Podcast: Play in new window
- Insider Equity Selling 50/1 Over Buying
- BOA “We Cannot Allow The Markets To Determine Interest Rates”
- Private Equity Nightmare: 28,000 Unsold Companies Worth $3 Trillion Dollars
“They’re trying to figure out why consumer sentiment isn’t stronger given a relatively strong economy. And if you look at cumulative inflation, cumulative inflation just in the last few years, now over 36.5%, it’s understated inflation. We know that. If you factor in housing and interest costs, that pushes the number to well over 50% just since 2019. Now, John Williams goes back even further to the original conception of CPI, and he would say, actually, since 2019, you’ve got cost of living up over a hundred percent.” –David McAlvany
Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany.
David, we just got out of our meeting, and Morgan was talking. He said many things that were shocking, but insider selling on the stock market right now, there’s somebody in the know. Morgan was talking about, you don’t want to be playing the old game when the new game starts. And there are people who are playing the new game right now and they’re the insiders. Insiders are the tops of each of these corporations, and they’re liquidating stocks at a pace 50 times more than they’re buying. They know something that the markets aren’t really showing, don’t they?
David: Well, the market is coming awake, at the edges anyways, to a number of fresh realities. They’re not fresh, they’ve been here in plain sight, but they’ve been ignored. And so the obvious things are beginning to sting. Michael Hartnett talking about inflation.
Kevin: He’s with Bank of America, isn’t he?
David: That’s right. Really sharp guy. And as we’ve been saying, we will see interest expense which is absolutely mind-numbing, $1.5 trillion this year. And he says, unless we lower rates 150 basis points, actually, he raises the number to 1.6 trillion. And again, this deals with the maturity wall we’ve talked about for weeks, this idea that we have trillions and trillions of dollars that have to be refinanced at higher numbers, and it is consequential. It’s consequential for our fiscal picture. It ultimately is consequential for the US dollar, but in the short run, it’s just a stress and strain on the Treasury.
Kevin: Well, and he said something else that really was fascinating too. He said, “We can no longer allow the markets to set interest rates.” That’s when you’re backed into a corner when you can no longer let the market do what the market would do.
David: Well, that’s right. So we have Japan who’s finally moving away from yield curve control, kind of, not really, and now the US will probably take the baton and run with it for a bit. Nearly a week ago, Fitch downgraded its long-term outlook on China to negative, and only a few days later we’ve got the country, which surprises with first quarter growth exceeding expectations coming in at 5.3%.
Kevin: Oh, I guess Fitch just missed the point.
David: Right. Things aren’t really that bad. What you have is fiscal policies moving to center stage in China as they were for us during COVID, where if you’ve got a gap to fill, the government will guarantee that the money gets spent. Now, as we’ve experienced, there are implications or ramifications—consequences—to that, but it’s worth returning to this idea that growth has many different styles or expressions, and growth is not of the organic nature in this case. We’re talking about, in our neck of the woods, government spending as a part of that growth component, and it’s debt that is giving us positive GDP figures. There, too, it’s government initiatives. Growth is not of an organic nature. It’s more like miracle grow. In fact, I would almost describe it as Roundup. You increase your crop yield but you cause cancer tomorrow.
Kevin: Isn’t that a little bit like saying we can’t allow the markets to determine interest rates? Okay. We can’t allow the markets to determine GDP growth. I mean organic growth and artificial growth, which do you want?
David: Well, I know what our policymakers want. And so Chinese manufacturers, at least on the other side of the pond, Chinese manufacturers are being subsidized. The state has basically said, “Okay, if real estate’s not going to be our go-to for a plug and play growth model, then we’ll go back to the mercantilist model. We’re just going to export to everyone, flood the global markets.” That is happening as we speak. Yet to illustrate, last week I came across a Financial Times article and it talks about the Netherlands and Germany. In both places, people are using solar panels as an alternative to traditional fencing because it’s so cheap.
Kevin: Because the Chinese made so many for so few dollars.
David: They’re flooding the markets. Manufacturing costs are down. People are saying, look, “I can’t afford to rent the scaffolding and have the crew come out and put it on, but I’ll get at least some benefit. And it has a new kind of 21st century beauty.” [Expression of disgust.] So you’ve got the landscape now being littered with photovoltaics because scaffold rental and labor for installation are unaffordable. And the knock-on effect is that your French photovoltaic manufacturers, your German, your Norwegian manufacturers, they’re fighting for survival as their profit margins have disappeared. So you’ve got the work of subsidized glut production from China, which is remaking the green energy movement. But on the bright side, economic activity is a measurable success, measurable success at 5.3% annualized growth, and you just can’t argue with success.
