The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“On today’s program, we contrast a world where blind investing is holding a Dow and a NASDAQ at all-time highs, just as the economy and the GDP matches the lack of growth numbers that we saw back during the Depression years of the 1930s. The canary in the coal mine is choking on its last breath.”
– Kevin Orrick
“Creative finance is allowing for things to happen in the real estate market which could not happen otherwise, and when you build a foundation on the basis of creative finance, it doesn’t end well. We’re doing the same thing. You have the ultra-leveraged ETFs. Again, it is mind-boggling to me that investors can forget so quickly what happens when these things come unwound.”
– David McAlvany
Kevin: There is a race that has a long history. Actually, it was started by a client of ours, Dave, back in the early 1970s. Bikers here in Durango race the train that goes from Durango to Silverton. The train takes about 3½ hours. Back in the early 1970s this client of ours had a brother who worked at the train station, on the train, and he said, “Guess what? I’m going to race the train this time, and I’m going to ride a bike.” It is 50 some-odd miles, but the elevation gain is over 5,000 feet. It’s a tough ride, and you’re just coming off of that this weekend. This is many, many years later. It has turned into an amazing event with thousands of people. How do your legs feel?
David: They feel pretty good, actually. Close to 6,000 vertical feet of climbing. What do we all share in common, 2,000 people that did the race? Most of them finished.
Kevin: Including our client, who goes back to the first race back in 1972. He rode this race with the bike that he rode in 1972. He’s a monster.
David: (laughs) That’s fantastic. Well, what we share in common is suffering. As beautiful as it was – we had great weather – it’s a lot of climbing. And if you have ever been over those two mountain passes in a car…
Kevin: Molas and Coal Bank.
David: That’s right. It can be unnerving in a car. And it is definitely unnerving on a bike. I think Memorial Day weekend was an interesting time as a family. We definitely reflect back on the things that we are grateful for, the men and women that we are grateful for. We spent more of the weekend watching Band of Brothers, also a group of people who shared suffering in common. We spent more time doing that, I think, than actually time at the race. Because to us, it is important to keep things in perspective.
I chose to take the boys, my two oldest, to the 70th anniversary of the D-Day invasion a few years back, and as we went to Carentan, as we went to Sainte-Mère-Église, as we road in a jeep with some guys who were all from the Netherlands, there on Utah Beach. And then we went up later and looked at what seemed like an endless sea of white crosses.
Kevin: Dave, for the first few waves, it was just a killing field. These guys knew that they were sacrificing their lives.
David: To look at the gravestones of all these men and women who have given – and thinking about our armed forces going back decades and decades and decades, and being grateful for everyone who is in service to the country today. We do this bike ride every year, and we also try to watch at least a few episodes of the Band of Brothers because it is important to reflect on what we have to be grateful for. Freedom is not something to take lightly. I won’t bore you with the John Stuart Mill quote, but that is how we started our morning this morning, talking about freedom, talking about courage, and what it takes to maintain liberty. I just think that Memorial Day weekend is a pretty special time of the year.
Kevin: Sometimes you don’t know how much effort it takes to have freedom until you lose it. And it is important to train your kids to show them. Even though they haven’t been through a major war, or haven’t seen the effects of that, there is history.
Dave, speaking of being at war, all around the world we see tensions building. I think people are getting a little worn out hearing the next thing that happens with North Korea. Freedman was talking about the various areas of tension last week. And I watched gold. Gold reacted a little bit when North Korea launched a scud missile up into Japanese waters this weekend, but not much. Gold went up $2.00, $3.00. I think people are starting to get worn out on reacting to international tension threats, don’t you?
David: Yes, you know, I sometimes look back at a book, very influential in my understanding of the gold market, by Roy Jastram, called The Golden Constant. It is fascinating to me to see the current trends as we move toward Ethereum and Bitcoin, and an age of people being interested in something like gold, that has the qualities of gold, in terms of scarcity and requiring cost to produce. And at the end of the day, the best merits of these digital currencies are that they are like gold.
Now, they have other aspects that are not like gold. Last week saw the introduction of a gold currency in Dubai, and it has blockchain technology as a part of it, and it is Sharia compliant. It is kind of like the old old world meeting the new new world, with all of the real merits of a currency, because again, it is the actual metal, itself.
Kevin: It’s gold. It’s public key cryptography. It’s like Bitcoin.
David: That’s right.
Kevin: But people are looking for something different. Back in the mid 1990s, Dave, I remember going out to New York to meet a man named Jeffrey Christian. I would have to say he is the king of understatement in gold. He is with the CPM group, and the mines pay him to give them an analysis of what he thinks gold will do. I will tell you, gold was about $300 an ounce at that time. And every time I have read Jeffrey Christian’s work, every year, he is the king of understatement. “Well, gold may go up a little bit this year.”
I think that may be job security. I’m not trying to be mean, but gold was $300 at that time, and we have gold at over $1200, between $1200 and $1300 now. I don’t think Jeffrey ever really stated anything of that kind of large effect in move, but he is changing his tune from being the king of understatement. He said something just recently, Dave, that got my attention, anyway.
