In PodCasts
  • Gap between household net worth & GDP has never been greater: 522%
  • Cornered Rhodium market puts platinum on slashed rate sale… reversal coming to up side
  • 30 year fixed mortgage closes in on 5% not good for homebuyers


The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick


October 3, 2018

“To increase your financial footprint by 20 times, and avoid systemic risk while doing it, you’re talking about an intergenerational financial coup. The process is slow. On a day-to-day basis this is not a rewarding process, but in the final analysis you are compressing time, and you are increasing your ability to compound wealth on a nearly incomparable scale.”

– David McAlvany

Kevin:So tell us, Dave, when we left you last we were talking about you taking your daughter to a London fashion show. How did it go?

David:It was good. I actually had some emailed material from Pete Kendall who wanted to make sure that I was aware from the socionomic perspective some trends in fashion and hemlines.

Kevin:Our guest from last week.

David:That’s right. And they love following and corroborating social trends with mood in the marketplace. I was fascinated watching the show.

Kevin:How was your little seven-year-old daughter, Tess?

David:Oh, it was great. I was whispering in her ear the entire time as we were sitting there on the front row of the catwalk. “What do you think of that?” “No, I don’t like it.” “What do you think of this? “Oh, it’s awful.” “What do you think about this?” “I would never wear that.” “What do you think about that?” “Oh, that’s fantastic.”

Kevin:Isn’t it amazing? We were talking about this last night. This little seven-year-old girl you are talking to about adult things and she wasn’t even born before 2010.

David:That’s right. So, that was a fun aspect. We’ve done business in London, and in Brussels and in Paris and in Hamburg pretty consistently over the last ten years, and even longer, but we actually set up an office in Brussels a number of years ago. To maintain business relationships in Europe, at least once a year I joint our team to meet with and continue opening up and maintaining those relationships there in Europe. Just a couple of observations from the trip – London does not appear to be suffering.

Kevin:So Brexit is not taking London down the tubes like a lot of people would like to have you believe.

David:It doesn’t really seem like much has change in terms of business or tourist travel. If anything, I would say that the currency depreciation in pound sterling has helped attract a fresh flow of visitors to the island.

Kevin:That needed to happen because when I went to London a few years ago it was very, very expensive.

David:It’s always expensive, it’s just less expensive now than it has been, really, at any time in my adult life. I experienced the exchange rate back in the 1990s when I lived there between 1.5 and 1.6 to the dollar. Today it is about 1.3. It is considerably off the levels that we saw circa 2008-2009. In 2007-2008-2009 it was in the range of 1.8 – I think at one point it even got up to 2.1-to-1. So two dollars exchanged for every one pound meant that everything was doubly expensive – a hamburger doubly expensive, a Coke doubly expensive. And London is not a cheap town to begin with.

Kevin:So you paid double for a single. That’s what you’re basically saying. But when you go to Europe, you’re not just meeting with various people who get us our product. You’re also going to refineries and looking at things that are sort of behind the curtain. I’ll just give you an example – platinum, palladium, rhodium. That was part of the trip, as well.

David:We’re interested in the supply chain and the product that flows from Europe to the United States. What I witnessed in 2008 was, even with the price of gold dropping off in the midst of that financial crisis, October and November of 2008, we were moving toward limited supplies, and it was this really weird world where you think, well, the price must be down because there is too much supply in the market, and yet we were limited to one kilo bar per client per day.

Kevin:I remember that.

David:And being on a very limited basis it encouraged me to make sure that we had an adequate supply chain. And a part of that was, as you say, going to refineries in Europe and making sure that we had direct supply circumventing any middlemen at all. So visiting a refinery on this trip, we were discussing the platinum group metals, platinum and palladium. There were a few helpful points made. Currently, of course, we have a depressed value for platinum and it ties in some part to over-production of platinum which is motivated by the by-product extraction.

Rhodium is a by-product and rhodium was cornered by a hedge fund a little less than a year ago. You have industry uses, so they must have it, and at a total supply squeeze. You have industries which have industrial uses for rhodium which are needing to cover those physical ounces and they can’t get it, so it is encouraging an over-production of platinum. Add to that the current trend for gasoline engines with more of a focus on palladium used in the catalytic converters for those, and you have a double whammy.

Kevin:This is why these trips are so important. Rhodium has been sky-rocketing because of this corner in the market, so obviously people are scrambling to get as much rhodium out of the ground as they can, which produces too much platinum for a short period of time. Then of course, you have the other dynamics. I remember a story where you had explorers going to find sunken ships that had sunk when they were carrying gold from South America hundreds of years ago.

Current-day explorers would look for these gold ships to get the gold. And then later they realized the cannon balls that had been made out of platinum that had been found and deemed relatively worthless, because it was a technological metal that we really didn’t discover what it was worth until later. Those cannon balls were worth far more than any of the gold on the ships.


