the number so that we’re still wondering where inflation is.

David: Yes, the perception game is alive and well there. “Of course, the inflation beast has been tamed.” And that is what you get from the statistics. It is modestly in the 2% range.

Kevin: And we’re working to make it higher. Come on, guys.

David: That’s right, because that is, of course, the core number versus the all-items number. The all-items number is what would include energy and food. So the core measurement, the one that is often quoted, takes out food, takes out energy, takes out anything else that would cause a big increase or decrease in the number. That includes home prices. Homes prices are not put into the core number.

Kevin: So if you don’t eat, and you don’t use energy, and you don’t live in a home, you really don’t have much inflation.

David: Right. They call it owner-equivalent rent. That’s how they measure the housing component into the core number. But along with rising equity prices, guess what else we have this year, and we’re talking about year-to-date numbers. You want to see a little bit of an inflation surprise, think about this. Crude is up 9½ percent year-to-date. That is from January 1 to the present – 9½ percent. Gasoline is up 8% year-to-date.

Natural gas – does anybody use that to heat a house, or maybe to drive energy costs as they cool their home in the summertime. Natural gas is up 19% since January 1^st to the present – that’s year-to-date figures. Is it possible that inflation stats languish in statistician hell while real world inflation reshapes the expectations of investors, and the bias in 2018 begins to shift toward greater inflation concerns?

Because again, there are two things that define inflation – the actual inflation number, and people’s expectation of where inflation is and where it is going, and that expectation is actually more powerful. What we have been trained to react to, like a good set of monkeys, is certain stimuli. And so we have statistics that are thrown at us and we respond to those and say, “It’s well in hand, it’s well-anchored.” That’s the fabulous phrase – it’s well-anchored. Inflation is well-anchored (laughs).

Kevin: You talk about expectations, but in Davos, it was interesting, within about a 48-hour period, Davos was told that the dollar was going to lose value, and then Trump flew out and said, “Oh, no, no, no. You misunderstood. The dollar is just going to gain strength.”

David: Right. And I think there is a little bit of crossover between his thinking about the strength of our country, and the pragmatic aspects of what makes the country strong from a manufacturing standpoint. That is predicated on a weaker currency. Mnuchin last week made no bones about the America-first benefits garnered from a weaker currency. It was weak last year. It actually is at a three-year low as we speak today, and it is still weak as we come into 2018. Time will tell the direction of long-term rates. That may, in fact, begin to curtail the enthusiasm in the stock markets as those rates are rising with a greater anticipation of inflation down the road.

But bear in mind that it is the deflation bogey-man who has been roaming the monetary policy haunts for the last nine years. And the objective has been to create inflation. That is the stated goal of the ECB, it’s the stated goal of the Fed, it’s the stated goal of the Bank of Japan. 2018 might just bring that old phrase back – Be careful what you wish for.

Kevin: That’s right, and you’re talking about this deflation bogey-man. A lot of it was just sort of a bogey-man, it was a ghost, because the central banks had to fuel the growth that we’ve seen, really, since 2011, fueled with quantitative easing, low interest rates. It was all central bank-driven.

David: What they are not piecing together is that all the stimulus they have put in has not been as effective as modeled in their various mathematical models because of how much debt is in the system. So we still have what Richard Koo calls a balance sheet recession. Even though we’re not technically in recession, we’re dealing with a balance sheet that is overladen with debt, which allows you very little latitude in terms of growth, ingenuity, moving forward. And so the economic growth that we are beginning to see doesn’t match the amount of debt and liquidity that has been put into the system.

Kevin: And you talk about the inflation number being doctored. Right now, the unemployment number would disagree with this gentleman that you were just quoting because they would say, “Oh, we can’t possibly be in a recession. Unemployment is at a low.”

David: Yes, so we have the stock market, which sort of doped up by central bank liquidity, sends a message. We have the bone market, which is likewise priced where it is due to regulation. Yes, regulation, prudent man rule, central bank liquidity. You have the unemployment rate, which conveniently count those that help the narrative, which leaves one-third of the total population aside. We have 95.5 million people who are not in the labor force – 95.5 million. Unemployment sits at 4.1% – it’s near the lowest in 60 years.

