In Transcripts

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

We have economic activity this week. We have financial firms that are closest to the central bank community in Japan and Germany which are being hurt, not helped, by their policies. It’s the backlash and the collapse of confidence that marks the tone and tenor of a real bear market low. And by the way, we never saw the behavioral backlash and the collapse in confidence in that 2008-2009 period, but I think we’re likely to see it soon.

– David McAlvany

Kevin: David, I was thinking about this because someone had made a comment about how debt really doesn’t matter, and I want to talk about that in a minute, but do you remember the first time you borrowed? The first time you ever went into debt to have something? It’s a really different feeling than when you’ve borrowed and borrowed and borrowed and you can’t pay it back. But in the beginning it’s really almost magical.

I remember when my wife and I got married. That was the first time we borrowed. I was 20 years old and we pulled the credit card out and bought something that we couldn’t afford, and we went home with it, and it felt great. And really, it was the argument, “Hey, it’s only going to cost us this much more a month.” You know, the old encyclopedia salesman, “Could you give up a Pepsi a day for a month to own this particular book?” But over time it adds up.

David: I do remember that experience, and it was not a positive one for me because borrowing from my dad – oh wow – not that he had usurious rates like a credit card, but he did expect to be paid back. I think it might have been for a skateboard. He was will to pay a part of it, but I had to pay a part of it back.

Kevin: Did you sort of consider it a gift until you found out that you had to pay the money back?

David: Well, it felt really good to have it, but I really did not like paying it back. It made the whole experience sort of sour for me. So, actually, I’m grateful for experiences like that. My first experience gambling was the same.

Kevin: (laughs)

David: At age 12, the fastest 20 dollars ever spent in my life, literally, Blackjack table, two seconds, gone. And I’m thinking to myself, “Why? Why do people do this?”

Kevin: To continue the story, we borrowed again, and we borrowed again. This is right after getting back from our honeymoon. We had credit cards. I had never had a credit card before; my wife had. Where it ended – actually I hate to say it – several times in our young married life, it ended with us sitting at the table crying, cutting credit cards up, realizing that we could never do it again.

What made me think of that was, we just came out of a meeting where one of the associates that we have here was talking to someone and they said, “What really is 20 trillion dollars in debt? What difference does it make? It’s numbers on the computer. Have we really ever felt the effect of the debt?”

David: I think this is where we do feel, for the first time in a long, long time, the effects of debt.

Kevin: Yes.

David: Because you have Stanley Fisher who is the Vice CEO at the Federal Reserve, who is saying, “Look, we’ve got low economic growth.” It’s what he calls structural low growth theory, and he has his explanation of why we’re seeing these structural issues in the economy, why the monetary policy that has been put in play has had less effect than expected and anticipated.

Kevin: Let’s talk about the effect. In the beginning when the United States was a creditor nation, when they borrowed there actually was GDP growth. You could measure actual growth beyond what was being borrowed, couldn’t you?

David: That’s right. I was looking at an interesting chart last week, looking at sort of our all-in debt figures. This would be private, corporate, governmental. If you look at the total debt in the country, well over 60 trillion dollars – 60 trillion…

Kevin: With a T.

David: Yes. It’s better than 350% compared to our total economy. What is interesting is, looking at this chart, the disconnect began. The gap began to widen starting at about 1971. 1971, of course, is when we lost our ties to gold that anchor to our monetary system, and with the closing of the gold window all of a sudden the gap begins to increase. The total debt that is allowed into the system really doesn’t have a governor anymore, and so debt continues to increase, even while the economy is increasing.

In that timeframe, it’s interesting, because there was this sort of golden era, and I think this is really where the Keynesians hang their hats. At one time a dollar in new debt drove five dollars of GDP growth.

Kevin: Almost made sense at that time.

David: Why wouldn’t you add to debt when you can expand the economy 5-to-1? That’s actually a pretty reasonable thing to do for a certain period of time. This was a recent study that showed these numbers, that at present, a dollar in new debt actually reduces GDP by nearly the same amount. The issue is this: When you have an economy which is creating growth, creating income, creating revenue, that revenue can then go to paying off the debt and servicing the debt that exists. But at a certain point there is not enough growth to supplement or service the interest and principle payments on the debt because the debt bubble has just gotten too big.

Kevin: So let’s say you’re giving up the Pepsi. Let’s go back to that – giving up a Pepsi. I can give up a Pepsi a day for a set of encyclopedias. I can’t give up 400 Pepsis a day because I don’t drink 400 Pepsis a day and I can’t afford them anyway. That’s sort of what happens. You get to that point where you sit down with your wife, crying, cutting the credit cards up.

David: (laughs)

Kevin: But this country hasn’t faced that at this point. We’ve only experienced what you’re talking about, which is a drop in the growth numbers to where we’re actually shrinking at this point based on debt.

David: That’s right. You have Larry Summers with his secular stagnation thesis. You have Fisher with his structural low growth theory. And they’re trying to wrap their minds around something that is actually pretty simple. It’s like they didn’t get the memo, or the memo that was sent out, Keynesians didn’t read it. And it is this, that persistent intervention in the marketplace and the rampant debt accumulated through the decades has caught up with us. And that is the reason why the economy is not growing. It can’t under this kind of burden. When you look at total debt-to-GDP it says it all. Secular stagnation is tied to a structural debt problem that is not being allowed to clear.

What do I mean by not being allowed to clear? Now you have the central bank, which is afraid of the solvency of its member banks, because guess what banks do? Banks loan out money. Loaning out money is what? Creating debt. But to the bank, that debt, that loan into the system, is treated like an asset. For the system to clear, you have to get rid of a certain amount of debt, which means that you are destroying a certain amount of assets, which also means that you are impairing the balance sheets of those financial institutions. So you have the central bank which is backing the play of your commercial banks and saying, “We cannot allow there to be any correction in the value of the bank assets,” which are loans, which is debt.

