The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“On today’s program, sluggish growth in America and China, yet every topping bell indicator is ringing in the over-valued U.S. stock market. How many times do we have to see these signs repeated – 1987, 1989, 2007 – to get out of the market in time?
– Kevin Orrick
“Again, count it all together. You have half a trillion dollars in borrowed money – margin money. Then you have 200-400 billion dollars in volatility-sensitive professionally managed assets which trades exactly like the portfolio insurance models of 1987, right? So selling begets selling, begets selling, and that is what your safety is based on – getting out of the way of the market.”
– David McAlvany
Kevin: It is interesting, Dave, over the last few years we have seen flight capital coming out of countries. I think of Cyprus, or I think of Greece. It looked like money was going to be trapped in a system, and it flowed to two major places. One was gold, when it could be had.
David: And typically, the other was Treasuries, although to a lesser degrees in terms of total volume you also saw some interest in things like your crypto currencies.
Kevin: Right. Well, and the thing is, Bitcoin soared during the Cypress thing, if you recall. That was a couple of years ago. Gold was also being purchased at that time. Now, we are seeing something fascinating right now. We are seeing Bitcoin absolutely going parabolic. Just the last few days, the last few weeks. And gold is seeing strange short types of activity. In other words, in low-volume periods of time you will all of a sudden see 20,000 contracts of paper gold shorted on the market. It is just fascinating to see that maybe there is something going on. You have flight capital possibly going into Bitcoin, and you have someone – I’m not going to name who it is – wanting gold to continue to stay down.
David: And particularly the traffic on Bitcoin is interesting because, on the consumer level, Chinese and Japanese investors have taken much more of an interest in it of late. And you look at the financial system in Japan. Is it fixed? No. Do we still have a six trillion yen commitment to buy ETFs and stocks on an annual basis by the Bank of Japan? Yes. So, what do you have there? You have this mirage of reality, you have this false sense of security within the Japanese stock market because of the extraordinarily large footprint of the Japanese central bank.
We have different versions of that in different parts of the world, but in Asia you have seen more intervention of late and sort of controlling of the levers, trying to get the market to go a certain direction, and it is having an effect. Meanwhile, here in the United States, and I quote Bill King, who says, “Once again, the evidence is clear that the stock market has degenerated into a gauge of hope and hype, as well as abject speculation that is detached from reality. Masters of the Universe?” He says, “No, it’s more like Munsters of the universe.”
Kevin: (laughs) Well, actually, I did go to see Masters of the Universe, the second movie. It’s a lot of fun. I’m not a Marvel Comic fan, to be honest with you, but it would keep you laughing. But the Masters of the Universe that I’m talking about that do control the levers, Dave, are the central bankers, and there is this assumption that the central bankers are in such control at this point that a stock market really can’t go down, even though it is as over-valued as it has ever been since 1987, 1999, 2007. Do you think they really are in mastery control at this point?
David: Well, they have to be, to some degree, because you continue to look at sales numbers for corporations and those are not exactly impressive. You look at tax receipts at the state level and there are very discouraging signs in terms of economic activity.
Kevin: Right. There is a slowdown. Look at the GDP figures.
David: We had a great time talking with Kamran Bokhari last week about everything Middle East, and did not have time to talk about the GDP figures which were out the week before, and those are worth some note because the soft patch is being described by the Fed this way. This is, again, in response to the GDP figures. He says, “The committee views the slowing in growth during the first quarter as likely to be transitory.”
Kevin: How many times have we heard the word transitory, Dave, in the last five or six years?
David: It’s one of their favorite words (laughs). We certainly hear it often enough. But here are some of the highlights. As we were talking, again, Turkey and everything Middle East last week, we didn’t cover the highlights of the report and we had the worst consumption decline since 2009, so consumer spending, not particularly attractive, inventories increased by 10.3 billion dollars.
Kevin: Right. And we’ve talked about that. When inventories are increasing it is because people aren’t buying.
David: Right. So there is this relation between bloating inventories and sales, and lo and behold, the price to sales for the S&P 500 is at new highs.
Kevin: So what you mean is, the S&P 500 is over-priced relative to sales. That is the ratio you are looking at.
David: Right. And I should say, while the S&P index is at new highs, the price to sales ratio with the S&P is within a stone’s throw of its all-time highs.
Kevin: That was back in 2007, wasn’t it?
David: Actually, the year 2000, and we are already far, far above the 2007-2008 timeframe.
Kevin: So we’ve passed the warning sign on that.
David: That’s right. So again, maybe sales are not a requirement in the new economy.
Kevin: Well, remember Richard Duncan. When we have him on he says, “Well, you can just make up those decreases with government spending.”
David: Right. But we did not see that in the last quarter. We actually saw government spending decline by 1.7%. So again, if you have a decrease in consumer activity, if you have a decrease in government spending, you are leaning pretty heavily on the corporate sector to make up the difference. And lo and behold, they didn’t, which is why we ended up with a pretty punk GDP number.
