The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“On today’s show we look at when to double down on the market, and when to quietly wait on the sidelines.”
– Kevin Orrick
“What isn’t already locked into the greater fool theory of investing, where you paid a high price, and you expect someone else to come in and pay an even higher price? Those are the pricing dynamics we see in the equity and bond and real estate markets today. If you are unwary today, I would suggest that you are unwise.”
– David McAlvany
Kevin: Dave, you’re just getting back from meeting your dad. I know that you all sometimes schedule just father/son time to reminisce and look forward, so I always look forward to hearing what the two of you have talked about.
David: It should be more often. I mentioned getting together with him in Shanghai, but that’s been five years ago.
Kevin: Can you believe how much time passes?
David: We see my folks at least once or twice a year. They live in Asia, so we’ll meet up with them, or they’ll come here, or what have you.
Kevin: This was specifically father/son time to talk, though, wasn’t it?
David: And that’s what is a little bit more rare, and I need to do more of that. It was a fantastic time just to think about life, reflect on life, what’s happening in our families, and some of our priorities combined – where they’re headed as a couple, and where we see our interests totally coalesced.
Kevin: It’s in keeping with what you have been talking about – encouraging families to look at legacy. So, let’s talk about that a little bit later in the program. I know this is a key program as far as interest rate rises. Today is the day that the interest rate goes up, probably just one of the times this year that the interest rate will rise.
David: That’s right. Yes, we have the third rate hike in a series, with several more anticipated. So, the language that we should listen for is sort of the pace and the timing of the next several rate rises. A 25 basis-point increase has been assumed, so they will be very careful about how to frame how much, how soon, etc.
Kevin: Honestly, it’s not as important as the debt ceiling talks that are coming up this month because we all just assume the interest rate rise, but the debt ceiling talks – that is going to be revealing.
David: Yes, and that could be a simple announcement, but it could also be a tough process of negotiation that extends into the fall. Treasury chief Steve Mnuchin has said that extraordinary measures will allow him to stretch the dollars available well into the fall. So, they’re out of money, say, mid June, but he’ll start figuring out which payments not to make so that he has a little bit more operating capital, and he can do that and sort of stretch things until the fall, if in fact, they don’t resolve things pretty quickly.
Kevin: You know, Dave, we are pretty tough on a magazine we both read, The Economist, because a lot of times they’re not as contrarian as we would like them to be, but as you know, the first place that I turn to when I read my Economist is actually the back page. As morbid as this sounds, I’ve learned more reading the beautifully written obituaries of famous people, reading The Economist, probably than any of the other material that comes in the magazine.
David: To rival that is the obituaries in the New York Times, and to me there is no better read, in terms of the encapsulation of a life story, than in the New York Times. Again, that theme of legacy – that is what you have captured, and it is done so professionally, so poetically. While most people have heard of the library of Alexandria, very few people know the name Mostafa El-Abbadi. He was a Cambridge educated Egyptian scholar. He studied ancient Greece and Rome – that was his specialty. He died just two days ago on the 13th of March at age 88.
Kevin: He was referenced in The Economist magazine.
David: Because he rebuilt the library of Alexandria. He rebuilt it in our time. He started the project in 1986. I was fascinated by his contribution and the lack of credit that he received, partially because he was willing to voice opinions not popular with the Mubarak regime.
Kevin: It’s interesting, he started the project to rebuild the library of Alexandria, which of course, was destroyed. It had most of the copies of the world’s books at the time in it. He had it rebuilt, but they wouldn’t invite him to the opening because they excavated history right below it.
David: That’s right. There was the Palace of Ptolemy, and they excavated without doing any real archeological work on it, and so they were literally dumping parts of ancient ruins into the sea.
Kevin: Mosaic tiles.
David: Yes, and he said, “You can’t do this.”
Kevin: “Not even from my library.”
David: (laughs) “Not even from my library can you do this.” So, he wasn’t even invited to the opening of the library, which was his brainchild. I think, if you’re not taught from a young age to value books, and if it is not a part of your ritual on a weekly basis to pick up a book, you typically won’t value them the way that someone does who grows up in a bibliophile home.
Kevin: Well, we’re in a digital age, Dave. Why wouldn’t you just read it quickly for free on the internet?