Yes, that may pressure wages higher, supporting the inflation thematic from higher commodity prices and a lower dollar. But you also have executives who are complaining that they can’t find qualified workers. Is that an educational deficiency? Is that a training deficiency? Are we really at full employment with the “not in the labor force” number streaking to all-time highs above 95½ million people?

Kevin: But some of those people are purposely retired.

David: Grant you. I would guess, a good number. Let’s say a third of those, let’s say 35 million, are legitimately retired and not ever coming back into the labor force. You have a growing number of unemployed people who are fresh from college and graduate schools, putting off the inevitable to go get a job, get more skills and more learning and higher degrees so you can get higher pay. But at the same time you have lots of boomers who are reluctant to retire, having inadequate resources to do so, having, frankly, inflated expectations of a retirement lifestyle, and in dealing with the insecurities about running out of money before they die. So there is actually not a lot of space in the workforce for younger people coming in, and you have a little bit of tension there.

Kevin: Looking at a lot of the retired friends that I have that thought they would retire but they are actually trying to work more than 30 hours because of health care costs, Dave. That is an uncertainty that if inflation were the kick in anymore, health care has already been rising. They don’t count that, either, in the inflation statistics.

David: Do you realize what has happened? Fifty years ago we looked at insurance and said, “In a worst case scenario, if something bad happens to me, I don’t want to recalibrate my whole financial picture. I think I want some insurance against that.” Now, we go from insurance to something called health care, where we expect concierge service for someone putting a Band-Aid on our butts because we expect it for free, and of course we pay for it dearly, but we’ve been conditioned to thinking that health care is insurance, insurance is health care, and we have morphed the two together. Now they’re indistinguishable, and someone who is in their 60s and 70s says, “Well, I shouldn’t have to pay for anything because my health coverage takes care of it.”

What are we talking about? What makes it so pricey is that it is no longer insurance, but it is, in fact, concierge service for every hangnail and toothache that we have. The reason why it is not sustainable and will ultimately fail is because we’re asking too much of the system, and we want a deal for it. But where it gets ragged around the edges is where people say, “Actually, if I’m not working full time I can’t afford it. I can’t pay for the kind of “service” that I’ve been receiving.”

How about you step back and say that you’re responsible for your own health, take care of your body, eat right, exercise, and know that you cannot live forever, and if you’re willing to invest in an apple a day, as they say, keeps the doctor away – why don’t we focus more on preventive health? Because health care takes care of us. I’m sorry, I’m on a rant.

Kevin: But I understand the other side, too, where that Band-Aid has scaled in price to the point where if you really do need a Band-Aid, that Band-Aid is going to cost several thousand dollars. And so, when a person is retired, you’re right, if they take of themselves they may not need health care. But for the person who does take care of themselves…

David: I’m going to give you an example. We were in Florida and I needed to have a test done while I was in Florida. So I went to the doctor and had a test done. This scan retailed at $8,000. I said, “Well, what if I pay in advance and don’t bill it through insurance?” “Oh, well, then we’ll give you a 65% discount, and that is if you put it on a payment plan.” I said, “Okay, well, so take the 65% off. I’d like to do that. What if I pay all in lump sum as opposed to some sort of a payment plan?” “Oh, well, we’ll discount it an additional 25%.”

Kevin: So you see the scaling right there.

David: When you take the insurers out of the picture, do you know what we have? We have affordable services. But when you factor in the insurance companies, guess what we have? We have insanity. We have something that is marked up 400% to take care of the insurers, not the insureds, you and me. Do you see how crazy this is?

Kevin: But if I’m an attorney, Dave, I’m going to go out of business if we can’t continue to spend that kind of money.

All right, we’ve talked about unemployment. We’ve talked about the reason to be employed. One of the reasons I think we have a lot of these younger people not working is because you do have older people who are saying, “You know, Dave, I understand what you’re saying, but I’m facing health needs right now where I can’t possibly stop working.” It is an interesting dynamic that you see, and it’s squeezing a lot of the younger people out of the workforce.

