The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“It was the view of the Fed that we would be raising interest rates when we got the employment number to 6.5. Now we are 5.5 and they haven’t done a cotton-pickin’ thing. And the difference between the investment community, it boils down to a group of people that believe in what the Fed says, and another group of people that believe something beyond what the Fed says, and it’s tied to what the Fed does, and that is tied the realities of the marketplace.”
– David McAlvany
Kevin: David, I saw in the news this weekend that ISIS isn’t just capturing people and doing the horrible things that they’ve been doing to Christians and other Muslims, but they are also now destroying the relics of the ancient empire that was there in Iraq, the Mesopotamian Empire there in Mosul, they had a museum, that they are just bulldozing everything. Even when you see the remnants of a society that are being re-dug up, we realize nothing is permanent. Even the remnants of a society are now being destroyed.
David: Well, that’s right. And I think that is true of the Ottoman Empire, which is gone, the Roman Empire, which is gone – of course, we have the remnants of the British Empire, which is gone. And if you wanted to shrink it down from countries to even companies, the Dutch East India Company, it’s broke, an historical footnote. RCA is gone, Polaroid is gone. Nothing is permanent, and whether that is nations, families, companies, we can hold on and try to project forward with great vision for longer periods of time than others. The Ottoman Empire lasted 800 years. What is the difference between that and the Roman Empire coming in at closer to 400?
Kevin: Well, Dave, let’s even use something shorter-term, like the NASDAQ. We were talking about the NASDAQ, that finally, after 15 years, has come back up over where it was back in the year 2000.
David: Half of the NASDAQ 100 stocks, these are the largest ones in the mix, out of 5,000, different companies, half of the NASDAQ 100 stocks that reached peaks in 2000, they aren’t even in the index anymore.
Kevin: Or they don’t exist at all.
David: Most are gone. So, nothing is permanent. You have bulls, that is, bull markets that turn into bear markets. And you have bear markets that turn into bull markets. You have interest rates that move up, as well as down. You have deflation which is a concern today, and it will remain a concern until it is replaced with inflation and concerns with the opposite. Again, it doesn’t seem that anything stays the same forever.
Kevin: One of the main conversations we are having with clients right now, Dave, is how long can they suppress prices? There is a definite finger on interest rates, there is a definite finger on the gold price, currency rates. There is suppression going on but that’s not permanent either, is it?
David: And I think, more generally, you could say, manipulation. Mark Carney this last week went to the equivalent of the financial crimes division, if you will, in Britain, and he said, “Listen, I’ve found, it’s been brought to my attention, at least 50 instances of market manipulation, and so they are actively pursuing over 40 of those right now. Whether it is price suppression or price support, we are really talking about something that works until it doesn’t. Gold goes down until it goes up again. Nothing is permanent. The problem for most investors is this one concept I would call extrapolation. Bears tend to reinforce bearishness until you have something the equivalent of a nihilistic hell. It’s depressive, it’s morbid, there are hopeless conclusions and that is all there is.
On the other hand, you have bulls which tend to extrapolate from an immediate experience and assume it’s going to be like this forever. You think of the irresponsible college student on a drinking binge, believing that this is sort of the life of Riley and this is reality. And real reality can wait. Who wants to grow up anyway? Whatever the experience is, perpetuated into the future, this, classically, has been called the problem of pessimism, or the error of pessimism, or the error or optimism, where people remain stuck in a particular mindset. This is what we have, this is what we’ll always have.
Kevin: And don’t you think, Dave, it’s because we live very short lifetimes in relation to the size of cycles. Let’s look at the Dow-gold cycle. You may see that thing cycle every 20-30 years. Lifetimes are only about two, to maximally, three times that, so you are only going to see a few cycles in your lifetime. It’s easy to get caught up on the shorter term trend, wouldn’t you say?
David: I would, and this is one of the things I have mentioned on the air before, but I’m working on a book dealing with legacy, and one of the things that I like to think in terms of is a family which thinks outside of a 20 or 30-year stretch. Or even that multiple, one lifetime, but is instead thinking about generations, thinking about not only the generation that came before, taking stock of what we have received, but also the next generation, what we leave, what they inherit, and making decisions which reflect not the short-term cycles, that could be months or even years, but strategic decisions as a family over the long-term.
Kevin: And that means ignoring popular consensus most of the time, if you think about it, Dave. If you are having a long-term view of virtually anything, you really can’t get caught up in whatever the popular consensus is currently.
David: The danger of consensus is just this: It takes a long time to build consensus, and by the time it is built, you are dealing with an old story. You are dealing with something that is more likely than not going to change. So, if you are investing with consensus, yes, you are going to be right, but more often than not, you are going to be right at the tail end of that trend. So, the danger of consensus investing is, yes, you will be right more than not, but you may be right at exactly the wrong time.
