Stock Traders Are 95% Bullish! Does That Worry You?

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• Headline: “Melt Up!”, ”Euphoria,” “No End In Sight”
• Is Ripple The Next Bitcoin?
• Best Returns Will Come To Those Savvy Investors Who Bet That The Market Is Too High

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

“The ETF market is a little bit like Frankenstein. We gave it life – now we get to see what happens to it, because it has never been tested in a liquidation mode, where market makers are absent from the market or are capital-constrained and cannot come in to any degree. So, with that in mind, 3.4 trillion dollars in assets – we don’t know what the impact is as they are liquidated in part.”

– David McAlvany

Kevin: Well, we’ve had a couple of programs where we had a chance to answer questions from our YouTube site and it was very educational for me – I think for you, as well, Dave. I love the fact that we have intelligent people listening, commenting. Just watching them comment to each other, not even necessarily asking us questions. It’s incredible to me to see just how deeply some of these people are thinking, and how a lot of them are not fooled by this incredible mania market optimism.

David: The dialogue clarifies things, and I think that is one of the things that is unique with technology today, is that it increases the amount of communication which can occur around a particular topic, and the speed with which it occurs. That dialogue can be upsetting if you go back to the Arab Spring where all of a sudden people are dialoguing about something they don’t like and they converge on a particular spatial location and they end up changing the world. So technology is a blessing, to authoritarians and autocrats something of a curse, but really a fascinating thing to participate in. And you’re right, we really enjoy watching the conversations come alive.

Kevin: The speed of information transfer has matched the speed of money transfer. We’re going to talk here in a little while about the SWIFT system and how quickly things change now, even compared to ten years ago when we had the financial crisis erupt last time and then if I were to go back another ten years before that, Dave, the IPO dotcom craze. Anything that was a new initial public offering that had dotcom behind it just immediately skyrocketed. That was a signal of the beginning of the end.

But could you imagine if we had a dotcom crash 20 years hence? Most people had slow Internet back then. Back in 1998? Come on, you were still connected to CompuServe. At this point, with the click of a mouse you could have billions, or even trillions of dollars try to liquidate, and find that it can’t.

David: Fast forward to 2007/2008 as the market was imploding that fall, into the spring of 2009, we had a number of instances where the big brokerage firms had to shut down their trading platforms. They could not take the volumes. And if you were putting trades online they weren’t taking them.

Kevin: I remember you tried to get out and you were locked out.

David: Yes, there were certain positions that I decided to keep on and certain that I had already sold out of, and in this case, Charles Schwab was not taking orders. That was a fascinating experience to realize that the New York Stock Exchange and NASDAQ are fully functional, and we do live in the Internet age and things do travel practically at the speed of light or faster. Lo and behold, it doesn’t really matter. Things can cause a grind to a halt.

Kevin: And the big boys always win, because if you remember the flash crash of 2011, the stock market lost 1000 points just almost instantly, and came back. Well, the people who actually placed beneficial trades, who were thinking and seeing a lower price, those trades actually got cancelled and reversed after the flash crash. So sometimes you can’t win for losing and you can’t lose for winning.

David: (laughs)

Kevin: Let’s talk about Greek treasuries for a moment. Greece is a country that we talked about a few years ago as always every week being in danger of going bankrupt, if you recall. Greece is a dangerous place to invest, yet you would never know it the way they are pricing the money right now, and interest rates are the way that you can tell how people price risk.

David: Looking at short-term rates, Greek treasuries maturing in 2019, so you’re talking about a rating of Caa2 which is pretty low on the scale of things. If you’re thinking of an A-F grading scale as in school, this would be like a D to D-.

Kevin: You would not let your grandmother invest in Caa bonds.

David: No, in fact it’s yielding 1.44%. That’s a little bit confusing. You ask yourself, “Are they speculative? Do they carry implicit risk? What do those numbers say? What do those numbers mean? And do they mean anything at present?” Because you can contrast a 1.44% – a 144 basis point return – contrast that with U.S. treasuries which mature in the same kind of time frame – 1 and 2 years – mind you, we’re not talking about triple-a paper, not Caa2. And triple-A, I understand some people contested that. Maybe the U.S. treasury market isn’t what it’s cracked up to be.

But by contrast, U.S. treasuries are on a far better footing than Greek treasury debt. That much is incontestable. The yield on U.S. paper is 1.75 and 1.95. That, just by the numbers, is suggestive of greater credit risk and higher inflation risk in the United States than in Greece. Or perhaps it is just suggestive of nothing at all, except that bond markets are, at present, an even lousier judge of quality and of risk than stock markets. So it is fascinating, but it is perhaps confusing, and certainly, it is a sign of the times.

Kevin: Talking about confusing, how in the world can you price anything accurately when there is a guaranteed buyer and that’s really what is happening. If you look at the Greek bonds, the buyer is the European Central Bank. They are going to come in and buy as many as they can, and that lowers the yield that Greece has to actually pay. They don’t have to pay for their risk because it is being socialized into the European Central Bank.