David: Right. So is the question, are they unprepared for the workforce? In what ways might they be unprepared? Are they going to be able to – frankly, we’re on the edge of another revolution which is that of robotics and AI displacing a large number of entry level jobs over the next five years. So there is that aspect, too, where the normal glide path for a career is your first two jobs are throw-away jobs, but you’re gaining experiences and garnering references according to how hard you’ve worked, and how diligent you’ve been, and if you show up on time, and those things set you in a place to then compete for better jobs. I see this, to a degree. There is a company that I’m directly interested in which produces a technology resource. In the next two years it is going to eliminate 15% to as much as 40% of all labor in the fast food industry.

Kevin: It is the trend.

David: Are we edging closer to the discovery that most public education above the high school and college levels are simply rubbish and counter-productive? There are so many different streams here because it could be qualitative aspects of education, it could be a change in the marketplace, with robots and technology being disruptive. There is the aspect of baby boomers who are not leaving the workforce through a variety of reasons, for a number of reasons, but the reality is we do have this ballooning group of 19-30-year-olds who are saying, “What kind of jobs can I get?” And by the way, how do I pay off my student loans because the jobs that I’m being offered won’t even help me pay the interest?

Kevin: Dave, last week you spent time with a number of students in California. This weekend you spent time with doctors in Huntsville, Alabama. Perfect timing for the tirade on health care. One of the topics was first-time homebuyers and how that affects the real estate market.

David: Yes, it was a fascinating group of doctors in Huntsville. We looked at the financial markets in general, the real estate market in particular, and there were several observations that were important. One of them is those first-time homebuyers and how there are less and less of them coming into the real estate market, which certainly hurts on the demand side. But the share of cash buyers peaked in the U.S. in 2012, so that is a significant factor. The influx of foreigners is now in decline, and a part of that is due to immigration, but a part of that is also policies that are outside of the United States.

So a combination of immigration policies that might impact an EB-5 status here in the states, or a Chinese crackdown on capital fight. Clearly, a number of cities in the U.S. that have benefitted from the influx of foreign capital are seeing a decline in sales. There is also a growing trend of people living longer in one place, so the average has moved up from five to six years in one place to 11 years on average. If you’re a real estate agent, that significantly reduces the volume of homes that are coming to market and are being sold and resold.

Kevin: And how about student loans? I look at the young who come out of college. They are well meaning, but they have $150,000 worth of debt.

David: Right. Constraints of student debt are diminishing the market for first-time homebuyers, and that is certainly a factor, as well. And so, if you look at the demand side and diminishment of the demand side, only a lack of housing supply has held prices together so well in this cycle. Look at December’s numbers. This is exactly what it implies. U.S. home sales declined more than expected as supplies dropped to record lows, but prices were pushed higher because again, supplies are low. We’re dealing with a 3.2-month inventory. That’s the lowest inventory in decades. Supplies are down 10.3% from a year ago, and supplies have been in decline for 31 months in a row. So again, the supply side is constrained, but actually masks the diminishment of demand, and I think that is a very important function.

Kevin: Right, and usually toward the end of a cycle when you have a limited supply type of product, not something that you can print out of thin air like the cash, but a limited supply product. When those supplies are down, prices are rising, which is exactly what we expect. That’s why we buy, oftentimes. But if there are declining sales, that is usually the end of a cycle. We’re getting close.

David: Right. As I have reflected on purchasers today, if you’re looking at people coming into the market to buy, purchases of existing homes, it is becoming obvious that no one has any money.

Kevin: You have to have debt.

David: Right.

Kevin: You have to borrow everything that you use to buy.

David: Yes, basically, if you’re putting a home up for sale today it needs to be move-in ready, with nothing to be done to it. Either there is a new home, which is preferred by a new buyer, or the existing home has to be perfect, because outside of the down payment, there is not a dollar left for making the changes to that place.

Kevin: Well, who needs cash? We have redefined the definition of money. It is now debt.

