Everything Rally is Awesome…or maybe Not

Weekly Commentary • Aug 17 2022
Everything Rally is Awesome…or maybe Not
David McAlvany Posted on August 17, 2022
  • Market surge creates a Catch-22 for wannabe Bulls
  • Wages rise, but not enough to keep up with inflation
  • China shocks with interest rate cut, hoping to delay a larger disaster

Everything Rally is Awesome—or Maybe Not
August 17, 2022

“A true bear market has a lot further to run because nothing has been learned, and the lessons that needed to be learned are not remembered. The second major phase of decline is what you would expect between now and year-end. You could look for geopolitical predicates for that. You could look at a cooling global economy. You can look at the declining economic reality within China. What it suggests is that we’re going to be challenged by at least one, if not multiple, factors by year end.” — David McAlvany

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

David, you and I have both flown small aircraft. If you recall, when you’re training, sometimes they put you under the hood where you can’t see outside of the window. You can only see your gauges. That’s an interesting experience because while you’re training, they put you into what they call an unusual attitude, unusual attitudes exercises. You can feel rising and falling in your body. You think you can fly by the seat of your pants, but if you actually look at the gauges, they’re oftentimes showing you opposite what you feel. I’m seeing in the markets right now, Dave, I’m seeing this surge. All of a sudden, inflation is less of a concern, that people who were getting their heads handed to them earlier are now going back and rebuying the various stocks that they got chopped up on. Do we look at the gauges? What are we looking at? What’s the narrative? What’s the truth versus what we feel?

David: I think the idea of an unusual attitude— I might draw a different meaning from that than is appropriate from the flying lingo.

Kevin: You’re thinking about your daughter, possibly, on the days where she might be a little bit more difficult than others, huh?

David: Oh yeah. Or me on a Tuesday morning. Occasionally, there’s a little grit in my craw. But it is interesting. The stocks have rallied to a key resistance level and—

Kevin: This is a test, isn’t it? We’re at a testing moment.

David: Absolutely. The S&P 500 is both at a 50% retracement level, that is 50% of the first half selloff has been recovered, and it’s also coming up to the 200-day moving average. That convergence provides a test for the bulls. When you look at those retracement levels, a 50% retracement is very common. If you had an additional move higher, your next destination would be 61.8. How these numbers mathematically coincide with the emotional energy of the markets is very, very intriguing. These are Fibonacci numbers, and somehow there’s coincidence. Maybe it’s more than a coincidence, but a 50% retracement, very common. Additional move to 61.8% retracement, also not unusual. What you have is a testing of the up trend at those junctures. Will additional buyers enter the fray? 

When autumn volumes pick up— There’s lower volumes in the summer times. As we get the kids back to school and fully engage with portfolio management, as autumn volumes pick up, will there be sufficient fear of missing out to draw individual investors back in? There’s a reasonable argument that short covering has run its course. In recent weeks, you’ve seen miraculous moves higher on very low summer volumes. That’s been the context. Now, you need. Now, you must have organic buyers to propel prices into a next leg higher. The enthusiasm is growing. Short covering being transformed into an extended rally, certainly that cannot be ruled out. But as a reminder, these kinds of rallies are frequent in the context of a broader market decline.

Kevin: Oh yeah. Remember the 2000 sell off? How many rallies did we have during that complete devastation of the market?

David: No less than seven mega-rallies occurred in the context of a greater than 75% decline. Each rally drew the public back in, the assumption being that the worst was in the rear view mirror, and an all clear signal was there according to price action. Obviously, in retrospect, it was not so. Ominously, last week ended with New York Stock Exchange volumes shrinking considerably compared to the midweek rally, by just shy of 20%. So decline in volumes, getting to the 50% retracement level, testing the 200-day moving average, these are points where you can see a reversal.

Kevin: Yeah. A friend of your dad’s first, and then you later, Bert Dohmen, he’s been writing a letter for a long, long time. He’s seen so many market moves. He can look at the contrary picture. I know he looks at the volatility index, especially right now. Volatility has just dropped through the floor, which means there must be some calm. Is that the calm before the storm?