David: One of the big trends of 2018 is a reduction in central bank footprint in the stock market and bond markets of the world. We have the ECB, who is cutting their purchases in half. They will be purchasing a mere 36 billion per month. And of course, the Bank of Japan has said, “We’ll continue on doing what we’re doing.” The U.S. has promised – it hasn’t taken strong actions on it, but has promised to shrink their balance sheet. So cumulatively, the estimates for 2018 are roughly 1 trillion dollars in the equivalent of quantitative easing or asset purchases by central banks. Even with that in place it seems to me that markets are really not taking into account that it was 2 and 3 and 4 trillion annually, if you add up all the central banks going back through the crisis years, and the stock market doesn’t really care. The stock market is assuming that nothing is changing and everything is well.

Kevin: Because of the Volatility Index. Look at the Volatility Index, Dave. If you were an investor 25-30 years ago, you would look at interest rates and say, “This is how much risk is in the market.” Or you would look at the price of a stock, “This is how much risk is in a stock.” Volatility in those indexes is one of the best ways to see if people are worried. The Volatility Index is virtually at a standstill right now. It is signaling massive complacency. If complacency were on a scale of 1-100, that’s what we’re talking about, it is 92-93% complacency right now.

David: That’s right. You would have to go back to 1991 to see the VIX numbers lower than they are at present – I should say in the last week. So to the market, you have a signal from traders, active participants in the market, and the signal is full speed ahead, there is smooth sailing as far as the eye can see. And again, these are extreme readings. The VIX at 8.96 in the last week – that hasn’t been lower since 1991. What does it mean to us? It is a reasonable indicator of psychological mood, more than it is, really, the economic or financial condition of the marketplace.

And the mood is unanimously bullish. The folks over at Elliott Wave International – Steve Hochberg I have met at a number of conferences before, and he says, “Every single class of investor is wildly bullish. You have institutional managers who are holding record low levels of cash relative to equities in their portfolios. The number of bullish investment advisors is the greatest in 30-40 years, option speculators, the most optimistic in 3½ years, toward the prospects of a continued rising market.” That’s the CBOE equity put/call ratio, again back to VIX. He continues, “Mutual fund investors have poured a record amount of money into bull mutual funds, relative to bear mutual funds. You have retail investors have allocated the highest percentage of their portfolios to stocks, relative to cash, since the great asset mania peak of 2000. You have equity speculators who have borrowed to buy stocks and have availed themselves of credit to a greater degree than at any time in history” – those are the margin measures, Kevin, which you and I talk about quite often. And he also says that, “stock traders are now 95% bullish the market.”

Kevin: Let’s think about that. 95 out of 100 people are bullish on the stock market. In other words, everyone is just buying. There are five guys out there who are saying, “Wait a second, this is too high.” Otherwise, 95 out of 100 – that’s incredible.

David: Yes, and he goes on to say that this is the highest optimism in 11 ½ years. So today we read – and these are quotes from various news headlines – “Equity euphoria grips the world.” And then another quote from a headline – “U.S. equity melt-up already obliterating analysts 2018 targets.” And this is how he finishes his comment – “These two headlines are highly significant in that they use words that are never used unless the market has already risen significantly in both price and time. Melt-up and euphoria – they represent exactly the message of the wide array of indicators shown in the Elliott Wave financial forecast – a historic top is in the making.”

Kevin: Isn’t it amazing, Dave? All of us know, everyone would acknowledge, that to invest you want to buy low and sell high. Yet when we see something high, it is incredibly difficult to fight the emotion to not think that it is going to go higher. And so, why don’t we learn? Why don’t we recognize? You were a broker with Morgan Stanley 20 years ago and you understood the signals even back then.

David: When I started at Morgan Stanley 20 years ago, Ibbotson charts were put in front of me to show that diversification across asset classes was key, because according to these charts and their look into history, there was a constant shift from over-performance to under-performance, and back again, between all asset classes. If you just picture this, a periodic table for investing with all of your small cap, mid cap, large cap, international, everything – the message was diversify because typically the movement of sectors is not coordinated, it’s not unidirectional.

Kevin: Exactly. If everything is moving in a uniform direction you’re almost guaranteeing that you are going to see a downtrend in a uniform direction. Ten years ago, Dave, when we were doing the Commentary during the financial crisis, every week we were talking about unidirectional movement, but it happened to be down.

David: It happened to be down, and there was almost a bit of fatigue through 2008 and 2009 because we would say, “This hedge fund blew up, this corporate giant failed.” And it was like every week something happened that cost billions of dollars and thousands or tens of thousands of jobs, and after a few weeks it was almost like casualty fatigue in the army.

Kevin: It was very dark.

David: What’s the difference between 10,000, 100,000, and a million body bags? It’s just a lot of people.

Kevin: Yes, so when all assets go down, you really do have a real problem.

