Podcast: Play in new window
- Crypto “Genius” will be missed by the liberal Davos Elite
- Rogoff will be proven right, innovation will now be regulated & appropriated
- Real estate prices will be the debacle of 2023
FTX, “Effective Altruism” Proves All-False
November 23, 2022
“This is that inflation theme playing out and this is the middle class being under greater and greater pressure already having to adapt their behavior. The middle class is being broadly pressured via inflation into a new identity, and that is an identity that’s sometimes painful to conjure up in the mind, this picture of ‘we’re all now the people of Walmart.’” —David McAlvany.
Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany.
I have a wonderful lady who’s a client. She’s purchased gold in the past, but she moved a different direction a couple of years ago. She started buying bitcoin, and she bought it well. I remember talking to her this time last year. It was right before Thanksgiving. She had four complete Bitcoins and you’d figure that 160,000 each, that was worth almost a quarter of a million dollars last year. I’ve been talking to her and she kept her head about her. She said, “I don’t know if this is real or not, but I’ve got a quarter of a million dollars worth of Bitcoin.” Well, I talked to her the other day, and not only had the bitcoin come down, if she still had the four, it would’ve come down to about $60,000 worth of value from a quarter of a million, but Dave, she had been hacked. She said, “Believe it or not, I don’t even have them anymore. I was hacked. They were taken.” So it’s a metaphor for what’s going on in the crypto universe, isn’t it?
David: I’d be hacked if I had been hacked.
Kevin: Very much so.
David: So many things in life are about where you start, and particularly with a Ponzi scheme. I highly suggest that if you’re going to be involved in a Ponzi scheme, that you be involved early and not late. Because if you’re involved early, you may be one of the few that gets out intact. I’m joking, of course. I’m not suggesting that anybody participate in the Ponzi scheme, or even that bitcoin is a Ponzi scheme. In fact, I know a very respectable gentleman who put a $100,000 into bitcoin. He did it at about a dollar to a dollar-twenty per Bitcoin. So he had a few more than those four that you were just mentioning.
Kevin: Yeah. Wow.
David: It did remarkably well. But in the end, we do find that there are complications with crypto. Financial Times put together a surprising piece called “The Crypt,” as in the crypto, but this is “The Crypt,” and this was November 16th. I highly recommend it. I think we’re all familiar with Sam Bankman-Fried and FTX’s crypto exchange at this point, but perhaps we did not know that this is actually number 15 this year on the list—
Kevin: Really? Wow.
David: —of crypto disruptions and implosions. For the sake of our conversation, when we think about a disruption, that’s either a partial or a complete gating of assets, in other words, you can’t withdraw when your assets are frozen. You may not get them back, or an implosion where you actually have a liquidation, some form of a bankruptcy filing. Number 15, you heard that right.
Kevin: Wow. Really? Well, I knew there had been others. Do you remember some of the names?
David: In no particular order, you’ve got BlockFi, Genesis, which, this is the Winklevoss twins, and actually, this is just as of today, they may be facing bankruptcy if they can’t raise a billion dollars. Yeah, a billion. That’s no big deal.
Kevin: Just a billion.
David: SALT Lending. There was FTX, which of course we mentioned, Hotbit, Hodlnaut. This one sounds like it’s a comic book: Invictus Capital. Vauld, Voyager, Babel Finance. Celsius goes back a little ways. Earlier in the year, we had the Terra and LUNA, that whole debacle, and of course that took down, as a part of it, Three Arrows Capital, Nuri, FinBlocks. The list goes on and on. So 2022 has been a tough year for the credibility of the crypto space. The common news releases, just in the days preceding these shutdowns, it’s something like, everything’s fine or this is a world-class offering, or we’re driving the industry forward. We remain fully operational in support of our clients. I think the coup de grâce if you look back at Sam Bankman-Fried, his quote November 7th was, “A competitor’s trying to go after us with false rumors. FTX is fine. Assets are fine.” That’s what he said.
Kevin: That’s true.
David: Then he followed it up. It was the same tweet. “FTX has enough to cover all client holdings. We don’t invest client assets, even in Treasurys.”
Kevin: Oh, wow. Well, it was done and it— Remember how you do things in the name of the children, whether it’s the crusades or whatever? Do it for the children. There is this philosophy that came out of Oxford and Cambridge that’s called effective altruism, and that’s what Sam Bankman-Fried was basically doing. I think he was the number one donor— He and Soros were number one donors to the liberal agenda, but this effective altruism is just another word for funding the politics and maneuvering the world with the free money that you got.
David: It would be worth anyone looking at the most recent copy of the Economist because here, you’ve got highlighted what typically is viewed as a conspiratorial idea that there are wealthy who are using their wealth to drive particular agendas, and yet the Economist does a really good job in explaining exactly what this is.
Kevin: Even the Los Angeles Times, quoting Hiltzik, and he says, “Effective altruism was just a cover for a crypto scam.”
