EPISODES / WEEKLY COMMENTARY

Free Money Plus Free Time Will End In Free Fall

EPISODES / WEEKLY COMMENTARY
Weekly Commentary • Sep 08 2020
Free Money Plus Free Time Will End In Free Fall
David McAlvany Posted on September 8, 2020
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  • When does Fear Of Missing Out change to Fear Of Staying In?
  • Complete reliance on complete control of the Fed
  • Inflation mixed with repression – Who loses?

 

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Free Money Plus Free Time Will End In Free Fall
September 9, 2020

“What does it mean to walk through the transition periods in the years, maybe it’s weeks or months, but I think years ahead, as we let some of these fundamental economic maladies play out? The reasons why we wanted gold a year ago, closer to $1200 an ounce, and we still want it today and don’t consider it overpriced, is because these are monumental problems which they are just beginning to address.”

– David McAlvany

Kevin: David, I’m looking at these markets, and I think a little bit of jazz. Somehow, some way, a lot of things remind me of jazz. As you know, I love to play the trumpet. In the 1980s I got a chance to get on the phone and talk to Dizzy Gillespie on the radio. He’s the famous trumpet player who played the horn with the bent bell. I didn’t know what to ask him so I asked him what mouthpiece he used. And I will never forget. He answered my question right there on the radio.

But see, Dizzy was still alive. The guy that made him really famous, actually, was Charlie Parker, who had died in the in the mid 1950s. The analogy I’d like to use here, Dave, is that Charlie Parker was amazing. Nobody could play like Charlie Parker. But the problem was, Charlie Parker had to use drugs to play the way he did, and he knew it. And Dizzy Gillespie refused to use the same drugs, take the same risks, and he lived much, much longer. But there is this allure, and this is where I’m going with the money. We’re getting free money everywhere, and people have free time, they have free money, they’re speculating on things.

You’ve been bringing up Tesla, and in a strange way, it’s a little like Charlie Parker’s band. There’s this urge to take more risk. There’s this urge to take drugs. Dizzy Gillespie basically lived because he didn’t. A lot of guys died of heroin just because it made them play better.

David: Well, I owe everything I know about jazz to you and the introduction to Keith Jarrett many years ago. I’ll be forever in your debt because it is still an amazing contribution we listen to almost on a weekly basis.

Kevin: But what about this? Is free money a little bit like heroin and jazz and risk taking? And where does it lead? Does it lead to an early death of the system?

David: Yes, it is a lot like debt, because debt, as we’ve often said, just brings tomorrow’s consumption into today. So you’re packing in a lot in a short period of time, but you can also expect maybe a faster flameout. And if Charlie was that guy, unfortunately, that was the case.

Our friend Alan Newman, who promises to retire and never will, sent me a special report at the end of last week. He said, “In the 56 years of observation, we can say with absolutely no reservation, that this is the riskiest environment we’ve ever seen.” I think it’s worth remembering that bear markets take on a certain character, and they typically do surprise a lot of participants. We were putting in all-time highs February 18th and 19th just before the stock market rolled over, and if he took a poll of any group of investors in the week leading up to that, it would have been smiles all around. It would have been Charlie Parker happy.

Kevin: That drug basically was replacing – once we got through March, drugs, the debt, was replacing actual GDP numbers or corporate profits. Look at the corporate debt markets. They were already rising before Covid hit, but at this point a lot of these businesses aren’t selling anything, they’re just borrowing.

David: Yes, the Financial Times marks the corporate debt market in the US at 1.919 trillion for the year, and I think I inverted the nine last week on the commentary and said, 1.6 trillion. How did I forget 300 billion? But the issuance has been startling – that’s just for the year – especially considering the tightness of liquidity there at the end of the first quarter. Basically, over the course of the next two quarters, 2nd and 3rd, we’ve surpassed any full year in history and we still have several months to go.

Kevin: But look at the NASDAQ. It is working. You can go out and take out debt, or you can just watch the Federal Reserve go in and buy things. I mean, the NASDAQ almost doubled since March, from its lows.

David: Rallying 84% off of the March lows. And that finally shifted last week from being a one-way bet. Now, actually, there’s a little bit of volatility. It can go both ways. So it gave up some ground. The NDX, or the NASDAQ 100, is up 42.2% for the year. That was at its peak. And, of course, it gave back 5.2% on Thursday, another 5% on Friday, before clawing its way off of the day’s lows.

What has defined the trend in this particular melt-up? Doug Noland pointed out that, first of all, it is a manifestation of monetary disorder. I always encourage you to read the Credit Bubble Bulletin on the Wealth Management website, mwealthm.com, but as Doug pointed out, this manifestation of monetary disorder is both the melt-up in equities as well as the massive issuance of bonds from corporate America, which is just sign and symptom of the times, neither of which fit a category of normal.