David: Well, obviously his comments, being a month or more old, he is not thinking about the Dubai currency which is backed by gold. He is just looking at the world, and he is looking at what is happening politically and geopolitically and saying, “We have the context for gold taking out its nominal highs.”
Kevin: Which was $1900.
David: $1900, $1920. And he is almost always bearish on gold. And yet, he sees U.S. political dysfunction and international relations strains pushing gold past those all-time highs over the next 36 months. So if you did the math on that, you’re talking about 12-15% per year returns over the next three years. What is his background? Goldman-Sachs used to have a commodity trading division called Aaron Trading, and this was his baby. He was running that before it got spun out of Goldman-Sachs.
And honestly, I don’t think I have ever heard the guy suggest a price move up of $50 or more. It didn’t matter, whatever the price was, it might go up $50, but it could go down $300. It has always been that disproportional, “Be prepared for the downside, don’t expect too much.” And you’re right, in that he is always understated, and he is putting himself in a position where he can’t be wrong.
Kevin: Right. He seems to be looking at the political situation worldwide. You have players right now like Merkel who are changing their tune with the major central bankers there in Europe.
David: I think one difference between, say, the drive for owning gold and, say, either a digital version of it like the Dubai currency, or even something like Ethereum or Bitcoin, is that gold is truly not only out of the system but it is also off the grid. That is the difference between those other currencies – they’re out of the system. And there are a number of smart people that want out of the system. They are not asking the question if they should be off the grid. It is in the context of political dysfunction and geopolitical tensions and should they rise from now to 2020, but perhaps the question of being off grid and out of the system coalesce.
Kevin: Dave, Jeffrey Christian looks at the dysfunction. It’s not just political, it’s financial. He wasn’t commenting on this at the time, but I noticed, day before yesterday, that a major hedge fund in Australia is giving all their clients their money back – millions and millions of dollars in money back – because they’re looking at the markets right now and they’re saying, “You know what? We don’t want to ride this next crash.” So you are seeing people who were making money in the market saying, “You know what? This is out of whack.”
Even looking at Europe right now, Merkel, who has benefitted from the European Central Bank bailouts – whatever you want to call it – the low interest rates, the printing of money, the quantitative easing – she has been distancing herself, not just from Donald Trump, but she has been distancing herself from Mario Draghi. That is a big throwdown.
David: Openly critical of his European-wide monetary policy. And of course, the euro, as a currency unit, has traded considerably lower over the last year or so. I think what Merkel is doing is essentially putting herself on record as the one who is not responsible for currency manipulation. That is as a prelude to a conversation with Donald Trump, and I think as evidence that she regards the ECB policy, that is Mario Draghi and what he has been doing, as solely responsible. So German goods may be comparatively cheap, which is not a bad thing if you want to sell …
Kevin: And he has delivered that by lowering the euro, right?
David: But it is controversial if it is done intentionally. And I think there is something more that she wants from this sort of Donald interaction. Perhaps she doesn’t want the scourge of criticism over a massive trade deficit with the U.S., and what Donald Trump over the weekend unleashed – inadequate NATO funding. “Step up, do your own part.” And she has lashed back and basically said, “The old partnership is gone, thank you very much.”
I think what is happening is they are both in negotiation mode and Trump wants the best deal possible. Merkel – what is she trying to do? Standing tall against Donald, I think, helps her odds of an election win, as most people in Europe – at least, most of the people that I’ve spoken to – dislike Trump, and they appreciate strength pitted against strength. So the more that she can kind of bull up a little bit and suggest, “Well, you can push anyone around, but not here.” That helps her in the election cycle.
Kevin: Strong leadership, a lot of people would argue, is what got Donald Trump elected. Now, whether he is doing what he said he would do or not is debatable, but if you talk to anybody they would say that Donald Trump at least exhibited strength in business, and that is what got him through. You think Merkel may be doing the same thing.
I want to shift to the markets, though, for a moment, Dave, because I mentioned this hedge fund that came out just recently and said, “You know what? We’re not going to play through this period of time because we sense that there is going to be a horrible, horrible crash. Now, when markets start to get really toppy, a lot of times volumes decrease, and the breadth of the market decreases. You start to find that the bigger players start moving to the side and you have just traders going in and buying, popping it up a little and then selling, popping it down a little bit. They call that a trader’s market, and that seems to be where we are right now.
David: Both of us fly planes, or have, in the past, and you know what indicators are good for. You use your instruments and they give you these ideas of what is going on. And it doesn’t matter if the lights are out or the weather is bad and you can’t see in front of you. You know where you are in light of the indicators that you are looking at. Again, you don’t have to see it, you don’t have to feel it, and sometimes, in fact, when you’re flying, what you feel can be deceptive. And if you trust what you feel, you can sometimes auger into the side of a mountain. You need to look at your instruments, you need to look at your indicators, and get a read on where you are and where you are going in light of those.
