The McAlvany Weekly Comment
with David McAlvany and Kevin Orrick
“How much of a deficit is there? What does it add to the present debt levels? Federal bureaucracy is given a free pass on this issue, and there is no accountability. And it has to do with how they account for their liabilities. Again, their feet are not held to the fire and they look better than they actually are —perception management again. The reality is, the federal government is defrauding the public.”
– David McAlvany
Kevin: David, you are just returning from a duck hunt. I think this was your first duck hunt. You have hunted dove – we hunted dove last year – and you have hunted other birds. But something that makes duck hunting different from, say, dove hunting and some of these others where they just fly by – you actually have to manage the environment. You have to manage the way the ducks see the environment so that they don’t know that you are there.
David: Yes, setting up a blind is something that happens up to a month in advance to allow natural growth to occur all around the blind to be something that just fits into the environment. And the whole process of effectively managing perceptions is in motion from the get-go. You have your decoys out. As a part of the decoys you have a number of birds that are known as confidence birds, if they are around, because they are naturally skittish. If they are around it conveys to the ducks overhead that it must be safe.
And then you even have – I’ve never seen this before – these sort of robotic birds which have wings that are flapping, and it looks from an aerial view like there are other birds that are landing, too. And so there is this constant enticement of the call that the robo-birds, the confidence-birds, the decoys, the natural environment. And everything is just right, except (laughs) I’m sitting there waiting for you with a 12-gauge.
Kevin: That’s the thing. That’s what makes them tentative, that their survival depends on accurately reading the situation. Now, I’ve been thinking about this from an economic standpoint because it seems that the only thing that people are paying any attention to right now is the decoy that is sitting in the water right now saying, “Is the Fed going to raise rates? Is the Fed going to lower rates?” It seems to be the only bit of economic news that is used. In fact, even when payrolls come out, or unemployment comes out, any number really just applies to, “Well, what does that mean that the Fed will do?”
David: And to some degree there is a parallel in terms of effective perception management, and there is the odd duck, the model bird that keeps the perfect distance and is very difficult to shoot and is always wary and not easily callable under any circumstances.
Kevin: And he ages well (laughs).
David: And he ages well. There are other birds, spoonbills and others, that love to come in close and are happy to be the first to land and the first to be peppered with shot. And it is interesting. I look at the nonfarm payrolls number – we’ll do a couple of things – one, looking at Friday’s job’s numbers. I also want to talk a little bit about the Chinese export figures, and then some of what we have seen in terms of the market impact. But I look at the nonfarm payroll number and the household survey, and the NFP at 217,000 jobs was great. Everybody looks at it—it was great. It’s great. It helps, I think, to look at the segments within the headline figure, 271,000 jobs created for the month, and to see if those little internal segments deserve a friendly nod, a round of applause, a standing ovation
Kevin: Well, I think you are asking the same question that the ducks are asking. “Do we land here, or do we move on?” The ones who moved on didn’t get shot. The ones who are landing on this and saying, “Oh yeah, well, this must mean that the Federal Reserve is going to raise rates,” that’s what happened Friday, isn’t it?
David: It may end well for them, it just depends on how sharp the shooter is (laughs). So 54% of the job gains out of that 271, 54%, 145,000 jobs, came from the birth/death modeling. So, how many companies are coming into existence, how many companies are going out of existence, in line with sort of a demographic birth-death statistical modeling. So, over half of that number was just that, a statistical model which says, “Yeah, on average we should be about right,” guessing that 145,000 jobs were created from this.
Interesting, this October, compared to the last five Octobers, was stronger by about 40,000 to 45,000 jobs for the month of October. So, a little bit stronger, a little bit of a push, if you will, higher on the birth/death modeling.
Kevin: And don’t they count, Dave, even the low-paying jobs? I mean, if a person has just a small part-time job, low-paying job, what have you, they count that equally with, say, the person who is making $150,000 a year.
David: Sure. So, out of the 271, you had 209,000 which were in what I would describe as a low-paying job category. So, what would examples be there? 44,000 for retail. And quite frankly, with traffic being down I think they must have used some very generous seasonal assumptions on the retail side. But in addition to that you have the food and beverage services. Again, the quality of those jobs, the income level, you’re not talking about six-figure salaries here, you are talking about minimum wage at best, food and beverage service, 42,000 factored into the number, and temporary jobs, 24,500. So those would be examples of the low-paying, which constitutes 209,000 out of the 271.