David: Well, and coming back to Sam’s comments that he doesn’t invest clients, I have to disagree. I have to disagree. When you’re courting, when you’re wining and dining politicians and regulators, when you’re giving tens of billions of dollars in political payola, that is an investment. I know you think that PAC stands for political action committee, and that’s really not the case. It’s a payola action committee.
David: I know that when you think investment, this is not the first thing that comes to mind in an asset allocation pie chart, but Sam was investing in the future of crypto. Make sure you know who’s got your back. Whether that’s folks at the SEC or in the House or the Senate, you need to know who’s going to back your play and keep this game going.
Kevin: Isn’t it amazing though? To take the quote, he says, “FTX has enough to cover all client holdings. We don’t invest client assets,” and yet that’s exactly what happened. It was a misappropriation of assets. In fact, it’s questionable if a lot of those assets even existed. They were made-up tokens out of thin air. It’s an amazing amount of misdirection and software manipulation.
David: Well, for depositors on the exchange, the unfortunate news is that the billions of their capital was misappropriated and used without their consent. Maybe it was, in Sam’s mind, for the sake of crypto’s future, but they probably disagree on the loose use of the word investment and would prefer to substitute the word fraud. That’s going to be determined in the courts. They’ll clarify definitions and the crossing of boundaries in the months ahead. Very intriguingly, it was John Ray III who helped unwind Enron. He’s now been brought in to run FTX and unwind the business, taking it through bankruptcy. His first impressions are fascinating. He said this, “Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here.” Then he went on to describe the company, “Run by a very small group of inexperienced unsophisticated individuals.” Then the last thing, he highlights the disturbing aspect of FTX when they were using software to conceal the misuse of customer funds. If that’s not an indictment— Again, this is the gentleman who’s been brought in to unwind the company. That last quote is a direct quote from the incoming CEO from the bankruptcy filings. “Disturbing aspect of FTX is the use of software to conceal the misuse of customer funds.” Wow.
Kevin: So here’s my question. Where was the SEC, the Securities Exchange Commission, the people who weigh out everything that we and everyone else in the financial industry say, do? Where were they? We’re talking $27 billion. Where were they?
David: They were probably at lunch with him the day before, like so many others in his back pocket already. That is an awkward question because you do have a staunch democrat, Gary Gensler—he actually was the CFO for Hillary Clinton’s campaign—he’s running the SEC and he is meeting with Sam Bankman-Fried earlier in the year to discuss an SEC-approved crypto trading platform. That is going to be awkward because are you the right person to be investigating? Can you “recuse” yourself or is there some sort of a conflict here? Again, maybe it’s just coincidence that you’ve got somebody who is the CFO for a major Democratic lead in a previous presidential election committee and then a guy who’s number two on the contribution list of the democrats. It’s fascinating. On the one hand, if you’re going to have oversight by the SEC, you might as well tell them how to set up that oversight.
Kevin: Did I hear right that they were actually even trying to get it to where the SEC would have no say on anything crypto?
David: Well, that’s on the other hand. On the other hand, you’ve got Sam Bankman-Fried who’s funding Kirsten Gillibrand. He’s backing the New York Senator who is also a massive crypto enthusiast and she’s sponsoring a bill to lock the SEC out of regulating the crypto market altogether. You wonder what your money gets you these days. Well, again, in terms of an investment, you can begin to see how the support of various senators was very critical to this whole scheme.
Kevin: This is going to change the face of those wonderful little community meetings at Davos where they meet to talk about how to clean up the air except for the exhaust from all the jets that flew them in. Sam’s been a regular guest over with those folks at Davos, has he not?
David: Well, you understand they’re all carbon neutral because they buy enough carbon credits to create offsets, right? There will be offsets for the carbon that they create. But this is a guy who is wicked smart, and sometimes, there’s a difference between smart and clever. I think he’s both. He got into MIT on smarts and I think what got him into trouble was probably the clever aspects of his personality. He’s actually a perfect compliment to this extreme liberal elite in Davos. This crowd, they definitely embraced him as his own. In this group, there seems to be a thread that exists and runs through most of the members. There’s this presumption of superiority. You talk to any bank chief on Wall Street, and they were confounded by Sam Bankman-Fried’s attitude. He was so much better than anyone from Wall Street. In fact, at one point, he suggested he was going to buy Goldman Sachs because he could.
Kevin: Effective altruism, yeah. It’s effective altruism right through Goldman Sachs.
David: So superiority is one aspect, and then there’s this assumption of responsibility for humanity’s mega problems, a burden that they will be willing to carry in a command and control style at cost plus 10%, at cost plus 10%. It’s all charity work, carbon trading, carbon credits. You saw how that played out. The man who inspired a global panic, you’ve got Al Gore. He didn’t get what he wanted for his company. It ultimately sold to the New York Stock Exchange for merely $600 million, his carbon credit business. So nearly a billionaire out of the global panic that he inspired.
Kevin: That’s inconvenient, isn’t it? That’s an inconvenient truth, I think.