David: You’re right. We have redefined money to not just be greenbacks or savings, but also credit. Credit availability is a part of what enhances our ability to navigate and to buy things, and what not, whether it is credit cards or mortgage debt or things like that. We have redefined money to include all debt instruments, and we pretend that because we can access the credit markets, that we have unlimited cash available to us. But there are limits, and those limits are showing up in the real estate market, and they are, in fact, sending signals. The most limiting natural factor is the cost of capital.

Kevin: Right. And the cost of capital is now beginning to go up. That is what the Federal Reserve is trying to communicate and telegraph to us. There could be three, four, five rate changes this year.

David: Yes, according to KKR, five this year. More conservative estimates, and probably the consensus, lies right around three.

Kevin: A lot of people also use home equity lines of credit for tax deductions, that type of thing, and that is being eliminated in this tax plan.

David: Right. If you wanted to come in, buy a house, fix it up, and use a HELOC, a Home Equity Line of Credit to do that, what changed in the newest tax plan is that those lines of credit are no longer tax deductible. That has the net effect of raising the cost of that financing option. And if the net effect is raising the cost of that financing option, it is just one more credit avenue which is closing. The question of what kind of impact rising rates will have on mortgage rates remains to be answered.

Kevin: Bill Gross – you brought out last week that the Rubicon was 2.6% on the ten-year treasury. We passed that. We’re now at 2.71%, so it has continued to rise.

David: So three to five years from now are we likely to see mortgage rates above 6%? Do the math on what makes a home affordable under those circumstances. Affordability is near all-time lows. Think about that. Affordability is near all-time lows. We have tight supplies, we have prices which are high, and we have rates which are well below historic averages – well below historic averages – and that puts affordability on a razor’s edge. What happens to affordability as the 30-year rate creeps higher? Does that price out the marginal buyer? Does it shrink the already shrinking audience of buyers?

Kevin: You brought up something earlier with the stock market and the equities market. You called it a slow-moving disaster. Could we see the same thing in the real estate market? We are conditioned for the crash that we had back in 2006-2007 in real estate, but maybe that is not what this one looks like.

David: I was talking to – I’ll just call him the real estate doctor – this weekend. He has been very successful running a fund that invests in real estate. Retired now to Puerto Rico and enjoying a different kind of life. I want to give him credit for that slow-moving disaster in real estate was his idea as we discussed things this weekend. The slow-moving disaster in real estate is not the kind that hurts you catastrophically, as in 2007 and 2008, but it is a slow-moving disaster, nonetheless. It’s not a crash like the mortgage-backed securities, the asset-backed securities, structured finance unraveling that we had nearly a decade ago. But you do go back to the basics of Economics 101. You have cost, you have supply, you have demand, which is driving prices according to natural constraints.

In the short run we have this cushion, because again, we’re dealing with short supply. So that is probably why we have a slow-moving disaster is because supplies are so tight. But if rates start to rise, I think you will see a number of sellers. I think you will see inventories will rise, as well, as you see new sellers seek to get what they can before the buyers’ monthly cash flow is squeezed excessively, because that is really where home prices are forced down. The real measure of affordability is, from a cash flow standpoint, who can pay what to support a mortgage.

Kevin: You talk about cash flow, and a few weeks ago you talked about credit card debt being at an all-time high. Credit card debt is very, very high. But you also see before a turn in the economy, defaults on that credit card debt, and that seems to be what is showing up at this point.

David: We’re beginning to see some changes at the margins in terms of the consumer, further evidence the consumer is out of cash, not just in the real estate market where they have nothing other than the down payment, if they even have that, is in the credit card space. So you have your big four U.S. retail banks that took losses on their credit card business in the fourth quarter. And they had expected 10½ billion dollars in losses. The surprise, as they tallied everything year-end, as the year ended – it was 20% higher than that. So add 2 billion dollars to the already expected 10.5 billion in credit card losses – this is City Group, this is J.P. Morgan, this is Bank of America, Wells Fargo – so, combined for the year, 12½ billion dollars in credit card defaults. The marginal consumer is already on the ropes.