David: Interestingly, just as movies have, to some degree, displaced the role that books have played in people’s lives as a pastime, we now have video games and virtual reality, which is displacing even movies, because there is something even more tantalizing than actual reality. And of course, yes, books are even more removed from relevance in that case. But it’s hard work for anyone to mine for small gems whether you’re reading on a Kindle or burying your nose in a hardback.
Kevin: What I’ve found Dave – I have to have the physical book, but I have to sometimes have the book now, so it’s costing me more. I’ve got a lot of books on Kindle that I have turned around and either ordered the physical copy or I order the physical copy first and still, I can’t wait. I’m currently doing that with a book on astronomy. It’s coming today, but I’ve been reading it all weekend.
David: (laughs) My wife and I are slowly building our own library. It’s obviously not stone by stone. More important to us is the book by book accumulation. I do prefer hardback. I can’t go the Kindle route, not to disparage anyone who likes books on Kindle, I appreciate the travelability, the ability to go with 50 different volumes in one Kindle. That is actually very appealing. But the way I engage a book is really important.
Kevin: Last night when we were meeting and talking about the program, you had a book on the table there at the restaurant that we meet at, by a favorite author of mine – Borges. When you and I went to Argentina a couple of years ago I couldn’t find my copy of Borges’ Labyrinths, and so I went to just a fabulous bookstore here that we have in Durango. It’s completely disorganized. The only person who knows where any of it is, is a guy named George, but George knows his books. He is probably the best educated of anyone here in Durango, as far as reading. He is an Argentinian. I walked in and said, “Hey, I need to get a copy of Borges. I’m going to Argentina. I want to read it on the way down there.” He said, “Well, I don’t have any on the shelf, but I do have one in the car.” So he went out and pulled out this old copy of Labyrinths, by Borges. I was pleased to see that you had picked up that copy yesterday.
David: Yes, he is a blind librarian, who was Argentinian, as you mentioned. He said, “The universe was called, by some, the library.” That is essentially what a library is supposed to have. It encompasses the codes and insights already discovered by past generations. You have, today, the age of information with its new codes, and what do you have prioritized in the age of information? Speed and quantity of datum.
You have quantum computing, which is taking us even further in that direction, but speed and quantity – frankly, they miss what occurs when an individual, in the process of discovery, is reshaped and changed by what they find. So, I think we grow and are transformed, not by a faster CPU, but by a slower and more penetrating look into a particular field, whatever field that is, whatever interest you have. And that is the question. What fascinates you? What topics are you most curious about?
Kevin: This is the key, Dave. The key is not getting the answer quickly. Even while I’m driving, I can ask Siri a question and get the answer. The real key is, “What is the question?” The person who has the better question usually has the better learning.
David: It is interesting, we were talking about quantum computing last night. You still have to have the right questions going in.
Kevin: It’s all about the program.
David: That’s right, because quantum computing can give you the fastest possible answer, but it may not be a relevant answer. It doesn’t have to be the right answer, it’s just an answer. And it does really begin with asking the right questions.
Kevin: Isn’t that why you say education is driven by curiosity?
David: Oh, absolutely. When someone asks me Dave, “What are you reading?” What I’m reading is irrelevant. “What are you interested in reading?” When someone wants a book recommendation it’s much more important to get to what they are interested in at present, because that is where the energy to continue to learn, and to do the hard work of mining for small gems is. That is where it actually happens. If education is best driven by curiosity, then a library is best built around the topics, around the idiosyncrasies of the treasure hunt.
Kevin: What were your questions?
David: Yes, so what are you looking for? In my opinion, the books on a person’s shelf, whether they are read or unread, tell more about a person than almost anything else. It’s the first thing I want to know when I’m invited into someone’s home. What are they reading? What are the ideas that fascinate them? My father and I had that conversation last week. “What fascinates you?” I asked. “And what are you most curious about?”
Kevin: Dave, you surround yourself with people who are asking good questions. Sometimes their questions, when I’m at a party at your house, I can have a fascinating conversation with a person and then I can walk away thinking, “I would never asked that question.” (laughs)
David: I know man here in Durango whose shelves are lined with a curious assortment of psychological texts, spiritual classics, philosophy. What they reflect is a man that has thought deeply about relationships, and spiritual growth, as well. All that pursuit is informed by a set of ideas that have served like a torch in the night. I know that by day he loves horses, and he loves people, and he is engaged in relationship. And by night, he is in search of fresh insight into the issues that trouble, that plague, that even inspire those who he will encounter tomorrow.
