EPISODES / WEEKLY COMMENTARY

Don’t Like The Inflation Number? Change The Math

EPISODES / WEEKLY COMMENTARY
Weekly Commentary • Jan 11 2022
Don’t Like The Inflation Number? Change The Math
David McAlvany Posted on January 11, 2022
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  • Bubbles everywhere – Where do we find cover?
  • Does Taper Tantrum possibly become Taper Tragedy

 

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Don’t Like The Inflation Number? Change The Math
January 11, 2022

“What do we do for an encore? Well, the encore comes tail end of the year, and now you’ve got the one-two punch of monetary policy largesse, fiscal policy largesse, and inflation statistics that would scare the whiskers off a cat. In the context of a declining equity market, you know what it spells to me, it’s like the perfect recipe for gold going to the moon, silver following suit. I think 2022 begins to look really attractive for the metals and it’s been underestimated, very, very underestimated by the US investor.” — David McAlvany

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

You know, you asked me last night. You said, what are your clients talking about? As I go through what we call triangle updates, we basically look at their assets, their gold, their income and growth assets, and their cash. What I’m finding, Dave, is that whatever happened over this last two years, the triangles are becoming very, very cash heavy. The question is becoming very much like it was back in the 1970s. We haven’t really had to worry about a lot of cash being on the right side of that triangle until now. But I remember the 1970s. In the 1970s, you couldn’t keep cash because the inflation rate was so high. I’d like to talk about that today because even the government is expecting a 7% number. But the truth of the matter is, if we were measuring like we did in the late ’70s, it’s really double that. And so, can we cover that after we cover employment numbers and some of the other things?

David: I think what you’re talking about is the demographics of the baby boom generation, who have already, in recent memory, they have this experience of significant loss. I talked to a gentleman just the other day who lost half his net worth in 2008. And you know, that was then. He was in his 50s then. He’s in his 60s now. Being that much closer to retirement, that baby boomer generation, he’s very cautious. Not so interested in taking the risks that he once did. He’s happy to sit in cash, and he looks at the 7% inflation number and says, well, that’s an inconvenience. But I’ll tell you what’s more of an inconvenience.

Kevin: Losing 30 or 40 or 50%. Yeah.

David: Exactly. I think that’s what we’re up against is the psychology of the boomer generation. Now there’s a whole host of folks that are in that category, demographically, who are assuming that they can get out in time. They’re assuming that there’ll be signals, there’ll be signs. There’ll be some sort of a trigger event. There’ll be bad news where they’re able to get out. I think what they perhaps don’t know or have forgotten is that bull markets don’t end on bad news. Bull markets end on the best of news.

Kevin: That’s a great point.

David: That’s one of the reasons why so few people see them, but they end on the best of news. It’s the end at peak euphoria. They end at peak euphoria. Everyone is very positive about prospects in the future. That’s frankly the nature of the bull market that gets you to those peaks. There’s worry, there’s worry, there’s worry. Climbing the wall of worry until the point where there’s reckless abandon, and all of a sudden speculation takes hold. When speculation has taken hold, you see everything as good news. Frankly, it doesn’t even matter if there’s bad news.

Kevin: You’re looking for a reason for good news. You know, let’s just take the employment numbers right now. You couldn’t say that we’re in a recession if you actually looked at what the stated employment numbers are.

David: No, but you can explain it with Covid, and you can explain it with Omicron. So the December nonfarm payroll is well below expectations of 487,000 new jobs. They came in at 199,000 instead. So we had the unemployment rate fall to 3.9%, down from 4.2 on the Household Survey’s extrapolation of 651,000 increased in the employment segment overall. There are seasonal adjustments. There’s a whole host of things that go into that 651 figure. But here we are, 3.9%. It’s perfect. Well, about as perfect as you can find for an employment number. Unemployment is very, very low. The number was not big enough. The number was a disappointment, but let’s look at the context. It’s really not that bad.

Kevin: Do you think maybe they’re going to try to distract us from the big news this week, which is probably going to be the inflation number?

David: Right, 7% is expected. It’s the inflation number more than anything else that has justified the slow-to-act stance by the Fed. I was fascinated to see criticism coming from retiree Bill Dudley. He was at the New York Fed. Very rarely does someone who’s just left office pick up the mic and start criticizing someone who’s in office. It’s a taboo thing, so it was fascinating to see him take his four points and throw Powell under the light. 

Number one, he said the framework was all wrong. You were going to be overheating before you took any action. That was the first mistake. The second mistake was misjudging the strength of the labor market. The third mistake was that the Fed was too tied to their view of inflation as transitory. The final mistake was the Fed was too worried about spooking the bond market and causing another taper tantrum. Dudley was tearing into Fed Powell, and that in itself is very unconventional. I think we’ve changed our way of, what do we used to call it? Decorum. There was a set of expectations. Like if you leave office, give it a rest. Don’t say anything.

Kevin: We’re in our 50th year as a company, but I remember, I’m in my 35th. So, 1987 when I came, Paul Volcker was the Fed chairman. He quietly left before the October crash. Greenspan quietly left before we had the 2008 crash. It’s interesting to watch these guys, you know, they have their career and then they exit stage left. You’re right, it’s very unusual to have an exiting Fed head like Dudley. You know, he was one of the Fed heads. He really needs to keep his mouth shut if he wants to get the 200, $300,000 honorariums for speaking, doesn’t he?

David: I would think so. They will say of Powell, Powell was no Volcker. Maybe he has time to change that. He’s got confirmation hearings for another term. Maybe he will show up with a little bit more muscle in a second term, but there’s consequences to being more muscular with his monetary policy.