Kevin: Let’s just look at one of the indexes, then. One of the great determiners of danger in the economy is the interest rate, and so, if we say let’s look at historic interest rates, and that, of course, is the price of bonds, what does consensus say there?
David: Going back in time, the consensus last believed that rates would remain low and would move lower in the context of a command economy. At the tail end of World War II you had long-dated treasuries which reached a low of about 2% in 1946. Of course, today’s generation of investor doesn’t remember it because they weren’t even alive, or certainly they weren’t paying attention, most of them. But a consensus of investors comes to a conclusion and then is surprised when things change and says we couldn’t have seen it coming. A consensus of investors say inflation going from bad to worse, and the dollar dropping off the chart in the late ’70s, and extrapolated from that into, again, thinking that gold would become an infinite number and the dollar would become nothing.
Kevin: Yes, Volcker came along and raised interest rates. A lot of people would say he did exactly what he should have done, but it certainly changed the consensus, didn’t it?
David: Well, he did. He confronted what was obvious to everyone and changed the direction of the market. And I would say this. When it’s obvious to everyone, it quits being relevant as a concern. That, I think, is one of the things that is interesting. We have so much evidence for deflation today, and yet, everyone has their eye on it. So, what are the risks of deflation in the context where everyone is assuming that that is the primary threat of the day? It is usually where markets are surprised, where there is the greatest damage done. Now, that is not to say there isn’t damage that can be done as a consequence of the deflationary pressure we do have in the system. It is just that they are not ignored.
Kevin: You think about the Weimar Republic, Dave. Back right after World War I they had huge debts that had to be paid, and so there was a concern about deflation at the time. They printed money and it turned into a legendary hyperinflation of billions of percent. So, you’re right, it can turn on a dime.
David: But today, if you look at the TIPS market, that is, the Treasury Inflation-Protected Securities, they would indicate virtually no concern with inflation. And when no one is concerned, the risk is that in that category, you are not tending to the real substance of the potential risk, and that is typically the quarter from which a surprise emerges. So, it is remarkable that you have tens of trillions in credit and money-like instruments that have been created, and everyone from Janet Yellen to Mario Draghi across the pond remain of the opinion that inflation is warranted, is desired, is needed, and is not a reason for concern, but is actually a goal and a target.
And part of that is self-seeking in the sense that if they can create inflation at the same time they are holding rates lower, that is, and we will talk about this a little bit later today, the classic financial repression, and that removes a tremendous burden of the debt that they are facing, and are required to pay. Again, going back to this notion of consensus, yes, you have deflation, which is a concern, but here is the true reality of deflation. It is a boon to consumers, and there have been long stretches of time where amazingly prosperous times were experienced, and they were inherently deflationary. Quite frankly, the only people who hate deflation are the people or the institutions who are overextended, who are over indebted, and yes, they have everything to fear.
Kevin: Because they don’t get as much in the way of tax revenue.
David: Well that’s true, too. You have ever-increasing tax revenue if you are increasing [the money supply]. But here’s one of the things that you need to keep in mind with that. There is an assumption that with the creation of inflation you are going to have something of a wage push, an increase in wages, and that is one of the challenges, the current models that the Fed and other central bankers have. What they are not taking into consideration is the collapse in labor costs which have occurred as a consequence of globalization. So, at the same time they are trying to create something of wage push inflation which does give them a larger piece of pie to be collecting taxes from. They’re not getting it.
Why are they not getting wage push inflation? Why are we not seeing the inflation that they would expect to see? Collapse in the cost of labor as a consequence of globalization is a big part of that. What I don’t know is if that collapse in labor costs because of globalization is sufficient to offset the massive amounts of inflation which is occurring because of central bank money printing and credit creation. So you have tens of trillions, on the one hand, which are implicitly inflationary, and you have labor deflation – deflationary in its nature. I don’t think it is sufficient to offset, I really don’t.
Kevin: One of the things that we have to keep in mind is, a lot of this debt has paved the way for a welfare state, and so it’s not like when you print a dollar you have a bunch of entrepreneurs out there who are turning those dollars over with great new opportunities. A lot of this is just to feed the welfare state at this point and so it makes it difficult to actually spur growth in an economy, does it not?
David: Do you remember the interview we did with Robert Higgs? I’m fascinated by his book, Crisis and Leviathan. I think it is an excellent read. Anyone with a general interest in the growth of government and how it necessitates more growth in the future, it gets to this point, and I think it ties in, dovetails with what you are saying, Kevin. It is because we are overextended and over-indebted that deflation is a problem. It is not a cyclical reality with benefits. It is this debt that has paved the way for a socialist welfare state, and only if that debt expands can the welfare state be maintained. So we would reflect, and I think agree with Higgs and his assessment, that we are in the late stages of a sociopolitical experiment which has promised more in benefits than the system has energy or capacity to produce. And as long as we maintain this course, government attempts to maintain this course of feeding the socialist welfare state, then we have some version of status quo. But I would circle back around to say, nothing is permanent.