David: There’s really no surprise that he’s a friend of my dad’s. They tend to see things differently. They’re interested in alternative medicine. They’re interested in alternative theories as it applies to economic analysis.

Kevin: So they’re similar in that they see things differently than most people?

David: That’s right.

Kevin: Yeah.

David: He likes to combine fundamental macroeconomic analysis with technicals, and has a trading service specifically for trading on the basis of technicals. So yeah. Our friend Bert Dohmen suggests that the VIX index dropping below 20 again is a good contra-indicator. Again, just seeing things a little bit differently. Instead of seeing the risk-on as a positive dynamic, the lower the VIX index goes, the more you have that contraindication that you’re getting ready to roll over, not roll higher. So perhaps we retest the April lows at 18.50. But in his view, it too is at a critical juncture. No, it’s not near the single digits where it has been—those levels a classic indicator of complacency—but the upper teens have been the lower boundary throughout this year, 2022.

Kevin: Okay. So volatility’s dropping, which, for a contrarian, they’re going to say, “All right. Well, then I think it might roll over.” But hasn’t this rally been pretty broad based? Aren’t most stocks above their moving averages right now?

David: Well, the volatility index is dropping. I would say that you’re seeing some pretty radical volatility in a variety of asset classes. It happens to be on the upside now, it was on the downside earlier in the year.

Kevin: Okay.

David: But the VIX is, again, a ratio of puts and calls. It just suggests that there’s less concern of a market decline than there was two weeks ago, four weeks ago, six weeks ago.

Kevin: So it’s not necessarily a measure of volatility as much as it is, looking forward, it’s less concern.

David: How much downside volatility is expected.

Kevin: Okay.

David: Also on Friday was the measure of equities. Now, the number of stocks that are above their 50-day moving average. The measure was at 11.7% two months ago. A fairly low reading. Now, it’s at 81.6% at the end of last week’s levels.

Kevin: That’s how many are above the moving average. What is it, the 200-day?

David: That’s the 50-day moving average.

Kevin: Oh, the 50-day.

David: Yeah. These are levels last seen in the first quarter of 2021 as a variety of indices were putting in their tops. So been a great rally. It’s been broad based. I would say there are concentrations of hyperactivity in the most shorted names, as we’ve recently discussed. An indication of that is month to date performance with the Goldman Sachs Most Short Index, up 20% since the beginning of the month, 47% from the June lows. That’s a huge move in a short period of time. But again, that needs to be converted to less shorted names, and again, continue to be broad based, for it to carry forward. There are only so many shares that are sold short, so only so many shares to repurchase and return to close out those positions. In other words, you’ve got to have organic buyers step in at this point.

Kevin: Well, you talk about organic buyers, but really there are two strategies that are really strange to me, Dave, that have worked pretty well for people over the last 10 years. One of them is, if you ask a person what stocks they buy, they don’t even know they’re in stocks. They just think they’re in indexes. So you just have passive investing. But the other one is the guy who gets on Reddit. He just It’s like, “Well, I don’t know anything about any of these companies, but everybody else on Reddit is buying this particular stock.” That’s happening again. That’s not healthy, is it?

David: Well, it’s an intriguing dynamic, where you have a company that has been largely left for dead, and a short seller steps in to extract the last bit of value—

Kevin: Game Stop.

David: — before the company goes bankrupt.

Kevin: Yeah. Game Stop.

David: Then all of a sudden, a group like Reddit finds this bear and traps them. All of a sudden, the buying ensues. You’ve got folks who are buying because everyone else is buying, not on the basis of company fundamentals, not on the basis of technical strength, just on the basis of the whimsical nature of finding a trapped bear and playing with them, toying with them. So buying begets short covering, which is another form of buying. Now, you’ve got an explosive move, which may be 100% in a day or 500% in a week. The bear is killed, and the bull wins and walks away victorious with what he considers to be a normal average return.

