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The Need For Risk Control In A Schizophrenic Market
August 10, 2022

“We had a year and a half, two years ago, the transitory references. Early on, as inflation was starting to heat up, it was going to be transitory. I think they were hoping that there’d be sufficient talk to keep inflation expectations modest, and to keep those expectations un-rooted, and I think they were hoping to avoid having to do anything. Don’t raise rates, but just talk it down. And now all of a sudden it’s here, and it wasn’t transitory, and it does require something of a more muscular action.” — David McAlvany

Kevin Orrick: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany.

You’ve been on a road trip, Dave, since you’ve come back from France, and you’re looking at colleges for your eldest son. And we were talking about it, life seems to have these decisions in it that at the time you think, “Oh my gosh, I’m making a decision for the rest of my life,” sometimes we put so much weight on it because we think, “Well, this is a definite, and it’s going to set the course of action for the rest of my life.” But actually when I look back at my life, yes, picking colleges, that type of thing could be very important. But I look back and I look at how unpredictable my life has actually been. I could have never actually planned any of the great things that have happened to me.

David McAlvany: Yeah, it is interesting how much stress there is around some of these decisions, and we’re getting to see that firsthand with our oldest. Class size and college size and emphasis, and people ask him what he’s going to study, and the reality is you got to have an answer, but it almost is irrelevant because, at least if he’s like his father, it’s going to change five times your freshman year anyways. 

But we take comfort in having answers, even if we don’t really know and can see the future. What we have is some alleviation of pressure and stress with this pretend world of coming to terms with what our future holds. And so much of that gets factored into the markets as well. If you think about, we just need something from the Fed, give me something to seek my teeth into, that way I feel better. It may not tie into reality, but it makes us feel better in the moment.

Kevin: Don’t you think the Federal Reserve for the last 10 or 12 years has offered a false sense of security, because they were able to print money and it didn’t create inflation really until just recently? I get a lot of my clients saying, “Well, gosh, is gold going to make up for inflation?” But we’re very centered here in America with how things are priced in dollars. If you look at gold, I mean, yeah, it’s off about 3% here in the United States this year, but look at what it’s doing in other currencies.

David: Well, and as you’re suggesting, the markets have gone to extremes on the basis of this false confidence. The Fed has projected a certain narrative about what the future holds and what they’re willing to do to guarantee that future, and people just speculate. People increase the size of their bets. The leverage that corporations and individuals or speculators, hedge funds are willing to take on has multiplied considerably based on the world, the certain world that the Fed has projected. Is it certain? Not exactly, but that’s what has been conveyed. And so, yeah, I mean, gold’s off 3% year to date in US dollar terms. Yes, it’s rallying off the lows of 1675. Yet, despite this— Call it poor performance in US dollar terms, the commodity’s up 12% in British pounds, it’s up 13% in euros, it’s up over 20% in yen. 

Gold is off, but we have certain things that we know from history in terms of the way gold behaves at particular junctures. We don’t really have that same sense of history when it comes to something like cryptocurrency. So when something’s off 50%, what do you really know about what happens next, or 70%, or 100%. It’s happened more than once in the last year. So in a re-reminder, last week on Monday, hackers took 200 million dollars in crypto assets in a two-hour period, what was described as the first decentralized crowd looting of a nine-figure bridge in history. This has been a couple months, things have been quiet, the cyber thieves have been quiet. 

I think this is particularly interesting because I’m here with my younger son as well, and one of the colleges we’re looking at is partnered with the NSA and department of Homeland Security for cyber security. They’ve got a great program for that and that’s right up his alley. 

But things have been quiet. What do I mean by that? Well, it’s been since March that we’ve had a major breach of these exchange bridges. In February it was 325 million dollars stolen. In March, it was 625 million dollars stolen. The exchange of digital tokens is not without risk. And so again, it’s interesting to me that gold can be the point of criticism, being off 3%, when it’s old, it’s boring, it doesn’t go anywhere, and it takes a lot of real coordination and logistics to pull off a heist. It doesn’t happen that often. Meanwhile, digital assets are so easy to rip off—in the hundreds of millions of dollars—and it happens every few months. So the reminder here is that the un-hackable asset is the offline asset. If you’re plugged in and internet connected, you’re hackable.

Kevin: Yeah, you’re talking about hacking. I got a text, like many of us may have, on my cell phone the other day, that looked very convincing. It looked like it had come from Amazon. It said, “Your Amazon account has been frozen due to suspicious activity.” And then it went on to talk about Mozilla, Firefox, and gave serial numbers, and then of course it gave a link that I could click to solve the problem. Of course, I did not click the link, but I thought, “Gosh, this can happen so quickly when you’re online.” And you talk about gold, why don’t you talk about the security that gold gives? Let’s face it, gold is un-hackable just by its nature.