Kevin: And a lot of that money that has been printed, the only growth we are really seeing is in the stock market. I remember when we were in Argentina back in October, the stock market lost 1,000 points just like that. It really took every little time. We are getting that same kind of volatility, it feels like, in the market right now, Dave.
David: Exactly. An up-move in the stock market. It is not as if that is permanent and you can perpetuate that growth into the future. There is natural cyclicality in any asset class. We will discuss the stock market a little bit later. Probably the biggest issues of the last six months, and they continue to circle around, and I think will ultimately instigate greater instability in the world – currency pressures are growing. As the dollar is rising, essentially what you are doing is compromising emerging market liquidity. You are squeezing emerging market liquidity. You are seeing assets flow out of emerging market debt, emerging market stocks, emerging market currencies, and the strong dollar which we have seen over the last 6, 8, 9 months, particularly strong, moving up 24% in a very short period of time, it is a stranglehold for many of your global currencies, and that includes developed and developing nations.
Just to give you an example, Indonesia’s rupiah is now at a low last seen in 1998 during the Asian financial crisis. I keep track of the rupiah because my brother lives in Indonesia, with family there, and the exchange rate is very significant. Now, he would tell you that gold, in rupiah terms, is doing quite well. They have just seen a 30-35% increase in the price, and it is not bothering him, as a gold-owner. Now, if he was sitting strictly in rupiah as savings, this clearly would be more than an upset. This would be catastrophic. A 30% decline. That means you need to make 30% more in a given year just to create an offset to the loss in purchasing power. But you see the same thing in Brazil. The Brazilian real is at an 11-year low this week, and of course, the euro has quickly traded from 1.3 to 1.4. Now it’s about 1.7.
And of course, with that, you see bullish sentiment for the euro which has dwindled, again amongst currency traders, to about 3%. So many people who were bearish the euro – the euro is going down, the euro is going out of existence, look at the problems with Greece, look at what Mario Draghi is doing – 3%, there is barely anyone who thinks something good can happen with the euro. Again, just as an investor, keeping some sense of humility, remember that nothing is permanent. The euro can move down and down and down, but it won’t go down in a straight line, and it suggests certainly with 3% bullish that you could actually have something of a short-term reversal. Things are getting a little overdone in almost all currencies.
Kevin: Well, and Dave, what you are talking about is so important to keep in mind. You are talking about your brother in Indonesia; he is in gold. He is not really worried about the currency fluctuation because the gold is going up. And really, sometimes here in America we are very America-centric. We say, “Oh, well gold has gone down. Gold is down another $30.” But in reality, gold has been going up against every currency, really, except for the U.S. dollar, and it has almost held its own with the dollar, really. If you look at how much the euro has gone down, if you look at how much, well, the currencies that you just named.
David: Including the Australian dollar, the Canadian dollar. We could make a long, long list of currencies that have gone down relative to the dollar, but as you just pointed out, this is a very critical point to make. You have gold going up in virtually all of these currencies. And so, we do tend to circle around our own malaise and say, “Oh, gold has gone down, it’s going to go down more, this is terrible.” The rest of the world is saying, “Okay, if you are willing to sell at these prices, just understand, it’s not only a reasonable value, but it is going up, and this is a trend that we would like to continue in, as an owner of the asset.” So, if you are Japanese, if you are Australian, if you are in New Zealand…
Kevin: You name it.
David: You name it.
Kevin: Other than U.S., you would want gold.
David: In Mexican peso terms, it really is an interesting thing that is happening as the dollar goes up.
Kevin: I was just thinking about this, too, Dave. My gold, even though it has come down a little bit in dollars, even here in America my gold buys twice as much oil as it did last year. It buys 30-40% more copper than it did last year. So, let’s switch to commodities. If I’m not buying currencies, but I’m buying something else, what does the commodities market tell us?
David: Your copper, your other basic commodities, they are lower by 20-30% in a matter of months, and so, looking at commodities, the argument is, of course, that a cheaper currency should boost trade competitiveness, so let’s say that I’m a minor in Australia, or cutting timber, or shipping oil from Canada, and the argument would be that I should have trade competitiveness given a cheaper currency. The counter-argument is that product demand needs to remain in place, and those products have to actually ship. And products appear, at least by the measure of the Baltic Dry Index, Baltic dry goods shipping index is sitting near the lowest levels we have ever seen, certainly in the last 20 years.
Kevin: And let’s again remind the listener that the Baltic dry goods index is basically the cost of shipping product, and it would be very high if there was a lot of product being shipped, and it would be low if you have a lot of stuff sitting in port.
