Podcast: Play in new window
- China’s “Glasnost” Rapidly Comes To An End
- Russia’s Putin Show His Missile Targeting Florida
- Stock Market Bull Confused, While Bonds Clearly In Bear Market
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“I don’t know that I want to be in a fully leveraged stock and bond portfolio moving into chaos. What I would prefer to have is cash, gold, silver, perhaps a short of the market. What I would be doing is digging my proverbial foxhole and figuring out who I’m going to be in the foxhole with and what resources, because the generals here – they’re not getting it. They’re not leading us toward a successful outcome.”
– David McAlvany
Kevin: Dave, you have talked about how crisis can transition from the financial to the economic, from the economic to the political, from the political, ultimately, to the geostrategic. I couldn’t help, when I was watching Putin announce his new missile, how the demonstration video, actually, looked like it was coming down on his house in Florida. Florida was in the video. Did you see that?
David: On Donald Trump’s house in Florida (laughs). And then, of course, it gets to the missile shields and heads south to around the tip of South America. You’re right, there is this connection between the economic, financial, political and geopolitical. And if you go back to our archives and the interviews that we did with Harold James a number of years ago, both relating to his book, The Creation and Destruction of Value, and then a book that he wrote eight or ten years before that called The End of Globalization, he looked very clearly at what is involved in periods where there is greater trade, cooperation and capital flows, and then it stops. So you’re on the cusp of moving into a new era of peace and prosperity, and then all of a sudden it starts to roll backward, as if momentum can go two ways, not just in markets, but also in terms of social trends.
Kevin: And there have been wars going on. We have been talking about currency wars that have been going on, how the U.S. dollar is used to maneuver and even manipulate allies and enemies. But we hear a lot of talk about trade wars. Now, trade wars, ultimately, do lead to fighting wars, often. That is what we saw, of course, back with the beginning of World War I. So Bill King, who is a regular guest of ours, Dave, has said, “Look, guys, you need to understand with the accusation that Trump is creating trade wars, that we have been in a trade war, and we have been losing for decades.
David: Right. So what about these tariffs? You have 25% on steel and aluminum. George Friedman would argue that it is a bigger deal for our trade partners than it is for us.
Kevin: It is making them squirm.
David: We win, they lose. And Freedman is right insofar as exports represent 12% of U.S. GDP compared to 20 for the Chinese, up to 38% for other of our bigger trade partners. So by the numbers, we have less to lose and more to gain. That doesn’t mean that there is not a high cost just because we win. It is difficult to calculate what the cost is. And we do know, definitively, that you have a higher cost for consumers.
For instance, LG hears, as of January 23rd, that washing machines are going to cost more because of an import tax, and they automatically add $50 onto the sticker price. That gets translated into a higher consumer cost. But as you say, around the world they have already imposed high tariffs on us. U.S. autos are one example, where we charge a 2.5% tariff on EU auto imports, but the EU imposes a 10% tariff on U.S. auto imports. So it is not exactly equal. And a part of this is just playing catch-up.
But before we get into tariffs, I think it is worth keeping three issues in mind. These are sort of backdrop issues – one Russian, one South African, and one Chinese, and you alluded to the Russian one already.
Kevin: As you bring up those issues, each one of those countries that you named has their own distinct problems that they are trying to solve. If we do see a breakdown of globalization, they are going to go right into solving their own problems, and to heck with the world.
David: Right. Employment is a big issue. It’s a big issue everywhere, but China, along with India, has very big employment hurdles. And this explains partly why the Chinese are running their steel industry the way they are. One reason for a glut of Chinese steel was that jobs need to be maintained, even if profits are non-existent for the corporations employing those people. So these are the two demographic giants in Asia – China and India. Combined, they have to create 20 million jobs a year to keep employment levels at a static level, so they are not regressing, they are progressing, or just keeping up with the number of new people entering the job force each year.
Kevin: And in a controlled society they have to keep the people under control. So if you are controlling a society – command and control – you have to make sure that you don’t have social unrest.
David: Right. In the context of rising youth unemployment unrest and social deterioration occur otherwise. So there is this massive over-capacity. Steel is just one area of over-capacity in China, and Trump has reason to be concerned with dumping of excess capacity onto the market. Our steel companies go broke in the context of Chinese excess capacity. And that excess capacity is allowed for in China for political, not necessarily economic reasons. Our companies don’t exist on the largesse of government. Yes, there are subsidies, whether it is grains – there are certain pockets where we have subsidies here in the United States. But our companies still go bankrupt without sufficient revenues. And that is just not so if you have a state-sponsored or subsidized entity.
