Negative rates, Immortality, & Frodo’s Ring

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• Does shifting interest rates to lowest possible levels tempt us to cheat time?
• Shiller P/E at nosebleed height of 30.28 – Could it go higher?
• Alan Newman: Stock market is now the most dangerous in history

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Negative rates, Immortality, & Frodo’s Ring
November 6, 2019

“If you can come to terms with finitude and mortality, you tend to look to the future, and you tend to look at future generations, and what the significance of your life is, in time, and throughout future history, what it will be. To me, that is the point of legacy. Be careful in the decisions that you make. Be calculated in the commitments that you make, and be aware of the things that you are saying yes to, with all the costs and benefits that are attached to them.”

– David McAlvany

Kevin: Part of today’s culture, Dave, has really been influenced by J.R.R. Tolkien’s stories, The Hobbit, and The Lord of the Rings. I think if you had to compress what those stories were about, it is about resisting irresistible power, sort of the pull of immortality and full control. I bring that up because we all have that type of a ring pulling at us in different parts of our lives, and even in society today in the form of going into debt that people know would never be paid back in a lifetime.

David: It is fascinating that Tolkien chose the name Gollum because there is another description for that in Jewish literature which is yetzer, and you have a yetzer hara and a yetzer ha-tov. Yetzer halav is the evil inclination and yetzer ha-tov is the good inclination. So you can be imaginatively inclined toward doing the good, imaginatively inclined toward doing evil, and what you see in the Gollum character is where an evil inclination has ultimately destroyed who the person was, and remade the person in a tragic, and as you described, slimy kind of character.

Kevin: But they didn’t start that way. Of course, The Hobbit came first and The Lord of the Rings series came second, but it still had to do with the way the characters reacted to the ring, and of course, Gollum ultimately took his life, the despair of not having the ring, not being able to avoid the temptation, or resist. But he didn’t start that way. He started as a hobbit, a little bit like Bilbo and Frodo, but he succumbed to the ring.

I think of other scenes in that movie – Boromir, who was a human, who when he had the ring in his hand you could see he changed. We even see Bilbo, when he is older, he holds that ring and you can see just a slight change, and Peter Jackson does a great job with that. Gandalf, a wizard, and Galadriel, the elf – they also understand from a longer-term perspective that they can’t hold that ring for long because they can’t resist. I think it is only Aragorn who actually purposely resists the ring the whole time – walks away.

I may have the story wrong, but Dave, what I am trying to say with this is, do we have a ring right now? We have negative interest rates. We have men who are in power who are spending money that they know they will never have to pay back. So there is always a cost, isn’t there, to choosing immortality and compressing time?

David: I think that is the issue. We’re talking about prices that relate to a measurement of time, and so how do we see the future, when you talk about the yetzer and you talk about that character Gollum, we’re talking about the use of imagination, how we see the future. Sometimes we have a very truncated view of the future where it is a very short period in time and the decisions that we make in light of that truncated imagination are different than if we have an expansive view of time, both past and in the future.

There is a quote that stopped me in my tracks this week. I wanted to share it. It is from a culture critic who has written a number of books that have been influential for me through the years. His name is Oz Guinness. Mostly recently, in a book that he wrote, Carpe Diem Redeemed, he says, “Our conquests of space are always at the expense of using up time.” What does that have to do with markets and the structure of finance today? The thing that strikes me is that when we shift the rate of interest to the lowest possible level, as we have done on the world scene – the ECB, the Bank of Japan, the Fed – does that allow us, or does that tempt us to cheat time?

Kevin: That’s interesting? Cheating time – in other words, looking at debt as a way of cheating time. That’s true, you’re moving things from the future to the present.

David: Yes, I think it does, even if we don’t do that consciously, we are all in a race, and we have a limited number of breaths, we have a limited number of days. This is just reality. We live and we die and everyone is involved in this. There are no exceptions to this. So when you look at the modern financial architecture, do we see something implicit there expressing dissatisfaction with mortality, giving us a sense of control, again, by doing something with interest rates and through the debt markets, which is really playing with time.

Doing more in less time is, in essence, like buying more time. I guess what I am framing here is this frenetic and frantic form of life extension, sucking as many tomorrows into today, and we’re able to do that because of this function – debt, credit, those markets, but particularly the cheapness of credit. So we borrow from the future to fit more now into now.

Kevin: You used the terminology of being in a race, and I know that that is where your mindset is because you’re training again for another race. But I remember reading – and Dave, I think you read the same book – about one of the first triathlons in Hawaii. One of the athletes likened the amount of energy that you have to a book of 24 matches. He said, as you race the long race you have to figure out when you are going to use the next match. Remember, he talked about ending the race with a match or two. You want to end with enough to spend it at the very end. In a way, burning all those matches at once, which seems to be like going into debt that is never going to be paid back, and then artificially lowering interest rates to where there is no interest on that debt, at least for now. There is a cost, though, isn’t there?

David: Yes. Again, if there is an internal sense of justification that we take on more debt and we can afford it because we’ve got lower rates, what is that enabling us? What kind of experiences is that bringing to us that we might not otherwise have? We get to live larger, more extravagantly, with greater material and experiential breadth. And part of that is knowing that life is fleeting, and if it is, so be it. But what we may be looking at is, instead, a cultural or socio-cultural thing where we live with comparisons, the old keeping up with the Joneses. And credit puty everything that we want in our hands today. It allows us to keep up with the Joneses.