Kevin: So where you are going with this is, the volume, the breadth, those types of things, are the instruments of the markets.
David: Exactly. So you have volumes and breadth, and as you say, it is a trader’s market. There are no real, large buyers, and haven’t been for weeks. And you have momentum, which is still coming through from the exchange-traded funds, and that is just a blind, broad sector buy, and that is driving the largest names in the industries.
Kevin: The FANG stocks – Facebook, Amazon, Netflix, what was Google – those are driving fine right now because of the ETFs, but otherwise everybody’s gone.
David: And I don’t think this can end well. Just think about it. Again, these are just indicators. Lower trading volumes on rallies. So, in other words, as the price is increasing there are less and less shares traded, and then higher volumes on any day where there are declines. So that is the smart money, like the folks from Australia saying, “Now is the time to probably exit stage left, so if we have the opportunity we’re going to take it.” So, less people participating on the upside, more people participating on the exit side, when you have a down day. And you also have regular end-of-day selloffs where people kind of take the survey of the land and say, “Um, yeah.”
Kevin: “Not going to stay until tomorrow.”
David: “Not going to stay until tomorrow, don’t need to see how it opens up.” A lot more of that. It’s all there, folks.
Kevin: So, do you think we’re going to have a black swan event this year? I’m going to throw a big question at you. Black swan is something we’ve talked about before where somebody says, “Well, we couldn’t see it coming.” But in reality, you can see it coming, you just don’t know the trigger.
David: I wrote a paper on this for a conference I am attending in July and will present the paper there. The issue is not one of black swans, because I think the idea is that a black swan is an event that surprises you. You really couldn’t see it coming, it was that low probability, once in a hundred year flood type of thing. But that is not reality. We have information, we have little yellow birds dropping like flies.
Kevin: Like canaries in a coal mine? Is that what you’re saying?
David: Exactly. And if anyone is surprised it is because they tuned out and turned off their thinking cap a long time ago, and have ignored the facts long enough to be surprised. But shame on them. Shame one them. At this point, any real surprise in the market is because people aren’t looking at the indicators.
Kevin: We’ve moved from 18,000 to 21,000 and some change on the stock market, on the Dow. Most of that has been based on the Trump effect, people thinking that there is going to be a change in the economy with Trump. But even yesterday morning, my wife had the news on, Good Morning America, and of course McCain came on, and he has his doubts right now about Trump because of the Russian affair. It seems like the first story every morning is, how are we going to attack Trump?
You know, Friedman even talked about that last week. He said the press is just going to continue to lay on him. But the expectation in the market – you’re talking about a trader’s market – the people who were fueling this market based on expectations that Trump is going to pull through and actually get some of these things done – it seems like that might be waning right now.
David: Right. So the question is, can he reasonably expect some sort of legislative coup? Because at this point, it would take that. You have investors who, I think, are beginning to wonder if Trump can make progress with his domestic agenda. And enough of those investors – I think the smart ones – are moving to the exits. You have the Democrats, you have the McCain Republicans, which are a type of Republican, and that is actually not a positive thing (laughs). They have too many years of doing too many shady deals to not try to absolutely crucify Trump. Those are his headwinds. His headwinds are the majority of corrupt Republicans and Democrats. That is not every Republican or Democrat – but the majority.
Kevin: The go along to get along crowd. That is Washington D.C., is it not?
David: Yes, well, he is digging, he is cleaning up at the margins in a town where, you are right, in D.C. you have to go along to get along to get anything done. It is about compromise and really not asking who has what hidden in their closet, skeleton or otherwise. So I think at this point you can divide investors into two broad categories. The sober-minded realists – hopeful, but with some doubts, uncertain that Trump can actually move the policy pigskin down the field. And more of the hope and hype suckers that see what they want to see, hear what they want to hear, and frankly, represent the guy at the very end of the buyer’s line. At the very end of the line – the last buyer.
Kevin: It’s the hopeful buyer. So, we’ve moved from 18,000 to 21,000. What does it take to take it from 21,000 to, say, 22,000 or 23,000, Dave?
David: To take the markets considerably higher you have to have a significant catalyst. Again, maybe that is a legislative coup where we go from theory to implementation of some of Trump’s policies. But I think, frankly, it would have to be something even bigger than that, because – you know, the whole buy the rumor, sell the news idea – by the time he succeeds in something we’re going to look back and say, “But yeah, that’s why the Dow moved up 3,000 points.” What do you do for an encore?
Kevin: It’s called pricing it in already.
Kevin: A lot of people don’t understand that, but when a news event happens that they think is going to push the market up or down, it has already gone up or down if they have an idea of the way it is going to go, and then the trade goes the other direction.
David: Yes, moving the needle from 21,000 on the Dow to some higher number – it’s a big task. And we’ve already come, as we mentioned, from 18,000 to 21,000 since the election, on the assumption that Trump is going to deliver a new style of growth. So say, for the sake of argument, that is priced in. You need more than the delivery of the promise. You need something more than what was expected, because it was expectations that added 3,000 points to the Dow, and it is expectations which are likely to be in the driver’s seat through year-end.
