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- The summer of ’69 and 2019 – Low Unemployment, Major Market Top?
- Corporate Bonds $9.2 trillion, can they ever be liquidated?
- Mutual funds & ETFs – the new investment banks & no reserve requirements
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
OUTER LIMITS AI TO THE MARKET “WE CONTROL
THE HORIZONTAL & THE VERTICAL”
May 8, 2019
“What are we talking about, really? We’re talking about propaganda, we’re talking about psychology, we’re talking about control of the mass mind via big data and AI, because if you can harness artificial intelligence and big data, if you control the algorithms, you are on the way to creating 21stcentury determinism. The question is – what could possibly go wrong?”
– David McAlvany
Kevin:We were talking about this weekend and your long swim over in the cold water here in Durango. You’re preparing for the Alcatraz swim. Your wife had your three other kids, but you had one of your sons with you. And you were saying, “Even if he never gets involved in triathlons, it’s a way of him spending father/son time and really learning the culture.
David:One of the things we prioritize is time together and so that could be in the kitchen cooking a meal, that could be sitting on the back porch and just sitting in two chairs next to each other as we read books that we both like. Or I’ll run while they ride their bikes and we can chat and kibbutz as we go. In this case he wanted to bring a book, sit in the sun, play with the dog, while I swam across the lake and back.
Kevin:We were talking about how you were discussing with your other son who is 13 some of his ideas of what maybe he wants to study in college. As I was looking back at the raising of my kids, we got to talking about how you can try to set the trajectory for your child as much as possible. You spoke for the home-schooling conference last week, and we talked about that, but it is really interesting how various events, various mentors and people who are interested in life can really change the trajectory of where we end up.
David:I’ve got one that wants to be an engineer. Math and science are really his greatest passions. And another where I just can’t stop him from reading. He has a book in his hand all the time.
Kevin:I can always ask him what he’s reading.
David:At mealtime I have to say, “Can you please put that down?” In other families you might say, “Can you not bring your phone?” I have to say, “Can you not bring your book? Or at least tell us what you’re reading.” But yes, 500 pages a week is a light week for him. He loves it. And I don’t know if that means that he is geared for history, or literature, or politics, or philosophy, or economics. We have no idea, but definitely, perhaps, the softer sciences. So we explore the possible, and that is one of the things that I like about doing some of these races and things.
I just want them to know what is possible, and what the spectrum is, because there are plenty of examples in our culture of what a couch potato looks like. And there are plenty of examples of an uneducated approach to living and voting and whatever, and I want them to know kind of full spectrum what is possible. I don’t have expectations of them to go to an Ivy League school or anything like that, but we do talk about the full range from community college to Oxford University and everything in between. What does it take to do this, or to do that, or to do this, or to do that. Your choices matter. And the little choices they begin to make today add up – they aggregate into something that is very important. Even now they are setting the trajectories for their legacies.
Kevin:It’s good to have a plan even though that plan can change many times. Something happened to me this last Friday that I shared with you, and it really was impressive to me. When I was in college I started in music. I’m a trumpet player. I switched over to business ultimately. I remember my first economics class, my macroeconomics class, I opened the book and it said, “Careers in Economics.” And I just laughed out loud. I thought, “Who in the world would want a career in economics?”
It was possibly because I didn’t really understand it. I had a class later, a money and banking class, that was taught by this unique, tall, lanky, genius kind of personality. That was what this guy was like. His name was Dr. John Cochran. He paced back and forth in front of the blackboard. He always had five or six dollars’ worth of change in his pocket and he would nervously rattle the change and he would put the ISLM curve up, or whatever, but he was fascinated with economics, and it was contagious.
David:It made you fascinated. Interested.
Kevin:Yes, and this was before I met your dad. I was in college and I was fascinated enough to ultimately interview for ICA and with your dad, and met a man named Howard Onstatt who later became a free market mentor of mine.
David:Fast forward to Friday.
Kevin:Friday. Yes. We talked about in the Commentary a couple of weeks ago has been distributing books to us. Howard is in his 90s. He has known that those cherished books that he has written in and put post-it in and notes to himself in. He wanted those to go to the right people. Well, there was a book that I hadn’t pulled off the shelf, I had just put it up when we got it. I pulled it off, and sure enough, it was about the debates between Frederic Hayek and John Maynard Keynes in the 1930, but it was written by Dr. John Cochran.
Kevin:I looked at the front of the book and it was signed by Dr. John Cochran.
Kevin:It was fascinating, but it really made me think about how trajectories change. At first I laughed at careers in economics, and then I met someone who was interested. We have always said, to be interesting, you have to be interested.
David:Yes. The things that we are interested in sometimes may seem odd, but they do tie together. Big data, AI – you may say, what does that have to do with the pricing of assets? Actually, more than you think, because in today’s world of high-frequency trading and black box models, there is more influence in the markets behind the scenes, on a programmed basis, and we’re moving toward a period of time when the desired outcome is a programmed outcome. It’s a predicted outcome. It’s a designed and planned outcome, and it’s according to someone’s algorithm and someone else’s desire. It’s fascinating because all of a sudden you see the confluence of public policy and computer science and psychology and market action and economics.
Kevin:It brings to mind Bookstaber, a guest of ours, and someone who you have gone out to see in New York.
David:Yes, his book,The End of Theory. We had him on the program maybe two years ago.
Kevin:The first time we had him on a few years ago.
David:That’s right. We talked about A Demon of Our Own Design, and then his subsequent book after he worked on the Dodd-Frank legislation and spent about six years in D.C. he wrote the book, The End of Theory. It is this fascinating look at 21stcentury determinism. You really have to kind of stop and think about that, but The End of Theoryis the end of human autonomy and freedom as we have known it. It really is the end of the free markets, if you think about it. Could something go wrong with that? Oh, certainly. But the designs are to control an outcome.