Kevin: And don’t you have another element with China, as far as the runaway credit growth that they have? Almost all major economic problems can be traced to too much debt, and in China it doesn’t seem that it is any different.
David: And there is the deeper story because China is preparing for change. Part I of that change relates to export-driven growth. It is a tough model to move away from, but Xi Jinping is going to make it happen. I think he has the resolve to, and if he has enough time, he can probably get it done, whereas earlier Chinese leaders, going back to 2006-2007, even though they talked about making this difficult economic transition, they never followed through, either because they ran out of time or ran out of resolve. I think he has both. So Part II relates to runaway credit growth, which you mentioned a moment ago. The likelihood of credit destabilizing the Chinese financial system grows with every day.
Kevin: And that really took off and ran after the financial crisis in 2008-2009.
David: That’s right. You had excessive credit growth and that defined that period, post 2009 to 2017, you had 20 trillion dollars in credit creation just in China between 2009 and 2017–20 trillion dollars. Compare that to the combined credit expansion of the European Central Bank, the Bank of England, the Fed, and the Bank of Japan. Add it all together at 13 trillion. What happened is, 2009, 2010, 2011, pundits were very interested in saying, “Look, maybe the Chinese model is really the free market model we need where you get greater state intervention, and maybe the state has a larger role to play in solving the world’s problems.” Why did they say that? Because their economy was moving along really without much of a hiccup at all while Europe and the United States were in a tailspin. How did that happen? You’re talking about limitless – limitless – amounts of money that were spent. That’s the 20 trillion dollars we are talking about.
Kevin: Do you think that is why we had this paradox going where China had characteristics of a capitalist economy, yet it was still maintaining this command and control. Do you think that was possibly purchased with debt? Normally, you have to pick one of the two. You are either a socialist or you are a capitalist. But China had this strange paradox going on this last decade or so.
David: And that is an interesting concept because if you think about it, we allow for greater degrees of socialism within a capitalist system because of an infinite amount of credit creation. If you had a responsible amount of credit creation you would find that capitalism and socialism are not compatible. So there is a political climate since Xi Jinping has taken office which has also radically shifted, and it is this last issue which is of greatest concern and suggests to me that we have an historical relapse, really, going back in time to the period of Mao Tse Tung because Deng Xiaoping recognized the problems that Mao had in his reign, this bringing of utopia to China. Of course, bringing the utopia cost tens of millions of lives.
But yes, we have spoken of capitalism with Chinese characteristics even a few years ago as we talked to Michael Pettis and a number of other folks from Claremont McKenna, other academics here in the United States who grew up in China. But the political structures which are being hardened at present in China are entirely command and control. They are entirely autocratic.
Kevin: Years ago your dad wrote about five glasnost perestroikas that had occurred in Russia where they westernized for a season and then they tightened back up. Are we seeing the end of glasnost perestroika in China?
David: It’s possible. You have Xi, who in recent days, has had the constitution in China rewritten to allow for no presidential or vice-presidential term limits. As I read excerpts from Sunday’s Beijing’s Xiang Hao newspaper I see a very troubling message, in these words: “The Chinese people, of all nationalities, will continue to adhere to the people’s democratic dictatorship. And the socialist road persevering in reform and opening to the outside world, steadily improving socialist institutions to develop the socialist market economy, develop socialist democracy, improve the socialist rule of law.”
Kevin, I could go on, and I don’t want to brush off these seeming contradictions… democratic dictatorship. I’m not even sure I have the mind space for how those two things meld. In many respects, though, it feels like a return to the Cold War. And again, there is certainly this re-affirmation of dictatorship. Lifelong leaders certainly have the opportunity to get more done, and there is no dissent from the crowd. You don’t have to worry about pandering to the people, but you are really talking about a system that operates at the expense of the people’s voice.
Going back to a classic book, Exit Voice and Loyalty, you are commanding loyalty, demanding and dictating it, and eliminating the voice of the people. The democratic voice and dictatorship – that is kind of an oxymoron in my world, so I’m not exactly sure how these things come together, but something in China has snapped.
Kevin: Anytime you hear democracy and socialism in the same sentence you can basically call that communism. You talked about a return to the Cold War, here we are seeing Putin talk about his latest missile, with Florida as the example.