Kevin: Which brings in the word “disappointment.” Disappointment seems to be more powerful and more ferocious than expectations, oftentimes.
David: Because of the experience of it. Disappointment of expectations is a very different thing than the meeting of expectations. A meeting of expectations just means that you got what you thought was going to be reality. And when you don’t get what you think is going to be reality, that is when you have a much more visceral response, and I think in the marketplace, much greater volatility.
Kevin: So you have said, “Sell in May,” and the old adage – that still holds.
David: Well, I think “Sell in May and go away,” is going to be, in retrospect, more than sort of folksy wisdom. I think the likelihood of panic selling later in the year by those investors that counted too much on the presidential promises – don’t forget, during the election, before November, it was Donald Trump describing the stock market as – these are his words – “A big, fat, ugly bubble.” And of course, that’s what he inherited – “No, no, no, he’s the reason why it’s going up. But it’s no longer a bubble. It’s all quite reasonable.” Again, we can sit back and ignore economic realities, but I think the more we do, there is more implicit risk in the market.
Kevin: I was with some people this weekend, Dave, that don’t necessarily politically agree with me, and I just listened, and they were very much pro-Obama. They were talking about the economy, and the Russian thing – this thing that the press has just been continuing to drum up as if it is the biggest thing. It wasn’t the biggest thing to them. They are waiting for a crash in the economy. What they are saying is, “Oh yeah, you have a lot of people out there that are positive for Trump, but he hasn’t had to endure a market downturn yet.” And I thought about that, and that probably is going to be his true test as far as people sticking with him.
But this press thing – let’s go back to the Russians for a second. It is so amazingly hypocritical. Dave, I haven’t met anybody who is at all interested in the Russian connection, whether they are liberal or conservative.
David: I was intrigued by an article that was reprinted from 2009. This was a Forbes magazine article. It highlighted Ted Kennedy’s pleading with the Russians to help turn the 1984 presidential election.
Kevin: That was before the wall fell, Dave. That’s when we had the Cold War at its peak.
David: That’s right. So Kennedy wants, and the DNC wants the Reagan guys out. Kennedy is willing to visit Moscow – this is in conversations with Andropov – and give them what they need to step up their propaganda war. This was in the middle of the Cold War, as you say! No investigation, no special prosecution, just a bleeding heart liberal in cahoots with communists to help throw the election to Democrats. Again, no evidence has emerged yet that Donald did anything illegal. Even Alan Dershowitz, not exactly Mr. Conservative, from a legal perspective, suggests, “Just move on. There is nothing here.” I think about this sometimes. In life, the loudest critics, the ones with the longest wagging fingers, they are usually attached to a very, very guilty conscience.
Kevin: Do you think there is something that they are wanting to distract us from? Possibly murder cases, possibly other emails, things that could indict?
David: I think that the Democrats have beaucoup secrets and the DNC is in the danger zone. You’re right, relating to that, there is a greater case for obstruction of justice with the DNC not giving their servers over, withholding those servers from the FBI investigation, that is, in the Seth Rich murder affair. And there is growing evidence that suggests that the Russians and their involvement in the election are a complete ruse. But again, what is necessary? Why are they continuing to pound the drumbeat so loudly? And why is the mainstream media so interested in making sure that this is what we are thinking about as Americans?
Kevin: I want to turn to growth in the economy for a moment, because our growth has been dismal. But something definitely is growing. I think I have shared in the past that I was in retail management the first five years of my marriage, and while I was going to college. And we didn’t watch sales nearly as much as we watched inventory. When inventory starts growing, you are really finding out everything you need to know about sales. And right now, inventory growth in almost any industry is high.
David: You look at Goldman-Sachs, look at Bank of America, look at Barclay’s, look at UBS, and they are all modifying their second quarter GDP estimates, and they are moving those estimates lower, and it is in light of a larger than expected trade deficit. And again, the reason why Trump is probably out there pointing fingers at Merkel, not realizing that an over-valued dollar is just as likely a possible explanation as an under-valued currency on the other side. There is a balance between deficits and surplus, and we do have some connection to the deficits that we are running from a trade standpoint.
But again, there is the growing business inventories, which is a huge factor, too. When you think about the inventory side of things, what does it suggest? Just as you said, it suggests a slowing of sales. And it also suggests that as you look further out in the calendar year 2017, industrial production in the latter part of the year is going to be headed lower. So, if someone is going to notice corporate America facing the music, there will be a response in the market, there will be a shift down in terms of stock prices.
Well, look, we also had Friday’s number on the durable goods side – they were negative. That is, if you’re looking at non-defense X-aircraft, which is a really good predictor of business spending in general, it was flat for the second month in a row. So we have a business arena which is weak, and almost universally the financials are saying, “Lower your expectations.” We see this constantly. Corporate America does this, too. “Lower expectations so you can get over the bar.” I think we will probably see Q2 GDP estimates lowered two or three times more before we get to the number.