A lot of this changed when we began to rethink the nature of retail. Sears was a major innovator, then sent out their catalogs, and then all of a sudden, the revolutionary move by Sears was creating an installment plan where you didn’t have to have the money up front, you could stretch out the payments. And of course, credit became a part of that. Why wait? We can buy the car today, we can buy the house today. You even have corporations that are buying back shares today, boosting the debt on their balance sheets, and of course, the consequence, or the positive impact for them is the boost of stock prices. Why wait, why see what the future holds when you can make it happen now?

Kevin: It is interesting you say keeping up with the Joneses. We can say, “I’m not going to do that,” but actually, let’s say that the Joneses are living in debt, it does push the price of everything up. Everything in our society is built for us to go into debt to be able to own a car, or to be able to own a house. I think about keeping up with the central bankers. Even Trump tweeted that he would like to see negative interest rates. Well, why is that? Because we also are competing with other countries that are competitively devaluing their currencies, and lowering interest rates below zero.

David: So back to this idea of playing with time. Perhaps there is a sense in which we are trying to redefine the boundaries of life, enhancing our sense of control over something we really have no control over. We don’t live in this reality, but our days are numbered.

Kevin: But look at the current trend. We have this new trend, life extension. You have people who, if they have enough money – even David Rockefeller ended up dying, but he did live until he was 100.

David: And so maybe there are life extension techniques that give us the ability to go to 125 years. You remember the gal from France who lived to, I think, 122? I think she died in 1989, so I believe it was from 1875 to 1989, roughly about 122 years. And futurists might consider those numbers sort of insultingly low, but you have billionaires who have stretched our imagination of what can be accomplished in space, whether it is the building of a business or the building of a fortune, that is something that they have accomplished in space. There is this still inconvenient boundary of time, and it is an equalizer. It is this brute fact that death comes to us all, and money doesn’t do anything for you in eternity, or in nothingness, depending on your cosmology.

Kevin: But we’ve heard in the past that the way you get ahead is other people’s money, but there are different ways of taking other people’s money. There could be the other people who are alive today, or what about taking other people’s money who are alive sometime in the future? I’m talking about our children.

David: This goes back to the issue of debt and interest. The individual can borrow, and the individual can extend credit to someone else. That is a choice between individuals. The consequences are fairly well defined between two people – the person who is the creditor, the person who is the debtor.

Kevin: That is ethical, though. To me, there is a form of ethics there, but when you are borrowing somebody’s money that hasn’t even been born yet, that is unethical.

David: So I think about corporate credit, I think about governmental credit, and there is something unbound and bordering on the unethical. Take the CEO or CFO of a corporation, or if you’re talking about public policy take the legislative branch, largely responsible for budgeting and spending. They are not making choices as individuals in a defined point in time, creating obligations that they are solely responsible for. When it comes to debt, they are creating obligations they will never have to pay back. The benefits are realized in the present, but the costs are meted out in the future to a totally different set of people. So they, the leaders we are describing, are sucking tomorrow’s productivity into today for the benefit of quarterly growth, or for the benefit of a re-election bid.

Kevin: But there is that temptation, Dave. That is the ring. How in the world do you resist the temptation of having it all now?

David: And I think the cost of capital, when it is set too low, incentivizes leaders to disregard the future for the present benefits only.

Kevin: Yes, there is no pain.

David: I think the temptation has always existed, but the enabling function is that of zero cost of capital, or very low cost of capital. A company manager with his name on the shingle, and generations that preceded, potentially generations that follow, is going to look at obligations, is going to look at a debt burden differently than the company manager who is in and out for a short period of time. A study by Harvard reports that CEOs now have an average tenure of five years.

Kevin: Five years. But they are borrowing for 30, 40, 50, to a degree.

David: Exactly. We’re talking about the majority of CEOs who are in for five years, that is the average tenure, five years and then they resign at the end of that timeframe. So when brevity is in the picture, shrinking time is paramount. And now you have politicians and CEOs who are faced with a set of choices. Do they consider the long-term?

Kevin: Well, how do you get re-elected, Dave? Talk about keeping up with the Joneses, you can’t even get re-elected unless you go into the same debt that your competitor does.

David: Right. So if you’re faced with the brevity of tenancy in that role, do you maximize all that you can in the present moment? Look, I’m not presuming to know the motivations of politicians or CEOs, but I think we can observe and conclude that low rates are a temptation that hardly anyone can bear.

Kevin: That’s right. That the ring.

David: The accumulation of debt, when accommodated with low, or virtually no cost, allows us to shift perspective from the future. And the weight of payback, whether it is by us or by others that we are obligating in the process, we shift perspective to the present because the cost is seemingly minimized, and we can squeeze more into this moment. So I come back again to Os Guinness’s observation that our conquests of space are always at the expense of using up time. Whose time are we using up? I don’t know, is it even appropriate for me to frame our debt problems in ethical terms?

Kevin: It reminds me of a conversation I was having with a man this morning at 5:30 as we were driving to a group that we attend, and I told him, “One of the most loving things you can do is to say no to things that you can’t fully commit to.” And there are people who commit to things that really cannot carry through. I even asked you last night – you are training for a race – my question wasn’t whether you are committed, my question was, how is your wife and your family with this?