David: And I guess the key here is that the uniformity of trend is indicative of a market extreme. Yes, if assets are going down in concert, you have a real problem. It’s not a matter of mere relative performance comparisons, looking for a sector that might out-perform, or one that has under-performed and looks like a value. Everything losing value – what that speaks to is the psychology in the market at the time. A universally pessimistic psychology puts you closer to a bottoming in the market price by the day.

And when all asset classes move up in uniform fashion, it also speaks to a lack of discrimination between asset classes, it’s just on the other end of the spectrum. So set aside individual attributes, set aside value, set aside risk metrics, we’re talking about favoring the opposite psychology – uniform bullishness. Uniformity of trend – up, up and away – that’s the mark of today, whether you are talking about stocks, bonds, real estate, you name it. Everything works, everything is working – until nothing works.

Kevin: Let me just throw out – back in 1987 I remember there was an article that said that you could throw a dart at the Wall Street Journal and actually beat the experts, and I think we saw the same thing in the late 1990s with tech stocks. I know we saw the same thing back in 2006-2007. I think we’re seeing the same thing now.

David: Well, the good news is we have new highs in the Dow, NASDAQ and S&P. The bad news, the sobering reality, is that every day of gains brings us that much closer to a reversal in trend, putting in a market top, as the Elliott Wave guys have said. So watching for uniformity is helpful. And again, it is not normal for all asset classes to be moving up. When they are, it just says that caution is being thrown to the wind and you are really getting a picture of the psychology in play because ordinary investing requires discrimination, one of the qualities, attributes, risk and reward metrics. “How am I going to benefit? What are the risks? Where could I lose? To what degree? How fast?” All of those things matter, except when they don’t matter. And again, they don’t matter when you are seeing a herd mentality and people just saying, “Bullishness, bearishness, one theme or the other.” Again, it is indicative of market extremes.

Kevin: Let’s look at something. I remember Chris Martenson, when we had him on. He was big on rate of change. That’s another key indicator as to where you are in a cycle. You can have something slowly climbing for many, many years, but when the rate of change increases and it starts to go parabolic, that is usually a signal that you had better pay attention.

David: I remember one of his analogies in, I think, his earliest book. A neat guy, background in science before he took an interest in economics. And so, when he is talking about what happens in a petri dish and the multiplication factor of bacteria in a petri dish and how you have cells dividing, and then those cells divide, and you have this, basically, what is a compounding function. But it overwhelms the petri dish with this mushy mess in the bottom. And that is what we’re talking about – rate of change is very significant – very, very significant.

So we mentioned the uniformity of trend – that’s a healthy indicator. The rate of change is, too. So watching for uniformity – helpful. Note to self – so, too, is looking at the rate of change. The rate of change in an asset class or sector – you can think of it as the steepness on a growth curve. It also gives you an indication of trend sustainability, and where you are in the trend. The longer the time involved, because you are racking up cumulative change, and also the more vertical the growth curve, the less sustainable.

So, as a percentage change from one year to the next, you might have 30-50% increase. That is fast. That is a very fast pace. But what if you have 50-100% increase? That rate of change is radical. If you get over 150% per year, or in a short period of time, say, 6-18 months, maybe even 24, you have the makings of a collapse.

Kevin: Dave, you are training for, I think I heard last night, three more half Ironman races this year. I have done one with you and I’ve done some shorter triathlons and I can tell you, the hilly triathlons are a lot harder than the ones that just slowly increase in elevation. In fact, there is one down in Phoenix we call Bartlett Lake. And you have to train for a rate of change increase on the bike, on the run. It’s not just gradual. You have massive rate of change increases, especially that last run. And in a way, you have to look at this as energy used. When you’re training for a half Ironman, or when you’re running one, you really have to conserve energy, because you realize how much extra energy is expended when you have a hill coming up.

David: That’s right. So rate of change growth, if you’re thinking of that curve, you can also think of it, like you’re saying, you take a walk in the park, and you may be able to amble along for 5, 10, 15 miles without interruption. It’s flat, it’s slow, it’s steady – you’re on a walk, you can enjoy it. And you can go on, seemingly, forever. Resting may ultimately be a need, but it’s not urgent. Contrast that with hiking a mountain. You reach an exhaustion point or a place where you need to rest much, much sooner. There is a different energy needed to ascend.

Now, take that one step further. Imagine climbing a vertical rock wall, and the exhaustion point comes even sooner because the energy required to go the distance increases, and the effects of energy expended become more obvious as time wears on. So you get near the peak of your climb, your arms are barely hanging on, your fingers and parts of your muscles in your back are cramping. You can barely hold on. Markets expend energy to climb, and we are witness to a vertical ascent not unlike past business cycles, where the steepness of the growth curve, what I have referred to as the rate of change, or ROC, becomes a critical factor in the sustainability of the trend. So 2017 marked the steepening of the curve coupled with the remarkable uniformity across all asset classes and geographies.