Kevin: And then they divide business and service jobs from manufacturing jobs, as well, don’t they?
David: Yes, so two points there. One, the business and professional services, roughly 78,000 jobs in that category, a decent number, but notably absent — no manufacturing jobs — zip, zero, zilch — which I think goes toward further supporting the idea that the U.S. industrial complex is in recession.
Kevin: Now Dave, they measure several things. I know there is the nonfarm payroll, but they also do a household survey, as well. Isn’t that what is also counted in the numbers?
David: Right, so you have, based on the sampling of 60,000 households, and then of course, it is extrapolated statistically to a national level, but that 60,000 is what they project on the basis of the household survey, 320,000 jobs which were added. 334,000 of those were women 20 years and older. So yes, you can have more of one than the other, 334 positive, because somewhere in the mix there is a negative, and the negative on this particular number was men in October, with a lot more layoffs for men, according to the survey, and a lot more additions for women 20+. So, the unemployment rate, that is, the U3, comes in at 5%, labor force participation rate still at the same 62.4 number dating back to the 1977 lows.
So, in summary, on the jobs front, and on the jobs numbers, we are at full employment, if, and I say if, because you would have to count all the part time jobs and treat them as full time, which they are happy to do. We are at full employment if you don’t count the 93-94 million people that have left the labor force. And by the way, I have been assuming that those people leaving the labor force was an age and retirement-related thing. But virtually all of the October jobs gains came in the 55 and over category, with a very strong showing, this was in table A6, in the 65 and over category. So, the main job losses were in the 25-54 age bracket where they lost significant numbers. So, no, the labor participation rate does not appear to be at the 1977 levels because of retiring baby boomers and retirees. There are just people discouraged and not wanting to look for a job anymore.
Kevin: Well, I think we should go back and highlight that a little bit. What we are talking about, in 1977 we had the worker base basically as low as 62%, like we have it now. Yet we are being told unemployment is only 5%, so this doesn’t match, especially what you were talking about. It is not because the 93-94 million people who are not actually going and getting a job are retired. It is retired people who are going and getting a job. That’s what you are saying, I think.
David: That’s right. There are a lot of people getting jobs in the 65 and over category. And that, I think, is very telling. And lastly, on this issue of full employment, which is very critical to the Fed. The Fed wants to get to full employment because of a lot of other things we will talk about in just a second. But full employment, we’re there, if you don’t count the discouraged worker category.
Kevin: Which are the workers who haven’t gotten a job for the last 12 months and so they just stop counting them.
David: They stop counting them once they quit looking for a job. If they’ve been looking for 12 months and then throw in the towel, that’s how they get the discouraged label, and they are not counted as unemployed. So, just because you don’t have a job doesn’t mean you are counted in that unemployed segment.
Kevin: Dave, we had a guest that counts those people still – John Williams. He is on at least once a year here on our show. And from his economic analysis, he puts our unemployment level closer to 22-23%, I think.
David: Right. So you throw back in the discouraged worker category and you do come up with a number revising unemployment to a figure closer to 23% versus the official 5%. Now, the actual reality is probably right in the middle. But when you contrast the official 5% with the 23%, and can appreciate how you get to that number, and can actually count the bodies, and not just on a statistical basis, but can count the people who are no longer looking, that gives me the idea that I should be giving a friendly nod to the nonfarm payroll numbers and I’m just simply going to hold the applause until we have a better circumstance. I’m going to hold the applause until it is better deserved.***
Kevin: We were talking about duck decoys, and the closer you get to a duck decoy the less it actually looks like a duck. Maybe from the air they look like ducks, but as you get closer you start to say, “Hmm. Boy, if they only could see it from my perspective they would never land here.” I’m thinking of some of the bad models that we use. The birth/death model — that can be a bad model. And we have bad models that the Federal Reserve is still using. I think of the Phillips curve. That thing was discredited 25 years ago and they are still following it.