David: Let me just say, you are talking about socialism, or you are talking about a curriculum at Harvard, because I’m reading Ken Rogoff this last week, and he is talking about the great need amongst capitalist societies to redistribute wealth from the rich to the poor. And I am thinking to myself, “Yes, it doesn’t matter if you are in South Africa or in China, or at the Kennedy School of Business.” Of course, he teaches in economics, but this is what is interesting to me. Socialism is always avant-garde within the university setting.
Kevin: Yes, it has very painful consequences when taken to the extreme. Remember a couple of years ago there was a gentleman that you interviewed here on the Commentary from Rhodesia. They had had their farmland redistributed to the government. Now, what we are seeing is a much larger economy – South Africa – it seems that we are seeing those same kinds of Marxist types of attitudes.
David: That’s right. It is a remarkable interview. For those of you who haven’t been to the archives, you could look for Craig Deall and Ben Freeth, men who had their livelihood stolen from them, their land stolen from them. Craig operated a farm of about 4,000 acres and exported his goods into the grocery stores and markets all throughout the European Union – a very successful, multi-million dollar annual enterprise. And it was taken from him. This goes back 18 years but that is what Mugabe decided to do, and today, his 4,000 acre farm lies fallow, because it is not as if anything was going to be done with it, it was just an asset expropriated and given to a crony within Mugabe’s system.
South African leadership today is doing the same thing. They are leaning toward Marxist land redistribution with no compensation provided to the current white owners of land. To me this is the obvious reverse racism at its worst, and the ANC now controls the country since 1994. They have had the opportunity to make the country a better place, and this is about as creative as they get.
Now, I’m grateful that Jacob Zuma is out of office. He provided a living example of the worst form of self-serving governmental corruption in the 20th century and he fumbled the opportunity to lead, not just South Africa, but all of Africa, out of and away from petty tribalism and personal greed expressed in corruption. After 750 – I think it was almost 1,000 counts of corruption which the courts were pursuing him for, he finally was thrown out. He was replaced by Cyril Ramaphosa, also part of the ANC. The fascinating thing about Ramaphosa is that for months now he has been courting the idea of stripping land from white landowners, but in the conversation was always compensation.
Kevin: Right. Now it is without compensation?
David: Now it is without compensation. As if nothing was learned from the land seizures north across the Limpopo River 18 years ago. The ANC Rural Affairs Minister said this last week, “The ANC unequivocally supports the principle of land expropriation without compensation. There is no doubt about it. Land will be expropriated with compensation.” Again, this is following Ramaphosa coming to power. You have a young Marxist upstart, rising political star, Julius Malema, who says, “The time for reconciliation is over. Now is the time for justice.”
Kevin: The ANC was represented by Mandela before that, but there is a huge contrast. It didn’t seem that Mandela promoted land grabs and revenge.
David: There are clearly two stories. Mandela pre-Robben Island, and Mandela post. Mandela post-Robben Island – once he was elected in the 1990s, he never promoted violence, land seizure or punishment.
Kevin: That’s true. Before he was imprisoned, he definitely did.
David: So he was a promoter of reconciliation. Again, when I think about changes that are occurring, and they are fairly radical in nature, something snapped in China, something just snapped in South Africa, and it sounds like a hardline Marxist war cry if there ever was one.
Kevin: In a less radical way we’re seeing populism rise worldwide. That was part of the Trump election. Trump does know how to play to the blue collar set of sympathies and that got him in. What we are seeing worldwide, however, are more radical expressions of that same thought process.
David: I spoke at an economic conference in South Africa in 2016, and one of the points that I made was that the world was changing rapidly in light of a populist shift. You had the five-star movement, the national front, and a number of changes which were occurring in Europe, and it was not clear at that point who was going to win the elections through the summer of 2016. But the populist theme from 2016 and 2017, you are right, has many expressions. Trump is now playing to a blue collar set of sympathies here in the United States via his tariffs and the promotion of exports.
Go back around the world to disaffected South Africans left behind as the world has grown wealthier on a sea of central bank liquidity. And you look back in time and think to yourself about a place like Soweto. I visited Soweto when I was 10, 12, 14 years old, on trips with my father to South Africa. Soweto has barely changed from 1976 to 1994, when apartheid ended, to 2018. And in that entire stretch of time nothing really has changed in that place. You can’t blame apartheid any longer. But go all the way across the Indian Ocean, if you will, to China – populism is not an option.