Again, I love the State of the Union, I love the fact that we are now living in some sort of economic nirvana, but appreciate that we are getting some signals that those at the margins, if you want to call it the periphery, are not doing so well. So, we’ve talked a lot about periphery and core migration in terms of problems at the periphery of Europe and how it moved to the core. We could see the same thing, periphery to core migration in terms of stress within the financial system, and within the U.S. economy.

Kevin: We’ve talked about blockchain, and this last week something happened that has never happened before to this degree. In fact, you can take blockchain out of the picture. I don’t think there has ever been a heist of any kind, bank robbery, whatever, that was as large as what happened in Japan last Friday. Half a billion dollars taken in cryptocurrency?

David: Yes, I think the reality – we’ve seen Oceans 11, we’ve seen Oceans 12. The next iteration, Oceans 13, is going to be Brad Pitt and his cadre of thieves putting together the ultimate heist, which is like a central bank heist and they’re going for a trillion dollars. But it is right after central banks have adopted cryptocurrencies into the SDR structure, and now you have private parties hacking central banks to gather the SDR reserve in cryptocurrencies. Wouldn’t that make a great story?

Kevin: Oh my gosh, so even before this heist, though, let’s just look at 2017, the 3.7 billion dollars raised in some of these new currencies. How much was lost in hacker attacks?

David: Reuters reported that Ernst and Young dug into how much money was stolen, and we’re not talking about the promoters of these initial coin offerings, the equivalent of an IPO for a cryptocurrency, the ICOs. 3.7 billion dollars was raised last year, 400 million of that was either lost or stolen in hacker attacks, according to Ernst and Young. That’s a haul. But as you mentioned last week, Friday, you had the Japanese currency exchange coin check. They had 530 million dollars in digital tokens stolen in one moment.

Kevin: Yes. That’s a heist. That is huge.

David: I don’t even know what to say. That’s half a billion dollars in one haul. That’s unbelievable. You really do start thinking, the guys at Oceans 11 and Oceans 12, they had no idea. They didn’t study computer science to understand that the real heists are not gold, not 100-dollar bills, not 500-euro notes, but cryptocurrency.

Kevin: You’d better put it on a thumb drive and keep it in your pocket. That’s what you were saying last night.

David: Without getting mugged, because by the way, last week was the first recorded incident of a man being mugged for what he had in his pocket, which was a thumb drive. And he was held at gunpoint. They’re not supposed to have guns in England. What is wrong with this picture? What is the world coming to? Criminals with guns in England? Holding up people for cryptocurrencies? This is so 21^st century – it’s out of control. We need something much more Victorian, Edwardian, and very much to our sensibilities, Kevin.

Kevin: You know, Dave, the reason you have been talking around the country, and will continue to do so, is because of the interest that people have in your book on legacy. One of the things that has been requested over and over is, “We love your book, I’ve read it several times, I’m trying to get my family to read it.” But a workbook format is really something that people have been crying out for so that they could sit down in a group and say, “Hey, let’s actually come to some points as to how you create a legacy, long-term, not just financial, but in every aspect of life, for your family.

David: Yes, you can’t pre-order it yet, but you will be able to here in the next couple of weeks, so looking on Amazon will give you a heads-up as to when you can do that – having a study guide, having a journal, having a short DVD series which introduces and opens up some of the ideas in the book, Intentional Legacy. This last weekend, sitting in a room full of successful dentists and doctors, the conversation about legacy was a lively one. They’re old enough to recognize the temptation to create a very healthy area in one area of their lives, again, building a financial balance sheet.

And they also are looking and saying, honestly, “I think I’ve done that at the expense of other aspects of life that need more attention – my wife, my children. What kind of a legacy do I want to leave? Is it going to be comprehensive in nature?” In a nutshell, the reason you want to read the Intentional Legacy, and consider working through the study guide, is to measure and balance the areas of your life where you are, or want to curate life experiences toward your legacy objectives.