David: And there are papers that are written that argue for the effective use of the birth/death model. It helps, on a rolling average, to account for changes in the business environment which can’t necessarily be quantified, but help you get to a better average number. But it is a place where you find lots of assumptions, and where there are lots of assumptions there are lots of things that can go wrong. When we talk about the Fed’s emphasis on labor and full employment as a means of stimulating inflation and economic growth, it is tied to their use of the Phillips curve.
And basically, the assumption is that in an environment of full employment there is more competition for jobs. And if there is more competition for jobs, that should lead to an increase in compensation. As wages increase, so should economic activity. And following on the heels of an increase in wages and economic activity is an increase in inflation. And so we can thereby assume that by focusing on the jobs number and getting us to full employment we are ultimately going to boost inflation and accomplish the economic growth desired by the Fed. All of that is tied in – and again, I don’t think the academics at the Fed sometimes read their memos – to the Phillips curve.
And the Phillips curve has been repeatedly discredited. A market practitioner will tell you that the Phillips curve is bunk, but you talk to any economist and they will say, “Of course, it is one of the primary assumptions that we use,” and certainly, the Fed does. So it should be, by now, clear, and I think the 1970s were where it really was a clear example of inflation and wages being disconnected. Why? Because we had rising inflation and it wasn’t based on wages (laughs). It was not based on wages. So this idea that, again, an increase in wages is going to drive inflation – it is not always the case.
Kevin: So Dave, the Phillips curve is a little bit like a Rube Goldberg machine. You know, the ball drops on the spoon, the spoon lights the match, the match then lights the candle, the candle then burns down, and other things happen. The problem is, the Rube Goldberg machine of the Phillips curve hasn’t worked for years, and yet, it was part of the fabric of what these academics at the Fed had been taught, but they don’t know what else to use.
David: No. They are assuming that it had mechanical reliability and that it was engineered properly up front, and are not looking at market examples that would shed light on its frailties. So, using the Phillips curve, assuming those economic relationships, that has remained central to Yellen’s analysis, regardless of evidence to the contrary. So, now that the jobs number is where they want it, roughly 5%, and wages grew – note that the wage numbers are pretty volatile on a short-term basis, so reading too much into one month, in my opinion, it is pretty dangerous. But you have the Fed concluding that they have been vindicated in their approach and they are now ready to raise rates. I don’t think this will stick. I think circumstances in the next 90 days are likely to mitigate against a new course of rate hikes, a single hike notwithstanding.
Kevin: Okay, but speaking of Rube Goldberg machines, it does set off a daisy chain of events. As people are looking for new and interesting market news, it seems that the only market news that they are interpreting right now is the interpretation that they think the Fed will use for raising or keeping rates the same.
David: This gets to assumptions related to market correlations, how different assets respond to each other, how different economic variables interact and correlate. And there are a variety of things that occur when people are making these correlation analyses. Are they doing it on a short-term basis? Are they doing it on a long-term basis? Do those correlations hold under environments of stress and strain or do the correlations break down completely? What does the market do with the numbers out on Friday?
Let’s look at how correlations and relationships are treated. You have the jobs number, plus the wages, which triggers an assumption of the Fed raising rates, which triggers an assumption of the dollar strengthening as higher rates in the future may attract overseas inflows. A stronger dollar and the higher rates send gold lower on the assumption that people will weigh the opportunity cost and not want to own gold. And yes, equities sold off, as well, because they have risen to the current stalled out level on the tide of low rates and monetary accommodation of every sort. So you are going to see some degree of tightening. You can expect to see the tide go out to some degree there, as well. So, markets were impacted in a variety of ways, all assuming the power of a rate increase as a fait accompli – already done.
Kevin: Yes, and you know, we were talking about ducks, assuming that the decoy is a duck, and fortunately for you, unfortunately for them, it makes them dinner. We’re not necessarily served for dinner when we assume something, Dave, but an assumption could get us into trouble.
David: You know the old aphorism about assumptions. They are the things that make an ass out of you and me. Put those letters together and you have the word, assume embedded in it. There are a lot of assumptions embedded in the daisy chain of market movements that we saw last week and this week, most of which are going to be flushed out as irrelevant in time. But the knee-jerk reactions of trading work off of these generally believable assumptions.