Kevin: Well, with the January 5th. I mean, January 5th, it sounded like he was going to flex a little bit of a muscle. The markets certainly didn’t like it.

David: Right. Well, January 5th is getting in line with trends that have been either obvious to some or have become obvious to all. I wrote a paper on the notion of inflation being transitory last year for an economics conference.

Kevin: And you discredited it.

David: Correct. I thought this is balderdash. That was not my primary way of arguing, but that was the shorthand conclusion in the white paper is that it’s not transitory. The Fed now has to shift directions with what is on display, with what is evidenced in a 3.9% employment number, and now with inflation ticking higher, they must do something. We saw that, January 5th FOMC meetings, that was a game changer for the markets. Bonds have been on the move ever since. Yields have been on the rise. Prices moving lower. Tech, if you’re looking at particular weakness within the equities markets, tech is that particular weakness. 

The high flyers of 2021, they’re on the run. And so if you look at last week to this week, the rotations have been violent. Moves into banks, moves into oil. The S&P was off only 1.87% last week. Nasdaq was off four and a half percent. You know, you used to hear the phrase as goes the first week of the year, so goes the year. That’s often bandied about by market pundits. But this year, those words simply don’t warm the heart. There was a lot of quietness, close of markets on Friday, and even through the early part of this week, little bit of silence. We don’t want to think about what the first week of the year might portend for 2022. That was in fact the worst start of the year for Nasdaq since the year 2000.

Kevin: Well, we’ve talked about interest rates being a measure of the temperature of concern. Even the 10-year, the 10-year Treasury is a good meter. Aren’t we starting to hit highs that we haven’t seen over the last couple of years in yields?

David: Sure, 2-year high into the 180s. The 2-year Treasury is another indicator of where Fed funds rate should be at a minimum. They’re about 80 points behind—80 basis points, that is—behind the curve. You have guesses within the marketplace, bond investors, even Neel Kashkari and others at the Fed, various Fed chiefs beginning to estimate. Are we going to have two? Are we going to have three? Are we going to have four rate increases in 2022? The reality is the Fed is following. They’re not leading the markets on rates. Again, you know, relative to the 2-year, the Fed funds rate is over 80 basis points behind and is going to have to play catch up. You could argue that the January 5th minutes from the FOMC set in motion the current market generations, so maybe they are directing flows. I would take the counterpoint to that. I would argue that the inflation picture has put them in a discredited position of having to say something. So there they are. They’re at least talking, at this point. Actions are still pending. We haven’t seen an actual tightening of financial conditions, but that may occur.

Kevin: The question always becomes leverage, because if you can think of a triangle or a pyramid upside down, that’s what the markets look like right now. They’re balancing on very little real equity. It’s mainly leverage in this market. What happens when that pyramid that’s flipped upside down, where you’ve got all the weight on the top, not on the bottom, what happens when that’s affected by the possibility of QE being QT instead? Quantitative tightening.

David: Well, your word picture is fantastic. We’re tempting fate with gravity. I mean, that’s really what we’re talking about in terms of asset classes being overvalued and being structured on a leveraged basis like that pyramid upside down. It’s inherently unstable with a leveraged financial system, an extremely leveraged financial system. It’d be difficult to go from accommodative policies, what we’ve come to know as QE, the euphemism for debt monetization and interest rate interventionism. To go from that to QT, quantitative tightening, an actual tightening of financial markets, without creating a lot of market volatility. As my colleague, Doug Noland commented here recently, “I fear decades of mismanagement come home to roost in 2022.” That’s just a statement of possibility as it relates to the unstable pyramid, upside down and waiting for gravity to have some natural impact.

Kevin: But it’s an election year. And so I just wonder if we’re not going to see changes in that. People who are in the positions of influence to say, well, inflation is actually coming down. What would happen? I mean, interest rates would still have to be six, seven, eight percent if inflation came back down to what, five or six.

David: Yeah. I don’t doubt that the Fed is going to raise rates. I simply doubt there is resolve to follow through with a tightening cycle. We’re talking about normalization of a rate structure, bringing borrowing costs back in line with inflation. Even if you assume inflation has peaked, give them the benefit of the doubt. It’s coming back down below 5%. You’re still talking about a tightening cycle and a normalization of rates, which would cause hemorrhaging within the financial markets, both stock and bond markets, because of the discount effect of future cash flows and the nature of interest rates on those future cash flows for discounting.

Kevin: Why would we call them the financial markets at all? These actually have become assumptive or presumptive markets. The presumption is that the Fed is always going to have their back, and that they’re going to have artificially low rates going forward.

David: Yeah, I think the implications for the financial markets are significant. You’ve got the debt markets, which are dependent on artificially low rates, and so are equities. You will quickly find the markets in decline with each step towards actual tightening. Talk is one thing, and that’s where they’re at today. They’re talking. The FOMC January 5th was significant enough to get the markets moving. The markets are moving on their verbal commitments. Action, in this case, an actual shift from accommodation to tightening, a balance sheet runoff as they like to say, which is basically balance sheet reduction. They combine the balance sheet reduction with an increase in rates. You’re talking about bringing volatility center stage.

Kevin: We’re talking a taper tantrum, more than likely, like we saw a few years ago.