David: Well, there’s this popular way of holding cryptocurrencies today, which is called cold storage, in other words, it’s offline. You put it on a thumb drive or some disconnected computer. Gold with a G, storage, is the old fashioned cold storage with a C, unplugged, non-network dependent, you’ve got serial numbers, you’ve got basic accounting, you have physical allocated existence, and in the end, that’s more secure than anything that you can get from encryption, complicated code— To me, this week is another week where old school wins again.

Kevin: Speaking of old school and new school, however, we’ve talked about the tech stocks and how they’ve been behaving, I’m considering that new school, but what was old school in making those tech stocks go up for so long was the margin debt. Remember talking just even a few months ago about margin debt hitting all time highs. Now we’re starting to see that margin debt come down. Let’s talk about Apple and Alphabet, Tesla, Amazon, and some of the stocks that are traded usually on very high margin.

David: The most popularly held companies make up a very short list. On average, they declined by 36.7%. That’s Apple, still off 9.6; Google, now called Alphabet, off 22%; Tesla, even with the rally, off 30%; Amazon, still down 25; and then you begin to see some really interesting numbers. Meta, of course we know that is the old Facebook, 56.5%; NVIDIA is off 45%. Now that one’s a really interesting case because they make video cards, which are used not only in gaming devices, but also have been used in Bitcoin mining, so there’s a double pressure there in terms of demand. And then if Netflix is off 67%— Again, an average of 36, these are your high flyers.

Six to 12 months ago, you couldn’t say anything negative about Netflix or NVIDIA. Meta, no way, it’s not going to trade off more than 50%. And yet here we are. We’ve never had, in the midst of this most recent selloff, we’ve never had any indications within the market about right panic or of total capitulation. What we’ve had is a steady grind lower over a six- to nine-month period, starting late last year, but without the telltales of a complete washout. So I suspect that sort of a decline may be coming. Look at it as a post-summer rally event. We get past the current hype in the market, and as we get into what is traditionally a seasonal period of weakness, September, October, maybe we see the second shoe drop.

Kevin: What do you think the effect of shorting those names has? Because we’ve seen before, if you short something, at some point it has to be covered. Somebody has to go back in, buy it, does the shorting of those stocks have any effect on what we’re seeing right now in this little rally?

David: Well, that’s right, to close out a short position is to go back in and buy that asset back, and it puts in a temporary floor, maybe even boosts the price. And the big movers in recent days are the most shorted names, where covering of shorts or hedges forces violent moves to the upside. I’ll give you an example. Over the last nine trading sessions, the Goldman Sachs most short index is up 22%. Twenty-two percent in nine trading days! During the same period, the SMP is up 6%. The 6%, nine days is one heck of a move, but more than three times the move on the most shorted names versus the major index. 

This is what Doug Nolan, my colleague, describes on the short side as a three beta problem. In a short squeeze, you’ve got single name stocks that can simply take you out, which is why you’ve got to be cognizant of risk management, which is why a certain strategy— If you’re going to be on the short side, a certain strategy needs to be employed, and only employed at particular stages within a bear market. 

Risk controls are important on the short side. Risk controls are important on the long side, too. What should now be obvious, following the last six months, is that very few Wall Street people, very few financial advisors, utilize any risk controls at all. You’re there and you’re long, and it’s going to be playing the patience game getting back to break even. So traditional money management, let alone in venues of alternative investing, you’ve got to have risk controls, you’ve got to have processes in place that reduce risk as price action is moving against you. And I think anyone listening can identify with this. If you’re working with a broker, you tell me, what were the risk controls in place and how were risks mitigated over the last six to nine months? Or are you suffering the Tesla losses of 30%, the NVIDIA losses and semiconductor stuff, 45% or more. Netflix down 67%. When you look at that hole in your portfolio, remember that what was missing was risk mitigation.

Kevin: A couple of weeks ago you talked to Doug Noland, and Doug is definitely into risk controls, both on the long and the short side. You can also look at these markets and say, “Well, gosh, they’re way overvalued. Let’s just go short.” Well, without risk controls, you can get into trouble both directions. 

But you’ve been talking about the longer-term trend. We were talking about looking for a college for your son. Yes, it will be important what he decides, and maybe the major that he decides will be the one that he finishes with. But the long-term trend of his life— All he really needs to do is avoid some really stupid decisions because the trend, if he picks the right place, is probably going to move him forward. 