David: Yes, because it certainly is a weight that they have to bear, too. So from our conversation last night, as I weigh the cost of things that I either say yes to, or no to, it is not me that bears the cost – not solely. We live in family, we live in community. That is not a vacuum. And if choices are not weighed, you might not appreciate the actual weight of each decision. Being intentional about those choices implies that there are trade-offs, and that those trade-offs have been considered.

Kevin: That’s the no. There are things that you will say no to for the yes that you say.

David: That’s right. So some people will prioritize work, making money. Yes, I’m prioritizing that particular exercise regimen and it comes at a cost. You have some cultures and individuals who prioritize rest and family connection, and you see how they order their lives to make those things happen. I guess what I’m driving at is that by distorting what is natural, and in this case you were playing with the idea of a natural rate. What is it? Is it zero? The central bankers used to have it set at around 4%, now it is less than half of that, moving toward zero. And there is a whole host of temptations that are introduced when you start distorting what is natural.

Kevin: Interest rates, themselves, are the cost of borrowing. It is the punishment, actually. If you want to just go ahead and say it, there is always punishment. It is the cost, it is the punishment. What if you eliminate the punishment?

David: Then all of a sudden within the financial markets you have speculation and risk-taking, which are aided by easy money policy, low rates. It is not unlike performance-enhancing drugs, shrinking time to enhance the results. It takes a lot of time to build muscle mass. It takes a lot of time to build muscle memory. There are long-term prices to pay when you play with time. You can see this in the guys who in their 30s and 40s were dead after using steroids to enhance muscle building. They got a lot in a short period of time.

Kevin: They compressed time, and then it caught up with them.

David: And then it caught up with them. I think central banks are really not much different than cyclists or body builders. They can sit back and mock the need for rest, and when I think of rest I think of the market cycle. There are ebbs and flows, and there is a point in time when you need to have a slowing down. Yes, it’s fine to speed up. Yes, it’s fine to push the limits. But then there is also a time to rest and recuperate, and that is a natural part of the business cycle.

So central banks, if they are anything like cyclists and body builders, it is in that sense that they can mock the need for rest, they can love to move faster and lift more than others, and there is this belief that they can do more. And I think it is enabled by performance-enhancing rates. In this case, copious quantities of debt are only possible because you have these performance-enhancing rates.

Kevin: Let’s just look at some of the people that we have interviewed in the past. We had a great guest over and over, a family friend, Ian McAvity. Ian pushed pretty darn hard until the day he died. He smoked like a chimney – he would tell you that – and I think he told you that the doctor told him to not stop smoking because he would probably die. He had learned to live on cigarettes.

David: Yes, his doctor was very honest. When you are smoking multiple packs per day and you’ve done it for 50+ years, his doc said the day you quit is the day you die. You have such a dependency on nicotine.

Kevin: But we have other guests – Alan Newman is a value, a real value, in our reading. We love Alan Newman’s report. He told us last year, “I’m slowing down. I know I still have things to say, guys, but I’m not going to be putting out the same amount of newsletters.” Now, I noticed, something is important enough for a man who is slowing down, to come out of retirement long enough to write about current market events, because he is concerned.

David: And he was frank. He said, “I’m moving to Florida. My wife and I are going to spend more time. There are family things that we still want to accomplish.” And he is accounting for how he is going to spend his time, recognizing that it is either/or in some respects. And I don’t think we have seen anything in writing from him since April, since that move to Florida. And so here we have a report from November, and there are some key things that have been influences for me from Newman which I think are revealing, including volume statistics and some of the market internals, advance declines.

Kevin: His market experience goes back to the days your dad was a stockbroker. He really goes back in time, so we can look and say, “What is your experience?”

David: He is also building on another generation because he his dad was a stockbroker in the 1930s.

Kevin: That’s right.

David: Remember, he was so demoralized at the end of that period of time, he took all of his stock certificates, put them in a safety deposit box and didn’t look at them for 30 years. In fact, a part of Alan’s fascination with the markets grew out of this dark secret, and it was, “Dad’s got money somewhere.” In fact, it was actually in a lockbox. The father was so demoralized from the decline in the 1930s, he left the business and left all those shares and he asked his son to just go through them and see if there was anything of value there. He didn’t want to know, he didn’t want to spend the time. If you think about the breaking of the back, the psychological impact to that kind of market gyration and volatility, it is telling.

One of the things that he compared the current environment to is the 1968 to 1972 period, in the sense that the broader markets had turned down in 1968, but you still had the nifty-fifty, the stocks that everyone believed were the wave of the future, and could not go lower. It was impossible to consider a future without Polaroid, a future without Eastman-Kodak, or even a future without Sears. We mentioned Sears as an innovator in retail. Again, things ebb and flow, and ultimately some of these companies are no longer around.

Kevin: Those were the FANG stocks of the day – the Facebook, Amazon, Netflix of today.

David: But the market dynamic he is pointing to is that the vast majority of stocks stopped moving up in 1968 and it was only a handful that continued moving up – the nifty-fifty.

Kevin: Does that sound familiar?

