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- Tobin’s Q value indicator shows all-time overvaluation in stocks – CLICK HERE TO VIEW THE CHART
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
New Normal or Old Trap? Buy High Then Buy Higher
December 9, 2020
“When you think about the policies that have to be implemented in order to manage this monstrosity – you’ve got the twin hammers of financial repression and inflation. I don’t know how low the dollar goes. Time will tell. But for my savings, I’m much more comfortable having ounces rather than handing money over to Biden, Yellen, Powell and the whole cast of central bank characters.”
– David McAlvany
Kevin: Here we are, 30,000 plus on the Dow today as we record. Oftentimes, Dave, we hear people talking about how this is a new time. You need to see things differently. All the signals that we had in the past aren’t the same because we’re in a new era. They’re printing money or we’ve got Bitcoin, or we’ve got this, or we’ve got that.
But I think about here in Durango, we’ve got a train that’s 130 years old that runs through town, and we have no crossing gates. Nothing closes down on the roads when the train goes through. There’s just an assumption, when you hear the train whistle, when it toots two times that means it’s going forward. When it toots three times, that means it’s going backward. And strangely enough, those train whistles have been a great signal for me, each time, to look both ways before I cross those crossings.
Now we have the same thing in the market. We look at the Dow. 30,000, people are like, “Yeah, it’s got nowhere else to go but up.” But we have some old train whistles, things that people have been looking at for years, like Tobin’s Q. We’ve got things that we can listen to and say, “Hey, anytime it gets beyond this point, it’s like a train whistle. It’s going to cross the path and you’d better not be on it.
David: Oftentimes there are sophomores that enter into our lives in different ways at different points. A sophomore is someone who has been at college a little while, but really doesn’t know what he or she doesn’t know. But they feel like they know a lot.
Kevin: I’ve been one of those, by the way. (laughs)
David: (laughs) And there’s a certain boldness, a certain confidence, a certain brashness. It’s the new guy, it’s the young guy or gal. And you contrast that with the old way of looking at things.
Kevin: And usually they’re enthusiastic, so you question yourself. Even if you’ve been through it a few times you thin, “Does he know something that maybe I don’t know, even though I’ve had experience?”
David: So also with valuations, we can look and say, “All right, but now that interest rates are so low, we should adjust all of our expectations to having valuations that much higher. It’s different this time.”
Jeremy Grantham was interviewed on CNBC in the middle of November, and he had this to say about market valuations and projected returns. I think it captures it perfectly. “The one reality,” he says, “that you can never change is that a higher priced asset will produce a lower return than a lower priced asset.” You can’t have your cake and eat it. You can enjoy it now, or you can enjoy it steadily in the distant future. But not both. And the price we pay for having this market go higher is a lower 10-year return from the peak.
Kevin: And the question is, how do we know if we’re over-paying for something? There is a Nobel Prize winner who basically said, “There’s an easy way to know if you’re over paying for something.”
David: I think this reality of projected 10-year returns is a reality we often have discussed since we interacted with Andrew Smithers. He wrote his book, Valuing Wall Street. I think it’s a must read. And in that book are so many intriguing studies showing the unreliability or the vulnerabilities of various valuation metrics, including price-to-earnings ratios. So he explores the longer-term Shiller PE, or what many people call the CAPE, Cyclically Adjusted Price earnings, the 10-year rolling average of the PE, which ends up being far more reliable.
And then he finally lands – this is Andrew Smithers – on Tobin’s Q. It was championed by the Nobel economist James Tobin. Smithers loves it because it’s evidentially superior, and it’s a measure of value that works through all market cycles.
Kevin: Andrew Smithers has been a favorite guest of yours, and you actually went over to Scotland and spent some time with him. But honestly, we can’t get him on the show anymore because he said, “I’m done. I heard I heard the train whistle.” Now he has missed some gains in the stock market since he heard the train whistle. Going back to the train, Dave, you can hear that thing where you guys live. You can hear that thing coming 15 miles up the canyon. Tobin’s Q is a little bit like that. You can hear that whistle. It’s getting a little bit closer, getting a little closer. When Tobin’s Q gets too high – you had mentioned price-to-earnings on stocks, and that’s another one that’s good to watch, but Tobin’s Q has been almost irrefutable through history, and that train whistle is getting very, very close. Smithers said, “I’m just too old to make this money back, so I’m going to move out of the market, and even if it gains a little bit, I hear the whistle.