Kevin: This is a subject that you do address with a full chapter, actually, in your book on Legacy.
David: The connection between legacy, being legacy-minded, and loving libraries – that may be purely idiosyncratic on my part, but that is something that I hope to perpetuate with my kids, constantly reminding them that the things of greatest value in life are not tangible assets. It is not a house, it is not real estate, it is not a ranch, it is not gold and silver. It is not anything that you can lay your hands on, but it really is the intangible asset. So, in a sense, the keeper of the library is a more important steward than the keeper of a checkbook or a financial balance sheet. That is my opinion, that is what I am trying to perpetuate in my family, and I’m open to criticism, but I make that stand.
And you’re right, I do talk about that in the book, where I make the case for a library, and I even make the case for hardbacks – again, very idiosyncratic. But some people, I think, have yet to discover the smell of treasure. For me, the smell of treasure is the pages of a book. It is the old and it’s the new. It doesn’t matter to me if it’s a musty smell or fresh off the press. For me, that is what treasure smells like.
Kevin: I can tell you, I love the smell of an old book, especially one that has been in a musty type of setting. Your new book – when you get a new book you don’t necessarily have that smell. Or if you get a Kindle copy, you never have that smell. But I’m going to give a shameless plug for your book again, and I would just recommend, for the person who is looking toward legacy in some of these concepts, I would highly recommend ordering your book, Dave, on Amazon – Intentional Legacy.
David: It’s not our topic today, but maybe it’s one that you add to your library. I think it becomes obvious to those around us what we value, and what our treasure is in life. I got a letter from a young man – I think I mentioned this in the Commentary a month or so ago, but it stuck with me – referring to himself as a corporate orphan. I think there is many a corporate orphan that can tell you exactly what their parents considered treasure to be. Their lives often reflect a very different approach to value and stewardship, as a response, and I think it’s positive. It’s good for them. We all have a choice in our lives, at a certain point, which cycles we want to perpetuate, and which we are willing to see fade into nothingness.
Kevin: Dave, I was talking to a friend of ours that we met in Seattle who lives in Kauai. He has a family, a number of kids, and he is what you would call a millennial, as far as the age goes. He called me the other day. He said, “I was out surfing in Kauai and I was talking to a guy on the surfboard next to me.” I guess there is quite a bit of time to sit out there when you’re waiting for waves. He said, “You’ve got to read this book. I’m going to be ordering dozens.” What he was saying was not the corporate orphan, but sort of is. He said, “People of my age group were never really taught about legacy of future generations.” He wants to restart that, at least in the community that he is in, there on probably the most beautiful place on earth.
David: Again, not our topic for today, but I am very interested in legacy and Mostafa El-Abbadi sort of got me thinking about that in the last day or two.
Kevin: Let’s talk about the markets then.
David: Significant details, but perhaps less meaningful (laughs).
Kevin: Yes, they might be less meaningful, but the thing is, you brought this out in the last couple of weeks, when people feel like they can’t lose, they start to double down. When you see someone betting, they’ll double down. We watch Jeopardy sometimes at night and when the person is really feeling like they’ve got the category they say, “Let’s make it a true daily double.” (laughs) That is what is happening in the markets right now.
David: You see it reflected at margins debts after declining, the margin debt numbers, for a very short period of time between 2015 and 2016, were back above 500 billion. We’re at a new record – 513 billion. That is 130 billion higher than the previous peak of 2007.
Kevin: That is half-trillion dollars of betting money. That is borrowed money to go into the market.
David: Yes, and I think the reason 2007 is relevant is it is the timeframe just prior to the crash. When you have borrowed money you realize that there is a sell-by date on that money. You have to pay it back at a certain point, continue to pay interest until you do, and so that represents a half-trillion dollars of market liquidations. Or let’s say, half to two-thirds of it will be liquidated at some point in the next 6-12 months. When margin debt numbers get very high, it is very dangerous for the stock market because when a market begins to move against you, you are not playing with your own money.
Kevin: You get something that is called a margin call. That is a horrible feeling when they call you and say, “Hey, the market is down 10%. Do you want to keep this bet going, or do you want to pay it all off?”
David: And if you get to a certain threshold they will force the liquidation for you.