David: It implies that there is a lot of product that is sitting there in excess, that volumes of delivered commodities are off, and you’re developing surpluses all over the world, and your commodities indexes certainly imply that your volumes of oil which are piling up in places like Cushing, Oklahoma where storage, and of course, more broadly, aggregate storage across the U.S., is at near capacity. Again, they are assuming that within the next month or two we could have reached full capacity in terms of all excess storage in the United States.
Kevin: Another thing you can look at is inventories. It sounds to me like inventories are building then.
David: Last week’s inventory numbers for oil increased by the largest amount since 2001, so you have a glut that is likely to add to further downside pressure in the price of many commodities. And part of the issue here is that your end demand is not as strong as they are hoping for. It would not indicate GDP growth domestically or globally. So, that’s one of the things that the commodities market is telling you, that GDP growth is not as robust globally as expected. So, demand is a bit of an issue. On the other side of the equation you still have over-supply from all of the infrastructure and supply projects which were brought on line 2006 to 2008, even through 2011, you have had a lot that is in the pipeline which has flooded the market with supply, you are talking industrial commodities, iron ore, oil, of course, etc.
Kevin: Well, and there was quite a bit of money going into oil as it was dropping this last year, Dave. A lot of people didn’t think that this was going to be quite as severe as, ultimately, Saudi Arabia made it. Now, what does that say when you have that much money going into oil? Is there a breaking point where some of that money is going to have to come back out of oil investments?
David: Sure. If you look at four years of a decline in the gold price, the incremental stops at 1500, at 1300, etc., you have, in retrospect, been looking at a market where buying at those levels may, long-term, have made sense, and may continue to make sense on an ongoing basis, but the decline was not over. And we see that with oil, too. Bianco Research – I think Jim Bianco is one of the best out there in terms of research, he looked at the dollar inflows into oil investments as the price was dropping, starting in the summer of 2014. Actually he looked back even further than that, but the inflows since mid-year, last year, have nearly doubled. That is, investment dollars into oil and crude, ETFs we’re talking about, if the price has not bottomed, and that is the assumption of these investors, that they were picking a bottom and not catching a falling knife.
If the price has not bottomed, these are all recent investments, most of which are already under water, and they do represent a further supply of sellers down the road. That is, investor capitulation may still be on the horizon. Let the knife fall. When it is finished, then consider the asset class. We like oil, we like natural gas. These are sort of on our buy list, if you will, but we haven’t bought anything yet. Why? Well, nothing is permanent. We know that the downside will come to an end and you will probably have upside again in oil. But, we do see further supply and demand issues driving the prices of most commodities, including oil, to lower levels in the short-run.
Kevin: Well, and we’ve seen the United States go through a quantitative easing push for the last few years. Now it seems like the baton has been passed to Mario Draghi. A currency war is now in action with the euro. It’s competitive devaluation.
David: And if this is a currency war, the shots are being fired, and it is as if everyone is ignoring them. The number of currencies, we could make a short list of five, we could expand that list to ten. If you wanted to press it, we could make a list of 25-30 currencies which all in the last year are down over 30%. And why is this not being discussed? Why is this not leading news by Bloomberg and CNBC? The reality is, we do have a currency war, the shots are being fired, the ECB is doing it, the bank of Japan is doing it. Everyone is doing it, and no one seems to care. One of the things that is interesting is, no one is really winning, and I think that’s the problem. You’re supposed to be able to gain competitive advantage in trade by devaluation. But what that assumes is that others are not doing the same thing, or are doing it to a lesser degree, because if you are going to gain a trade advantage, your currency needs to have depressed relative to one of your trade competitors.
Kevin: But Dave, this is a race to the bottom. That’s the thing that’s amazing. You know, people look at the dollar and they say, “We must be in recovery. Look at the strength of the dollar.” It’s really not that. It’s the fact that these other countries are destroying their currencies relative to the dollar.
David: Right, and it’s not just the euro, but again, we could make a list of dozens of countries where their currencies are down, not just double-digit, but now 20-30% in a 12-month period, or less. And what we find now is a world full of paper, and as you said, it is being devalued in unison. And what is the real cost of this? Who bears the real cost of this? The real cost goes to households. The real cost goes to savers. The real cost goes to those living on a fixed income. There is very little net benefit going to the tradable goods producers and exporters because everyone is doing it, and I think that is one of the reasons why you are not hearing anyone really draw attention to it because they would actually like to, in a sneaky way, get ahead of the curve, and devalue more, and to draw attention to anyone else’s shenanigans in terms of currency butchery, if you will, would be to draw attention to their own monetary policies.
