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The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Will Turbulent Trump Tweets Force Powell’s Fed To Comply?
December 4, 2019

“When someone is actively funding the market, actively participating in saying yes, and then doesn’t show up, they chose not to. So the repo market interventions continue to suggest that the surface level calm that you have in the credit markets is ignoring something just under the surface, issues which at least a few banks are more sensitive to. So if you’re in the habit of lending overnight, and choose not to, what are your reasons?”

– David McAlvany

Kevin: David, as a reminder to the listeners, at the end of each year for the last 11 years we have asked them to send questions in so that we can have end of year, early beginning of next year, 2020, answers to those questions. So we would encourage you to, as a listener, send those questions to We usually try to address just about everything that we are sent.

David: Kevin, it’s a little bit like getting ready for a race. I get a little nervous because each year I experience a little bit of anxiety when we get the questions in because I think every year they have gotten harder and harder and harder, and I feel less qualified to even take a stab at answering them.

Kevin: Well, we have very deliberate listeners. It is interesting, Dave, how engaged the listeners are. You were just talking about somebody you were visiting with the other day who knew more about what you had said on the show than you had probably remembered.

David: (laughs) Right. So somebody who has been listening for years and years and years, it has been part of their educational process, and the accumulation of that information all of a sudden makes the questions harder and harder and harder. But send them in and at we will do our very best over one show or two, depending on how many questions we get.

Kevin: Another thing we have been doing for 11 or so years is meeting early in a restaurant here in Durango. They open it up a half an hour early for us. We sit at a back table. We discuss, the day before the recording, some of the things that are on our minds. It doesn’t always show up in the recordings, but it is amazing how it smooths things out as far as what we’re going to talk about.

Last night we were sitting and talking and saying, “Gosh, the news cycle feels like shock therapy. It’s like zap! And then you get this little bit of a release. And then zap! And then a little bit a release. But don’t you feel like we’re just hearing the same thing over and over, and over and over, and over again, and they are expecting reactions in the markets, and reactions in the voting booths – getting tired.

David: Yes, there are times when keeping up with current events, political affairs, market dynamics, it feels like observing an unhealthy co-dependent relationship, because there is a cycle to it. There is a similarity, a pattern of saying this and that, doing this and that, and the reactions that follow. There is hope that things are going to change, and that this time will be different, and then that hope lasts for a little while, or at least until you kind of re-enter that negative part of the cycle all over again. The weeks wear on, and again, it’s on again, off again, posturing with Donald Trump and Xi-Jinping.

Kevin: It’s the China thing, over and over and over.

David: It’s on again, it’s off again, it’s on again, it’s off. The inquiry aimed at Trump’s ouster, taking him out of office, at a certain point, again, it’s a feeling like the news cycle – I don’t know, maybe another way of looking at it is like being snared in a sticky spider’s web. There is the content, which is there, and I have done enough interviews with Bloomberg and CNBC and Fox, the content is produced, it’s curated. You have a production team who is deciding what they want to talk about, and who they are going to talk about, on those particular things. When I say it is produced, it is crafted. And the crafted content is driven, not just by a point of view on a particular issue, but more fundamentally by assumptions that tie to a particular philosophy.

If you’re trying to figure out what news organization is going to present a certain set of facts in a certain way, then you are talking about the assumptions tied to a particular philosophy. I guess that is why it feels like a captured conversation, a news cycle that feels a bit like a spun web. In the end, the stickiness of the messaging is so that the viewers can be drawn in – they know who their audience is, given that sort of philosophical or world view perspective. In the end they are trying to market products and advertising is the primary money-maker. But on that issue of philosophy driving the interpretation of events, that is kind of the news filtration and representation process.

Kevin: It’s funny, you mentioned products. As you know, when I was going to school, before I interviewed here 32 years ago, I was a toy store manager. And there was a change in the entertainment and toy industry about that time back in the 1980s, where you started seeing movies and television shows coming out to actually market products, so you had shows that were actually toys that kids could go buy, and large product lines that they could buy.

I think of the same thing now, that products are marketed in the market itself. You think about this news cycle, Dave, Bloomberg is producing an awful lot of the news, but they also sell the algorithm program for Wall Street to trade on that news with keywords. So it is sort of a vicious loop where, let’s go ahead and make the news, let the algorithm react, and then let’s change the news, let the algorithm react. It’s sort of dehumanizing.