Kevin: Yes, it’s not just here in America.

David: Right, so if you’re looking at overseas equities, the Austrian market was up 47%, the Athens stock exchange for 2017 was up 41%, Warsaw was up 41%, Argentina was up 49%, the Chilean Index was up 44%. Stocks in Budapest were up 37%, stocks in Vietnam were up 45%. Do you see the uniformity? This is not normal. When it happens, it’s telling you something.

Kevin: Let me ask you, then. If you threw a dart at the globe are you just going to win?

David: Yes, for 2017, you throw a dart at the globe, and you win. India is up 35%, South Korea is up 34%. It doesn’t even matter if your dart hits South Korea on the brink of war. Really, if you’re looking at the South Korean equities, the KOSPI market, what it indicates is that South Koreans are not actually concerned about what is occurring north of them. Maybe we’re more concerned than they are. They may have better information than we do. But their stock market is not giving any indication of imminent missile launch over there. The only sad spot, I think, if you’re throwing a dart, if you were to be the donkey’s tail – pin that one on the map – the one sad spot is in Pakistan. Pakistani investors were down 22% for the year.

Kevin: So that’s the unlucky dart.

David: Right. But note that these are uncommon single year gains in any market, and it is truly remarkable to see what is the equivalent. Again, going back to those Ibbotson chart squares, it’s like everything is lighting up simultaneously.

Kevin: We talked about volatility. Now, there has been something that has been humorous, and puzzling, this last year. The humorous part is, the volatility. If you want to see volatility, get a crypto-currency.

David: (laughs)

Kevin: That’s incredible. You can see 20%, 30%, 40% gains in a day. You can see the same thing on the loss side.

David: Exactly. Depending on the day it’s a mixture of melt up, it’s a mixture of melt down, and it continues to draw late-comers into the fray. You have hedge fund managers and a few venture capital guys who are like, “Oh yeah, I’m going to make my next half a billion on this stuff.” So, basically, they are unable at this point to keep themselves from a P&L fantasyland, because what it is combining is infinite wealth, and in a record short timeframe. You can look at history and say there are massive innovations that changed the world. Whether it was the steam engine or railways, lots of things as the world has become industrialized, you could say, moved us forward. The Internet was certainly one of those things. Trying to figure out how crypto-currencies are as radical a revolution – maybe they are, maybe they aren’t. You look at Ripple, as an example. It opened the year 2018 with a single day gain of over 50%. That’s one day. After finishing 2017 as the biggest winner in the crypto-currency space, up 38,200% in one year. Might we suggest that mania exists in the mind, and then just expresses itself in the market?

Kevin: I think this is something that we have to recognize. The original bitcoin, most of the people who were buying it early on saw it as an alternative to government-endorsed currency. I thought it was interesting that about a month ago Ben Bernanke was at the Ripple conference and he said, “You know, I don’t see bitcoin really having much of a future, but boy, Ripple does. It’s the blockchain of the future.” I just wonder how invested Ben Bernanke is.

David: If my memory serves me correctly, our interest in bitcoin goes back to our interview with Charles Vollum four years ago. After the Vollum conversation three to four years ago, we talked to George Gilder who was a big fan of bitcoin, and this goes back at least two years ago. But prices, if they are not reflective of value, they definitely provide commentary on the current state of the market practitioners. Going back to Greek debt for a minute, which we started with – that is exhibit A. Maybe Ripple is exhibit B, with its impact into the banking community. I appreciate what it is, shrinking transaction settlement time from days via the old SWIFT system, to seconds. And there is value to that. There is value in the addition of time, the condensation of transaction costs – that is of value.

But apparently that contribution is on par with the creation of Microsoft. If you look at Ripple’s founder, Chris Larson, on paper, last week he was tied for net worth with former Microsoft CEO, Eric Ballmer, both of them worth about 40 billion dollars – billion dollars. That takes Larson’s rising star to the number 15 position, and that was, again, last week. So Bill Gates, you should watch out. Warren Buffet, be prepared to be passed like you’re standing still. Jeff Bezos, you might want to hold on to the number one seat while you can. Because investors are now betting that your tenure, Mr. Jeff, as the richest man, is going to be very short-lived.

Again, there are other factors which are not particularly relevant at this point, like, what is Ripple’s revenue stream? Do they have earnings? Are they profitable at this juncture? We have been trained to think that those are concerns that only apply to old economy stocks, and maybe they apply to some of the stodgy technology stocks, with Apple, Google and the like being stodgy, of course, relative to the cryptos.

Kevin: I remember this discussion going on back during in the Internet stock boom, as well. They would use the words “old economy” and “What are you talking about? You don’t need profits these days because we have ideas.”

David: (laughs) It’s fascinating to me that Apple, today, is treated like a preferred stock because of its balance sheet, and then you’ve got something that is offering crazier returns than the options market – naked call options on the cryptos. What has Amazon proven? They have proven that you don’t need margins for business. You don’t need to make money. Ask Tesla about that. You can be in business and have a massive franchise and actually generating profits doesn’t matter.