Kevin: Last week you brought up video games. I think of the markets. At this point, a lot of people are on Robin Hood, and they’ve got a lot of free time, they’ve got a lot of free money, thanks to the Treasury and the Fed, and so they don’t necessarily understand fully what’s going on in the markets other than that they only go up.

David: Yes, and as the general public has entered the market with that free time, with free money from the Treasury, there’s been a surge in derivative trades. Retail investors have looked for the quick, profitable trade in buying call options. It’s a fascinating dynamic that Doug explains in this weekend’s Credit Bubble Bulletin. You’ve got momentum in the big tech stocks and a massive surge in call-buying, which creates a self-reinforcing cycle because on the other side of the call buyer is the call writer.

This is a fascinating dynamic because as the underlying stock moves higher, the call buyer is your initial winner. And the person who’s written the call is then forced to hedge the loss in the option that he’s written through buying the underlying shares. So the up-cycle is reinforced by the layering in of the derivative trade, and with call options becoming very, very popular amongst retail investors, this has been a fascinating dynamic. It brings an actual purchase of shares into the equation. That happens via a synthetic option spread.

Kevin: Yes, but how long does that last? You have this reinforcing on the upside, but you’re going to have a seller at some point, are you not?

David: Yes, because the buyer today is a seller tomorrow, particularly if the seller is the writer of an option who wasn’t buying it is an investment whose only motivation in owning the shares was to hedge the option risk.

Kevin: You also brought up last week cash positions. Cash positions are something that you can watch, and managed funds, to see just how speculative people are feeling now. Cash is being drawn down to record levels at this point. Low levels.

David: It comes as no surprise that as that speculation increases exponentially that investors are draining cash reserves. It was Bloomberg who reported 14 weeks in a row of liquidations from the largest ultra-short duration ETF. So this is somebody who is wanting to own a cash equivalent, can buy and sell it cheaply. You have a portfolio of short-term treasuries, and this happens to be the largest short-term treasury ETF on the market.

Kevin: So it would be considered cash. It’s like a cash ETF that earns a little bit of interest, right?

David: Yes, that’s right. So investors are abandoning cash holdings at a record clip as momentum continues to build behind 2020’s risk rally. That’s what was said in the Bloomberg article. And options trading is a part of this speculative trend where the risk rally is on, and people want money in what they believe to be a fast money option. These are the dynamics you expect when a significant market top is being put in. And fascinating for us is that warning signs are often ignored. Risk-taking ratchets higher, prices don’t reflect the fundamental landscape, which has already shifted lower, and yet investors are only too happy to chase what they think is the promise of almost guaranteed positive results.

Kevin: Bank professionals have always tried to figure out ways of squeezing out, still having cash, still having reserves, but squeezing out extra return. In this risk-taking environment, these cash positions aren’t necessarily fear-based at all, are they? It’s just cash to be spent basically like ammunition for the speculative markets.

David: Yes, so the retail investor is not alone in their enthusiasm for call options. SoftBank, a Japanese institution, bet on technology first and foremost, but was a significant player in the call option market over the last several months. And those positions were going crazy, obviously very profitable for them. But the Financial Times covered this over the weekend. The objective the Financial Times looked at by Softbank was enhancing returns on cash balances. That’s what they put in their article. The market didn’t take kindly to that because you’re talking about option trading, and option trading is more suitable to a hedge fund running a high-risk strategy than a bank. A bank. So this is where investors said to themselves, “Wait a minute. You made $4 billion in profits on those trades, but what kind of a bank are you?” And so there was a $9 billion loss in market cap because, again, are banks supposed to take risky bets to enhance returns on cash balances?

This also fits, I think, what Doug would describe as the manifestation of monetary disorder, where you start to speculate in order to get an above-market return, because the market return is now reasonably low. I guess what comes to mind is, wouldn’t you like to know all of the institutional games being played to enhance returns? You could think of pension funds or insurance companies or endowments, and it’s tough to stay off the casino tables when everyone else seems to be winning.

Kevin: Put yourself in the shoes of a banker at this point. How would you like to be a banker at this point?

David: (laughs).

Kevin: Virtually zero interest rates in the markets. What are banks stocks down this year?

David: I had a great lunch meeting in June with a gentleman who was retiring in July. He had spent 43 years in the banking industry, and had grown up in a small town, I believe in Kentucky, and his grandfather was a banker, his father was a banker, he was a banker. I think actually his great-grandfather was a banker. So he knew something about the trade.

Kevin: At this point, I picture the guy in Mary Poppins, just generation after generation of being a banker.