I look at the markets right now, Dave. We went through, what, 12, 13 years of what we would consider a bull market? Now, a lot of it was artificially stimulated by a Federal Reserve that printed a lot of money and artificially lowered interest rates. But you’re still seeing this—the long-term trend, what we call the secular trend—as being a bear. Am I correct?

David: That’s correct, and I think when you think of these long-term trends, what’s important in terms of the action to take, or the perspective, what’s important is what happens next. And to the degree that you haven’t closed off options—we’re talking about investing—it’s that you haven’t so catastrophically lost money that it takes you 30 years to make it back. But what happens next is really important. 

I think about that for my kids, too. Get through college, but what happens next is the most important thing. And what happens next after that is the most important thing. Because when you’re making decisions, you see a series of options open up that could not have been anticipated prior to. And when you’re investing, you just don’t want to take the major hit. So what we had on the first half of the year was a healthy first round in what we view as a longer-term bear market. We suspect this to be a secular long-term move. We put that in the context of the liquidity constraints introduced by global central banks in response to the global inflation problem, and this is a very different environment than we had two, three, four, five years ago.

Kevin: Dave, I remember the 1970s, and I bring that up because of the inflation that we’re experiencing right now. But we’re going to get, just like we did in the 1970s, probably whipsawed back and forth with good news reports that inflation is going away, and then bad news reports or big bills at the grocery store. So we have to have that longer-horizon view, even with what’s being reported on inflation.

David: We’ve often referenced 1968 being the end of a bull market, which really started post World War II, so 1949 to 1968 was a great bull run in equities, and then things were not so bright between ’68 and ’82. Except when you dig into the details further, what you find is that within that bear trend there actually were not only significant declines, but also significant increases in equity values. And so, to your point, things were not on a straight-down basis. Just because it was negative didn’t mean that it was catastrophic every day for 10, 12, 15 years. 

The inflationary surge and fade pattern of the ’70s — again, it would be a real issue. Inflation would be in your face, and then all of a sudden it would begin to fade and things would appear to get better. Again, getting considerably worse and then much better, and the shifts from down trend to up trend in the stock market during that same timeframe, they reflected a bifurcated market response to policy choices, to uncertainty, and it made the investment backdrop frustrating. 

You look at the modern investor, particularly today, who’s so accustomed to just buying an index that seemingly only moves higher and higher, and this is a new reality. Again, the surge we’ve had of inflation— I think we’ll have some fade and then another surge again. But very clearly, financial assets are not a one way bet. When I talk about stocks and bonds, financial assets represent volatility both ways, and I think there’s a negative bias for financial assets coming. 

I would base that on extreme overvaluation as the starting point, circa 2021, and secondly the gradual working off of a multi-decade binge on debt. A super-cycle in debt accumulation is what preceded this period of time. Not surprisingly, it’s going to be followed by a long period of time where excess accumulation of debt is worked off—is worked off via higher rates of inflation and a phase shift to higher costs on debt. 

The net result is ultimately in the marketplace a shrinkage of the audience for new issuance, and system-wide capacity constraints—which people are bumping up against, which companies are bumping up against—and that curtails further credit expansion. But what we’re talking about is a stop and go market. 

Literally six weeks ago, four weeks ago, Doug Noland and our whole team is talking about the freezing up of the high yield market and of the investment grade market. And then in the last few days we’ve had full pedal-to-the-metal as we’ve had issuance of investment grade and high yield debt go absolutely crazy. Stop and go. Press the gas and then slam on the brakes. I think you also have a general description here of the central bank policy responses. Again, a surge and fade in statistics, and then a surge and fade in the policy responses, and then a surge and fade in market pricing. So the important piece is to see whether the broader trend in terms of market pricing is higher or lower. That I think you do have to get right.

Kevin: It reminds me of something that your dad taught me back in the 1980s. He talked about— There are times in the market where it’s like pulling up to a stoplight that’s going green, yellow, red, green, yellow, red, all at the same time. And you have to try to make a decision based on that. Obviously you don’t want to use the light as your indicator.

David: Yeah, and that was his best description of stagflation, where you’ve got all kinds of things happening which are just not sending clear signals. You don’t have good information, and it’s not crystal clean and clear, and so there’s confusion. Sitting there, is it red, do I stop? Is it green, do I go? Is it yellow, should I proceed with caution? So we think the process, which has held true for hundreds of years, one of extremes in valuation from extremely overvalued to extremely undervalued, that is in effect, that is what is unfolding, and it’s going to take a long time to play out. 

This week’s CPI [Consumer Price Index] report is likely to be an improvement from last month’s negative surprise. Does that mean it’s the end of the trend? No. Does it mean that there’s temporary moderation of the trend? Sure, I think that’s fair. Have we hit peak inflation? Maybe. But a long period of above-target inflation, I think that’s a given, and what the market is going to want is certainties. The market is going to want to say inflation is over, everything’s okay, let’s go speculate on the basis of what we had in the last 40 years. 