David: It was inconvenient because it wasn’t quite the 10% he was hoping for. You had Sam, who spoke at Davos last year in the last meeting, he has a presence on the WEF website as a corporate partner.
Kevin: Still? Really?
David: No, until last week. Until last week. No, when it comes to bad press, you understand your web designer can get in there and clean things up. The problem is there’s a historical footprint because the reality is, anything that happens in the digital world has a permanent presence. There’s no such thing as privacy, and there is no such thing as erasing history. So the fact that Sam and the Davos crowd are linked and he’s a corporate partner—
Kevin: So it’s trapped in the blockchain. Yeah, you’re right. You can’t change the past, based on their own technology. It’s locked in the blockchain, but he’s going to have to get himself a good attorney because he may spend some time in jail.
David: Well, I think he’s hired the best. This is from the rumor mill, but I understand that he’s retained Zuckerberg’s finest lawyer from the Metaverse, and is even considering a move from The Bahamas to a non-extradition segment of Mark’s digital geography. You can do that. This metaverse is, it’s so real. You can escape the law and have your presence there. Wouldn’t surprise me if he’s working with Zuckerberg to do some sort of a 1031 exchange on that Bahamas penthouse. $40 million in The Bahamas for a $40 million property in the Metaverse. The only difference is you need some VR goggles to fully experience it, but it’s something.
Kevin: Well, let me ask, though. Okay, so Dave, you manage money. There are many hedge funds out there that got sucked into this and had quite a bit of money there. How about you? For our investors, did you own any of this?
David: The easy answer to that question is no, so I’m sorry, not sorry. But it is really curious that the spirit of the age, which is greed and speculation, comes over even the best and brightest in the field. It’s amazing to me the number of A-level hedge funds, venture capital, private equity funds that really do know how to crunch numbers, which basically set aside their due diligence for a rate of return that proved irresistible, so high a rate of return on offer. You bring out a guy from MIT, and the offering, even though it’s too good to be true, it becomes irresistible, seduced by the sirens of sky-high returns. Where does this come? It comes at the end of an era of easy money. Easy money does dull the risk mitigation senses, and that’s why I think even the best and brightest have a hard time separating themselves from the current spirit of the age.
Kevin: It’s good to look back and say when people ask questions, when something doesn’t quite make sense, you need to remember the question even if you don’t know the answer. For years, people have been saying, why is the blockchain, or these tokens, why are they so valuable? But Bill King, a guest of ours on a regular basis, he’s been asking the question, why hasn’t there been a crackdown on cryptocurrencies? Why? When things don’t make sense, we need to remember that the question was there because a lot of times, later it does.
David: Well, he suggests that most likely it’s because the NSA and CIA are tracking illicit activity in the crypto market, and this has been a fabulous look into the world of illicit activity. Was FTX a money laundering and intel operation? If so, who was involved? These are the questions that Bill asks, and I think he does so as a reasonable human being, saying that this actually went on for a good bit of time. Is it possible that really the best and brightest, some of them, at least on the regulatory side, were not snookered. They just were taking advantage of information flow, and that comes at a very high cost, and they were willing to pay?
Kevin: Are we going to see the pattern repeat that you have brought up many times? That’s what Ken Rogoff said, and that is whatever the private sector innovates, the public sector will regulate and then appropriate. Are we going to see that pattern? We’ve seen the innovation pattern and it’s made and lost people an awful lot of money. Are we moving into that regulate and then ultimately appropriate it to the government?
David: Yeah, I think Rogoff defined the crypto script years ago, well advance of the pilot projects that we’re now calling central bank digital currencies. As we move towards central bank digital currencies, that is the appropriation stage. So we’re launching into the regulation stage now. The public will cry out for it. You can’t lose billions of dollars in individual savings. Look, you can go to any of your major Wall Street firms today and they’ve jumped on board too. You go to a Fidelity and guess what? They have an entire suite that allows you to invest in cryptocurrencies. You can invest your 401(k), your IRA, your retirement assets in cryptocurrencies through their venues.
So when things begin to explode or implode, regulators have to come in and say, was this really the best choice for the general public? I don’t think so. We’re going to have to regulate. But the central bank digital currencies, you can already see that as the final stage of appropriation. So there’s a whole host of questions, and you can see how, on the one hand, the libertarian, the anarchist would look at this dream of decentralization and say, “I know why I like cryptocurrencies. There’s a philosophical thread that runs through it that’s very attractive.” But it would appear to me that that same libertarian and anarchist, with the dream of decentralization, has stepped full weight into the bear trap of central planning and control, the dream of what might be, the possibility there. I think actually, they’re waking up to the reality of what is a dystopian tool.