It reminds me again of a conversation I had with my 13-year-old who said, “Why have you been reading so many books on utopias and dystopias these days?” Part of it is because my wife is designing the curriculum that just happens to be the right age to be asking questions about systems and how they work and whether they work, and whether a perfect system is possible, etc. But this is a new version of the old issue of let’s design ourselves a utopia. The End of Theoryis utopian thinking for the 21stcentury, and it ties to creating a determinism using big data and artificial intelligence.
Kevin:Dave, I recently took a course on complexity theory. I would recommend to any person, if that is new to them, to go online and try to read a little bit about complexity science. It is very different from the old chaos, or what have you. Complexity is actually a lot of simple systems acting autonomously, or so they think, and actually creating a larger whole. Remember, Dave, we talked a couple of years ago about how the government Plunge Protection Team set up an office in Chicago that was specifically designed to influence high-frequency trading. Now, that’s what we’re talking about. This is when you actually go to supposedly autonomous actors, but you’re influencing, or inputting, into that to try to control the system.
David:Did you say specifically designed, or suspiciously designed? (laughs) The idea that we can control markets, again, this is not a new concept, we’re just using new tools to go after the same thing. So we look at the markets and begin to see some weaknesses, and where there are weaknesses you see, again, state actors stepping in to try to smooth them out, to try to make it go away, to try to mute the signal that usually market actors would respond to. And so we see a tightening of financial conditions, and then all of a sudden announcements from various prominent people, and those algorithms get fed into the markets, and all of a sudden it is calm once again. So there is never the ability for things to get wild and wooly, and this is by design.
Kevin:It seems like perception management and liquidity management are the two tools that they use continually. They try to manage perception by a Fed chairman or one of the Fed presidents saying something to balance what was thought before, or they just apply liquidity directly to what may turn into a crisis.
David:And they get liquidity to that specific spot that needs it, where they are trying to paint the numbers, so to say. Look at the semi-conductors, for instance. They are up 30-35% this year, yet you have significant declines in sales and increases in inventory. If you look at the fundamentals of the semi-conductor industry, in the last 90-120 days you are talking about one of the worst time frames in two or three decades.
Kevin:Yet they are up 30%.
David:And they are at all-time highs, so again, to paint a number, to take liquidity and push it in a particular direction, it does influence the mass mind, and as long as you can continue to influence the mass mind, then the narrative, whatever you want that narrative to be, almost has a supporting aspect. There are supporting characters that go toward the main features that you are trying to drive that narrative forward. It all makes sense, it is all working, and no one questions the veracity of it because it all seems to be on tune, in key and moving forward in the direction that it is, in fact, designed to go.
Kevin:Jim Grant has written The Interest Rate Observerfor years because he believes that bonds are probably a more clear way of looking at the market. Bonds, right now, are looking down the road, and they don’t necessarily like what they see.
David:Particularly in the treasury market. You begin to see some traffic into treasuries even while last week we had stocks sitting at all-time highs. This week, of course, we have a little bit of jitters, but is it related to trade? And of course, we will have a tweet or an announcement or something that will soften those conditions before too long.
We also have this notion of sell in May and go away. Certainly, on our side, starting the week on the Tactical Short, we are increasing our short position – we did Monday – in advance of the market’s weakness and volatility, looking at the myriad of indicators we did through the weekend. Because what we see is emerging market weakness, and that weakness at the periphery does tend to migrate to the core, even if that migration takes six or nine months, we think we will see it front and center here in the U.S. before too long.
Kevin:Earlier, before we started recording, we were talking about how 2019 seems an awful lot like the summer of 1969. If you go back 50 years, that was the lunar landing, the United States landing on the moon. But we had other things going on at that same time. We had a speculative market. You actually had a market that was peaking out, didn’t you, but you had this feeling that it would go on forever.
David:See, you think about the lunar landing. For me, it’s not the lunar landing, it’s the ditty that Brian Adams wrote, the Summer of ’69. “Oh, when I look back now, that summer should last forever. If I had the choice, yeah, I always want to be there. Those were the best days of my life.”
Kevin:It was the summer of ’69, he said. Yes.
David:Here is the fascinating thing. We quickly forget that what was happening in 1969, employment numbers, as of last week hit new lows, 3.6%. We haven’t seen this level in employment since the summer of ’69, which is fascinating because that is the year after the stock market topped, a year earlier. 1968, if you look at the economic figures, it is very fascinating, because you had the stock market, which had been in motion, a bull market since 1949, and it rolled forward, a big bull market up to 1968. And yet you still had economic indicators saying, “Hey, this is great, everything’s great, summer of ’69, it’s like Paradise, right? The market had already turned, but nobody was really aware of it. It was just the best days of our lives.
Kevin:And I would say that some people were aware of it – maybe not the market – but look what else happened in 1969. The central banks were buying massive amounts of gold. They were cashing their dollars in for gold. Look at 2018, last year, 74% more gold purchased by central banks. We hadn’t seen anything like that, really, since 1969.
David:You’re right, there was a massive shift then. There was a massive shift just last year, 2018, 50 years to the year.
Kevin:So do you think this time is different?
David:No, I don’t, and I think it really depends on how you frame that, Kevin, because we have the book written back in 2009, or what it 2011? I forget.
Kevin:No it was 2009. You’re talking about Rogoff?