David: Different than a taper tantrum because you could be at the end of a long-term credit cycle which puts equity markets at risk not to a 20% decline or a 30% decline, but to a 50, 60 or 70% decline. I mean, these are the dynamics. I love reading some of the guys that are now retired and not in the financial markets anymore as operators, but had enough experience. Jeremy Grantham comes to mind. Steven Roach comes to mind. These are guys who are more or less in academic posts and writing what they want to write when they want to write, but they get to bring experience and perspective to the current environment. I think they would argue that valuation, valuation is critical to understanding where we are going in 2022 and beyond, to the degree that we’re starting from the perch of overvaluation. You’re talking about subpar returns for the next 10 to 12 years. And if we were, if you could argue, I do not think you can, but if you could argue for undervaluation, that’s where you begin to project positive rates of return in equities.

Kevin: So that would follow. Instead of a taper tantrum, we’re talking about a taper tragedy here for the person who is too far invested into the equities market. But after the tragedy, after the blood is in the streets, was it Rothschild who said when there’s blood running in the streets?

David: Yep.

Kevin: That’s when you buy.

David: Well, and so I think there’s a predictable reaction from the Fed. Maybe there’s other central banks involved. But predictable action from the central banks in response to that kind of volatility. So when do we see the volatility? Do we see it in 2022? Is it a Q1 event? 

My guess is that they stay consistent—that is, the Fed stays consistent with their verbal commitments and slows the monthly purchases of mortgage-backed securities and Treasurys. They’ll be done with that by June. Maybe, maybe if they accelerate that by March. So now you’re talking about where the rubber meets the road. Somewhere between Q1 and Q2, do they begin to shrink their balance sheet? Are they earnest? Do they deliver of the goods on raising rates 25 basis points, 50 basis points once or twice before the middle of the year so that they can have some latitude to do more in the latter part of the year? When they are moving to QT, I think that’s where you’re talking about volatility emerging within the equity and bond markets and then they have to reverse course. 

Why? Because there’s only so much volatility which they’re willing to tolerate. This market was weaned, and really in its early developmental stages conditioned, to expect cheap credit and artificial central bank flows to over-liquefy it. That excess liquidity has fed into the areas of speculative excess we’ve often talked about on the Commentary. They’re fairly obvious if you just look at a chart. But when excess liquidity dries up, this is the critical point, where, again, the old guys who are retired and writing what they want when they want, the perspective that they would bring is that we’ve been here before. We’ve seen this before. When excess liquidity dries up, the business model so popular in those periods of time where you didn’t need revenue, all you needed was a story, all you needed was the sizzle, no stake necessary, now all of a sudden those cases start looking like tulip bulbs. Scarce, they may be. Rare, they are indeed. Digital, perhaps. But when you lose the audience, the price declines in a pretty dramatic fashion.

Kevin: You talked about excess liquidity. The Covid period of time was such an interesting period of time. I have some clients who own a car dealership, and they bought a RZR dealership right before Covid broke out. We talked about it. They were worried. Honestly, they thought that this was going to be an economic downturn and that nobody would buy RZR. You know, those are the four-wheel drive— My son and I went to Moab and rode some of those around. They’re really fun. But the question was, since this was over and above, sort of a luxury item, now that Covid is breaking out, this was back in 2019 when we talked, or actually 2020. The concern was that the dealership wasn’t going to go, instead RZRs really, really sold. There was excess liquidity everywhere. Try to buy boat or a camper or a RZR, anything that takes you outdoors. 

Now talking to them, like I said, they own a used car dealership and a RZR dealership. They cannot get inventory, Dave, at all for these things. And so when the excess liquidity dries up, I’m just wondering, will people be able to afford? When they finally can get inventory— people are using their credit cards again. I don’t know that they’re necessarily spending the stimulus checks that they had before.

David: I’ve got a friend named Bert Dohman who writes about it as almost a military analogy. The generals lead the charge. If they’re not careful, they can get too far out in front of the troops. In this case, we’ve had Nasdaq and your tech stocks get way out in front of the troops. Is that any surprise that that’s where we’re seeing the initial weakness? Are we likely to see even more follow through where the generals are in full retreat and now the troops are following?

Kevin: The troops represent the general market, and the generals are the ones who are the leaders. Those are few and far between, it’s just they’re way, way out there.

David: And they’ve benefited. The mega caps have benefited from inflows into equity, specifically ETF indexes, and they’re cap weighted. In other words, the larger the company, the more money of those new dollars that gets allocated to you on an automatic basis. But money goes in, they get the benefit. Money comes out, they pay the price. Now we’ve already seen some of the more popular stocks. These are not the generals, but some of the more popular stocks from Covid already hitting the skids. Virgin Galactic is down 85% from its peak a year ago. Feels like a crash to me.

Kevin: Yeah. That’s using the word tragedy not tantrum.

David: Peloton. Yeah, I love to cycle. I don’t think you’re going to have a hard time getting supplies now. Stocks down 81%. 81%. We’re talking about from last January to this January, there’s already a change in the air, right? If you’re not paying attention, you might say, well, look, the indexes were up. We had the S&P up X percent. We had Nasdaq up X percent. We had Dow up X percent. If you’re not looking at the details, the majority of stocks in the S&P 500 were suffering last year. You’ve got the majority right now. I think 384 different companies of the S&P 500 which are below their 50-day moving average. That is deteriorating, technically. Even with the S&P just a few percentage points from all time highs.

Kevin: That’s where these indexes can be deceptive. You know, I would love if you could just look across the country to see how people were paying for Christmas this year. Because last year you did, you had the stimulus checks, you had a lot of excess liquidity, but I would bet that you’ve got a lot more credit card spending this year. People are starting to realize that it’s tightening up.