Kevin: Well, it wasn’t all down though.
David: Residential investment was okay, so if you’re talking about housing, residential investment improved nearly 14%.
Kevin: Right. And I know we’re drilling more with oil.
David: And of course, the bright spot there with real estate was attributable to good weather. But right, oil drilling – that’s another source of investment which was on the rise. That is another bright spot in the GDP report.
Kevin: Speaking of the Middle East, that is what is hurting the Middle East and Russia right now, is that we are drilling more.
David: It’s true that the greater efficiencies gained in the shale drilling – we are now producing 9.3 million barrels a day – when you throw in Libyan production, and various and sundry sources in the Middle East that are trickling in that don’t really play ball with OPEC, it makes OPEC’s cuts from last year very muted. And of course, prices are dropping again. So, you have crude which is down pretty significantly here in recent weeks, actually, the commodity that has been pummeled the most. And yes, it is edging lower because you have supplies which are very elevated. But more on commodities in just a minute. I think it is worth noting that there are numerous tensions in the Middle East which are being glossed over at this point.
Kevin: Yes, what Kamran Bokhari was talking about last week – it is just not being priced into the markets right now.
David: And that’s why we spent a little bit of time talking about it, because what is not in view for the market is usually what takes you by surprise and what represents shock. So, I can appreciate why we are talking about the Middle East, it is not on anyone’s mind. Well, that’s right, it’s not on anyone’s mind. That’s why we’re talking about it. Because again, it is those things that surprise you that can often be damaging to one’s portfolio.
Kevin: Historically, Dave, when you have stock markets that are hitting all-time highs and financial manias going on at the same time that the economy is slowing, I think the GDP for the first quarter puts us in at less than 1% — I think it is 0.7%.
David: That’s right. The U.S. economy grew at the slowest pace in three years. This is the case that we are making for brave moves higher in the stock market is that it is supported by broad-based economic recovery?
Kevin: This is why I think you are carefully approaching a short fund at this point and recommending people who need to hedge their stock portfolio. At least look at the short side while we’re hitting these highs.
David: That’s right. We actively manage a short exposure with Doug Noland, and I found it very interesting, Kevin, that in talking with a number of institutional asset managers about what we do, and what we can do for them, along with high net worth individuals, there is a professional asset manager, probably age 45, certainly low to mid 40s, and his response was this. “We don’t need anything like that. It’s not like Armageddon is around the corner.”
And it was interesting because there is the view of the seasoned investor who has been through multiple market cycles, has a few more gray hairs, a few more years behind them, and their response to our offering is so different. It has been very receptive there – big interest. But it’s curious because it reminds me of the kind of conversations I had when I started at Morgan Stanley back in the year 2000. It was before any real significant price declines had occurred in tech.
Kevin: It had been 13 years since a stock market crash.
David: There was a generation that had never seen a decline of more than 10-20%, and any time it happened it was very short-term in nature. And it always lacks that quality of sort of a corporate Darwinian event. “Extinction is not in question here…”
Kevin: Well, we have the Masters of the Universe now, Dave.
David: And that is the ingrained belief, that central bankers can, in the modern era, the 21st century, somehow control the downside. There are tools in the toolbox which today have changed the investment landscape. Or so it is believed. It is interesting, because again, we get this feedback from experienced investors, whether it is private or professional, and they recall earlier iterations of the same sort of enthusiastic justification. And there are still doubts about central bank alchemy and the events that follow.
Kevin: I think we should probably look at things in a more broad way. When we talk about the stock market we’re not talking about all stocks. A big part of what is going on in the stock market really just boils down to just a few stocks – Facebook, Apple, Netflix, Google, Amazon. We’re looking at a very small number of stocks representing what percentage of the stock market right now?
David: Right. With the theme of index buying, and indexes now representing the better part of 25% of the total stock market where people are buying ETFs, and that is a huge change in the market in recent years.
Kevin: Right. They’re not picking stocks, they’re just picking an index of stocks.
David: Because they feel they need an exposure to a certain sector, or what have you, and what that does is, it concentrates buying in the biggest names within those indexes. So there is a disproportionate amount of buying that is done because the index is weighted a certain way, and it is not buying on the basis of a thoughtful, discretionary process where a professional is looking at the business prospects, looking at the balance sheet, weighing liabilities, and determining whether the management of that particular company is going to drive future growth. Again, it is a disproportionate volume into companies just because of their position in the index.
Kevin: And right now the beanie-baby of the realm. Remember beanies babies? They were the hottest thing – and then they weren’t. But the Beanie Baby of the realm is the acronym FANGs, which is Facebook, Amazon, Netflix, Google.
David: Yes. We’ve seen it in every age. We’ve got your nifty-fifties, we’ve got your dogs of the Dow, you’ve got a variety of things which become popular themes that you invest in. And these themes kind of define a generation’s view of where you should be putting money. The FANGs, of course, Facebook, Amazon, Netflix, Google, which is now Alphabet, and Tesla – these kinds of companies.