David: Tuppence?

Kevin: Tuppence.

David: Why is he getting out? Clearly he spent on a lot of time doing it, and the fifth wheel life was calling. So I had a great conversation with him and I wanted to pick his brain before he left town and left the profession, because he’s seen a lot of things change. He’s been around for multiple booms and busts. And, I think it’s worth noting that banks have been particularly hard hit this year. Year-to-date returns in the banking sector is negative 30.1%.

Kevin: Wow.

David: When we think about oil and the catastrophe in the energy space, banks are only a few percentage points away from that. The reality is, you have lower rates for longer. That’s the Fed-induced policy. On the other hand you have the Fed’s expansion of tolerance for higher inflation at the most recent meeting in Jackson Hole. And that’s not exactly heartwarming for U.S. banks or U.S. bankers, or frankly, for their investors. So the parade of sellers continues.

Kevin: Including Mr. Buffett himself, who never bets against America, does he?

David: No, but he took a massive chunk of Wells Fargo and dumped that here most recently. So since Buffett is generally not viewed as a trader, and instead kind of seen as a long-term buy and hold guy – I think he has owned Wells Fargo, if I am not mistaken, since the late 1990s, maybe even late 1980s. His exit from banks is fodder for consideration of a market shift with, well, I think it has legs. A significant market shift that’s not a one-day wonder.

Again, monetary disorder drives benefits on a selective basis, and it also comes with drawbacks. And this is ironic in my mind. Banks, ironically, are one party that is paying the price for what originally started as central banks protecting the commercial banking sector.

Kevin: We started with talking about drugs enhancing things, but over time the drugs just ultimately start taking their toll. I told the story of Charlie Parker. There was actually an occasion where he needed drugs so much that he sold his sax for drugs and he had to play that night. So, you know, he was taking drugs to play better originally. And then he ended up selling his saxophone before the gig that night to take drugs. So it seems to me like that’s what’s happened to the markets at this point.

David: And I think something else has changed in terms of the banking sector. Because while 10, 12, 15 years ago you could have said commercial banking was critical to everything that happened within the financial sector, actually, the complete financialization of lending has occurred in that period of time where all of a sudden the bond market is far more important than the bank loan. And that didn’t used to be the case.

So when you’re looking at both concentrations of risk, dependencies, liquidity problems, you could look at individual institutions, whether it’s J.P. Morgan or Citigroup, or what have you, and do some hard analysis bank by bank. And you still can. Look at the disaster within the commercial real estate market today – Zions and M&T, and there are a couple that have high concentrations of loans that are going south very quickly.

But the real point is that with the complete financialization you don’t need banks. What we used to call shadow banks, that really is the bigger part of the world of finance today. And so banks aren’t as critical.

There was a Financial Times article this past week that said, if 2008 was a heart attack for the world’s banks, 2020 is showing the sector to be morbidly obese and dangerously addicted to prescription drugs.

Kevin: So there’s the drug analogy right there.

David: The same article accurately describes many banks as essentially uninvestable because of policymakers’ insistence on things that you don’t have to have if you’re just putting loans into the market through the bond market. Banks have to have capital buffers, and then they have to deal with the further lowering of ultra-low rates. That’s a consequence of quantitative easing. So what is happening is they’re getting squeezed and squeezed, and it’s actually concentrating a lot of the benefits and gains. Not everyone in the financial sector is taking it on the chin.

Kevin: Yes, and this is the difference between banks and central banks. Central banks are actually getting what they want. Banks are being squeezed out. But central banks are getting what they want in one respect.

David: Well they are. And what do they want? They want low rates. And so you might say, “Well, central banks have what they want.” You know the old saw – be careful what you wish for, you might actually get it. Well, they’re getting low rates, and it does come with other consequences.

Last week was great. If you had your entertainment snacks ready, whether it’s popcorn. Twizzlers, maybe Milk Duds, you had the volatility index, which moved from 26 the previous Friday to 38 at its peak. This last Friday you had treasury yields which collapsed in one week from 0.78 on the 10-year to 0.6. That’s a 23% change in the rate of interest over a seven-day period. And then, of course, you had the crazy eight. They came under pressure in a major way as you started to see a little pressure Wednesday, follow through to Thursday, Friday and Tuesday after the holiday.

Kevin: Well, the volatility index is something that you definitely watch. And you’re right, for entertainment value, the higher the volatility, the more entertaining it is. But going back to these self-reinforcing cycles, you were talking about call options buyers – they were coming in – and sellers. What that does is it reinforces the market to the upside. But you’re also reinforcing to the downside, are you not?