David: Do you think Michael Bloomberg would be interested in influencing the outcome of the election?

Kevin: Oh, not at all.

David: Owning one of the primary business news outlets? Do you think there might be any influence in terms of articles that are allowed to run?

Kevin: Maybe editorial [unclear] voting booth algorithms, as well. Maybe he could do the counting there.

David: (laughs) This last week my son and I discussed the difference between a social democracy and republicanism, mind you, nothing to do with the Republican Party. There is a big distinction there between republicanism and the Republican Party. But you are talking about a political philosophy which was refined in Rome, it evolved further in Britain, and then was repopularized following the Enlightenment by Montesquieu, a French philosopher, and then here in the United States by Madison. It centers on ideas like the rule of law being a priority. There is an emphasis on rights, but more on the responsibilities of citizens.

Kevin: That’s the key, responsibilities. People don’t want to take responsibility right now. They want to be comforted.

David: A week or so ago I had several friends, Bob and Matt, thank you very much, you were keen to remind me that this was the system of government put in motion by our founders.

Kevin: A republic.

David: That’s right. So officially, we are a republic. When I describe the USA as a democracy, I do so as an observer of what we are shifting to, and more and more it is toward not just a democracy but a social democracy, with an enhanced role for the state. The state is to act as guarantor for the programs, the collective redistribution of wealth in keeping with a set of values which are expressed by a cohort of the loudest, maybe even the most prolific set of voters at any particular point in time. So what we are, and what we are becoming, is not what we were, or were intended to be.

I think that was the clarification I probably need to make a week or so ago in talking about our democracy. My point is that, to a degree, now, the news feels familiar. The pundits seem repetitive. And the messaging is somewhat monotonous, but it is consistent with an operative political philosophy.

Kevin: We were having a discussion this morning before we came into the studio, not you and I, but one of the other guys who I work with here. He said, “You know, we live in a period of time when the victims are becoming the heroes.” I hadn’t really thought that through, but if you look at society right now – you were talking about social democracy versus actually a republic, which requires responsibility. The heroes of a republic were people who stood up and took responsibility for what they did.

We now seem to be moving socially to where it is victims, victims, victims crying out, and they are sort of the heroes. You are talking about the news cycle, but I think we see that as well. We joke about snowflakes, or what have you, but how often are you actually seeing people being given credit for taking responsibility for action, either sinking or swimming based on their actions?

David: But again, public policy circles are coming around to the issues which represent the values of our day, whether that is a priority on global warming and climate change, or whether that is a priority on re-equalizing the world. There have been income disparities, there are wealth disparities, the gaps between the rich and poor are growing. And now there are new initiatives. Powell is talking about how monetary policy could be used. Neel Kashkari at the Minnesota Fed is talking about how monetary policy can be used for redistribution of wealth.

Kevin: Socialized redistribution. It’s the difference between that and a republic, or responsibility.

David: Yes. I guess, when I look at the news, is there anything new to discuss?

Kevin: Right. Sometimes no.

David: Kind of same song, different verse, but then again, of course there is. Yes, we have home sale figures which are very positive, just out. And we have GDP figures, which according to GDPNow at the Atlanta Fed, that’s their production deal, they’re on track for a much more positive 4th quarter.

Kevin: It’s amazing what 60 billion dollars a month does, Dave. We’re getting some nice positive numbers, for what?

David: I read a fascinating article over the weekend and it was being argued, and this was kind of an argument pro modern monetary theory, that we should be giving money to the poor because it increases economic activity.

Kevin: And we can print that because we don’t actually make it in revenue, so we’ll just print it.

David: I’m thinking to myself, yes, no, duh, of course it does. What do you do with money? You go spend it. And it’s going to have an ancillary benefit to those in your community because this is what we call velocity. You take one dollar and spend it, and the person who receives it from you is going to end up spending some portion, or all, of it, so yes, there is an economic benefit or boost.

Kevin: Just like there was in Germany in 1920-1921.

David: That’s right, so on the front edge, you have economic benefits, but on the tail end you have something which can be cataclysmic in terms of its consequence. So you have employment figures which are still positive, you have Chinese industrial production figures which were not positive, they were off almost 10%, which really does suggest that global demand is still under the gun, and all of these things are important signals. You look at them over and over again, and you talk about them over and over again, and they’re different every time you talk about them.