Kevin: And the prices earnings ratio, Dave. It reminds me of back in 1999 when price earnings ratios, which should have been in the 14 or 15 range, were in the, sometimes, 100s of percent range for single stocks, but as an average they got up into the 60s, 70s, 80s range. I think these FANGs are up in that range, are they not?
David: Right. If you just take five companies, they represent one-third of the move in price from the beginning of the year in the S&P 500. Barron’s has been asking a very reasonable question, and it is this. Is the collective PE, which is averaging 92.3, of these companies, indicative of a bull market which is long in the tooth?
Kevin: That means it would take 92 years to break even from the profits or dividends of the company.
David: It is not stopping the parade. The investors who step in and say, “I don’t care if it is 92 years or 1,000 years, you don’t understand the story.” And I read more and more about sort of this idea of a market melt-up which you just can’t afford to miss out on. And as I recall, market melt-ups last a fraction of the time that the ensuing market melt-down and recovery does. So, you look at Japan melting up over a period of months, and it circles ever lower, working off the excessive enthusiasm for the next 20 years. That is a long time to recover value on the basis of your view of a storied company. When others are excessively brave – again, this is not necessarily brave for any particular solid reason, but just blindly brave – when others are excessively brave, you should be cautious.
Kevin: And there is an error in being too optimistic. When you are an investor, probably one of the best ways to measure where you are, as far as the overall attitude of the people, is to just look at the Volatility Index. When the Volatility Index is low, then at that point that means that there is an awful lot of artificial comfort built into the system. We’re at all-time highs on some of these markets, all-time margin debt on some of these markets, yet the comfort with the market, which a low Volatility Index would show, seems to be really in place.
David: That’s right. And I think this matters because the fear index, as that Volatility Index is also known, you can think of it as a sort of investor confidence gauge. When you slip from those double-digit levels to single-digits, the consensus view amongst investors, as indicated by their buying behavior, the view is off the charts bullish. And frankly, it is typically a great contrarian indicator. What would we do in response to the VIX, which is now below 10? The VIX has reached 9.77.
Kevin: When was the last time that happened?
David: 2007.
Kevin: Right before the last crash.
David: That’s right. When you get to single-digit levels in the VIX, it’s not a timing indicator, it doesn’t tell you that things are about to crack apart in the next 24 hours. On the other hand, it does give you an indication that everyone in the investment community is all on one side of the boat. And that is not a very good place to be. It doesn’t represent stability.
Kevin: I saw a picture on the news yesterday, Dave, of a pilot who has now been put on suspension. They showed the picture of where he was for 2½ hours during the flight, and it was a reclined seat in First Class with a blanket over him. He was just sleeping. Now, he was only one of the pilots on board, but that was a clear breach of the rules. What is interesting to me is, I picture the average investor like that. They’re at 40,000 feet, they’re flying at 500 miles an hour, and they’ve got a blanket over them, and the Volatility Index is up. They’re just pulling that Volatility Index all the way down to single digits, because “the stock market is fine. Don’t worry that we’re at 40,000 feet. Don’t worry that we’re at 500 miles an hour.”
David: Hush little baby, don’t you cry (laugh). Yes, what is that nursery rhyme about, “when the bough breaks?” Well, the VIX tells us that we may have found sort of the gateway to nirvana. That’s the idea. You have central banks, who are the modern-day alchemists, and they have created this context where you just assume that it’s different this time. And who is in line for the easy money? The easy money is looking for the one-way bet because stocks can’t go down, they only go up. We know that. That’s the nature of central bank alchemy.
Kevin: And you are not a panic-oriented guy, Dave. You’re very calm. People who have listened to the show for years have heard that you have a healthy dose of skepticism, but you’re not a guy that panics. I’ve been with you in situations where I probably would have panicked (laughs). You know, sports types of situations, that type of thing. And you’re very level-headed. I certainly wouldn’t have gone climbing with my son on the spires that you did over in Moab. But healthy skepticism – we were talking about that earlier. When you get into the car and put a seatbelt on, it’s not that you’re panicking, it is that you have a healthy sense of skepticism that you are going to arrive the way you started.
David: Right. And I don’t think there is any reason for us to ever take a tone of fear or panic, but I agree, healthy skepticism is what keeps an investor intact through long cycles. And when you get to periods of excessive valuation, it is pretty easy to second guess and say, “Well, gosh, it’s gone this far, maybe it will go further. Yeah, I wouldn’t want to miss out.”
Kevin: Well, and maybe it will, Dave.
David: And maybe it will. But I think you need to remember this. There is the opposite danger at the other end of the spectrum – too much pessimism, and too little optimism – and that is the birthplace of a long-term bull market.
Kevin: And we’re not there right now.