David: “I don’t care.”
If you’ve watched Hugh Jackman’s film, The Greatest Showman, there’s this brilliant song. It’s beautiful, chilling – Never Enough. And the lead singer belts it out, and I mean, it may change your life. Beyond the song and the melody and the lyric is the message, and the message is, it is never enough. And that’s one of the things that Smithers says, “Actually, I have enough. It’s okay.
Kevin: Even if it goes up a little more.
David: “I don’t need more.” The Q ratio reached extreme levels at every major market top of the 20th century and now the 21st century. So it’s a significant signal of, really, we’re not able to go much further here. And there’s no surprise, it’s there again, it’s at an all-time high by a country mile.
All you’re comparing when you’re looking at Tobin’s Q is market price compared to replacement cost. So take the assets of a company or the reported assets you find collectively in the Federal Reserve’s Z-1 report, and you compare the replacement cost of those assets with the current stock price or market price. You can either look at it on a company-specific basis or the market as a whole. And if we constructed a roughly similar ratio for a house, you could compare time and materials, your labor and materials cost, compared with the current sticker cost – what’s a house going for these days?
Kevin: That’s a great analogy because, actually, that’s how you buy a house. What is the replacement value of the house?
David: And it tells you, this market is way hot, it’s gone way too far. And, you know, because you look and say, if I tore it down, I could build it back for half the cost they’re asking right now
Kevin: Really? I hadn’t even thought of that, but that’s true. It’s not a business, but it’s an interesting analogy. It’s the same thing with ICA. What are we replaceable at?
David: Yes, so if you can more affordably build than buy, you know the current prices on an existing home are high, or maybe too high. And that sort of ratio would tell you just how high. Is it too high by 10%? Is it too high by 50%? Is it too high by 200%. You see what I mean? So if I over pay for an existing structure, my odds of making money on that asset diminish into the future. But if my cost basis is reasonable, my odds improve of being able to make money on that investment.
Certainly, that’s the case in the equities market. The analogy to a degree breaks down with real estate because you’ve got the idiosyncratic variable of location, location, location. It takes us back to Grantham’s comment. While it’s not a precise timing tool for trading the stock market, it is the single best guide for any investor looking to predict the next 10 years. What could I expect on the horizon? So although we can’t see the future, we know axiomatically that returns enjoyed today, bringing the ratio to new highs, they are at the expense of returns tomorrow.
Kevin: Yes, but there are no bragging rights. When you’re golfing with your buddies or you’re at dinner with people who are making money in equities, you want to be buying what they’re buying, but usually if they’re buying it and they’re bragging about it, that means that it’s already pretty high. So the question is, do you really have the veracity to go in and buy what nobody’s talking about, and maybe what you’ll be mocked for buying?
David: Right. Just to illustrate it further, in the fullness of time an investor that was coming into the oil market at $140 a barrel, maybe he makes some money. But to pay $140 is the highest it’s ever been. To this day you’re at $40. We’ve seen negative numbers this year. You got a long way to go before you’re at break even. I don’t know if it’s a decade, I don’t know if it’s two decades. I don’t know when we exceed $140 a barrel, but if you pay too high a price, it is going to affect your future returns.
And it’s clearly easier for someone interested in oil who’s establishing a cost basis at $30 or $40 a barrel to make money, given their entry point. So as we mentioned last week, you’ve got energy sliding from 30% of the total makeup of the S&P 500 to about 2.4%, and that puts you in a compelling entry point, at least for the long-term investor. And so going back away from commodities, Q, this ratio, simply captures a demonstrable and tested measure of something we already know. You know this almost, I wouldn’t say it’s intuitive, but you’ve heard it 1,000 times, the adage, buy low, sell high.
Kevin: We all nod and we say, “Yeah, that’s exactly how you do it. Buy low. But I didn’t buy any oil when it was 40 bucks a barrel, Dave, and I know with McAlvany Wealth Management, you guys moved into energy because you said, “Hey, this is cheap.”
David: Right. It’s not the other way around. You don’t buy high and sell low, except that’s what is oft repeated because it’s that easy. You do what everyone else is doing, you do it on the basis of momentum. And some young guy, either with an MBA, or a sophomore in some capacity comes in and says that we just don’t understand the technology.