Kevin: This goes back to playing the new game or still sticking with the old game. The old game doesn’t work. I wonder, have the banks actually hedged for the new game?
David: Yeah. From the crew at the National Bureau of Economic Research. A couple of different articles that I came across. One, fascinating research on last year’s banking sector turmoil, and of course we’re just past the one-year anniversary of that last March, I think was March 10th that SVB went under. And the talk at the time was, “Gosh, this is really silly. In fact, borderline stupid. What were they thinking? They should have hedged interest rate risk.” At least most in the banking industry do, and this is your sort of anomaly. Sun was in their eyes, they didn’t see it coming. No one expected rates to go that high so fast.
Kevin: But was it true? Do most of the banks actually hedge for this?
David: While the NBER paper dug into the assets hedged and unhedged from interest rate risk, and they found that the majority of banks, two thirds did not hedge the risk.
Kevin: Wow.
David: We’re not talking about a one-off. We’re talking about the majority of banks did not hedge interest rate risk. It’s not just a few financial fiddlers failing to hedge. Instead, they leaned heavily, and this is where those two thirds banks did not get into trouble. They leaned heavily on accounting reclassification.
Kevin: Apples are called oranges for a little while.
David: Yeah, so it’s sleight of hand, shifted over a trillion dollars in underwater assets from one category known as the available-for-sale category to the held-to-maturity classification, which shifts because when you’ve got available-for-sale, these assets are mark-to-market. That’s how they’re appraised, that’s how they’re valued on the balance sheet. But once you move them to the held-to-maturity category, you can appraise those assets at par. You don’t have to account for any losses. Where will they be when maturing in the future? Again, some people would call that a mark-to-make-believe instead of mark-to-market, just make up the number. They’re not making up the number. It actually ties to the par value of those bonds, but it was a free pass on the basis of accounting reclassification.
Kevin: Wow, which means it’s still baked into the cake. Dave, if I was able to do that, let’s say when my wife and I first bought our house, let’s say we put $20,000 down on a $400,000 house, I would be counting that house as mine at $400,000. I’m basically saying, “Look, I’m going to hold this to maturity, so it’s going to be a $400,000 house.” On paper, I would look like I had a whole lot more than I did. The thing that worries me, because we’ve heard that there are 1200 banks on the imminent failure list. This is still baked into the cake. It might even be more than 1200 banks.
David: Well, that’s right. There’s no immediate pressure. And from a pragmatic standpoint, this was a stroke of genius. But in practical terms, you’re dealing with dozens if not hundreds of bank insolvencies. They’re walking zombie corporations, but they get a free pass because of the accounting reclassification. So the bank failures were contained more by the bad press of the few as opposed to the many, which scurried to rectify their balance sheets being upended by losses. In this respect, think about this. Commercial banks and our central bank are roughly similar. When our central bank takes a loss, it too is reclassified. They have operating losses today in the hundreds of billions, but they just give them a new identity. What you would think of as a liability or a loss is reborn for the Federal Reserve as what they literally call a deferred asset. So you take a loss, and no, no, no, it’s a deferred asset. Let’s be clear on what that means. Similarly, commercial banks can relieve pressure, can buy time with the wave of an accounting wand.
Kevin: Well, and how much are we talking here?
David: And by the way, just looking back a ways to 20-plus years, we had Enron who wanted to do the same thing. They had wins, they had losses. They told everyone about their wins, and then they stuffed their losses into special purpose vehicles. That ended up being an accounting scandal. Arthur Anderson, who approved all of those SPVs and signed off on them, disappeared. One of the Big five. Now we only have the big four accounting firms. It was such a reputational hit. And it’s just fascinating to me that we have sort of these pockets where— It’s acceptable behavior if it’s the central bank. It’s acceptable behavior, sleight of hand, if it’s a commercial bank. But if you’re a publicly traded company, clearly there’s malfeasance involved. And lo and behold, between Ken Lay and Jeffrey Skilling, there was jail time involved, and for good reason perhaps.
Kevin: How much in the way of losses are we talking about? These are pockets. If they put it in a pocket— It makes me think of Napoleon Dynamite with those tater tots in his pocket. How many tater tots are in the pocket, these losses that nobody really wants to talk about?
David: Yeah. Again, this is the National Bureau of Economic Research. Their team estimates that 175 billion in losses were avoided. And for that, again, we can be thankful because we do have banking system stability. The FDIC is inadequately reserved to handle those numbers.
Kevin: Wow.