David: Absolutely. Noland hit the nail on the head this weekend. “If as much leverage has accumulated in technology stocks, within derivatives in particular, as I suspect,” said Doug, “then a reversal in NASDAQ holds the clear potential to spark an unwind of derivative-related leverage. Those that have written or sold call options, previously aggressive buyers, to hedge exposure, would reverse course to become forceful sellers in a declining market.”

And he’s right. That’s the dynamic afoot. I see it this way. Sellers get lost when you’re in a buying frenzy. Somebody wants to sell a few shares, nobody even notices. And that works in reverse as well. The occasional buyer who thinks that they’re buying the dip can get lost in the context of a selling frenzy. So there’s an unwind in NASDAQ, the real question then becomes sort of a spillover. Does an unwind in NASDAQ become a catalyst for more broad-based de-risking and de-leveraging?

Kevin: I was just thinking, FOMO is the fear of missing out. Help me with this one. If you’re stuck in a market and there’s no buyers and you’re trying to get out, maybe it’s FOSI, fear of staying in, because there is a period of time when there is not a buyer at any price. We’ve talked about this before.

David: Jim Deeds used to say – this is back when bonds traded and you actually had to deliver the physical bond certificates. There were times where the bond Department, and actually it was it was the compliance department, would be stacking up these papers and you’d have a whole room full of them, and they had not sold them. They took possession of them so that they could then re-offer them for sale, but there were no buyers. So it was kind of this limbo land where the bond investor said, “Get me out,” and your broker said, “I’ll see what I can do,” put you on a wait list and maybe you’re there for a week, two weeks, as you wait for a bit – as you wait for a bit! Can you imagine?

Kevin: Going back to the 1980s, the markets have really found ways of insuring themselves. You watch cash balances. That’s one of the things you talk about often. The other thing you talk about often is the VIX, the Volatility Index. But the other thing that you can watch is the cost of insurance. How worried are people that the market could go down? That’s the credit default swap market. It’s simply just who’s ensuring against what we’re talking about?

David: Right, against corporate default or what have you? So that was a missing element from last week’s selloff. You had credit default swap pricing remain virtually unchanged. So the cost to insure against default, I agree, is a generally good signal of corporate pressure, particularly in tune with corporate credit. It showed no signs of stress last week. So NASDAQ heavy.

Kevin: Isn’t that strange?

David: Well, is that because there’s truly no stress in corporate credit markets? And at present, you have $10.5 trillion in corporate debt obligations.

Kevin: How much of that is strong corporate debt obligations versus, say, junk?

David: About a third is strong. 3.6 trillion is investment-grade, 3.6 trillion is the BBB paper, the lowest rung of investment-grade, really hard to consider such, and it’s sitting on the downgrade default cliff.

Kevin: Let’s repeat that. So about a third of it is good, a third of it is close to junk, and then a third of it is junk.

David: Yes, and then 3.3 is junk paper.

Kevin: That sounds like two-thirds bad to me (laughs).

David: It’s at least two-thirds at risk, with one-third of it being sort of like a cornice over an avalanche chute. That’s the way I look a triple-B paper. It’s just kind of hanging out there, and it’s hanging out there unless it decides to not hang out there, and then you’ve got problems for everything down below it, too.

Kevin: You’ve had that experience. We’ve told it on the commentary before, where you were sitting up on a – where were you? Was it Mt. Hood?

David: It was Mt. Rainier.

Kevin: Rainier.

David: I was not sitting on top of a cornice.

Kevin: It wasn’t a cornice, but it was an avalanche waiting to happen, because it settled. You scrambled off the hill and within a week a large group of people were killed in that same avalanche.

David: On that particular slope, it did slide within the next seven days.

Kevin: So whether you’re buying CDS paper or not, it’s probably necessary to be buying credit default swaps at this point.

David: Yes, the real lesson of playing in the snow is you don’t want to be Charlie Parker. Sometimes you just leave it alone. We did have a great ski day the next day, coming off of Mt. Rainier. There’s nothing like skiing above the clouds and then skiing back into the clouds on fresh powder.

Kevin: On a big volcano.

David: Debt instruments – are they appropriately priced? I don’t think so. Perceptions of liquidity – you have that. You have ample support on display, but that’s because the Fed continues its massive purchase schemes.

Kevin: Do you think they have their back? That’s the question. Does the Fed have our back? If the Fed has our back, who cares what the price of anything is? It’s always going to make money.

David: For the sake of argument, you would say yes, they are appropriately priced, when the artificial purchases from the Fed are kept in the equation. And perhaps the calm in the corporate credit markets is just another symptom of, again, manifestation of monetary disorder. You could say that they’re appropriately priced, which is also to say that they’re dangerously priced when you consider the single greatest factor driving the supply and demand balance is the Federal Reserve balance sheet. And again, keep in mind that batch of triple B sitting at $3.6 trillion. I think that’s the game changer.