Kevin: You had mentioned earlier about watching indicators rather than seat-of-the-pants. Now, seat-of-the-pants, when you’re flying, sometimes can lie – not just with power planes, but gliders. You can be in heavy duty sink, and unless you’re looking at the indicator you can think that you are actually in a thermal and going up. Flying gliders – it’s an amazing lesson in paying attention to the indicators because your seat-of-the-pants is just not going to do it.
Now, let’s look at the indicators again. We have a stock market that is at all-time highs. It is 21,000 points.
David: And NASDAQ at all-time highs, too.
Kevin: Yes. Okay, that may be a seat-of-the-pants type of thing where you say, “Oh, things must be fine.” But these are Depression-era numbers that we have. Our growth right now, I think, is matching what our growth was back in the 1930s.
David: You’re talking about economic growth and you are contrasting it with stock market growth. And this is where, if you look at the NASDAQ, stock market growth in the NASDAQ from 2009 to the present is up almost five times. That is impressive, but it exactly mirrors the kind of rate of growth that we saw in Japanese equities between 1982 and 1989.
Kevin: Before their crash.
David: Yes. You’re talking about 4.7, 4.8. That is very comparable moves higher. And yes, we were in a speculative blow-off phase in Japanese equities in that timeframe. The same is true today in the U.S. markets, but you contrast the growth in pricing, that is, financial market pricing compared to economic growth, and you should see explosive growth in the economy if it were going to be supportive of a long-term trend in the stock market.
Kevin: If you don’t, it is unsustainable.
David: Right. Jeffrey Gundlach, the new bond king, replacing, for all intents and purposes, Bill Gross, recently asked about the significance of real GDP. Real GDP for the past decade has been identical to that of the 1930s.
Kevin: Repeat that, Dave. That is amazing.
David: Real GDP for the last decade has been identical to that of the 1930s.
Kevin: The Depression decade.
David: That’s right – 1.33% annualized. So our growth is in line with the Depression era. And if you pause and reflect on that, just keep in mind what the mainstream media message is of happy days being here again. The happy days here again – it really is just focused on one of those two realities, and that is, the pricing of financial assets, that is securities, stocks and bonds, and how they are priced today. When you see this kind of divergence where it is flat-to-negative growth, and explosive growth on the upside, in the assets in question, you have to ask the question, “Is this sustainable?”
Kevin: You’re looking at a decade though, Dave – in the 1930s they could not print trillions of dollars. We had a gold standard. They could only print so many dollars. We have had a decade of more money-printing than any time in world history, yet we still have GDP growth at the rate that it was at in the decade of the 1930s.
David: Right. So how do you respond? How do you respond if a skeptical investor asks the question? There is so little growth in the context where economic growth, where trillions of cheap currency and credit units are being floated about? You have had the most radical central bank interventions of all time…
Kevin: Not to mention low interests rates?
David: The economy has not responded. How do you respond? What happens next? You can ignore the facts, you can – I don’t know, go out and buy more Amazon, that is certainly the market trend, ignore the facts and just buy an index, at least, if not an individual company. Again, this is where people are behaving badly. As investors, they are letting greed get out in front of them, and determine a course which is ultimately going to put them in a very difficult position.
Kevin: And we know that GDP – remember, we’re talking about a low GDP that is already fudged. It seems that they do something different each time they report GDP, where you think, “Uh, yeah, right. Where did you get that?”
David: Choose your own results. What is the meme that we need to be focusing on, and we can tabulate? That’s modern tabulation. This is statistics, after all. Now, let me back up. We do have GDP revisions from the first quarter, positive revisions, an upgrade, this is Friday, for the Q1 timeframe. And it was helped greatly by an almost 12-billion dollar increase in non-profit spending. Who knew? Religious groups and the like just spent 12 billion dollars in the first quarter because they were flush with cash.
Kevin: Churches and charities just went wild. You know, just, “Somebody stop me.”
David: I know, I know. It’s like everybody really did give a lot this year in that little Salvation Army box.
Kevin: So that was the adjustment.
David: Right. So, when I see that – it is numbers like that that make me think, economics is the softest of the sciences. They want to be a hard science, they want to bring math to it, and the reality is, this is more of a literary adventure. It is a choose your own adventure – modern tabulation, modern statistics – “Yeah, let’s just throw in 12 billion dollars.” Where do these guys come up with this stuff?
Kevin: It’s amazing. Well, I look at the way things are changing. You had mentioned before – just ignore all the facts and go buy more Amazon. But you look at brick and mortar retail. I was mentioning retail before, and mentioning inventories. Gosh, that’s an old-fashioned word – inventory. But you look at what is happening to the retail space, like Macy’s and J.C. Penney’s and Sears and all these people are sort of disappearing. The only ones that are surviving are actually making money on credit card debt right now. They’re pushing their credit cards and they’re turning more into financial institutions than they are retail operations.