David: Well, this week we’ve got a couple things. We talked about the inflation number being in the data for announcements. We’ve got CPI, midweek PPI at the end of the week, Producer Price Index. Then we’ve got the University of Michigan’s consumer sentiment numbers at the end of the week. We’ve also got this week the NFIB Small Business Survey. I’m curious to see how the consumer sentiment numbers and the small business outlook, I’m curious to see what those come out this week. Consumer credit already has shifted from reflecting excess savings to now, let’s call it savings scarcity. These are numbers that are delayed so now we’re talking about November consumer credit. It jumped 40 billion. Consumer credit November jumped 40 billion.

Kevin: So they are pulling the credit cards out. Yeah.

David: Well, it’s two times what was expected. 20 billion was expected. 40 billion is what came through. Credit cards tripled from 6.6 billion in October to 19.8 billion in November. Certainly we’re talking about holiday spending, but it suggests that savings from the pandemic stimulus checks have been used up and Christmas was financed using plastic. We’re already seeing a shift in terms of excess resources and maybe things that would further drive pressure, supply chain pressure, et cetera, et cetera early 2022. Maybe those are beginning to fade and consumer credit’s an indicator there.

Kevin: One of the things that you predicted a few weeks ago is that inflation numbers will come down at least officially. Part of that is because there are—the main reason is because they’re going to change the way they actually count. Right?

David: That’s exactly right. We got a metric reset starting in January. Go back a few weeks, that was our conversation. The inflation stats are likely to come down in Q1 from calculation changes—that’s just shifts in the weighting of various components. Awfully convenient for Biden coming into an election and awfully convenient for the Fed. Takes away some of the pressure thanks to the friends over at the BLS. But you also have this issue of stimulus checks. If they’re exhausted, you’ve got a huge source of inflationary pressure that is also letting up. That’s just in the short term, but clearly you’ve got some things that are going to shine a bright light on inflation. Maybe peaking at seven and coming down to six and a half, six percent as we move forward.

Kevin: Inflation sometimes can be measured in the financial markets. You know, inflation shows up in different places, and you’ve brought this out. When you have monetary stimulus, a lot of times you have financial market inflation, right? Asset inflation. So stocks, bonds, what have you, real estate. But fiscal stimulus, Build Back Better, we’ve been told by the powers that be that that’s going to be anti-inflationary, which is ridiculous. It’s saying the opposite of what it is. But fiscal stimulus, that’s a different kind of inflation. Isn’t it? It’s not asset inflation, where the wealthy are getting wealthier, this is consumers getting poorer, right? It affects the consumer.

David: Well, and that’s one of the distinctions I made in that white paper I wrote a year ago is we’re transitioning from monetary stimulus to fiscal stimulus. The transition has helped with the transition from mere asset price inflation to a broad-based consumer price inflation. This is where Harvard economist Robert Barro has described big state inflation. The larger the role— If you imagine a script being written to the degree that the government writes themselves a larger role—a lead role in the economy, in activity, in solving problems—you’re talking about building a kind of inflation into the system with the state getting bigger and bigger so that the fiscal interventions are going to continue. They will be key in pressuring the CPI and PPI. You may have a new way of counting the numbers. We talked about that with the Bureau of Labor Statistics. How many times have they done this in recent memory, where it’s just not the way we measure inflation anymore. You know, pork is the new chicken. Chicken is the new beef. Whatever it may be, you can create substitutions and weighting differences. All of a sudden, inflation vanishes.

Kevin: You call it prettying up the pig, but that’s really the truth.

David: Well, that’s right. But the causal chain from the fiscal side has got to be watched carefully. It’s not just monetary accommodation and Fed policy largesse that are factors. If we start to see monetary policy tightening and that largesse recede, we’re still talking about other factors that are more significant towards driving the current consumer price inflation. The stimi checks drive excess demand, and the stimi checks drive shifts in labor dynamics and wages—which, if you think about the change in the structure of wages, becomes an additional prop for inflation trends on a longer-term basis. Once wages are increased, there’s a broad based repricing of goods and services. A lot of that is still in the works.

Kevin: You know, there’s a different kind of scarcity, though, not just scarcity of goods. There’s a scarcity of entitlement programs. According to the current administration, we need more entitlement programs. How does that scarcity factor in?

David: It’s a fascinating discovery. I mean, it’s like a certain form of alchemy. I didn’t know you could do that. As if direct physical stimulus wasn’t enough, we have what Robert Barro of Harvard calls, like I mentioned, big state inflation. The current administration is addressing this shortage—shortage of entitlement programs—through an expanded governmental footprint. This goes back a little ways, Kevin, but two years ago we described C19, Covid-19 as Convenient 19. Indeed it has been convenient for introducing draconian measures of control not seen since 9/11 and the imposition of the Patriot Act. We are redefining the structure of the free markets and governmental interactions. I guess the news flash for everyone listening: you probably didn’t realize that we had this shortage of entitlement programs.

Kevin: To the rescue, always, is Leviathan.

David: Build Back Better.

Kevin: Leviathan, Leviathan. Higgs is the one who brought that up in his book, Crisis and Leviathan. But you’re right, Build Back Better, or Leviathan.

David: The Build Back Better program is the latest. It’s not the first to be put in motion, and it will not be the last of these iterations of government involvement in creating new entitlement programs. Robert Higgs accurately described in his book Crisis and Leviathan how this process occurs. In US history, there’s never been a crisis that did not considerably ratchet the scale of governmental control and involvement to new levels. Covid was a once-in-a-century opportunity to remake our interactions with government and install a more comprehensive bureaucracy. Social infrastructure—you probably didn’t know there was such a thing. You knew that there was infrastructure like roads and bridges and sewer systems, and maybe even a digital infrastructure for data and communications and whatever, but social infrastructure? 