If you wanted to see a populist uprising, this is I think one of the reasons why you see one belt/one road. You have the opportunity to spend trillions of dollars and funnel energy – this is one of the reasons why they have the largest military force in the world in terms of manpower. And they could double, triple, quadruple it. Why? Because it is better to keep youth busy digging ditches and running drills than it is seeing them on the streets wreaking havoc and upsetting the body politic. There are simply too many mouths to feed in a place like China to allow the populace a voice. So dictatorship seems to be the route that they are taking instead of having any expression of populism.
Kevin: You mentioned the return of the Cold War and we see that with China. Now we have President for a lifetime. Xi Jinping can be President for a lifetime, getting rid of term limits. We mentioned at the beginning of the show, Mr. Putin, who at this point is starting to parade his military, I wonder if he actually was taking some lessons from North Korea, because North Korea threatened the world with nuclear annihilation, and they got to go to the Olympics.
David: Right. That is nationalist pride, that’s a part of the key, and he is tapping into that. But you can go anywhere on the planet and these hypersonic models, the ICBMs he has been showing and parading, they are unstoppable, he claims. There is no existing missile defense which can take it down, and it can go an unlimited distance. Yes, he is tapping into nationalist pride, he is recollecting the greatness of the Russian Empire for the people. He wants to gain their support, continue to have their respect. He’s not going to be pushed around by Señor Toupee.
Kevin: So we bring these issues up, even though some sound like they are military, some sound like they are financial. Because we do have tariffs at this point, increasing. Starting solar panels, you mentioned washing machines, steel and aluminum tariffs – those types of things. But look at the financial markets, Dave. Granted, we have had some volatility over the last couple of weeks, but they seem to be ignoring this bigger picture that you are talking about.
David: Right. And I think they can reasonably take the tariffs in stride. I think they can. Again, we are talking about January 23rd, tariffs on solar panels and washing machines. Now we include steel and aluminum. Those are all part of the backdrop. But even behind that, you have the cooling of international relationship and a return to less-free markets. Those two things, I think, will be enduring issues, and some iteration of tariffs is going to bounce into, at some point, run into a brick wall. I said earlier, we are just playing catch-up for existing tariffs on U.S. exports, and to a degree, that is true.
Kevin: One of the guests that we have had on multiple times – I won’t name him just in this particular case because he has expressed tension increasing in China. You went out to visit him and it became very apparent that he can say less and less in his letters, and in his commentaries, about what is actually going on. Do you think that is one of the signals that things could be heating up with China?
David: I think that is precisely the case. You have Chinese officials who, in the last several weeks, appointed Wang Chen as Deputy to the National People’s Congress. And very critically, this is after his retirement at age 69 from both the Politburo Standing Committee and the Central Commission for discipline inspection. Why? Forced retirement at 69 is the rule, and yet, he was brought back nearly a month ago. He is known to have very strong relationships in the United States, which is critical. It is critical as our relationship rapidly deteriorates over trade with China. And it is also rumored that he may be the next appointment for Vice President, as soon as this month, March, and that would be Vice President for life as of the new constitutional changes.
Kevin: The great changes that we saw in China and in Russia and most of the East. A lot of those came after the Berlin Wall fell. When what we considered the old Cold War was over, it increased what you would call labor arbitrage because they could provide much cheaper labor.
David: You’re right. Capital flows improved at the end of the Cold War and there was an expansion of friendship and of cooperation. The most recent iteration of globalization really found its stride after that. So there was a dark side to global labor arbitrage, but the bright side is a radically improved welfare on a global basis. If you look at net worth figures, if you look at average income, you find that there is a move away from poverty from 1989 to the present.
But the political shifts occurring in South Africa – you look at capital flows, you look at if people trust each other, and I think what you are seeing in South Africa is going to precipitate massive capital flight, not unlike what we saw in China for the last 36 months, but with greater capital flight comes greater capital controls. The South Africans have had capital controls in place for a long time, but I think they will be even tighter. Now you have the exaggerated levels of corruption, which just to the north in Zimbabwe have been on display for decades.
And you’d assume that they had learned the lessons, the mistakes, from Mugabe, but in fact what they took note of was the best route toward revenge, the best way to steal in the name of social justice, and the quickest route to destruction of the rule of law, the destruction of property rights, and ultimately, I think, decimation of investment in capital markets, which will impoverish the southern tip of Africa. To me, it almost feels like a drug addict. Power and corruption are only too easy to revert back to, and that is what it seems to be coming to, full cycle in South Africa, the same old/same old chorus and verse on the African continent.