Kevin:So you look at this and you say, “Why is platinum depressed?”

David:I think a part of it is the pendulum swings back and forth amongst the consumers between gasoline and diesel engines, and you see a big rebound of interest in platinum as it swings back toward diesel engines. And of course, as we mentioned, as that corner is resolved with rhodium. So I guess one of the things this underscores is how economically sensitive the platinum group metals are.

And we are interested in the platinum group metals but in our allocations within portfolios, they do make up a much smaller percentage of the total compared to either gold or silver, and it is because they are so economically sensitive, and silver and gold are less so. Silver was still sitting the middle ground between industrial use and a quasi-monetary metal versus gold, which has been reserved for central banks, and a monetary metal, and the record of that is about 5,000 years.

Kevin:And you are really not interested in the price in dollars of these anyway. It is the ratio that is important – the ratio of platinum to palladium, gold to silver. That’s really where the interest is.

David:Yes, well, it is for the long-term play, and I think it does make sense, when you’re looking at gold as a stable asset, or the precious metals as a portfolio stabilizer there, through good times and bad. If you can maximize the value of your allocations by having some dynamic afoot, then I think it does help you along the way, so the ratios are worth playing, particularly if you can do that in tax-deferred accounts. That is, I think, the obviously place. But modest allocations to the platinum group metals, I think, are sufficient. It is the ratios, as you said, not the price, which is the most relevant factor in the platinum group metals.

Kevin:I remember going to Germany back in the mid 1990s and Brussels, Belgium played a key role in all of Europe as the European community was coming together. It really was the place to be. And I asked you last night if you had tried any of these monk-made Belgian beers, and you said that you had.

David:Yes, Brussels is always a favorite place for me to visit. You have Grand-Place, which is architecture from the 15thcentury. It is absolutely stunning. It made its way through the war without being destroyed. A very unique place there in downtown Brussels. But I think Brussels is in a long-term structural decline. I was surprised to see the number of shops and restaurants closed in the downtown area.

Kevin:Even though it is sort of the center of the euro.

David:Yes, and I think of Brussels as being there in sort of the belly of the eurozone beast. It is the last place to go hungry, it’s the last place to run out of funds because it is so central to the eurozone project. But since 2010 I’ve seen the contrast of vibrant and bustling activity, and now things being considerably slower. And certainly, the terrorist activity in 2015 didn’t help from the standpoint of tourist traffic through that city. I could tell, getting off the tourist beaten track into more of the local areas, it was still okay, but they really don’t have the flow of people through the city anymore.

Kevin:That seems like it is awfully different than when your brother, Scott, was out there setting up the European office a few years ago.

David:The shift that you see in Brussels is the same in Paris, and I think you could extrapolate to a few other cities throughout Europe. There now are parts of town where you might consider them no-go zones unless you are directly tied to the immigrant community. Scott was in Brussels assisting with setting up our European operations and while living there he had a number of conversations with Muslim immigrants. I remember one conversation in particular with two brothers running a barbershop. He was just sitting there, and of course, what do you do when you’re in a barbershop? You talk and talk.

And they were bragging about shifting and being a part of a community that was shifting the balance of European power. Within a generation, it was their belief that they could do this simply by having multiple wives and having countless children with each of those wives. Again, I’m not trying to poison a well or create unnecessary controversy. Some of this boils down to numbers and you can see the tension and stress growing within Europe, as Europe has a number of issues that it has to deal with, not the least of which is that they don’t have a unified fiscal policy while they do have a unified monetary policy. And yet, you have diverse interests in every country. And of course, you have individual and diverse interests within each city within each country.

So it gets very complex, but at the heart of the European crisis is this identity crisis, and I think there has been a growing trend, sort of a gutless unwillingness to keep common sense in the political equation. You have to be ultra-sensitive to all parties. I think whether you are looking at the U.S. as a melting pot, or Europe as a melting pot, it’s not racist and it’s not bigoted to encourage cultural integration. If you want to move someplace, if you want to move in, great – learn the language, appreciate the culture, and things go very well for you.

Certainly, as an immigrant country, which we are here in America, that is part and parcel to what we reflect. If you lack a sense of place, and I think this is really back to the European identity crisis – if you lack a sense of place, if you lack a sense of self and identity, you bring in a strong-willed personality and you will simply get rolled over. And Europe is getting rolled over. Brussels is a microcosm of that change.

Kevin:And you ended up shutting down the office, I think, partially because of that.

David:Yes, we have shut down our office there because we can feel the crisis dynamics bubbling up again. Whether it is Italy here in the last week or so – the debt markets and bank shares in Italy – there are other reasons why we have concerns about the eurozone project, but there is a real change afoot in terms of how it is managed.