David: No. What I’m arguing for is that the sentiment in the market indicates that we have universal enthusiasm, record valuations, and really, the birthplace of a bear market. But the birthplace of a bear market is not obvious, any more than the birthplace of a bull market is obvious, because the tone and tenor – think about that. You have generational disillusionment at a market low. Nobody wants to touch the asset that they should be buying with both fists. Nobody wants to touch it because it is viewed as toxic, as worthless, the story is dead, the love affair is over, and people are ready to move on, maybe for a generation. Again, we’re at the opposite end of the spectrum here. But in both of those ranges, if you will, at the extremes you have the birth of a new market. And I think that is where we are.
Kevin: We were talking about GDP here in America, and a person would say, “Well, you know, GDP doesn’t necessarily have to rise, as long as you have an engine of growth somewhere in the world. Now, the last decade, especially, China has been that hope. It has been the engine of growth. But we are starting to see some of the commodities that China holds a large amount of, some of these industrial metals. They have been plummeting over the last few weeks.
David: The real issue with China is not so much the commodities, but what commodities are attached to. We’re talking about commodity-related credit. Commodity-related credit is like what we had here in the United States in the 2005, 2006, and 2007 timeframe leading up to the global financial crisis. We had mortgage-backed securities as real estate based credit, and ours is, to some degree. It is the same story, but a different iteration, in China, because what has happened is, commodity stockpiles have been used on a massive scale as collateral for real estate development projects. It is very interesting, the connection between commodities, the pricing of commodities, the nature of collateral, in China, and the growth in the real estate market.
Kevin: So when you see a drop in those commodity prices, then it may be saying something about another market.
David: Right. It is very complex, because you ordinarily would say that the industrial commodities are telling you a story about global growth. Maybe – maybe not. Maybe it is just a story about China. And we already have a slowing down in the Chinese markets. Prices continue to move higher. Tess Lombard out of London is saying that they would expect a 15-20% decline in sales in China, that is, in real estate. And the nature of a slowing market is that often a slowing market becomes a seizing market because you have dynamics on the downside which become self-reinforcing. And we saw that in the 1987 crash, but also in China, I think that is a real possibility.
Kevin: So when the value of the collateral that is securing the loan goes down beyond a certain point it becomes a self-fulfilling prophecy that it will go lower.
David: Right. There is added complexity within the Chinese market because the Chinese government, and specifically, the People’s Bank of China, has tried to rein in credit expansion through natural channels, and it has forced credit expansion into the shadows – that is, shadow banks – and through what are known as wealth management products. And the wealth management products are sort of these structured products that are supposed to look like money market funds, but give you an 8%, 10%, 12% “guaranteed” return.
Kevin: And they are gigantic, Dave. We’re talking trillions of dollars.
David: Keep that in mind. How do you have something that is a monetary equivalent, a low risk money equivalent, that yields 6%, 8%, 10%, 12%? But that is the way it is being sold, and you’re right, it has attracted four trillion U.S. dollars under those wealth management products. So again, China becomes a market issue, right here, right now. We had big declines last week in iron ore, and in steel, in the industrial commodities, and it seems to be related to concerns of tightening measures.
Again, there are risk problems which then emerge in the wealth management products, and within the shadow banking. Not a small issue. Four trillion dollars is not a small issue. The industrial commodities are implicated in two ways. Number one, you have over-supply, and that is because you have above-ground stockpiles, which we mentioned have been use as sort of a basis for asset-backed financing. And you have the inventory financing which, again, same thing. That has fed into the Chinese real estate bubble. And number two, you have global demand for those commodities, which is less than ideal.
So, in the final analysis, it is important to keep China in mind, not just because of its growing economic contribution to global GDP, the size of their economy relative to the rest of the world’s economies is continuing to inch up, theirs inching up, ours inching down. And the massive effect – I think this is the other reason you have to remember China – it has on commodities and on commodity-producing nations.
Kevin: Right. And what we want to see, as a potential enemy some day of China – we want to see peace over there, because if there is any kind of social disruption, or if the slowdown actually affects the pocketbook, they have a substantial military.
David: That’s right. So, if their credit bubble moves into a dangerous phase – they are tightening down expectations on insurance companies in recent weeks here, and again, kind of focusing on wealth management products and shadow banking. That’s where they are nitpicking right now and trying to tighten credit. But if economic weakness in that country accelerates, you have massive political implications within your own borders, if you are in China. So, in the final analysis, political implications in China, it is very difficult to see that not spilling out into the region, and beyond that, into the world.
So, I guess one of the big questions that we have is that as the PBOC continues to try to manage 28 trillion dollars in credit – 28 trillion dollars in credit – which is, relative to the size of their economy, absolutely mind-boggling, we have to figure out, is China going to be the primary exporter, over the next three to five years, of deflation, or are they going to be the exporter of inflation. Because I think they may set the tone for global financial markets and global economic conditions on the basis of what they are exporting.