David: So Jerome Powell, who supposedly was a very conservative Fed chairman coming in – how is history going to treat Jerome Powell for feeding a market at all-time highs?

David: Not with kindness. No. Because you have equities at record levels and just to keep momentum going, we have that insurance stimulus – insurance stimulus. Generally you see interventions come in at a market bottom, not at a market top. But the gods of the marketplace appreciated it. They love any and all accommodation. Yes, there may be long-term costs which are building. But the market-devoted, the followers, the worshippers of the gods of the marketplace – they are as sanguine as ever, they are as enthusiastic, because they got exactly what they wanted.

I guess one of the questions remaining as we’re coming into this gladiatorial election season that’s dead ahead: can people maintain that sort of sanguine feel with that ahead? I don’t I don’t know how they do.

Kevin: There has been a fundamental shift in how we think about our investments. What used to be an investment in a particular company, with a particular outlook as far as whether it would be successful or not, has been replaced with single question. Does the Fed have my back? Will they lose control?

David: It’s interesting, I talked to some young guys about six months ago and they said, “We’re interested in owning gold.” I said, “That’s great. I think it makes sense.” I introduced them to the Vaulted program. And they said, “No, no, no, I think we want something with a little bit more juice to it. And I said, “You can get that if you want to take more risk. You’re talking about a different vehicle. If you move from bullion to mining shares, a notoriously cyclical business, you gotta know when to hold ’em, know when to fold ’em, know when to walk away, and certainly know when to run.

Kevin: Know when to run, that’s exactly right.

David: And they said, “No, no, no. We’re looking for something with a little bit more juice.” And I said, “Well, what do you mean?” They said, “Well, isn’t there like a two-times leveraged fund on gold shares?” And then the other one pipes up and says, “No, there’s a three-times leveraged.” And I’m thinking to myself, “This is the nature of derivatives, right? People want added growth. If the underlying asset moves 1% they want a 3% or 4% return. If the underlying moves 10% they want to see a 40% return, 30% to 40%.

Kevin: As long as it only goes up.

David: Right. And this is where I think leverage – there is a lack of experience for anyone who’s stepping into levered products, mainly because they can be very, very painful to own. And if you don’t know that now, you will know that very soon.

Kevin: Well, when you read the bottom of the – you know just about how much risk you take when it says. “These are actually fairly safe. You can only lose all of your investment.”

David: (laughs).

Kevin: When you read something like that it’s like, “What do you mean by that?” Well, that’s always the case with leverage, except there are some that you can lose more than your investment. We won’t go into today.

David: Yes, I know, but it’s almost like – we talk about velocity of money. This is the velocity of finance, where, on the downside, the velocity of losses, it can be shocking.

Kevin: But if they lose their grip, we’re talking about the Fed now, we’re not talking about investments anymore. Invest in whatever you want, it’s going to go up if the Fed continues to pump money.

David: And that’s what that’s Doug was getting at over the weekend is that when you get the derivatives market involved in any sell-off, it brings a tremendous amount of pressure to the whole system of financial leverage that we’ve been playing fast and loose with. Losing a grip on things is extremely consequential, not only for the election results, but also specifically for the Fed’s credibility.

I think that’s a big thing that is in play here. You have the insurance rate cuts that ultimately prevent crisis dynamics. You’ve got the spending effects which are supposed to keep us moving forward and higher and onward, and ultimately prevent crisis dynamics. If that comes unwound, it reflects very poorly on the Fed’s tools. And by tools I mean policy tools, not PhDs.

Kevin: Not degrees on the wall. So how we doing for the year? Let’s just go ahead and look at the scorecard, starting with the S&P 500.

David: So, a broad measure of markets includes some of the big tech names. It’s still up a few percentage points for the year, say, hanging around 5%. We’ll see. By the end of this week it may not, it may be negative. But the Dow’s basically at breakeven. Banks are down 30% as we mentioned earlier.

Kevin: Say that again. And again and again. Banks are down 30%.

David: Banks are down 30%. Fed credit has not smiled evenly. It’s like a tan which was only received on one side of the body and not the other (laughs). The Fed’s sunshine has not smiled evenly on the financial markets. The mid-caps and Russell 2000 are tracking in line with each other. They’re both down between 8% and 10%. The big winner, of course, is the NDX, NASDAQ 100. It’s still up about a third.

Kevin: How about gold stocks? We talk gold on this program – gold stocks, silver, gold itself.