Kevin:Last week when we were talking to the Elliott Wave team they were saying that this isn’t just a localized super-cycle dynamic, they said that this is a worldwide kind of phenomenon. We need to talk about some of the Italian debt crumbling here, and a few other discussions about Europe. So last week with the Elliott Wave team we discussed a potential top in the super cycle – they were talking about super-cycle dynamics. They talked about all-time highs, certain all-time highs hitting all at the same time. And we have another all-time high right now, talking about ratios.

David:Right, for your consideration, this is not really a timing mechanism type of thing, something that you use to trade the market, but it does support the idea that we are at a significant top. Look at household net worth, compare that to your GDP figures. This gives a comparison between the overall economy and the value of the assets which are owned by the U.S. citizens.

Kevin:And nobody is going to argue about having a high household net worth. That sounds great, but what we have to do is compare it to what our actual productivity is. What is supporting it?

David:Right, so when the financial assets and the real estate assets – those two components, financial assets and real estate – they figure into your net worth figures. Take out debt, of course. When it reaches extremes relative to the underlying economy and the actual activity which is occurring in the economy, at a minimum you can expect a period of sort of digestion, where prices are not necessarily on the increase, and maybe GDP is catching up to where prices have gone, but it is quite typical that as you reach new highs, particularly in this statistic, what follows is a significant period of consolidation, of loss occasionally.

In nominal terms you see a precipitous decline in prices, and occasionally you have the pain which shows up in real terms. This was that period of the late 1960s to early 1980s where the price of stocks did not decline very considerably, but inflation increased each year as time went on and it began to wreak the same kind of havoc, in real terms, that a nominal price decline would have.

Kevin:Yes, so you can either lose it with a crash in prices or you can narrow that ratio, actually. But what would be good would be if the GDP rose. But let’s go ahead and look and contrast that with these periods of time that you are talking about. Household net worth right now sits at what relative to GDP?

David:Household net worth sits at 522% of GDP currently. Better numbers have never been seen.

Kevin:If you want to call it better – higher.

David:Higher numbers have never been seen. So just for reference, in the 1970s it was 342% at its very best. In the 1980s it stretched a little bit further to 378% at its best. At the market peak in 1999 it got to levels never seen before – 447% of GDP.

Kevin:Before the tech stock bubble popped?

David:Yes. And obviously, there was some mean reversion, which is a nice way of saying…

Kevin:Real mean.

David:Real mean, exactly. In 2007 – 473% of net worth to GDP.

Kevin:A real mean reversion again.

David:Another mean reversion – nasty one. The contrast between these numbers currently and those of the past is the financial asset piece – you’re talking stocks and bonds. It has grown far more than the real estate piece. I don’t have to tell you the potential for faster declines in the financial markets. The flow is faster, the flows are larger.

Think about how long it takes to transact on real estate. You usually have homeowners who, even if their neighbor’s house sells for $50,000 less, or $250,000 less, believe that it was an anomaly, and they believe that they can ask what they want to ask and are likely to get the price that they want for their house.

So there is a slower process for price adjustment within the real estate market compared to stocks and bonds, which is why it tends to be nastier. And lo and behold, the largest components of that 522% of GDP to household net worth, the largest growth component has been there in the financial market – stocks and bonds.

Let’s go back to the discussion last week with Pete and Steve. The relative value between stocks and gold is compelling. You have the Dow-gold ratio sitting right around 22-to-1. That says two things to me. Number one, it says that on a cyclical basis gold is cheap. And number two, it says that on a secular trends basis gold is strong. Why would I say that? It has dropped from $1900 to $1200 – how can gold be strong? On a secular trend basis, keep in mind that gold has still outperformed the stock market over the last 18 years, significantly.

Kevin:Yes, we got to 43-to-1 in the year 2000.

David:That’s right. Now we’re at 22-to-1. And we have maintained the majority of the gains from that 2000-2012 period. We have maintained the majority of those gains.

Kevin:And so for the listener who is new to this, what we are basically saying is, the stock market, the Dow-Jones Industrial Average was worth 43 ounces of gold in the year 2000. Now it has dropped to 22. And typically, when you go through the full cycle it will drop to 3, maybe 2-to-1.

David:And maybe even 1-to-1. So the bull market in gold started the current trend at a relative ratio to stocks, 43-to-1, 22-to-1 signifies the gold market has still outperformed stocks, from then to now. Even with stocks at record highs, when you price the stock market in real money terms, it is only half of its former value. Isn’t that amazing?

Kevin:That’s amazing. So how probable is it that we get down to that 5, 4, 3, 2-to-1?

David:I think 5, 4, and 3, highly probable. 1-to-1 is a real possibility. Both of those would happen over the next three to five years. And our point last week was this – to increase your financial footprint by 20x – to increase your financial footprint by 20 times, and avoid systemic risk while doing it – I talked about MF Global, one of my Wall of Shame moments – and in side-stepping the traditional bank savings programs which pay you nothing, you’re talking about an intergenerational financial coup. Now, the process is slow. On a day-to-day basis this is not a rewarding process, but in the final analysis, you’re compressing time, and you’re increasing your ability to compound wealth on a nearly incomparable scale.