They have also proven that investors will line up. I think of Amazon here. They’ll line up with their money. They’ll buy your shares, even if it does take 300-plus years for them to recoup their cash from the skinny earnings that you have. So I guess my word of advice to Mr. Larson – talk to Elon Musk, because he is going to agree that making money, as a business, is passé. And if you ask Elon, he is also going to say that the sky is the limit for the 2018 man of modern ideas.

Kevin: Yes, ideas. That’s the thing. I keep saying it, but going back to the tech stock boom, it was all about ideas. It had nothing to do with actual profitability.

David: The reality is, the Ripple contribution to the financial landscape is significant. I like it. I’m just not sure it’s worth what the market thinks it’s worth today. But infinite imagination is the hallmark of a bull market top. Obviously, it is not the hallmark of a bottom, and it’s not really even somewhere fitted in between. After nine years of growth in the stock market it’s difficult to argue that we’re in the middle of a move, and we’re certainly not at the beginning. So where are we? I think some of the indicators, whether it is rate of change, or the uniformity of trend, suggest that we are getting ever close to the end.

Do stocks suffer from the same euphoric trends as the cryptos? Think of this. They do in some sectors. Jim Grant sent out a note last week regarding Chanticleer Holdings, which owns the Hooters restaurant chain, not a restaurant chain that I frequent, or in fact, have ever been to, but it is among other assets that they hold in the Chanticleer Holding Company. They announced a customer loyalty reward program. Do you know of a restaurant that offers customer loyalty reward programs?

Kevin: Most of them do.

David: So nothing novel there, but this one will be built, according to their announcement, on a blockchain architected platform. So you have the key words for the modern buyer, or the algorithm which includes blockchain, and guess what happens? The announcement sends shares up 100% in pre-market trading.

Kevin: Just with the word blockchain.

David: By the end of the day, after it’s not just bots, robots, and algorithms, and it’s actually people engaged, they’ve still increased by 41% by the close of the day. Because they’re doing what? “Oh, didn’t you know, it’s a blockchain architected platform.” Now, I’m just wondering if there are better tips at hooters, or if there is a different profit structure because of the food that they serve? What is improving their business? Well, it’s the customer loyalty reward program based on blockchain. That’s worth 41% to market capitalization, don’t you think?

Kevin: Well, for the sake of discretion, Dave, I’m not going to say what a lot of people are thinking right now, that the Hooters chain is now using blockchain to gain stock increases. I’m sure people can probably fill in the blanks. But what is interesting, and I’m going to sound like a repeating record, but all you had to have was the word dotcom at the end of your company back in 1998/1999. And again, you didn’t need anything but that and you had incredible gains. They had IPOs that were for companies that had no potential of ever performing.

David: Or were about something else. And by the way, this kind of mania involves itself in every space and sector. In the 1970s there was a bread company that decided to include the word “gold” in their title, and as they relisted their company their shares shot up 400%. Why? They didn’t have anything to do with gold but they attached the name “gold” to the bread company.

Kevin: This was in the late 1970s.

David: Theoretically, if I owned a company that made nicotine patches and we called the company Cryptopatch, how do you think my shares would trade with the name “Cryptopatch” as opposed to just the “I’m going to help you stop smoking patch.” Larson’s, the founder of Ripple – I guess one of the things that he is learning here in the last few days is the transience of wealth because – Oops, it’s off by a third. Did I mention 40 billion? I bet you’ve never lost 15 billion dollars in less than a week. I can hardly hold back my tears.

Kevin: You’ve talked about before – when we’re watching markets sometimes it’s easy to look at this one or that one and say, “Wow, those are incredible gains, but actually, you need to look at the breadth of the market. You need to see how much is gaining, how many stocks, or how many items are gaining.

David: If there is one thing that marks 2018 in the early stages as disconcerting, we have new gains, so prices are saying everything is good, prices are affirming the fact that we have de-regulation, which is positive for the economy and economic growth and business-making decisions. We have green lights here at the early stages of 2018, but the troubling part of the backdrop is the divergence of price and market breadth. Over the last seven to ten trading sessions you have had fewer and fewer stocks rising as the indexes march to fresher highs. There is a very unhealthy market dynamic. I don’t know if that tells you that we’re putting in a top in the next week, or two weeks, or if that is an indication that there is smart money that sees every move higher as an opportunity to sell shares. I’m just telling you that when you have bad breadth – market breadth, not bad breath – it’s not going to go well.

Kevin: Dave, as you know, we record this program, and if we were to say something over and over and over, we could actually save ourselves the time by just recording it once. I’m thinking in this particular market why don’t we just record, put a clip in that just says, “all-time highs, all-time highs, all-time highs?”

David: Never-seen pricing (laughs).