David: So if you think about it, we could have lost not just SVB in 2023, we could have lost the entire commercial banking system as you see the frailties revealed. Frailties still exist, but they’ve been papered over. They’re inadequately reserved—that is, the FDIC. It does remind you, coming back to the similarity between the Fed and the commercial banks, that you have a confidence game, a confidence game, and it requires suckers to continue. Confidence in our commercial banks, like confidence in our central banks, requires a suspension of disbelief and an embrace of what I would think of as Potemkin financial engineering. The Potemkin Village was sort of this facade of success, and this goes back to Russia.
I remember being in North Korea actually right on the border. We got to cross the line and be in the meeting room where one foot’s in the north and one foot’s in the south. But you look just a few miles away from this center for negotiations there on the North/South Korean border, and you’ve got an entire village. They play music all day long on loudspeakers. These are empty buildings, but they want to prove to the south their economic success. How different is the Federal Reserve from what you have just on the other side of the North Korean border? This is Potemkin financial engineering.
When people see past a facade of security, guess what they choose instead? Guess what they choose instead? To be Vaulted. Sorry for the pun, but to be Vaulted. You’ve got ounces over empty promises. And it reminds me of Old Bullion. Old Bullion was the nickname given to Chemical Bank in the 19th century, early 20th century, because they held 100% of their deposits. This was a bank that could not go under. 100% of their deposits were held in ounces. You paid to have your reserves there. You weren’t paid to have your resources at Chemical Bank. Why? Because Old Bullion was where you knew you were going to get 100% of your money back.
Kevin: Dave, last week when we were recording the program, I had a crew come out to our house. We have some acreage. We’ve got a lot of woods. We live in a very dry area down here in Southwest Colorado. And this year may be a big fire season. So to appease the insurance company, we are doing a lot of fire mitigation. And I didn’t realize I had so much wooded coverage. I really didn’t have to deal with a lot of the junk that was on my property. And so I had it hidden behind this pine and this juniper, and didn’t really realize how much I had neglected the property until Tuesday, Wednesday, and Thursday. They just did a major clear.
Everything that was dead, they cut everything. The things that were alive, they cut all the branches up high. And I looked out my window and I thought, “Oh my gosh. We’re trailer trash. We really are.” And so I spent the weekend getting rid of and doing dump runs and what have you. But it reminds me of what will be exposed when these banks find out that interest rates are not coming down, but they’re going up.
David: Right. And you see that revealed in other parts of the financial universe as well. So in private equity, the bloom is off the rose. In private equity, the bloom is off the rose. The private equity bloom was fully on display 18 months ago. The height of popularity, the perfect investment, higher rates of return, clearly, for more sophisticated investors. Do you want higher rates of return? Well, if you want to, you can join the company of those more sophisticated investors and perhaps even feel like one, a sophisticated investor, for a while.
Kevin: Yeah. It boils down to renaming things. At one point last week, I could say, “No, that’s a tree.” Now that the tree’s been trimmed back, I can say, “No, that’s a junk pile.” Okay. There’s a big difference. And the banks have been doing the same thing. They’ve been hiding their losses in pockets.
David: Well, right. So if you hold to maturity versus have an asset available for sale, or if your liabilities become deferred assets, what is wholly unsophisticated about the private equity space is it’s renaming, and not only renaming it, but treating it differently in light of that new veneer. Private equity is nothing more than a rebrand of the leveraged buyout corporate rating, which was led and popularized by the junk bond king, Michael Milken. And we found the frailties of the LBO days, leveraged buyout days. When you finance all that stuff with junk and something goes wrong in the junk bond market, you can’t make the numbers work on an acquisition when rates begin to go higher.
But this is what has worked so well for private equity. If you’re looking at an asset and it’s not perfectly priced, doesn’t matter. If you’ve got free money, you buy it anyways. Add leverage to the equation. Multiply your low single digit margins into anything you want. You just increase your return by adding leverage to the equation. Money’s cheap. The returns have no cap. Just add more leverage.
Kevin: And you bring up leverage. It reminds me of a friend that I grew up with in high school. And he always swings for the fences. And I remember when he was talking about, “Oh, you need to be playing day trading.” He quit his job. He was day trading. And then the flash crash came—what was that, about 10 years ago? And it set him back to where it took working a couple of jobs to make back what it was that he gave up. Well, private equity. They came to have dinner with us about five months ago. And he was like, “Oh, it’s all in private equity. Private equity’s the place to be. I just participated in private equity.” That’s a thing of the past, isn’t it? I’m thinking he may be going back to his day job again.