David: Yes. Macy’s have had their shares decline from $70 down to $22. And you are right, selling stuff has ceded ground to charging interest on the stuff that consumers had to buy on credit. That’s credit cards. So literally, finance is nearly the retail business. And you thought that the retail business was selling merchandise. Oh, silly you. You have Macy’s branded credit cards, which provided 39% of their operating profits, and that is up from 26% of their operating profits just four years ago. So, yes, it says that their total business is going down relative to the interest that they are collecting on that outstanding debt.
But here is the rub. Synchrony Financial is a major provider of white-labeled credits cards. They will help folks like J.C. Penney’s and others, and this is in the same vein as a Macy’s card, right? Synchrony has just increased their provisions for bad loans by 45%.
Kevin: So they see something coming. I was just about to say this, Dave, credit card debt actually pays the bills only when people don’t. In other words, you have these credit cards, and they don’t give credit cards so that people will pay them off, they give them credit cards so that they won’t pay them off. You’re talking about Macy’s having almost 40% of their take-in on cards, on people who are continuing to finance things.
David: Yes, a retail business makes interest income more than selling merchandise – almost more. That’s fascinating.
Kevin: But you say they are providing for bad loans at this point.
David: And again, this is the behind-the-scenes provider of these credit cards. So you end up with a white-labeled product that says J.C. Penney, Macy’s, what have you. Who is the financial entity behind them? Synchrony Financial. In the same vein you have Capital One. Their net income was down 20% year-over-year. You have Discover Financial, also counting on higher credit card losses throughout 2017. What does this suggest about the state of consumer spending?
We talked about business spending and durable goods a second ago, but what does that suggest about the state of consumer spending, and the financial strength of the man on the street? What do these card companies see at the periphery of the credit markets? We need to think about that? What are they watching roll through? They are watching the numbers of non-paying card-holders. And those non-paying card-holders? Those numbers? Those are hard numbers, and they don’t lie.
Kevin: That is like inventories rising. It is something that the public doesn’t necessarily see, but the people behind the scenes realize it. You had mentioned a canary in the coal mine earlier. Less and less I am hearing the singing, and more and more I am hearing the thud at the bottom of the cage.
David: That’s right. Do you hear the bird singing sweetly? The whistling of the canary? If you can’t hear the bird sing, it may have already expired, as you say. The Fed reports that as of last month credit card debt surpassed a trillion dollars. So now it joins the ranks of student loans, close to 1.4, auto loans, which have already passed the trillion mark. And what I am telling you, Kevin, is that the credit cycle has turned, and the stock market hasn’t figured it out yet.
Kevin: You know, when debt starts to look like it’s getting riskier, there is another indicator – talking about watching the dials on the dash. Historically, long-term debt should be higher interest than short-term debt. That’s what they call the yield curve. You look out and say, “Okay, well, five-year debt is a little less than what it would cost for ten-year debt, and then 20, and 30-year debt.” But when risk starts to enter the market, you have something called an inversion of the yield curve where people are saying, “No, there are going to be some defaults here soon, so we’re going to start charging more interest right now because we have to prepare.”
David: That’s right. And this is also sort of a change in credit dynamics. You have in the month of April, the Chinese cancelled 120 billion dollars of RMB debt issuance. That is, if you translate it to dollar terms, about 17.4 billion in bond sales which were cancelled. That is, in part, because you have an interest rate increased in RMB terms, and again, what you described as yield curve inversion. So what did they do instead? They still had financing needs, and they decided to go to the U.S. dollar markets and finance, actually, 24 billion dollars, new financing, because the Fed has kept rates cheap, lowered rates, kept them artificially low, and it’s cheaper to finance in U.S. dollar terms than it is in RMB terms.
Kevin: Something interesting, though, Dave, if they are borrowing in U.S. dollars, they are also counting on the dollar not strengthening, right?
David: Well, they’ve just crossed the currency line. When someone is lending, you are judging a variety of risks. Can this person pay me back? This is a credit-quality issue. What is the duration of the loan going to be? What do I think is going to happen during that duration? Do I think inflation is going to be a factor during that timeframe? Am I adequately pricing this loan to factor in all of these things? Well, the folks on the other side of the equation who are getting the loan are now saying, “We’ll take U.S. dollar debt. It doesn’t have to be RMB.” And frankly, it speaks to desperate finance. It speaks to a certain degree of pragmatism that says, “We need it, and we need it now. And no, we don’t like the current price of debt in China, but we’re willing to cross the currency line.” And this is an absolutely critical thing. They’re financing in U.S. dollar terms.
What you said earlier was one of the most important things that you could say. The yield curve inversion tells you how healthy the Chinese economy is. When you have an inverted yield curve it is absolutely telling you something. For the five-year government bond to push past the ten-year in yield, that absolutely suggests trouble ahead in China. The yield curve inversion – yes, you have another canary.
Kevin: So at the same time that you have all these dropping canaries, and all these indicators of risk increasing, from inverted yield curves to over-priced stock markets, we have another phenomenon going on that has never gone on in our lifetimes, Dave. You call it passive investing. I think that’s a little too weak. I call it blind investing. That is where people say, “You know what? I want to own this sector. I am going to put my money into this sector, I don’t care what it costs, I don’t care what their profits are, I don’t care what the PE ratio is – just give me some.”