We’re now broadly defining what we are going to create for a better, a new and better and braver world. But they’ve been able to do this and get everyone to sign off on it in the context of limitless fear. Even the 130 billion dollars in school upgrades, for new air systems and whatever else, it’s oozed with the language of social justice, and it’s had political design. Fascinatingly, Chicago decides that that’s not good enough. They’re still not going to show up and teach kids because they can, that’s the nature of a teacher’s union. They can do whatever the heck they want. 

What Covid has set the stage for is a US version of what the Chinese have referred to as common prosperity. I would put in brackets after that, or lack thereof, common lack of prosperity. It’s a new branding of socialism for the 21st century. The Chinese have their version. Our version is probably less egalitarian and more corporatist, but I digress. Back to the BLS. By the way, Higgs’ book is required reading. We interviewed him back in 2012, 2013. If you have not read Crisis and Leviathan, you’re missing out. Very important conceptually, and just a major contribution. If you don’t know the author, if you don’t know the book, order it.

Kevin: Leviathan doesn’t just grow to protect you, it lies to protect you because the Bureau of Labor Statistics has said that they need to change methodology so that they can remove the biases that cause CPI, the Consumer Price Index to be overstated. Boy, I was concerned that they were overstating CPI. Weren’t you? Leviathan is here to help.

David: While we’re talking about Crisis and Leviathan, a book by similar title, and we spent some time in 2019 with the author, Crisis by Design. Crisis by Design, because really what happens— it’s not just the BLS and the BS that they can pump out. It’s also the nature of politics and the nature of the credit markets, designed to be fragile, designed to be fragile because they’re designed to dole out money to specific constituency groups. It’s power and politics that flows through the credit markets that ultimately creates weakness within the structures of credit and within the financial markets themselves.

Kevin: Well, and you need fear and dependency to be able to put a lot of these policies in place.

David: The BLS says, I mean, this is what they say of themselves: We’re changing the methodology. We’re removing the bias that causes the CPI to be overstated.

Kevin: Yeah. You’d hate to see that happen.

David: Surprise, surprise. If you’re looking at history, all the revisions are down. Inflation is smaller than we thought. Smaller than we thought. Smaller than we thought. Smaller than we thought.

Kevin: It’s like the Grinch’s heart, it gets smaller and smaller and smaller till the end of the show.

David: Well, so the BLS has their own implicit downward bias, it would seem. We’ve referenced a 13 or 14% rate of inflation. Two times what is expected this week. Again, 7% was expected this week. The actual number, real world inflation is closer to double that, 13, 14%. This is not pie in the sky. We’re not wearing tin foil hats to come up with this math. It’s the number that would be calculated today if we’re still under Volcker’s older CPI methodology. This is from the ’70s, the way they did math. Did you know that we’re doing new math? Well, nobody assumes that Volcker was daft or that inflation of the ’70s was fictional, a mirage. But our statisticians will tell us that the numbers we feel each day are in fact incorrect. Only what we read in print should be trusted, from the right sources of course. Inflation is going to be transitory after all. And I say that truly. Inflation is going to be transitory after all, thanks to our friends from the Bureau of Labor Statistics.

Kevin: Well, to defend their side of things, we do consume different things. I’m sure that they took bell bottom blue jeans out of the calculation from the late ’70s because I don’t have any bell bottom blue jeans. I did back in the late ’70s, Dave. Maybe the pet rock. I can’t remember exactly when the pet rock was in there, but they might have removed that from the basket that they measure as far as inflation goes. But for the most part, I still eat chicken, asparagus on occasion, lettuce, still use gas, still use propane to heat the house. Gosh, most of the things other than the bell bottom blue jeans should still be in the basket.

David: Well, you bring up bell bottom blue jeans, and I think that’s a great point. Because if we’ve gone from bell bottoms to tight jeans, I mean tight jeans, you get the hedonics adjustment. I mean, because honestly, who wants bell bottoms when you can have tight jeans. They get the hedonic adjustment. It’s not a weighting adjustment, it’s a hedonics thing.

Kevin: It’s a hedonics thing. Okay. But you know, we’ve got to be careful what we say because Twitter might cut everything. They might cut us out or YouTube or you name it. They want to control the narrative, don’t they?

David: We may be cut off. Any discussion contrary with what the BLS says is the truth about inflation. If we are going to have a contrary narrative, if we’re going to have a discussion or dialogue about Volcker’s math versus the current math, well, it could be a problem.

Kevin: For the bots that are listening, we love the BLS. We love the BLS.

David: Absolutely. I mean, again, that’s why I say thank you to our friends at the BLS. I think as we launch into the next period of time, we’ve got a couple more years, it looks like, with Powell. I think we need to bring Twitter in, the truth arbiters to run the Ministry of Truth and Information and to help with the dispersion and the distribution of all the salient points, little short things that we need to know as absolutely true. Big T, truth.

Kevin: The Ministry of Truth.

David: I mentioned Galactic, Virgin Galactic. I mentioned Peloton. I didn’t mention Twitter. They’re down 50% from their peak.

Kevin: Oh, what a shame. What a shame. Well, you know, big brother.

David: That breaks my heart.

Kevin: You know, when Orwell wrote 1984, he was thinking it would be big government that actually was doing this. But what’s interesting is Big Brother, the Ministry of Truth is really big tech. You know, when we talk about what Mussolini said about fascism, that it’s really just corporatism, right? It’s corporations and governments hand in hand. You look at the complete censorship of what’s going on with information. You’re not really allowed to talk about truth in any kind of electronic format without it being manipulated.