David: So people tend to borrow for their purchases when they are convinced that the bets that they are making are guaranteed winners. The interesting thing, psychologically, that level of confidence always comes before a crash. Mind you, no one can tell you the precise date of a major market decline, but when you begin to stack up enough weighty variables into one pile, that pile will ultimately move like you would expect an overloaded mound of sand.
Kevin: There are people who are the opposite of this. They are looking at the situation and they are saying, “Wait a second. The stock market is overvalued.” Dave, I know you are one of these people. I think Dave Burgess is feeling the same way. There are other people in these markets that are saying, “No, we’re not going to double down. In fact, what we are going to do is, we’re going to make an active portfolio management decision to move to cash.”
David: Yes, a man I have great respect for, Jeremy Grantham, tends to suffer massive client outflows and liquidations at the end of a cycle. You may say, “Why are people dumping Jeremy Grantham?” Well, he has moved to 25% cash, he only has a 7% allocation to U.S. equities, he has greater emphasis on emerging markets. He is trying to reduce risk as fast as he can. He gets conservative and moves more to cash and clients jump ship, wanting as much growth as they can get.
Kevin: “Don’t they know? He’s missing an opportunity, and why should we pay him anyway, to manage cash?”
David: I actually call it the Grantham indicator because, again, he tends to see client outflows and liquidations at the end of a cycle, and he is early, but he is never wrong. At 78 years old, actually, I think he has gotten used to being treated sort of like the leftover potato salad at the church picnic (laughs). He is used to it. His clients forget that he has a very strong track record. And yes, he is early, but he is not wrong. He is risk-aware in an environment that rewards the opposite posture. So he is moving against the spirit of the market at that point, where full-throttle risk-taking is what is fashionable. And of course, we’ve been here before. Grantham’s analysis is a part of my living library of market mistakes. This is where investor greed drives investors to make, actually, what are very predictable mistakes.
Kevin: Let’s stop on that, because last night when we were talking you said something that I think is really profound. And that is, most black swans, actually, can be recognized ahead of time. You are going to be giving a talk in July to a group of businessmen. Part of your point is that a black swan doesn’t just come out of nowhere. A black swan, actually, can be predictable. In fact, would it be cheating if you told the story about your son and birds?
David: This was just a few years ago. He casually reaches over to feed a bird on the other side of this little hedge, and the bird, not as kind as it was beautiful, bites him.
Kevin: But he had never been bitten by a bird before.
David: He had never been bitten by a bird before.
Kevin: It’s predictable to us, not to him.
David: Right. It happened to be, literally, his first experience with a black swan (laughs). I thought it was absolutely hilarious. It wasn’t hilarious that he was bleeding, but that the surprise should be from a black swan was, indeed, ironic.
Kevin: When you see black swans, when somebody says, “Oh, my gosh, we had a market crash, it’s a black swan, nobody saw it coming,” that’s not true.
David: The events were there. If you look at different cycle studies you will see echoes through time of the same mistakes being made over and over again. You could be talking business cycle studies, you could be talking monetary history, you could be talking political cycles. I think that you could write an algorithm and pick up most of that, and adjust the portfolio accordingly. But even the people writing the codes today which might drive such an algorithm, they still are subject to the same errors of optimism and pessimism that drive markets to extremes.
Kevin: Right. So just because we’re in a period of time of this high-frequency trading, HFT, and a lot of it is algorithm-generated, those algorithms are not perfect, and they can’t see into the future.
David: They’re not perfect, and speaking of extremes, we have five names today in the stock market that have a combined valuation of 2.6 trillion dollars – five companies, 2.6 trillion dollars. Thanks, Mr. Hickey, for pointing this out. You have Apple, Alphabet (which is the new name for Google), Microsoft, Amazon and Facebook. In the last quarter, with these companies, you have either missed revenue guidance, you’ve missed earnings forecasts, you’ve had warnings of declining advertising revenue growth, and with all that unpleasant news…
Kevin: Boom, boom, boom! It’s just been going straight up.
David: Yes, the market pushed all of these shares to new highs.
Kevin: You know what this reminds me of, Dave? In the late 1990s it didn’t matter if a company was making money as long as it looked like a good idea, the shares would be bought. Do you remember that tech stock boom? In fact, you were a stockbroker during that period of time. You have to remember that.