Kevin: You need to know – Tesla! Tesla! I had a client who called three weeks ago who called and said, “Should I sell some of my gold and buy Tesla? The question would be, is Tesla overvalued?
David: And look how easy it is for Elon Musk to raise money in this environment. And yet a company like Exxon Mobil, or just in the energy patch at all, it’s almost impossible to raise money. So liquidity flows, but it doesn’t flow equally to all places. And you can see where imagination fills in the gaps. Tesla’s now the 7th highest valued stock. It’s amazing. $560 billion. It trades at 1129 times earnings.
Kevin: So if they keep earning what they’re earning, it would take 1129 years to break even on the value of the stock.
David: Yes, but just to be clear, those earnings are primarily from selling carbon credits and not cars.
Kevin: Ah. I’ve got a few of those in my pocket. Carbon credits?
David: This is where imagination meets magic, and this is not like the stuff of Disney 94 years ago, where imagination and magic created something really remarkable. We’re still talking about more or less a pipe dream. I’m not saying it couldn’t become something, but 21 times sales? You’re paying a lot for Tesla.
Meanwhile, Exxon Mobil, $173 billion market cap, less than half of Exxon Mobil’s, it sells for less than one times sales. They they’re doing about $190-195 billion in annual revenue. So Tesla is a miracle of imagination. You can pick a price. I mean, why not have it as a trillion dollar company or two trillion? Price doesn’t have to be tied to reality in that sense.
Kevin: So can you pick a peak on a price? You really can’t. But it’s the same thing as trying to time the train. I keep going back to the train. I can’t really time the train, so I don’t bother. I just move away when I hear the whistle. So do we know a peak when we see one, Dave?
David: You may not be able to time the train here in Durango, but you can time your life off of the trains in Switzerland.
Kevin: I remember that.
David: A religion of precision is sort of in the DNA.
Kevin: Dave, remember when we went to Switzerland and we were in Wengen, which is right at the foot of the Eiger? It’s a beautiful place. I got to stay an extra day and was taking a train back. You had left a day early. But I remember how aggravated, because we had seen that the trains ran exactly on time in Switzerland. Well, this train was about 35 seconds late, and the conductor said, “I started in Italy.” In other words, the Italians were the ones who had made them late, because Italy is south of Switzerland. So the Swiss, you’re exactly right, when people say the trains run on time, they literally set their watch to it.
David: We’re talking about peaks, and do we know a peak when we see one?
Kevin: “Yes, we can time it like a Swiss train.”
David: I think it’s always in retrospect that we see it. Look at an old chart. Look at the market realities which become crystal clear.
Kevin: And then you say, “Of course, of course, we saw it.”
David: But that’s the same as hindsight in other aspects of life. We understand, in retrospect, far more clearly than we do by peering into the future.
Kevin: This reminds me of our friend Jim Deeds. I know you talked to him recently. He called me last week, as well. He always states, “You may not know the future, but try to figure out over the next two years what is unloved and unpopular now. Try to figure out what will be loved in the future.” This is a man who’s been very successful at that.
David: I know one of the things that he’s assuming is that the efficient market hypothesis is bunk. The future is not yet, so if it’s not yet, it is unbound, and it can be otherwise. Put out any scenario you want and it can be otherwise. I’m thinking, that puts me back to a paper I wrote for Rory Fox, a tutor at Oxford, on Augustine’s view of foreknowledge, and future contingent events. Everybody, back to the fourth century, had these ideas of, can you know the future, who could know the future, to what degree can even God know the future? Is there a limitation of future knowledge in that cut?
It’s the future that keeps us more intrigued. Markets and investing are all about discounting the future. Jim Deeds is 88-89. He reminds you of a strategy through the decades. Find an area of the market that is unloved – translate: buy low – that you have reason to believe will capture market attention two years from now, and build a position in it. You may be right, or you may be wrong, on what you anticipate will be popular, but you are sure as hell not over-paying for an asset. Again, the first rule of investing, buy low.
Clearly, there are other successful approaches to investing, but I think Jim’s approach is similar to what Grantham is suggesting in his comments. And it’s the opposite of the spectrum from the current market’s valuations – way high. Q valuation would say, “Yes, the next 10 years could be a tough road for anyone who has expectations of positive gains.”