David: Well, and what’s clear is regulation is coming to big tech. The problem is, regulation is not to control, as in put a governor on, big tech, but it’s regulation in the form of reins. Imagine big tech having the bit in their teeth and being able to do whatever they want, run as fast and as hard as they want without recourse. Bit in the teeth. Regulation is simply government getting control of the reins, getting the bit out of the horse’s teeth, and now they’re back in the dominant position.

Kevin: Yeah. So you wonder if Mussolini wouldn’t say, well, yeah, that’s just part of it. That’s part of it. You’ve got to have that connection even through regulation.

David: Right. Thank you, Huxley. Well, quite competent within certain parameters is kind of how I think about the BLS. They do a good job, and it’s a little bit like an intelligent young math student, maybe quasi-intelligent. Plug and play with any equation without necessarily understanding the meaning of the results. I see the folks, they’ve given a new metric at the BLS. Okay. We’re counting inflation this way. Great. They’re not thinking about what has happened. They’re not thinking about the fact that if you understate inflation, that you overstate GDP growth. They’re not thinking about understanding inflation as having consequences for those living on Social Security or fixed income where the cost of living adjustment if inadequately representing real world inflation is putting a squeeze, social pressure, and existential threat to our retirees.

I mean, again, this is where I think the work that’s done is good work. It’s in such a tight box. They don’t necessarily see the implications. Biden, I think he’s very confident. If we go back to his comments in December, very confident that inflation has peaked. And the reason he is confident is because the equation is shifted, and the BLS numbers will spit out a better number. That’s guaranteed.

Kevin: I just wonder sometimes if the facts no longer matter at all. We talk about fake news, but actually when you look all the way up to the top, I mean, even in the Supreme Court. When you’ve got people talking about Covid and misstating fact after fact after fact, you wonder where are people getting their information. Even if it’s censored, where are people getting their information?

David: I mean, you’re still talking about competence or quasi-intelligence. I mean, honestly, you’re talking about some of the brightest people in the world on the Supreme Court. But you’re right. It’s been shocking, very frustrating to see Sotomayor’s lack of awareness on Covid specifics. She’s helping to determine workplace requirements for Covid vaccination, and she’s doing what?

Kevin: She’s changing the math. I don’t think she even knows it.

David: Well, I mean, she claims that Covid deaths are at all time highs, which in one sense is true. Any single death added to the previous total gives you a new all time high. I mean, that’s pretty straightforward.

Kevin: Which means we’re at an all time high in days so far since the creation of the universe. Right. We’re at an all time high.

David: Exactly. I’m in an all time high in terms of my personal longevity.

Kevin: There you go, so far.

David: Yeah, so far. But we’re talking about the run rate. We’re talking about the changes from day to day, week to week, month to month on any time metric. We’re not setting those kinds of records. The other thing that was odd was that she was claiming that Omicron, maybe we can call it Omnicron. Omicron has been deadlier than Delta. She said this in her remarks. I don’t know what her primary sources are for that, but she’s not following the science. I mean, that’s not what the science says. Well, maybe she’s not following the math either and is following the science. 

Well, or at this point, it’s just obvious that the science has to be carried in quotes, “the science.” The third thing that was just flat crazy, this should not come from the hallowed halls of the Supreme Court. But according to her, 100,000 children have been hospitalized with Covid. This is why we need to take these measures so significantly. The CDC director jumped on her immediately, quick to correct publicly, the actual number tallies to 3,500.

Kevin: Instead of 100,000, 3,500.

David: Again, economists and statisticians, they can play with numbers. We’re talking about the law, and if you’re basing law on facts, the facts matter, the law ultimately will matter. It’s just fascinating. More and more it’s like we’re hearing the phrase, I have the answer. What was the question? That seems to be the 21st century version of the scientific method that seems to be the way the Supreme Court is approaching these issues. Is it competent? What’s revealed is sort of the lack of information absorption. It’s almost like, you know, there’s been a block. You can’t go on the internet. You can’t read anything. You can’t even read scientific journals apparently. I want to go back to Doug’s reflections on the markets. I’m digressing repeatedly. My apologies. I want to go back to Doug’s reflection on the markets because the ETF space is headed quickly to 10 trillion dollars in assets. This is your passively managed money. Coming up on 10 trillion, bond ETFs took in another 244 billion dollars last year for 2021. 244 billion, that’s a new record. It’s the third year north of 200 billion in a row.

Kevin: Let’s take a break here for a second and think about this. Okay. When you have all of this coming into a passive investment vehicle, and this has really been the phenomenon of the last decade, these passive investment vehicles. Everybody’s buying the same thing. We’ve talked about it before. When it comes time to sell, everybody will be selling the same thing, but there is no market for that. Where’s the market maker? When you’ve got, you said 244 billion, a quarter of a trillion came into bond ETFs. That’s not selected types of items. That’s just, it’s all the same stuff going into the same, these ETFs. What happens when people do sell?

David: Well, it’s fascinating even watching the inflows into investment grade debt and high yield debt, that is junk bonds, last week. I mean, these were huge numbers for a given week. Over three billion into investment grade debt. This is in the context of interest rates aggressively rising. Like you actually have a loss. If you’re looking at the price of HYG, if you’re looking at the price of LQD, there’s pressure in those markets, and yet money is still being thrown— Even in the midst of Treasurys and government bonds around the world moving higher last week, people are still throwing money at investment grade and high yield debt like nothing has changed. It really is as if they did not get the memo. January 5th, it did not compute that there is a significant shift and there are implications to rising rates, which is why the structure of those ETFs, the bond ETFs, matters so much. The implications of rising rates, that’s what we’re talking about. The structure of bond ETFs makes purchase easy.