David: Gold stocks for the year up about 40%. And if the market comes under pressure, they’re going to come under pressure, too, because keep in mind, selling is typically not discriminating. Everything goes. So silver up 49% for the year. Gold, nearly 30. So kind of the inverse of banks. Banks down 30, gold up 30.

Kevin: But that’s not all commodities, is it? Gold and silver are up, but the commodities themselves are not necessarily going up,

David: Particularly when you look at the commodity indexes, they are mostly negative year-to-date, in large part due to their energy weightings. Natural gas has had a little life breathed backed into it. Crude is still off between 35-40%. And your industrial commodities have started to peak up, but they have a lower weighting in most of your commodity indices. So even with their recent moves higher, you could still look at something like the Bloomberg Commodities Index and see it down 10.5% for the year.

Kevin: Something that has always fascinated me about the markets, I don’t really understand why it works this way, but the more bullish the consensus is, the more bearish you should really be. I mean, history has proven, when the consensus goes for a long time, especially as it’s bullish, that’s when you actually make a bearish kind of investment, and you either move out of the market or you buy something that goes up when everything else goes down.

David: I think that’s generally true. The problem is, it doesn’t give you the perfect day or hour to get bearish.

Kevin: This is your patience bit that you’ve talked about.

David: That’s right. When you see the handwriting on the wall, it’s worth paying attention to it because significant events may be getting ready to occur. Now, is that that very night, or is it sometime in the future? Citigroup has this panic/euphoria model which looks at options trading and short selling. Hulbert’s used to do this newsletter, sentiment indicator. I think they bring that in, as well, or something like it. The model ended August with the longest run of extreme bullishness since the early 2000s. This was followed by Bloomberg. Do you judge those extreme bullish streaks as contra-indicators?

David: Well, from an emotional aspect, no. Emotionally, it makes you want to go buy something.

David: That’s right. So for most investors it feeds confidence. What you’re saying is, you should take the other side of the trade. But bullishness begets more bullishness, and so things get crazy at the end of a cycle until something snaps.

And quite frankly, Kevin, it looked like something snapped last weekend. It’s a weird disconnect, but you have Pew Research, who reports public attitudes toward the economy as bleak, as very bleak. Two-thirds of the population, or two-thirds of those who were interviewed, see the overall economy is bad. And yet stock investors are in that fear of missing out mode to the degree that buying equities on margin doesn’t even scratch the itch. You have them migrating to options trading.

Again, what does that mean? Should that feed your bullish conclusion, or is that also one of those ridiculously late cycle indicators? Risk considerations have been completely set aside, even when the majority of people can see that the economy is in a bad place.

Kevin: This weekend we went down to Farmington and just walked through the mall, and it’s like a ghost town. These businesses, most of them, will never come back. They’re just empty. So what we’re talking about, this amazing euphoria in the market – nothing can go down, and this money is getting into the markets – is such a contrast to real economics, the real economy.

David: This is where Stephen Roach recently was writing about America’s coming double dip, and he said, “Look, 8 out of the last 11 recessions have included double dip, and this one has all the signs and symptoms of, yes, a very significant and substantial double dip.” He says, “To put the pandemic impact in perspective, consider that transportation, recreation, restaurants and accommodations, the most Covid-sensitive segments of the consumer demand, account for 21% of total household expenditure on services.

Before the pandemic hit full force, combined spending on these categories plunged at an 86% annual rate in real inflation-adjusted terms in the second quarter.” He’s like, yes, we got a double dip. This is a guarantee. Of course, he didn’t say guarantee, but his language is strong enough to convey that, come on, guys, we’re not playing with these things rationally.

We don’t appreciate that the real economy is disconnected from the financial markets, and it’s going to be the financial markets catching up with the real economy on the downside. But when you think about it, these are trends that begin with lowering rates and forcing the issue for investors of increasing risk.

Kevin: A little bit of heroin here and there to make you play a little faster.

David: And frankly, if you’re living on a fixed income, you understand why. You increase risk to meet your current financial or cash flow needs. What the market is asking is similar to what Lila reflected on a few weeks ago in the commentary. Are we in a period of reassessing all valuation metrics in light of the lower-for-longer QE to infinity backdrop? And if so, maybe we just get used to things being really expensive, Apple trading at 40 times earnings or what have you. Is it reasonable to expect all assets to trade at higher valuations in light of the lower-for-longer QE to infinity?

Kevin: What about the currency? That’s what you always run up. You rob the currency’s value, rob Peter to pay Paul, but they both end up dying.

David: So is it fair also to say it’s reasonable, but it’s a mistake? It’s a mistake because there is the fly in the ointment and that is the assumptions relating to currency values and an implied control of interest rates. Those are deadly assumptions for the risk-taker, and particularly terminal for the leveraged speculator, because you get either of those moving in a less favorable direction – currency decline, or an increase in interest rates, a tightening of financial conditions, and, boy, if you’re the leveraged speculator you’re not the fly in the ointment, you’re the fly on the end of fly-swatter. It’s over.