Kevin: Dave, as we close, one of the things that we lamented over the last few years is this lack of volatility in the market, because it’s a lack of truthfulness. It is almost like a family that can’t talk about any of their skeletons that they have in their closet. Everybody just sits quietly and resonates and wonders what the heck is going on. Well, now we have a return of volatility. We’re seeing it in a number of markets. We’re seeing it in gold and silver. We’re seeing it in the dollar. So as far as what you would tell someone at this point, where to set course – we talked about navigation, we talk about legacy – what should be the heading right now of a portfolio?

David: One of the most important aspects that we put into the study guide and the journal is a discussion on a family legacy map, and figuring out where you want to go. What are the most important priorities that you have from a financial standpoint, from a cultural standpoint, from a relational, from a spiritual, from an intellectual standpoint? Where are you? Where are going? Making sure that you appreciate what resources that you have available to you, and have an open discussion about where you hope to go in the next 5, 10, 15, 20 years. That act of intentionality is so important. So for me, it begins with the accounting function. What are you working with? What liabilities and debts do you have? From the financial standpoint, it is the easiest to talk about because it doesn’t get into anyone’s personal space. It’s just, “Well, do you have debts, do you have student loans, do you credit card debt, do you have a mortgage, do you have company debt?”

Kevin: And what is the plan to eliminate them?

David: Yes. And then what are your assets? How are you growing your assets, how are you re-investing, what are you spending, what is your cash burn? You can look at things from a balance sheet and an income statement perspective, and those accounting functions are very helpful. I would say the same thing applies in every other area of your life. It starts with taking an account of the deficit factors and the areas where you have actual strengths.

Kevin: One of the things that I like, Dave, when you talk about finances, and I think this could be applied to legacy, is just putting the buckets, or the bowls, in front of you and saying, “How full are your buckets?” When we do this with finance we basically say, okay, there are four or five buckets. You have real estate, you have cash, you have stocks, you have bonds, you have gold. And then you just ask yourself, “What bucket should my assets be in now, with the long-term goal of ultimately filling all the buckets?”

David: Yes, the long-term goal is to fill all the buckets. But you don’t feel compelled to necessarily do that all at once, or in equal quantities. There is the value equation of what makes the most sense. Would I step into the stock market today?

Kevin: Not much in that bucket.

David: It’s difficult. But that doesn’t mean that’s not going to be a full bucket at some point. Time and the tide of events will reveal value and allow you to move from gold to shares, or move from cash to acres. There are other buckets, whether it is real estate, or a private business, or stocks, as we mentioned, coins, precious metals, what have you. Fill them all up, and be clear on what your objectives are. Again, I think one of the easiest things for people to do is to lay it out and say, “What do I have? Which buckets do I have at all? Which buckets do I need to create?”

Kevin: Where do I have a hole in the bucket, which is debt?

David: (laughs) That’s right. And where can I constructively move the ball forward? What am I doing to live beneath my means? You remember, the nature of capitalism is savings. You have to have capital. Where does capital come from? It comes from the difference of what you make, and what you spend. That is the leftover capital which becomes savings, which becomes the means by which you fill every bucket. If you’re not living beneath your means, you don’t have a shot at filling any of those buckets, and your financial future looks, frankly, very dim.

But it doesn’t have to, and that is the point of being intentional about asking, “Where do you want to be 20 years from now, 30 years from now, 50 years from now?” That active intentionality cross-applies to every aspect of life, and hopefully, these skills are learned through the journal, learned through the study guide.

More on that. We’ll let you know when it’s available at Amazon or directly from us. By the way, Amazon lists my book for sale. I was very interested in this. The new copy costs you $23.99. If you want to buy a used copy, apparently there is a first edition available for $3,211. And I thought to myself, “Wow, that’s interesting.” Please don’t spend $3,211. If you want a first edition, I’ll even sign it for you, and you don’t have to spend that kind of money. If you do want to pay that amount of money, I’ll pay shipping to you.

Kevin: You know what it makes me think. It makes me think, when this workbook comes out, I’m going to save the first one. I hope you don’t mind.

David: (laughs)