You can see how, from the standpoint of human nature, participants got suckered in by the enticement of a quick buck and not just a quick, small buck, but a very large buck, turn $5,000 into $10 million. If I change my plight and my lot in life, could I go from being someone who may never retire to having a fat retirement? It’ll just take a few dollars and why not gamble with it? I think what you’ve had is so many people become guinea pigs and trial specimens for an exclusive electronic—again, we go back to the central bank digital currencies, the electronic means of exchange and store of value. Maybe it’s not a store of value. I think that part is absolutely debatable, but the digital world of dependent connectivity and zero privacy has provided a fresh opportunity to experiment with a new era of Keynesian demand management. And that really is what the central bank digital currencies, the reason why they’re attractive from the standpoint of monetary management, is they give you more leverage in terms of Keynesian demand management. Regulation and appropriation are the next steps in crypto.
Kevin: You brought up store of value and I can’t help but think back 400 or 500 years ago where people were getting rich just overnight with tulip bulbs. Wouldn’t there be a temptation at that time to maybe start telling people, “Well, maybe gold is no longer the store of value. Tulip bulbs have become not only the new store of value, but the new way of getting rich”? We’ve heard some of this over the last few years, Dave. We’ve had people say, “Don’t you understand? Gold, that’s for yesterday. It may have worked for 4,000 years, but not anymore. Now we’re in the electronic age. Now, we have this store of value that’s based on blockchain technology.”
David: Yeah, I think what most technologists don’t recognize is that there’s always new technology in any period of time. You could argue that the printing press was the equivalent of the internet in a different age. There’s these different iterations of technology, which seems so new, novel, and earth-shattering that everything must be different this time, and you begin to redefine the world in light of this small bit of advantage technologically.
It was a smug belief that a digital asset had displaced the physical. Gold was said to be dead and a new gold was alive for the 21st century in the form of digital currencies. Not really. When you look at the back doors, the fraud, the theft, the insecurity, no store of value. Means of exchange, sure. I’ll grant you that, but no store of value. And last but not least, you have counterparty risk. FTX, what comes to mind for me? Counterparty, failure. Genesis today, imploding. This is the Winklevoss twins, and this is just one small part of their business. The lending side of their business. Listen, we’ve got more demands for return to assets, 175 million, than we do liquid assets to meet those demands. We’re going to have to suspend, temporarily, the redemptions. Then all of a sudden, just a few days later, if we don’t raise a billion dollars, we’re toast.
So after more than a decade to develop use cases for cryptos, it remains first and foremost a means of speculation. From that standpoint, it’s just a sign of the times. It’s another typical tulip emerging at the end of a credit boom. So excess credit becomes the key enabler for justifying anything and for justifying anything at any price, but those conditions are changing. One thing that’s nice about gold, no counterparty risk. It’s a boring asset. It’s all steak, no sizzle. It’s like the opposite of a digital asset.
Kevin: Your dad used to say gold is real estate that you can put in your pocket. It’s liquid. I want to shift to the real estate market for a moment then, because I do remember a conversation with a client back in 2005 that your dad was having. I was in the room, and it was a conference call. And this man had over 100 properties. He was highly leveraged, but he had been reading your dad’s newsletter, and he was like, “I’m very concerned that real estate is going to drop and going to drop substantially. What do you think?” Your dad said, “Sell everything. Put the money into gold and wait because the prices haven’t adjusted to the reality that’s already setting in.” So there is this sequence. We talked about the sequence. There’s a sequence where all the signs are there that something bad is going to happen to the price, but the price hasn’t fallen yet. Are we there again? Because this man did what your dad said, and he came back in and he tripled his footprint in real estate and he was—
David: With no debt.
Kevin: With no debt. With no debt.
David: Yeah. I love my dad, and we are so very different. He is so clear in his thinking. To some degree, this is not a gradual shift, like, oh, reduce your real estate exposure by—
Kevin: No, it was all or nothing.
Kevin: Oh, it scared me. Yeah.
David: There’s a part of me that does not understand the man who is my father. On the other hand, I respect the hell out of him. He’s an amazing guy. The fact that he gives that advice and this man takes that advice to heart and does it 100% and it works, I have to reconcile that in my mind because by personality, I think I’m more of a gradualist. But you look at real estate today, and real estate is in the crosshairs. You’ve got residential and commercial, which are both in danger as we come into 2023. Rates go up, and prices ultimately have to adjust to that reality.
So the first thing that happens is the shift lower in the volume of sales. Then the second thing is the price adjustment. We’ve already seen the shift lower in volume of sales. We’re just waiting for the price adjustment. Existing home sales were down for the ninth consecutive month, which is a record. This is volume, not price. Volumes are down 28% year over year and down 5.9% month over month. That’s for existing home sales. New home sales are not in any better position. But, think about this, for existing home sales the median selling price is still 6.65% higher year over year. So this is the key. Volumes drop first, then prices follow. Even though we’ve seen a reduction in volume, nothing has happened yet in terms of the price. Volumes drop first, then prices follow. We haven’t seen anything yet.
Kevin: So then, how much more do you think the prices will fall? When they start falling, what’s the downside on this?