Kevin: But the bull dies the next day. I got to tell you a quick story. Okay. John Max, my uncle, he’s passed on, but I loved John Max. He actually was quite successful, but I remember standing in his pool down in Texas one day. He says, “I just never make a good investment decision.” Then he told me about this bull he bought. He spent thousands and thousands of dollars on a bull, and the bull died the next day, literally. He couldn’t get his money back. That’s what made me think of that, because yeah, the bull walks away victorious, but for how long?

David: Well, right, because it’s still like the walking dead. There’s nothing there to support future business activity. Popular meme stocks are coming back into the picture for traders. It’s not a sign of health. It’s more an indicator of reward being prioritized over risk management, which in my view suggests that a true bear market has a lot further to run because nothing has been learned, and the lessons that needed to be learned are not remembered. The second major phase of decline is what you would expect between now and year end. You could look for geopolitical predicates for that. You could look at a cooling global economy. You can look at declining economic reality within China. What it suggests is that we’re going to be challenged by at least one, if not multiple, factors by year-end.

Kevin: What amazes me is the disconnect between the markets—the surging and abating and surging—that disconnect from the normal housewife, or a person who’s just buying for a home. My wife is very concerned about inflation, but you talk to the markets right now, and the markets are like, “I guess inflation’s not going to be that big a deal.”

David: Again, so much of this is dealing with extrapolation. People tend to extrapolate on both sides of the trend. If inflation is surging, we’re moving to hyperinflation because they just extend the trend infinitely. If inflation begins to recede or fade, extrapolate that trend to zero. Again, inflation must not be an issue. Inflation is receding at present, as a concern for investors, which I believe is premature. We have one report where the number improves marginally, and where almost all the improvement comes from the volatile energy component. That, again, in my view, should not be taken as an end of the trend. Yes, it’s fair to account for food and energy volatility, and realize that they add an interesting dynamic, but that’s one aspect of this inflation, and one place it’s shown up. The more concerning aspect is sticky prices, or prices that do not quickly adjust.

Kevin: Like wages, right? Wages don’t come down. They just keep going up.

David: You see sticky prices as more of a concern when you’ve got wage inflation. So energy and food volatility are a consumer consideration, but for economists, the more concerning inflation is one that can’t be influenced by the fate of commodity prices. The jobs market. If you’re looking at, again, what we have is this really strong indication of strength within the economy, the jobs market suggests that wage inflation is a real and enduring issue. So again, don’t read too much into a single CPI, PPI report that has 80% of its move coming from the energy cost decreases.

Kevin: Right. I’ve seen the prices drop on gas. It’s nice. I like to see it drop from five to four. But go to a restaurant, Dave. Go to a restaurant or look at rent. How many people do you know in your family that rent, and they’re facing a bill that’s not— It’s not slightly larger. It’s astoundingly larger.

David: Yeah. Certainly the gas pump scenario, it’s helpful for inflation psychology, but that surge and fade, that’s the pattern we spoke of last week. That’s an important dynamic to keep front of mind. We have the fade right now, to a small degree. In all likelihood, we have another significant surge by the end of the year, probably post-November. We talked about seasonal adjustments last week, as it relates to non-farm payrolls numbers. A big deal. So we get to 3.5% on the unemployment rate. We add 528,000 jobs. At least that’s the expression of statistical artistry that we had on display with the most recent non-farm payroll numbers. We should remember, too, that CPI and PPI also have seasonal adjustments. There’s room to create and portray and tell the right story. Would it surprise you to see wonky seasonal adjustments with CPI and PPI as we lead into the November elections? Not really. 

Kevin: You’re talking about adjusting the numbers, the data.

Let’s just pretend for a second. Let’s play a mind experiment that everybody was getting good data. You know what you’d still have? You still have multiple narratives. You can take the same data. Let’s say that we’re all agreed that no one’s playing with the numbers. You can tell whatever story you want, even with good data. Now, apply that to people who are adjusting the numbers, seasonally, whatever. Your narrative is going to be so far off the rails, how do we determine truth?