Kevin: It is fair to say that people who don’t necessarily spend all of their time looking at these numbers – we all reduce the information that we take and we say, “Okay, with the limited information that I have, what do I do?” You were with a number of diverse guys during this duck-hunting weekend. I think you said that part of the conversation had to do with, “What’s the Fed going to do?”
David: Yes, and it was a very interesting group of guys – a workout specialist, somebody that helps indebted companies figure out whether they need to be dismantled and bankrupted, or chart a different course toward recovery. Also, the bank lender gets repaid. And who else did we have on the trip? I hunted with him for the day. There was another turn-around specialist, retired now, but responsible for reviving a number of sizeable companies in his career, a surgical pathologist, another guy that owns and raises horses – a brilliant 84-year-old oil magnate. I hope I am half as bright a light as he is when I am in my mid 80s. There is a young man that manufactures cell phone towers and runs a second generation family business, as I do. The CFO for a large family office. And one of the greatest hosts of all time, my very business-savvy uncle. This was the group. And one of the points of discussion through the weekend, like with any group of invested entrepreneurial, risk-taking people – “When will the Fed raise rates?” And of course, because they knew I had some interest or knowledge of gold, they asked the question, “And what will the impact be on the price of gold?”
Kevin: Well, let’s face it. It’s a fair question. We haven’t seen rates rise in nine years – almost a decade. I don’t know that that has ever happened before.
David: Well, the last tightening cycle, that is, rates moving higher, was from the summer of 2004 to the fall of 2007. Rates rose from 1% to over 5%.
Kevin: This was between 2004 and 2007?
David: That’s right. So, you have the Fed’s funds rate, 400 basis points moved higher, and now if we follow the assumptions that we were talking about earlier, raising rates, a rise in the dollar, a fall in gold – that’s what we should have seen. Did those relationships hold? Can we assume that rising rates will, in fact, crush the price of gold? And this is where there is a number of counter examples that would suggest that those relationships may function in nanoseconds for traders, but over a longer period of time are completely irrelevant.
Kevin: Well, yes, if you look back at 2004-2007, gold rose substantially. It rose hundreds of dollars.
David: Well, rates were rising significantly, too. So, four percentage points higher for interest rates, the dollar moved sideways to down – it did not improve in a rising interest rate environment. And again, gold rose – what was it – 75% in that same period of time from $400 to $700. So, when you are looking at these assumptions, it is oops, and oops, and oops! They appear to work if you are talking about the way that assets trade on a daily or weekly basis, but beyond the nanoseconds of relevance, you see that on a longer-term basis they are completely irrelevant.
Kevin: Well, let’s go back to 2007 then. You took us from 2004 to 2007, but from 2007 to present the dollar is up 20%. I mean, gold should be way, way down.
David: Yes, and gold, arguably, should be in the toilet if those relationships hold. Yet gold is 55% higher than 2007 levels.
Kevin: And this is with the dollar being up 20% at that same time.
David: That’s right. So, what you see is a daily trading correlation which does not hold over long periods of time. The same correlation failure was obvious in the 1970s, where after the dollar declined, and initial dollar decline in the early 1970s, and gold increased, which was suggesting a negative correlation, the dollar then stabilized and began to improve into the late 1970s while gold moved up eight-fold. So gold’s move in the 1970s was not predicated on a weaker dollar. Gold’s move lower in the 1980s was not predicated on a rise in rates, any more than the rise in rates from 2004-2007 was detrimental to gold, which as we noted, it was not. Rates only become relevant at a threshold level. So, it’s not the movement higher that spells trouble for gold, it is if they reach a certain threshold. That’s worth knowing.
Kevin: Dave, there was a thesis that Larry Summers wrote with Barsky, and you have brought it up a number of times, that talks about interest rates do hit a level at a certain point, or can, where the interest becomes more attractive than holding gold, which does not pay interest, of course.
David: That’s right. Significantly positive real rates of return offer an investor a substantive opportunity cost, so people will tend to sell gold if what is on offer is very, very attractive on the other side. When rates are at the zero bound, that opportunity does not exist. In a world with low, to no opportunity, gold is a great option, and this is what the Summers-Barsky thesis was all about. It is a great option in that low-to-negative rate environment. So, if you factor in inflation, take your rate of return, subtract out the inflation rate, that’s what Summers-Barsky concluded. You want to own gold in those low periods in terms of the interest rate cycle.