David: Yeah, it’s not a question of how much more, because they haven’t budged. It’s 20% I think is a conservative number. 25% frankly is not outlandish, because we’re talking about all-time highs for these numbers. If you took the median price for an existing or new home and shaved off 25%, you would look at that sticker price and still say, that’s pretty expensive. That’s pretty expensive. The only reason it hurts is because someone has paid a lot more money at a very unjustifiable price. We mentioned a few weeks ago that some home equity has already been erased. That is a part of the excess gain. There was even more gain on the table earlier in the year, so we are retaining 6.65% of the gain year to date. It’s still up. It just traded higher. So that portion that we’ve given up is the access equity that we talked about a few weeks ago.
Kevin: Well, and you times that by all the houses out there and how many trillion is that? What are the losses to the overall economy?
David: Well, I think going forward we’re talking about upwards of $10 trillion in household net worth which is at risk in real estate assets. That’s what I think we’ll lose next year.
Kevin: Along with the stocks because we’re probably going to have a down year in the stock market unless something miraculous happens in December.
David: Corporate equities so far this year have lost $7.7 trillion. These are slightly dated numbers. This is Q2 from the Z.1 report. We won’t get another report until December 9th, so just around the corner. But this level of losses in equities exceeds the first quarter of 2020 and the pandemic sell-off, so a significant hit to the equities markets. This loss, again, it was 7.7 trillion, that was offset in part by a $1.4 trillion increase in residential real estate.
Kevin: And it’s the real estate and stocks, the two put together, isn’t that what made up that— We were hitting peaks on household net worth quarter four of 2021. Household net worth, I think, was as large as it had ever been, and that was mainly real estate and equities, wasn’t it? What was happening in the 401(k) and what was happening with the value of people’s homes?
David: Those are the two biggest chunks. There’s some other little pieces, but those are the two biggest chunks. So yeah, household net worth peaked in the fourth quarter of 2021. Liquid assets have taken the first hit. So that down stroke of 7.7 trillion, those are liquid assets. You need to raise some cash. That’s where you go. You sell with the click of a mouse. A little bit harder to sell private businesses. A little bit harder to sell real estate, so it’s now time for the illiquid assets to take a hit. As we said earlier, no losses in real estate yet. Through Q2, there’s actually been an increase both for existing homes and new homes. They’ve registered fresh record-high prices up through October, up through October. So when you think about real estate, think about losses in the bond market as a leading indicator of losses in real estate. They trade on a similar basis with a tie to interest rates. Bonds have already racked up their worst year in decades. Real estate, I think, is the debacle of 2023. If you think about that, by extension, of course, there is an implicit pressure both in the mortgage sector and for banks because these are assets that are oftentimes not securitized and sold off, but, particularly for local banks, held onto. Real estate is the debacle of 2023. I said $10 trillion in losses. This is how we get there. Out of $150 trillion in household net worth, quantifying real estate only, you come up with $41.2 trillion. That’s the chunk, 41 out of 150. 41.2 trillion, $10 trillion is a 25% decline, which by historical standards, off of all-time peaks, is fairly unremarkable. This is not a collapse in real estate. This is a correction and it just happens to be off of a very large number, 10 trillion.
Kevin: Sometimes you have to have past history though to remember that. I’ll never forget the pictures of the beach before the tsunami hit. The beach, there’s no better time to find seashells than right before a tsunami because the water goes out. I think they said it’ll go out as much as a half a mile and you’ll have people wandering out and picking up seashells and things that they never thought they’d see. The problem is they don’t know what’s coming next, maybe based on the fact that they’ve never seen one before. Maybe I’m overstating it, but with real estate prices still rising or at least looking like they’re going to have a gain for the year, is that going up and picking up those seashells right before the tsunami? Or, tell you what, this is Thanksgiving.
David: I think—
Kevin: Is this more like the turkey? Is this being the Turkey the day before?
David: I think, yeah. If you’re hoping to time the market and get out at the top, you missed it. You are the turkey, stuffed and happy up until the last day when everything changed, and now stuffed and ready for service. My daughter’s joke of the day was, why didn’t the turkey have dessert on Thanksgiving?
David: It was already stuffed.
Kevin: Had dark humor.
David: Exiting opportunistically would have been prior to the breach of 5% on mortgage rates. Why do I say that? Because that’s when you had an audience, a large base of buyers. This is the way markets work. Prices go higher as long as you have a broad base of buyers, and in this case, with real estate, you also had a post pandemic tightness in supply. So an abundance of buyers and a tightness in supply and prices are racing higher. But with a shrinking base of buyers, you are going to find inventories eventually rise and prices fall. The fact that financing costs are 100% higher than a year ago is meaningful. It’s consequential for the scope and scale of that base of buyers.
Kevin: We talked about household net worth. Peeking back in the fourth quarter of 2021, how does that affect the overall economy, especially if interest rates continue to rise?
David: Net worth is two things, it’s your assets and it’s your liabilities. So the current number on liabilities, if you’re looking in households, $18.9 trillion in liabilities, 18.9. Just write that down. 64% of that is home mortgages, 24% is consumer credit, we’re talking credit cards and the like, and the remainder, a very small other category. So that’s 18.9. Assets set at 163 trillion, and that’s now down from the Q4 2021 peak.