David: This is something that we’ve been dealing with for only a few thousand years. We engage the world, and we have an interpretive grid for it. You end up with multiple grids, multiple lenses that you see the world through. All of a sudden, it’s different. Protestants, whether they know it or not, are Neoplatonists. Catholics are, whether they know it or not, Neo-Aristotelians. They’ve got these ideas, and ways of thinking, and patterns that inform how they interpret a particular text, not really giving deep consideration to the fact that the hermeneutics are informed by a certain set of preconditions and preconceived notions about the nature of reality. There’s still a lot of people who see data as factual and indisputable in its meaning.

Kevin: Even science, Dave, even scientists have a bias.

David: Of course. I see data as built on assumptions, built on models, and built around agendas. How data is presented, what is left out, the methodologies used to gather, to calculate, to organize details in support of conclusions. That’s the stuff of philosophy and politics, as much as it is of statistics, and should not ever be confused as brute fact.

Kevin: Note Thomas Kuhn. What does it take? The same data, it still takes 100 years to change the narrative in a scientific revolution.

David: You can even look at academic journals. How do they start? With the description of how and why particular data was collected. The process is as important as the conclusions you draw from it, but that is not a common realization in a world of headlines. Most people determine what is going on in the world, not on the basis of deep analysis and reflection, but on the basis of a few headlines and suggested conclusions, forgetting that there’s actually a whole host of assumptions that went into the data that was collected and that was presented. So again, we’re left to a world of headlines and algorithmic information management. So to pretend that data is neutral, whether we’re talking about climate change, we’re talking about inflation, we’re talking about jobs numbers, is to suspend reasonable skepticism about the motives that drive narrative creation and form the basis of belief. Look. I could model the productivity of a dairy farm, the productivity of a dairy farm or its environmental disgrace. I could model that off of a quantity of steaming BS. In the end, that may be all I’m really dealing with, a big pile of BS.

Kevin: We’re all subject to that. Yeah. I had a conversation with somebody who did not agree with me on Saturday. I couldn’t extract myself from the conversation. Facts didn’t matter. Stereotype did. It was just interesting. I had been stereotyped as a certain type of person, and so there was no possible way we could move forward in anything, whether we agreed or disagreed. I just yearned at that point, Dave, when I was talking to this person, for truth. What is truth? What is truth? Remember Pilate asked that question.

David: Well, we mentioned last year that, heading into the modern vernacular actually adopted by a recent— a dictionary is this idea of post-truth. We live in a post-truth era, where shared objective standards of truth are no longer accepted, cross-culturally. Relativism is, to some degree, biting us on the butt. Really no surprise there. But what you see, what you believe, your reality, your truth, different than my truth, we can’t agree what is around us, what is inside of us. If we cannot even agree on what is outside of us, how do we agree on what’s inside of us, in terms of thoughts and feelings and emotions? This is— Good luck. We’ve entered a free for all. 

We shouldn’t be surprised that there are those with a desire for power, or on an ascendant administrative path, forcing facts through a convenient interpretive grid, providing an interpretation of, and not just a report of, the facts. I know this veers away from the inflation conversation, but all data has carefully chosen parameters put to it. That’s where the legitimacy or illegitimacy lies. When we criticize an inflation number as bogus, it relates to the construction of the figure and the intended result that follows. Weighting components in a basket is a part of that. Applying hedonic adjustments is a part of that. Bringing in seasonal adjustments, or as we saw in the midst of COVID, creating a custom framework for the pandemic. CPI took on a whole new framework just to be able to deal with these strange anomalies and things that could not apply anymore as it related to seasonal adjustments. There is a lot that goes into the sausage.

Kevin: It reminds me of— Remember those old 3D glasses that you’d wear. One side was blue, one side was red, but if you were closing one eye, and weren’t looking through both lenses, you would think everything was either blue or everything was red. Isn’t that hermeneutics? It’s what lens you’re wearing, right?