Kevin: Never-seen-before pricing. Just like ten years ago when we would say, “all-time lows, all-time lows, all-time lows, out of business, bankrupt.”

David: Lost another $100,000, $500,000 lost, these companies being forced into a shotgun wedding. Yes, I know, it hits the ears like Persian rug sales. Have you ever driven by the neighborhood?

Kevin: They’re always going out of business, Dave.

David: Right. A going out of business sale. And how many times do you drive past it and see the sign before you just don’t engage with it, you block it out? So there is something of a fatigue. At least for you and me, it’s getting tedious talking about new highs in margin debt, new highs in this, record levels of this and that.

Kevin: But there are things that we can say historically have always pointed to a crash. Look at the Buffet indicator. That is one of those indicators that Warren Buffet looks at to say if something is too high. Look at the Buffet indicator. Don’t listen to Buffet, now, because he is publicly saying he sees the stock market continuing to rise, but his indicator that he has always used and signed on for, that is basically signaling a crash.

David: I challenge someone in the audience to do a news search and look at all of Buffet’s comments on the Buffet indicator, and he loves the indicator, particularly when it is at 50% of GDP. Again, this is comparing the stock market capitalization to the engine of the economy, the total all-in number in terms of economic activity – stock market capitalization, financial assets, set right next aside the activity in the market, GDP. He loves it when it’s low, and he doesn’t talk about it when it’s high. You get above 100% stock market capitalization and GDP and he gets very quiet. His silence is actually a way that he talks his book. Again, we have discussed the Buffet indicator, it is a little bit like the Persian rug sale. Here is the novelty for you. It’s at all-time highs (laughs).

Kevin: There you go, play the clip.

David: So it surpassed the peak which we set in March of 2000, and currently is perched at 144% stock market capitalization compared to GDP.

Kevin: Which is about three times what he likes to see it at when he is buying stocks.

David: Right. So Wall Street monkeys will see no bubble, they will hear no bubble, they will speak no bubble, and if you throw the Fed into the Wall Street barrel of monkeys, what you have is so much fun (laughs). There is a party going on right now. Don’t distract the people on Wall and Broad. There is a lot going on, it’s fast money, and it’s good times.

Kevin: And there is another indicator, we use it all the time, but it’s always been an indicator of a stock market that is too high before a crash. That is the Shiller PE, the price-to-earnings ratio.

David: And never a timing indicator in terms of tomorrow it will crash.

Kevin: It’s a value indicator.

David: It’s a value statement which says, over a period of time to follow, you will either make money in stocks or lose money in stocks based on your cost basis. That is really what the Shiller PE is about. So the fact that it has reached 33 – Deutsche Bank’s Chief Investment Officer responds to the Shiller PE reaching 33. He is saying, “We’ll just scrap the measure. It’s useless. It’s antiquated. It doesn’t tell us anything anymore.” It doesn’t tell you what you don’t want to hear.

Kevin: Kill the messenger is what he is saying.

David: Has the CEO ever read Andrew Smithers? Excuse me, the CIO, the Chief Investment Officer, better well check his library, and if he hasn’t read the book by Andrew Smithers, which looks at how the Shiller PE, which is not Shiller – cyclically adjusted price earnings ratio long before Shiller adopted it and popularized it – what he will discover is it is one of two of the most reliable value indicators that people on Wall Street use. I would venture to say that the CIO of Deutsche Bank needs to have his resume checked, because that needs to be not only on his bookshelf, but well read, and he needs to have a better appreciation for what is happening in the market dynamics.

Kevin: So what he’s saying is, “Kill the Shiller PE, kill the Buffet indicator, kill anything that doesn’t confirm the upward bias.”

David: That’s right, because we’re in a “to infinity and beyond” mode.

Kevin: It’s the unidirectional trend that you’re talking about. Everything is rising.

David: Yes. The Buffet indicator and the Shiller PE tell of a future which is not pleasant, certainly not as pleasant as the recent past, and I think that is where Wall Street, including many investment officers and analysts, prefers extrapolation, to take what just happened and say it’s going to happen today, tomorrow, forever, or at least as far as the eye can see.

You know that 2017 was remarkable for the unidirectional trend of virtually all asset classes, in many of the geographies, if not most of the geographies of the world. Because comparisons come so easy to people, and I find this as one of the absurdities of human beings, put us in a social setting and there is oftentimes a sort of one-upsmanship. You go to a cocktail party, a golf club, a social gathering of some kind, and we have to compare and one-up each other. It could be baseball statistics, it could be you name it. Portfolios, how we’re doing, what we invested in. I think what you should do is ask your broker why the heck he or she did not invest in the Ukrainian stock market, because as long as we’re comparing, I forgot to mention earlier, out of that list of emerging markets that have done so well, the Ukrainian stock market was north of 70%. I forgot to mention it!

Kevin: That’s not my first thought when I’m investing in stocks, Dave.