Kevin:It takes a discipline to look at something in a different way. I was hearing somebody talk about a movie called Vantage Point the other night with Dennis Quaid. It is about an assassination attempt on a president. There were seven different witnesses and they all tell a little bit of a different story. But the truth comes out, through those different witnesses, of what actually happened – different vantage points. If a person can change their vantage point and start measuring things relative to ounces of gold instead of dollars, it is that 20-fold return that you are looking at. If you cannot understand that, you miss the game.

David:In my lifetime, I will have gone from entering the gold market with a sizeable investment at around 40-to-1, and I will exit many of those ounces at closer to a 1-to-1 ratio.

Kevin:Which is like a 40-fold return on your gains.

David:Within an adult lifetime, just one adult lifetime, to have seen a 20, 30, or 40-fold increase (laughs) – keep in mind, when you are doing the math and compounding wealth using the rule of 72 basis, and you are compounding your wealth at 10% a year, you are doubling every seven years. So you have doubled, you have doubled again, so you might have a three or four-fold return over a 30-40 year period. We are talking about 40-foldreturn over a comparable timeframe and it is painstaking, can be ugly, totally boring, and oftentimes demoralizing.

The question is, do you have your eyes on the prize? I think history suggests that we are going to see a 3-to-1 ratio on the basis of economics and finance. The only time you see a 1-to-1 ratio of Dow-gold is when you have a financial market catastrophe overlaid with geopolitical catastrophe. And with that geopolitical catastrophe, 1-to-1 has happened multiple times in the last 100 years.

Kevin:And you have preached, make sure that you figure out what your exit strategy is. When you buy your gold, understand the exit strategy.

I’m going to shift back to stocks for a moment because we oftentimes look at the Dow-Jones Industrial Average, which is continually changing. In fact, we have talked for years about how there was just one stock left – General Electric – from the original Dow, and that dropped off in June. So we no longer have any of the original stocks from the Dow when it first started back in 1896. But probably another way, speaking of vantage points, to look at the stock market is to look at the composite index, in other words, look at a much broader index and say, “What is really happening to the composite versus just a very small grouping of stocks?”

David:Before we go to the New York Stock Exchange Composite, GE has always been one of my favorite examples because when I was working at Morgan Stanley GE shares had just sold off like $5 off their peak. They had gone from 60 to 55, and there in Pasadena, California blue-blood families like you can’t believe, and there at the Ritz-Carlton they flew in the CFO from GE and he gave a presentation to calm the nerves of investors.

Kevin:Because it had fallen five dollars.

David:And maybe this was a peak and maybe they wanted to change allocations, and they just needed some reassurance that this was not a big deal. So it was off five bucks, it was off seven bucks, but in a short period of time and they were a little nervous. $30,000 at the time would have bought you 500 shares of GE, or 100 ounces of gold. Now, this is just an example of the kind of purchasing power gain that you can have when you prioritize one asset class versus another for a certain period of time. I have chosen gold over this period of time. Someday I will prioritize GE or comparable shares to it.

Kevin:So $30,000 would buy 500 shares of GE or 100 ounces of gold back in the year 2000?

David:2000-2001. So today those 500 shares of GE are worth about $6,000 and your 100 ounces of gold are worth about $120,000. So you are up more than four-fold in your metals, and you have lost a huge amount of money in the GE shares. The point is, at some point, to make a lateral move out of your metals and back into GE means that you don’t have the original proposition of 500 shares, but maybe it is 5,000 shares, or maybe it is 50,000 shares. All of a sudden your financial footprint has increased considerably and there is no amount of re-investing dividends on 500 shares that will ever get you to 50,000 shares.

Kevin:You have gone from Tiny Tim to Big Foot is what you have done. It is just a dramatic difference in your footprint.

David:But these are things that take time and patience, something that most investors don’t really prioritize, they want to know what the market has done for them today.

Kevin:In dollars.

David:In dollars. And these are, again, relative terms, or in many senses, more important than nominal terms.

You mentioned the New York Stock Exchange Composite Index. It captures the broadest cross-section of stocks and it sends a very clear message. It clearly depicts the bull market rally hit its peak in January. That was not only the peak in price, but also it was a peak in the number of companies that were hitting new highs.

Since then, the number of new highs versus new lows creates a compelling case for the best already being behind us and the current uptrend in price being, really, on borrowed time and on borrowed energy, because you don’t have the vast majority of companies – even though we have new highs in the Dow, the S&P and the NASDAQ, what have you – you don’t have the number of companies setting new highs. It is very narrow in terms of the investor interest and you are seeing greater and greater concentrations in just a few names.

You can go back in time – any time this has happened there has been carnage that followed. Pick your timeframe – the nifty-fifty, the NASDAQ stocks of the 2000 period – when there is a concentration of interest in just a few shares, those are usually the shares that get pummeled the worst.