David: In many of our in-house conversations, Doug Noland, who is on our team, talks about risk indifference, and how being short all the time doesn’t make any sense. You need to be tactically short if you’re going to be short, and there are times that you really want to want to be short, and there are times to sit on the sidelines and not get run over. I was reading through a recent Grants report and I was struck by sort of a variation on the theme of risk indifference. I just sat and reflected, sitting in a rocking chair doing some of my reading over the weekend. Not risk indifference, but value indifference. This is exactly what you are talking about. The amount of passively invested dollars grows by the day.
Kevin: Would you explain passively invested dollars? I call it blind investing, but explain your version of passively invested dollars, Dave.
David: Value in this case has nothing to do with the decision-making process. My point is that you are in a dangerous investment environment when various parties prefer to ignore value and buy with value indifference. I think that is an environment that is more fixated with reward than implicit risk, and passively invested dollars…
Kevin: Blind invested dollars…
David: Are growing to a really huge number. Again, when someone is actively investing, and actively analyzing risk, they are doing the heavy lifting of looking at individual balance sheets. They want to get into the fundamentals of an investment.
Kevin: Dave, you do this all day long. You’re looking at the fundamentals to say, “Are we buying value or not?”
David: And our team does. But you look at the Fed securities portfolio. Do they buy securities on the basis of a value proposition? No. They have a portfolio that is now 4.25 trillion dollars.
Kevin: How about the Europeans?
David: The ECB securities portfolio, just looking at the securities portion, is 2.4 trillion. Believe it or not, they just passed our total balance sheet. Theirs is now close to 4.5. There is larger than ours. But just in terms of securities, going back to this category of value indifference, the ECB owns 2.4 trillion dollars’ worth of assets, and it is not on the basis of a value proposition. You have the Bank of England, which has their loan to asset facility – 484 billion dollars. The Bank of Japan has combined holdings of government debt, of corporate bonds, of exchange-traded funds.
Kevin: ETFs. Yes.
David: And REITs? Real estate investment trusts? They’re at about 3.9 trillion dollars of value indifferent invested assets. And then if you count in what the Chinese have, if you also count in the worldwide exchange-traded funds market, if you look at the index mutual funds – count all those up, you’re adding another 9 to 9.5 trillion dollars. All told, value-indifferent invested assets today are 21 trillion in total – 21 trillion. When people don’t care about the price they pay, and the expected rate of return, which is determined by valuations at the time of purchase, you can argue for very significant challenges on the horizon. You could argue for a market crash.
Kevin: We’re in an environment, Dave, that values things that don’t even exist. We talk about ETFs, we talk about derivatives. These are agreements and pseudo types of representations of things.
David: At least on the derivative side.
Kevin: On the derivative side it is. ETFs right now – that’s just the way to invest. If a person says, “You know, I think I would rather not pick my stocks, I’d rather not pick my gold or my silver. I think what I’m going to do is just go ahead and put it into this exchange-traded fund.”
David: Interesting, the SEC is in the process of approving new ultra-leveraged ETFs. We have had two and three times leveraged ETFs, and now we are adding to the danger of passive investing by using these highly leveraged ETFs.
Kevin: So you put a dollar in and you can get four dollars’ worth of ETFs.
David: That’s right. The ETFs don’t actually own the index, or the underlying assets. They just trade in derivative swaps. Let that sink in. They don’t actually own anything but treasuries on the one side which they use as collateral for swap transactions, which means that counter-party risk is absolutely enormous, and you have county-party banks that are taking the other side of the trade.
Kevin: Doesn’t this sound like 2007?
David: It is amazing how much systemic risk we are building in, as if the 2008/2009 events never occurred. I think we’re at an inflection point, when finance becomes more of an end in itself, rather than being a part of an industrial balance sheet equation, ultimately with the end goal being producing things. It’s legitimate – I understand that if you need to borrow money, and you need to create a financial structure to do that – issuing bonds, or what have you – to be able to grow and expand your plant and infrastructure, so that you can make stuff, and expand your enterprise – I get that.
Kevin: But to borrow just to breed more risk, and more risk, and more risk, and it really doesn’t produce anything. An ETF makes nothing.
David: I remember when my dad and I were traveling in 2005 and 2006, in that timeframe, and we were doing client conferences all over the country, our conversation was about the danger of derivatives. We looked at all of the derivatives which were propping up the mortgage-backed securities market. You had your CDOs and your CLSs, and your CDSs and your CDO squareds, and this was our conversation in 2005 and 2006, saying that creative finance is allowing for things to happen in the real estate market which could not happen otherwise, and when you build a foundation on the basis of creative finance, it doesn’t end well.
We’re doing the same thing. You have the ultra-leveraged ETFs. Again, it is mind-boggling to me that investors can forget so quickly what happens when these things come unwound.