Kevin: Who are buying equities at this time. And I think about it, there are listeners who are thinking, “I don’t do a very good job buying low and selling high.” But don’t start with buying low and selling high. Start with, don’t buy high, at least. You may not know what is low, but don’t buy high.
David: So we’re attaching the chart in the notes for the show so you can see what we’re talking about in the Q ratio. But at every market peak in the Q ratio prior to the end of Bretton Woods – think about the period of time prior to 1968-69-70-71 – the ratio barely went past one.
Kevin: This is Tobin’s Q, what you can replace a business for. You don’t pay more than one for.
David: Exactly. So if it costs you $100 to buy assets to build a company, why would you go into the public market and pay $110? Again, look at that chart because the ratio back then barely went over 1, and that is, you paid a 6%, 7% or 8% premium for an existing business, and those premiums marked the highs of the market. We’re talking about the premiums that you would have paid at market peaks like 1907, 1929, 1937, the stock market peak in 1968. You were paying a hefty premium of 6-8% versus replacing assets of the business at cost.
Prior to the end of Bretton Woods, making money in equities was really about buying something at a deep discount to a company’s replacement value. Now, when we say value, we can borrow it and say, this is really the heart of value investing. And in fact, this timeframe prior to the end of Bretton Woods was the birthplace and the great success, the demonstration of success, for the Graham and Dodd way of investing – buy low in order to compound returns. That’s the capital gains portion, certainly, and your dividend income. And the deeper the discount in terms of what you’re paying, the healthier the long-term returns.
Kevin: Remember when you turned me on to the book, Anatomy of the Bear? Russell Napier. It was fascinating. This was a guy who was fascinated as to, when are you over-paying and when are you under-paying? He went back and read every Wall Street Journal going all the way back. Didn’t he go back into the late 1800s? He wrote a book, it is beautiful book. He’s been a guest on here. He found points where he said, “This is exactly when you would have been under-paying.”
David: Yes, the entry points for an investor, the most compelling starting points for investing in equities were 1921, 1932, 1949 and 1982. The end of a bear market, in each case, not at, certainly not near all-time highs.
Kevin: Can I interrupt just for a second? Thinking about this I just literally stepped off of a call, before I walked into the studio, Dave, with a client, explaining the gold-to-Dow ratio, the Dow-gold ratio. If you look at those dates that Napier’s picking, and he’s not even looking at gold – 1921, 1932, 1949 and 1982 – gold was pretty close to a 1or 2-to-1 ratio, at least two of those dates. So when we do the Dow-gold ratio, if you’re wanting to look at valuations, yes, Tobin’s Q is beautiful. Price earnings ratio is beautiful. Something probably even more pristine is the Dow-to-gold ratio. Look at those dates. They correspond.
David: And I would say the Cyclically Adjusted Price Earnings ratio is more beautiful. But the end of a bear market in each case for equities, you are right, coincided with a pretty unique opportunity to be moving from gold into equities. So what changed in 1968 to 1971? What changed at that point at the end of Bretton Woods was the nature of money, and we returned to an already failed system of fiat currency.
I say already failed because we’ve done this before. We’ve done it multiple times, maybe hundreds of times, in a 1,000-year period across the globe, certainly dozens of times. So we returned to an already failed system of fiat currency, and that liberated corporate values and the value of stocks from having a basis in real replaceable things.
And so we’ve re-priced the universe of assets over the last 30-50 years using balance sheet leverage and a tremendous amount of financial engineering. And with that has come a tremendous amount of latent instability within the financial markets because leverage has been in a dead sprint with complexity. And that’s been going on for many years now, many decades.
When something goes wrong within a complex system these days, the amount of complexity and leverage, it means the slightest thing goes wrong and you’re on the brink of collapse every time. And that’s part of the package. Originally this all bases out of having changed the nature of money.
Kevin: I love how you combined complexity and leverage. That’s really the truth, isn’t it? It gets more and more complex. Things become more and more dependent. Systems become more and more dependent on each other. And then the leverage kicks in because it starts really, really working. But when you’re on a fiat currency system and half the crowd can print money and the other half the crowd has to work for it, how does that work?
David: You need some perspective on how the Q ratio worked in the pre full-fiat era, and now in the full fiat era. So the Q ratio has to be understood in that light, a new and more flexible currency. In other words, since 1971 it’s been easier to debase. Today the ratio is not 1.06, showing a 6% premium, or 1.8, an 8% premium, like it was at passable market peaks. Now, in a world of easy money and easier credit, the ratio is 2.46.