David: It was amazing that people were spending millions of dollars on NFL advertising for the Super Bowl selling things like sock puppets. You think to yourself, “What’s the margin on a sock puppet? What are we talking about here? This is insanity.”
Kevin: Pets.com is what it was called and I think the capitalization was larger than all the airlines in the United States at one point. And it wasn’t even making any money.
David: Well, and of course, it is no more. But fast forward to today. Netflix, according to Jim Grant, had negative free cash flow of 127 million dollars in 2014.
Kevin: They’re bleeding money.
David: That was 2014. Negative free cash flow of 921 million – that’s an improvement, isn’t it? Only we’re moving the wrong direction. That was 2015. And a negative free cash flow of 1.66 billion in 2016. It’s currently paying the equivalent of 108 dollars per user to create their own content. I subscribe to Netflix. I love the service. But if I’m paying less than 20 bucks and they’re spending 108, this is not a profitable business.
Kevin: They’re making it a true daily double – double – double – double (laughs) – they’re just assuming that at some point this is going to reverse.
David: So Wall Street sees a disruptive technology, which it has been – just ask any Blockbuster shareholder how they like streaming content. This has been truly an upset of the apple cart. But at some point, doesn’t a technology have to pencil out? So the boom in stocks has made that point irrelevant because limitless amounts of capital, when the stock market is rising, can be thrown at a concept, or just a promise which is in the future. And I think less important is actually delivering on those promises. You can just make promises. So, delivering on those promises seems to be irrelevant in the short-run, at least, in the current market.
Kevin: Well, and even if it’s a great idea – one of the listeners treated me to a ride in his beta model Tesla last year. We were in Idaho, and he said, “Hey, Kevin, come on out here. I’m going to take you on a ride.” Little did I know, when he said he was take me on a ride, what that meant was that I keep my hands in my lap as I sit in the driver’s side going 75 mph over a bridge over water, and the car was driving itself. Now, that was a good idea at the time, maybe not a good idea to always do it that way. It’s a weird feeling.
But let’s go ahead and look at Musk for a moment. He’s bleeding cash, as well. He just has to continue to go raise more funds based on future hope.
David: It’s an interesting thing because Tesla has some amazing technological innovations and they, too, are sort of upsetting the apple cart. But it’s the promise of the future which is priced into the stock today, and it stands out as a significant story stock. You are promising, and continually spending, more than you bring in with this particular company. Four billion dollars in sales — look, that’s no paltry sum. That’s great. I’m glad he’s making four billion dollars. Actually, not making – bringing in, in sales. But that supports a market cap of 40 billion dollars. Just for comparison – again, thanks to Fred Hickey on these numbers – you look at Ford’s sales annually – last year 152 billion, compared to Tesla’s four billion. Their sales are 38 times larger than Tesla’s, but their market cap is 49 billion compared to Tesla’s 40 billion.
Kevin: So they are almost similar in market cap, but as far as sales…
David: Right. One sells for 0.33 times the sales figure, and the other for ten times sales. Tesla has had negative free cash flow for 11 consecutive quarters. They missed their delivery guidance three out of the last four quarters, and it doesn’t matter – it doesn’t matter – when you have bubble dynamics in the stock market. Musk raises more investor capital all the time, just to keep the company moving ahead – 2½ billion dollars in CAPEX spending is the estimate for the first half of this year. That’s new money that he is going to have to raise because they have already spent most of the 1.4 billion dollars that they raised in the fourth quarter last year. They redefine the term “cash burn.” This is like a funeral pyre.
I think the company does have a future, I just see significant market downside. I’m not short the company, but I do see significant market downside because in a bubble environment these numbers and this kind of trending works, but in a market downturn, you know where the greatest weakness lies. It is where the greatest games have been played. Investor enthusiasm today is for a company that is trying to take its fearless leader and literally put him on Mars for his retirement.
Kevin: Right – an interesting place to retire.
David: But that’s the conversation. “Our guy’s going to be on Mars. Where are you going to be in your retirement? You’re going to be playing golf on what course? You just have to think big. We’re talking about thinking so big…” These are bubble-type expectations.
Kevin: It doesn’t mean that the company won’t survive. You’re not down on the companies, you’re not down on the future, but you’re talking about an investor putting money into the stock market. Dave, I had a client back in the late 1990s who was all about Blackberry. He bought some gold, and then he took the rest of his money and over time he continued to feed the machine with margin debt, and he continued to double down on Blackberry.