Kevin: When you say correction, you’re talking about going down.

David: (laughs) That’s right. So you have an ebb and flow in the business cycle where at times there is an expansion in debt, and then there is a contraction, and then an expansion, and then a contraction. And that’s the way a normal system works.

Kevin: But you can’t allow contraction these days.

David: Well, it’s abnormal, because the stakes are so high, and to see some pocket of debt be cleared, in other words, be wiped out, and to eliminate that burden on the economy – they won’t do it, they won’t allow for it to happen because they’re afraid of the unintended consequences into the derivatives market, they’re afraid of who in the banking sector may go out of business, and how that changes many things.

Kevin: This is definitely not just a United States issue. What we saw with the global financial crisis is the United States went through the quantitative easing programs 1, 2 and 3, they lowered the interest rates, but actually, it’s a global issue. We’re seeing this growth slowing elsewhere – China, Europe, all over.

David: Right. When you’re talking about global growth, global GDP has been suffering, and we saw this last week with the horrid trade data from China – exports down 10% year on year, imports down 1.9% year on year. And in that part of the world this is the stuff of revolutions.

Kevin: Sure.

David: No surprise then, that in anticipation of a significant economic slowdown in China you have a re-invigoration of Maoism. And this is just when Chinese capitalism was emerging to save the day and show us a bright and brand new form of capitalism. Maybe they, with their command and control dynamics, could teach us something about capitalism. And lo and behold, we’ve got Mao re-emerging. We’ve got him re-emerging to save the day, and it’s Xi Jinping (laughs) almost wearing the mask of Mao, flexing his muscle and consolidating power.

Kevin: What we have is a revisitation of what Carmen Reinhart talked about, being a need to create a captive audience. Now, in China, the way they create a captive audience is a return of communism. But look at what is going on here in America. We have growing wealth inequality, and what we’re seeing – we may not have a return of Maoism, but we certainly are having a return of either socialism or statism, right on the election podium.

David: Maybe you could classically say that the choices between the red shirts and the blue shirts are socialist party A and socialist party B. In this election it’s actually statist party A and socialist party B.

Kevin: Right. We’re not given a free market or a constitutional freedom choice, we’re given a statist choice in Trump, or a socialist choice in Hillary.

David: What is interesting is, there is a lot of banter about wealth and equality, and there is a lot of blame being laid at the feet of globalization. The challenge here is, really, to properly understand the cause, and on that basis, a proper remedy, and I think a remedy has to be sought because politics can, and is, moving to extremes, so it needs to be addressed sooner than later.

It’s a topic we’re going to explore as we move toward the end of the year and as we get past the election in November I want to explore again this notion of globalism versus globalization, and get some clear definitions, because again, the issue of wealth and equality is being blamed on globalization, but I think, actually, closer top the truth is the unmooring of our monetary system and what has developed as a consequence of that from 1971 to the present. But we’ll get into that in future programs.

Kevin: Well, let’s just look, actually, at corporations here in America. You were talking about revenue, nationally or worldwide, not being able to keep up with debt. Let’s look at the stock market and look at how stocks are valued in relation to the revenues of companies, because revenues may not be growing when the equity prices are.

David: We’ve talked about lots of metrics on the program. We’ve talked about price earnings multiples as one valuation metric, we’ve talked about price to book. We’ve talked about the ten-year rolling average of the price earnings ratio. We’ve talked about Tobin’s Q and the replacement value of stocks, looking at buying them either at a discount or at a premium. Those are all different metrics of valuing equities. John Hussman, who I’ve quoted before, drew an interesting chart recently showing the average price of the S&P 500 going back to 1986, and he’s dividing it by revenue. So you have a picture, again, of valuations for companies, another valuation metric using revenue generation and market price for the index.

Kevin: And just to make it simple, revenue generation is, what is your income? For the guy who comes home every week or every two weeks with his paycheck, that’s his revenue.

David: That’s right. So you look at things back in 1999 and things were very expensive, in fact, the most expensive they had ever been on this metric. And then by the time we got to 2008, again, looking at the price of the S&P 500 relative to the revenues generated by those large companies, you now had valuations in the S&P 500 at levels never seen before.

Kevin: Right before the two great crashes of the last 20-25 years.

David: Right. Now, it’s interesting, because we’re at even more extreme levels today, looking at this particular ratio, than at any other time in stock market history. So again, looking at corporate revenues, we’ve had stock prices which have remained elevated over the last year or year-and-a-half. At the same time, corporate revenues have been falling, and so the ratio is at all-time highs because of this. Again, we’ve stayed above 18,000 on the Dow, very healthy numbers on the S&P equally, and even though prices have remained high, revenues have been in decline, the ratio spikes on that basis.

Kevin: Right.

David: So for most people, they look at price only. What we have said over and over again is that you have had five, coming up on six, quarters of a decline in revenues which is very, very, very significant. Revenues are a very important factor, and quite interestingly, they are not subject to the same chicanery that earnings are. When you look at how people report their earnings, are they using GAAP versus non-GAAP – that’s Generally Accepted Accounting Principles – or are they just kind of making is up and taking advantage of various write-offs and things that allow them to pretty up the pig, so to say. I like revenues because they do tell a pretty clean story.

Kevin: It is interesting the way you explained why debt affects us. For the gentleman who said, “What’s 20 trillion in debt?” What you pointed out was, debt now creates a shrinking of GDP. That would be considered revenue, as well.