Kevin:I remember the late 1990s it was, “Don’t bother me with the facts, just tell me what Cisco has done. Just tell me what has done.”

David:Sun Microsystems?

Kevin:Like Bill King says, “How did that turn out for you?” Not real good. So let’s go across the pond again because we have talked about interest rates sky-rocketing in some of these countries like Turkey, Argentina, Brazil, but now we have Italy. This has been a fly in the ointment for a while. Italy and Spain have been sitting out there waiting to happen. Is it happening?

David:The Italian bonds sold off sharply last week. Italian bank stocks were notably weaker. What the markets were reacting to is the new government’s budget for 2019. It is going to leave about a 2.4% deficit versus their economy, versus GDP. And what was on tap, what was expected, was 2%.

Kevin:The person listening has to be saying, “How does that work?”

David:How does 4/10 of a percent matter?


David:Well, it’s a frail system

Kevin:Well, where is the United States? We’re in worse shape, are we not?

David:I love Doug Noland’s comments this last week. He is just wondering why there is such a forceful reaction in Italy when we are coming up on 5% here in the United States where our deficit is a real number. It is a far bigger number than what we have in Italy. Obviously, the advantage we have is that we are the world’s reserve currency and there are a few things that we get to get away with because we can push our weight around.

Kevin:Exorbitant privilege.

David:But we get to keep that privilege as long as we are willing to push our weight around. Not always appreciated, not always easy to maintain, but that is where we are today. European worries – they pushed the euro lower last week, the U.S. dollar higher, and of course as the dollar hits higher on any given week there are further consequences for the emerging markets and emerging market currencies. So two weeks ago Argentina’s currency had increased over 7%, then the dollar bumps up last week, and lo and behold the Argentine currency is down 9.9%.

Kevin:That’s a little bit of volatility. We’re not seeing a lot of volatility in our stock markets so I guess we can see it in currency.

David:That’s a lot of volatility – up 7% one week, down almost 10% the next. Also of note was the strong quarterly finish for most of our U.S. indexes. Just finished the quarter and I think there was an obvious exception, which was U.S. banks finishing Friday down 4.7%, just last week closing out the quarter on a low note. So I like watching the financials. The financials can often lead the markets on the upside and the downside. Financials and small caps are two places that sometimes you get some signaling as to the market heading significantly higher or significantly lower. So we will continue to watch the bank stocks and see if they are beginning a longer-term trend, presaging something for the rest of the markets, too.

Kevin:You were talking about Brussels, Belgium, which used to be the gemstone of the euro, being a signal that it may be waning. Is the Italian sovereign debt also showing us that this euro project is starting to crumble?

David:It underscores political dysfunction in Italy, and the problems the eurozone faces in the years ahead will be problems the eurozone faces in the years ahead will be problems of survival. The populist movement, the Five-Star movement, is just one iteration where you have national interests trumping European interests – no pun intended. It is very difficult to imagine the next crisis, globally, not destroying a massive amount of wealth there in Europe, particularly the sovereign debt markets.

This is where you see the absurd on display almost every day, where most of the government debt in Europe is still priced to yield a fraction of what the U.S. ten-year is today. Last week we got over 3%, 3.09% on the ten-year treasury, and relatively speaking, you are talking about micro-yields in Europe, which really tells you the footprint of the European Central Bank. Those are not sustainable markets, and ultimately there is going to be hemorrhaging in investor pockets if they own sovereign debt in Europe.

Kevin:So being in London last week you probably sensed that it was wise, there was a wisdom to Brexit breaking away from what could be a very strong deflationary trend in Europe.

David:Oh yes, absolutely. In the fullness of time I think Brexit will be viewed as the choice that separated the U.K. from eurozone implosion, something that gave them some protection from it. As the eurozone was circling the drain, they were able to extricate themselves at the 11thhour and 59thminute, but it is still seen as a very contentious issue in the City of London – particularlyin the City of London. London proper was the only place in Europe where you had a strong “stay” vote. It was the rest of England which was – “What’s the benefit?”

Kevin:That happens here in America all the time. It is the cities that stay on the liberal socialist side, and in the country, the people who are actually out there – wait, if the farm doesn’t grow, it doesn’t grow. You earn it out there.

David:That’s right. Socialist benefits accrue in clusters of people where the most people are there. No surprise there.

Kevin:That was George Washington’s warning. Remember that? George Washington said he sees the future of America in the West because he sees the East turning back toward Europe.

David:Again, I know there has been a lot of argumentation and debate about the way we have our system set up here with the Electoral College, but this is why, because you would have three cities in the United States which would control the entire vote versus being a representation of a whole cross-section of culture and society.