David: Absolutely. And they continued to go higher up until 1972-1973, then all stocks ended up in the same boat – down 50%. So they basically bucked the trend, and he points out that the trend for highs and lows in the market has been, since 2011, the same kind of a trend where you have a smaller number of companies each year since 2011 making new highs and more and more companies making new lows. This declining pattern where you are netting out the two, is, to him, and indication of the bull market being long in the tooth.

Additionally, Newman looks at the advance-decline volume studies and this includes the New York Stock Exchange, NASDAQ and the S&P 500, and a key observation there is that the highs are being driven by lower and lower advancing volumes. That is typically the type of behavior you see before a major bear market.

Kevin: One of the things I love about Newman, there are two things that he really focuses on that we do, too. One is the Shiller PE, price-earnings ratio. The other is the Dow-gold ratio. I’d like to get to that in a few minutes. But going back to the Shiller PE, when I’m talking to clients on the phone I say, “When you look at the price that you are paying for a stock, let’s pretend like you had a hot dog stand in Manhattan, and you were selling hot dogs to the point where you were earning $100,000 per year. If I walked up to you and I said, “I’ll give you a million bucks for that hot dog stand,” that’s a 10-to-1 earnings ratio. If I said, “Two million bucks for that hot dog stand,” that’s 20-to-1.

The stock market doesn’t seem to do well once you get above 20. You know it’s going to probably come down at some point. Now, it can go higher, but the Shiller PE Newman addresses in this latest letter that he sends out, and he talks about that hot dog stand being over three million right now.

David: Gotta sell a lot of dogs.

Kevin: We’re over 30 right now.

David: One of the things he does not point out, and we do like both Tobin’s Q, the replacement value. You can draw that from the Z1 report/

Kevin: That’s Andrew Smithers that likes that. We’ve had him as a guest on the show.

David: Yes, and in the Buffet ratio, which is if you’re looking at the comparison of GDP to stock market capitalization, something that Buffet, at least back in 2002, was very keen on, and again, we have pointed this out, you watch what a man does, not only what he says. He is rabidly bullish on the markets today, but he just increased his cash position yet again, 128 billion, the largest it has ever been, at Berkshire Hathaway, which suggests that he is not able to find, or doesn’t want to find, doesn’t want to put that money to work, because it is not a reasonable time to do it. In other words, valuations are high and you have to pay dearly in order to have that money in something other than cash.

So you have Buffet with 128 billion at Berkshire Hathaway, you have J.P. Morgan who has just slid 130 billion dollars over into bonds, and longer-term bonds from cash, which implies a significant – their view is that rates are going lower. And honestly, I would think that at least reading between the lines from J.P. Morgan’s 130 billion-dollar company allocation to bonds, they are assuming we are moving toward recession.

Kevin: And they are sliding sideways out of the stock market. Yes, they are betting that the rates are going down, but they are moving that money from stocks, right?

David: Moving it from cash.

Kevin: Oh, they’re moving it from cash into bonds?

David: Yes, it’s an interest rate play.

Kevin: Okay, so interest rates – as we go negative, the only play on bonds, if it is negative you’re not going there for the interest anymore, you’re going there for the appreciation of the bond as interest rates drop.

David: That’s right.

Kevin: That’s a speculation.

David: But on Newman, the commentary he gives us on the Shiller PE – we’re now at 30.28.

Kevin: That’s the three million dollar hot dog stand.

David: Nowhere near the high of 45 which we set in the year 2000, and right now you have earnings from corporate America that remain relatively robust. So I ask the question, could we get back to those peak numbers like we saw in 2000?

Kevin: In the tech stock bubble.

David: And I think it’s possible, because remember, PE is made up of two components. You have the price of a company divided by the earnings of a company, and that gives you, as you described with the hot dog stand – how many years’ worth of earnings are you paying for if you’re buying that hot dog stand?

Kevin: So let’s just make that clear. If the hot dog stand started earning more than 100,000 a year – let’s say I offered a million bucks but the hot dog stand is now making 500,000 dollars a year. At that point, the PE starts making sense. That’s 2.

David: Exactly. So it is possible to get the price earnings ratios back to 45, and here is how. We expect recession in the next 12 months. That is our view. And with it, you have the earnings portion, which can decline. But keep in mind, in the backdrop you still have the Fed in interventionist mode, and it is possible that stock prices remain elevated even as your earnings component comes down. Under that scenario you are dividing a smaller earnings number into the price. The PE could very well spike. And so, it’s not as if it is unreasonable to think of recession over the next 12 months. I recognize we have something that doesn’t look good in the international markets, but here in the U.S. market so far we have bucked the trend.

Duke University conducted a quarterly survey of CFOs, and it is not unlike the conference board which we discussed two weeks ago on the Commentary. In the Fuqua, their business school, 50% of the CFOs expected a recession by the end of the year. By the end of the year! That’s a pretty short timeframe. Again, you have equity believers who are not looking for a downturn, you have algorithmic traders who continue to react positively to Fed activity, and every announcement that comes from every Fed president, and it doesn’t matter if it is Mnuchin at the Treasury, or any of the regional Fed chiefs.

Kevin: Well, those algorithms don’t expect recession because they don’t even know how to look for a recession. Those algorithms are keying off words from the news and automatically trading.