David: That’s right, because what we’re talking about is the requirement of that additional debt to take future income and revenue to service it. So at one point, it did create more growth. Now, it’s actually requiring more in terms of revenue sucking, if you will, out of the economy. So it has a negative effect. Flabbergasting to me that academics don’t see this.

Kevin: But look at the stock prices, just exactly what you’re saying. The Federal Reserve is keeping asset prices high, we know by whatever means that they do it, whether it is the plunge protection team or whether it is some other mechanism.

David: While corporate reality is showing up in revenues.

Kevin: Revenues are dropping, just like that are on, like we said, the comparison to debt side.

David: Yes, IBM had their 18th consecutive quarter of declining revenues.

Kevin: That’s IBM. But as a whole, isn’t it five straight quarters of declining revenues?

David: That’s right. And I think as we move toward this next quarter it will be six.

Kevin: So this brings up a question, Dave. Is there any normalization or exit for the Fed?

David: No.

Kevin: The Fed is going to have to keep these asset prices high.

David: No.

Kevin: Because everything else is shrinking.

David: That’s right. No exit for the Fed. As much as everyone has hoped for normalization you have aggregate central bank accommodation globally. It has remained high and it is vital. At least, it’s vital to the financial markets. It’s become obvious that it’s not vital to the economy, but it is vital to the financial markets. September came and went, you had Dudley in Boston, and Stanley Fisher, who is a key player and an essential vote. They were unable to move the ball down the field.

They said in September that there was a possibility for a rate hike. It becomes more and more difficult to raise rates when corporate and Wall Street buddies call and complain about five quarters of sequential earnings in decline and with a sixth expected, which will match the longest earnings recession on record. Keep that in mind – the longest earnings recession on record. We have one more quarter of a decline in earnings and we’ll have the longest earnings recession on record.

Kevin: And add to that Hussman’s chart, which is, we also have the highest asset valuation. The stock prices are higher than any time in history based on those same revenues that have been declining.

David: Right. So earnings revenues in decline, prices still high. You remember that in January stocks were tanking, and the economic news was grim. The conversation was that the second half of the year would pull up GDP performance.

Kevin: Oh yes, it was the glass half full. “Hey guys, it will be the second half of the year that will do it.”

David: That’s right. And so corporations would see strong growth in the second half and that hasn’t happened. The fly in the ointment in January was the energy sector. So a part of the argument was to allow some stabilization to occur in the energy sector and earnings and revenues will recover, but that was supposed to be cleared out by the second half, with energy companies coping a little bit better. Of course, we have the new reality of stabilized oil and gas revenues, stabilized at lower levels, and it’s not in freefall, actually at much higher levels than we had in January, and yet we’re still struggling.

We don’t see GDP soaring. We are actually seeing many of the fourth quarter estimates coming down, the New York Fed among them. The New York Fed took their third quarter estimates and lowered them to 2.2%, and they took their fourth quarter estimates and lowered them to 1.2%, the annualized number. So the year-end won’t be as strong as expected if those forecasts, in fact, from the New York Fed prove accurate.

Where are we, in fact? We are back to the beginning of the year, which was 1.4 to 0.8, if you’re talking about the GDP growth numbers. That’s where we were in the first half of the year, and why we were so worried, why the Fed was immediately in January and February recanting its “We’re going to raise rates four times.”

Kevin: I think we should go back and think about that for a second.

David: That was the December 2015 prognostication, four rate hikes in 2016 because the economy is humming.

Kevin: Because we’re going to have growth. Okay, so it doesn’t help that industrial production for August is sliding, as well, right? So industry, at this point, is contracting, along with revenues.

David: Well, right. So do we sneak in an interest rate hike toward the end of the year? I think, clearly – we’ve talked about this in the Commentary before – we’re too close to the election to see anything right now. What happens in November? Is it a punitive message to Trump? Is it a supportive message to Clinton? The challenge with raising rates is you have industrial production for August, which did slide, you have had capacity utilization right around 75%. In other words, the industrial sector – think about this – the industrial sector is not firing on all cylinders as you would expect in a broad-based economic recovery.

Kevin: But let’s look at what the Fed is looking at. The Fed also said they’re looking at jobs numbers, which, even though they use errant kinds of measures, they are improving.

David: Well, it depends on what you’re looking at. This is where you see the Fed sort of living a double life, because on the one hand they are very positive about the job numbers, but the danger of a double life becomes obvious. If you’re prognosticating on Fed policy, and you’re thinking, “Oh, well, look, they’re going to raise rates because jobs have improved. You have U6 down to 9.7%, U3 is hanging in right at around 5%. This is okay. We’re near full employment.” And yet! And yet, remember the Fed set up its own metrics for jobs, the Labor Market Conditions Index, and it continues to disappoint.

So what is this exactly? The Fed is looking at one reality, making decisions on the basis of that reality, and then talking about a totally separate and false reality, and assuming that the general public is perfectly happy, listening to the words spoken, “It corresponds to U3, U6, all is well, let’s move forward.” “Why aren’t you moving forward,” the general public asks?

Kevin: Right. “Pay no attention to the positive numbers,” which is really what they’re saying. It used to be, “Pay no attention to the negative numbers,” but now, any positive number causes the stock market to go down because people anticipate the potential for a Fed rate hike.

David: We live in an age of data dependence, we’ve just redefined what it means to be “data dependent.” Just watch the Fed as they dance all around the data and do nothing.

Kevin: So, if the Federal Reserve is beginning to lose its effectiveness, and I say that without laughing, purposely, because they have lost their effectiveness, there is the other side of the equation, Dave. Anyone who has taken Economics 101 and has been taught Keynesian Economics, there are two factors in Keynesian economics. You have monetary theory, which is the Federal Reserve, but you also have government fiscal spending. We’ve talked about this before. Both parties, whether it is Hillary or Trump, are saying, “Look, we’re going to spend more money. That’s going to get us out of the problem.”