Call it justice all you want, but it is an excuse to take what you want. You have envy, you have greed, you have selfishness, which are ever-present without a deliberate effort to behave otherwise, and that is what is coming out on that continent.
Kevin: The loss of property rights is only one part of losing your wealth. Zimbabwe, of course, is the modern day example of the early Germany hyperinflation. So you talk about possibly South Africa suffering something very similar to that. And you wonder, with Xi Jinping and some of these other changes, if we are not going to see some of these changes come in the currency markets.
David: Right. It remains to be seen how hardline Xi Jinping may become, but there is no doubt that he is battening down the hatches for a massive economic transformation which is likely to be accompanied by credit crisis and perhaps even social and political crisis. But it seems that his power consolidation over the last several years may have been in anticipation of all of this.
Kevin: We talked about six weeks ago about a 103-month recovery in the stock market and how it looked like it had no ending, that there was no volatility, that we had nothing but gains ahead. Of course, we were mocking that because we knew that volatility would enter the market. Let’s go ahead and talk about the markets here over the last few weeks, because we are seeing volatility increase.
David: January 26th to February 9th we traveled from a peak level of 26,617 on the Dow, down 12.2% and precisely 3,256 points. That is significant. You are right, we broke the 103-month stock recovery. You might argue that stocks are, as we speak, recovering those losses and we will be back to put in new highs later this year. And while that is possible, what we do have is the ceaseless rise from 2009 and those lows, which are over. We can move higher, but if it does, it is going to be with doubts – with doubts that did not exist in the December and early January timeframe.
Kevin: Do you think fear is back?
David: That is the element that I think is beginning to encroach upon the market. I believe the combination of rising rates, inflation, and of course those inflation expectations ultimately getting ahead of what officials want as the “perfect number.” Then of course, there is this discussion of tariffs. Perhaps even their implementation will add to the negative mood, which causes institutional asset managers to de-risk, and to not be completely invested as they are today – de-leverage to some degree.
Kevin: So interest rates rising, inflation – those are a big deal.
David: Those are the bigger deals, far bigger than the issues relating to trade, but as institutional re-risking occurs, the man on the street, the Johnny-come-lately, what some would call the dumb money, which raced from the sidelines into the autopilot universe of exchange-traded funds and wanted to blindly participate in this last January’s hurrah – that is where the volume is going to come from. That is where the volume is and as people being to sell will drive the market far, far lower than I think most investors have an imagination for at this point.
Kevin: So this can either happen quickly or it can take a year or two.
David: Just a reminder of how quickly it can take. No one, January 1, had the imagination for a 3,000-point drop on the Dow – no one. And so to say that the Dow could lose 6,000 to 8,000, or even 10,000 points, that is preposterous. Really. And did anyone foresee a 3200-point snap in a matter of days, January 26th through February 9th? Not a single soul.
Kevin: And the algorithms have no idea how to handle that. So could we see 2019 as a major downturn in the market?
David: Right, it could be. And we could have it sooner, but as we have suggested several times before, the market itself, if we are talking about stocks and bonds, they can separate from the economy and be subject to selling pressure that has nothing to do with fiscal policies or economic growth – completely separate. 1968-1981 – double-digit economic growth, and at the same time you had a severe bear market in stocks. The stock market is not the economy. And many confuse the two and assume that the signals from stocks shine a very bright light onto the strengths or weaknesses in the economy. And so if the stock market is going up, then everything is fine, and that should tell us that everything is going to be fine on an ongoing fashion.
Kevin: It is worth pointing out that from 1968-1981 when the stock market came down we also suffered very, very high inflation, high interest rates. There was a Federal Reserve change and Paul Volcker came in and actually raised rates even higher to stop the inflation. Jerome Powell is sort of an unknown at this point. I think he is pointing out what you are point out, Dave, that the economy, which he sees more responsibility for, is not the financial markets. He doesn’t seem to feel that he is responsible for a continuing stock market rise.
David: His comments last week at his first hearing in his new role leading the Fed – I think those comments were critical. What he pointed out is that he appreciates the difference between the two, financial asset prices on the one hand, and the underlying economy on the other. And he is not beholden to prop up the former. So as he is speaking you have massive volatility in the stock market as algorithms, computer trading models, are concerned with the implications of a particular word or a particular grouping of words. And they are actually not listening and taking in the whole message. I think that was missed.