David: Right. So I guess what I’m saying is, if we’re right, and we do have recession, you have earnings which begin to fade as revenue and sales compress in the context of recession, you could have a similar scenario to the 1999-2000 valuation moonshot. Mind you, 30.28 is high. It is the same level we saw at the 1929 stock market peak, and we’re 22% higher than the 1968 stock market peak. At these levels we are just one notch below the all-time highs set in that 1999-2000 period. So it is not a stretch of the imagination to assume that earnings begin to drop, but share prices remain stubborn, and again, valuations all of a sudden blow out and you have this number that prints, not just at 30, but 35, not just at 40, but maybe even 45.

Kevin: We talked about Alan Newman. He picks numbers because he uses technical analysis, as well, and he is talking about the stock market being a good 10,000 points or more lower than it is right now.

David: I realize it is probably laughable for most people on Wall Street today. You could hardly imagine it going lower by 500-1000 points without the Fed getting involved. But he targets the Dow at an interim low of about 16,674, and he maintains that this is on its way to his long-term bear market target of 14,719. Again, that is better than 12,000 points lower. One of the ways that he gets there is, again, referencing the Shiller PE. That is a gauge that he has in mind, and if he says the Shiller median level would put the Dow at about 15,000, 15,041, and if you went to the mean, the mean level for this valuation metric, which is basically just the cyclically adjusted price earnings ratio, a ten-year rolling average of PEs, then you are talking 14,220, and 14,220 is a fraction away from his long-term target.

The reality is that valuations swing. Valuations swing in light of earnings volatility, and obviously, a recession is a major catalyst for reduced corporate earnings.

Kevin: Do you think that is why he sort of slipped out from behind the curtain of retirement to put this November issue out? Alan Newman – he can’t help himself. He has been analyzing markets, really, since he was a very young man. I think he thinks there is danger in the wind.

David: We are at a fascinating point in history, and his conclusion is that the current stock market is the most dangerous environment in stock market history. I would probably temper that and say that it is among the most dangerous, not necessarily the most dangerous. Now, we could certainly check in with Doug Noland and he would say, no, but you look at the structure of financing and the amount of leverage implicit to the system, back to our original comment on what has been done to bring more tomorrows into the present moment without regard to the cost for the future, and those who bear that cost into the future, and I think Doug might say, and agree with him, “Yes, this is the most dangerous stock market in all history.”

Kevin: And Newman gives reasons. He says, “Look, it’s over-valued, but you have anemic volume. That’s critical.

David: And this is what we’ve picked on, too, over the past months, is that valuation is an issue – it is over-valued – anemic volumes, which again, are largely driven by algorithmic models which are reading headlines, and then that last point, that there is a lack of broad participation, going back to that analogy of 1968 to 1972-1973, by the time we were in recession, 1972-1973, all stocks were moving lower, and all stocks moved lower by at least 50%.

Kevin: Those were humans.

David: But there was a disconnect in those few years where a certain number of stocks did quite well while everyone else was suffering, and that is what I mean by a lack of broad participation in the advance.

Kevin: Yes, but the robots – those were humans back in the 1970s. Humans were actually making those decisions. Now, every news event seems to cause a blip in the stock market. Is that the robot element?

David: Right, because whether it is the trade talks or some other positive announcement, you get a fresh rally, even though you hear the same things said over and over again and it’s almost like week-old bread in terms of its staleness. You and I say that headline was just repeated from two weeks ago, four weeks ago, eight weeks ago – they didn’t even bother to shift it around.

Kevin: But if you’re a robot, it’s all new to you.

David: Exactly. So we hear it for the umpteenth time and are cynical about it, but machines – it’s like hearing it for the first time. Algorithms that read headlines and place trades on the basis of published words – algorithms are not cynical.

Kevin: Another thing I really like about Newman – I have to say after being 32 years in the gold business, I really like a guy who likes gold and understands gold. He’s not looking at gold in dollar terms only right now. He points out that gold is skyrocketing in yen and euros. In other currencies it is hitting new highs.

David: We have recently hit all-time highs in yen, and in euros, and in British pounds. So add that to your market lens because much of the rest of the world sees a development in the metals price which, if your thinking is sort of denominated in U.S. dollars, as your money is, we don’t see it. We tend to minimize what is happening elsewhere. And I think we will continue to do that for the time being.

But it is not out of the realm of possibility or high probability that new all-time highs are coming in U.S. dollars, as well, and I think it will be sooner than later. You combine the monthly liquidity being pumped into the financial markets by the bank of Japan, by the European central bank and the Fed, and they’re pumping into the financial markets, reliquefying, in essence, at about a one trillion dollar annual run rate, and that might, in fact, drive a few investor dollars in the direction of gold.

Kevin: You started the program talking about the compression of time that debt brings, but there is always a cost. So what you do is you compress time, you get it now, but you pay later. Gold is a little different. You own gold now so that you can own more of something real later. Talk about a space footprint, you were talking about how space is confined. You can do more in a shorter period of time with debt. But with gold, what we’ve seen is, you stay liquid with gold. We’re not talking about owning gold for a lifetime – all of your gold – we’re talking about what you turn it into when the prices drop. How do you capitalize on that situation?

David: Yes, we’ve often repeated, it’s not the gold you own today, but what assets you turn it into tomorrow that matters the most. And clearly one precedes the other. You have to be thinking about the future, anticipating the future, and I like the idea of leaning into the future with some cognizance of the decisions made in the present.