Why are they still important? Because they send indications of change, and it is the change that they suggest that is so important. Doug Noland – we talk about this on a weekly basis, multiple times a week, on our team – he is one of the leads for our Wealth Management Team, Manager of our market short product. Small shifts in the myriad indicators we watch, these are the telltales, which in retrospect hold prognostic and predictive value.

Kevin: But let me ask you, because the central banks are so integral at this point. In a way, they are like training wheels for the market. Remember when your kids were learning to ride a bike, you put training wheels on, and the training wheels allowed that bike not to fall over so they could actually think that they were riding a bicycle? That’s not a bad idea, but it you put the training wheels back on the bike later, are you really riding the bike the way it should be ridden, or are you relying on the training wheels?

David: That’s right, so there is always news to consider, but the dominant themes continue to repeat – trade conflict, required central bank accommodation. What is it going to take to extend the asset price inflation? But central is the role of central bank monetary policy.

Kevin: The training wheels.

David: They are creating a perfect backdrop for speculation and for leverage to grow. We have seen this sort of a cycle before where leverage grows to heights that are rarely seen in the history of finance, and that is still a dominant, and yes, a recurrent theme. Nothing matters more than that. But of course it all matters. Again, you look at it over and over and over again, and does this really matter? Yes, it does.

Kevin: I will tell you, one of the more humiliating things, as a man, is to not be able to get a fire started. When you go gather wood, and we’ve both done this, I’m sure, at times, where you gather wood, you get your tinder together, you light the fire, and the wood is just a little too moist. So you get your fire starter out, or you start cheating. You pour that fire-starter on the fire. You’ve got a certain amount in the bottle. And I will tell you, Dave, there have been fires where I have used pretty much the whole bottle and still not gotten the fire started. I wonder, with all this liquidity coming into the markets, are we actually just trying to start a wet wood fire?

David: You look at the consequence of QE and you’re starting to get some feedback from various economic powerhouses in Europe saying, “Look, QE is not helping us here. It’s not helping us.” They’re talking about the long-term deleterious effects. Yes, it’s great in a crisis, but is it so good as sort of an ongoing thing? That is, I think, what is in question now. We have stock markets this week, which are, let’s face it, off to a rough start straight out of the gate. Trump was getting things kicked off with the announcement of metals tariffs on Brazil and Argentina, and then adding to downside pressure was a lower than expected ISM factory number. By mid-week we had Donald raising tariff stakes with France, which is an inconvenience.

Kevin: You’re a champagne drinker.

David: When it comes to New Year’s I don’t look at sparkling wine as my preference.

Kevin: It’s going to be more expensive this year.

David: It is an inconvenience for any of you who prefer champagne to sparkling wine for New Year’s, 2.4 billion in tariffs to the French. Then you have, following shortly thereafter, comments that Trump made from London that it might be better to – and it was funny, because literally, if you look at the sequence of comments that he made, we got the deal done. The trade deal is done, we’re just working on the details now.

Kevin: It’s shock therapy.

David: It’s almost wrapped up. It was almost like something snapped, but frankly, we’ll probably wait until after the election, probably better wait until after the election for a trade deal with China. This is why it appears like an abusive relationship. “It’s terrible. Now it’s better. Now it’s terrible. No, it’s all better now.” This back and forth is like a yo-yo effect in the market. “We’re down. No, we’re up. No, we’re down.” Who is holding the string of the yo-yo?

Kevin: Do you think, though, possibly, that’s part of how Trump negotiates, to keep everybody on edge all the time?

David: Absolutely, and so from his standpoint he is going from win to win. I think there are some consequences, relational consequences, but his tweets and announcements are enough to keep things on edge, which is to say, what he wants to say is sufficient to direct the markets up or down. Keep in mind what is behind the scenes. You have algorithmic, headline-reading manic reactiveness, which is driving 70-80% of market volumes these days – algorithmic reactions or overreactions to headlines. And in turn, will his tweeting and sort of feeding the machine, if you will, with the headlines that he wants – is that enough to force the hand of Jerome Powell?

Kevin: That’s an interesting thought, to me, because Jerome Powell, like most Fed chairmen, tries to maintain, at least publicly, some sort of distance from the political spectrum. Trump has been very, very vocal about Powell. There are times when he is praising him, more times when he is criticizing him, but it seems that if you’re having to try to manage price stability and you have, actually, a number of tweets that are coming out and changing perception of the people without you actually managing the money, it’s a weird thing, you have a lot of waves rippling the pond.