David: Well, this is almost two years ago. Grant’s Interest Rate Observer drew attention to the best days of private equity already being in the rearview. So these stellar rates of returns by the Yale Endowment and others who were willing to take on illiquid assets for a little bit more juice, that is in the rearview. Critical analysis of the dynamics that had yet been undone prior to rates increasing, right? So this is where it works under a certain set of circumstances, but you have to look at things under the new regime. Rates have increased, and the game has changed, but people are still playing as if the old set of rules was in place.
Now the reality of higher rates is revealing the frailty of leveraged buyout corporate raiding as a business model. The only way it works is with access to massive amounts of capital at minuscule costs. These are the support pillars for private equity. And without them, those pillars get blown out.
Kevin: Okay. So we have seen some of these private equity companies actually restrict exit out of the company where they really don’t have liquidity. But for those who are able to exit, are they coming out at a profit?
David: Well, according to the Financial Times, 99% of exits from portfolio companies—this is for 2023—they’re being done at or below the net asset values of the company. So instead of getting premiums, at this point, things have shifted and the promoters haven’t really advertised that. So we’re not in the usual exit formats where it’s fresh acquisition. A new private equity is buying from an old private equity company. So you’re talking about M&A activity within private equity. Or you take the company and you take it to the public markets. You do an IPO, initial public offering.
Now things have changed. You have to dump those assets into the secondary market to be recycled to the new money coming into the space. The market shifted. The new money feels that it’s an honor to play in the big leagues. The new money doesn’t have the first mover advantage of 20 years ago. They are the proverbial bag holders, the privileged that are now— I would describe them as somewhat privileged because they’re getting ready to learn a lot. They are preparing to pay tuition. Tuition can be very expensive. And they’re going to learn the basic truths of, not all that glitters is gold, and that there’s very little difference between private equity and a pyramid scheme.
Kevin: Well, and maybe all that glitters is gold. It’s just this is fake gold. This is fool’s gold. But you were talking about leverage. Private equity really depends on leverage. And so interest rates have to have an effect.
David: Well, and their plan is to exit their portfolio companies within three to five years. So they finance things on a very short-term basis, and know that if they hold the company, they’ll have to refinance the debt. Or they’re going to sell it off to someone else who will finance the purchase at whatever the prevailing interest rate is. Higher interest rates introduce a slowly suffocating element for private equity operators. They need ample access to cheap money to get deals done. Short-term financing allows for these low initial rates, and it also allows for bigger deals to be done at higher multiples. It allows for big payouts, huge dividends to the private equity operators on the front end. And it’s all assuming that disposal of the assets will take place in no more than three to five years.
Kevin: Yeah. I liked your analogy of slowly suffocating. We have carbon monoxide detectors in the house because you can’t smell it. It’s not like natural gas or something which is tainted with a smell. Slowly suffocating. That means these bag holders have absolutely no idea that this debt refinancing is going to expose the junk that was hidden behind the trees.
David: The baton of ownership is getting passed. Or theoretically it should get passed. And I think you get the same thing as we talked about with Michael Hartnett, and this notion of government debt that has to be refinanced at higher numbers all of a sudden makes the existing stock of debt untenable, unbearable, right? $1.6 trillion in interest payments. You’d say, “Well, this is kind of terminal math.” Well, debt refinancing is a part of the forced reality within private equity. New buyers emerge and they’ve got to pay the new prevailing rate, or those assets have to be discounted sufficiently, and that’s where the rub is currently. If money’s not cheaper, then you have to look at the current value of those assets. If money’s more expensive, the multiples which you thought were justified when the assets were originally purchased, now you’ve got a shadow cast not only of the current value of the assets, but also of the exit, if that exit is a part of the strategy.
Kevin: So a little like the banks. Private equity is a little bit like engineering and renaming and making sure that you can hand off the liability to somebody else.
David: But certainly, private equity is first and foremost about financial engineering. And it’s about extracting as much value as possible without killing the entity. It’s not a value creation model. It is a value extraction model. And what enables the process is access to cheap money. Again, the difference between value extraction and value creation. Imagine if a butcher was able to take the best cuts off of a cow while still leaving the cow on hoof. That’s what a private equity group wants to do. They want to take the best cuts and then leave you with whatever’s left on hoof.
Kevin: So it goes to the cost of capital. We’ve interviewed guests here recently that talk about the cost of capital. And the cost of money is critical to making things work.