And again, there’s such a desire for certainty and an alleviation of uncertainty that I think there’s too much in that process of extrapolation, of one data point and what can we conclude from that? Maybe we have a higher number. Do we finish this inflation surge actually in the double digits before the fade? Or is the fade, again— Following the surge in inflation, is the fade already in effect because we’ve seen commodity prices that are receding considerably? Yeah, I would just say this. However the statistics take shape, the reality of inflation driving asset price volatility, and valuation mean reversion, and Fed policy towards tightening, that’s what we have for several years ahead of us.

Kevin: You mentioned peak inflation, and we’re very close to double digits, even using the government’s numbers, which are usually understated. But the Bank of England just recently said that they don’t see peak inflation coming out until we hit 13, and they’re seeing that a couple of years down the road. Let me ask you about hard assets because hard assets usually are where you go when you’re experiencing inflation.

David: Well— And when I mentioned financial assets earlier, I mentioned there being a negative bias. What I mean by that is you have continued pressures that are punctuated by relief rallies. And I think hard assets are on the other side of that equation. Continued positive pressure, the bias is positive with punctuated downturns. So hard assets are going to have glorious quarters, there’ll be some abysmal quarters with the bias being higher in line with supply constraints and with other secular inflation pressures coming both from monetary and fiscal policy desperation. 

So again, there’s a contrast here between hard assets and financial assets. Financial assets on the other hand are going to grind lower with glorious rallies. I think that’ll continue to entice households and the average investor back in, the proverbial burnt bandaged finger wabbling back to the flame. But with the bias being lower in line with Andrew Smithers’ conclusion that based on Q and based on Shiller metrics, your average annual performance inequities will disappoint merely as a consequence of a buy-high starting point as a very valuable input. Positively compounding returns is going to be the exception, not the rule for your typical investor.

Kevin: Okay, so we’re talking about the long-term secular trends, which you feel the financial markets—it’s down, and with hard assets it’s up—but we also have to talk about seasonal trends. We’re coming into that fall season that’s usually not real friendly to stocks. What’s your thought?

David: Yeah, summer rallies are not uncommon, in part because volumes are very, very low, and so it’s easier to push prices around, in essence manipulate prices where you want them to go. We do have runway for this current rally to extend through month-end. The moment of truth comes when you’re out of the low-volume summer months—again, easier to manipulate a low-volume market—and we come back into the higher volumes of autumn in what typically has a negative seasonal bias.

Kevin: If you look at the convergence of events, we don’t just have October coming, which is usually a really bad month for stocks, but the Federal Reserve is reducing its balance sheet right now, or at least that’s what they’re threatening.

David: Yeah. So when you add to the negative seasonal bias—that September, October negativity—the Fed’s expected increase in balance sheet reduction, if I’ve said that correctly, that’s supposed to begin in September. Again, they’re already supposed to reduce or have a limit of— I forget what it was, $40, $50 billion in mortgage backed securities and Treasurys, but they’re nearly doubling that to almost $90 billion on a monthly basis. Now, again, this is a cap. they’re not required to do this, but it will not exceed that number. 

So to begin in September, you’re adding supply to the Treasury and mortgage backed securities market, and you might find both equities and bonds under pressure again in that timeframe, factoring in seasonality. But also keep in mind what we had the first half of the year. We had—let’s call it first-half synchronicity, correlation between fixed income and equities, both moving down at the same time to the chagrin and surprise of most investors. 

There’s a reference point here, and there’s a commonality here. The inconvenient truth of financial assets is that they share a common ground in valuation of performance. Stocks and bonds, again, this was to the surprise of many in the first half of the year, but they’re impacted by the cost of capital. If interest rates are moving higher, bonds are going lower. If interest rates are moving higher, stocks are moving lower. Who knew? 

The extra concern in September, and this was noted in a recent Barron’s article, titled, “The Fed is about to ramp up balance sheet shrinkage, it may get dicey.” To be honest, there’s a lot that’s lacking from the Barron’s magazine these days, including the titles to their articles. I don’t think that article ever would’ve been published with that caption or whatever under Alan Abelson, but it’s a different letter. So anyways, September is when principle payments of 25 billion dollars monthly no longer get recycled, reinvested into that paper. So that was a large offset to the negative impact from QT, or quantitative tightening, and again, those principle payments of 25 billion monthly, according to this Barron’s article—no more. Not as we head into September. So, the real bite of quantitative tightening arguably has not been felt, but will be as we head into September.