But it was not lost on the other Fed members. You have Bullard, Kashkari and others, who were stepping in to verbally intervene after his presentation to the legislature to keep stocks from cratering. And the sum of Powell’s message was this: “Financial prices are high enough. They’re fine.” And it’s going to take some time. It would take quite a lot of bloodletting before the Fed would take considerable action to hold equity prices up. Because you have unemployment at 4.1% that matches the level set in December of 2000, and unemployment, full employment or close to full employment, is one of the Fed’s mandates. Price stability is the other.
And inflation, that price stability piece, is not at worrying levels today. So as far as Powell is concerned, their mandates are just fine and it is time to begin tightening. So he is saying things that are very hawkish, and Kashkari and Bullard are coming out to balance it and saying, “We want you to understand that he is not saying, that he is not going to be overly hawkish.” They are trying to calm the nerves of the market so that there is not an overreaction to what he is very clearly saying.
And Powell’s message is, “I might have a little bit of Volker in me – not a lot, but a little bit – and I’m not going to be the first guy out of the chutes to accommodate a 1,000, 2,000, 5,000-point decline in the Dow, because what we really care about is unemployment and price stability.”
Kevin: We have had several guests that were behind the curtain of the central banking community. Carmen Reinhart is one of them, and of course, White. The concern that they have is that central banks are always fighting the last war. They are always looking backward or picking the wrong targets. That is why, oftentimes, inflation can get ahead of them because they are looking at something that is not the right target.
David: Right. So the last war was a deflationary battle, and to avoid a nasty deleveraging within the financial markets, they did everything that they could to prop up the system, including zero interest rate policies, negative interest rate policies, and ultimately, a very clear, definitive inflation target. So that inflation target is to hold deflation at bay, suggesting that they are still fighting the old fight of deflation. On that last point, it is worth noting that Carmen and her husband, Vincent Reinhart, have expressed their concerns about this fixation with targets, leaving the Fed members lost in history, again, fighting the last war. In a recent article they published, I quote: “They will be poorly prepared for the next battle against too high inflation.”
Kevin: One of the things that we have here in Durango – we had a chance to see this – is bad timing for business decisions. Oftentimes, right before a major turn in the economy you will see everybody getting involved with what worked last year or the year before. I think about our resort – Purgatory. They shifted their business model during the real estate rise back in the early 2000s, and built just a ton of condos. Then all of a sudden we had the real estate crisis. They were late to the game and a lot of those condos are still unsold. I’m wondering if we are not seeing that nationwide. There is a general consensus right now that things are just going to get better.
David: That’s right. You check in with the National Federation of Independent Businesses, your small business owners, and they are sampled with a variety of questions from time to time, and indexes created on the basis of sentiment relating to these small business-owners. Now is a good time to expand. That is the question on the table. And the answer to that question is at the highest positive level in the 45-year history of the survey. So now is a good time to expand my business. Small business-owners would say, “Oh, yeah. I talked to my banker. This is a great time. There is nothing but up from here.” Recall that pendulums swing in two directions. And also recall that the happiest day of the turkey’s life is – which day? You know it, you know it.
Kevin: The day before Thanksgiving.
David: I stop and talk to a small business-owner probably once a month here in town. He sells patio furniture and pool tables and other niceties to very well-heeled customers, primarily owners of second homes in Telluride and in Durango, throughout the four corners area. Things are so good he has decided to open up a second location in Santa Fe. Business has never been better. This is where my dad’s famous recollection of when they changed the carpet at Merrill and major Wall Street firms. They always do a renovation of the building. They always do a renovation of the building as the market is coming to a peak. And with grand irony, we, too, were replacing our carpet here in the office in the year 2012 as gold was reaching its peak.
Kevin: (laughs)
David: And I should have reflected on it, but the reality is, you make those decisions when cash flow justifies it, but it justifies it, typically, when business has never been better.
Kevin: Last week you brought up Warren Buffet, and he seems to be on the right side of the equation enough to where people are listening to him. He has been accumulating cash this last year, as you have pointed out. In fact, this is one of the largest cash hoards Berkshire Hathaway has ever had.
David: Right. So allocating capital into businesses, opportunistically, occurs at market lows, not at market highs. Yet it is always easiest to allocate capital at highs because you have the feelings of optimism, and they are the only feelings operating at that particular point in time.
Kevin: And that cash is burning a hole in your pocket at that point, too. There are times when we listen to Buffet because he is talking, and there are times we listen to Buffet even more when he is not talking. The Buffet ratio is something that he talks about, and there are also times when you don’t hear him talking much about the Buffet ratio. A lot of times that is when he has a lot of cash and he is sitting on the side.