David: Yes. And so last Wednesday, where were we on the trade bill? Final stages, it’s considered done. Well, then we have the Hong Kong thing, the bill just passed to support the pro-democracy demonstrators as they have now been tagged. So that notwithstanding, Trump is in the marketplace, he is asking Powell to lower rates, he is asking for a lower value of the dollar, and this is the issue. Perhaps the power of the tweet is now how he intends to coerce Powell to get on board. No trade deal – what does that equal? It equals market volatility.

Kevin: Hundreds of points have dropped.

David: And that’s not rocket science. But too much volatility and the Fed must act. Is this sort of a grand scale game of chicken between – pick your parties – Trump and Xi? Is it a game of chicken between Trump and Powell, or between Trump and the whole world?

Kevin: And if it all works it might actually benefit us, but if you think about these dials, Dave, there are large, large dials that are being turned. We have trade deal dials, we have liquidity in the market dials with the Federal Reserve. These are large dials that are actually very, very dependent on public perception. And if that changes, or if something happens that is outside of the control of those large dials, unintended consequences will show up all around the world.

David: So we go back to where we started because we actually had futures which were suggesting a positive open on Monday, and then right as the market is getting opened we have the Brazil/Argentina tariffs. In the case of Brazil and Argentina, the pillar of the argument was massive currency devaluation.

Kevin: Do you think that was purposeful, though? Do you think Argentina purposely devaluated their currency?

David: Argentina has experienced a 60% loss in the value of its currency this year, and if you look at the 30% the year before or 35-40% the year before that, it can hardly be argued that was a deliberate choice. You have a currency in freefall, so you look at the Argentine peso and you can almost view it as the stock of Argentina. It is being sold off because the market looks at the new management which is now…

Kevin: It’s the old management (laughs).

David: It’s the old management, which frankly, is bad news for the company, and the future trajectory of the company, or in this case, the country. So Macri is out, and a puppet Kirchner government is back in, which is, again, like the CEO or the board of a company. Are they choosing to lower the share price or is this the market reacting? And I think it is – the market is signaling the election results as a catastrophic mistake from an economic perspective.

Kevin: Five years ago we were there, and 40% inflation was the rate at the time and it increased from there after we left. But remember, we had to operate in what they called, not the black market, but the blue market. So we have seen the effects of the Kirchner government, but isn’t it interesting that people still voted socialism back, Dave?

David: It’s not a surprise because people, when they are uncomfortable or insecure want someone to come up with big picture solutions.

Kevin: The victim is the hero.

David: So to try to contain the flood of money leaving the country in Argentina, you have an exaggerated currency slide in effect now, you have capital controls which are back in place. So I think this is a part of what we are seeing here. Trump liked Macri; Trump doesn’t like Kirchner or the new president, Alberto Fernandez.

Speaking of capital controls, there was a critical article from the Financial Times over the weekend, I forget the exact title, “Turning the Tank” or something like that, and it is basically the IMF moving the opposite direction from what is known as the Washington consensus, basically that the free flows of capital are beneficial to all the countries who have sort of lowered the barriers to entry. So if you allow for the free flows of capital, if you don’t have tight restrictions in place, then you see economic growth and benefits.

So the IMF is flirting with research which supports a directional shift, a 180, away from open markets and toward broad-based capital controls. It’s like, we’ve been here and done that, this is just reaction to the fact that we do have income disparities and wealth disparities, and it is being viewed as: globalization is to blame. Actually, what is to blame is central banks holding at bay the natural market function.

Kevin: Carmen Reinhart told us that to be able to really control things you have to have captive audiences. Capital controls – that is exactly what we are talking about. If you were a Venezuelan over the last few years and you wanted to get your currency out of the Venezuelan markets, you couldn’t. You just basically failed with the Venezuelan currency.

David: Right, so we should never forget that capital controls are like a Berlin wall. They are not there to keep others out, but to maintain that captive audience. And not only is this idea of a return toward broad-based capital controls reflective of the end of globalization. That’s a long-term thematic for us and we have talked about this many times with our guest Harold James, but it underscores and reinforces economic nationalism.