David: We talk about debt oftentimes, and we think, “Oh, well, that’s the government, or that’s a corporation. But debt held by the public is something that we’re hearing more and more about. Let’s talk about that. How much debt is held by the public, and really, is that holding the bag?

David: It’s been a frustrating thing to me because they’ve shifted the measure. You can go online and find out what the current gross debt is for a country. It’s just shy of $27 trillion, and that’s gross debt. We always thought of, what is our debt number? We look at the debt clock, what is it saying? And actually, there’s been a little bit of a shift over the last 3-6 months where nobody wants to publish that number. It’s getting too big.

And yes, there’s going to be a crack in terms of sentiment, when you look at it and say, “Holy cow, I can’t believe that.” And what is the number? For some people it was 2 trillion. Looking back in time, when Reagan took us from 1 to 2 trillion, my dad said, “Holy cow.” Now we’ve gone to 27 trillion, and what we’ve done basically is say. “Let’s not look at the big number, let’s instead start talking about “debt held by the public.”

Kevin: That’s a fairly new phrase. That a phrase we don’t hear that often, and now we hear much more.

David: And it’s not new in academic circles, but it definitely is new in the public arena. So gross debt is coming in close to 27 trillion, with debt held by the public at the end of August perched around 20.1 trillion, the difference being inter-governmental debt. I’m seeing this debt held by the public quoted almost exclusively now, and I think it’s likely so that the debt-to-GDP figures are less scary. You take 103%, best case, or 110%, it kind of depends on what your GDP figure is. So somewhere between 103% and 110%. And that prints better than 129-142%, which is the gross debt figure based on a reduced 2020 GDP status. The estimate is for around 19 trillion for GDP this year, with the 1st and 2nd quarter being under pressure.

1st quarter GDP figures were down 5%, and 2nd quarter were down 31.9%, according to the Bureau of Economic Analysis. If you factor in inflation, in real terms you’re talking about a GDP reduction in the 2nd quarter of 32.9%. So all the stats are going to be ugly for 2020 by the time we get to the end of the year. Still, it’s perceptions that have to be managed so that the references to debt are gravitating to something that people are not likely to freak out about.

Kevin: Do you remember when you went up to Boston and met Larry Kotlikoff? First we read his book. I think it was called Jimmy Stewart Is Dead. It was a reference to It’s A Wonderful Life. But you’re talking about debt held by the public, which is a way of maybe padding this a little bit. He would go the opposite direction. He’d say, “Oh my gosh, no, go ahead and count all you want. You’re not even coming close to counting the entire future liability that we need to be looking at.

David: That’s right. It’s a dose of realism. A good friend of mine here in town teaches philosophy, and he sent me an email today saying, “How is it that we’re doing this to our children? How is it that we are accumulating this?” And of course, there’s a moral element. As an ethicist, to someone who studies that professionally, it bothers him. But it also bothers him as a father. And I think what Kotlikoff was getting at is serving up a dose of realism. While everyone was trying to diminish the impact of how much debt is in the system, years ago Kotlikoff said, “Look, this is not about debt held by the public. This is about what everyone seems to forget – liabilities that are only partially on the books.” Actually, if you want to go to Forbes magazine earlier this year, I think it was January or February, Kotlikoff printed a few observations in the same vein as Jimmy Stewart Is Dead, and he is typically worth reading.

Kevin: You enjoyed that interview even though he was a little bit late that day. Remember that?

David: Actually, it made the interview even better because he asked for an extra half hour. He was working on something, so I was meeting him at his apartment there in Boston. The main topic was the fiscal gap, the difference between projected tax revenue and the net present value of future liabilities. So you’re factoring into the total obligations, or debts, Social Security and Medicare. At the time we were talking 222 trillion.

David: Was that about a decade ago?

David: Yes, this is not an insignificant gap to fill. But he was running late and he asked for an extra half hour, so I walked around the corner to a used bookstore. I found a compendium called Monetary Reform and the Price of Gold.

Kevin: As a treasure. You found a treasure.

David: Oh, it was fantastic. There is a chapter where Lord Robbins, who was Chairman of the Financial Times and was an economics professor at the London School of Economics from the 1930s to the 1960s, and he is having this dialogue with Keynes. And Keynes comments, and of course this was post-war, “What’s all this talk about the dangers of deflation? Inflation, not deflation, is the post war problem, dear Lionel.”