David:Yes, Rogoff and Reinhart, This Time Is Different. As you know, I like to read on the plane and I was reading that on the way down to Argentina about 2012. This Time Is Differentis the title. A paper that I think is worth reading, and if you want to look it up, it’s 50 pages, a small commitment, but very important I think, titled, This Time Is Different, But It Will End the Same. There is a longer subtitle to that, but concluding what we had discussed two years ago, actually, with Richard Bookstaber, the conclusion of this paper just written here in the last month or so. This is where we basically now have under-appreciated bottlenecks in the marketplace, and it has been a result of the post crisis legislation. He came back on our program and said, “Look, I think we fixed a lot with Dodd-Frank, and I think we also set the stage for the next crisis because we created these bottlenecks. We re-incentivized certain behaviors and disincentivized others. The net result is that there are fewer market-makers, and that means there is going to be a real concern in terms of liquidity, greater liquidity constraints in a large market sell-off. So just as Bookstaber did a few years ago with us, the authors of the paper looked back at the growth in corporate credit as a place of real concentrated risk, alongside a sort of mismatch of asset and liability structures.
Kevin:I thought it was interesting, Richard Bookstaber has been very honest about his inputs into helping or hindering the markets. In 1987 he was involved and he said, “Yeah, my bad.” If you remember when he said, “It was my bad, I was one of the guys who was there trying to engineer safety in the 1987 market, and it turned out poorly.” When he was part of the Dodd-Frank.
David:Like Chernobyl poorly
Kevin:(laughs) Yeah. It was the worst crash since 1929.
David:Just a safety check, don’t worry about it. We’re just melting down here.
Kevin:But when he wrote The End of Theory, he was saying the same thing. “Yes, I was involved in some of the solutions, but we have to realize,” and this goes back to complexity, “a lot of those solutions are probably going to create the next crisis.
David:Yes, so in this paper it is mostly a review of the financial system not being able to handle the flows of liquidations as investors started to concentrate positions in exchange-traded funds and mutual funds.
Kevin:Do liquidations ever happen anymore, Dave?
David:Well, these are products that work very well on the purchase side, but begin to have structural issues, and you can see their flaws revealed if there are liquidations through those products. So again, it is the ETFs and mutual funds focused on fixed income, particularly corporate bonds, which imply liquidity, but in no way can guarantee liquidity because of the limitations of the structures.
Kevin:The Hotel California. You can check in, but you can never leave
David:Yes. So the big picture is that there are no bids, there is no price discovery, and there are no exits. Those are the predictions made by the authors – no bids, no price discovery, and ultimately, no exits from the products. That, again, relates specifically to fixed income instruments within the ETF and mutual fund universes.
Kevin:One of the things that Bookstaber brought up as a real problem is that because of the Volcker rule, you don’t have dealers necessarily incentivized to come in and soften the market. We have talked about market-makers before, and you need dealers in the market so that when you don’t have two parties – one selling and one buying – that know each other, you need a dealer who is going to be the interim step.
David:Yes, the three authors of this paper looked at the trend for 2013 to the present, and the primary dealers are holding less and less bond inventory, because as Bookstaber pointed out, the incentives to do so have all but been eliminated. So market-makers, again, have traditionally been the buyers of last resort in the past, and they have been willing to increase their inventories when the market comes under pressure because they are paid very handsomely to do so.
The Volcker rule makes it difficult to distinguish between proprietary trading, where they are trading for their own account, and the market-making function, whether inventory to resell to someone else, and so they have crushed the benefits for the market-making because of the confusion over prop trading and market-making.
Prop trading has been frowned upon, because as we have seen with Goldman-Sachs and other firms, they have traded in the best interest of the firm and taken the other side of the trade from their firm clients. So the SEC has not smiled on that nicely. The government doesn’t like it at all. The unintended consequence of a crackdown on prop trading is that no one wants to buy and hold inventories.
Kevin:You’ll recall when we had Jim Deeds on the program, he talked about when he first started his career he walked into an office that had municipal bonds – not just a few municipal bonds, but stacks and stacks and stacks all through the office. Well, that was a market-maker on municipal bonds and this guy was basically saying, “Hey, there is no liquidity right now but there is no way we’re going to collapse this market, either.” So they were taking an inventory long enough to be able to clear those bonds out into a new buying community.
David:This is a feature within this paper. The trading of many fixed income instruments is OTC, which stands for over-the-counter, which further adds to the inefficiency and the opacity of the fixed income sector relative to stocks. Stocks trade very easily. They are a simple instrument to buy and sell, and there is just greater complexity, greater inefficiency, within the corporate fixed income space. The real significant difference is if you are comparing one versus the other.
And in the OTC market, the over-the-counter market, it’s a slower process, and it really only works well in one direction. Add to that that bonds have layers of complexity that stocks don’t because you are talking about liabilities. That structure is different than an equity, and it relates to some collateral, or is backed by some asset of the company. It’s just a tougher thing to get your arms around altogether.
Kevin:Yes. We have really not seen in over 30 years a bond market that collapses and has no bids. We really haven’t had that because we have had falling interest rates and demand for bonds.
David:Right, so 30 plus years of a bull market in bonds, this one-way flow of money into bonds. We don’t even know what it looks like to have money flow out in earnest. So if bonds trade through relatively few institutional entities so that the price of the asset is in question, those entities come into question. Go back, if you will, to Lehman. Lehman was really involved in the mortgage-backed securities market, so they had huge exposure to MBS, mortgage-backed securities. And when there were questions about the value of the assets backing those loans, then the next question was, who is playing with those loans the most, and can we trust them? So like Lehman, with its outsized MBS exposure, when you have concerns emerge, that is where all of a sudden liquidity is no longer extended to those entities on concern that you might not get your money back.
Kevin:Again, you have several types of bond markets. You have the government bond market. That’s huge. We talked about that with deficits. You have the municipal bond market, which is cities and states, what have you. But the corporate bond market, you have been focusing on that. If you think about it, it took from George Washington, all the way to Obama, to get to 9.2 trillion dollars in U.S. debt. The corporate bond market is about that size right now.