David: Absolutely. You have between now and 2028 $2 trillion in private equity. This is debt that has supported these deals that has to be rolled over at newer and higher rates. The lessons of 2023, for those taking note, were that private equity illiquidity is, in fact, meaningful. It’s very meaningful. And again, I say 2023. Here we are in 2024. Why am I reflecting back on this? Because the change has already happened. Yet, few in the marketplace are willing to acknowledge it at this point. There’s a little bit of an ostrich syndrome when it comes to this space. But we’re not talking about insignificant sums of money. Between here and 2028, you’ve got a massive rollover in private equity debt. So with the change in rates, illiquidity is now a meaningful factor. Deal volumes have collapsed to the lowest levels in a decade. We’re, for 2023, 44% below 2022 numbers in terms of deal flow. So we now have, according to the Financial Times, 28,000 unsold companies worth $3 trillion.
Kevin: $3 trillion.
David: That’s what’s clogging the pipes.
Kevin: Wow.
David: 28,000. You heard that right. All of these assets, the reporting of the current value is delayed on about a six-month basis. And it provides operators what is an apparent non-correlation to financial assets. If you’re looking at a portfolio and your stock portfolio is down 10%, your private equity is holding nicely where it was two months ago, three months ago, four months ago because, again, in most cases, you’re talking about a six-month delay before you get the repricing of those assets. But it is correlated. It is correlated. It’s just that delayed reporting function that makes it appear to be separated out from the public markets. Values have shifted already, even if reporting is out of sync.
And of course, many of these assets are subject to modeled pricing versus market pricing because you’re not talking about something that trades in the open market. If it’s real estate, you have to have comparables. If it’s a private business— Again, what was the last similar company sold, and what were the multiples of that company? So with fewer transactions occurring, it’s harder to know how to price things.
The same things that affect public stocks and bonds, they affect their private brethren. Publicly traded or not, you’re coming back to this one core issue. The cost of capital matters. Where interest rates are and where they’re going, they absolutely matter. So the “illiquidity premium” for this investment space turns out to be an excess of returns tied more to financial engineering and high levels of debt, not just some sort of magical private market dynamic.
Kevin: It reminds me of a chain letter or a pyramid scheme. I remember my parents were involved with a multi-level type of business at one time. And I remember going and seeing the people who were early in, and they were called the diamonds, and the diamonds would get off their jet and they’d come and they’d talk to everybody else. The whole concept was, if they could keep talking to people with five friends, everybody had to have five friends, and if you had five friends, you’d have them over, you’d show them the presentation, then they’d find five friends, and then they’d find five friends.
The problem is, there’s no sustainability to that model because you run out of friends at some point. And I think about this, Dave, you can run this with free money. That’s sort of almost an analogy of the friends. As long as you have free money, you can continue to run these pyramid schemes but at high interest.
What you’re saying, I think, is that these friends are going to be extracting much higher interest down the road. And the pyramid scheme, if that’s what this is, this is 28,000 unsold companies and—what’d you say? $3 trillion? This is not a small issue.
David: No, it’s not. And when investors want their money back, that’s when you begin to see a bit of the reveal. Blackstone had a real estate investment trust which, they gated withdrawals and would not allow them last year. They’re finally back to allowing for withdrawals, but it’s fascinating. Even that particular product, their dividend payouts to investors exceeded the income from the underlying assets last year. I don’t know that that’s sustainable.
Kevin: I guess not.
David: The fresh expectation is now that if you want your money back from a private equity deal, you’re going to have to wait between two to three years because liquidity has dried up. Now, promoters want to get paid too, and honestly that’ll happen regardless of the market environment. Again, a part of the financial engineering of these products is they’ve got these huge dividends which get them paid as quickly as possible. Fat dividends paid up front for financial engineering, this is nothing more than the leveraged buyout excess 2.0. Think of it as sand in the gears. As they’re experiencing less smooth operating, they’re having to get creative. And for anyone with an objective view to this, you can see that it’s problematic. NAV [net asset value] loans, that’s what they’re doing right now. NAV loans provide that much needed liquidity.
Kevin: And what is that?
David: Well, you take an indebted portfolio and you borrow against the indebted portfolio, so you’re laying debt upon debt. Think of it as a second or third mortgage on your home that allows for cash out liquidity generation. If you want to look at the health of a household balance sheet, reflected in that second and third mortgage is a picture of weakness. Private equity is no different. These NAV loans are an indication of acute stress within the system. System’s not working, so they’re coping. Coping very creatively, but that’s what you’re seeing more and more. Commercial banks coping creatively, the Federal Reserve coping creatively. What a beautiful concept. I’d love to have a deferred asset, wouldn’t you? What a deal?
In true pyramid fashion, the game goes on. The game will continue to go on, even if it takes self-dealing to maintain those perceptions of strength. I’m not seeing amongst a lot of institutions real concern. They should have been concerned two years ago as that market was at its pinnacle of strength.
Kevin: They’re still playing the old game.