David: That’s right. That’s the reality is we have a whole world, particularly coming into November, we’ve got a whole world that is one eyed. Hermeneutics is not a new study. We all have a lens we see things through. Interpretation is a demonstration of preconceived ideas. That’s really what it is. We all have preconceived ideas. But neither are the theories of knowledge new. Hermeneutics is not new. Theories of knowledge are not new to academic and scientific circles. Thus, we have the distinction between first order questions, first order questions relate to direct knowledge of the world. It’s the what questions. What is this that we’re dealing with? What are we measuring in a beaker? Versus second order questions that get at the why. Why is it important to measure this? Why do we gather this to add to our mix of knowledge? Second order questions often inform the data we collect, and serve as a basis for bias. That’s for better or for worse. 

What an academic tries to do, or should do, is account for and acknowledge the biases. The process is supposed to reveal that. Prejudices of the mind are very real, very common. Again, we return to the sausage recipe, and a rationale existing for what goes in and what doesn’t. We leave certain things out because it’s just not the right mix. That’s the reality is, when you get to second order questions, you’re choosing to include things, you’re choosing to exclude things. So the conclusions that you come to are not just about your interaction with what exists in the world. You’ve constructed it.

Kevin: You’ve brought up academics several times, and the idea of an academic. A lot of times, we think, “Academics, they don’t know what they’re doing,” but actually, there is a set of rules in the academy where, to be published, you need to be read and approved by your peers. That is supposed to be differentiating between the ingredients of the sausage, and maybe checking what’s inaccurate or not. Is the academy itself, on these academics, at this point, so biased that it doesn’t even work?

David: That’s a good question. Some people are more innocent than others in the conclusions that are arrived at, or the, gosh, in this day and age, the coercive steps that may follow from the conclusions, whether it’s on the basis of science or some other authoritative body or organization. You can see this on Wall Street. “Our economists conclude,” and therefore, you should do X, Y, and Z. “The math shows,” and therefore, you should do X, Y, and Z. “There’s consensus on this topic,” meaning that everyone with a PhD would agree with this. If you don’t agree with it, you’re outside of consensus, and probably contrary enough to be discounted. Your view is not consensus. 

There’s these ways that conclusions become somewhat coercive, and you find yourself outside of an accepted step sequence. Alternative theories always exist. Alternative explanations should always be considered. Otherwise, do you know what you are? Whether this is religious, or scientific, or medical, you are a mere dogmatist. That’s what you are. You’re a mere dogmatist. You’ve not fully engaged. You have to consider the other point of view. Theories and models are incredibly helpful tools for organizing information and driving towards conclusions, but they can be flawed, even if they’re helpful. They can break down at certain points and lose efficacy at a certain point. So what may be true in some respects may not be true in all respects, as you find the limitations of a model, right?

Kevin: Yeah. You know what I’m thinking though? Okay. We’re talking about this. If something questions your past thought, you have to have humility. Is that what we’re missing? You’re talking about dogmatism. Is it humility that we lack at this point? Because you have to be able to accept that there may be data that does not match your narrative.

David: Yeah. The dogmatist seems to have forgotten that what they’re working with is a theory and a model, and have confused it with brute fact, indisputable, unchallengeable.

Kevin: Then they get their emotion involved.

David: Absolutely, because you’re challenging the structure and the fabric of reality. How stupid can you be that you would question this? It’s confusion over an explanatory theory versus an actual fact. Again—

Kevin: Doesn’t this happen in politics?

David: All the time.

Kevin: Okay. What occurred on Saturday was I was immediately stereotyped into a group of people that this person felt was led by Trump. It’s like, “Well, wait a second. What I just now said had nothing to do with Donald Trump or Joe Biden. Why would you think—” It’s this taking everything, not just being dogmatic about a particular issue, it’s being dogmatic about an entire worldview.

David: Right.

Kevin: It’s just— Okay. All right.

David: Maybe that’s enough epistemology for—

Kevin: Enough for now. Yeah. Okay. All I know is that people, their wages are not keeping up with this inflation that nobody’s worried about.