David:And it has doubled since the global financial crisis – just about doubled – from 5 to 9, not quite, but 9.2 trillion is the corporate bond market today and there simply is no entity large enough to backstop, to support that market, other than the Fed. We talked about the market-maker being the buyer of last resort. That has shifted from market-maker corporate entity, what have you, private function, to the central bank. And that is the net result here is that now the only entity capable, with enough room, if you will, on their balance sheet, to step in and buy assets and support prices in the corporate bond sector, buying a trillion, a trillion-and-a-half, two trillion dollars in debt.
Kevin:And you think that might be purposeful?
David:It’s the Fed, and perhaps it was intended, but that would be consistent with Bookstaber’s argument in The End of Theory. I think it is a must-read if you want to appreciate the 21stcentury command and control dynamics within the financial marketplace.
Kevin:It’s brilliantly written.
David:It’s brilliantly written. I will tell you, it’s very thick and plan on reading it twice. It’s not going to be obvious. It’s definitely not light reading by any stretch. But it’s worth looking at because this is how you engineer your 21stcentury command and control dynamics within the financial markets.
Kevin:And it’s not dry. He has a mixed interest level and he knows how to tie things together.
David:The paper also discusses a cavalier approach to leverage ratios within the corporate environment. So scale is important. You have that 9.2 trillion dollars. But also the health of the issuer is important. And you have many of these firms which have earnings of X, but now have debt of 5 and 6X relative to their earnings before interest, depreciation, taxes, amortization, before EBIDTA, or relative to EBIDTA, and the ratios are getting way out of whack. Again, this is not healthy. You have a scale issue, but you also have a health issue in terms of these unhealthy ratios.
Kevin:So you are saying that they are tending toward junk bond status.
David:Triple B today in a market downturn, a lot of those triple B barely investment-grade bonds, will quickly be re-categorized as high-yield. High-yield is the euphemism we use today. Junk bonds is what we called them yesterday. What does that do? It causes major ripple effects into the junk bond space. For instance, you have junk bond prices, but what happens when the market supply of junk increases by 20-30% overnight? Well, it’s easy. Over-supply is solved by a quick reduction in price. And that is how you find demand. The price drops to a point where demand steps in. Investors come in and buy at that particular price.
Kevin:Well, let’s talk about those investors, too, because we talk to an awful lot of people who are retired and cannot live on their interest. And so they have been forced, either into the stock market, or forced into the high-yield market. But it’s not just the individual investor. We are talking at this point about insurance companies and pension funds, people who would never touch a junk bond in the past have been forced, because of interest commitments, to go into markets that they would have never gone to before.
David:But this grand experiment with central planning through the central bank mechanisms, controlling interest rates, and through interest rates controlling prices, has a very dark side. And that dark side is that investors don’t realize how much risk they are taking as they are buying things like junk bonds. And it is very interesting that high-yield has been so popular in recent years. Everyone is yield-starved as a result of central bank negative or zero interest rate policies, and they are being forced to compromise the quality of the products they are purchasing, the credit quality, to get the income that they require.
So again, the grand experiment works until it doesn’t, and I don’t know who is going to be held accountable. I would love to place the blame squarely at the feet of the central bank community who with great pride and hubris had said, “No, we can, as masters of the universe, hold the sun, moon and stars in place.”
Kevin:We aren’t necessarily just talking about the largest corporations that are affected here. We are talking also about companies that are sort of in the middle of things also having to highly leverage their companies just to continue to keep up.
David:Right. So let’s say you’re borrowing less than 100 million. Your middle market companies, 50 million in borrowing, things like that – your smaller borrowers. The leverage ratios are higher now for your middle market companies that are issuing bonds, their leverage ratios are higher now, on average, than they were just before the financial crisis. So you have the regulatory push, post global financial crisis, which had a positive impact on leverage ratios as it applied to the banks. So again, regulatory push, post global financial crisis, improves leverage ratios with banks, but merely pushes it around like so many peas on a plate, because it went somewhere else. The leverage ratios are now out of whack in places like insurance companies and pension funds and private fund offerings.
So the banks have kind of cleaned up their act. That sector is better looking than it was 2007 and 2008, but we have had massive credit expansion since then and you don’t have as much concentrated risk in those entities which, frankly, makes it that much harder to bail out in the midst of a crisis because now you’re talking about a hodge-podge of 150 million there, 2 billion there, 7 billion there – it’s all pocketed and the declines are tougher to say like they did with Merrill and B of A, “We’re just going to do a little shotgun wedding here and you guys are going to marry up and it will be all right.”
Kevin:It’s harder to isolate where the problem is when it is not just in the banks. We talk about shadow banking overseas. We have shadow banking here.
David:That’s right, and that’s what has happened. We have had the proliferation of credit. It has enabled credit expansion by other means. It is around the banks instead of through them. So your mutual funds, your ETFs, your hedge funds, are a part of the shadow bank system that finances corporations, but these areas carry even more risk due to the outright opacity.
Kevin:Well, banks have reserve requirements.
David:That’s another factor, yes.
Kevin:So the bank has to have a certain amount of money to loan a certain amount of money. These guys don’t.
David:That’s right. And the reserve requirements mean that you have always held something back. You don’t have to do that. Bank finance, as squirrelly as it can get, still requires cash to be reserved for volatility, cash to be reserved in the event of default on some of your loans. These other vehicles, where you are talking about mutual funds, ETFs, hedge funds, are unconstrained, and when something goes wrong, the transmission mechanism into the market, that weakness happens much quicker. There is not the same kind of liquidity reserves on hand.
Kevin:You talk about the summer of ’69, but I can’t help but also go back to 2007, 2008. We had acronym after acronym, after acronym, and talk about opacity. It was hard, even when you were a professional in the industry, to keep up with the acronyms, but the acronyms really only represented sub-prime.