So on the one hand you have academics who will criticize nationalism in the political sphere, but moving in the direction of economic nationalism, again, a rhetoric of us versus them, is dangerous. And I think what they are doing will ultimately serve as a veil covering over the detrimental domestic policies, including inflation and massive economic redistributions.

So the IMF policy recommendations, I think, should be very carefully scrutinized as we go forward and as they further develop, because this is not an accidental thing. You do the “rigorous” academic research to figure out if an idea can be presented or is a plausible policy solution or recommendation, and then it is recommended to politicians, and then it becomes legislation. That is the nature of how an economic think tank or a group like the IMF vets an idea that way, and then promotes the idea, and then the idea becomes the world as we know it.

Kevin: I think it is important sometimes – I even get confused if I’m not stopping and listening when I hear. You talk about the end of globalization. Globalization is a good thing where currency can flow between countries. That is not the same thing as globalism. What we are really talking about here is, as you shift control to larger and larger entities – we’ve talked about the illumined few who are ruling the world, that’s globalism. That is not something that we are for. But globalization is very, very important for the free market to function. Capital controls keep that from occurring, and, let’s face it, the tariffs that we are talking about, that also is the end of free market globalization, or at least working that direction.

David: I think Brazil is a little bit different than Argentina. Brazil was also mentioned earlier this week and Trump continues to like Bolsonaro. They have some personality similarities. But here is the reality. There is an election priority that has more urgency even over that friendship. You have, here in the United States, the farm belt, and the audience in Iowa. So we are less than a year from the election, and I think it is fair to say that everything crafted, whether it is by Trump or by the Democrats or by Schiff – you name it – has a singular purpose, and the purpose is election 2020.

Kevin: That’s another one of the big dials, Dave. So let’s say you’re trying to now turn up votes here in America. There are unintended consequences worldwide, whether you like it or not.

David: Yes, it shows well to a particular audience, an Iowa caucus and the farm belt, but the misstep in this case, Brazil, is that while Trump could arguably win some benefits on the commodity front, his audience, undoubtedly the Iowa farmer, he is driving two partners directly into the arms of the Chinese. The commodities produced and exported from these locales are in high demand in China, and improved trade with the Chinese serves to shift balance in trade and in power relations. And so I think what we see is a short-term political benefit, November 2020, with a very long-term cost to multi-lateral trade and sort of healthy geopolitical relationships.

Kevin: So let me quiz you on something because you said it was two things. We talked about the commodities between Brazil and China, but we have talked before about Russian supply of Europe, Germany getting half of their oil from Russia. That is a big, big dial, as well. How would you like to try to build a pipeline from Russia through Siberia to China that is two-thirds of the length of the entire United States, and to do that in rapid fire and start flowing oil, not to the West, like we’re used to, but now to the East, the Chinese. You were talking about driving them into Chinese hands: where the energy flows, that is where the politics flow.

David: Yes, and it is gas pipelines. I think the big headline here is that our foreign policy in the present moment is helping to strengthen the cooperation, not between us and other nations, but the cooperation between other nations. And it is undercutting our role in the global economy, and I think, ultimately, as a geopolitical power. And on that front, you’re hinting at the Power of the Siberia Pipeline. That’s what it is called – Power of Siberia – that’s the name of the pipeline. This week it was initiated, the first flows of gas from Russia to China. It is the largest pipeline project in Russian history. Gazprom is very proud of having covered 3,000 kilometers across Siberia to the southeastern border of China, what they call the deal of the century.

Kevin: 4500 kilometers is the United States, coast to coast. We’re talking a 3,000 kilometer pipeline. I’m not sure what state to what state that would be, but that is huge. The bigger issue historically – we’ll look back and say, “Look how history changed when the oil started flowing east.”

David: Yes, 55 billion dollars is no small project. That is a significant investment. It is no accident that the project was launched immediately following the US/EU sanctions on Russia over Crimea. So as relations with Russia have deteriorated – and this is both a European issue as well as a US issue – Trump has attempted, actually to maintain some civility with Putin. Of course, he has gotten criticized and we have all the imbroglio related to the Russian interference in the election and all of that.

But Trump, I think, has seen pretty clearly that if the US and EU relations with Russia are not improving, then they are probably devolving, and that is, in fact, what has taken place. And there are no power vacuums on the world scene, so to the degree that one was being created through the devolution of the relationship, China is more than happy to fill that.