In the markets this last week we saw silver outperforming gold, moving higher on a quicker basis than gold, diverging, if you will. Crude finished the quarter at 21% gain for the year so far. Natural gas has just peeked its head into the positive territory. It had suffered losses for most of the year so far. Copper is still under pressure. Copper is down 15% year-to-date, which people should remember, copper is the bellwether for economic activity. It flies in the face of what we know from economic statistics here in the United States. It is probably a clear picture into the trajectory of global economic activity and growth for 2019.

Kevin:I know for commodities people like to call copper The Doctor – Dr. Copper. But actually, another doctor that you could look at, another bellwether is how much does somebody have to pay to actually buy a house, because nobody actually buys houses anymore, they just borrow to buy a house. There are very few people who can do that.

David:The first house that we purchased we financed at 6¾%. By the time we moved to Colorado and were able to refinance our house here in Colorado we financed it at under 3¼%.

Kevin:You get an awful lot more house.

David:You get an awful lot more house, and now we’re coming up on that 5% number, 4.72, up nearly three quarters of a point year-over-year. There is a point where the price of single family homes is no longer affordable and it drives people into the rental market. We look at the inflation in rents and you see that up again in the last monthly reading up over 2%, and home-builders aren’t really doing much to solve the supply issue. If you look at their share prices they have continued to march lower along with copper.

Take Lennar, for instance. It is no higher today than it was in 2015. Stocks all across the board at higher levels, right? Not the home builders. The home builders and autos – these should be giving you an indication of what is happening on a broad basis within the economy, and they are suggesting that, at best, we have mixed signals. We have some official statistics, and certainly the confidence indicators, which are lagging indicators, not leading, that say that it really hasn’t been better in the last 10-15 years.

Kevin:When we were in the mid 2000s we started warning people about the rising prices of real estate getting way beyond what they could sustain. I remember your dad even sent out a CD to all of our clients saying, “Get out of real estate.” I think that was 2005. I just listened to it the other day. It was really amazing. And then, of course, we had the crash. Last time we had our financial crash that was led by real estate the banks were the ones that were exposed. They held the debt. Is that still the case or has that burden shifted?

David:Good question. One of the reasons I like to travel is because I get a lot of reading done. I got two books read on the way over and the way back and we will be talking with one of those authors here at the end of the month. I’m very excited about those conversations. But also, reading the Financial Timesthis past week while on the road, John Authers, Brooke Fox, two writers who pointed out that the speculative excesses of that period, 2008-2009, just migrated. They haven’t gone away. You now have pension funds which hold the risk that banks once did.

Kevin:So that answers the question. Banks held the risk before. Now you have people who are counting on this for retirement.

David:Pension funds and savers seeking higher yield, and by necessity, in a low-rate environment from 2008-2009 to the present, have been shifting their risk profile to include high-yield bonds, to include hedge funds, to include private equity. And all of these products have leverage built into their structures, and that leverage is not very well accounted for in the aggregate. We probably have more leverage in the system than even groups like the BIS would necessarily account for. So in essence, these writers are suggesting that the migration of risk has gone from shareholders to savers. What you risk now is a social crisis in the next financial downturn.

Kevin:Already the temperature is high with all the things going on in Washington right now. Could you imagine if we actually had a financial downturn?

David:Right. So the political backdrop – we know that it is contentious here in the United States, but it is also contentious in Europe. And I don’t know that they can take much more pressure. A few days later the Financial Timescommented on the Bank of International Settlements, the BIS, their assessment of debt growth since the financial crisis, and the move has been away from bank-funded debts toward bond issuance instead.

So, big substitution – no longer bank loans, now it’s bonds, which is interesting because as we have discussed previously, a lot of that funding has focused on U.S. dollar-denominated bonds and to a slightly lesser degree, euro-denominated bonds, with some cross-exchange rate risk. So debt securities – we’re talking bonds – now make up 57% of total international credit, according to the Bank of International Settlements, up from 48% just a few years ago.

You have bank debt, which is being displaced by the financial market bond issuance, and I think what is really important to note is that when you are bailing out institutions it is far easier to step in and define what the terms will be for that particular institution. In some instances – we remember Bank of America and Merrill Lynch, that was like a weekend shotgun wedding. It was like, “We have just introduced you, you will be happy together, and you will take these losses, and you will now properly live under the same household.” (laughs) That was Bank of America, Merrill Lynch, and a whole bunch of other forced marriages in the last financial crisis.

Kevin:Isolate that. How do you coordinate an intervention when you have it all spread out in bonds, in pension funds that are holding it?

David:Exactly. Now you are talking about sifting through which creditors and which investors, which savers, will be helped. The idea of a coordinated intervention in the next financial crisis is pretty hard to fathom. And I think the will of the people, if you’re looking at taking the temperature here in the United States, as well as in Europe, the will of the people is not behind helping other countries and getting into the business of other geographies. It is just harder to pull off a humanitarian effort when lots of countries are in crisis and they really have to, or have the inclination to, take care of themselves first.