David: It’s very interesting. There are deals being done, but it’s curious how a lot of those deals are getting done. If I buy an asset and then sell it to myself, you might say, is that a sign of health? I’ve got two entities, two different financial structures and financial structure A buys the asset and a year later sells to financial structure B. You see what I’m getting at? I mean, it’s creative. Everyone appears to be happy.
Kevin: We lose money on every sale, but we make it up on volume.
David: Actually, the description of private equity as a pyramid scheme comes from a March 10th Financial Times article. I mean, I’m not making this up. Just one last comment. I was on a call for one of the foundations I advise for, and I asked the unthinkable. It was about three weeks ago. How do our private credit assets perform in the scenario where rates increase instead of decrease?
Kevin: What was the answer?
David: Well, the answer was both harrowing and, to me, a bit hollow. I hold this person in high regard. He said rates will go down. The Fed’s forward guidance assures us of that. So there was no discussion about where rates would go. So on that basis, we have no concern in private equity. His second comment, though, was the part that was harrowing. Again, hollow was the first, harrowing in the second. “You have to remember,” he said, “these are assets with a timeframe we’ve invested in for perpetuity. As long-term investors, we’ll be fine.” That was the big reveal for me. An expert in private equity acknowledging the allocations that we’re now in are nowhere close to being out of a pricing crucible, and we’re just going to have to suffer through this. But don’t worry, we’re long-term investors.
Kevin: Yeah, so it was a nice way of saying we’re stuck.
David: Well, precisely. Higher returns are predicated on borrowed funds. The success of the LBO market and of private equity today, quick exits, and of course what facilitates all of that is the accommodative interest rate. That was yesterday. Not necessarily tomorrow.
Kevin: Old game, new game.
David: Yeah. Tomorrow promises to be difficult in private equity. And again, I mentioned 2 trillion. It’s 1.95 trillion in debt which is coming due. It needs refinancing. And this is all considered below investment grade debt. So just let me frame that a little bit better. If it’s below investment grade debt, it’s borderline junk or it is junk. It’s this replay of the Michael Milken LBO blow up. Not only the accumulation of debt, but then when they turn sour, they turn really sour because they weren’t great quality anyways. Not only are rates potentially going higher, but then you have credit spreads on the below investment grade paper, which can widen on top of that rate increase. It brings greater downside to the space than I think anyone in the space has an imagination for.
Private credit is a little bit different. As bank lending slows, there is an opportunity within private credit to fill a gap, but it’s the IMF writing in the last few days that they have growing concerns for financial market stability because of the loans that are being made in private credit. It’s an unregulated space. And wherever there is a lack of regulation, a lack of look through, there you have problems growing, particularly when you marry up lack of transparency with Wall Street’s motivations of greed and profit. But private equity—again, going to that—I think that should be avoided like a plague till you know where interest rates settle out. That’s not going to be for several more years.
Private equity is, in my view, currently uninvestable, which puts it in a category like Russian equities. How’s that for a duo? Russian stocks or private equity. Clearly the perception gap hasn’t shifted, but I think it will as interest rates creep a little higher.
Kevin: So for the listener who says, “All right Dave, I hear that, but I’m not in private equity, but I am in the stock market right now.” The stock market had priced in what? Six or seven potential interest rate cuts going through this year. Those are all being taken off the table at this point.
David: Well, that’s right. The pep in the step that we saw in the equities markets Q4 of last year and the first quarter of this year have a lot to do with the anticipation of lower rates. Going back to my colleague on the board level who basically said, we’re not worried. We have forward guidance, and that assures us that rates are going lower. There might be a little bit of surprise there. To your point earlier, if we’ve got 50 times the liquidations in the public markets that is in the stock market—
Kevin: Yeah, from insider selling.
David: —insiders, CEOs, CFOs, I love to see when someone puts their money where mouth is. If they’re like, “I’m going to manage this business towards greater success and I want to own an extra million dollars worth of shares in the company.” But what if it’s the opposite? 50 times the liquidations to purchases? That is a telltale. Where does the wind blow? I think you’re seeing CEOs say, “We know that we’ve got headwinds ahead, and I don’t necessarily want to navigate these waters.”
Kevin: So they’re possibly seeing that we may not have rate cuts coming and that’s causing damage to the markets.
David: Yeah, financial markets are just in the last few days beginning to adjust their outlook to no rate cuts in the first half of the year. Maybe not even in the last half of the year. And if that’s the case, equities are very vulnerable. You’ve already got technical damage hitting the major indices. If you’re looking at the NASDAQ, the S&P, the Dow, you are beginning to see a breakdown in price. Bonds have had a terrible 10 days since beginning this sort of adjustment process to higher rates. No safe haven bid has emerged for Treasurys, which is really critical, I think, to pay attention to. Just a little detail, but as equities have softened, bonds have softened too with interest rates rising to reflect not a lot of buying, in fact net selling in the Treasury markets. Concerns of higher rates and higher inflation are more present every day.