I’ve got some assumptions here. One of them is that liabilities will continue to grow as we head into 2023, not by much. It’s still a sizeable number, but it’s not dramatic. If we are at 18.9 trillion today, I think we’ll finish 2023 at 19 and a half, 19 and a half trillion by the end of next year. So that’s the liability side. Then look at financial assets. You get a total of about 74 trillion. Fixed income, equity, combine those mostly publicly traded assets. I’m going to throw in equity and private businesses for good measure. That brings us to 74 trillion. Out of that 163, 74 fits that category of financial assets. The reason why I want to look at that number is because I think that’s where you’ve got some volatility. You’ve got volatility in real estate, which we were talking about earlier. You still have some volatility within your financial asset space. I think an additional 20% decline.
You can find bears out there who would say, “Oh, no, no, no, no, it’s going to be 50% from here, 60% from here, 70% from here.” A modest 20% decline from here, because again, I don’t believe the bear market in equities is over, and it’s unclear that the bear market in bonds is over either. Look, you’ve got Bullard, who’s discussing interest rates. They’re pushing rates up to 5% or even higher. In the charts that he used to explain where he think that the yields could or should go, the range was 5% to 7%. If they’re raising rates into this range of 5% to 7%, as an outside figure 7%? No, we’re not done with the bond bear market either. So again, 20% off of 74 trillion, roughly 15 trillion. That’s your losses on financial assets.
We talked about 10 trillion in losses from real estate assets, that combines for a $25 trillion subtraction from household net worth. 163 minus 25, the result, 138 trillion in total assets. Then of course, we’ve got the liability side, which I think is bumping up. That leaves you with 118.5 in household net worth. Again, if you’re factoring in the liabilities into that equation, not just looking at assets and the reduction of assets, but factoring in liabilities for a net worth figure, 118 is household net worth versus the peak of 150. Very interesting. Again, the change in debt versus equity or debt versus assets, it’s from 11.5% to 16.5%. To be honest with you, Kevin, it’s not the end of the world.
Kevin: Well, what I was going to ask you to do, because trillions, what does that mean anymore? Even percentage drops, what does it mean? So that’s exactly what I was thinking. I was thinking, okay, how do we scale this as human beings? Whether it’s a bright new day or whether it’s a normal day or whether it’s the end of the world. You just now said it’s not the end of the world, so what is it?
David: No, it’s not the end of the world. It does mark a radical change in sentiment and it does mark a radical change in consumption. So if sentiment changes and consumption changes because attitudes have changed, and attitudes are influenced by our net worth—we feel good about the world and we spend lots, we don’t feel good about the world and our net worth and we spend less—so negative wealth effects define 2023. Negative wealth effects define 2023 as real estate is revalued or devalued to lower levels. Again, this is the natural consequence of high and rising rates.
I think equities move into the next phase of a bear market—also a consequence of tighter financial conditions, that is, rising interest rates. Recession’s not really guesswork at this point. That’s what we get in 2023. You can almost get to the same conclusion by looking at the yield curve inversion. There is the reality of increasing rates in the short term, but when you move out on the yield curve, if you look at the three-year, the five-year, the 10-year, rates are considerably lower. You now have the two-year versus the 10-year, that inversion, where the two-year is significantly higher than the 10-year by over 75 basis points, three quarters of a percent. It’s amazing. It’s amazing. In fact, so amazing that I am a buyer at the short end of the curve.
Kevin: For the listener who’s saying, “Okay, well how do we see forward into the future using interest rates,” you just now said it. If the yield curve is inverted, what we’re seeing is we’re seeing more inflation. Maybe this rise we’re talking about, and maybe the bubble continues to expand to a degree right before it pops, but down the road, they’re seeing lower interest rates and that would probably be a reaction by the Federal Reserve or what have you to try to restart a recessionary economy. But I want to bring something else into the talk here, because we even saw this with FTX. You can talk about things going up or down, but there are some times when you have to talk about them absolutely disappearing. In other words, credit quality, it’s not just about interest rates, it’s credit quality. When you loan somebody money, it’s sometimes about the interest rate, but sometimes it’s about, well, are you ever even going to pay me back?
David: Well, I think that’s the other debacle of 2023. It’s the transition from a rates-driven bear market in bonds to a credit quality dimension moving front and center. So far, all you’ve had is central banks move interest rates and so anything that’s interest rate-sensitive has taken a hit, but you really have not seen deterioration in credit quality, and that is something that I think is commensurate with a recession. So deterioration in credit quality as a recession unfolds should not be a surprise.
Kevin: So you have a lot of these corporations who were assuming a certain amount of business coming in, and they took an amount of debt out, in other words, corporate bonds. They borrowed a certain amount of money. If the household is demoralized, let’s say, because you’re talking about this decrease, you were talking about net worth decrease, that can change the buying patterns pretty dramatically. What happens to those corporations who borrowed with the thought that that wouldn’t happen?