Kevin: Most people are looking for income, in the longer run. We talk about retirement. A lot of people don’t necessarily want to retire fully, but they need their assets to generate an income.

David: There is no problem with that. Income generation and growth, diversification – all of these are sort of worthy objectives, and to a degree, they can be satisfied today. Obviously, income is harder and harder to find as we have a race to the bottom in terms of interest rates. But the real investment market coup gets closer by the day. When you engage that two-step process of a healthy metals position, but also keep in mind a clear view of when to sell off a portion of it and transition it to other assets.

Kevin: That brings us to the Dow-gold ratio, because you can own stocks today with the idea that you may lose 50% of their value or more, or you can own gold now. I think you should explain a little bit about the Dow-gold ratio because that is an important concept. You can buy many, many times more stocks that you may want to own today in the future if you first own gold.

David: I did a radio interview this last week, and the question was asked – the host wanted me to review a presentation I gave in Manhattan a week or so ago. The host had been at the gathering in New York. He said that there was one chart that really summed up that sequence relevant to an investor today to both minimize risk and maximize reward over a full cycle, not necessarily just in this miniature time slice, but over a full cycle, and it was the Dow-gold ratio.

Kevin: These are decades. When you are talking about cycles, we’re talking about multiple decades.

David: Exactly. In a nutshell, there are 10 to 30-year periods where owning financial assets makes more sense than tangible assets, from a reward perspective. If that is the only thing in your lens – reward – then it is clear. And there are 10 to 30-year periods when owning tangible or hard assets makes more sense from a risk perspective. What the ratio does is clarify a relative valuation. It tells you where you should be in terms of favoring hard assets, real things, versus paper or financial assets. It removes a lot of the guesswork about prices. We talked about Newman and his price projections for the Dow. Just scrap that, forget it. Disregard Newman’s lower Dow price targets, and set aside any of the gold bugs’ bullion price targets which are somewhere between here and infinity.

Kevin: I know, they just make it up.

David: And some of them, you may have well-founded, in terms of an inflation-adjusted price, but you can go from 2,000 to a million dollars, and frankly, infinity does become a possibility if you were talking about an extinction event for your currency. So the point of the ratio is that it captures both sides of the equation, both at the price of gold and the price of the Dow, and it gives you something that you can actually sink your teeth into, because who knows what the value of gold should be, or will be, if you are going through a currency extinction event? And again, we talked about this in yen terms earlier. The price of gold in yen is hundreds of thousands of dollars today. Is it unreasonable to think that the yen could lose further value relative to gold and we could have gold priced in yen in the millions? Is that even a relevant number? At some point it becomes an absurdity and you have to anchor your thinking in terms of relative values. The ratio does that for you.

Kevin: So let’s go to the Dow-gold and talk about a repeating pattern. I was joking about the robots not really looking long-term, but we can. We can go back and say, in 1896 it was 1-to-1. The Dow and gold were the same. By 1929-1930 the Dow was 20 ounces of gold. But then it came back down to 2-to-1, and then it went up to 30 ounces of gold, and then it came back down to 1-to-1, and then it went to 40 ounces of gold, a little over, and then now it is down to about 20 ounces. It’s a really simple conversion. You take the Dow, you divide it by ounces of gold and you say, “How many ounces of gold is the Dow worth?” And it usually gets back down to 1, 2, 3 ounces of gold before it’s time to move back into the Dow.

David: Yes, so that, to me, is a way of putting time on your side, where all of a sudden you are basically saying, progress can be made, particularly if you extend beyond one generation and see how these cycles can be played very, very effectively. I would much rather do that than try to maximize dollars today at the expense of someone else, which is really what the debt markets have inclined us to do.

Earlier this year, just kind of for perspective on debt, quantitative easing, where we are at present, there are these men who have been in my life since I was a young boy. Bert Dohmen is one of them. We got to spend some personal time at his house in Hawaii earlier this year. We always talk politics and markets, diet and nutrition. There is always lots of sage-like advice, even dipping into relationships, whatever. I enjoy it.

But one of his recent observations was this QE initiative which shall not be called QE. We are actually talking about a 1.5 trillion dollar liquidity swing. I thought that was helpful because what he is doing is, we were in the process of reducing balance sheet exposure in the Fed’s balance sheet by 60 billion monthly, and now we’re adding 60 billion a month in new liquidity. So the numbers are actually far more considerable looking at both sides of the equation, what we were reducing, now what we are adding. That is a 1.5 trillion dollar annual liquidity swing. I think one of the things it is important to keep in mind is the kind of liquidity activity we are seeing from the Fed. To match what we are doing today you would have to go back to when, A) the markets were crashing, and B) we had 9% unemployment.

Kevin: That brings us to Bill King, another guest that we have on a regular basis. Bill is saying, “Why is the Fed panicking? We are supposed to have all these good economic numbers, but what we are seeing is full-out life support, from a liquidity standpoint.

David: Yes, the Fed balance sheet increased by over 50 billion dollars last week. We have just crested 4 trillion. We’re over 4 trillion. Halloween is behind us and the Fed is still spooked. And his lingering question week after week is, what are they spooked by? It could be any number of things. It could be WeWork. Why does WeWork matter? You see 11 million square feet of leased commercial real estate that is not being used, and you have people who have borrowed a tremendous amount of money.