David: Oh yeah. So this is a dead issue, adding to our nearly 20 trillion dollars in debt. That is an issue. Broadly speaking, the trend has been deterioration in fundamentals, even as the financial market pricing has remained very positive, so deterioration on one side, acceleration or stabilized levels at a very high level on the other.

Kevin: But if they’re spending more money, doesn’t that create a larger fiscal deficit? We’ve already seen an increase in the fiscal deficit just the last few months.

David: Yes, we have, and I think that’s a part of both the dangerous environment that we live in, but also the multiple opportunities that are opening up. Yes, we have a fiscal deficit, according to the Congressional Budget Office, that is higher, by 152 billion, than expected, compared to last year. So that puts us at about 590 billion for this year. Remember, year-end for the U.S. government is September, so we’ve booked the year, 590 billion is done. And recall that the number does not include the financing needs for 2016 which are in that category of the national debt. What did we add to the national debt this year? Oh, just 1.4 trillion for the year.

Kevin: We’re going to hit 20 soon, aren’t we?

David: That’s right. It looks like Obama may just miss the 20 trillion dollar mark as he exits stage left.

Kevin: Missed it by that much.

David: Well, and we’re at 19.6. Who knows, we still have a few days left, and this is political season, so the opportunity to spend a couple of hundred billion dollars, that would be fun, as you’re getting ready to leave the Oval Office. Would you enjoy that?

Kevin: I told you about my first debt (laughs).

David: (laughs). Well, curiously, both presidential candidates look at the increase in spending as a major objective. That’s a major objective in the years ahead. And what happens to debt levels? What happens to annual deficits between 2017 and 2020?

Kevin: I think they’re going to shrink, Dave.

David: Well, clearly. We’re going to cut defense, we’re going to cut infrastructure spending, we’re definitely going to cut entitlements.

Kevin: You’re speaking tongue in cheek, of course.

David: (laughs) I’ve joined you. So yes, whether it is defense and infrastructure or your run of the mill entitlement spending, you have your traditional parties, statist part A, socialist party B, which, the bottom line is, they like to party on someone else’s dime, and I think what we’re leaving for our children’s children’s children is encumbrance and burden, and that bothers me.

Kevin: Well, you know, the new book that you’re coming out with deals with legacy, the prioritizing the future generations instead of ignoring or indebting the future generations.

David: You can actually pre-order it if you’re interested, if you go to

Kevin: Well, good.

David: If you want to pre-order the book it will be here the second week of November, hardback. It’s like a 24-month gestation period and the baby is born (laughs). But actually, there are some themes in there that do resonate with this particular issue.

Kevin: I read the pre-reader copy, and Dave, I work for you, and a person may say, “Oh, he’s just saying that.” But I can tell you, my wife asked me after I finished it, “All right, Kevin, if you didn’t know Dave, and you didn’t know the family history, and you hadn’t worked with Dave and his family for 30 years, would it be a book you would have been interested in?” I thought about it, because you’ve got a lot of personal stories in there that I, myself, can say, “Yes, I saw those actually happen,” and you apply them to the philosophies and the things you’re teaching in the book. I told her at the breakfast table this morning, “I really thought about your question and I’m being honest. Yes, this is a book that I would have had on my shelf.”

If legacy for my kids was an area of interest, which it should have been, that would have been something if I hadn’t have known you, would have been an interesting concept, I would have read the book. There were so many things, and I would like to talk about it as we go on through the commentaries, just a piece here, or a piece there, some of the things that people can learn about how to create legacy thinking, where you are actually thinking positively forward, instead of negatively forward, about your family.

David: I think one of the key elements of the book is that legacy is not something that you are going to leave, but it’s something that you are creating every day.

Kevin: It’s an activity.

David: It is.

Kevin: It’s a verb.

David: And it’s something that you’re doing actively right now. It just depends on what kind of legacy you want to leave, and you are either giving some thought, you are either being intentional about it – that’s the title of the book – or you’re not. And it’s what makes the current policies so irksome to me because you look and you say, “How, within the D.C. beltway, can they rationalize leaving financial burdens instead of blessings?” I think, actually, the bond market is beginning to smell a brewing crisis. You have long rates which are on the move up, and right now we should spend some time considering what is the message embedded in the action of the bond market because it’s telling you that there is, today, a minor revolt that could turn into a full-blown revolution, as in return of the bond vigilantes, assuming that the Fed doesn’t redouble its efforts and introduce QE-4 shortly.

Kevin: Dave, I was thinking about something. You said something in a meeting recently which is absolutely true. We love what we do here. I love what I’ve done the last three decades here because I can take paper assets that are devaluing and I can turn them into gold and send somebody gold. But you made a great point. If we were on a gold standard, and if we were on fair and right trading methods, we really wouldn’t have a job. There wouldn’t be a need for me. But let me translate that to the central bankers for a moment. The central bankers – Janet Yellen, Ben Bernanke, going back to Alan Greenspan – would be out of a job if they didn’t need to stabilize things based on this debt.

David: That’s interesting. We do exist because of the extreme dysfunction in the economy and in the financial markets today.

Kevin: Exactly. If cancer didn’t exist you wouldn’t need a doctor to cure cancer.

David: Right. And gold represents something of a financial insurance policy, which in a world of safety where you have sound money, actually, there is a self-correcting mechanism within the economy which you don’t have today. And you see that, going back to that debt-to-GDP figure, and the numbers dating to 1971, the gap between those two lines where debt continues to rise exponentially. And yes, the size of our economy is moving up, but the gap between those two lines grows and grows and grows and grows and grows.