Kevin: Yeah. Morgan, one of your economists, Dave, here at the office, just basically said a lot of times you don’t feel the impact of some of these things for as much as 18 to 24 months. 

And so, I have to just digress a little bit because you brought back good memories. Alan Abelson, you mentioned his name. Maybe some of the listeners don’t remember who he was, but he was a wordsmith at Barron’s. And I remember when you interviewed him on this Commentary before he passed away. Alan Abelson really will be missed. It brings me back to some of the days— We were talking last week about forward guidance. The Fed has gotten so much into talking the market that I think everyone expects it. But I remember when I was in college and I was studying economics, you had Volcker and then you had Greenspan after that. Those guys didn’t show their cards.

David: No, I still have Abelson’s home number and work number in my contact details on my phone. I know—

Kevin: Good memories, he was a great guy.

David: I know he is not there anymore, and Westchester is missing one of the greats. But when I was growing up, that was one of the things my dad always referenced was, “Read Barron’s, but particularly the opening article by Abelson.” And so Abelson had made an impression on my dad, and that was must reading as often as Barron’s comes out. 

Well, last week we talked about the move away from forward guidance by both the Fed and the ECB. And maybe that’s a temporary move on their part, but that is the idea of forward guidance—the idea that you let the market know well in advance where you’re going with a policy choice so that there’s no market surprises, and things get priced in pretty efficiently. And so it reduces your emergency management measures that might be necessary later on. 

Sometimes telling the market what to expect is enough to create a reality within the marketplace, because that’s what behavior you see elicited from speculators. Behavior among speculators is to anticipate the change before it occurs, and in this case, if you’re going to give details, game the system for a profit. Central bankers like the fact that they can, in effect, trigger investor behavior through forward guidance, and move markets just by speaking about what’s going to happen next, regardless of the actions that they take, regardless of actual follow through. 

Now, the reality is, credibility necessitates a degree of follow-through, but you can say one thing and occasionally not even follow through because if market conditions have shifted sufficiently in the interim, the justification for policy shift may have gone away, meaning that jawboning on a particular topic can be as powerful as actually shifting the policy. And this is pretty interesting, that this forward guidance is being put on the shelf.

Kevin: I just got off the phone with a client who spent months in France, and she was here back in the United States for a few weeks. She’s headed back to New Zealand tomorrow. And I joked with her, she’s a moving target—she and her husband are a moving target—all the time. But she listened to last week’s show, and she was actually, Dave, in France I think when you were there, climbing that hill. 

But you mentioned follow-through last week. You and I were talking about, it’s so important to have follow-through. Otherwise you become untrustworthy. She brought that up just before I came into the studio today. I was talking to her on the phone and she said, “I really appreciated what you were saying about follow-through.” But there are certain market conditions, Dave, that, no matter what you try to jawbone as far as talking, force the issue. I mean, doesn’t the fact that the Fed can’t just randomly print up as much money as they want without inflation, doesn’t inflation force a particular action?

David: Yeah. Well, I mean, if you look at how silly the ECB looks today in their inflation fight, when they’ve really not done anything of a muscular nature, I think inflation does change the environment that central bankers are taking action in. Unique element, maybe something of a more muscular action and not just talk is brought out. So we had, a year and a half, two years ago, the transitory references early on as inflation was starting to heat up. It was going to be transitory. And I think they were hoping that it’d be sufficient talk to keep inflation expectations modest, and to keep those expectations un-rooted, and I think they were hoping to avoid having to do anything. Don’t raise rates, but just talk it down. And now all of a sudden it’s here and it wasn’t transitory, and it does require something of a more muscular action. But last week that didn’t keep Neel Kashkari of the Minneapolis Fed from trying to make the case that in fact inflation will be transitory indeed. And this is— It’s almost like, has he been reading the news headlines, is he disconnected from market realities?

Kevin: Transitory—

David: Has he even forgotten to look at the CPI and PPI [Producer Price Index] prints of the last year?

Kevin: Yeah.

David: This is last week, and it would be humorous if he was wearing a bright red clown nose or was dressed for the occasion and intended the messaging as humor, but it’s less amusing and more tone deaf when you consider a current reality of near double-digit CPI.

Kevin: Okay, so let’s go back to that, all right? Because they can say whatever they want. I mean, Kashkari, that’s just ridiculous to continue to talk about inflation as transitory when we’re almost at double digits. But forward guidance, if it is indeed shrinking— This takes us back to the ’80s, early ’90s, when, remember the word Greenspeak, which means you can’t tell what’s going to happen next from Greenspan?