There are really interesting connecting points with WeWork because if you look at the primary investor in WeWork it is Softbank. Softbank is running the Vision Fund. Guess who the primary contributor to the Vision Fund is? It is the Saudi royal family. So you have Project 2030 where the Saudis are trying to diversify out of oil, and they have put tens of billions of dollars into Softbank and the Vision Fund, and the Vision Fund has mismanaged or underestimated the risks involved in some of their investments, and they are going sour. You have multiple entities – granted, maybe we’re overthinking the WeWork thing and 11 million square feet of leased commercial real estate that don’t have tenants who can actually pay as sort of a sublease.

Kevin: You know, when something opens up, Dave, there are times when you look at it and say, okay, well, we’d better eat there now because they won’t be in business next year. Here in Durango we see that kind of flow. I remember when my wife and I first got married we went to the mall and there was this obviously very expensive retail space in this very popular mall at the time. That’s when malls were popular. There was a store that opened up that had five globes in it – big, expensive globes – and it was called The Globe Store. We just looked at each other, and thought, “Okay, if we’re going to buy a globe, we’d better do it today because they won’t be here tomorrow.”

I only tell that story because when I saw WeWork and I saw how big it got, and the vision that they have, it reminded me of The Globe Store. It reminded me of Pets.com back in 1999, the sock puppet that was capitalized at a larger level than all the airlines in America before it completely collapsed.

David: There is nothing wrong with vision, but this is going back to that earlier concept of yetzer hara or yetzer ha-tov. There is an evil possibility with imagination, and I think what WeWork has become is something that is so distorted, and only made possible, it only could exist – the imagination and the vision for WeWork only could have existed in an environment where you have a zero cost of capital. He wasn’t creating something with a good inclination based on sound money.

Kevin: It was based on free money.

David: It was, from the start, based on something that was ultimately not real. And so, yes, I think – is it WeWork? Is it Deutsche Bank? They missed earnings pretty significantly here in the 3^rd quarter.

Kevin: But the Fed keeps cutting rates.

David: Something has their attention. Last week we had the rate cuts, 25 basis points. That leaves the upper bound at 1.75. No surprises there. We had the interest on excess reserves which was cut to 1.55 down from 1.8. I thought that was very significant.

Kevin: It is, but I mean, it’s crazy. We’re paying banks not to loan money. What is that?

David: I know. What they are doing is, over time they are slowing the incentive. The banks have been shoveling cash back to the Fed, and as that incentive dissipates, in our view, that money comes back into the market, that money comes back into regular loans, and ultimately, fuels inflation. So the money which is collecting interest, the “excess reserves” held at the Federal Reserve, again, the motivation, the incentive structure, has to be removed for it to come back into the market. Gradually, that is happening. 1.8 is where it was, 1.55 is what it is at now, post last Wednesday’s announcement from the Fed.

Kevin: But as Powell continues to cut rates, which you would only really do when you are trying to stimulate an economy that supposedly is lagging, he is telling us consumers are doing well. He gives you all the positives and yet still cuts rates. What’s up?

David: Consumers are doing pretty well. The ones who are probably a little bit more under pressure, if there was one point of critique, it was in corporate America, a little high in terms of their debt levels. He was fair enough there. Completely left out of the equation, government debt levels in any category, whether it is in Europe or in the United States. So some of the highlights – yes, consumers are doing well. He said that to raise interest rates at this point he would have to see a significant move higher in inflation statistics. Well, we’re not going to see that anytime soon. They’re not anticipating raising rates.

Kevin: What does that say about the repos, though? The stuff that we don’t see, all this liquidity that they are having to throw into the market. What did he say about that?

David: Well, one last thing on the inflation target, and not hitting it and not raising rates. He was signaling to the market pretty clearly that you don’t have to worry about us doing what we did in the 4^th quarter of 2018, raising rates and significantly tightening financial conditions.

Kevin: Wink wink, nod nod, know what I mean, know what I mean?

David: In terms of the repo market, this was odd because banks had ample liquidity but they would not lend it out. And yes, they are supporting the repo market, but why weren’t banks lending out liquidity that they had? It’s a funny thing because you start saying, “Well, do they know something?” Is there an unwillingness to lend because they see something that is unhealthy, and the Fed sees something that is unhealthy, and the general public is just kind the patsy sitting there.

Kevin: Just like Buffet. Buffet is moving to cash. So what do these folks know?

David: I don’t know. We’ll find out in the fullness of time. But the Fed was not willing to lower their capital or liquidity requirements for banks and they looked at the jobless claims and they said, “Hey, this is a positive sign for the U.S. economy.” And that’s fine, they’re right, it is a positive sign for the U.S. economy. I think one of the things that people often forget is that if you are looking for lagging economic indicators, the jobless claims are the “laggiest.” They are the last in line. It’s kind of like the caboose turning the corner. You kind of want to know where the engine is, not necessarily the caboose, in terms of the direction of travel. It is telling you what has happened, not will happen. Again, lagging economic indicators are not particularly helpful, except as confirming what is past tense.