Kevin: But here is the illusion, Dave. Okay, it has grown, we haven’t really felt it. It’s boiling the frog slowly. We haven’t truly felt it. The Federal Reserve, if you think about it, what gold used to do for people, and still does, for people who understand, which is to allow for stability, the Federal Reserve has become the stabilizer.

David: So here’s what they have stabilized. They are supposed to be in the business of price stabilization. They’re actually in the business of perception stabilization. So the danger in the marketplace is one of disillusionment and disorientation. I say that because when individuals feel that they have been led down the primrose path, and then they confront a much harsher reality than expected, you can reasonably anticipate behavioral backlash.

Kevin: That has not happened yet, Dave.

David: No. The central bankers have positioned globally – actually, they’ve advertised this – that their actions are the source and cause of the recovery, not a source and cause of the problem which has been building structurally over 30 or 40 years.

Kevin: “We’re the central bankers. We’re here to help.”

David: Yet, we have economic activity that is weak. We have financial firms that are closest to the central bank community in Japan and Germany which are being hurt, not helped, by their policies. Again, I’m thinking specifically of those affected by zero and negative rates. It’s the backlash – the backlash and the collapse of confidence that marks the tone and tenor of a real bear market low. And by the way, we never saw that. We never saw the behavioral backlash and the collapse in confidence in that 2008-2009 period. But I think we’re likely to see it soon.

Kevin: There’s another illusion, Dave, that there is a lot of money sitting on the sidelines, we’ve even talked about it, that is waiting to go into the market. Jim Deeds pointed something out last week. I love it when we talk to Jim Deeds because he remembers the good old days where you could measure risk, you could measure opportunity, and you could take your pick. But there is a lot of money flowing – you’ve brought this out before, too – into either passive investments where you just put your money in and forget about it. That could be a money market, or it could be an index. But really, let’s talk about those indexes for a moment, because an index isn’t really a true investment. An index, actually, is a betting line on a true investment, is it not?

David: Indexes and index funds serve a valuable purpose for giving people exposure to a particular asset class, but it’s an interesting mechanism that takes place when you’re buying an index, particularly because the indexes, the vast majority of them, whether it’s the NASDAQ, NASDAQ 100, S&P 500, if you look at the New York Stock Exchange in aggregate, the Russell 2000. These indexes and more are capitalization-weighted, and so, basically, you have the largest companies which have the greatest representation in the index, which means that when someone buys the index there is even larger purchasing of the largest companies in that index.

Kevin: The ratios don’t change. In other words, they are getting a chunk of a certain amount of companies, but the companies with the highest capitalization are going to be the ones that represent the largest part of that index. Is that what you’re saying?

David: Right. And it just compounds on itself. So you have the indexes which have driven this trend. Fund managers are tending to exaggerate this trend where the money flows. Individual investors using the indexes are along for the ride, and it’s the cap-weighting nature that exaggerates the buying in companies within the index.

Kevin: So companies like Apple and some of the bigger companies may be growing, not based on revenue, not based on performance, but based on how many people are buying an index that buys them.

David: That’s exactly right, so this is what you’re saying. Purchases are not made selectively on the basis of the merits of a company, the fundamentals and growth prospects of a company, but on the basis of an existing position in the index. So think about this. The top five market cap stocks today are Apple, Google, which is now called Alphabet, Microsoft, Amazon and Facebook. These five companies have a value of 2.35 trillion dollars.

Just think about this. You have indiscriminate buying in index funds, and we know that there are massive purchases which are then made of these five companies. And they are made, not on an evaluation basis, but on the pre-existing position within the index. They see massive purchasing today. And I want to underscore a key word here. It is indiscriminate. To discriminate means to have a reason to choose or not to choose. What is your reasoning process behind saying yes or no to this or that? This is indiscriminate. You’re getting Apple, Google, Microsoft, Amazon, Facebook, because of their positions in the indexes.

Kevin: Well, let me flip the coin then, because something that is purchased is always someday sold. What happens? Is it indiscriminately sold, as well?

David: That’s correct. That’s correct. So, if buying today is selling tomorrow, you’re assuming that there are always ready buyers on the other side. We have discussed the myth of liquidity before and how in an up market you assume that you can always get out. In a down market you typically can get out, but it’s at a price. So if you don’t mind getting skinned alive, no problem. Once everyone owns a particular asset, and no one is left to make additional purchases, the question is, who drives the price higher?

This is Larry Summers’ prophecy. I hear him echoing down the streets in New York, down Wall Street and Broad Street. Maybe – maybe it’s the government who steps in and is the buyer of last resort and keeps on driving prices higher.

Kevin: Like Japan.

David: But here’s the thing. Just point and counter-point. Even if Summers and that idea of the Japanese government stepping in and buying index funds to support the stock market – even if that is an action that is taken, look, you’ve had help from the Plunge Protection Team back in the period of 2000, and when stocks were collapsing in 2008. It wasn’t like all of a sudden the Plunge Protection Team hung their heads low, their tails between their legs, and hid under their desks and said, “We don’t have anything to do today, I guess we’ll just wait until tomorrow.” No, they were active in the market all the way down, which says something. You couldn’t stop the train from rolling down the tracks at high speed. Shares of the most popular and crowded companies at that time, both in 2000 and 2008, ended up being down 50-85%.

Kevin: Even with the Plunge Protection Team and the government directly intervening.

David: That’s right. Look at companies like Cisco, one of the high flyers of the era. Fred Hickey points out that Cisco is still down 72% from its peak valuation. Intel is only slightly better. It is still down 65% from its peak valuation. So as Fred Hickey notes, it’s getting crowded again.

Kevin: Let’s talk about that – it’s getting crowded again. In the trading vernacular, when everybody is going one direction, either buying or selling, that’s called a crowded trade.