Kevin:Something that caused, or at least was a symptom of the last debt crisis, was this debt securitization. There was this opacity to understanding what actually was the problem. You were talking about how it is hard to actually see where the leverage is because it is just spread out.

David:And the place where you can see it is with the sovereigns. In the corporate structure, yes, we have the debt securitization craze. It is back. One of the lingering signs of the past crisis is the total stock of sovereign debt, because it is off the scales, and you can see that. I don’t disagree with the Prechter crew. The deflation is coming. I just see it as selectively hitting asset classes.

We were talking about the Italian debt markets. You can see an evaporation of wealth in a quarantined and isolated area and it is absolutely deflationary, not necessarily system-wide, but on a case by case – it almost reminds of Ebola. If you can control and quarantine it, it is going to selectively hit a population group.

This morning I enjoyed reading Robert Prechter’s most recent October letter. He took a very balanced view where, yes, you want to own treasuries, and yes, there is going to be crisis of confidence in the debt markets such that interest rates should rise, so if you’re going to own treasuries make sure you own floating-rate notes and balance that exposure with gold. And I thought, “Wait a minute, wait a minute! Was he listening to last week’s Commentary?” (laughs)

Kevin:Isn’t that exactly what we talked about last week? I was thinking of the movie, The Big Short, the movie about the 2008 crisis, and how there were selective people who became very, very wealthy betting on the short side of this market. It seems that we may have another movie in the making.

David:When I think of deflation as hitting select asset classes and not a broad, universal deflation, what is not selective at all, but is a very broad, universal blanket thrown over all the financial markets globally, is an inflation bias from the central bank community.

Kevin:Who does it benefit? The central bank community loves inflation, they don’t hate it.

David:Right, because if you look at the debt markets, you see increasing quantities of debt which are not a big deal if you can inflate the pressure of that debt away. So inflation has always been the friend of an over-leveraged or over-indebted actor, and here you have the sovereigns which are amongst the worst offenders in that category today. And then they happen to control the monetary policy mechanisms which promote inflation. So the gradual lifting of the debt burden via a long and very tedious process of currency devaluation – that is who they are, that is how they operate, and it is one of the most predicable things that you have in play. And yes, you will have select deflations in select asset classes. But inflation is coming. And yes, in that broader context you can expect to see sector and individual asset class price implosion, which is what we talked about last week – deflating of price.

Kevin:And you are talking about more rapid inflation coming, because I went back and looked at the price of a loaf of bread in 1987 when I started working here, Dave. It was 80 cents. So 350-365 loaves of bread, if you ate a loaf of bread a day, would be about $300 back then. Guess what gold was? It was $300. I remember your dad telling the story, 100 years before a loaf of bread was six cents and gold was $21. Well, that is still about a loaf of bread a day. Today, a loaf of bread is in the mid $3 range. It’s not 80 cents anymore, just in the years that I have been here. And in the years that I have been here no one would say we have had high inflation, yet a loaf of bread has gone from 80 cents to the mid $3s and an ounce of gold has gone from $300 to $1200.

David:Still covers your loaf of bread a day.

Kevin:So we have had inflation. Gold has protected me against inflation. But going forward, if that inflation increases, could we have another late 1970s event like what your dad went through when the company first started?

David:This is one of the aspects that I want to talk about with our guest at the end of the month, Ed Easterling. He has an interesting view on the role that inflation plays. Actually, his point is more profound than inflation versus deflation. He is saying that any move away from price stability is negative for asset prices. So stocks and bonds are vulnerable if you have a dramatic move away from price stability. It doesn’t matter if it is inflation or deflation.

So the question is, what has the trend been and what are the likelihoods, what are the probabilities of trend mean reversion, moving in the opposite direction? It will be an interesting conversation because he is very keen on secular trends in the stock market and bond market. In complement to what we talked about last week with the Prechter team, fundamentals matter. To him, you cannot ignore fundamentals. Fundamentals ultimately determine the course of the market.

Kevin:One of the magazines that your dad got you reading when you were little was Barron’smagazine. You saw your dad reading it. We have had guests on who were key editors.

David:Alan Abelson, for years.

Kevin:Yes, Alan Abelson. But last week Barron’salso mentioned the fact that inflation, very conservative Barron’sis saying, “Hmm. Could we possibly be looking at higher inflation?”

David:Yes, the gold market has been too neglected of late, and I can hear the question from one of you out there as a listener, “If Barron’sis giving a plug for gold, is that ever a good thing?”

Kevin:(laughs) Good point.

David:I would say that the environment is hardly one of bullish momentum. In fact, you have Vanguard which is dumping its only precious metals fund here in recent weeks, which is far more suggestive of reaching a low. So I would look at the Barron’sarticle not as a tip-off of gold heading lower, but rather, representing a contrarian possibility, not a full-fledged endorsement.

Kevin:You mentioned Vanguard dumping its only precious metals fund. Vanguard really is the vanguard in this whole passive investing mentality where you really don’t need a manager anymore, just put it in and it works.