Kevin: And I guess the excuse for devaluing a currency, or printing of currency, is to spur growth. Look at this country. We went from 8 trillion in debt to 18 trillion in debt in just a matter of a few years. It took from George Washington to Jimmy Carter to get to a trillion. And now we’re at 18 trillion. But how much has that helped GDP growth? We need 10% or greater GDP growth a year for many years just to take care of the debt that we have.
David: And this is, I think, worth reflecting on. You have U.S. GDP growth which has remained below 3% for a record nine years.
Kevin: Even with all that printing, Dave.
David: With all that printing, we still have growth that again for a nine-year stretch – that’s never happened before. You’d have to go back to the early ’80s to see a couple of years in succession where we were sub 3% GDP growth. And that was following the last major bear market of the 1970s and that was following Volcker jacking up interest rates, and arguably, causing a deeper recession initially, which ended up solving the inflation problem, and then ultimately, through a variety of reforms in the early ’80s, set us on a 4-6% annual rate of economic growth thereafter. Something is now, in this present environment, absent – recovery. Move beyond the hype in the headlines. Growth is not there. Because what you end up seeing in a normal recession is a lot of consumer demand which gets pent up, and then you see massive growth on the other side of recession as that consumer demand is released. Where is the release of pent-up consumer demand? Again, we’re nine years into sub 3% GDP growth. It’s never happened in the United States.
Kevin: Well, there used to be a commercial where this older lady would say, “Where’s the beef? Where’s the beef?” And that’s what I’m wondering on GDP growth. But if we’re close to what they call full employment, which, last week, the stock market started falling because the expectation is, now that the Fed is going to start raising rates now that we are at “full employment.” We know that that is not a real number. Are there experts that probably would understand that, as well, or are we all just in lockstep playing this game?
David: Well, what is the game, exactly? Because Bernanke said that when we got to 6.5% they would raise rates. We are now at 5.5% on the unemployment number, and they are only talking. They haven’t done anything. That was a long time ago that we had 6.5%, so what are they looking at, and what are they looking for? I think the reality is, they can talk about full employment, but you look at the reflections of the CEO from Gallup, the polling company, very reputable, he was highlighting the labor numbers last week, saying that, simply put, they’re bogus. When you look at the U-3 number, his conjecture is that you have nearly 30 million people that remain unemployed or underemployed, and that is the real drag on the economy. The U-3 number, again, now 5.5%, glosses over 30 million people who are under- or unemployed. Of course we had a stellar number last week. But again, you dig into the details, 132,000 of those jobs were from the birth/death modeling.
Kevin: Right, they just come up with that.
David: So, without the birth/death model, and I’m not including seasonal adjustments. Seasonal adjustments gave you a healthy boost, too, but your birth/death models, subtract out 132,000 statistically generated jobs, and you have a less than impressive 163,000 jobs. The real reason you move the needle on the U-3 number, that is, dropped to 5.5%, is because it was massively influenced by the number of people leaving the workforce.
Kevin: Well, and something very, very scary, Dave. Speaking of people leaving the workforce, unintended, wasn’t over 40% of our GDP over the last year or two from the energy sector, which has just been decimated with the price of oil?
David: So, what are you going to do for an encore? What’s your replacement? My assumption is this. My assumption is that Apple is going to sell so many watches that it will replace the GDP expansion that we had from the energy sector for about the last 4-5 years. Because, you understand, I’m ready to throw away my watch to own an Apple watch with a battery time of, worst case scenario, three hours.
Kevin: Yeah. Well, and not to mention that is it putting microwave radiation into your hand, and not to mention that it is called the iWatch. They’re really trying to keep away from that word, iWatch, but that’s what everybody is going to call it, and with the NSA these days…
David: Who’s watching, who’s tracking? I love the GPS abilities or coordination that can happen with your iWatch. Big Brother’s latest tool, perhaps? But seriously, you’re right, 40% of GDP growth in recent years, if it came from the energy sector and the energy sector is, for all intents and purposes, imploding with the price of oil, where do you think GDP growth is going to come from? We mentioned that GDP growth is below 3%, has remained below 3% for nine years. What this suggests, bottom line, is that 2015 and 2016 are going to see added pressure, and you will probably see diminished growth coming into the end of 2015 and moving into the beginning of 2016.
Kevin: Well, Dave, you know, when the tsunami was about to hit in Banda Aceh, they say that the animals began moving up the hill before it hit. It’s like they had this knowledge that a tsunami was about to hit. And there are certain things that you can look at in a stock market and see animals rising up into the hills before the tsunami hits. And you know, corporate profits has been a very, very good indicator. When corporate profits peak, isn’t it usually within about 18 months that we have a major stock market collapse?