David:All they were doing is taking one product and multiplying it, or slicing and dicing it, rather, into tiers of other products, and then saying, “Well, what piece of this puzzle, what piece of this whole, do you want?” The nature of a derivative is to take one product, slice it up into ten products, charge ten commissions instead of one. Wall Street loves that stuff.
Kevin:And take three really bad investments, put it together and call it a triple-A wonderful investment.
David:(laughs) Yes. So subprime still exists, yes. We had the nasty, toxic investments, everything kind of cobbled together, what you are describing. But subprime still exists today and it is popular in this cycle in the form of asset-backed securities.
David:Instead of MBS, mortgage-backed securities. So asset-backed loans, a whole lot of which are now to the auto sector, and what you are seeing right now is the quality of asset-backed loans into the auto sector fast declining – fast declining. And what are they doing? The loans are being offered to more and more people who can’t necessarily qualify them on the basis of a healthy FICO score because auto manufacturers need to move inventory. You already have inventory, with your big three auto, between 83 and 90 days, those inventory levels pretty high, and they’re motivated to move the product. Financing helps that. But again, you are financing on lower and lower FICO scores. What does that do? That expands the audience of potential buyers, and the beauty is, for the dealer, you’re rarely holding the paper. You don’t care. As long as you’re moving the product, let someone else…
Kevin:Sell the loan right away.
David:Exactly, which is what banks were doing with mortgages. Originate that loan, get it out the door, off the books. It’s not your risk exposure. All you wanted to do was take the 1% fee and move on down the road, and I think dealers are kind of doing the same thing, eliminating their risk, not holding the paper in house. So it moves to credit unions, it gets stuffed into structured products where investors can buy a nice ABS package, have a diversified portfolio of crap. Again, the only concern is through-put. It’s volume of transactions, how many vehicles are being sold just like the real estate market at the end of the cycle.
There was a recent deal put together, a 154 million dollar deal. Not a big deal in the grand scheme of things, but 14% of the borrowers thrown into that pool structure had a zero credit score. We’re not talking 500 – they didn’t have any credit history, and yet they are being given loans to buy new vehicles – 14% that went into the pot. And they have no credit score. And you wonder how that ends? The reality is, you already know.
Kevin:And we know that a lot of the loans are not being paid. It amazed me how many commercials I saw this last weekend by Title Max. Get your title back with Title Max. Well, somebody is paying to give the title back to the person – high-risk loans. If that person wasn’t able to pay the loan before, there is still a likelihood that they are not going to be able to pay the loan now, but it is extending the credit cycle, just like what we saw with the subprime loans back in 2007.
David:The two areas where we have seen massive amounts of debt growth – obviously we have seen it in corporate debt, we talked about that earlier, 9.2 trillion dollars. That’s a big deal. But the two areas where it seems like you will see significant social change – one, you go to the student loan market, 1.5 trillion dollars, up from 400 billion just a few years ago, and these are debts that are very difficult to pay. You are talking about a generation that will have a difficult time saving for retirement, buying a first-time home. It’s a major game-changer unless there is some sort of debt relief there. We have talked about that in recent weeks with Elizabeth Warren suggesting to buy your vote for $50,000 – no, I mean, she didn’t say buy your vote (laughs). She was going to forgive $50,000 of debt if you’re not making $100,000 or more.
Kevin:Who’s not going to take that?
David:Buy your vote for $50,000 (laughs). But the other area, this auto loan segment, that has grown pretty rapidly to 1.2 trillion dollars. And it has all the signs of lower quality and higher risk, which are associated with the end of a cycle.
Kevin:Going back to 2006 because that was our last major crisis.
David:And yet subprime mortgages in that 2006 timeframe were about 13% of the total, just over 1 trillion dollars. In the paper I mentioned earlier, what they discuss is, obviously, a change in credit quality, where you have growth in the lower tier quality as you move farther along in the process of the credit cycle. They also talk above leveraged loans. We talked about leveraged loans are few weeks ago – very low quality corporate credit. That, now, is over 2.2 trillion. Again, you have all these pockets of risk. By the way, the 2.2 trillion dollars that is low quality corporate, what they call leveraged loans – guess what percentage of that leveraged loan segment is covenant light?
Kevin:You said 2006 was 13%, right?
David:80% of this leveraged loan market is covenant light. In other words, if you can fog a mirror they will give you money.
David:It doesn’t take much.
Kevin:We never learn from history.
David:No. Well, that’s just it. What do we learn from history? That we learn little from history. That’s the reality, we’re doing this all over again, we’re just doing it in other places. It’s not in the mortgage-backed securities market this time, it’s in the asset-backed securities market. It’s in a variety of corporate sectors.
Kevin:But give it a three-letter acronym and it can exist, and it can be called good paper.
David:I’m just surprised that they haven’t come up with an acronym for a financial product that is like SEXY – S-E-X-Y – don’t you want to buy that? They come very close, they make it attractive, it’s a euphemism, everything is good, high-yield. Isn’t that better than junk? Who wants junk when you can have high-yield? It’s what you need, isn’t it?
Kevin:So the name of this paper is “This Time It’s Different, Only It’s Not” right?
David:“Only it’s not.” That’s right. They look at proliferation in that paper of CDOs and CLOs, the structured products, the derivative products which contributed to a lot of the uncertainty, and obviously a lot of the pain, that we went through during the global financial crisis. There was a footnote on page 27 which I really liked. It was discussing a February 2018 U.S. Court of Appeals case, and it was ruling in favor of a CLO fund manager. They basically said you no longer have to comply with risk retention rules. So the skin in the game rules designed to align the interest between the structured product manager and the potential investor, according to this 2018 February – you no longer have to have skin in the game. Again, didn’t we learn something from the 2008-2009 timeframe?
Kevin:But if you know you’re going to get bailed out… I mean, the words for that are moral hazard. You create a moral hazard when someone can gain from taking a risk, but know that they don’t have to lose if the risk goes badly.