David: Right. You just have to let that sink in. You have five companies with a market capitalization of nearly 2½ trillion dollars (laughs) – that is unbelievable. Five companies that have a market capitalization that is larger than many of the world’s total stock markets.

Kevin: And they’re being indiscriminately purchased in these huge index…

David: Yes, that’s what I’m saying, is that the passive index investor is involved in indiscriminate buying today driving up the prices and valuations of these kinds of companies, and that passive index investor selling tomorrow sells indiscriminately in the context of panic. And how do the mighty fall? This is how the mighty fall. They got to levels that were unwarranted, unmerited, and they also get to levels when they sell off that are unwarranted and unmerited. This is the nature of market extremes. It’s crazy at both ends. It’s irrationally exuberant on the upside, it’s irrationally panic-drive and fearful on the downside, and we are, as Fred Hickey says, getting to that point of being crowded again.

Kevin: And we talk about creating a captive audience. Carmen Reinhart talked about that, as well. How do you create a captive audience? One of the keys ways is you do it through regulation, or you do it through control of the media. Control what is coming out and you can control the people for a certain period of time, but look at these email dumps that are coming out right now. You were talking about how the mighty fall. The mighty may just fall when you don’t have one of the three top networks actually giving you the news.

David: One of the things, before we move to politics, because this is one of the changes of the guard and people don’t know it – April of 2017. Doesn’t matter which party gets elected. Honestly doesn’t matter, because there are things in the works. The Department of Labor has put in motion some things that come into play April of 2017. And basically, it looks at compensation for asset managers, brokers, insurance salesman and what not. And do you know what we are going to inadvertently move to? A whole world of passive investing, where professionals and advisors are taken out of the equation completely.

It’s very interesting because we’ve just gone through eight years where if you were blindfolded and throwing a dart at the newspaper, any stock you bought would have gone up. Why? Because all boats rise with the rising tide. That’s the nature of excess money printing and asset price inflation. It didn’t take talent in the last eight years to make money in the stock market.

Kevin: So there is regulation coming out that penalizes someone from picking and choosing and telling their clients what to pick and choose.

David: What it does is, it says, “Look, we haven’t needed talent in the last eight years, let’s just face it. We don’t need talent at all.” And so, basically, one of the transitions which is afoot is that the talent pool simply goes away, and about the time that old saw of, just invest in an index fund and the market is going to do you favors – when that fails, and fails miserably, guess what? The compensation for professional advice and investment is going away.

Kevin: So the Jim Deeds style of position trading, finding the best opportunity and sharing that with your clients, that’s going away.

David: Well, here’s the rationale. Did you make money on that transaction? You recommended something to your client.

Kevin: “Mr. Deeds, did you own that yourself?”

David: “Oh, so you had a motive to own that and you made money? Yes, well clearly, then you should not have made that advice.”

Kevin: “You should have just been buying an index fund which indiscriminately buys the largest capitalization.”

David: You realize that Deeds existed in a world where you could charge 2% for a stock transaction. And today you have Vanguard index funds which charge less than 25 basis points. So the way that Vanguard is lobbying the Department of Labor is to say, “We don’t want any competition. We want to be the only game in town, and we’re willing to do it for two basis points, or for nothing, and we’re capturing the whole market.” Again, that works in a world that allows for autopilot. We’ve addressed this in past conversations. We’re moving into a very tumultuous period of time where the last thing you want is to be on autopilot.

Kevin: Chuck Yeager, the first man to break the sound barrier, was on the board when they analyzed the Challenger disaster back in the 1980s. Chuck Yeager came from a day and age when the pilot got into the plane and flew that X1, and he knew every piece. He said, “A pilot should be able to take the plane apart and put it back together.” I’m a pilot. You’ve flown planes. We know that there is a walk-around on that plane. You do a pre-flight for a reason. What he pointed out was this. The complexity of the Challenger, the Space Shuttle program, had exceeded the ability of any one person being an expert on the whole thing.

It seems to me like what we’re doing is, we’re building a complexity into the system through these index funds, through passive investing, where you have no experts left. So when the selling does begin, and people start panicking, not only do you not have anyone to buy, you don’t have any experts out there that are even allowed to recommend buying opportunities when they exist.

David: We have academics, but no experts, and there is a difference.

Kevin: So you’re killing the liquidity of the market, Dave.

David: Oh, you are. You mentioned Yeager. I forget to tell you last week that I was able to spend some time with two young guys, the grandkids of the man who engineered the Saturn V rocket.

Kevin: Really. Wow.

David: He grew up in South Dakota on a farm and just tinkered with things on the farm, built things, constantly. He knew every piece of the Saturn V rocket, and he told his kids and his grandkids, if you don’t understand it, don’t do it.

Kevin: Dave, I see where you’re going on this. Honestly, when you eliminate the experts, when you eliminate the people who can come in and actually do the tinkering, and in this particular case Jim Deeds was a great example of someone who is now being eliminated by the academics, all of this seems to be in the name of managing the perception and the economy from the top down.

David: And I have to be honest, the distinction here is between experts and academics, and only rarely is there an academic that is also an expert in the sense that they have enough real world experience to matter. When you talk about a market practitioner, a market practitioner is not someone who, like a brain in a vat, has sat in an ivory tower and written white papers all their lives. That person may have tremendous value to add, but it needs to be taken with a grain of salt because how do those theories actually work in practice? This is where the rubber meets the road. This is where an expert is someone with direct experience. I like a guy who builds a rocket who knows how to take apart a John Deere tractor. I don’t like a guy who builds a rocket who has only worked on a computer and with simulations.

Kevin: Chuck Yeager said that if a pilot could have actually done a walk-around on that Challenger and had things been done in the way they were done in the past, he could have said, “Look, it’s too cold to fly. Those O-rings are too tight.”