David: Yes, it is very interesting. Again, nothing is permanent. And to go through a cycle of increasing corporate profits is good, but the higher you go, the closer you are to the end of that particular cycle. The lower you go, the closer you are to the end of that particular cycle. And it is interesting because psychology works at odds with investor success in that regard. The best value is when things are cheap, and yet, people tend to extrapolate and say, “It’s gone lower, it will go lower still. I’ll wait.” And the same thing is done on the upside. Prices go higher, people get exuberant about that. Profits go higher. People assume that that will continue indefinitely. If you are looking back to 1998, that timeframe, profits peaked more than 6-18 months before the prices peaked in the Dow and ultimately started to go down.
Kevin: So, ’98 and then the crash was in 2000.
David: That’s right. The same thing occurred in 2007 with corporate profits turning down from a very lofty level before equity prices sold off. So, I’m sure you are curious. We are already reversing from the highs of corporate profits, 1.67 trillion dollars, this is for 2013. We reached a peak, not last year, but in the middle of 2013. Corporate profits peaked in the middle of 2013, and these numbers are aggregated from the 5.7 million corporate income tax returns by the Bureau of Economic Analysis. It is not a matter of if, it is a matter of when, we see corporate profits decline by 20-40%. They have already peaked and started to come down. Equities have continued to motor higher since the mid-year 2013. That disconnect between corporate profits and the pricing of those companies: that is not going to feel very comfortable for anyone who is long out the ears in U.S. equities.
Kevin: Well, incredibly, one of the things sending a false signal is just how many shares are being purchased by the companies, themselves. That represents a large part of the market, does it not?
David: I think this is where corporate profits turning down is a news item that has been masked, or should I say, concerns have been papered over by massive volumes of purchases in shares. And this is what is interesting. It is not by investors, it is by the companies, themselves. So, look at buy-backs for 2014, in aggregate. Add up all the months, and your corporate buy-backs totaled 565 billion dollars.
Kevin: Just in 2014, so you’re talking over half a trillion dollars…
David: In corporate buy-backs…
Kevin: That are just corporations buying their own shares back.
David: That’s exactly right. Now, if you stretch the timeframe back to, say, 2010, a five-year period of cumulative mutual fund liquidations, this is net purchases liquidations, you have had an exodus of 443 billion dollars of investor capital from the stock market over the last five years. Give this some consideration, will you? The Dow continues to go higher, the S&P continues to go higher, NASDAQ continues to go higher, even as Joe and Suzy Lunchbox are moving out of the market. Now, I will tell you, the average stock broker will say, “See? You see how foolish Joe and Suzy Lunchbox are? They’re getting out of the stock market and they missed the gains of 2013. They missed the gains of 2014. They missed the gains of 2015.
But the reality is, in a world of supply and demand, you have to have more demand for shares than supply being brought to the market. Where has the excess demand come from to drive the price higher? It has come from corporations buying back their own shares? Again, outside of the daily volume which we have talked about, high-frequency trading, you’re in and you’re out, and you may be in and out of a given stock position five times in a day, the largest footprint in the marketplace is companies, themselves, buying and holding those shares. Look, for the month of February, we have 98 billion dollars in buy-backs which have been announced from corporations. That is announcements, that is not actual. That is what is going to happen, but typically, announcements and the actual pace mirror each other. According to Bloomberg, buy-backs dwarfed ETF and mutual fund inflows by a 6-to-1 margin.
Kevin: That’s just an amazing number, and you know, we’re talking earnings peaking in 2013, but even though they have peaked, these corporate earnings, even the expectations for earnings are down at this point.
David: And specifically, company profits. Company profits have peaked in 2013 because what they have been able to do, via these share buy-backs, is goose their earnings, or earnings per share. A company didn’t make any more money. If you made ten dollars, that’s what you made. But if you divide that by ten shares, or you divide it by two shares, it has a dramatic impact on your earnings per share. Ten divided by ten is one. Ten divided by two is five. So, you can go from one dollar earnings per share to five dollar earnings per share simply by shrinking the number of shares that you have outstanding. And that is what they have accomplished, is a radical increase in earnings per share, even while corporate profits have already peaked and that drives several things. Of course, it drives headlines and positive sentiment in the marketplace, but it also drives executive compensation. This conversation we had over a year-and-a-half ago with Andrew Smithers, who said, “This is unconscionable! Do you understand the game that is being played here? Do you understand that this is like the Chinese 59th year? The joke in China is this. Forced retirement aged 60 means that in your 59th year you walk out with the paperclips, you walk out with the stapler, you walk out with an extra roll of Scotch tape. If it’s not nailed down, you’re stealing it, because this is all you get!”
Kevin: What you’re saying is that these corporate executives are doing the same thing.
David: I think corporate executives are looking on the horizon and seeing that their future is compromised, and the best thing that they can do for themselves and their families is get out of Dodge as fast as they can with as much dough as they can, and so the whole game of share buy-backs is simply to generate the triggers which give them their bonus and compensation packages.