David: Yes, call it the Buffet indicator – the Buffet ratio. If you take the stock market capitalization compared to gross domestic product, he is interested in buying, and he will talk about it, if the stock market is selling at, or below, 50% of gross domestic product. And you are right. There is a lot of silence right now. Of course, the number is at 154% of GDP, so financial markets have never been higher relative to the scale and scope of our economy – not in 2008 before the financial collapse when real estate and many other factors in the economy were really humming along, not in the year 2000 prior to the technology boom.
We’re talking about years of plenty when we were operating in surplus and the economy had grown through the latter years of the Clinton administration, but we did not, even in the year 2000, reach 154% of stock market capitalization to GDP – this Buffet ratio. And of course, we did not get that high in 1929 either. So our record levels suggest that we have a generation of speculators today in the marketplace – not producers, not people who are making things, but people who are betting on the future.
And the bets are in. Bullish sentiment remains intact in spite of the late January cracks that appeared in the ice. Again, we are talking about a 3200-point decline in a matter of days, and that has done nothing to dispel the confidence that people have in the economy, but also in speculations within the stock market. Bloomberg, on February 22nd, noted that not one Wall Street strategist changed their calls for a bullish year-end forecast. I will quote Bloomberg here. They said, “Amid the sound and fury of the U.S. stock market’s first 10% correction in two years, nary a peep was heard from forecasters. Instead, calls to buy the dip grew louder, and one strategist even increased his estimate for 2018.”
You might also recall that in recent months we have discussed the uniformity of belief amongst investors. There is no discussion. There is no spirited debate on which fundamentals support a bear market, which fundamentals support a bull market case, whichever side you wanted to take, because there is only one side. The one side is the bull market case. As you know, fundamentals were set aside four to five years ago.
Kevin: You had mentioned speculators versus production. When you can look at production of a country and say, “I’m going to invest in their stock market because they are producing something. These companies are going to show greater and greater gains because of profits,” that is one thing. But speculation has a tendency to mimic itself. If you have made money, one of the worst things that can happen to somebody young is to gamble and win, because it can turn into an addiction. In a way, it is a little like a dog chasing its tail. You fish, Dave, and here in Durango there is a disease that fish have where they just spin in circles.
David: A parasite attacks their cartilage and brain, and they spin in circles. You’re right, there is an infection within the investor community. The average investor swims erratically in a circle, and the market has gone up, therefore the market will go up. It is sort of a circular reasoning and it is a recognizable late-stage, terminal-stage of market excess.
Kevin: But we’re talking about the stock market. There is another market that has already signaled the beginning of a bear, and it is much larger.
David: This is boggling the mind, Kevin. Meanwhile, as we speculate as to whether or not stocks go higher, take out the highs or some of the speculative sauce comes out, you have a 19-month-old bear market in bonds – a 19-month old bear market – which saw the ten-year treasury yield easily slip through the 2.6% resistance levels. And this is hardly on the radar for most investors. We have said it before. The foreign currency markets are highly sensitive to change, as leveraged as they are, and they show it.
The foreign currency exchange rates show a shift in sentiment and a shift in direction in terms of where investors are going, without necessarily giving you all the reasons why. The bond market is also highly sensitive to change, as large, and frankly, more intelligent investors are beginning to make their calculations. Bond investors are known to be the ones in math class who set the curve.
Kevin: So what does that say about stock investors leaving the market.
David: (laughs) They impact the curve in other ways. Investors in stocks are generally the last group to clue into changes, and to quote Bill King, “They are always the last ones to get it.”
Kevin: One of the markets in the bond market that people can still get reasonable gains in, even though they had high risk, was the junk bond market. But at this point we are also seeing money flow out of there.
David: Yes, which suggests that a few market operators are lightening up on risk, and still, the Elliot Wave Financial Forecast points outs that over 25% – 25% – of the junk bond market is held by exchange-traded funds, and they are quoting Jim Bianco. And those index funds have not seen high volumes of liquidations. So you have your very low-quality credit paper, Caa rated bonds, that are, in all likelihood, going to see a massive spike in yields due to the structure of the market – the structure of the market – where 25% of it is held in that autopilot allocation in exchange-traded funds. There is so much implicit illiquidity in that market. To see rates double in a short period of time, ultimately returning to nearly 20%? Not going to be a surprise. That will not be a surprise.