Kevin: Sure. It’s convenient. It’s convenient, easy. You don’t have to pick. You just go on. Give me some bonds.

David: It implies a liquidation, which is just as easy, which is true if new buyers replace the sellers. But the structure does not imply a robust market maker of scale who’s willing to inventory hundreds of billions of dollars in paper when losses are accruing to the bond investor as a result of increasing rates. As investors sell their bond investments, they’re hoping that there’s new entrance into the market. They’re reliant on new entrance to the market. But when buyers go on strike, the structure of the bond ETF is revealed as particularly frail, particularly frail. I mean, the reality is the retail investor doesn’t know the path to the exits.

Kevin: You know, you’ve talked about this, Dave. When we talk to clients even with gold and silver, we start with what is the exit strategy, not how to buy. It’s, what is your exit strategy? You’d have to ask that for the person who owns an ETF. Do they even know where the exits are? Like you said.

David: It’s funny that you bring that up because we’ve been in the financial markets and in the metals markets for 50 years, and that is one of the first questions that we ask. It’s a weird question to ask, but it’s a priority that we’ve put for five decades on our client’s wellbeing. We’re not asking what you should be buying today. We’re asking what makes sense to be buying today in light of a liquidation event which takes place in the future. We’re willing to imaginatively engage and say, under what conditions are you planning on liquidating? So your timeframes matter to us. 

Furthermore, what are the conditions under which you might be liquidating? Do you have liquidity with product A, B, C, D? Is this a rarity, not a rarity? Is this a bullion-oriented product? “What is your exit strategy” is absolutely critical. When we talk about the perspective triangle and migrating assets from gold and silver, out of gold and silver into equities, when we talk about moving from cash into gold and silver, when we’re migrating from one part of the perspective trying to another, we’re constantly asking. We know where we’re starting, but isn’t it also important to know where we finish? What’s your game plan? There’s multiple steps to this and your exit strategy is absolutely critical. Nobody is asking that question when they’re buying a bond ETF. They are not asking that.

Kevin: Being a pilot, Dave, you practice. If you’re going to crash land, let’s say that you lose the engine, you practice by opening up the door before you land. I don’t know if you remember that, but with little Cessna or what have you. You don’t want to get stuck in the plane if it crash lands. And so if you have the ability to glide to a landing but it may be a hard landing, you pop that latch on that door and you get it open so that you have the quickest way to get out of what could be a fiery aircraft.

David: It’s been a long time since I worked on my pilot license, it’s almost 30 years ago. The practice of engines out routine, you have to know what you’re going to do, where are you going to land? And how to scout the best spot to put this plane down. There’s a mindset when you’re in the air, always, you could fly over any landscape. You’re still judging whether or not it’s a harsh condition to land in or the best place to go. Where do I glide next? If I don’t have power, where do I go? There’s always a mindset of plan B, plan C. Plan A is not guaranteed.

Kevin: Going back to what we’re talking about on these ETFs and these passively managed funds that are just gigantic, are there exits, or is this something where you just go down with the plane if they can’t get out themselves? What market do they sell it to?

David: I think that’s the issue and why Doug’s harping on look at the structure, 10 trillion dollars moving into autopilot investments. The assumption is that we’ve got a significant market maker who’s going to keep liquidity flows there. No, we’re anticipating the market maker of last resort is the Federal Reserve. So we can talk about QT today, and we can get quite cute about what it looks like to have, again, a rolling off of assets from their balance sheet. And yes, we should start to adjust to that. But the realities are, by year-end, within a six to 12 month timeframe from the actual initiation of QT, we’ve got a crash situation. We have got a market crash situation, and the structure is such the doors are locked and you’re not getting out. So no, you don’t get to land in the field and pop that door open last minute. No. In that case, the structure of the ETF universe is not particularly friendly. 

You’ve got total equity exposure if you’re talking about the retail investment space, who owns what within equities and bonds. Total stock market exposure is now at 184% of GDP. It’s by far the highest in US financial market history. And you’ve got bonds, which, I mean, to me, they are like the proverbial fire. You can go from the frying pan, equities, into the fire, bonds. 

I think we’re set up for turmoil in the US markets with a lot of intrigue focused as we get to the third and fourth quarter this year, because this is where you begin to see the bite of QT, that is quantitative tightening, and the step sequence of where the Fed gets very uncomfortable with market volatility and has to do something. What are they going to do? How do we judge? How do we manage money? How do you position a portfolio in light of a clear statement from the Fed that QE is going away? They’re going to roll off assets from their balance sheet, and this is a new era of tightening. Oh, but wait, there’s more. There’s too much leverage in the system and you can only press that so far before things become unhinged.

Kevin: Well, and there’s more, too. I mean, this is an election year. Okay. In an election year, you can talk all you want about tightening, right. But that’s going to factor in, too.

David: Oh, absolutely. First, we have the runoff, tightening of financial conditions. Later on we’re forced to expand, accommodate again, another version of QE and policy reversal. Maybe it goes something like this. Imagine a September to October low in equities. Now I’m asking you to imagine a lot because we haven’t even really started to decline. I think we may be setting up for a major market top now. But imagine a September to October low in the equities markets.

Kevin: You’re talking going forward.