Kevin: Yesterday, I felt like the old guy in the office because I was telling one of the guys in his 30s that I was here when Volker— Volcker was still the chairman of the Fed when I first started here. And back in the days of Volcker, the way they measured inflation— You’re talking about inflation. They’re telling us two, three, 4% right now. That’s ridiculous. If we just continued to measure inflation the way we did in the ’80s, what are we at? We’re at eight, nine, 10%.
David: Jim Grant takes us back to a key component in the CPI which was conveniently extracted, and it makes the official statistic look much better than it actually is. 1983. 1983, the CPI was overhauled and interest expense was extracted from the cost of living.
Kevin: As if it wasn’t even a cost. They just took it out.
David: Add that one thing back and you’re moving towards higher rates of inflation. We talked about Larry Summers’ critique of CPI. Here it is. And he says, when interest paid is considered as a cost— This is another NBER paper by the way, National Bureau of Economic Research. He was on the team that wrote this. “When interest paid is considered as a cost borne by consumers and included in CPI, the year-on-year inflation rate increases by one percentage point throughout. When both personal interest payments and the cost of homeownership are accounted for in CPI, the year-on-year inflation rate increases from 3% to 9% in November of last year.”
Kevin: Wow. Three to nine?
David: Yeah. “Including the cost of money…” This is how he finishes, “Including the cost of money as a part of purchases makes for a higher rate of measured inflation.” That’s how that team at the NBER is looking at things in February. Now, we’ve got three months in a row of an increase in rates. The article is titled “The Cost of Money is Part of the Cost of Living: New Evidence on the Consumer Sentiment Anomaly.”
Kevin: Sure, because I pay interest when I’m in debt. Everyone out there buying bread at the grocery store is paying interest, probably, on debt. Why wouldn’t you factor that in?
David: Well, the title is important because they’re trying to figure out why consumer sentiment isn’t stronger given a relatively strong economy.
Kevin: Why aren’t you happier?
David: And if you look at cumulative inflation, cumulative inflation just in the last few years, now over 36.5%. It’s understated inflation. We know that. If you factor in housing and interest costs, again, going back to what was extracted in 1983, that pushes the number to well over 50% just since 2019, again.
Kevin: And we’re talking about cumulative inflation from 2019 until now.
David: That’s right. Now, John Williams goes back even further to the original conception of CPI, even earlier than the ’83 shifts. And he would say, actually, since 2019, you’ve got cost of living up over 100% in that same timeframe. So, pick your poison. We’re only up 36 and a half percent since 2019. Oh, no, we forgot a couple of things. You are paying for them, but we’re not counting them, well over 50%. Oh, if we want to go back to the original model used for the Consumer Price Index, now your costs have gone up over 100%.
Kevin: It’s as if we’re living in South America, Brazil, Venezuela, Argentina, all these inflationary places.
David: That reality has households under pressure. And of course, that’s what is defining sentiment. They’re viewing it as an anomaly, something that can’t be explained, and it’s a fresh discovery that the CPI is a falsified number. It’s actually a new discovery for them.
Kevin: So, this has got to be an election issue. I mean, if you’re Joe Biden, you’ve got to wonder.
David: Well, I think the one part of Fed policy which is tough to rationalize is, returning to 2% inflation target, why are we even doing that? And even if we do, let’s say that we agree intellectually, just as a thought experiment, we’re comfortable with a 2% inflation target, that’s the way it is. That doesn’t reverse the 50% increase in prices we’ve already experienced.
Kevin: That adds to it.
David: We’re compounding. Maybe it’s at a low level of 2 or 3%, but we’re compounding at a low level off of a much higher base. And so, any marginal increase inflation on top of the already 50% increase, again, sort of your year-over-year impacts, cumulatively is just devastating.
Kevin: So, they’re completely detached when they’re saying, “Gosh, why aren’t they happier? Why is there so much discontent right now?”
David: So, to your point, inflation remains an election issue. Of course, it does. And maybe it’s the election issue for middle-class families. The question of a 2% inflation target, that may well be the straw that breaks the camel’s back in terms of central bank credibility. From Jim Grant’s most recent letter, “you will have scant patience for the Fed’s self-assigned remit of skimming 2% a year from the purchasing power of the dollar. What is it, really, besides monetary shoplifting tricked out in the econometrician’s algebra.”