Kevin: We have talked before about Dr. Copper, and Dr. Copper has been showing a substantial drop here recently. So, whatever that means, we could still have an inflationary outcome in some areas. But Dr. Copper is signaling deflation, at least right now, isn’t it?
David: And that’s the deal. Are we talking about the global economy, or are we talking about China? Dr. Copper had its worst drop in 19 months. The price of Copper has been in decline now for, actually, several years off of its more recent peaks.
Kevin: Well, is it a global barometer?
David: And that is the question. Is this Chinese growth concerns? Yes, those factor in. But the bigger question is – is it the global barometer for growth? And you, at least, don’t have it as evidence of an increase in construction, an increase in demand, and increase in economic activity, on a scale that surpasses above-ground stocks and available supplies. So, the other industrial metals are an issue, as well, and what we want to try to determine in coming months is whether the slowing trend goes beyond China and a stockpile issue, or whether there is a slowing trend in the emerging markets, as well?
Kevin: So, we talked about the markets being at highs, and all the indicators right now showing us 1987, 1999, 2007. And we talked about slowing GDP growth here in America, and possibly slowing GDP growth in the other engine of growth, which is China. There is an insurance policy, Dave, for people who are out in the investment world. They call them derivatives. They build these insurance policies that are all just a little bit different, but they are supposed to secure a portfolio. It is a little like what you are talking about – shorting a market. You are trying to secure a portfolio.
But derivatives are a little bit different. There are all these little types of contracts that have strange ties, and in the past we have talked to people who analyzed the market crashes, like in 1987. I’m thinking of Richard Bookstaber, who wrote A Demon of Our Own Design. He was talking about how derivatives actually became the problem. The insurance product that was supposed to insure the market from volatility and insure the market from crashes, actually turned into an accelerator of the crash.
David: Yes. That is the self-reinforcing nature of a decline, and that is what happened in 1987 when market crashed. Bill King reminded us a number of weeks ago that you had Dan Rostenkowski, head of the House Ways and Mean Committee, who was proposing disallowing a deduction on corporate takeovers.
Kevin: Tax deduction?
David: Yes. And then at the same time, Jim Baker, over the weekend, preceding the collapse in the stock market October 19th, started slamming Germany for different policy measures. Again, you think, does any of this matter? Well, it ended up triggering something that was sort of a self-cascading, or self-reinforcing event.
Kevin: And it was derivatives, wasn’t it?
David: That was, again, Jim Baker on the 18th. The 19th opens up on a very interesting note – that is, October 19th, 1987. Your insurance derivatives took over from there. And it is interesting that we have, roughly, today, 200 billion dollars in the market that is practicing a very similar dynamic hedge strategy as we saw in 1987, where, again, if volatility increases, you reduce your holdings – that is, you swell stocks – and when volatility decreases, going back to the VIX, again, it is shrinking in size.
Kevin: Right. And the VIX right now, you said, is as low as it has been in eight years.
David: It’s the lowest level it has been in eight years.
Kevin: Since the last crash.
David: So what do you do? If you’re trading volatility, then you’re buying more and more stocks as the Volatility Index gets lower and lower. And there is 200-300 billion dollars trading this kind of a model right now. So, yes, VIX is at its eight-year low, and you can assume that hundreds of billions of dollars of managed money are as fully invested as they have been in the last decade.
Go back to 1987, and managing equity exposure based on volatility is precisely what triggered the cascade of selling in 1987.
Kevin: Right. And then volatility starts increasing. At that point, the VIX just skyrockets.
David: Right. So then you get market selling, market selling increases volatility, which begets more selling, which increases losses, and forces models to sell even more. And the amount of money implicated in the 1987 crash – we’re talking about 60 billion dollars on a three-trillion dollar market cap back then – and now you’re talking about hundreds of billions in a space that is now 25, almost 30 trillion dollars. So, the numbers are bigger, and the percentages are bigger, because again, the 1987 crash – the portfolio insurance modeling was less than 2% of the total stock market capitalization.
Kevin: So what you are talking about is this 2% played a key role back in 1987.
David: (laughs) Yes, a 21% downside in one day.
Kevin: What is the percentage right now?
David: 4-5%. Now, I’m saying 4-5% if you also include your margin assets, as well.
Kevin: It sounds small, Dave, but it was 2% in 1987.
David: 2% in 1987 absolutely bludgeoned the snot out of the market. And there is 4-5% that is equally vulnerable, if not more so. Same dynamics in terms of volatility trading, on top of that a record amount of margin date, which again, there is a sell-by date – you have to pay it back at some point. And people generally tend to liquidate positions on margin if it starts to go against them. Either they liquidate it, or the house liquidates it for them. It doesn’t sound like much – 4-5% – until you recall that we have in play risk assets that are equal to 100% more than what is needed to drive equities 20-25% lower on a day – in a day.