David:And it will work until it doesn’t.


David:Bank of America/Merrill Lynch released a paper here in recent weeks ranking countries by the quality of their domestic finances. For the purpose of the comparison they combined the current account deficits and the budget deficits as a percentage of 2019 GDP.

Kevin:Basically, just trying to test the health of these various countries.

David:Yes. So where do you think the U.S. lands out of the 45 countries they were outlining?

Kevin:You mean the greatest economy in the world, the United States, with the reserve currency? With Trump? How are we doing?

David:Fifth from last.

Kevin:Out of 45 countries, we are fifth from the last.

David:We have maintained a lead over Argentina, Turkey, Brazil and Pakistan. Of course, this is because our current account deficit and our budget deficits are just whacky. So we have something that those other countries don’t have. We have the reserve currency status.

Kevin:And the military to enforce it.

David:That’s right, like I said earlier, because we get to push our weight around. The only way you get to push your weight around is with healthy contracts to Lockheed Martin and other arms manufacturers which makes sure you have the best, the latest, the greatest technology.

Kevin:We’re in the navy now.

David:(laughs) Next week I am going to be with Jim Grant for his company’s 35thanniversary celebration.

Kevin:Interest Rate Observer, Jim Grant, 35 years writing the paper.

David:He asked the question recently, “We wonder if the demand for dollars is infinitely sustainable at current interest rates, at current exchange rates, and with the current state of geopolitical play.” He went on to say, “There is a silent party at the monetary policy table. He or she is the person who elects to hold dollars, or instead, chooses euros, yen, Singapore dollars, or gold.” His point was, really, toward this end. Today, the dollar is, hands down, the currency of choice. But other considerations may weigh in the scales tomorrow.

Kevin:Dave, do you remember from the 1970s all the way until the tech stock bubble popped, where the United States actually had to pay people interest to hold dollars? Do you remember that?

David:Yes. Well, the Fed funds rate averaged 7% through that period, probably from 1970 to the year 2000. Most of my adult life the average Fed funds rate was 7%, and now we get a one-quarter of a point tick up last week, which is great. That’s the first interest rate move we have had in this whole tightening cycle that has brought the rate of interest above the inflation rate. So arguably, and I thought about this while I was in Europe, is this really where we initiate the three steps and then a stumble? Because up to this point it has been less accommodative monetary policy, but by no means restrictive.

When you are now seeing an interest rate that is above the rate of inflation, could you argue that we now have a restrictive monetary policy? This was the first of three restrictive monetary policies. Have we initiated our three steps and a stumble? Who knows what the threshold is, but there is going to be a point at which asset prices recalibrate. That is also something that I want to talk with Ed Easterling about because interest rates are a factor. Inflation is a factor. There are some really significant elements here which are going to determine the course of investor returns over the next decade.

Kevin:You know, there is a whiff in the wind that the market might be too high when you look at the executives who run those companies not actually holding the shares of their own companies, even though they are using company assets to buy back shares en masse. You know what it reminds me of? When you have an executive selling shares and then taking the same assets of the company and buying back shares that come back onto the books of the company, it reminds me of an analogy. Let’s say you walked into a MacDonald’s, and Ronald Macdonald was walking out. You just followed Ronald MacDonald. Now, Ronald is there to sell you burgers, to tell you that burgers are the greatest thing. But he goes next door to the salad bar, and he is eating salad, and you think, “What does Ronald MacDonald know that I don’t?

David:About those hamburgers.

Kevin:And you have these executives selling their own shares at, I think, record levels.

David:Certainly August was a record. The Wall Street Journalwas talking about the record number of share buy-backs, and we are still on track, 189 billion here recently, keeps us on track for the 800 billion to 1 trillion end-of-year finale. And of course, if you’re buying back all of those shares, you are boosting your earnings-per-share.

Kevin:And the price of the shares. That does push the market up, too.

David:Yes, you’re limiting supply, bumping up the price. The improvement in earnings-per-share, remember that compensation packages are triggered off of earnings improvements. So you get an earnings improvement off of the share buy-backs which triggers compensation packages for the executives. And lo and behold, executives are doing the opposite with their own shares versus what they are doing with company capital.

Kevin:So they boost the compensation package, they get shares, they sell their shares and they buy back more with company assets and boost their compensation packages. They do this over and over. That is what Smithers was talking about.

David:Right. In September they unloaded 5.7 billion dollars in shares, according to Trim Tabs – great organization. They do some great research. 5.7 billion dollars in insider selling, according to Trim Tabs. That is their own shares. They are quietly slipping to the exits as the crowd enthusiasm for new high prices is sucking the average investor into the indexes.

Kevin:Ronald is going to the salad bar.

David:But August was even worse. August was at a ten-year record, 10.3 billion dollars in insider selling. I think it is worth lingering on that question. Buy-backs and insider selling – how do you translate the difference?

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