Kevin: We were talking about earnings a minute ago, and even the expectations are being lowered at this point for the first quarter of this year.
David: Well, analysts are doing what corporate executives have already done in their own minds. If a corporate executive is trying to get out of Dodge with as much money in his personal bank account as possible, he is not going to announce that. He can’t. He is at odds with that because the second the public knows what he is after and what he is about, they begin to ask the question, “So you don’t think tomorrow is as bright and as cheery as you are leading us to believe?” And what we are seeing now is that analysts are changing their expectations for not only the first quarter, but for the full year. 2015 first quarter earnings expectations have been lowered in every category except telecom and utilities. So, we talked about the contributor to GDP in the last few years being energy.
Well, listen, this is not a decline in expectations in energy, alone. We are talking about industrials, we are talking about materials, we are talking about consumers, consumer cyclical staples. Basically, every category of equities is being lowered. I mentioned the exception of Q1 was telecom and utilities. That is since the beginning of January. But even these have been radically lowered compared to the estimates that were put out there in 2014. So, analysts on Wall Street are beginning to say, “Yeah, listen, there are a number of things that we don’t like.” They realize that profits have peaked. Again, the cheerleading happens by Wall Street firms. This has to be done very delicately because you don’t want to cause a stampede out of equities. But they are lowering their expectations.
A part of what that allows them to do is beat expectations. Even though you’re not making as much money, it gives the news media something to advertise as a success story. “I made a dollar last year. This year I’m making 59 cents. But because the estimate came in at 55 cents, I beat estimates by four cents. I’m a hero!” You see? That kind of game-playing is happening, it allows analysts to begin to lower the bar, and create a success story for 2015. But for a long-term investor, again, what happened in 1998 was significant; profits peaked. What happened in 2007 was significant; profits peaked. What happened in 2013 is significant; profits peaked.
I know this is switching gears a bit, but we’ve said this over and over again. Margin debt peaked a year ago in February, and it lingered through, or near, the highs, up until about October of last year. It has contracted about 20 billion dollars, so it has gone from 464 billion dollars’ worth of borrowed money that has bought stocks, 20 billion of that has been paid back, that is 20 billion in liquidations and equities in order to pay back the bank. There is still 444 billion in borrowed assets and that is well above the numbers that we saw in 2007. That is well above, not only the nominal values, but relative to stock market capitalization, the numbers that we saw in 1999. So, you’re talking about the perfect setup for a catastrophe in the Dow, a perfect setup for it. And yet, the pied piper of Wall Street has every mouse in town following in lockstep.
Kevin: So Dave, even with all the numbers, and messing with numbers, there is really a simplicity to all of this. You are one of two types of people here in America. You either believe that this monetary gaming that is going on with the Federal Reserve and the dollar and the government, and what is going on in Europe, you either believe that it is working, or you don’t. You don’t think it’s going to last. You basically feel like that’s probably something that is not permanent.
David: Right. Which are you, and why? Do you believe in the efficacy of zero interest rate policies? Do you believe in the efficacy of quantitative easing, that is, massive monetization of debt, expansion of the Fed’s balance sheet to subsidize, in a Ponzi-esque way, the Treasury Department and excess spending at the federal level? Do you believe that this is what will instigate, trigger, perpetuate, create, a recovery in the economy, a return to employment, robust wages and growth, or do you not?
Kevin: If it did work, by the way, it would be the first time in world history that just printing money out of thin air worked.
David: But see, this has been the appeal of the alchemists. The alchemists always wanted to find a way to turn dirt into gold. They always wanted to find a way to create something of value out of nothing. And that’s what our central banks have done. They’ve tried to assume, and project that assumption onto you, that what they create does have value, when in fact, it is paper and ink. At best, it is paper and ink, because if you are talking about digits, ones and zeroes in the digital ether, credit creation just at a computer terminal, it doesn’t even have the substance of cotton and ink. You see, this is where it does boil down to one basic question. Either you believe in the efficacy of modern day monetary methods, or you don’t.
Kevin: Right. And if you don’t, the only thing you can do is buy gold and wait until you see the impermanency of what is going on right now.
David: But I would ask you the question, if you do believe in the efficacy of modern day monetary methods, then why is the money multiplier down 65% and stuck there? Why is velocity, that is GDP divided by M2, down 23% and stuck there? We’ve put tens of trillions of dollars into the system, and it should be showing up as economic activity. And velocity and the money multiplier are suggesting to you that the Fed has failed, and if you’re not looking at the money multiplier, if you’re not looking at velocity, and you are saying to yourself, “I believe in the efficacy of modern day monetary methods, you realize that your faith is a blind faith. Your faith is contrary to the evidence. You understand that?
Kevin: I had brought up earlier that we needed double-digit growth for decades, and that actually was not my thought, Dave, that was David Walker’s thought when we had him on the show.