David: Well, again, we’re talking about the knock-on effects of the spending penchants for the household. If the household is not feeling great, if there’s that demoralization you described, then yes, it ultimately affects the business cycle and it affects corporations. It compounds the pressures that corporations have. Yes, I think the surprise will be less about volatility tied to an increase in rates, because there we’re just talking about monetary policy and the direction of rates. Now we’re talking about a transition. Think about 2022. You’ve had investment grade debt, which has underperformed high-yield debt. You’ve got long US Treasurys, which arguably don’t have any credit quality risk or less credit quality risk than investment grade or high-yield debt and they’ve underperformed both. So it really has had to do with interest rates, not with credit. Again, I think that’s where the surprise— The marginal borrower is going to be stressed in 2023. If there’s a rebound, it may be in the investment grade debt segment as more pressure increases on the junk sector.
Kevin: I think about sometimes when we see a bubble—we called this the everything bubble, and the Economist magazine called it the everything bubble—but what brings me back to even my early years here, Dave, Carl Icahn. Remember mergers and acquisitions just gobbling up companies? That was happening before the tech stock bubble popped back in 2000, and I think it was happening to a degree up to 2008. Usually, you can see there’re just a voracious appetite for risk when mergers and acquisitions are at a peak. Where are we at now?
David: It’s so funny. I forget who I had a conversation with the other day, but an experienced Wall Street hand, and he just chuckled about this notion of private equity and private credit. He’s like, “This is so funny because we used to call it just a leverage buyout. We used to have these things before we started trading in CDS, which is credit default swaps. We called it insurance. Then one day we decided, well, we can’t call it insurance because it doesn’t actually behave like insurance, but we don’t have to tell the market that. We’ll just call it a credit default swap. Then we transition again, just sort of linguistic magic. We go from leveraged buyouts, which implies that you could be over-leveraged—”
Kevin: Right. Always, almost always, yeah.
David: “—to private credit.” What does that mean, or private equity? Basically, there is a leveraged buyout, but you don’t know that on the face of it. It’s much more opaque. We’re talking about the implications of a change in credit quality, and already the volumes in mergers and acquisitions are down by a third compared to last year.
David: And this is to be expected with tighter credit conditions. You’re going to see M&A decline, and that’s already happened. So private equity deals are slowing significantly. Private credit is too. The only ones who are cranking through deals still, KKR, Carlyle, Blackstone, probably three big groups that are in that space. Your smaller fish, all of a sudden rates are taking a bite and the hurdle to success is that much higher. It’s much harder to get to, and deals are being scrutinized much more carefully. Easy credit makes for terrible decision-making. Tighter credit makes for more careful decision-making, which ultimately is good. But it does tell you where we’re at in the cycle.
Kevin: So for the average person who actually doesn’t borrow using mergers and acquisitions or take things over, but actually just borrows from the bank, rising interest rates oftentimes slow down borrowing. Where are the banks right now as far as that goes?
David: Well, that was a remarkable part of our conversation with Doug Noland not too long ago, looking at the exceptional growth in bank lending in the most recent Z.1 Report. Because on the one hand you’ve had a tightening of credit in the bond market, but not in bank lending. So if you’re talking about credit as it flows through Wall Street channels, that’s one thing, and it’s getting more and more restrictive. Few weeks ago, that was the exception into the tightening credit conditions this year. It was in the bank lending where credit accessibility has been very good for most of 2022. Actually, that is now beginning to change. The other side, I think to keep in mind, with bank loans is deposits.
Kevin: That’s what I want to know. Why are we sitting in banks that are still paying us? Look at Treasurys. Treasurys now, you can get 3% or 4% on a Treasury. Why are people still sitting in a bank at less than 1%? You talk about hot money when it’s willing to move for a rate. Are we going to see hot money moves, just basically depositors saying it’s safer in Treasurys anyway? Why wouldn’t I go get 3% or 4%? Why would I sit in my bank, my local bank?
David: You have to have a good reason to stay, and sometimes it’s only in your local bank that you do have a good reason. I would say that that reason is relationship. If you look at your entire professional life cycle, 30, 40, 50 years of working and saving, you’re going to have opportunity to engage, whether it’s on a personal basis or as a business owner, with a banker. Your small town bank, that’s somebody that you’ve shaken their hand. You know them, they know you, and you’ve done business first and foremost because you like each other.
I think there are reasons to stay, but as rates continue to rise, you do have hot money flows which increased. This is not just going from one bank to another, but it’s into Treasurys. Think about this. A one-year Treasury has a current yield of 4.6%. Now if you want to, you can go online and you can chase the highest bank savings rate at 3%, 3.5% that’s on a savings deposit. Or you can invest with credulity at a place like Wells Fargo, where savings accounts offer a whopping quarter of a percent interest, 25 basis points if you’re under $100,000 in your deposits, or wait, four times the generosity, will pay you 1% if you have $100,000 or more. So here’s a case in point where you don’t have a relationship at Wells. You don’t have a relationship at BofA. These large banks, it’s not relationship banking. So why you stay? Why? I have no idea. Again, you’ve got short rates in the Treasury market of between 4% and 5%, and that puts pressure on the stability of bank deposits. Maybe not for your local small town bank where relationship matters, but at a place like Wells or BofA or these large mega banks, oh, my goodness, talk about instability.