David:So we’re back to packaging garbage and selling it on to unsuspecting investors. Or they’re not unsuspecting. They are investors that the Fed has forced out of bank CDs, earning a relatively safe 5% into junk bonds yielding 5%. And who is to blame? On the one hand, you have very clever and unscrupulous product creators on Wall Street. But the reality is, they are operating within legal limits. We go back to that 2018 ruling. They’re not breaking the law if they don’t have skin in the game.
Kevin:That’s what was happening back in 2006 and 2007. People were not breaking the law because the laws allowed them to do it.
David:And so the problem is a legislative problem. There is a strange morphology within the public sphere where they are out to help the common man. On the other hand, it’s just not the way it rolls most of the time.
Kevin:Right. But wouldn’t you blame the central bankers, as well, because they back up everything.
David:I would tend to, yes, because again, as clever and as unscrupulous as Wall Street can be, they tend to operate within the legal limits. But on the other hand you have central bankers that know the history of credit. They know the history of credit excess and they are still playing fast and loose with their utopian ideas of perpetual growth.
Kevin:This goes back to utopia – what your son is studying.
David:Yes. So here they are – the central bank community is flogging the asset markets to extract their dreams and establish their place in history as setting a new standard for growth and prosperity. But on my short list for the tarring and feathering, they all have Ph.D.’s, they are all in economics, and the reality is history, I don’t think, will treat them kindly because their deeds are not as benign as they want to believe they are. So the bottom line from his paper is that there are structural limitations and flaws within a sector that continues to grow and thereby increase total systemic risk.
Kevin:We have talked about World War II being just an extension of an unfinished war called World War I. In a way, I look at 2006, 2007, 2008, 2009 – that crisis never really ended, we just painted over it with a lot of liquidity. It looks to me like we’re doing exactly the same thing, just putting together a bunch of horrible investments, calling them by a different name, and then putting them into what people would trust for their pension or for their retirement.
David:Have you ever known someone who had a black mold issue in their house? The smartest thing that they can do is start over. Just strip it out, go down to the studs. You have to bleach it, disinfect it, get it all out. So the drywall comes out. You go down to the studs. Your furniture is gone, your clothes are gone. A real black mold issue, you have to go back to the very basics. There has to be a total cleansing. In this case, all we did is we discovered black mold 2006-2007.
Kevin:And we painted over it.
David:Well, or put up new drywall on top of the old drywall, and painted over that, and it looks great. The reality is, it’s there, it’s always been there, it’s never gone away, we never resolved the issue. It’s just waiting to be revealed yet again. Stephanie Pomboy – I listen to her comments occasionally, read her comments occasionally, and she was quoted in Barron’s earlier this year. She said, “In 2007 the lie was that you could take a cornucopia of crap, package it together, and somehow make it triple A. This time the lie is that you can take a bunch of bonds that trade by appointment,” in other words there is no liquidity, “lump them together in an ETF and magically make them liquid. The upshot is that these vehicles are only liquid in one direction.
Kevin:That is what I’m saying, Dave. I don’t think people believe you have to liquidate anything anymore. All we have had is passive investing here this last few years, where people are just putting money in. There was no need to liquidate because the central banks had everybody’s backs.
David:And the central banks will continue to try to have everyone’s backs. The question is if they can keep the psychology of the market pinned and held together, because that is their attempt. Their attempt is to control the mass mind, whether it is through propaganda, whether it is through algorithms, anyway that they can. But you have the same issue in mutual funds as you have in ETFs.
Kevin:Yes, you said that was the shadow banking. It’s where you have mutual funds, ETFs – everybody is jumping in on this.
David:And from 2008 to the present, you have had the same trend where your allocation to corporate fixed income within the mutual fund complex was a 7% allocation then, it’s now a 15% allocation today. That is 2 trillion dollars in corporate bonds sitting in mutual funds, and they have similar liquidity constraints to your ETFs. Now, that didn’t used to be. We have mentioned this in recent months where mutual fund managers are being pressured by the owners of those mutual funds to eliminate the cash component within the mutual fund because it causes them to under-perform whatever index they are being compared to, and when they under-perform you see money flow out. You have 2 trillion dollars in corporate bonds in the mutual fund space. Ordinarily, you would have a little bit of liquidity cushion, but that is going away, too. The retail investor believes that he or she has same-day liquidity, or even better – instant liquidity with an ETF.
Kevin:Sure. “I can always sell it.”
David:Do you see the mismatch that Stephanie is talking about? You believe that you have liquidity, but if you sell, along with three other people, all of a sudden three people can’t fit through the door.
Kevin:One of the things that the complexity class taught me was that you have to be careful how you set the goals. If you are trying to manage something, make sure you don’t set a goal that will create a problem larger than the one you are trying to avoid. I look at what you are talking about with the mutual funds. The goal now has just been to keep up. It’s whoever can run the race the fastest, so there is no need for liquidity. But look at another goal. If the goal for the corporate sector is to have higher earnings and raise the share price at the same time, all you have to do is borrow money and buy back the shares.
David:Think about the business that we own, or any other private business out there. You manage the business not for what the company is worth today – “What is the company worth today? What is the company worth today?” Every day you ask the ask the same question – “What is the company worth today?” It doesn’t matter. I’m not selling. It doesn’t matter what the company is worth. I’m managing an enterprise for the next two to three decades, and I make decisions to invest according to a two or three decade timeline.
So what becomes disturbing and where you have perverse incentives enter corporate America is where people actually care about how they are marked-to-market on a daily basis. “What is my share price doing today?” If you look at the expansion of corporate debt, back to this 9.2 trillion dollar number, it moves in very close correlation to your stock buy-backs.
Kevin:Isn’t that suspicious? So they are borrowing money to buy stocks.