David: Yeah, and I think that’s one of the things that is shifting. The market’s going to have to get used to the old ambiguities again. Some of the things that they’ve grown accustomed to knowing they’re not going to be permitted to know any longer. There’s going to be more guesswork. And forward guidance is shrinking in prominence in large part because there’s an element of power embedded in being unreadable and unpredictable, and that’s the power that they want today. It’s almost power that you would see in game theory. Greenspan perfected this in an earlier era by uttering Greenspeak, as you mentioned, for which there is no Rosetta stone. Nobody knew what he was talking about. I’m not even sure he knew what he was talking about. And that made it very convincing that he knows what he’s doing, even though we don’t understand it. 

And so the Fed, for one, cannot afford to be gamed, cannot afford to be front-run in the current environment where the stakes—we’re talking about financial market stability, even viability—where the stakes are so high. So no one wants to raise rates. That’s true. They need to raise rates. They don’t want to. So the market has grown accustomed to saying, “Well, tell us how much and when, and we won’t throw a hissy fit.” And again, the Fed doesn’t want to be held to that standard. As long as inflation is an issue, central banks are going to be facing this conundrum of, “How clearly do we communicate, or do we regain the old power of Greenspeak—the world in which no one understands our language?”

Kevin: I remember reading an article when Greenspan was in by someone who knew him well. They said that not only can you not predict what he’s saying, but you really can’t predict where he’s getting his information. Apparently he had a penchant for taking a two-hour-long bath every morning and reading things as random as the receipts for dry cleaning, because he felt like that tied into just an understanding of economic health. It probably did, to be honest with you. Greenspan was an interesting guy. He wasn’t perfect. He changed quite a bit from the 1960s when he was good friends with Ayn Rand, and later became an inflationary Fed chief. 

But let’s talk about the cost of capital, Dave, because money’s been free. Money’s been free really for the last few decades. They’ve been able to print an awful lot without having this inflationary beast ready to devour them, and so what changes when capital starts to become expensive?

David: Yeah, everything changes. And I think we’re at the front edge of a longer-term increase in capital costs. As long as we’ve been doing the commentary, Kevin, I’ve thought that we were on the edge of a change in the bond market. So just for credibility’s sake, keep in mind, I’ve thought that there was a shift to higher rates for more than a decade, so don’t take this very seriously.

Kevin: Missed it by 14 years, missed it by 14 years.

David: But I think we’ve just seen a change—

Kevin: Okay.

David: —in the environment, and the revelation is scary. If in fact, we are moving into a longer-term period of increasing capital costs, you’ve got so many financial structures which are unsustainable with higher rates. And what that suggests ultimately is that insolvencies are a wave of the future. Zombie companies that operate very efficiently with free money don’t exist when the cost of capital goes up. So if we see that the next inflation number comes in lower, just wait. 

We talked about the surge and then the receding aspects of inflation, maybe we’ve got an ebb and a flow, a temporary reprieve, right? So these zombie companies can gain comfort again, and maybe if CPI is coming off the boil, rates are not going higher anymore. This temporary reprieve would be great for those companies. They need the free money for their existence. 

We don’t even have those inflation numbers. We will this week Wednesday, and investors are trying to determine when rates are coming down. There’s an urgency to see how soon this whole nightmare of increasing interest rates is going to be behind us, as if that’s the length of a cycle. And I think it’s really intriguing because most people forget just how long these bond cycles last. The shortest in a 200-year period of US interest rate history was a 22-year period. The longest was 36, and we just took that out, arguably with an over 40-year period of declining rates from, let’s call it 1982, to last year. So when the Fed is moving the opposite direction, with cuts instead of hikes, that’s what the market’s trying to figure out now. 

The assumption is we will see lower rates soon—that’s what we see in the yield curve. And frankly, it suggests that a lot of market participants think only in short timeframes. Clearly we’ve seen that with options traders. We’ve seen that with investors that determine the value of a strategy on a monthly basis, not on a quarterly basis. But I think it’s fair to say that there is a huge number of investors who underestimate how high rates might actually have to go, and for how long.

Kevin: Well, correct me if I’m wrong, but rates are going to have to get above the inflation number at some point, whatever that looks like, they’re going to have to get above it before we probably are finished seeing the rates rise.

David: Well, that’s right, and Stanley Druckenmiller is the first to point out that if you’ve got inflation historically over 5%, it’s going to take a rise in interest rates above that inflation rate to kill the inflation trend. And that’s a lot of pain. We’re at 9% inflation now. Let’s say it moderates to five, six or seven. We still have to see rates go above that to kill this beast. That is very game-changing for a lot of financial institutions. 