David: How do we know what we know, is what we were just talking about. There’s some confusion. There’s different theories of knowledge. Again, maybe that’s enough on epistemology. But how do we know what we know about inflation? A part of it is because our actual paychecks don’t buy what they used to buy, and our wages don’t keep up. Wages continue to rise, but not enough to stay ahead of inflation. Thus, we had 3.6% decline, over the last year, in terms of wages versus inflation. Wages, yes, they’re coming up. So back to that sticky inflation issue and sticky pricing issue. Yeah. We’ve got it. But it’s still not enough of a wage increase to keep ahead of inflation. This last week’s measure of real wages, once we have the CPI and PPI numbers, they suggest that people are feeling a real pinch, and the decline in inflation doesn’t come anywhere close to providing relief. So the White House’s risible claim, both from the president and vice president, completely risible claim last week that there was no inflation, because the monthly number was unchanged, and because the annual number declined to 8.5%, what that ignores is the fact that we are maintaining inflation at a high level—

Kevin: Yeah.

David: Just not as high as the level it was.

Kevin: A year ago, it was 2. Okay, so 8.5, to think that, “Well, there’s no problem now— It’s 8.5.”

David: It’s higher by six, but it doesn’t exist, because it was unchanged for the month. It’s like no, no, no. That’s not math. The CPI was lower. PPI also fell with the decline, being driven in both cases by energy costs coming down. In other conversations you and I have talked about, the CPI number has this massive component contribution coming from owner’s equivalent rent. It’s the real estate housing component, which has been, and it continues to be, massively understated. For the most recent report, it was counted as an annual increase of 5.7%.

Kevin: That’s ridiculous. The rubber meets the road. Talk about wages. That’s what people are worried about.

David: Yeah. It’s nowhere close to what people are experiencing in rent increases, or actual housing inflation. When you consider, over the last decade, that real estate— This is just, again, back of the napkin math. When you consider the last decade, real estate, as reflected in household net worth, has increased from just under 20 trillion in total value, in aggregate, to over 44 trillion at present, that’s like 130% gain. It’s a huge gain over 10 years in terms of the value of real estate owned by the average American household. Even back of the napkin math puts that at a 13% annual rate.

Kevin: Yeah. You can’t put much bias into that. Back of the napkin math, that’s the real math. Forget the narrative. That’s the real math. 13%.

David: Well, back to methodologies, and driving data and driving conclusions. Last year, it was fascinating. Freddie Mac pencils out the rent increase nationwide at an average of 14.9%. That was from 2020 to 2021, 14.9%.

Kevin: What did they say rent was?

David: In the same timeframe, the Bureau of Labor Statistics says that rent was up 3.8% for 2021.

Kevin: So Freddie Mac’s not talking to— Who does that math?

David: Bureau of Labor Statistics cranks out owner’s equivalent rent as a component within the CPI. Freddie Mac knows something about real estate. They’ve been financing purchases. This is our mortgage backed securities market maker, if you will.

Kevin: Yeah. So what was rent? What is that? 10 or 11% difference between the two?

David: 11.1% difference is more than a rounding error. For the sake of CPI, owner’s equivalent rent is a weighted component contributing 23.9% to the total CPI figure. So you’re taking 5.7%, the most recent number, and saying that this is basically close to a quarter of our total CPI figure. Nearly a quarter of the number is tied to it. Currently running at 5.7. That alone understates inflation. What’s the actual number? Here, ’21 through 2022, if not 5.7, still between 10 and 15%. So we can feel good about what the model says, and inflation’s coming down, except the reality is no, actually, it’s not. Back to epistemology. How do you know what you know? A part of it is, yeah, I just lost something out of my hide. I think I know because the pain is still there. The hair is still singed. Red hot inflation is still having an impact.

Kevin: Yeah. What is it though? The bandaged finger waggling back to the flame. Isn’t that what— You quote that poem all the time.

David: Oh yeah. Yeah. The burnt bandaged finger wobbling back to the flame, from The Gods of the Copybook Headings, Rudyard Kipling.

Kevin: See. That’s a contradiction. So I’m sorry. We’ll bring epistemology back into the conversation. Because contradiction— When you’re discussing something with somebody, and they say, “Well, the reason I believe this is this,” and actually, you can hear them contradicting themselves— Yeah. You look at the markets. They’re like, “Inflation isn’t a concern.” “It is a concern.” “Well, the market’s going to go up because of this.” “The market’s going to go down because of this.” But a lot of times, you have contradiction. There’s conflict there. That’s how you learn. It’s like, “Wait a second. I thought this was going to happen because of this. But instead, this ultimately happened.” This is why we have to look back at history.