Kevin: That is certainly not the case right now. There are not positive interest rates being paid, virtually, on anything. We all know that interest is paying zero, we’re being told that inflation is pretty much zero, but other than gas prices, I can tell you that prices are still rising on most of the things that we buy at the store.
David: Yes, anyone that gets out and lives a little knows that deflation is not an issue threatening consumers today. Actually, that would be welcome in some respects. It is inflation of prices which adds pressure to the ongoing family budget battle. You are right, gas is cheaper at present, and that’s about it. So, no, the concern over positive rates of return, net of inflation, creating a compelling opportunity cost to gold owners – it’s a long way off. Rates would need to be in the 8-10% range for real damage to occur in the gold market. We are at zero. I wouldn’t panic out of gold.
Kevin: Who would think that economics would break your heart, but one of the things that breaks my heart is the fact that it has been the retirement-age person – we have talked about how retirement-age people right now are the ones who are having to go back and get jobs. Why is that? Well, it is because they have two sources of income. The major source of income, if you go back and look at the past generations that have retired, wasn’t social security. Social security helped, but it was the interest on the savings that they had. And of course, no one right now is earning any safe interest and so they are living on their social security, and they are just hoping that social security will adjust each year to keep up with the cost of living.
David: Right. In some respects, I don’t think we should play nice here, because as you know, the COLA adjustment for those living on a fixed income, will be for 2016, zero.
Kevin: They’re not going to raise it at all. There will be no cost of living increase.
David: And why? Well, because D.C., the folks in Washington, in their infinite wisdom, argue that inflation is zero, so the cost of living has to be static, flat, zero. If inflation is zero, you should be sitting on positive returns on cash instruments. And you look around and you say, “No, no, no, no, I’m not getting anything for my cash returns, I am paying more for virtually everything under the sun, and it is galling, it’s frustrating.” Listen, I’m not even receiving social security, but I can understand in some sort of a social contract language, you put in, you want to take out of the system, and you expect it to be there on a fair basis. And it’s really not. It’s an insignificantly small renege on the part of the government, but if you’re running out of money before you’re running out of month, then it’s not insignificant to you.
Kevin: I think we should try something, Dave. You know, mcalvany.com is where people can send their comments, and if there is anyone who is listening right now who is retired, who is finding that each month they are coming up with a little bit more money using the same standard of living, we would like those comments to come in. Please, send us comments. Maybe we’re missing something. Maybe we are in a deflation and retirement is becoming easier and easier without cost of living increases on social security.
David: My tendency is to think that, just as John Kerry suggested that the price of an iPad is going down and the general response from the crowd was, “Hey, moron. We don’t eat iPads.” There is a case to be made for a number of things going down in price. They just don’t have to do with the essentials of shelter and food and clothing. So maybe D.C. has an agenda, and they’re working it. And I think that’s really what we see here in play behind the scenes. You promise the sun, moon, and stars to garner votes, and you create these obligations, but they are long-term obligations. Make payment on those obligations in the future and then over time you can eliminate a good part of the burden of those obligations by inflating them away. So, you advertise a zero percent rate of inflation, run a realistic, real-world inflation rate of 3-5 percentage points higher, and of course, you are taking advantage of foreign creditors, you are taking advantage of the elderly, retirees, fixed income recipients.
But this is, I think, the game plan. The political elite – they promise pork barrel spending up front. They promise you the sun, moon, and stars in terms of social benefits. You don’t have to deliver them today, you deliver them over the next 30 years. You get the votes in up front, and then inflate away those obligations over time. There is an ingrained, I think, lack of integrity in that, and it is enough to be irritating. Again, I’m not receiving social security, but if I was in those shoes I would be significantly irritated.
Kevin: Dave, Jonathan Swift wrote a piece called A Modest Proposal. They were basically extracting the English, they were extracting the youth and throwing them into coal mines. A lot of them were dying of tuberculosis and other issues. And he basically wrote A Modest Proposal saying, “Why would we put kids to work so that we can eat? Why don’t we just eat kids?” It reminds me of a dark movie that came out years ago with Charlton Heston – Soilent Green.