Kevin: Yeah, I just wonder if it’s not the rapidity. You talked about short-term Treasurys offering over 4%. It takes a little while for people to actually recognize something like that because a year ago, short-term Treasurys were under 1%, weren’t they? Where were we a year ago? This thing has gone up very, very quickly. So I would think that it’s going to be tougher on the banks going forward because if these interest rates hold, people are going to have to move, especially if we’ve got a recession where every penny counts.
David: Yeah, and I also want to be clear that when I talk about a continuing bear market in bonds, we are talking about risk at the far end of the curve, even in Treasurys, but the primary phase two of a bear market in bonds has to do with credit quality, which again would imply that in a recessionary period you actually have a migration to the short end of the curve, and there’s pressure only at the long end of the curve and with those riskier credits.
Kevin: And those Treasurys are very, very safe. The short-term Treasurys are one of the safest things that you can own even—
Kevin: —if you’re in a bond bear market.
David: I just wanted to clarify because it may sound like I’m talking out of both sides of my mouth, want to own short-term Treasurys and think that we’re still in the context of a bond bear market. I think that the key there is we’re moving to phase two where credit quality is paramount to understand. But again, we come back to this notion of banks and losing their depositors. There’s going to be tougher waters for banks to navigate next year. 2023 is going to be a challenge. How do banks feel about their loan books as collateral values fall? This is commercial real estate. Again, if you see any comps on a particular property or properties that you have loaned against, collateral values fall, loan to value figures shift, this gets very uncomfortable. If deposits leave, another portion of your portfolio that comes under pressure, because if deposits leave, you’ve got to sell your short-term securities. As you liquidate your securities portfolio, that portion which you liquidate for redemptions is marked to market. Anything but the shortest maturities is going to register a loss of capital. So I think 2023 becomes real interesting for banks, not a particularly positive timeframe.
Kevin: Dave, we’re coming into what they call Black Friday and the shopping season. I remember I was a toy store manager when I was going to school, and we did 75% of our business from Thanksgiving through Christmas. This is really a critical time period. Retail sales. We’re talking recession here, or at least the beginnings of a recession. How are retail sales? What do you see?
David: Recession in 2023, this is tough because there’s mixed data. You’ve got retail sales which are pretty decent at this point. You’ve got mixed results from retailers, and maybe actually comparing some of the details of those retailers give us some important clues. You had Target’s numbers, which were horrible. Earnings per share was a $1.54. $2.13 per share was what was expected, so a major sell-off in Target shares because their store traffic is terrible. Shoppers are pulling back. On the other hand, you’ve got Walmart’s numbers, which are much better. You could almost put them in the category of impressive. Can you guess what the difference is?
Kevin: Huh. Does Target sell food? Because Walmart sure does.
David: Yeah. This is where Walmart cleaned up relative to Target. They attracted shoppers with low-priced groceries. This is that inflation theme playing out, and this is the middle class being under greater and greater pressure, already having to adapt to their behavior. The middle class is being broadly pressured via inflation into a new identity, and that is an identity that’s sometimes painful to conjure up in the mind, this picture of, we’re all now the people of Walmart.
Kevin: You see, that’s so telling, Dave, because I think some Targets actually do sell food, but not enough. Walmart has moved to that, and they know how to cut prices. Easy money, you can just buy anything. But when money’s not easy anymore, you have to find out what you value the most, and food, historically, obviously, has been the thing that people value the most. If you’ve got the choice of buying a new knickknack for the house or getting groceries, getting food on the table for your kids, you’re going to buy the food on the table for the kids. So that’s what we’re seeing with this Walmart. It makes me think, going all the way back to what we were talking about in the beginning with cryptocurrency and Bitcoin and FTX and the difference between a tulip bulb and gold value, it always comes back to long-term lasting value, doesn’t it? Whether it’s food, whether it’s gold, and whether it’s just actually having a historic investment strategy where you’re not looking at the tsunami for the first time.
David: We contrast the ethereal value of a cryptocurrency with gold, and it’s just one version of seeking value. It reminds me, Kevin, we sent out copies of my book on legacy to a number of our clients, in part because as we come into the holiday season, there’s a refresh that needs to take place as to what real value is beyond an iteration of money through 4,000 or 5,000 years of history or the most contemporary attempt to redefine it. As we have these experimentations with reality, it’s worth coming back and saying, what are the things that we value most as a family? What are the things that we cling to and prioritize? It is this moment in time that even a shock like FTX and the exposure of grave counterparty risk, it can cause you to just pause and say, what have we put our faith in? What have we put our confidence in? What are we building towards? How do we look at the future with a firm foundation in the present? This again, I think, is where re-valuing value and considering the legacy dynamics that play into that are so important.
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.