Kevin: Wow, is that a record? Is that the highest?
David: Takes out the highest number we’ve ever seen at 2.15 in the year 2000.
Kevin: Which was the top of the tech stock bubble. The dot.com crash came right after that.
David: You’re not just paying a slight premium to own an index today, you’re paying just shy of 2.5 times the replacement cost of assets. So going back to the house analogy, it is now far cheaper to build than it is to buy, a company in this case. That would be great encouragement to entrepreneurs. Build a company from scratch because you could do it cheaper. It would be great news if it weren’t for a fly in the ointment, and that is that easy credit enables the existence of zombie corporations and makes it far more challenging for new entrants into the marketplace. So it’s a very unhealthy dynamic. But it does serve as a warning, this Q ratio at 2.46.
Kevin: It’s the train whistle.
David: It serves as a warning to investors who may not recognize how overvalued the market is. Q tells you it’s the most expensive ever, not only in terms of price – Dow 30,000, NASDAQ 12,500, S&P 500 3700, let’s call it pushing 4,000. Those numbers speak for themselves. Are you getting what you pay for?
Kevin: What would Tobin say?
David: If you’re asking the Nobel Laureate, James Tobin, if you’re getting what you pay for, at 2.5 times replacement costs, the answer, definitively, is no. If you own equities today with a blind eye to the next decade, guess what you are? Guess who you are? You are the proverbial bag-holder. Who gets caught holding the bag at the end of a cycle? The folks that enjoy enthusiasm and speculation over and above axiomatic truths and investment history.
Kevin: It goes to bragging rights. It’s like, “Hey, do you own Tesla? I do. Do you own _____. whatever it is?” And I’m joking, I don’t own Tesla right now. But it is the bragging right. What you own, if it’s undervalued, you just don’t talk about.
David: The opposite end of the equation, there are hundreds of companies that fit the value equation well now that are indeed cheap. But finding them and buying them requires peering into the next two years and seeing where investor foot traffic will go, not where it has already gone and is going today. The efficient market hypothesis says that’s not possible. The efficient market hypothesis declares that prices reflect all knowledge available. Opportunities, in essence, are already recognized and currently reflected in the market price.
Kevin: So because we’re human, we can’t predict the future. I would imagine your paper that you wrote in Oxford was leaning that direction. You had used the word declaring, and it reminds me of a verse in Isaiah 46 when God is differentiating himself from anything else. He says, “Remember the former things of old, for I am God, and there is none else, declaring the end from the beginning and from ancient times the things that are not yet done.”
So God can do it. That could be an answer on that paper. I would imagine you had that in the paper. God can do it, but humans? No, we had better have some history to look at.
David: I actually took a very different argument in that paper. Whether you agree with the existence of God or not, or agree with the existence of foreknowledge or not, I would argue that as long as the future remains undetermined – you’ve got central planners who don’t mind trying to play God, that’s the end of theory stuff that we’ve brought into our conversation a number of times – but if the future remains undetermined, the only possible being with foreknowledge would be God. And since we’re not God, we can assume that our knowledge, and that of the marketplace, is incomplete. And future contingent events represent opportunities if we can guess correctly.
Kevin: So what we’re saying is you work all your life for savings, and then you just start guessing. Is that what you’re saying? This is just a guess?
David: It’s an educated guess, yes. And if you don’t like that, everything in life is an educated guess. We can pretend to have certainty in almost any area or endeavor, and I think what that neglects is how much we assume, how much we hope for, how much we believe. An educated guess looks at evidence, it looks at data, the more the better, and you need the preponderance of evidence to favor a certain outcome. And that’s where you decide to invest money.
For me, the Q ratio provides evidence in support of that adage. Very simple. So you may disdain simplicity. Do what you want with it. Buy low, sell high. I think the Q ratio supports it fully. But if you buck that trend, you have to be either exceedingly smart or comfortable being exceedingly wrong for a long, long time – five years, 10 years, however long it is. A decade of negative returns is painful.
Kevin: You said, educated guess. Let’s attach the Tobin’s Q chart. Didn’t you say you would do that? So it will be on this particular site so you can click on it and just see, this is an educated guess. Just look at the chart at the all-time high of the Tobin’s Q and say, “Do I really want to buy equities right now?”