David: (laughs) Sure, sure.
Kevin: And what it really was about was eating the retirement class age people. Basically, the story goes that a person lives to a certain age and then they just quietly depart to a room where they are carefully taken gently into death, and then of course, and this was the dark part of the movie, they were turned into food for the rest of the people. I’m thinking about that for the retired people right now. Their social security – they’re not getting cost of living increases. They’re not getting any interest because we are at a zero interest rate policy. Dave, we’re eating the old people.
David: Right. Hasn’t D.C. settled on that as being responsible ecology? (laughs) It’s very interesting. We’ve talked about the idea of financial repression, and it is basically stealing from one group of people to pay to another, create a subsidy for one on the backs of the labor and savings of another. And that’s what we have today in a zero interest rate environment. You say, “Well, after nine years we are about to be done with that.” I don’t think so. I don’t think so.
We have an environment where the banks have been catered to by the central bank, and they’ve been catered to for one particular reason. The way a bank works, and I think everyone knows this, your assets are the loans that you put into the market. And so you have debt which goes into the system and the bank counts that as their assets. The reality is, using fractional reserve banking, they have a fraction of actual capital backing those assets. Any fluctuation up or down in the value of those assets is significant because of the small amount of capital they actually have. A 10%, 12% decline in the value of those loans, what they consider assets, categorically wipes out the banking system.
Kevin: So, we’re fueling the value of those assets with printed money and zero interest money.
David: Yellen inherited a tradition from Ben Bernanke of fighting deflation. The fight against deflation is a fight to preserve the banking community, and fortify the banking community.
Kevin: On the backs of the people who would be earning interest otherwise.
David: That’s exactly right. The baby boomers should be up in arms about this. The fact that the AARP has said nothing and done nothing on this issue – I don’t know what to say.
Kevin: Well, you can get a discount, though, at hotels. That’s what the AARP is there for, I think.
David: AARP – it should be C-R-A-P. That’s what I think it should be called, because they do nothing, not in the real interests of retirees. This is outright theft. 5% on a million bucks, which most people have counted on, if you have been able to save 100,000, 200,000, a million dollars, through your working years, and supplement your retirement income, you’ve counted on that income.
Kevin: That $50,000 a year, or so, right.
David: And now that $50,000, rather than dropping to your bottom line, is going to subsidize the rebuilding of the banking system. And again – why? Because the central bank understands their mandate quite well.
Kevin: And bank bonuses are at all-time highs right now, Dave. They’re doing just fine, thank you very much.
David: Those central bankers know full well whose bread needs to be buttered, and it is the community of banks which they must defend, because they realize that they can see the entire system implode because of the amount of leverage that is in the banking system, because of how much debt is in the system, because that is what a bank does is put their “assets” out to market and hope that they stay at full value.
Kevin: Then I’m going to ask you a question, Dave, because if the zero interest policy is so successful, why would the Federal Reserve be motivated to raise rates at all?
David: I don’t think they are interested in raising rates. I think they’re interested in talking about raising rates. I think that they are not likely to raise them significantly, if at all, and they need to indicate to the world that their theories are intact, that their textbook approach has worked perfectly – look at the 5% unemployment number – still a little frustrated that inflation is not higher because to them that is an indication of activity in the economy. But again, this goes back to the Phillips curve. There is a disconnect. They are not seeing an increase in inflation commensurate with an improvement in the jobs numbers. And again, you say, “Well, they are assuming that the Phillips curve holds.” That’s the problem. That’s the problem, it’s irrelevant. And yes, we do have a “deflationary” environment, as it relates to bank assets.
Kevin: As it relates to the way they measure.
David: There are too many loans out there, so in that sense, in the financial system there is a deflationary pressure in the system, there is a deflationary bias in the way they count for consumer price inflation. But the real world stacks up inflation differently. The rise of goods and services, the cost of those goods and services, has been inexorably higher.
Kevin: And for them to really prove that their model has worked they are going to have to somehow, some way, prove that we are in a recovery. And I guess that’s where this jobs number comes in. But you look at Chinese exports, Dave, and you look at the things that we are buying right now – those are recessionary numbers.