David: Yeah. Nobody’s assuming a crash in ’22. Perhaps we are, but not very many are. And a fresh round of interventions that follow in that September to October time. You bring up the elections, well, the elections are in full swing. You’ve got a huge amount of political pressure on Powell to do something. Plus, you’ve got high motivation to spend fiscal dollars like they are simply going out of style. 

I think this gets really interesting as we get to the end of the year where whatever low we have in inflation midyear, all of a sudden becomes a roaring nightmare at year end because you’ve got the forced hand of the Fed coming back with monetary policy largesse, and the forced fiscal hand where we’ve already run. That’s why we mentioned the credit numbers earlier, the consumer credit numbers. It would appear that the consumer is already out of the stimi checks and into their wallets with credit on display. 

What do we do for an encore? Well, the encore comes tail end of the year, and now you’ve got the one-two punch of monetary policy largesse, fiscal policy largesse, and inflation statistics that would scare the whiskers off a cat. In the context of a declining equity market, you know what it spells to me, it’s like the perfect recipe. Of course, this is a work of fiction today, but I think this becomes fact tomorrow. This is the recipe for gold going to the moon, silver following suit. I think 2022 begins to look really attractive for the metals and it’s been underestimated very, very underestimated by the US investor.

Kevin: Well, the US investor has been looking back and saying, you know what? You guys have been saying that we’ve been overvalued for years. I mean, what is overvalued if you can get over more valued and over more valued and over more valued? The question would be, have we started to take overvaluation for granted?

David: I think so.

Kevin: To where there really is no downside.

David: No. I mean, you grow used to it. You’re flying at such an altitude and you just say, this is it. We’re great. Look at this. We’re soaring. Happy up here. Why would this change? Well, you can ignore certain realities. Doug’s reflections in the Credit Bubble Bulletin this weekend, they echoed Jeremy Grantham’s thoughts as he sort of closed out the tail end of last year—you know, third and fourth quarter last year. Doug says, “pain on the downside will be proportional to the excess and duration of the proceeding boom.” Sounds very von Misesian. I think he’s right. 

Grantham in August said we’ve checked all the boxes. Now the question is, how high is high? Very hard to tell, always, what the peak will be. But what you do know is that how high the peak is has no bearing at all on what the fair value is. What it does change is the amount of pain that you get to go back to fair value and below. You profoundly do not wish for a super high level to your bubble. You profoundly do not wish for more than one asset class to be bubbling at the same time. I’ve been very clear about what I consider a definition of success, and that is only that sooner or later you will have made money to have sidestepped the bubble phase. I mean, again, Grantham makes money on the upside. Doug, in some respects, makes money on the downside. But they come to the same conclusion here. The pain ahead is the inevitable part of the story. Now, are we talking 2022 or are we talking 2023 and ’4? We’ve loaded the boat with opportunities for downside.

Kevin: Well, the question is do you really want to be in a bubble even if you’re making money— if that downside— I mean, that’s a long fall. How do you sidestep the bubble? I mean, I sort of know how I sidestep it, but how does an investor sidestep the bubble if they go, yeah, you guys are right. I don’t want to be there.

David: Right. To Grantham’s point. And you started the conversation this way. We’ll maybe move to cash. We are seeing that with a lot of clients, move to cash. Hey, I think that’s smart. I think that’s smart. You do have to manage the inflationary risks of moving entirely to cash. Are you sidestepping the bubble phase? I mean, because you’re really talking about both equities and bonds. 

I think this is where gold is an excellent compliment. Gold bull markets quite often run in a parallel track, kind of move in the opposite direction, with equities and equity underperformance, equity underperformance. To the degree that stocks are moving lower or sideways, going nowhere quickly, gold kind of does well. I can think of a number of historical references for that, 1929 to ’32, ’68 to ’74, ’76 to ’82, 2000 to 2012. I believe 2022 to 2030, where we begin to see the markets underperform. That is, the stock and bond markets underperform. And for many of the reasons we’ve discussed today, we begin to see gold and silver outperform.

Kevin: This is why it’s so important to not just value gold in paper dollars, but like in stocks. You had mentioned the ’29 to ’32 period. Well, an ounce of gold ended up buying 10 times more stock than it did in ’29 by 1932.

David: Almost 20. We went from an 18/1 ratio down to a 1/1 ratio.

Kevin: Wow. Wow.

David: By the time you got to 1968, that was a market peak. And then we went into a bear market, ’68 to ’74. The Dow/gold ratio in ’68 was 28/1.

Kevin: You could buy 30 times, almost 30 times more stocks.

David: That’s right. By the time you got to 1982, the market low in equities and the peak in gold, you were back to a 1/1 ratio.

Kevin: Which is about 30 times. Yeah.

David: Almost 30 times. And then we peak again in the year 2000, 43/1. We’re sitting right around 20/1 today. 21 today puts the gold/Dow ratio comparable to where we were in 1929. Right? And it shines a bright light on the fact that the nominal prices for stocks are one thing. The real money prices for stocks are something completely different. 

I’d sum it up this way. The trifecta of enduring inflation, that’s what we have, not transitory, but enduring inflation. That being the first variable. Equity weakness being a second variable. I think we’re just getting that kicked off here, first week and first month of the year. And a credit-tightening phase which takes so much of the air out of the panoply of bubbles. Those three factors are wind at the back for the precious metals investor. I would just simply conclude, this is one of the most compelling times to own, to add, to sit with and expand a position in gold and silver certainly that we’ve seen in our 50 years of operating in these markets.

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. M-C-A-L-V-A-N-Y.com. 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.

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