David: Not far from Crimea, neighboring Russia, a stone’s throw from Syria. We’re talking your easy money, your risk-free returns, north of 70%. And I know it’s galling to miss gains in the marketplace and you’re tempted to say, “Well, if he did better, then why am I invested in what I’m invested in?” This is the bottom line.

Kevin: So the Ukraine and Greek debt – that’s really where we should have been.

David: Well, that’s the reality, because if you look at Greek debt, and look at that 2015/2016 to the present, take two years, your average returns on Greek debt were better, even in the one single year of a 70% return on Ukrainian paper. It’s really interesting. The market is pricing that paper today in Greece below the risk-free rate. I’m talking about U.S. treasuries. So maybe we need to change our reference point. Maybe Greek debt needs to be the new risk-free rate. Greece has been around a lot longer, after all. What is it we’re looking at?

Kevin: One of our favorite guests, who actually is responsible for, by his own admission, some of the major crashes that we have experienced in the last 30 years, is Richard Bookstaber. To be fair, he has been hired by the government to try to eliminate risk, and each time we try to eliminate some risk – it’s a little bit like NFL football. Every time you try to put more padding on guys and give them a little bit more protection, say with the concussion rules, the hits get harder, and things change just enough that the danger increases.

Bookstaber brings that out as well. One of the things that you and I have talked about, and Bookstaber is recently talking about, is this passive investing trend. If everything is rising and all you have to do is throw a dart at the Wall Street Journal to win, then really, why do you need an advisor? So you have all these passively managed funds and ETFs that, really, there is no discretion used.

David: He writes a fascinating look into the world of junk bonds, and specifically, we don’t call them junk bonds anymore, we call them high-yield debt. So high-yield debt in the form of an ETF remains very popular. This last year I think the return on high-yield bonds is about 6%, a little bit of capital appreciation, most of that coming from the interest component. One of the things that he points out is that you can have this divergence between the price of the ETF and the underlying asset.

Junk bonds trade by appointment. In other words, you don’t really have a two-way flow of capital in and out of that market all the time. It’s not as liquid as you would think it is. You trade by appointment. If you have a sale, you put it up there and it takes a little while to settle that trade because there is not that much liquidity. So you can have a divergence between the price of the ETF and the underlying asset. Ultimately, what that causes is a massive rupturing of the product, itself.

So his concern is that when you look at the ETF universe there is a built-in liquidity detonator, and it creates a real problem within the ETF universe. And he is not saying that the entire ETF universe is at risk, that 3.4 trillion dollar universe, but he is saying, you look at products like HYG, and other high-yield exchange-traded fund products, and they do represent something that changes the way people trade.

Now, if a large investment house begins to see the high-yield ETFs implode, guess what they do? They look at the structure of their ETFs, which are going to be your SPYs and your other large index funds, and they will begin to get liquid because they don’t want to see those products tested, even though they know, in terms of the price of the product and the cash market, there is not going to be a divergence in value.

Kevin: They will begin selling before the others do.

David: They absolutely will.

Kevin: A little like what we saw with the Intel executive this week.

David: Yes, the problem is to sell early, which means you’re at the front edge of something, because someone sells in the front edge, in the middle, and at last. And it is interesting, because Bookstaber – again, you said responsible. I don’t that I would say responsible. I think he was in the vicinity (laughs).

Kevin: Right, that’s what he said.

David: Every time there was a blow-up in the derivatives market he was in the vicinity. Now he is risk manager at the University of California for their pension fund, and you’re right, he did spend the last six to seven years in Washington crafting the Volcker rule, helping with it, and looking at the unintended consequences of it. He is basically looking at it and saying that we have something already in place that gives us the ability to say, “We built this monster, and now it’s just a question of how much time goes by before that monster bites us.”

In essence, do you know what he’s saying? He is saying that the ETF market is a little bit like Frankenstein. We gave it life – now we get to see what happens to it, because it has never been tested in a liquidation mode, where market-makers are absent from the market, or are capital-constrained, and cannot come in to any degree. So with that in mind, 3.4 trillion dollars in assets, we don’t know what the impact is as they are liquidated, in part.

Kevin: And it hasn’t been tested because we have a uniform rising market. Now, we have been talking about prices rising, Dave, but I was explaining something to my son the other night. I said that 25-30 years ago if you were investing in stocks, the idea was to buy a company that you could share in the profitability of. Now, all people are doing is just buying a stock with the thought that it will rise higher. They don’t care about profits. So clear this up for me. When I was a little kid I remember setting up a little blue lemonade stand. Actually, it was a Kool-Aid stand. The only thing that I was really concerned about was delivering a product at a price that was a little higher than what I put into it so that I could have earnings. Now, where did the earnings go this year? People aren’t really thinking about that. They’re thinking about momentum of price, but they’re not really thinking about the earnings of the companies that underlie those stocks.

David: 2017 earnings were impressive compared to 2016 earnings, and I think that is the key note there, because 2016 was so ugly that 2017, by comparison, won the beauty contest. And you say, “Well, this is just beautiful.”