David: From the Government Accountability Office. He looked at all our liabilities and said, “No, listen, we can do this. We can grow our way out, we just need double-digit rates of GDP growth for decades uninterrupted.”
Kevin: Not 3% for nine years.
David: No, double digit. We’re not even 3% for the last decade. So, we’re missing it. We’re missing it here to say, what does it mean for the Fed’s policies to actually work? What does it mean for them to actually work? Here’s the problem that they have. The financial system is overburdened with debt. We have gotten to the point where there is so much debt that the growth in the economy cannot keep up with the amount of debt, and the burden that we continue to pay on that debt. The only reason it worked last year in 2014 is that we managed to massage the average debt payment down to 1.7%. If you are looking at what we are paying in terms of interest on the national debt, of all maturities blended together, we averaged 1.7% last year. We needed that.
What is at work here is the old financial repression which we have talked about ad nauseam on the program. And it works only as long as you can force the investment community to comply. Keep in mind, you have to have capital controls or intimidation, that’s what was used in the ’80s and ’90s all over the world. And that may be something that we find ourselves back in the middle of, but if it’s not forced, what are they trying to do? You keep rates below the level of inflation so that you can inflate away your debt, hold on to the total stock of debt without compromising the security of the creditor community. You keep banks solvent by suppressing interest rates, and you pay off the burden of that debt by running a higher inflation rate. That is what they have to do.
That’s the central bank QE scheme, and I’m telling you, we can’t be finished with it. We can’t be finished with it, because even at a 3% rate of growth, it’s not what we need to get ahead of our debt burden. We need double-digit rates of growth and we’re not even close to that. So, what are we defining as efficacy in terms of the modern day monetary methods? What are defining as a success story? You can look at housing, you can look at employment, and as we talked about, the CEO from Gallup just in recent weeks has said, “It’s a joke.”
You can pretend that 5.5% is a success story and you’re moving toward full employment, but our back-of-the-napkin estimate is that out of 300 million people in this country, you have closer to 30 million that have an employment problem, and that’s why the economy is not going on all cylinders. That’s why velocity is not picking up. That’s why the money multiplier is stuck in the mud. And that’s why, frankly, the Fed is in the same position they were in in 2012, 2013, 2014, working themselves further into a trap, where the only option, the only alternative, is to print and inflate, or die.
Kevin: So, let’s just boil it down to a single question, Dave. Do we believe, and every listener should ask themselves this – do we believe that what the Federal Reserve is doing will work? Or, do we buy gold?
David: I think you can put it in one of those two camps. You’re either a buyer or a seller, and I would say there are two different questions. One, do I believe that their policies are working, or not working? And I come down on the side of not working. It’s not working. Am I a buyer or seller of the metals? I’m a buyer. I’m a buyer, and someday I will be a seller, but it’s on the basis of value that I’ll be a seller, relative value between gold and other assets. But we are not there, and what we continue to see is that the Fed is in the same position they’ve been in for a long time.
You realize, last week, with the release of the 2009 Fed papers, we get to see Janet Yellen before she was running the Fed, say, “We should be increasing interest rates very quickly, and it’s only going to take 500 billion dollars to solve the whole problem.” 500 billion. That was before they added an extra 2½, almost 3 trillion dollars, to that number, and lowered rates even further. Her view was that this was an easy fix and we’d be out of the woods in no time. That was her view in 2009. Her view was that we would, and should, be raising interest rates in 2012, and here we are in 2015. It was the view of the Fed that we would be, would be, raising interest rates when we got the employment number to 6.5. Now we’re 5.5 and they haven’t done a cotton-pickin’ thing.
The reality is, they know the reality, and the difference between the investment community, it boils down to a group of people that believe in what the Fed says, and another group of people that believe something beyond what the Fed says, and it’s tied to what the Fed does, and that’s tied to the realities of the marketplace.
Kevin: So, Dave, it sounds to me like Janet Yellen, or whoever is the Federal Reserve Chairman is in the future, is trapped, and we have to identify that ourselves with our own financial decisions. As for me, Dave, I’m not playing the game. I’m not going to buy into this efficacy of Federal Reserve printing, or QE, or whether they’re going to raise or lower rates. Actually, as an investor, Dave, I don’t think they’ve got it under control.
David: And as I said, nothing’s permanent. The increase in the value of the stock market, the increase in corporate profits. The decline in gold. All of these things are mean-reverting. Everything goes up, everything goes down, and nothing goes any direction forever. If I sat down and made a long, long list of the reasons why I would be a buyer or a seller of the metals today, it would be a very long, long list, indeed. And to that list I could add countless things. Austria had their first bail-in in the last few days. A bank bail-in, like we had in Cyprus. We continue to see things that support the notion that you should be a buyer, not a seller, at these prices.