And Lionel Robbins, who is Lord Robbins, was a little bit indignant that people were treating the fall in the value of money as something that was harmless, or even beneficial. So Robbins talked about this being a cruel, distributive injustice. He talked about the effect on civic virtue and that there was an effect on general culture, and that, in fact, it created an economic atmosphere approximating that of a casino.

And I think of it, and then I realize this is not post-war, but we are still fixated with deflation. Even if Keynes was alive today, he might say to us what he said to his friend Lionel Robbins. “What’s all this talk about the dangers of deflation? Inflation, not deflation, is the post-pandemic problem.”

And so that’s what I wonder. Inflation is not new, neither are the social and cultural maladies that come with it. But that’s not the primary concern of central bankers. I think Kotlikoff’s point is that our liability structure is massive, and that the primary goal of central bankers is to alleviate this pressure. We’ve said this before and we will say it again, that the two tools that they want to use are inflation on the one hand, and financial repression on the other.

Kevin: Yes, things just get inverted. You talked about the central banks’ main goal being to relieve pressure, a little bit like administering a drug, as when we were talking about Charlie Parker. But you know that you’ve gone too far with the drug when you sell your sax. You first start taking the drug to play the sax better, and then you sell the sax to take the drug. I think a little bit about what Richard Duncan talks about. I know people’s blood pressure just goes straight up when I bring up the name, but actually what he’s talking about is that we are post-capitalist.

David: That’s right, and this is all we’re dealing with is policy pragmatism. Yanis Varoufakis was the former finance minister in Greece, and he’s still an economics professor at the University of Athens. He was quoted in a Project Syndicate article recently saying, “The pandemic has reinforced that which has been undermining the foundation of capitalism since 2008, the link between profit and capital accumulation. The current crisis has revealed a post capitalist economy in which the markets for real goods and services no longer coordinate economic decision-making.”

Kevin: And I hate to say that I agree with a man who characterizes himself as a Marxist libertarian, but in a way he is at this point analyzing something. It’s true. It’s post capitalist.

David: For most libertarians in the U. S. you think of being a libertarian Marxist is being an oxymoron. It’s actually not. You have right-leaning and left-leaning libertarians, and it’s sort of the basis of your philosophy, which ends up being very different in terms of your starting assumptions. But yes, you can be a Marxist libertarian and Yanis is one.

Kevin: When we talked to Carmen Reinhart, it was strange because pragmatism had taken over. Carmen was a real person who had real finances, with a real family, with real problems. She understood the real economy. Yet she understood that we’ve gone so far that financial repression is the only way to handle things at this point, which is negative interest rates or low interest rates that are below inflation. That’s the only way the central bankers can keep this game going.

David: I thought a critical piece of reading from this weekend was, “Financial Repression Revisited.” It is a Project Syndicate article by Anne Krueger. Anne was the former World Bank chief economist. Now Carmen Reinhart is the World Bank chief economist, but she has also spent time at the IMF and at Johns Hopkins and Stanford, and is no slouch in the field of economics. But she basically in this article is saying that you have to set an interest rate ceiling and you begin to press inflation up against it.

This is what she says: “When used in the past, financial repression has worked, reducing the U.S. debt-to-GDP ratio after World War II from 116% in 1945 to 66.2% in 1955, and further thereafter. Moreover, Carmen Reinhart, now the World Bank chief economist, and Maria Sbrancia of the International Monetary Fund, have estimated that between 1946 and 1955 the US liquidated debt amounting to 5.7% of GDP per year through financial repression.”

I’m not joking when I say that academics and policymakers adopt a certain pragmatism, and there will be losers and there will be winners.

Kevin: Yes, but there are ethics. You had talked about your friend who runs the philosophy department. He’s bringing up ethics and money. Gosh, isn’t that a strange thing to tie together?

David: I know, but when you’re talking economics, right and wrong are influenced by functionality, by outcomes. And if you’re looking at the possibility of a game-over event, a hard restart where anyone who is in charge may be discredited permanently, guess what you do? Policy pragmatism is the order of the day.

I think this is one of the reasons why when we consider financial repression on the one hand, and inflation on the other hand, and those two things acting as almost a pincer on the average investor, you have to consider for yourself, what is the best road ahead? How do I protect family wealth?

What does it mean to walk through the transition periods in the years, maybe it’s weeks or months, but I think years ahead, as we let some of these fundamental economic maladies play out, and as we see them take shape in the form of financial market catastrophe, with, of course, the policy implementation thereafter to try to keep things held together.

What do I want? Of course, I want some cash. Of course I want some gold. Am I a broken record here? This is where I think the reasons why we wanted gold a year ago closer to $1200 an ounce, and we still want it today and don’t considered overpriced, is because these are monumental problems which they are just beginning – just beginning – to address.

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