David: Politicians – you were mentioning the new reality. I think, to transition, you have the 9th iteration this last week of the Podesta emails which have been released.

Kevin: Right. Wikileaks. Yes.

David: I think this is very important. It’s a new reality, and it, frankly, is of greater importance than the Arab Spring, because politicians have never been more vulnerable, and in the future they may actually have to embrace transparency. That represents a radical shift for politicians, not only here in the United States, but overseas, to realize that, actually, they could be held accountable for everything that they say and do because their private lives, the private expressions of their minds, held in confidence between coworkers, and in the food chain, politically, it all of a sudden is wide open.

Kevin: Well, let me ask you – do you really think they’re going to adapt that way and embrace transparency, or do you think they’re going to do what Wall Street is doing and that is, regulate away everything that is a distraction?

David: I think that is an interesting point because while nothing is private, it’s very fascinating to watch how the political landscape is being affected by revelation after revelation of slime. And to be honest, this has nothing to do with Republicans or Democrats. In this case, maybe, Podesta has to do with Democrats, but there is just as much slime – remember that for every email that is revealed from Podesta’s Inbox or Outbox, it can be revealed on anyone and everyone, anywhere in the world.

Kevin: My son has told me for years, “Dad, the Internet is the Wild West right now. Enjoy it. This is when it’s free, information can flow for free, but there is no way that the powers that be can leave it in that state.”

David: That’s right. We need to revisit the Nazli Choucri interview. It was either December 2014 or December 2015. You’ve got to revisit and listen to that interview. What is up for consideration is that the next administration will react to Wikileaks, will react to Anonymous. Anonymous is saying that they can release the 33,000 deleted emails at any time – just boom – they already have them. That is power. That is power that the political class is not used to dealing with.

Kevin: They’re going to try to protect themselves in the name of protecting us.

David: Right. So how do they create an Internet with Teflon or bullet-proofing for government. Maybe that is, if you’re online it allows for access from hackers, so you look at the offline versions, the Intranet instead of the Internet, and selectively cut services. Maybe that’s a part of the answer, I don’t know, but the interview with Choucri was really good.

Kevin: There is a question that has to be asked continually. Who controls the Internet?

David: That’s a very important question, and while governments are clamoring to control, it’s worth noting that there is a revolution that is brewing, because all of a sudden the mainstream media has lost its voice, and they’ve lost their voice to the Wild, Wild West, which is the Internet.

Kevin: This brings me back to what I was talking about this morning also. My wife had Good Morning America on. They were talking about Trump. The media, whether you like Trump or whether you like Hillary, I don’t care, you can definitely see the media, where they lean. They had George Stephanopoulos asking questions, and of course they brought Cokie Roberts on, for an objective analysis of what was going on with Trump. I looked at my wife and I said, “It doesn’t matter who you’re going to vote for, I can tell you right now, Cokie Roberts does not bring an objective analysis, and George Stephanopoulos worked for the Clinton administration back in the 1990s.”

David: I was listening to a fund raising program for National Public Radio, and it was funny because NPR has said, “Bringing objective news and analysis,” for years and years and years and years.

Kevin: Oh, right.

David: And I’m thinking, right, because their view of fair appraisal is, on the left they have Pacifica Radio, and on the right they have your regular NPR reporting, and that is their version of conservative reporting, fair and balanced.

Kevin: But politicians are losing their control through the Internet. They don’t have that same control unless you watch Good Morning America.

David: That’s the point. Politicians are losing their ability to control the narrative via the media. And so informational access and dissemination via the Internet is eclipsing the relevance of the mainstream media. Today, the news outlets don’t report after investigative inquiry. They don’t. You’re talking about a team of producers which analyze blogs, they look at headlines which someone else has put up, to see what’s trending. And on a last-minute basis, they bring in experts to comment on popular trending themes.

But the main point is that Internet communications have circumvented the normal information channels and have placed a few tech companies in a position of transnational power never imagined by the governing class, never imagined by the political class.

Kevin: Right. There are no borders with the Internet. You can have companies like Google that actually represent probably far more power than almost any nation state in the world, and they have no borders. There is no nationality. There is no national anthem.

David: They may have headquarters in the United States but the companies are global, the interactions are transnational. The control of these companies – this is a real challenge. Look, I’m not advocating control, I’m just suggesting that just as Twitter has been a powerful tool in the hands of Donald Trump, look how much time he has spent doing that as opposed to creating ads and spending millions and millions and millions on ads. This is actually quite funny. Media giants are suffering catastrophic income loss. They had expected major revenue from the Republican party, and the Republicans aren’t spending hardly anything at all.

Kevin: And look at what Trump is doing, virtually no mainline media, whatsoever. The mainline media has turned against him, yet he has an amazing appeal based on Internet information.

David: Right. So I’m suggesting that just as Twitter has been a powerful tool in the hands of Trump, social media has become a dominant factor in the campaign. That tool can be taken from someone and abused, as well. So Trump’s use of the Internet would suggest that he knows how powerful it has become in the making and remaking of the political landscape, and it’s not a tool you leave unguarded or open for opposition to use. So control – this is a very relevant issue. We get past the November election – who has control? How will it be exercised? The next few years you can expect a big sheriff to step in and try to bring law and order to the Wild, Wild West of the Internet. And I frankly don’t mind the Wild West. We’ve seen a second information revolution occur.

Kevin: The first revolution was the Gutenberg press, right?

David: Fast forward. I’m thinking of a shift in the means of communication.

Kevin: Okay, so the Internet, itself.