David: And more to the point, why should I sell stocks now? And I’m not saying that today is the perfect day. I frankly don’t give a rip if I’m within 10% or 20% of the all-time market highs, and Andrew Smithers would say, “I don’t give a rip if I’m within 30% or 40% of the all-time highs. Enough is enough.”
Kevin: This was a man who could take his winnings and go home.
David: Of course. Adequate millions. Financial Times columnist for years, writer, very established researcher and very successful investor.
Kevin: So your dad would say, keep your powder dry. What you’re saying is, keep your powder dry.
David: I think so. And if you don’t have sufficient powder, then you’d better get some. Again, why sell stocks now? Look at the Q ratio since 1900. Can you picture, in this 100-year period, any time that would be better to be getting liquid? You make the case. You argue for the Q ratio going from 2.5 to 5. If you are a naysayer on the Q ratio, fine. Show me the evidence.
Kevin: I’m looking at the chart. Listener, please, go to this site. Click on the chart.
David: Cash allows the patient investor to establish a better cost basis, and on that basis, line up superior long-term compounded returns. What we like, what I love about gold and the Dow-gold ratio is that gold as a substitute for cash allows for a multiplication of purchasing power. So if buying at discount is a good idea, then buying at discount with an appreciated currency is even better.
Kevin: This reminds me of the triangle, which we do with every client. You draw a triangle. The base of the triangle is gold. The left side is growth and income – that could be equities. The right side is cash. And oftentimes, if they’re printing too much cash, that cash can also be gold. We use Vaulted. Every two weeks, I buy more vaulted because it comes out of my savings account automatically.
David: It’s like $150-200. Whatever. You can do it automatically straight from payroll.
Kevin: Because the government can’t print gold.
David: On the topic of gold, a currency. That’s as I like to remember it. Maybe that’s in its former and perhaps future glory. It has corrected in price since July, and it’s in the process of entering its strongest seasonal three-month period. Historically, this period, a move to the upside should be expected December to February, capture a very intriguing period, in part because it overlaps the Chinese New Year, a very considerable source of demand.
Each year, investor demand, globally, ebbs and flows with macroeconomic variables. But you have things like Ramadan and the ag cycle in India, which coincides with the Indian wedding season. And then, of course, this other seasonal factor, as we get into the December to February period, capturing the Chinese New Year. These are the timeframes when you tend to see a spike in price.
We’ve been down $150-200 off of the peak. $2,070 was the peak. We trended to about $1775. We have recovered, already, some of that loss, and coming into the strong season, if you will. The extraordinary move we saw earlier this year, 2020, up to July, was in large measure tied to global economic uncertainties. And of course, we had the impact and the anticipation of what the consequences would be of radical monetary and fiscal interventions. These policy measures we’ve had in 2020 we expect to continue well into the future.
So it’s not as if that was then, this is now. We remain very bullish on all your precious metals. We’ve got a caveat or two, but we remain very bullish on precious metals because we’re watching the global central bank community go absolutely bonkers, doing it all at the same time. They’ve been able to do it and keep the system of debt going under the cover of Covid. (laughs) I don’t remember what we used is an acronym, but C-19 for us, Covid-19, C stood for something.
Kevin: It was a convenient way for the central bankers to continue the perception that they were in control. Remember, we talked about that.
David: And that put trillions into the financial system.
Kevin: Which they were doing before.
David: Everyone saying, “Bring it, create more, we need more.”
Kevin: But that started in September of 2019. That started almost six months before the United States recognized Covid as a problem. You started talking about this. We were talking about this in September. Wow, Look at this. Look at all this repurchase stuff going on as far as the repo markets go. Then in October they restarted quantitative easing. Now we were supposed to be just chugging along fine, the greatest economy of all time, and we were doing quantitative easing. Then Covid came along. So that was pretty convenient. That’s Convenience-19.
David: Insurance accommodation. Insurance cuts, as they were called by Jerome Powell. Why will policies remain the same in 2021 and 2022? I think a part of that ties to the equity and bond markets, which have gotten in a bluff with the central bank community and, in essence, have gained control of central bankers’ greatest fears. That is, central bankers won’t allow for a drop in asset values because it plays with a number of ratios. When asset values drop, equity is gone and debt remains. That’s one factor, now you’ve got an imbalance, only debt, no equity to offset it.