Finally, I remember him calling. This guy was a millionaire. He called me and he was down to his last $30,000 in gold. That was it. That was all he had. He said, “Kevin, I need to sell this gold.” I said, “What are you planning on doing with it?” He said, “Well, I have this debt with Blackberry and I just know it’s going to work.” The problem is, Blackberry may or may not be a good company, it may or may not be a good idea, but the thing is, the margin debt completely ate his lunch to where he really had nothing left except for the $30,000 in gold.
David: It’s a sad story, but it’s a common story, and it’s one that you are going to hear a lot more about over the next two to three years. Last week we talked about the Dow-gold ratio. We had, during the lost decade for stocks, gold doing very well, obviously, stocks not doing anything. That’s why they called it the lost decade. That took us through 2011. We talked about that in ratio terms last week, and as stocks have become popular again, of course gold has fallen out of favor, at least, here in the United States it has fallen out of favor.
But demand dynamics overseas still remain very robust. You have gold’s recovery in 2016 from the 2012 to 2015 cyclical bear, and we see that as the beginning of a multi-year rise in the price of gold and silver. I think we can assume, as bubble dynamics in the U.S. stock market resolve themselves in the way that bubble dynamics do, seeking the proverbial pinprick, gold will come back onto the radar for U.S. investors. At that time, any gold and silver product that is sort of U.S. centric, you are going to see premiums again like we witnessed in the last run-up.
You have U.S. minted coins, which, as of February, last month, were at a 14-month low, and this is typical. It’s typical before a big run-up. No one cares. No one cares here. That is not to say they don’t care everywhere else in the world where demand has remained fairly robust. So, if it is typical just before a big run-up to have no one care, the opposite it also true. Before a big decline, everyone cares and everyone is already in.
That is the way the market moves, from greed to fear. People load up in one sector, or one area, and typically, everyone is in just before a major market decline. Tesla, Apple – they’re the rave today. Gold, silver – they’re not. From under-demand to over-demand, every market is notable at its extremes.
Kevin: Dave, what I have found is, most people, when they buy gold and silver – you were talking about out of demand – but a lot of times a person will buy gold or silver and they just sort of do it with their eyes closed, they just leave it be forever. And that’s not a bad strategy, you can do that. But there are strategic ways you can position a portfolio to actually gain ounces as you hold ounces without adding new money.
David: Yes, you’re talking sort of the intra-market dynamics between gold and silver in the platinum group metals. There is a company we’ve been doing that for nearly five decades. I have been doing this, making some strategic shifts, that is, in recent months, and have been advising clients to do the same. That is an area that you probably want some advice. And in a bull market, everyone is a genius.
In a bear market you get to hone your craft, and here I’m speaking of sort of the 2012-2015 timeframe, but even more than that, the 20 years that we existed as a company through a bear market from 1980 to the year 2000. The company is coming up on its 50-year anniversary. That’s our next big number. Basically, for half of the life of our company we have existed in a bear market, we know how to help clients, even in a down market.
Kevin: Yes, even as it is falling you can add ounces.
David: That has everything to do with portfolio construction, not just buying the cheapest ounces on offer. So, what are we talking about? Again, I think we are leaving a bear market in gold behind. The question is whether you are ideally positioned. We are talking about silver, we are talking about platinum, we are talking about a variety of things. There are at least three things that I would be doing right now while demand, domestically, still lags, at least, lags the global trend.
Kevin: Sometimes it is easy, though, to look at the gold price and say, “Oh, it’s around $1200 right now.” And to look at the stock market, “Oh, 21,000, something in that neighborhood.” I don’t really feel like I need to do anything now. Now, we try to stay away from timing, but I’m going to ask you, Dave, why should people act now, if they should do anything at all?
David: Sure. A couple of things come to mind. One, as it relates to the metals market, the 65-week moving average which is a long-term moving average, we sent out a video to our clients in recent weeks updating them on that. Just like the turning of a big barge, it takes time to turn, but once it turns, it stays and moves in that direction for several years. The 65-week moving average has turned up, and indicates the gold market has two to three years of growth ahead of it.
Now, here are some reasons that I would be acting now, and this relates not only to gold and silver but also sort of getting conservative in an equity or bond portfolio. Our friend, Bill King, describes the last hour of trading in the markets over the last two weeks as very selling-dominant.