David: Well, I think this is also the importance of maintaining a conversation, and not operating as dogmatists.

Kevin: There you go.

David: Because to the degree that you’re operating as a dogmatist, you might not learn of your own contradictions. You might not learn and grow. How often have you met a dogmatist, in any field of endeavor, where you just go, “Man, life with that person would suck.” You’re either on board and you agree with them, or you are rejected. Life is difficult with a dogmatist. It’s my way or the highway.

Kevin: I hate to say, I’ve been one. I’ve been one on many occasions. So I have to look at myself and go— The older I get the less, hopefully, dogmatic.

David: Typically, that’s the case. The older you get, those hard edges get rubbed off. My colleague, Morgan, had a great summary of the markets, dealing with the Catch 22, in his most recent Hard Asset Insights. Read it every Saturday. Seriously, you should. Read it. It’s on our asset management site, mwealthm.com. Look for Hard Asset Insights. 

I love being able to spend hours and hours each week on research, and finding some of the more thoughtful commentary out there being generated internally. He says, “Despite a positive first step in CPI and PPI data, if the current market reaction persists, and market based financial conditions remain loose, commodity prices will likely rebound along with other inflationary inputs. We have a potential Catch 22 here. Risk-on and loose financial conditions are taking hold because markets now think that Fed policy will reduce inflation enough to declare victory and pivot back to economically stimulative policy. The market’s risk-on loosening of financial conditions, however, likely won’t let the economy slow enough to actually lower inflation. The market’s thesis for this risk-on rally contradicts and negates its own premise.”

Kevin: There’s the contradiction. Yeah. Again. Yeah.

David: “The result will only force the Fed to keep raising interest rates higher for longer. With the full negative economic impact of Fed rate hikes running at a minimum six month lag, higher rates for longer increases the risk of an even bigger problem for the economy and markets in the future.”

Kevin: Right now, as we speak, I’ve got a couple of guys working on the house. I have a cedar house. No one ever told me how much maintenance goes into a cedar house in the Colorado Southwest. It’s just a lot of maintenance. We’re having to replace some of the siding. We’re getting stain put on there. What’s amazing to me is how much extra it’s costing beyond what was being bid. This guy really feels terrible about it, but he’s still operating on a model that’s not at all like inflation. His expectation and his hope was that commodities were going to start coming down, that inflation wasn’t there. Inflation is just still taking huge bites. In fact, my wife asked me this morning, “Can we approve more wood being purchased for the side of the house?” Of course, we’re going to do that. But the costs right now are so high. Are we going to have a softer global economy and have these commodity prices come down? We’re talking about inflation. We’re talking about rents. We’re talking about wages. But how about commodities?

David: Very, very curious. Great conversation this weekend with somebody who knows something about commodities directly as a builder. Lumber’s come down. It was well over $1,000. Now, it’s closer to 500.

Kevin: It’s still high.

David: Great relief.

Kevin: Yeah.

David: The place where it’s not moving at all is in your manufactured products, because they have petroleum products as a part of them. If you’re talking about—

Kevin: Stain.

David: —OSB board. What house doesn’t have compressed wood boards going up? It’s a part of how we build these days. Stain. Anything that has been refined and has a petroleum component is very expensive. The bottlenecks still exist for refining. In fact, I read this list of close to a dozen different refineries that have had explosions and various problems in the last 12 months.

Kevin: What is with that?

David: It’s amazing. We’ve got external pressures. Supply chain issues have obviously been a concern for some time now. But Goldman Sachs echoes the concern, saying, “Investors counting on a softer global economy to pull commodity prices lower may, instead, be faced with scarce supplies and inflation as the market is awash in contradictions.”

Kevin: Do you think those contradictions are all innocent, or do you think maybe they’re driven purposely in some cases?