So we agree, this is a three- to five-year process at the minimum. And again, if we’re referencing longer-term interest rate trends, then we’re talking about multiple decades to see this really unfold. So the fade cycle is something that we might see right here, right now. Lower interest rates with a lower inflation number. Inflation heading to 5 or 6%, or in that neighborhood. But we are talking about, again, an ebb and flow. Maybe we’ve hit the peak. Maybe we’ve not hit the peak. What we certainly have not hit is the end of this cycle, and it’s a much longer-term trend. So I would be careful to take a number this week, or something that is proof positive for you that things have improved considerably, and extrapolate that trend indefinitely.

Kevin: So the equities markets, I mean, we’ve not seen them revalue themselves back into a point where we would say that they are of value. There’s still danger—I mean, probably could be extreme danger—in the equities markets.

David: Yeah. I mean, the danger in the equities markets is critical, though prices are not presently cascading lower. You wouldn’t think that there’s a lot of danger there now, but we know that inflation has removed much of the central banks’ willingness to intervene. They can very quickly accelerate inflationary pressures with implementation of the Greenspan put or any version of a put. And so, because inflation’s already in play, any action that they take that exacerbates the inflation problem has to be considered very, very carefully. They will proceed with caution. In essence, it’s raised the bar for what would bring them off the sidelines, would bring them back into the game as most valuable player, market stabilizer, and whatnot. What level of pain do the financial markets have to see before the central banks are willing to intervene? That is a market mystery, that is something that the markets are not real keen on figuring out, but they don’t have a clear picture of, either from the ECB or from the Federal Reserve.

Kevin: So if you could picture the market speculator sitting across from the Federal Reserve— Up to this point, over the last few years, the Federal Reserve would tell you ahead of time what cards they’re holding. But right now the market speculator’s having to guess— Wouldn’t you say, what the point of pain is for just— Will they allow a recession, or are they going to lower rates? We have this inversion in the interest rates right now where short-term rates are almost half a point higher than long-term rates. This is a pretty radical inversion, which seems that the market speculators right now are thinking that the Fed is going to probably break soon to the downside on interest rates.

David: Yeah, which implies that the bond market is still very concerned, and probably anticipating some sort of an event which the Fed will have to respond to and lower rates. It’s almost the clearest indication of bad news coming is the bond market yield curve inversion, which suggests that, not too far down the road, the Fed’s going to be forced to do something. And the question is, what is the point of pain? Market speculators now have to second guess where the point of pain is, and try to more adequately hedge market risks. 

In this new world of delayed policy response to pain, this gets tricky. The classic Greenspan put is more elusive, so if you’re looking at the markets right now, we talked about the most-short index skyrocketing 22% in nine sessions. There’s no surprise that more hedging has been in play, because they don’t know when and where the central bank will back them and back their play. And so that’s on display right now in the current rally. This is a rally that has short-covering dynamics to it, so more covering of hedges with explosive price moves to the upside. That’s characteristic of a bear market rally far more than a fresh bull trend which is gradually, slowly, methodically climbing the wall of worry. 

This has the hallmarks of a spirited bear market short covering, which, again, suggests an interesting dynamic as we stretch out our imaginations to September and October. When the bear is back, generously let’s say if the bear is back, re-hedging has the same effect as selling without actually exiting a position. So downward pressure, negative price action as we come into September, October, and the re-hedging will be back this fall, and the question of when or if the Fed will support the markets remains unanswered, whereas inflation— More data on that this week. 

Where’s the balance sheet reduction? Time will tell. To what degree has quantitative tightening faded from the narrative in favor of accommodations of one sort or another? Markets are going to dictate that. But you can already see the yield curve suggesting that there’s not going to be a lot of flexibility in terms of shrinking the balance sheet. There’s not going to be a lot of flexibility in terms of continuing to raise interest rates. In fact, something will happen necessitating a move lower in rates. 

So where did forward guidance go? This is a 20-year communication tool being set aside, even as rates are increasing potentially into a recession, technically in a recession now. The market wants assurances. The market wants certainties. The market wants confidence to trade into a growth trend. And without those things, the assurances and the certainties and the confidence to trade into a growth trend, the market looks for a bid.

Kevin: So pretend I’m Joe Biden for a moment, and Joe Biden is going to say, “Yes, Dave, you’re awfully worried for no reason. Just look at employment. Just look at the jobs.” Did somebody throw a seasonal bone to Joe Biden, just because we’re going into an election period of time here over the next couple of months, with the employment report? It sure seemed to be a lot better employment than what was predicted.

David: I’m Joe Biden. I’m at the beach. Or I’m Joe Biden—I’m trying to imagine I’m Joe Biden. I’m Joe Biden, I’m in Delaware for the weekend, an extended weekend. I’m Joe Biden, I have Covid again, and again, and again, I’m Joe Biden and the BLS just did me a solid. 