David:Companies are exchanging debt for equity. It’s driving share prices higher, executives are exiting their stock option plans at higher share prices, and they game the earnings-per-share game, creating the perception of an improved company. There are, I think, a number of unforgiveable things here, because nothing new here, if you’ve listened to the Commentary for any period of time you know that these are pet peeves. The earnings that are being reported – this is the first thing you have to recognize, this is totally perverse – are no longer compliant with the generally accepted accounting principles. So when you see earnings reports, understand that you don’t have the full story.
David:It’s non-GAAP – noncompliant with the generally accepted accounting principles, and the SEC has determined that that is okay. It obscures just how over-valued most companies are. Fred Hickey points this out recently, that if you look at the median stock price, compare it to sales, the ratio of sales to the price of those shares is two times what it was in the year 2000 as the stock bubble was topping.
Kevin:That was the dot.com.
David:Right. So the most expensive market we have ever seen, and price-to-sales were two times that today.
David:But you will never see that in the PEs because the PEs you are looking at are non-GAAP versus GAAP. If you look at GAAP earnings, your earnings are going to be significantly less, and your earnings ratio is going to be significantly higher. So you see it elsewhere, this issue of over-valuation in stocks, if you have eyes to see it.
Kevin:Okay, so you said there are four unforgiveable – the first one is the earnings that are being reported.
David:Earnings being reported are noncompliant with GAAP. Then the second one would be earnings on a per-share basis continue to improve, in part by reducing the denominator in the earnings-per-share equation. And this is just basic math, again, but you are comparing the earnings of a company to the share price of the company.
Kevin:Okay, so let me get this. The first one is that they are not even having to report according to general accounting principles. The second one is that they are reducing the amount of shares, like we talked about before, and creating an earnings-per-share boost that is not real.
David:That’s right. They shrink the shares outstanding and the earnings on a per-share basis go up. So your earnings divided by a fewer number of shares is how it is improving. These are games that have been played very consistently for the last five or ten years. Share buy-backs go back to the early 1980s. This is not entirely new. But where you see this massive increase in debt in exchange for shares, this is what is getting nasty, where they are adulterating their balance sheet in order to game the earnings-per-share numbers and look better than they are.
So think about this. Apple loses market share in the last quarter. Their Smartphone market share drops from 15.7% of all market share in the Smartphone category to 11.7. Should the shares go up or down. Well, they went up, of course.
Kevin:Well, they should go down.
David:But, but, but, but they went up, of course (laughs). Their sales overall declined by 5%. Their iPhone revenues fell by 17%.
Kevin:So what do you do? You buy back shares.
David:You buy back 75 billion dollars’ worth of shares and your shares go up again because the facts of the company having a decline in sales and revenue don’t matter as long as you are changing the denominator. So Q1 earnings beat expectations. And most investors have the memory of a gnat because Apple was radically reducing their Q1 expectations on earnings, lowered the bar, made it that much easier to get over it, so they beat expectations. They met expectations after lowering them. They lower the bar to make it easier to get over it. Nobody seems to care that year-over-year their operating income was down 16% in the first quarter.
Kevin:When you went to Scotland you sat and talked to Smithers, and one of Smithers’ main obsessions was that this was absolutely wrong because the executives who are part of those corporations have stock programs. And what are they going to do? They are going to sell those stocks every time they kick those earnings up, and they put their company in debt doing it.
David:Well, this is the third unforgiveable in my opinion. And you’re right, Smithers was keen on making sure that remuneration committees were held to account for creating these misalignments in terms of incentives. You can get the managers of a business directing the capital of that business in a way that benefits them personally as executives, and costs the shareholder, the owner of the business, and benefits the manager.
Kevin:No, they wouldn’t do that. Greed doesn’t really exist, does it, Dave?
David:Well, it’s a figment, right? But this is the third unforgiveable in my mind. Share prices go up and executives and insiders are selling their shares aggressively. And this is what strikes me as odd. Doesn’t this strike you as odd? You use capital from the company treasury to repurchase shares, and even create a liability on the balance sheet to repurchase shares, and you do that at elevated prices, and at those elevated prices you sell what belongs to you.
Kevin:Take a little profit.
David:This is not a problem with capitalism. This is what I’m afraid, as we move toward the 2020 election, capitalism gets thrown under the bus for stuff like this. This is not a failure of capitalism. This is human greed. This is self-interest. These factors are old as dirt, and we have allowed for these loopholes to find expression. So you have remuneration committees who aren’t doing their jobs. This is an issue of corporate governance. This is not a failure of capitalism, this is a failure within the context of corporate governance.
Since the global financial crisis we’re talking about trillions of dollars extracted from corporate entities. At the same time, trillions of dollars in new debt has been added to those corporate entities’ balance sheets. It’s the future of the company which seems to pale in contrast to the present value benefit those companies are providing for managers. This is a crisis of corporate governance. It’s a conflict of interest between the owners, that is, the share-holders, and the managers. They are way out of alignment.
Kevin:Dave, you have rules here in the company that we all have to follow, and many of the things that we do have to be approved by a committee before we can do it with a client, or what have you. It is interesting that corporations don’t demand. Why wouldn’t share-holders demand that their executives be held accountable for this type of behavior?
David:(laughs) So if you’re on a board, and you’re on the remuneration committee, you don’t have to be invited back to the board next year. There is this issue of, are you going to be invited back, are we going to vote you in again, and are we going to even put your name in the hopper to be re-elected as a board member? There is a lot of pressure that comes from being against the existing executive committee, the existing C-suite. Maybe I jumped the gun on that last point because number four – I would say, balance sheet destabilization is the fourth unforgiveable.
David:Oh yes. When you’re adding lots of debt – okay, so you have rates that are low, and a part of that looks genius because you’re financing operations at a very low cost of capital. But I think one of the things that ignores is the fact that those debts are with you for the long haul. The prices, or the interest rates, associated with them do change through time.