Kevin: Did some of that have to do with stock buy-back, though?

David: Well, there are games that can be played with earnings, for sure, on the earnings-per-share front, but what I’m interested in is the question of 2018 and when you have a good number year-on-year, can you duplicate that year-on-year improvement into the next year, and into the next year? So these year-on-year comparisons are really critical. The reason why 2017 shines like a diamond is because 2016 was punk. Now, because 2017 shined like a diamond, it’s going to be very hard to see an earnings improvement that impresses Wall Street as we head into and through 2018.

A lot of the market is about expectations and euphoria, and I’m just doubtful that you are going to have a lot of euphoria that is the surprise aspect of beating expectations. We have had easy money, which has helped us with asset price inflation. One of the things that it has not done is, it has not inflated sales, it has not inflated revenues. So we do have an improvement on earnings, but earnings can be gained pretty easily. The truth of the matter, in terms of the health of corporate America, sales and revenue still lagging relative to the price increases.

Kevin: Let’s go back to rate of change then, because if you have rate of change dramatically increasing in the stock price, you should also have the rate of change dramatically increasing in earnings, should you not?

David: You’re not going to see that year-on-year change for earnings. You won’t see it in 2018. If we have an improvement, it’s going to be unimpressive. Again, how do you take the Dow from 25,000 to 30,000, or 25,000 to 40,000? You have to have a continual march, a continual resetting, with new and better information, new and better sales, increasing demographics. There has to be fundamentals supporting it. So far we have had games and funny money, but nothing else.

Kevin: So we talked before, as the curve steepens, you have to ask yourself the question, on rate of change, where are you in the cycle, and where are the investments that you hold in that cycle?

David: I looked at a fascinating conversation with an investor that I had a lot of respect for, Jeremy Grantham. He runs a multi-billion dollar fund out of Massachusetts. It was just interesting to look at his comments because I thought they reflected a person who had been snake bit. He lost half of his assets in 2000 and he lost half of his assets in 2007, not because of market losses, but because investors looked at what he did, which was cautious, and he was under-performing the market, and they fired him. Now, he was under-performing the market in 1999 as stocks went into a parabolic move higher because he wanted to preserve value and he went into cash and people fired him for doing what ended up being the exact right thing. And he was fired in 2008 and 2009 because he did the exact right thing.

Kevin: It’s like Jeremiah the prophet, Dave. He was right over and over, and over, but they continued to fire him and wanted to kill him.

David: So this is Jeremiah the Grantham and I think he is snake bit. When I read his most recent comments I thought the one thing that he wants to hedge right now is not downside risk, he wants to hedge against under-performance.

Kevin: He’s fatigued, Dave. He’s fatigued.

David: I think so. He’s 79. I have a tremendous amount of respect for him. But you look at the fear of missing out, you look at what happened in 2000 and 2007. I understand there are parabolic moves which happen at the end of every bull market. Perhaps that is what we are into, perhaps that is what we are on the edge of, perhaps that is what we have already completed. But the fear of missing out is spreading and it’s spreading far and wide, and it is even entering the minds of some of this era’s very best investors.

Kevin: Including Grantham.

David: And again, I’m just look at indicators, whether it is FOMO with Grantham, or whether it is the uniformity of trend with the global equity markets, whether it is the VIX sitting at less than nine, whether it is a rate of change increasing at a rate which says, “You know what? We’re going to have to take a break in here. You’re spending energy to get to these levels, and you cannot continue that ascent.” These are all things that just say that 2018 is a fascinating year. It’s going to be a fun year, it’s going to be a dynamic year, it’s going to be a year where you need to be nimble. I would suggest being liquid.

Does it make sense to own gold? I think it does, because one of the things that you have in play here, and I think plays particularly well for gold, is neither an inflation nor a deflation theme, but it is a confidence issue in central banks. Should we have the slightest hiccup in the Dow, S&P, NASDAQ, bond market, or currency markets, guess what is in play? What is in play is a questioning of the veracity of central bank monetary policies. And to the degree that there is a lack of confidence in the masters of the universe, there is a lack of confidence in the universe in which they operate.

This is where I begin to have real concerns. I think there are opportunities on the downside. We launched our tactical short for a solid reason. But I think that issue of lack of confidence in the central planning, central banking community, is what drives gold higher in the 2018/2019 timeframe. What is unique about this is that we have already spent a tremendous amount of energy getting ourselves back up on the pony that bucked us off from 2008 and 2009, and for the general public, falling off again, it’s a walk away moment, where no longer are they looking for value in stocks, it’s a throw away, walk away, never touch it again moment.

And that’s the kind of move that we were looking for at the bottom in March of 2009. We never saw it because of the interventions, but we may very well have it in the 2018 timeframe, maybe stretched to 2019. But that’s what we’re playing with, and I think that is why gold is particularly interesting in this environment.