I mean, ordinarily last week’s non-farm payroll number would be considered positive. You got a surprise beat—528,000 jobs versus the 258 which were expected—and an unemployment rate that shrank to 3½%. Except that what you have from the markets—particularly your equity markets—the equity markets want a reason for the Fed to accommodate and bring back lower rates. The labor market improvement does not help the markets. The labor market improvement may be a political win generously served up for the Biden white house— And by the way, that’s not farfetched when you look at the seasonal adjustments, when you look at the other statistical aberrations in the number, not to mention the extreme divergence that you’ve got from the household survey, which has been showing job losses, not gains, since March. The markets in fact need bad news to bring the Fed posture back to one of accommodation. So in this case, good news, the non-farm payroll numbers, is bad news.

Kevin: Well, but there are other reports other than what the BLS put out, the JOLTS report, the JOLTS numbers, which is current job openings, those also dropped. So it didn’t drop quite as significantly, could it be that good news is bad news right now? Well, for the markets, it is.

David: These are odd statistics, and making sense of them is not going to be easy. The JOLTS numbers, current job openings drops to 10.7 million from over 11 million, which adds to an odd fact set when judging the current labor environment. Post Covid, these are very strange currents to try to figure out. The shrinking labor force, right? Labor participation continues to decline. We have increasing openings, going back to the JOLTS numbers, and what that trend has been in recent months and quarters. Not enough workers, particularly skilled workers, and you hear this from the business sector routinely. We have increasing wages. What does a recession look like if you have declining economic activity, which certainly the GDP figures suggest, and strong demand for labor, which is the opposite— It’s just not clear, things are not clear post-Covid. The waters are muddy, and frankly, the way that the last non-farm payroll report read, some of the muddying seems intentional. 

July 2021, going back to that issue of seasonal adjustments, July 2021 seasonal adjustments were negative 67,000. Same season, but for July 2022, it’s a positive 287,000. That’s a swing of over 350,000 jobs, and that’s just on the seasonal adjustment. So not seasonally adjusted, your non-farm payroll number is 152,000. That’s interesting. So instead of bring out the pompoms and cheer lead, 528,000, an amazingly strong economy, you start taking away the statistical creations and actually look at jobs filled, and you’re closer to 150,000. A big deal. 

So the seasonal adjustment was huge, then you add in 85,000 jobs for the birth-death modeling, that’s 85,000 more than the 2021 numbers, and you end up with an impressive reported figure, the reported figure of 528. How many jobs were created in July? That’s still not clear, the question is one for the business community to really report on and tell, not government statisticians. So, I mean, BLS, Bureau of Labor Statistics, has counted 1.68 million new jobs since March. Meanwhile, you look at the household survey since March. It shows a loss of 141,000 full time employees and a loss of 78,000 part-time employees. Something ain’t right. Something ain’t right. I say, we just go with the BLS numbers, shouldn’t we? They’re as good as gold, aren’t they?

Kevin: Well, we talked about gold earlier, gold being off about 3% right now, but actually up in just about every other currency.

David: Well, and at the same time you get silver rebounding aggressively off the lows, both metals are trading positively. The real question is, how will they behave in the next downdraft? We have some concerns, if you will, or if you want to say that we’ve taken a more conservative posture— We don’t know what the next phase of liquidation and the equities markets looks like given the fact that the market has no idea what the Fed will do to save them. So what’s the downside, and how dark does sentiment get? And to what degree does that negatively impair a great asset over the short run? Will these metals be under pressure if liquidity is prioritized and cash needs to be raised in the context of hedge fund blowups and mass liquidations coming into September and October. 

Will they soar? I mean, they could do the opposite, they could soar. As the central bank put lingers in limbo, and that creates solvency issues, and all of a sudden you’ve got the 2008, 2009 discussion of counterparty concerns that drive investor security needs into the arms of a gold position. 

I can make the case either way that this fall is dynamic for the metals. I’m going to own them either way, but the bias for metals, again, if you stretch back the timeframes and stand back from the current events of the day, the bias for metals remains positive, with intermittent volatility, which is an uncomfortable fact. That is far more comforting than owning an asset, stocks and bonds, where the bias is negative, and a mere rally is all the comfort you get.

Kevin: You’ve been listening to the McAlvany Weekly Commentary. I’m Kevin Orrick along with David McAlvany. You can find us at, And you can call us at 800 5-2-5-9-5-5-6.

This has been the McAlvany Weekly Commentary, the views expressed should not be considered to be a solicitation or a recommendation for your investment portfolio. You should consult a professional financial advisor to assess your suitability for risk and investment. Join us again next week for a new edition of the McAlvany Weekly Commentary.

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