David: Now we see the changes that come from dissemination of privileged information and the consequences of an open architecture where the whole world knows more than you hoped it would about – let’s see, what would make its way into private emails? Internecine conflict, policy priorities, back-stabbing. If you can imagine playing cards in a room full of mirrors, there really is nothing close to the vest anymore. And it makes me wonder if politicians simply accept this as progress or try to prove – and I think this is more likely what is going to happen – a level of vulnerability and risk on that basis and legislate and control the Internet via fear.

Kevin: Right. And we’re only talking about political things, Dave. You remember that Ashley Madison thing that happened about a year ago where all of a sudden 30 million guys who thought that they had a little secret…

David: Oh no.

Kevin: It wasn’t a secret anymore.

David: It’s not a secret anymore.

Kevin: In one respect, it’s actually good that people not have secrets like that.

David: I agree on that point, but what I’m afraid of is the equivalent of a fairness doctrine coming into play.

Kevin: I hear you.

David: Where all of a sudden, fair and even reporting, I can’t say a comment, positive or negative, about anything, without having the opposite view equally represented by someone who represents the other side. We could take an hour Commentary and turn it into a five-hour Commentary by having caveats and the balanced perspective. I think we offer a fairly balanced perspective. We have our opinions and views, but again, the fairness doctrine would require sort of a tit-for-tat. Everything that is said is balanced and measured with someone else saying the exact opposite.

Kevin: Well, let’s return to finance just for a moment, Dave, because this Wells Fargo thing has just been a complete mess.

David: Oh, speaking of dirty laundry, yes, this is the Ashley Madison of finance. Buffet – you would think that he has either suffered a stroke or has laryngitis, I don’t know, but he has been awfully quiet. He has been awfully quiet on the Wells Fargo business. And it is interesting, because he speaks through a bullhorn when it’s the ethics dealing with someone else, or something else.

Kevin: Right, but because he’s related to this.

David: He does the same thing with taxes. As long as it’s someone else’s money he’s always willing to advocate taxing more of it. When it’s his own money, he’s one of the most efficient – he is the Donald Trump of the Democratic Party, in terms of finding tax-efficient means of managing Berkshire Hathaway. It’s brilliant on the one hand, it’s just irksome because it’s disingenuous on the other. So yes, there is Wells Fargo, the business of Wells Fargo. Why has he been so quiet? (laughs)

Kevin: Right. Well, I want to address something, Dave, that honestly, I don’t have a full feel of right now. I enjoy the fact that the Internet can give us a lot of information, but sometimes it is so unfiltered it can be spectacular on both sides of the coin.

David: And spectacularly unhelpful and untrue.

Kevin: Exactly. So I want to bring up Russia here for a moment, because things are happening in Russia and Syria, but there are Internet avenues right now that are making us think that we’re going to have a nuclear war sometime this week. I think it can be overstated sometimes, and this is where we have to have discernment, and I’m using a word right now that has a tremendous amount of power, but we have to have wisdom and discernment, even when we’re reading a message that reinforces what we already believe.

Now, I believe that there is an issue in Syria. I also believe that it’s going to get worse. But I think we have to be very careful and analyze the situation and say, “Okay, what is really happening?” We know that Russia ordered all of its officials to fly home relatives abroad, according to a United Kingdom paper. But how close are we to, let’s say, World War III?

David: Right. Well, between the yes and the no, is the maybe. And so, there are lots of things that are possible. And this is one of those variables that you should keep track of, you should look at.

Kevin: But there is saber-rattling.

David: A huge amount of saber-rattling, and I think when Russia orders their officials to fly relatives home who are living abroad, that according to the U.K.’s paper, the Daily Mail, maybe it’s saber-rattling, maybe it’s more than saber-rattling. We know that tensions peaked over the weekend. We know that last week the RAF was given a green light to shoot down Russian jets in Syria.

Kevin: Which would be an act of war.

David: True. So there are things that you say, “Well, is it going to happen? Yes! No!” I say, between the yes and the no is the maybe. There is the possibility. Honestly, let’s look at the context. Syria may go down in modern statecraft as one of the greatest disasters of our time, and that, to me, is really an issue. By not adequately responding, the Obama administration has contributed to a regional destabilization, Middle Eastern destabilization, European destabilization, that counts over 300,000 people dead, and a refugee crisis which is now driving European politicians to the wall.

You realize that a well-entrenched political party headed by Angela Merkel is now in a fight for survival, in large part because of an immigration issue. Think about that. The general sentiment on immigration in the last three years has changed dramatically, and right smack dab in the middle of it is a response to Syria and ISIS, both of which have remained front-page items for all the world to consider.

Kevin: So whether we call it xenophobia, whether we call it immigration, whether we call it just plain old raw fear, that’s actually the motivation, Dave. There is raw fear. And actually, some of it is warranted.

David: The unintended consequences are that there is a growing concern over immigration here in the United States. There is a growing concern over immigration in Europe. There is a growing concern over immigration everywhere that is fear-based, and it is at a fear-based level that we haven’t seen in generations. Again, in future weeks, not today, but I want to discuss and define globalization and globalism. I want to contrast the two.

And in preview, I think it’s enough to say that anti-globalization – that theme – is completely consistent with an immigration and refugee concern, with hyper-intervention from central banks, and with the consequences of a growing wealth gap that ties directly to central bank activism. What we may be witness to is a less than rational period of torches and pitchforks. So if it’s torches and pitchforks in the future representing popular discontent, we need to get very clear on the definitions and understanding of globalization versus globalism.

As we mentioned earlier, we have the means of disseminating ideas and views through channels that government has not yet clamped down on. That’s a story for the next four years. I think we’ll see that change, to some degree. Before we have that discussion, November and beyond, both in terms of the change of who controls what on the Internet, and globalization and globalism, please go back to December’s interview with Nazli Choucri. It’s critical.

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