So you have balance sheet management in corporate America that suggests to me that the attitude in the C-suite, your executive suite, is a little bit cavalier in terms of its approach to the future. Again, I am all for financing on long terms at cheap rates, but it still has to be on projects that have a positive rate of return. You can’t do it on things that have no rate of return, or just there to dissolve shares outstanding.
Kevin:I think peoples’ resolve, though, as far as the real market ever kicking in, all these things are fine that you and I are talking about, and you and I know through many years of doing this that cycles repeat. But I have had several conversations, one just this morning in a meeting, where a person who should know better just basically is saying, “Why should we worry about a downturn? The banks have got it.” Why would you be needed in these markets if you are defensive in your position?
David:Yes. Barron’s last month ran the front cover with a giant bull on the front. This was April. The title of the lead article reads, “Is the Bull Unstoppable?”
Kevin:That’s the question people have on their minds.
David:And the subtitle for that was, “The Decade-Long Rally Could Continue For Years, the Optimists Say.” This was a Barron’s article in April, and it reminds me of what happened at Barron’s after ten years of a bull market in gold. They tend to extrapolate, get very bold, when they could actually be getting cautious. So you have ten years of gold prices increasing an average of 12% a year. Barron’s runs a lead story on why gold is the most important asset for investors to own – can’t do without it – and honestly, that was a signal. When Barron’s gets confident about anything, and is unabashedly, “Hey, this is the direction to go,” you should be cautious. They are a great contra-indicator.
Kevin:It might have been a good time to take a profit back in 2011 when Barron’s did that. I think maybe we missed that.
David:Absolutely, we did. But you have Europe in the throes of crisis in 2011, and I ignored the signal because we were watching the European monetary unit collapse in front of us, and it is very difficult to let go of gold when you look at a project that goes back to the 1950s, and it is in the context of existential demise.
Kevin:And you have to remember, too, Draghi in August of 2011 came out and basically spoke for all the central bankers of the world, “We will do whatever it takes.”
Kevin:And that was something that, I think, was unpredictable. But you’re right, let’s remember the Barron’s signal next time. Could we do that?
David:Bloomberg wrote last month that inflation is dead, and the caption and the question is next to a dinosaur carcass. So we have no worries about inflation, the bull market in stocks will go on forever. You have another Bloomberg article which asks, “Did Capitalism Kill Inflation?” So again, inflation is dead, capitalism wins, inflation is no longer a worry. Late April, also from Bloomberg, the print reads, “History’s longest bull market gets a new lease on life.” And then Barron’s again, here in an article just in the last week, the article reads, “This bull market has no expiration date.”
Kevin:I told you about Fortune Magazine in 1987 when I first started here in the summer of 1987 when the market was just screaming. It looked like it could go on forever. Fortune Magazine said, “Is the market too high? Expectations say it could go on for many years.”
David:(laughs) “This bull market has no expiration date.” So much of what we are talking about is sentiment, and being able to maintain positive sentiment is really what the central banks are trying to do. When you think about market intervention, they don’t care about prices, they care about people, because people end up determining the ultimate direction of prices.
Kevin:If you’re trying to sell a hedge fund or a mutual fund, you have to go with the crowd.
David:Today we have hedge funds jumping on the bandwagon with enthusiasm, taking out the largest short position on volatility ever recorded.
Kevin:So they are saying it is going to stay stable.
David:Right. Again, VIX is a measure of volatility. They are betting that the VIX Index, that price, will go down, indicating that all is well in the stock market, there is nothing to be worried about, on the horizon we see no concerns or increase in volatility. They are betting on the death of volatility. The largest hedge fund bet against volatility is in the market right now and it’s ironic that that bet follows the best quarterly performance in decades. Feelings are the issue, and circumstances are what drive them. Greed is a natural expression, as is over-confidence, in an environment where you have just experienced success. What have we had? Success. What does that breed? A feeling of ebullience.
Kevin:There is no fear in the market. Like I was saying, the conversations I’m having with people outside of our purview as a business, the man-on-the-street, is like, “What are you talking about? Why would the market come down?”
David:That’s right. So the bond market investor today has no fears of default. Maybe you have a few investors scrambling for treasuries because they don’t like what they see by the time we get to the end of the year. But the bond investor, in general, who is coming into corporate credit, who is coming into high-yield bonds, they have no fear of default, they have no fears of inflation, because they read it and they believe it. Capitalism has killed inflation and we associate inflation as being a dinosaur carcass – long dead, now irrelevant, no longer part of the equation.
Kevin:Even the Federal Reserve is coming out and saying, “Gosh, we just don’t have enough inflation.”
David:Right. The stock market investor has the twin supports of Trump Twitter posts – obviously he is doing everything he can to prop up the market, he loves the stock market – and you have central bank resolve, the other buttress, if you will, and they have said, “We’re going to keep the game going forever.” Go back to where we started the conversation today, Kevin. The End of Theoryis a book. It is also a playbook. It is a picture into the world of big data and AI, Artificial Intelligence, and the ways in which investor sentiment can be led and prodded like a bull with a ring in its nose. In your conscious or unconscious mind you feel ebullient forever, and the market behaves a certain way forever. The market has been bested, the expansion of credit will drive prices to infinity. This is the world the central bankers are working with.
Kevin:You’ve got to keep the story going.
David:Right. What are we talking about, really? We’re talking about propaganda, we’re talking about psychology. We’re talking about control of the mass mind via big data and AI, because if you can harness artificial intelligence and big data, if you can control the algorithms, you’re on the way to creating 21stcentury determinism, and that more than anything is what Bookstaber was being a proponent of in his book, The End of Theory – 21stcentury determinism. The project is in motion. The question is – what could possibly go wrong?