Kevin: I remember when I was taking economics in college, it hit. I had an economics teacher, Dr. Cochran, who basically said, “Here’s the black box theory of how these things work.” And when you’re taking economics, you have to sort of have a black box theory. And one of the black box theories is if interest rates are rising and the currency is rising, then gold falls. That’s part of the black box thinking. If interest rates are rising, the dollar’s rising in value against other currencies, then you would guess that gold would fall. And Morgan was talking about this again this morning too. He said, “In a normal economy, I would expect gold to have fallen 400 bucks at this point, based on the fact that interest rates are rising, the dollar is strong, yet the opposite has happened.” Gold is up $400, not down $400 over the last few months.
David: And I think the key qualifier there with the black box model of rates higher, dollar higher, gold lower is the qualifier “all else being equal.” Not all else is equal. Gold’s moving higher in that context of rising rates and a strong dollar. This is very significant because it’s telling you that the buyer today is considering other factors. All else is not equal. Geopolitics and fiscal suicide, those are the two factors that first come to mind. Yes, resurgence of inflation would be a third factor. But you look at geopolitical tensions, you look at fiscal suicide which is unfolding, maybe it’s different in China. They’re the ones who are buying gold hand over fist. Do you know the biggest cohort of Chinese gold buyers today? 59% of the consumers buying gold in China today are between the ages of 25 and 34 years old.
Kevin: That’s amazing. Okay, so the major buyers, because we know the buyers aren’t here in the United States yet, we’re selling. I mean, it’s crazy. We’re still playing the old game. We haven’t adapted. But you’re saying that 59% of the buying that’s in China, which is robust right now, they’re paying pretty substantial premiums on the Shanghai Exchange just to get physical gold, their age group is 25 to 34. Dave, I started here 38 years ago. They’ve all been born since I started working in this field. It’s the young generation that’s actually trying to hedge right now. What are they coming out of?
David: That geography is defined by a loss of hope, and that demographic is defined by a loss of hope. If real estate is in free fall, if the stock market doesn’t offer you upside, if you can’t speculate in cryptocurrency, where are you going?
Kevin: Where do you go?
David: Right. So, in the West, we’ve got year-to-date liquidations equal to 5.3% of the assets in GLD. 16% of assets have been liquidated since the beginning of 2022. That defines here in the West a pattern of disinterest.
Kevin: We are so disconnected.
David: Eastern buying is different, both in the scale of physical metal purchases and frankly also in the companies that produce the commodity. Grant’s points out that the Chinese authorities have halted trading in a gold mining ETF for the second time in a week, as the premium over the underlying assets have swelled to over 30%.
Kevin: Wow.
David: In the U.S., just by contrast, again, if you’re talking about consumption of gold, okay, that’s one thing. In the U.S., your top-tier producers, these are the companies that dig in the dirt and mine for it, they trade at nearly a 30% discount.
Kevin: So, 30% premium over what’s in basically the assets in the mine in China. The Chinese halted the mining shares being sold on the ETF. But we have the opposite. Right now, we’ve got a 30% discount to what’s in the ground.
David: What a contrast.
Kevin: Wow.
David: China, 30% premium, the U.S., proportional discount. Of course, again, in China, the real estate market is broken.
Kevin: That hasn’t happened here yet, has it?
David: Nope. And the stock market is in year three of a decline. Again, that’s overseas. Add to the list of uninvestable assets— For many Western investors, China is considered to be uninvestable. If real estate and stocks are out, gold is in. Now, if you give the U.S. real estate tree, if you give the U.S. equity tree a real good shake, I think you see retail gold demand revive here. If you focus the attention of today’s Western speculator on the untenable nature of higher rates, and that’s for corporate borrowers, that’s for private equity borrowers, that’s for government borrowers, and if you get a reallocation at the margins of a portfolio into precious metals, you’re going to overwhelm available precious metal supplies within months. Prices reflect the pressure. We don’t have a lot of pressure today.
David Dredge of Convex Strategies, I got to listen to him present back in New York about a year ago. He runs Convex Strategies out of Singapore. He sums it up well. In many aspects, gold looks attractive relative to bonds in a world where people are choking on bonds. And Kevin, I think choking might be an understatement.
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Kevin: You’ve been listening to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany. You can find us at mcalvany.com, and you can call us at (800) 525-9556.
This has been the McAlvany Weekly Commentary. The views expressed should not be considered to be a solicitation or a recommendation for your investment portfolio. You should consult a professional financial advisor to assess your suitability for risk and investment. Join us again next week for a new edition of the McAlvany Weekly Commentary.