Kevin: Well, okay, I’m thinking ahead here, Dave. In July, you and your dad are going to be on the West Coast. You are going to be meeting with clients. And then in November you are going to do some more meetings. Your dad is coming in from the Philippines. But this does remind me of 2005, 2006, 2007, when you were meeting with people to say, “Look, we need to meet with you to tell you what you are about to experience.” I remember even CDs going out to our clients saying, “Sell your real estate.” This was in 2006. We still have some back in the back.
David: (laughs) If you want one, call us. We’ll send you one. Just for the record’s sake. This is what we were talking about in 2006 – warning people to get out of real estate.
Kevin: It was timed well. But you said something this morning when we were meeting, and I thought this was important. These meetings that you are going to have in July probably are going to be meetings where you are telling somebody, “Hey, this is what will probably happen this fall.” By November, when you are meeting with people as we go further to the East Coast…
David: I think we’re going to be in a completely different market.
Kevin: You’re going to be telling them, “Here’s how to survive what just happened.”
David: That’s right. The ultra-leveraged ETFs are not big enough to be anything but a catalyst, but they add pressure to the market and it’s not positive pressure. When people are buying them, the way they square their positions is in a rising market they keep on adding to their leveraged positions. In a selling market, in a down trending market, they sell. It is the same technique that was used by the portfolio insurance traders in 1987. It can create a vortex of selling, feeding on itself because of the structure of the funds.
And we don’t learn from history, and I think that is why Santayana said we’re doomed to repeat it. This is why markets run in cycles, and it is why it is naïve to think that this time is different. Because again, we don’t learn from the lessons of the past, and we try to convince ourselves, in fact, this time is different, when frankly, we’re just in the process of repeating yet again.
Kevin: There was a man who was there in 1987, who was manufacturing risk management. His name was Richard Bookstaber. He was also there for the LTCM risk management in the late 1990s. And then he was also there in 2007 writing a book saying, “You know what? In 1987 I was trying to manage risk for the markets, and it didn’t work.” And with LTCM it didn’t work. He has been a guest of ours before, and he just came out with a new book.
So this weekend I went back to his old book, A Demon of Our Own Design. Dave, I like your book, I like a lot of books, but I think this is probably, other than Charles Dickens saying, “It was the best of times, it was the worst of times,” one of the greatest opening paragraphs. Let me read this, because he was well positioned to the point where he probably could have spent jail time, I mean, if he were indicted for the amount of money that was lost. Let me just read the first paragraph that I read this weekend again. He wrote this book in 2007 as a warning. He said that there probably would be a crash coming very soon.
Here is what he said. “While it is not strictly true that I caused the two great financial crises of the late 20th century, the 1987 stock market crash and the Long-Term Capital Management, LTCM, hedge fund debacle 11 years later, let’s just say I was in the vicinity. If Wall Street is the economy’s powerhouse, I was definitely one of the guys fiddling with the controls. My actions seemed insignificant at the time, and certainly the consequences were unintended. You don’t deliberately obliterate hundreds of billions of dollars of investor money. And that is at the heart of this book. It’s going to happen again. The financial markets that we have constructed are now so complex, and the speed of transactions so fast, that apparently isolated actions and even minor events can have catastrophic consequences.”
David: Well, as we wrap up, I want to recall that the stock market, whenever it has reached over-valued levels like this, whether you are looking at a new record in price-to-sales, or a near-record in price-to-book value, price-to-GDP, which is the Buffet indicator, the Shiller PE which is your CAPE, CyclicallyAdjusted Price Earnings multiple – when you get to these levels, most of them only bested two other times in history, 1929 and the year 2000, you know what always happens? Investor portfolios decline by 50%. And that happens 100% of the time.
Kevin: Every time.
David: Right. So, this time may be different. This time may be different. But the market has declined by 50% when we have had these circumstances.
Kevin: The indicators on the dash.
David: What do you think advertising-sensitive revenues look like in a recession? History tells you that a 50% haircut may be very kind. You look at a Google and a Facebook, some of the most popular stocks out there, and this is their business – selling advertising. 60-80% declines might be more reasonable, because in a recession, that is what happens. People quit spending the dollars that they were spending before. When I buy something as an investment, I am very curious how long it is going to take me to recoup my initial investment. In the case of Amazon, I’m going to break even in the year 2205. That defines optimism – a price earnings multiple of 188, and investors calling that normal. It’s actually not investors calling it normal. We’re in that environment again where there is an indifference to value, an indifference to value. And so price doesn’t matter when there is an indifference to value.
It is amazing to me. You look at the other indicators. Corporate tax receipts are in decline. State tax receipts are in decline. I spoke with a client the other day that works for the IRS. She said, “Dave, look, I think that what Trump is going to do is very positive.” And I asked her a question: “You see, every day, in what you do, the real evidence of how strong the economy is. Is there a growth in income such that we are seeing a growth in tax receipts?” She said, “No, actually it’s slipping. It’s not as strong as it was.”
Kevin: There is that Depression GDP, Dave, right there.
David: This is the year – not for black swans, but for canaries.