David: October was worse than September for the Chinese. Overseas shipments dropped 3.6%. Imports into China fell for the 12th month in a row, down 16%. Exports overall were also negative for the fourth month in a row, with the one bright spot being an improvement in exports to the United States, improved by 5.8%. The rest of the world trade continues to deteriorate. European consumption – the exports from China to Europe – they remain weak. U.S. imports of Chinese goods – again, I mention that is improved mildly, but looking at this period from July to October, it should be considerably higher in a period which represents preparation for the year-end Christmas retail bonanza. But low imports from Asia actually suggest that retailers are being cautious.
Kevin: So, if you really were looking at the real numbers, and I have to think that the Fed, at some point, is looking at real numbers, they know that in a recessionary environment you cannot raise interest rates and get a good outcome.
David: I agree. There is not enough evidence of economic activity to warrant a rise in rates. Regardless of what they say, I think we are likely to see a continuation of the kinds of actions we have seen for the last five years, perhaps with the exception of a token 25 basis point move.
Kevin: So they’ll throw the dog the bone, basically, a quarter of a percent, a half of a percent, but they can’t do much more than that.
David: Which is already priced in. In the last two weeks you have seen the ten-year treasury go from 2.05 to 2.35. That’s a major move. It says it’s already done. So, by the time they get to raising rates by 25 basis points, that’s a non-event.
Kevin: Because the market has already responded.
David: The market has already responded. Now, I don’t think the market has responded in the equities market if, in fact, we have, not one increase, but several increases to come, in that classic two steps and then a stumble, where you raise interest rates three times and then you send the stock market on its keister. Why? Because when you are analyzing equities, something called the discounted cash flow model. The discounted cash flow model has a number which you impute – it is the interest rate number. And you use that in determining the value of a particular company. Is it fairly valued? Is it over-valued? Is it under-valued? What is the fair market value of that company? The discounted cash flow model uses an interest rate component, and right now it is at zero, basically. You start raising rates, and using a DCF model – guess what happens?
Kevin: Equities come down.
David: They have to. They have to. I flew through Houston this weekend, and speaking of the coming Christmas retail bonanza, last week we mentioned discounting as something to keep an eye on as you do some of your own shopping. And I flew through Houston, did a little Christmas shopping myself at one of Houston’s largest malls, and it was an interesting experience. Half the stores were offering 20-40% storewide sales. In select stores you could find the seasonal blowout sales on last year’s products, so on those select products 65-75% off. But that is what you would expect in a sales section. I was particularly interested to see the storewide sales, 10%, 20%, 30%, 40% off, and that early discounting prior to the Black Friday holiday traffic…
Kevin: That’s what you brought up last week. That’s what Burgess was talking about.
David: That’s right. It suggests that traffic and sales are already a disappointment, and that their expectations are being set for not being stuck with too much inventory come January. So, I looked at the U.S. retailers index, basically a cross-section of all retailers, and it stalled out probably last February, and at this point it appears ready to break to lower levels.
Kevin: Well, still thinking of the duck decoys, Dave, things really are not what they seem. For our own survival, we can’t buy into the decoy, we have to make our own decisions. We have to look at the figures, look at what is going on and say, “Do I really buy what’s coming out of Wall Street and Washington, D.C. right now? Especially being an election year. Do I really buy what’s coming out of the Federal Reserve?” And if a person is skeptical at all they are going to have to make different decisions than the overall market and financial TV is telling them.
David: Right. I think there is a reality gap and that is what we discussed earlier in terms of the decoys. You are trying to create the perception that this is an inviting and perfect environment, everything is normal, and you should be landing and going about your business. That perception management – the gap that is there in the official numbers – is a very significant one. David Walker pointed this out – again – this last week.
Kevin: David Walker has been a guest. He was head of the Government Accountability Office for years, and he stepped away because he did not see the kind of reaction that needed to be taken for the numbers that were coming in as far as our debt.
David: And he is just trying to apply a realist view to our debt numbers. In the accounting world, GAAP stands for Generally Accepted Accounting Principles. And according to David Walker, if you apply those same rules, regulations, and requirements that corporations have to abide by in accounting for their liabilities, that actually, our debt today is not 18½ trillion, but right around 65 trillion. So, the GAAP 65, according to David Walker, is in line with what we’ve mentioned – Boston University’s Larry Kotlikoff, of course, has even larger numbers. He expands not only the list of liabilities, but he also captures a longer timeframe for accrual, and comes up with a number of about 210 trillion. His number was 60 twelve years ago and it has compounded rapidly.