Kevin: So, they play for the day, but then they sell out as they come out.
David: That’s right. So, what it indicates to Bill, what it indicates to us, is that buyers are actually disappearing. Buyers in the U.S. stock market are disappearing. Market breadth has been awful. A sell-off in stocks would not be a black swan event. This is becoming more predictable all the time.
Number two, why I would be acting now, according to the Taylor rule, the Fed is way behind the curve. You have the gap between the Federal funds rate, and where rates should be, according to Taylor’s guide, if you will, and it’s the biggest gap since 1977.
Kevin: Dave, you have interviewed and gone to a number of Jim Grant’s conferences, and of course, he writes The Interest Rate Observer. It is actually written to people who don’t borrow money, necessarily, as much as they loan money. That’s what a bond-holder does – he loans money. What he says is that interest rates right now are not attractive for a person who wants to loan out money. Now, that’s what generates the market, so where should Federal funds be right now for a person to say, “Well, at this point, the lenders are going to come out of the woodwork.”
David: Yes, Fed funds should be closer to 3%, and again, just going back to the Taylor rule, and being inflation aware, real world inflation aware, we don’t have to time to talk about it this week but Grant does spend a good bit of time in his most recent letter talking about the Billion Prices Project and how inflation, if you are looking at, literally, a billion prices, indicates that inflation is probably closer to 3% or 3.6%, as opposed to the CPI which is almost two points lower than that.
Kevin: So, why would you loan money for less than what the inflation rate is? That’s the point.
David: Basically, it is saying, according to the Billion Prices Project, there is nothing in the U.S. interest rate structure from 30-year, to 20, to 10, and obviously down to the shorter term treasury notes and bills, that is positive. When you factor in inflation, they are all sporting negative real rates.
So, back to the Fed funds rates. If you go back to what it should be, according to the Taylor rule – Fed funds at 3% — they will probably bump at 25 basis points today and make it 1%. Well, of course that would turn the financial world inside-out. So, turning the financial world inside-out – is that a reason to take action now? I do think so.
Kevin: Yes, 3% — that would three times the 1% that we are moving toward.
David: The Fed is way behind the curve. The third thing that stands out to me, the Atlanta Fed lowered its first quarter GDP growth figure to 1.2% last week, and remember where we were in January 2016. As we disappointed with the GDP statistics the market sold off considerably. Remember also that the economy was weaker than expected and everyone said, “But that’s okay, by the fourth quarter we’ll see a pickup in GDP growth here in the United States.” But, what did we end up with? GDP in the fourth quarter was a disappointment. We were at 1.9% for the year, I think 1.6% for the fourth quarter. Why does that matter? Well, if you’re looking at trends, 1960 to, let’s say, 2010, your average GDP growth rate was 3.1%. And the average from 2010 to the present has been about 2.1%, and we did not even get above those averages for the year, with the help of the fourth quarter which was supposed to be incredibly strong, and wasn’t, and here we are starting the first quarter of the year, and the mantra is, “Growth in the economy, growth in the economy – can’t you see it?” And lo and behold, there are some relevant statistics to say, “No, we can’t see it. We can’t seem to find it. What happened to that? That economic growth we’ve been talking about – where did you put it?”
Kevin: Well, and you need it, because we have the debt. We’ve talked about that with Richard Duncan. But look at Europe. Draghi has been sort of the guy with quantitative easing over the last few years. He picked up the baton after we slowed down and tapered. Draghi has been upbeat, but it’s the whole talk the market up type of upbeat.
David: Right. I thank Dave Burgess on this on the MWM team for this insight. If you haven’t read his Friday recap, I would. Particularly for the busy executive that needs sort of a three-minute market summary at the end of the week on Friday, his recap is superb, at mwealthm.com. What he was pointing out is that Draghi is taking an upbeat tone on the European economy. That is what he is saying with his language. He said, “They’re on the eve of a 25% reduction in QE. They’re going to cut back what they’re buying.”
Again, this is monetization of government debt, and they’re going to cut that back by 25%, except how do you do that when factory orders are in decline by over 7% and industrial production numbers are disappointing. Germany is looking at some of the ugliest numbers that it has seen in years, and yet Draghi is trying to talk positive about the European economy. It is kind of an interesting juxtaposition.