Kevin: Let’s look at what is a little bit different this time, Dave, or a lot different, because I was there in 1987. That was my first year here with your family. That was an amazing year, but back then people were actually managing their money. You didn’t have index finds, that I remember. You had people actually buying and selling real stocks.
David: Right. The dynamic of the market became one of panic where people were selling indiscriminately, but the unique nature in 1987 is, that’s a rare thing to happen because people normally buy and sell…
Kevin: Selectively.
David: That’s right, and they weed through what they have.
Kevin: But an index fund doesn’t allow you the selection.
David: That’s the difference because today, 25% of the market – you’re talking seven trillion dollars – 25% of the market today is in index products. When you’re buying or selling, it is the equivalent of a panic sell where everything goes or everything is bought.
Kevin: It’s like a fruitcake. You cut it, it has all these different stocks in it – there could be very good stocks being cut away and sold at that time. Everybody goes, doesn’t it? When you have these index funds, especially, we were talking about Facebook and Amazon and those guys.
David: I love it.
Kevin: If you have the slice of fruitcake coming off…
David: (laughs) Fruitcake investing for the modern era! Welcome to the world of index funds. It’s preferred for those that love fruitcakes – or who are. Now, there is the allure of liquidity, the desire for sector exposure. “I need to own some biotech. I need to own this, I need to own that.” But the merits of an individual company have been lost. What it has done is, it has concentrated investors into ETFs. And yes, it is very easy to buy. And yes, it is very easy to sell. Unless – and this is the thing I think most investors don’t remember – unless it’s not easy to sell. We may test this in the not-too-distant future – a large number of sellers show up at once.
Kevin: Dave, you’ve got to have a buyer. If you have this 25% selling, you need a buyer. Who is going to buy Amazon, Facebook, Netflix?
David: Or the indexes? And the composite – all the other stuff that is in there? The market has to have buyers and sellers. And when buyers go on strike, it doesn’t take very many sellers to drive the market to nothing, or to near nothing, to see 20%, 30%, 40%, 50%, 60%, 80% declines. That happens. Now we’re talking about seven trillion dollars in non-discriminating, trend-following allocations via passive vehicles. And who takes the other side of the trade? Who takes the other side of the trade on 100 billion dollars? Who takes the other side of the trade on 500 billion dollars? Who takes the other side of the trade on two trillion dollars?
Kevin: Yes, but we have the Federal Reserve, Dave. Of course, they’re going to just buy everything.
David: Back to the Bank of Japan. Back to what we see modeled with the European Central Bank. How do you see a balance sheet go from 4½ trillion – and I realize, the Fed just two weeks ago was saying, “Oh, we’ll shrink our 4½ trillion dollar balance sheet,” and the market didn’t bat an eye. I think the market didn’t bat an eye because the market doesn’t believe them. There are massive ramifications to shrinking the Fed balance sheet, and there is actually good reason to believe that the Fed balance sheet’s next significant move – and I say significant – is higher, not lower. Because again, what we’re doing here is, we’re building in systemic vulnerability by our buying preferences with these autopilot funds, the ETFs. Again, count it all together. You have half a trillion dollars in borrowed money, margin money, the highest amount relative to stock market capitalization, relative to GDP, in history. Then you have 200-400 billion dollars in volatility-sensitive, professionally managed assets, which trades exactly like the portfolio insurance models of 1987. So, selling begets selling, begets selling. And that is what your safety is based on – getting out of the way of the market.
Kevin: And you have the fear, or comfort, index, at a low that we haven’t seen since before the last crash.
David: (laughs) Yes. And then we’re pretending that we have normal liquidity. And hypothetically, we do. But is there such a thing as an abnormal day where there are more sellers than buyers? Because the market structure today doesn’t support it. The market structure and the way we’re building index funds and exposure – it’s actually not necessarily panic that will show up in the market, it is just a blind liquidation, which is virtually the same thing when it comes to sorting out the trades.
Kevin: And there are things that can happen that we have never seen before, or haven’t seen in over a 100 years. A couple of weeks ago we were talking about World War I. When the assassination occurred in Sarajevo, which we all look back on and say that was the beginning of World War I – it really wasn’t. That was June 28, 1914. Everything just tooled along, the stock market was just fine, very little reaction when that occurred. And then, one month later, July 28, 1914, it was announced that war had been declared. And they just shut the stock market down for four months, Dave. The stocks started falling. There were no buyers. This goes to what you are talking about. When there are no buyers, what do you do? Well, it reminds me of the end of the movie Rollover, that Kris Kristofferson movie, where they just covered up all the screens.
David: Jane Fonda. It’s a family classic, as a matter of fact. If you haven’t seen it, you need to see it.
Kevin: It was based on the market just crumbling, and so they just covered everything up and shut it down.
David: To some degree, I think people are willfully blind to what they don’t want to see. We know that is true in human psychology. The things we don’t want to see about ourselves, we ignore. We cover it over. We have the equivalent of make-up which we put on subconsciously. And I think investors have certain beliefs that they want to maintain, and maybe that is about the style of their retirement, or the allure of some particular thing in the future. And you can ignore certain things which I think are very pertinent.