Kevin: It is like what we saw in the 1970s, early 1980s. It could repeat itself.
David: Yes, even in more recent years. But it is going to be a surprise to the unsuspecting. It is going to be a surprise to the yield-chasing. It is going to be a surprise to the autopilot investor who was not a student of credit, but rather, was indulgent in a late-stage bull market as an enthusiast.
Kevin: All of these things, whether it is inflation, whether it is geopolitics, whether it is interest rates, the reason for the show is so that we can continue to look forward, not look backward. We look backward so that we can learn about what is forward, but one of the worst things that we can do is what Carmen Reinhart and her husband are talking about, and that is, fight the last war with the last war’s weapons.
I can’t but remember back before World War II, you had a couple of lone voices out there, including both on the German and the U.S. side. You had Rommel, who really believed that the next war after World War I would be fought on the ground with tanks. You had Patton, who believed the same thing. And he continued to cry out for more emphasis on tank battle. You had Billy Mitchell, who was in World War I. He was in the army. Billy Mitchell said, “The next war is going to be won in the air. We have to have an air force that can actually compete.” They say without Billy Mitchell we could have easily lost the first couple of years of World War II because he was the father of the air force. So in this particular case, if we are ahead of the curve, we can beat this thing.
What I mean by that is, you talked about the stock investor at the high end of the market. Sometimes I talk to people who understand what we are saying, but they like the games too much. They like the comfort of doing what everybody else is doing. Actually, they are fighting the last war with the last war’s weapons, and they are going to end up just like they did back in 2007-2008 giving back 30%, 40%, 50% of the money that they have saved. How do we instruct people and say, “Look forward, this is what is coming.” What would you recommend right now?
David: It is important to recognize that the generals in this fight are committed, and they are committed already to a strategy. When we are talking about the generals, these are our policy-makers. These are our central bank chiefs. These are the Wall Street titans and the firms who are allocating capital according to the efficient market hypothesis, modern portfolio theory.
Kevin: These are the people who, not one of them changed their outlook for 2018.
David: That’s right. With cracks emerging through the VIX meltdown a few weeks ago, not one of them has said, “Maybe we should revise downward slightly.” There is just as much enthusiasm as there ever was before. Again, allocations have not shifted. And if the generals are not going to make strategic decisions that put us in a better position, then I think it is imperative that the individual do that for themselves.
We have talked about the gold standard and how, frankly, our gold business, one of our two businesses, would be unnecessary and would go out of business if we had sound money. If we had a monetary standard based on gold there would be no reason for us to suggest that an individual solve that problem themselves. But it is a matter of historical fact that the two mandates that the Fed has adopted – full employment and price stability – one of those they have failed at miserably. Price stability from 1913 to the present – the dollar has lost close to 98% of its purchasing power. That is not exactly a record that gets you an A mark in grade school or in any professional school. That is the kind of work that a general would be court-martialed for.
And yet, we still have confidence in the road that our current monetary and economic generals are taking us down. Am I suggesting a revolt of the masses? Am I suggesting that we all go AWOL and do our own thing? In this regard, financially, I am. I am suggesting that they don’t understand the need for a different approach.
Kevin: So if you are not in a country that has a gold standard, put yourself on a gold standard.
David: That is the point. They are fighting deflation and they will do anything they can to prop up asset prices without recognizing that they are seeding the next great inflation. I thought it was fascinating to look through Carmen and Vincent’s most recent article. They quote Charles Goodhart. Of course, he has been on our program to talk about Goodhart’s law. As a British economist, he says these are the problems with creating targets. You undo the soundness of the objective by stating the target.
Additionally, what is clear to me is that what Harold James instinctively was getting at, and has written two books about in the last two decades, is that we have come to the end of a globalization cycle, and it is not uncommon at the end of the globalization cycle to see an increase in violence, to see an increase in tension, to see a decrease in capital flows, to see an increase in tariffs and trade wars. We have talked about the Treasury, we have talked about currency wars, we have talked about the Treasury Department actually instigating wars.
This is a period, the period ahead, which will be chaotic. I don’t know that I want to be in a fully leveraged stock and bond portfolio moving into chaos. What I would prefer to have is cash, gold, silver, perhaps a short of the market. What I would be doing is battening down the hatches. What I would be doing is digging my proverbial foxhole and figuring out who I’m going to be in the foxhole with and what resources. And yes, that does mean looking at asset allocation in a slightly different way, because the generals here – they’re not getting it. They’re not leading us toward a successful outcome.