Kevin: One of the best indicators that you have talked about in the past is, don’t look at what they say, but go ahead and look at what the tax receipts are.
Kevin: Because we all have to pay taxes – supposedly – and if your tax receipts are lower, then guess what? Usually, your revenues are lower.
David: The Rockefeller Institute reports tax receipts growth down at the state level, and that is across several categories – personal income tax, sales tax, and corporate income tax. Corporate income tax saw its fourth consecutive quarterly decline, and this one by 10.4%. Folks, tax receipts don’t lie. Where is the economic growth? Stock markets say we have it, tax receipts say we don’t. What do you take to the bank?
So, why would I be acting now, getting more conservative in a portfolio, being risk-aware, instituting a short to offset long positions, adding to gold positions, moving to cash? There are some things that you can do to reduce your risk profile, and if you’re not doing them, I’m saying it’s going to be problematic for you.
Another thing that stands out to me as a reason why: January – insider buying saw 279 U.S. executives adding to their company stock positions.
Kevin: Only 279, out of all the executives?
David: That’s the lowest in records going back to 1988, according to the Wall Street Journal.
Kevin: So, you talk about tax receipts not lying, but because of the law, and if you are an executive for a corporation, you have to show when you’re buying and selling, it’s a simple thing to look and say, “Where are all the executives?” Because a good portion of their payment program is in shares.
David: Yes, and if they believe that they are going to be seeing growth in their company shares from this point forward, why not add? Well, it’s the man-on-the-street who is adding. The executive looks and says, “Thanks, but not now. In fact, I’m a seller, not buyer.” Friday’s non-farm payroll numbers were interesting because they came in, basically, where they were supposed to. 200,000 was the estimate. Everyone on Wall Street said, “Yeah, but 230,000 is probably the more realistic number.” Friday’s non-farm payroll was in line with those expectations at 235.
What I don’t like is that seasonal adjustments added 145,000 of those. And birth/death modeling added another 124,000 of those. So, again, strong jobs growth over the last two years should be showing up in tax receipts, right? So why isn’t it? Or are we really talking about strong jobs growth? No. We’re talking about a statistical aberration where out of 235,000 jobs, 145,000 can come from seasonal adjustments, 124,000 can come from a birth/death model which is literally, “Well, we think there should be this number of people born, and statistically, a certain number of years ago they were born, so they should be starting businesses and hiring people today.” That is the birth/death model – a certain number of people dying and closing down businesses, a certain number of people being born and creating new ones. And they come up with 124,000 jobs? That is fiction. I would say, well, maybe I’m just being a negative Nancy – apologies to any Nancies out there – but tax receipts should tell you that jobs growth is real or not. Jobs growth is positive.
Kevin: Something you brought out a couple of weeks ago was the thought that at some point the excess reserves are going to be coming back in to the market in the form of bank loans, but it seems that there has been a sudden reversal that was unexpected, actually.
David: I think we will see some of those reserves trickle into the system. I don’t know where, I don’t know when those loans will be made, but bank loans in the commercial and industrial category unexpectedly dropped to a five-year low. Is that an aberration? Is that sort of, again, sussing out who has the best credit and who is going to get the money flowing through the banking system? I think there will be a massive influx of loan dollars from those excess reserves of depository institutions into the economy, but we have to decide, is this an aberration, or is this credit flow shifting at the periphery of the market? And it is worth trying to figure out what is happening with the commercial and industrial category there.
Kevin: Well, with all the reasons that you have listed, I think the moral to the story is, you don’t rush right now into an over-priced stock market. It is probably best to stay conservative.
David: Now, folks, if you want to get out of a conservative allocation, whether that is metals, cash, or some combination – be my guest. Months from now, the world is going to be scrambling to get in. Where are you going to go anyway? This is kind of an interesting thing. If you wanted to sell gold today, where are you going to go?
Kevin: Where is value?
David: What is cheap? What isn’t already locked into the greater fool theory of investing, where you paid a high price, and you expect someone else to come in and pay an even higher price? Those are the pricing dynamics we see in the equity, and bond, and real estate markets today? If you are unwary today, I would suggest that you are unwise. That’s all I can say.
Next week we are going to have two in-house guests from our Wealth Management Team to look at the world from their perspective. I’m going to send you a link later this week. It is a short interview featuring our favorite credit analyst, Doug Noland. And until next time, have a great week.