Fiscal policy – this was a key point for him. Fiscal policy is key for economic growth to be inclusive. The word inclusive is popping up everywhere in every corner within our culture. He was talking, basically, about the gap between the rich and the poor. And I think there is an implicit admission there that monetary policy has widened the gap between rich and poor and it would take fiscal policy to see “economic growth become more inclusive.” But that admission of monetary policy widening the gap? To me, that was fascinating.

Kevin: Yes, but are there any bubbles right now?

David: Zero.

Kevin: I remember Greenspan before, he was concerned about bubbles but he would just move from bubble to bubble.

David: No, and I think that is probably one of the aspects of this report which could, doing a historical retrospective, I think people will look at Powell and say, “Come on, how did he miss this?” No bubbles, no imbalances. That is a little bit like Irving Fisher saying just on the eve of the Great Depression and the 1929 stock market collapse, “I think we’ve reached a permanent high plateau.” Little did he know that things were already crumbling under his feet. We talked about Rosenberg last week.

Kevin: He was concerned. Rosenberg was concerned.

David: Yes, Gluskin Sheff – that’s 80% odds of recession. Obviously, a very different analytical framework than the Fed, where at the Fed you have Rosie as the only shade of lens that they can see things through, and obviously, they’re not talking to Rosie, the other Rosie, Rosenberg. They probably should talk to him a little bit more often.

Kevin: Yes, a different kind Rosie-colored glasses, right? He would be basically saying you need to be concerned. We talked a couple of weeks ago about a potential black hole with these repos and the need for all this liquidity. Could it possibly be this gigantic black hole of Deutsche Bank? And you told me you were just starting a book by a guest of ours, Harold James, on Deutsche Bank.

David: Yes, and I like the history. Anytime we want to understand, whether it is Middle East politics or any particular interest, it is really important to have some historical background. So fortunately, a part of the library that I have includes multiple volumes by Harold James. One of them us a history that he wrote on the inter-war period and describes how Deutsche Bank was the primary facilitator for extracting Jewish assets for the Nazis.

This is another point. Yes, I am interested in Deutsche Bank, but I am also very interested in the historical precedents of commercial banks doing the bidding of a state. And here is what he is developing as a real historical precedent. Harold James wrote the book and it stems from a research project which was commissioned by Deutsche Bank.

Kevin: Isn’t that interesting?

David: Good for them. I appreciate when anyone is willing to sort of own the skeletons in the closet. But I am interested in seeing how the incentives were structured by the state for Deutsche Bank such that Deutsche Bank was complicit in the appropriation of Jewish enterprises. The interplay between commercial banks and the state is something we have to do some good thinking on because I think we need to understand as we look forward to how rates and negative rates are potentially orchestrated, what does that look like? Remember the paper we talked about in April of this year, the IMF suggested that commercial banks would be the ones to implement and orchestrate negative interest rates within the financial system?

Kevin: So you’re wondering if this isn’t something you could learn from Deutsche Bank back in the 1930s, 1940s, how they extracted assets from the Jewish community.

David: But it is the interplay. On that particular point I am even less interested, but I want to know what the interplay was and how the state set up an incentive structure for a commercial bank to kind of get them on board with a particular agenda, whatever the agenda is. As interested as I am in the history of it, I would like to see how those decisions are made, what has to be put in place for those decisions to be sort of the obvious conclusions for the commercial banks. Again, we all operate according to incentives – carrots, sticks, what have you.

Kevin: Carmen Reinhart told us, because we asked, how do you keep people in the system when they no longer want to be there? She said, “You have to create a captive audience.” As we move closer and closer to negative rates here in America, and ultimately into negative rates, what is to keep the person from extracting their money from that banking system? And of course, that is what the IMF paper was about, basically talking about here is how we do this and keep it from being too unpopular.

David: Right. So low to negative rates – what are they?

Kevin: They’re the ring, Dave. They’re the ring. They’re the irresistible temptation.

David: In our modern financial context, they are enablers. They have created perverse incentives and continue to cause malinvestment. They alter the way we value things. This is where everything is cheapened when you cheapen the cost of capital, when you lower the cost of money. Nothing is really weighed. You can have it all, and you don’t have to make choices, exclusionary choices – I am saying yes to this and no to that – because in a world of free money, risks are virtually eliminated by low to negative interest rates.

Kevin: Eliminated for now. The theme for your family since I have known you guys has been legacy. That is the name of your book. Legacy can only be built, not by extracting things from the future and using them today, but, instead, putting things away today for the future.

David: Right. So we are at odds with this cultural motif which is shifting burdens forward in time, and extracting value from the future for present pleasure and present benefit.

Kevin: Dave, this has really been compelling today to me, just the way you approach debt. Really, what we are seeing is human nature in the story that Plato wrote, The Republic, which was repurposed by Tolkien. It is still the same story. We crave immortality, and are we willing to sacrifice everything for immortality, when in reality, shouldn’t we accept mortality and be willing to pass on a legacy?

David: I couldn’t agree more. If you can come to terms with finitude and mortality, you tend to look to the future and you tend to look at future generations and what the significance of your life is, in time, and throughout future history, what it will be. To me, that is the point of legacy. Rather than evade mortality, be careful in the decisions that you make. Be calculated in the commitments that you make. And be aware of the things that you are saying yes to, with all the costs and benefits that are attached to them.