The point is, 18½ trillion is a number that is mind-boggling in and of itself, and of course, we’ll be at 20 trillion by the end of next year. But Walker’s point is, “You can almost fall into a sense of complacency, because the number is actually three times worse than that, we just happen to give government a free pass in terms of how they do their accounting.”
Kevin: So, when you’re talking about GAAP versus non-GAAP, what are you talking about?
David: Again, in accounting terms, it is the difference between cash versus accrual accounting which shows the clearest differences. Timing is the critical difference. The timeframe in which you acknowledge revenues and expenses is radically different between these two methods. Most simply put, cash accrual is like a real-time accounting system, and accrual accounting, as the name suggests, is drawing the future income expenses into the present. You’re accruing them and recognizing them today even though they are a future liability. So, small corporations can work on a cash accounting basis. Large corporations must move to accrual accounting. And of course, all publicly traded firms operate on accrual accounting basis, as well, which is consistent with the GAAP, Generally Accepted Accounting Principles. Our government, as large as they are, get to ignore accrual accounting, and they operate like a business that has less than a million dollars in revenue…
Kevin: So, they operate like a lemonade stand, that doesn’t really have to figure out what they are going to come up with in a year, or two, or five.
David: That’s exactly right. So, what are the starkest contrasts between the private and public sectors? The private sector recognizes their long-term liabilities. Things like pensions and health care are a part of each year’s cost of doing business, requiring funding in the present for those future liabilities so that employees working with you today are taken care of tomorrow and you are setting aside those funds now, in escrow, for them tomorrow. So, the pension fund puts aside money that you pay when they retire. The liability is accrued and the issue is addressed now, even though those funds won’t be tapped for years to come. Our federal government ignores these liabilities. And this is, again, what David Walker is getting to. If they operated like a corporation, it would not be 18½, on its way to 20, it would be 65, on its way to 70.
Kevin: And let’s just look at Social Security. Everyone has their estimate as to when Social Security will be broke, but pretty much everyone agrees it will be at some point.
David: The money is running out, and instead of being a reserve fund for the future, it has become a slush fund, really, for the immediate gratification of spendthrift politicians. There is no anticipation. I mean, a company of our size could never ignore payables and receivables, pretending like the only moment that exists is the now. What are this year’s revenues? Counting them just as they trickle in and not anticipating expenses and revenues and paying attention to payables and receivables would be suicide.
What is this year’s expenses in keeping with the budget? This is something that the government should do, and they should even look beyond that to say, “What are our expenses that we are accruing now that we will have to pay in the future? How much of a deficit is there? What does it add to the present debt levels? Federal bureaucracy is given a free pass on this issue, and there is no accountability for the promises they make today which are paid out tomorrow. And it has to do with how they account for their liabilities. Again, their feet are not held to the fire and they look better than they actually are – perception management again. The reality is, the federal government is defrauding the public.
Kevin: And it seems to be a flaw in the system that they can make those economic decisions at all, because frankly, the moment that they win an election they actually start thinking about the next re-election, so they are continually trying to figure out how to get votes, not how to solve the problem.
David: Right. And I suppose today matters if you are Oprah Winfrey, if you are Ekhart Tolle, if you are a Buddhist monk. But if you can’t peer into the future and do a little strategic planning, you’re up the creek without a paddle. The U.S. government is, in fact, in trouble, as are the taxpayers that have allowed this debt to grow in the shadows. So again, when you are talking about the perfect environment, 18½, apparently Boehner and McConnell thought that moving to 20 would be no big deal, that sense of normalcy. Just let the ducks land.
Kevin: Just let the ducks land.
David: Everything is fine.
Kevin: What you would say is probably, “Don’t land here right now.”
David: I would rather be the model duck that keeps his distance, is cautious at this point, and says, “You know, I don’t have every reason to land, therefore I’m not going to.” The cautious duck wants every reason to land, not just any reason. And I guess what we have with a variety of government statistics today is many, but not sufficient reasons for me, to be putting myself down in the water.