Kevin: So we talked about the length of the pipeline, but why don’t we put it in perspective, how much oil Russia is supplying to Europe versus what the increase is, or what percentage does this play for China relative to the European flow?

David: Xi Jinping has set a goal of 200 billion dollars in trade with Russia by 2024, and this is one of the things that gets them a long way toward that. So yes, when you look at the gas that flows in the pipeline, it will carry roughly 20% of the production quantity currently supplied to Europe.

Kevin: Yes, and I had said oil. This is a gas pipeline.

David: Yes, the Russia to China flows are targeted at 38 billion cubic meters per year versus 200 billion that flows to Europe at present. And they already have two more pipelines being discussed to bring an additional 30-40 billion meters of gas production per year from Russia to China. It is the erosion of diplomatic ties. It is the loss of leverage in existing relationships which is one of the characteristics of the Trump-era foreign policy – we are getting better deals done.

I don’t disagree with that. We are, in fact, increasing our slice of the pie. But the consequence of deglobalization, which I am not pinning on Trump, I am merely suggesting that he is adding momentum to that existing trend. The consequence of deglobalization is that we are talking about a larger slice of a smaller pie.

Kevin: One of the major themes over the last quarter, Dave, is all the signals that we have been talking about that remind us of 2007, 2008, right before the crash, and also 1999.

David: 2000.

Kevin: Yes, 2000. And whether it is mergers, acquisitions, insider selling, corporate buy-backs. But ETFs – 6 trillion dollars flowing into ETFs?

David: Yes, it is a product that barely existed 20 years ago. Exchange-traded funds hit the 6 trillion mark, so you have, in recent weeks, new records for stocks, and new records for – if you think about ETFs, it is kind of a grab bag of purchasing for investors. You don’t really know what you get in the bag, it’s the mystery purchase. And I guess what investors need to be reminded of, or be cognizant of, is that indiscriminate buying with the grab bag approach using ETFs begets greater degrees of indiscriminate selling at some point.

Kevin: It’s passive investing until all of a sudden it is panic. So passive investing works, you can use that P word, passive – passive, passive, passive, and you’re passive – and then all of a sudden you wonder why there are no buyers for the passive investing funds.

David: And of course, if you took the time to look inside the grab bag, what do you find? One of the big things is Apple.

Kevin: You reach in and get an Apple.

David: Apple stock is worth more than all the large cap US energy stocks combined.

Kevin: Wow!

David: That wasn’t always the case. You might recall our comments on Apple a few weeks ago. It is a company that has a total market value of over 1.2 trillion dollars.

Kevin: And that’s worth more than all the large cap US energy stocks combined.

David: Right. So we’re talking about that the value of the company has increased between 75% and 80% in one year, to 1.2 trillion dollars. So how do you extend those gains into 2020? Could you say, “Oh, we’re just going to do the same thing for 2020. Let’s see another 75% increase in the value of Apple stock. That will take it closer to a 2-trillion dollar company.

Kevin: The sky’s the limit.

David: Is that possible? Well, someone ultimately says, “Look, 75%, 80% in one year? I’m going to take some profits.” And the issue here is that, in this case, it is detrimental to most of your major indexes.

Kevin: That is the passive, passive, passive, passive – panic.

David: But you go back to this comparison between US energy stocks and Apple, and it is like a ratio. There are two components. In this case you have the ubiquitously owned Apple stuffed in every large cap ETF, all the primary indexes. And you have component number two, energy, which has been sold off aggressively to levels that suggest we no longer need fossil fuels, that it’s a part of our history, not a part of our present or future (laughs), which is just not the case, whether you like it or not. I drove back after Thanksgiving from Texas and had to fill up with this stuff called gasoline.

Kevin: Oh, I thought you would fill up with an Apple iPhone because the capitalization is so much more for Apple than energy stocks. Can’t you put an Apple in your tank?

David: Well, I mean, the Democrats think you can eat them, so maybe. Maybe there is more that we can do with Apple products than we know. Oil is up for the year, natural gas is down. Lila Murphy, a part of our team, has said energy, in general, is priced for nuclear winter. So if you said, “How would you guys bet?” Our bet is that energy outperforms Apple over the next 1, 3, 5 years.

Kevin: So what Lila is talking about is, everything is dead. No real need for energy. So it sounds to me like energy is a deal at this point.