The other thing to think about is when debt is re-priced, interest rates become punitive and unsustainable, and that may not impact the existing stock of debt, but if you’re talking about refinancing or evergreening debt, that becomes very costly. This is best captured by Jane Fonda in the movie Rollover in the 1980s.
Kevin: Jane and Kris Kristofferson.
David: Right. So if you’ve got a huge amount of debt, interest rates start to edge higher, the cost to refinance then all of a sudden is highly punitive and very expensive. It takes a major toll on the financial markets as a result.
So here’s where you see central bank monetization. Here’s where you see that they are committed to lowering interest costs and maintaining the high value of asset prices. And they’re willing to do that. They have to do it. Otherwise the markets will throw a fit. The bond markets of the world will throw a fit. The stock markets of the world will throw a fit.
This is what I mean. The equity and bond markets have gotten in the bluff, right? Everyone is pretty well leveraged to the hilt, if you’re talking about the corporate and governmental sectors. And central bank monetization is in defense of the leveraged entities, both private and public. Why wouldn’t you be leveraged when the money is free to borrow? Zero rates, negative rates, free money.
Kevin: Money for nothing and interest rates for free? In the 1980s, my wife and I bought a stereo. One of the first CDs that we owned was Dire Straits because it was demonstrated to us, I think, a Sears on a huge speaker. It was like money for nothing, and I won’t fill in the rest, but we could do money for nothing, interest rates for free.
David: Any wonder that the number of re-fis right now are breaking all previous records?
Kevin: We probably should be refinancing, too, don’t you think if interest rates could go up?
David: Is there any surprise that corporate debt issuance is also shockingly high? Or that governments are taking advantage of low rates to improve their cash flows? And that is like you and me. If you think like they do, if you think like the Treasury Department officials do all over the world, why not refinance? Why not save yourself the extra $200, $400 dollars, $1000 a month in interest?
Kevin: Well, the Spanish are doing it, the Portuguese are doing it. the Greeks are doing it. they’re all refinancing their country because the European Central Bank says, “Yes, we’re going to keep buying.
David: That’s right. Monetization gives them an opportunity. Reuters was reporting that Spain and Portugal are on track to collectively save $20 billion in interest payments between now and the end of 2022. $20 billion in interest payments, they can go use that on something else. Their debt levels are rising, but the interest component on the debt continues to drop, so nobody is concerned about the debt levels increasing. Nobody’s concerned about debt/equity ratios. The pandemic gave the European Central Bank the justification to underwrite almost all of the European debt market and to reduce borrowing costs across the board.
Kevin: So that means if you want to go buy a Spanish bond, you almost can’t do it because they’re devouring everything. They’re just buying everything.
David: You almost have to say to yourself, “Be careful what you wish for. When this pandemic goes away, the ECB doesn’t have the justification to buy 100% of Spain’s newly issued debt. Is it within their mandate to continue to buy 80% of Portuguese debt? And what happens to the cost of borrowing the price of existing debt when everything goes back to normal? You might recall that some of these PIGS, Portugal and Italy, Greece and Spain, it was just a few years ago that we referred to them as that, and you’re talking about 15-17% rates of interest.
Now you’re talking about negative rates in some cases. Everyone is sanguine about the debt-to-GDP figures in Europe rising, and in the United States, because the central banks have radically reduced the interest expenditures through de facto monetization.
Kevin: Money for nothing, interest rates for free.
David: But the scale of this de facto monetization, if you’re not bullish gold, you’re not really checking in with reality these days. Maybe you’re smoking a little too much Tesla weed. It’s crazy to think that this is the normal which we’re getting accustomed to.
Kevin: Can we get the European Central Bank to buy all of U.S. debt then? Because, gosh, it costs more for our government to borrow money than it does for Greece.
David: So you look at the 10-year Treasury, 97 basis points last week. We’re talking about a hair’s breadth from 1%, which is relatively high when you consider Greece at 63 basis points, Portugal at 4. That’s basis points, not percent. Basis points. Virtually zero. Greece at 63 basis points. Portugal at 4, Spain, I think they are at 8, Italy is also at 63, the French are negative 31 basis points, Germany, their bunds are trading negative 55 basis points. These are all from last week, but we’re still in the same range.
Kevin: Just a reminder. We never had an interest rate that was negative until 2015. So this is a new phenomenon.