David: I would suggest that a number of these contradictions are crafted, and not merely coincidental. Math takes on a different character in the run up to an election. The red shirts and the blue shirts both operate with biased calculations. It’s as if they have a magic calculator that starts running numbers differently the closer you get to election day. We might have a better sense for the asset markets post-election. I think we already have a pretty good sense for inflation, again, with what is— Maybe our model is a flawed model, the fade and then surge model of inflation, where we understand it’s going to get to a certain high level and then recede, and then come back. But regardless of how and when inflation fades and then surges again, I think a lot of that becomes much more clear after the election.

Kevin: Do you think some of the signals that people are wishing for come from just past training? The Federal Reserve gave people what they wanted for so long, served it on a platter. You look at China right now. China’s such an anomaly, because yeah, it’s a communist country, but they also have a central bank that adjusts the market forces. They are cutting rates again. What’s with that?

David: Well, a lot of the volatility in commodities this week, and particularly in the oil markets, had to do with very weak economic numbers coming out of China. There was kind of a one-two punch specifically for Brent Crude and WTI. Oil traded lower with the idea that we might be getting a deal done with Iran. That could bring back another million barrels a day in oil production. An increase in supply, along with a decrease in demand, extrapolating forward the decline in economic activity in China, and there was all kinds of fireworks in the energy space this week. Nasty signals from China this week as a surprise rate cut followed the disappointing economic data. Nobody was looking for that. Exports are expected to decline from China. This is really critical, because there’s no relief for the property developers yet. Your other strong pillar of economic activity in China is the export sector, manufacturing and exports. We can see it here in the US. We can see inventories being discounted in order to blow them out, both in the US and Europe. You’ve got inklings of this or indications of this elsewhere too. Same is true in inventories of semiconductors.

Kevin: Isn’t it interesting? Semiconductors, you couldn’t get one the last few months. All of a sudden, now you have inventory?

David: Ironic that we’ve got $52 billion which is going to get spent in building out infrastructure for semiconductors here in the US, and yet Micron Technologies reports, and they’re dealing with massive inventory overhang. If Micron and a few others in that category are indicative, there’s growing supplies. The question is, will there be sufficient demand? You’ve got Chinese troubles. You’ve got Japanese troubles. You’ve got emerging market troubles. You’ve got European troubles. They’re almost all— Those concerns are all on hold in recent days. Over the last few weeks, this has really become an intriguing ramp. The everything rally is taking the trash up along with the treasure. We talked about memes. We talked about cryptos. Well, we didn’t talk about cryptos today. But you’ve got prices increasing. You’ve got credit default swaps, the cost of ensuring against default within the fixed income market, falling precipitously. You get the VIX, as we mentioned earlier, that’s flirting with the teens, and commodities are still suggesting that the worst is behind us. Consistent with the equity melt up, prices are going to recede on commodities. You’re not going to have to pay higher and more into the future.

Kevin: I don’t know, Dave. This reminds me of John Max’s story. I think this equities melt up is like buying a bull—

David: On the last day of his life.

Kevin: —on the last day of his life.

David: Well, you remember Nassim Taleb’s comment about the happiest day of the turkey’s life is the day before it gets slaughtered. It’s getting stuffed up until the point where it’s getting served. Lest we forget, we no longer have unlimited access to cheap Chinese labor. What are the components that drove disinflation and the kind of asset growth that we’ve had for decades? We no longer have unlimited access to cheap Chinese labor. We no longer have unlimited access to cheap Russian commodities.

Kevin: How about central bank money?

David: Cheap central bank money is gone. On top of that, we may now be in a new era of declining globalization, in which everything—everything—has more economic frictions built into price. So sure, today we have the fade. Tomorrow, the surge. I think you anticipate and position your portfolio accordingly.

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. And you can call us at (800) 525-9556.

This has been the McAlvany Weekly Commentary. The views expressed should not be considered to be a solicitation or a recommendation for your investment portfolio. You should consult a professional financial advisor to assess your suitability for risk and investment. Join us again next week for a new edition of the McAlvany Weekly Commentary.

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