David: Yes, investor appetite is virtually nothing. If you took a contrarian view to that you would say, “Apple got a little over-priced at a 75-80% move in one year.” Current market valuation, with its current cash, it’s probably more of a bond play, or call it a preferred stock play, than even an equity play.

Kevin: You know, in 1987 mergers and acquisitions were huge. And then in 1999 before the crash then, mergers and acquisitions were huge. We saw the same thing in the mid 2000s before the crash. We’re seeing a lot of merger mania at this point, right?

David: Sure. Tiffany’s gets bought by Louis Vuitton, LVMH. Schwab is buying TD Ameritrade. Fascinating that last week, in one week, we had 70 billion dollars’ worth of deals done. Look, we’re still on track for a sub 4 trillion dollar number for the year, a very high number. I forget if it’s 3.4 or 3.6.

Kevin: Is this how you hide a drop in earnings? Do you just go into mergers and that type of thing? Because we’ve talked about the earnings turning down.

David: I think that is the critical point here, and as Winston Chua has said at TrimTabs, you have these flurries of M&A, mergers and acquisitions, which tend to peak around market tops. He says that companies attempt to buy growth rather than grow companies organically. But you’re right, Kevin, in terms of trying to create something out of nothing, if your earnings are in decline, can you pretty up the pig, so to say? And yes, we have had previous M&A peaks, 1999 to 2000, 2006 to 2007.

And as we have discussed, it is the corporate earnings growth which has already reversed, already moved into its own version of recession, and now companies are choosing to get creative. It is a corporate version of extending the trend, just like the central banks have done in other ways. In more and more cases they are using stock for those purchases, so if your stock share price has gone to the moon, then you use that instead of cash. With stocks trading near record levels, it’s the new money for the purchase of other assets. That is becoming more and more common.

Kevin: A couple of weeks ago you brought up Walgreens. We don’t want to take that off the table. That is still a 70 billion dollar possible deal.

David: Right, 70 billion if it goes through, a private equity deal, largest ever, leveraged buyout initiated by KKR. I think one of the things that is very important to know is that you are already seeing a shift in the leveraged loan market, which is where you go to get a lot of money for private equity deals, and you are already seeing some fundamental deterioration and price shifts, both with the cost of borrowing going higher, and the value of existing loan portfolios moving lower. So I think, really, if we look back in time, we get out onto the horizon three, six, nine months, and look back in time, that KKR deal for Walgreens will probably be one of those major market top indicators.

Kevin: You mentioned a lot of money going into leverage, but where is that money coming from? Like a broken record we are going to continue to talk about 60 billion dollars a month in this QE-4 whether they want to call it that or not. Plus we have the repo markets that are providing liquidity. It doesn’t seem like the banks are wanting to participate much. The banks have liquidity, they are just not putting it out there. We’re having to, as the taxpayer, or however you figure it out with the Fed.

David: Yes, so if you extend, as we said, by the end of January, over 11 trillion dollars in liquidity to the repo market in aggregate. Going back to September when the repo issue started to emerge, banks in aggregate have had sufficient liquidity to lend into the overnight market.

Kevin: And it didn’t show up.

David: This is, I think, when something doesn’t happen you have to recognize that a choice was involved. When someone actively is funding a market, actively participating in saying yes, and then doesn’t show up, they chose not to. So the repo market interventions continue to suggest that the surface level calm you have in the credit markets is ignoring something subcutaneous, just under the surface, issues which at least a few banks are more sensitive to. So if you are in the habit of lending overnight, and choose not to, what are your reasons?

Kevin: Do you remember when Bookstaber was on the program and he talked about some of the new regulations? A lot of time regulations seem to be one of the chief causes of the next crisis. So they will regulate after a crisis, and then the next crisis nine or ten years later is actually caused by the regulations. Do you think that some of the regulations, the fear that the banks might have going back to the global financial crisis, factor into them not wanting to loan money in this environment?

David: I think this observation might be helpful, because now you have periodic snapshots which measure capital ratios, and they are far more of a sensitive issue to manage in this post global financial crisis regulatory environment. So yes, Bookstaber is right, Dodd-Frank fixes many problems. But now you have a regulatory regime which also creates new pressure points within the markets. I think of what the banks did in September as hoarding – hoarding by the banks, a certain degree of stinginess as you get to month-end, as you get to quarter-end, as you get to year-end.