David: You’ve got 17+ trillion globally, and these are monetized rates. These are not natural rates determined by the markets. So out of this, what do we have? We have malinvestment resulting from the strategic choice of central banks to monetize and crowd out normal investor capital flows into safe haven bonds. Usually government bonds are considered very safe. So your very conservative investor goes there.
Now you can’t squeeze into it. Why? Again, 100% of new issuance from Spain is being bought by the ECB, 80% of Portuguese issuance is bought by the ECB. If you were wanting to buy them, have a little extra yield, you’re not going to get the extra yield. In fact, you got to stand in line to buy them, stand in line behind the ECB.
So investor risk goes up. Investor risk-taking today is emboldened by central bank policies. And then you also have to fill the income gap some way. The investor is required to fill the income gap because low rates and negative rates have imposed this stress on investors for 2020. Look, we print $3 trillion in the US and then we run a $3 trillion budget deficit.
Kevin: That’s for 2020. That’s unprecedented. But aren’t you getting sick, I mean, really sick, of the word unprecedented?
David: It wins the award for the most overused vocabulary word of 2020. I think I prefer synonyms like anomalous, atypical, freakish.
Kevin: How about unethical and immoral? But I’ll just step back from that.
David: Well, it certainly is beyond the normal mandates. We could at least put it in those terms. And so maybe, just maybe, we get more rules-based application of fiscal policy from Janet Yellen. We’ll just have to wait and see.
October is the first month of the new fiscal year for the U. S. Government. The budget deficit in the first month of the new fiscal year is up 111% from the year earlier.
One month deficit, $284 billion for the month. For the month. Roll back the clock a few decades and you could count on half that amount for an entire year.
So again – unprecedented? Leave it alone. That is anomalous, it is atypical, and it is freakish, right? And so, too, is the M2 money supply, which is up $3.6 trillion in less than 40 weeks. This is running at a 23% annualized rate. That is the highest rate in 75 years, and has only been matched in the U.S., in terms of our financial history, in one other year, during World War II. So atypical? Yes. Freakish? That, too.
Kevin: So you’re talking 23% more money for nothing, right? More money for nothing. And if you compare that to money that God made that nobody can make any more of, gold, I think, what do we add, about 1.5 to 2% a year to gold supplies, whereas we just saw a 23% gain in the money printing, the more money.
David: So what does it mean for an investor? I would suggest that the justifications for denominating savings in gold ounces rather than any fiat currency, any other fiat currency, those justifications have never been greater. Biden, Yellen, the Federal Reserve team that’s likely to oversee this generation’s last stage of debasement, that’s ironic. We are talking about monetary debasement, by the way.
Kevin: Not Biden’s debasement?
David: No, not Biden’s debasement, but monetary debasement. Let’s be clear.
David: $80 trillion in total U.S debt, $277 trillion in debt worldwide. And when you think about the policies that have to be implemented in order to manage this monstrosity, you’ve got the twin hammers – and I’m talking about hammers that hit the investment community and the financial markets in a very hard way, the twin hammers of financial repression and inflation. They’re here.
And for those who doubt that that is going to happen, perhaps you still favor the deflationary endgame, look at what’s happening to the copper market, look at natural gas, look at zinc, look at nickel, look at gold and silver, look at platinum. If you want to close in on the entire commodities complex, it suggests that something is shifting. Drop a chart of the Goldman-Sachs Commodity Index. It tends to be a little energy heavy.
If you want something that’s even broader-based, look at the Rogers Raw Material Fund. His RICI, or Rogers International Commodity Index, gives you a pretty broad base of what’s happening in commodities, a recent move of 20% up. Okay, great, but it’s still 60-70% lower than the last cycle peak in 2008. Commodities have a long way to run, and I think they’re sending a very clear signal. And that signal is that, yes, the financial markets are great as long as we can keep the money flowing, as long as the monetization continues, as long as everyone thinks that this is healthy.
The irony here, again, is that we begin to see evidence of this being a failed project in currency valuations. I don’t think it’s an accident, the dollar slipping below 92, below 91, maybe it slips to 85. I don’t know how low the dollar goes…
Kevin: But I can hear the train whistle.
David: And on that basis, I’m not sure we know how high gold goes, either. Time will tell, but for my savings, I’m much more comfortable having ounces rather than handing money over to Biden, Yellen, Powell and the whole cast of central bank characters.