So since the 2008-2009 global financial crisis consumer credit has grown considerably. And the areas where it has grown the most – of course, we’ve talked about student loans before – it has also grown considerably in the auto sector. And seeing auto weakness here the fourth month in a row is significant. Four months down in terms of sales growth and inventories, and now you’re having banks who are starting to pull back from the auto loan business. And when you look at used cars, prices have begun to plummet.
And again, this was a huge source of growth in the consumer lending space. This is a key point to linger on because consumer credit growth – again, post 2008-2009, autos were a primary feature. As the cycle gets further and further along, what have we seen? The trend is, if you’re going to keep the trend in place and keep the momentum going, you have to find enough bodies to keep momentum going. So you lower your standards in terms of who qualifies for a loan, you extend the terms to make the payments cheaper, and maybe extend it out even to 70 months, or what have you.
But right now, banks are starting to take losses, and they are on a significant enough sized loan book that they say, “We have to be careful here.” It is interesting, it is kind of then, and only then, that bankers change behavior. They always have skin in the game, but very rarely do they lose skin. When they do, it’s like, “Oh wait, wait, let’s be cautious here.”
Kevin: And there is a pressure on bankers, just like there is a pressure on, say, hedge fund managers. When everybody is doing something, and you’re not, and they’re making money, and you’re not, well, they’re going to lose their job. So, what I’ve found through the years, Dave – it’s amazing. We can predict these crashes up to a point. We can’t predict exactly when they will happen, but when the numbers line up we can start warning people and say, “Well, look, when the PE gets this high, when the margin debt gets this high, there is going to be a crash.” But what is amazing after it happens, and everybody loses, that is what everybody says. They say, “Oh, well, but everybody lost.” When you talk to somebody, they say, “Oh yeah, it was 2008. Everybody lost.” That’s not true, but there is a consolation in just saying that everybody lost.
David: That’s Keynes. Keynes, many, many years ago, said, “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way, along with his fellows, so that no one can really blame him.”
Kevin: He was just part of the crowd, even though the warning signs were there.
David: And we’ve talked about sort of trends that are self-reinforcing. Bull market trends are self-reinforcing. Bear market trends are self-reinforcing. And I don’t know if that is close enough to swarm theory, which we have talked about in the past, but you just see that it moves and it moves and it moves, and then all of a sudden it just shifts. And everything shifts.
Kevin: So, when we have gone diving before, and we see a school of fish – thousands and thousands of little fish – they can go one direction, they can swirl, and then all of a sudden there is a predator and they go poof – at the same time. It’s because they’re making the decision based on each other’s reaction. This is very similar to what you are talking about, this exit with index funds.
David: I don’t know how the market accommodates 25% of all stock market capitalization being tied up in what is the equivalent of a mass swarm. And I don’t know what liquidations look like. And we have really, I think, done ourselves a disservice in creating efficiencies and lowering our cost for money management and things of this nature. We have actually underscored a primary weakness within the market. You assume you can sell. Good luck with that.
Kevin: Let me ask you a question. Like a Larry Fink, who manages between four and five trillion dollars.
David: And he is a part of that theme. A part of the reason why he manages nearly five trillion dollars is because he owns iShares, and iShares is a big index fund company.
Kevin: Even he is scratching his chin right now and saying, “Hmm. I’m a little concerned about the auto industry right now.”
David: Right. But he would say that is a front edge to an economic decline. It is a leading indicator. And yes, he has concerns about the economy, and that is something that he has been very vocal about. But how do we react?
Kevin: Vehicles have gone up pretty dramatically in my adult life. To go buy a car or an SUV right now you are talking $40,000 to $55,000. The profits in that vehicle are just miniscule at this point, are they not?
David: It is interesting. Better to be the dealer and sort of self-finance your inventory than to be the manufacturer, because GM makes an average of $1,418 per vehicle.
Kevin: On probably, what, an average being $40,000 vehicle?
David: Yes. Ford makes $1,174. Again, this is where swarm theory – everyone loves the idea of our modern day nifty fifty. And one of those being Tesla, throw Tesla in the mix – a very popular theme, it’s going to change the world, it’s clean energy, it’s everything positive including Mom’s apple pie.
Kevin: How much money does Tesla make when they sell one of their vehicles?
David: They lose $15,855, average vehicle.
Kevin: Yes, but they make it up on volume (laughs)! And it’s electric!
David: This is the nature of publicly traded markets. There is somebody who is a patsy, every day, in every generation. Maybe in the fullness of time Tesla wipes out GM and Ford and everyone else, but between here and there, you have some serious vulnerability. The only way they stay alive is to raise new capital. They are burning through investor capital like nobody’s business. Why? Oh, because they lose an average of $15,855 per vehicle sold. That is not a way of doing business. And yet, we have this opinion.