Kevin: Because the regulators are watching.

David: Exactly – any time when there is greater balance sheet scrutiny than in the in-between times. And so that is where your snapshot it taken, and that is where behaviors are going to change. If you know that regulators are going to put you under the microscope periodically, then you change your behavior for those periods of time when the bank regulator is viewing the balance sheet snapshot. The bottom line is this, that regulatory shifts may very well be responsible for the volatility we see in the repo markets, with reserves increasing exponentially to satisfy the new regulatory regime criteria. Stinginess is still a choice. You could operate as you have previously, but the weight of compliance has increased since 2008 and 2009.

Kevin: So let’s put ourselves in the place of a bank. Do you really need to step in? You know the Fed has the back of the market. The Fed is going to provide whatever liquidity you used to, and you get paid interest on your reserves by these guys. That is incredible that they actually pay them to not loan, and they manage that interest rate up and down based on how much liquidity they want to release from the banks. This is that sterilization that we were told about years ago, Dave.

David: Yes, so you have a part of the issue here – what you are pointing to is moral hazard, where banks don’t have to do what they have always done, or can opt out any time they choose if they know the Fed is willing to step in. But I think this moves past the point of there being different kinds of reserves. There are some reserves that banks are required to have, and those are capital adequacy. Do you have enough money if somebody comes knocking and they want their deposits back?

Kevin: Which is not a bad regulatory requirement.

David: No, so having a minimum level for capital adequacy – great. Then you have a whole different kind of reserves, excess reserves, which you mention are left with the Fed, and they are being paid. Of course, the rate got lowered, I think, to 1.55%, so it is not as generous as it was at 1.8 (laughs).

Kevin: They are still paid to not do anything with their money.

David: Still paid to not do anything – exactly. But as the weight of compliance has shifted since 2008, 2009, or the aftermath of that period, then the impact is that the Fed gets written into the script more often, and with larger amounts of capital, just to keep things running smoothly. So we have moved beyond the crisis management stopgap and now they have an enduring market presence.

Kevin: It’s the training wheels. The Fed has put training wheels on and adjusts the training wheels, but the market is not running on its own anymore.

David: Liquidity stresses show up in the repo market, and what they suggest is that the Fed is not going to be able to shrink their balance sheet. Because remember, the liquidity stresses in the repo market only revealed themselves after the Fed began their attempt to shrink the balance sheet. This goes back to 2018, significant market sell-off Q4 of 2018, which again revealed a very low level of tolerance in the credit markets and in the asset markets in general for policies that were going to be anything less than accommodative. What are we talking about in the end? We’re talking about debt addiction, and the volatile withdrawal symptoms that are here for the duration.

Kevin: But we still have shock therapy, Dave. You get those algorithms trading up and down. You’re right, we have debt addiction, but one of the points that you were talking about – telltales – both of us have sailed a little. I don’t want to claim to be a sailor. But we had a sailboat for a while, we had a telltale up there which is the little string, it’s the little yarn. We had one also in the glider, the sailplane that I flew. It tells you what direction the wind is coming from. Sometimes you can’t feel it, but you can see that little telltale.

Now, the VIX, the Volatility Index, has been so quiet, Dave, so quiet. You brought that out last week, the week before, and then shock therapy. Boom! And yesterday.

David: The VIX measured 11.75 at the low a few days ago. By mid-week this week it reached 18. That is a 53% increase in a matter of days. What did we say just a few weeks ago? We can’t tell you how high the stock market might go, but we know how low the VIX goes. It can only go to zero. And the closer it gets to a single digit number, it is matching up with every other major market peak and coincides as it gets to those low numbers, with every major market decline. It tells us a lot about the direction of stocks and the equity market volatility going forward. What was our recommendation then? What does it continue to be?

Kevin: Hedge.

David: Hedge accordingly. An ounce of prevention is worth a pound of cure.

Kevin: Passive, passive, passive, passive – panic! Passive, passive, passive – panic! We want to remind the listeners, send your questions in to Dave, you’re going to get to as many of those questions, maybe all of the questions, as they are sent in. We are going to do that over the next few weeks.

David: We will do our very best to answer them, and in the event that there is a question that is well beyond our pay grade, we will just bring on an expert as a guest on the Commentary to address those issues. Every question is important. No question is unimportant. So please send them, and we will do our very best to answer them.

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