Again, imagine the swarm. This is a company who is being judged on the basis of its market cap and the trend for its share price, not on the basis of revenues, not on the basis of sales, not on the basis of profits. Which one of these is not like the other? GM is making money. Ford is making money. Tesla is not making money, but man, have they got a great story.
And so, the swarm does what it does, everything shifts, and it doesn’t matter if you make a little or a lot. The swarm has moved. When the swarm moves back and shifts a different direction, quite frankly, I’m afraid that there are frailties within the financial system today that are going to shock and amaze investors. They thought they were saving a few bucks buying an index fund. Little did they know that they participated – in retrospect I think this will be sort of the way the story is written. We understand the dynamics of 1987. We are setting those same dynamics in motion today, and actually, index funds play a part.
Kevin: Over the last year, Dave, we have been talking to people about the 65-week moving average on gold. Now, gold has had some increase this year, and that is what we would call an A-wave increase. A, B, C, D-wave, A being up. We’ve discussed this in the past. A B-wave correction, which is always expected, then a C-wave usually takes you to higher highs, and then a D-wave correction.
We’ve been in this A-wave for the last couple of months and it seems that we’re having a B-wave correction, yet the longer moving average, which usually tells the trend, the 65-week moving average, has continued to just plot higher and higher. So, I wanted to bring that up because people are saying, “Hey, what’s happening to gold right now?” Well, part of it is predictable.
David: And a part of it is inconsequential. I had this conversation this last week with Sean from the SGT Report. For our listeners who don’t know what that is, the sgtreport.com has a very large web presence and YouTube channel. What we were talking about is sort of economic uncertainty, unrest, and we brought up cryptocurrencies. I think he has an audience that is keen on knowing what are alternatives to the system.
Kevin: Bitcoin, that type of thing.
David: Yes, and I continually look at the system dependencies that crypto currencies have, and think that, ultimately, gold and silver – cryptocurrencies are like the digital version of gold and silver. The problem with the digital version is it is still system-dependent, and those are difficult dependencies to work around.
Kevin: When the power is off, whether it is EMP, or just the light switch – you don’t get it.
David: You don’t have anything. But we were also talking about the dangerously high levels of the stock market, the bond market, etc. And I think his audience and ours are less sensitive to price movements in the middle, seeing it more as opportunity to add ounces, as opposed to, “Oh my gosh, what’s happening? It’s down $20, or it’s down $5, or it’s down $50, or it’s up $3.”
The short-term moves aren’t particularly relevant to an audience that is concerned about maintaining value, maintaining purchasing power, having real money, and having something that is outside of the system, and not subject to a kill switch. And that, I think, is important. Gold and silver are outside of the system. Cryptocurrencies are outside of the system. Gold and silver are not subject to a kill switch. Cryptocurrencies are.
Kevin: So A-wave, B-wave, C, D, and none of that really matters in the long run because you are talking about preservation of an asset.
David: I understand from establishing cost basis, it is more advantageous to establish a cost basis at $1200 than it is $1400. But we’re talking about a small difference in price relative to not only where we have been, but also to where we are going. Over the next three to five years do we expect gold to be in a $3,000, $4,000, $5,000 range? We do. And we can map that out, and show you why, from a technical basis, from a fundamental basis.
But honestly, it has less to do – and this is the big point. We’re seeing these gyrations in price, and it’s like a short-term popularity contest out on the playground. Who is popular at this recess? Who is popular at the next recess? Does it really matter? If you looked back at the playground conflicts of yester-year, and said, “Who was actually successful in life, did it tie to who was most popular for five minutes on the playground when you were eight years old, or ten years old? I don’t think so. I’m not trying to win a popularity contest, and I don’t think the gold and silver owners are. We like real things, and we know that through time real things are worth owning.
Kevin: Something that has hit me over and over through the years is that there is no generation in the history of man, that if a person owned gold they would have gone broke. It’s hard to say that about most assets, but gold – no one every goes broke owning an ounce of gold.
David: It is equally fair to say, very few people have gotten rich owning gold. It does what it does, and there are opportunities to use gold as a currency to buy real assets, and I think that is where riches are made, in the transference of value between cash, or your best cash equivalent, in my opinion, gold and silver ounces, for real assets. And that is a value exchange I can be patient and wait for. I think our investors can, too.
It was interesting, I had a great rapport with Sean. My sense was that his listeners were in that same category of, “Volatility? One day to the next? One week to the next? This is not what we sweat.” What we worry about are the system frailties that exist, some of them by design, some of them by accident, some of them by investor preference where people think they know what they want, until the get what they want, and are disappointed.
Kevin: I really liked the interview. I think we should post it on this site this week so that people can listen to it. Even though it is a different service, it was a great interview.
David: Yes, we’ll post a link to the interview on our website, mcalvanyweeklycommentary.com, and for our YouTube listeners, they can find a link to the interview in the description below the video.
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