EPISODES / WEEKLY COMMENTARY

Housing Hits Record Unaffordability

EPISODES / WEEKLY COMMENTARY
Weekly Commentary • May 03 2023
Housing Hits Record Unaffordability
David McAlvany Posted on May 3, 2023
Play
  • Goldman Sachs Housing Affordability Index At Lowest Level Ever
  • Non-confirmation in the DJIA & DJTA Could Spell Trouble
  • Richard Russell: “Every Wealthy Family Should Have 3000 Ounces Of Gold”

Housing Hits Record Unaffordability
May 3, 2023

“History shows change is the constant. So measuring change and knowing the direction of flows is imperative. Caution even there is not to extrapolate too far. Extrapolation of the trend to infinity starts to look like the parabolic curve if you’re looking at a chart, because the exponential function pictured as sort of the parabolic curve is resolved, as you mentioned, by the logistics equation. Something happens. Something always happens. It’s just something. What is it? I don’t know. But something happens that smooths the curve.” — David McAlvany.

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

Well, you can hear them like dominos, Dave. We went a few weeks between bank failures, but now First Republic—or was that a shotgun wedding?

David: Didn’t we talk about this last week, where the original cause is the same for a lot of these banks? Deposits are leaving. When deposits leave—and there’s a reason for that, self-interest being the primary reason. Why would you stay for one, one and a half when you can get five? JPMorgan’s offering three and a half percent for a five-year CD? Why would you do that when you can be uncommitted for three to six months and have five percent? The money is moving for obvious reasons and it’s causing a variety of problems. Why would that stop? This week is a case in point. We’re likely to see another 25 basis point increase for the Fed funds rate that drags the short end of the curve even higher and exaggerates the same problem in motion.

Kevin: So you think the movement is actually for self-interest? It’s not so much out of fear necessarily, because everybody feels like everything’s insured at this point.

David: What do you have to be afraid of when Janet Yellen has implicitly promised to cover every last dollar in the banking system? Is it prudent to stay under the 250? Sure. But does it matter? I mean, at this point we will avoid panic at all costs, which is one of the reasons why I favor gold is because the at all costs ultimately is dangerous for the dollar, dangerous for the currency itself.

Kevin: Yeah. Yeah. Okay, so you favor gold. But let’s face it, we’ve got kids who are at some point going to want to buy a house. They can’t afford it anymore. We’ve destroyed the dollar.

David: So First Republic, the continuation of banking concerns there, we’re in a full-blown credit contraction, and the odds of avoiding a broader based crisis are getting slimmer by the day. I would encourage you, if you didn’t read Morgan Lewis’s comments in Hard Asset Insights this weekend, it’s a definite must read. Frankly, I think as I read through the Credit Bubble Bulletin, I sent Doug a text early on Saturday morning saying, “This is superb, really on target.” Both were excellent this week. 

The reality is, crisis is episodic. Crisis is not a moment and then done. It kind of unfolds gradually and has different periods and stages to it. And so the fact that we’re not done because SVB is now in the rear-view mirror—no, there’s more ahead because that’s how crisis unfolds. It’s a little bit by a little bit. It is worth remembering that the three banks that have failed this year are bigger than the 25 that crumbled in 2008. So we’re talking about 532 billion in assets. First Republic Bank, again, this is the third major US bank. There’s a little one in there too, but this is a big deal, and it’s not finished.

Kevin: Dave, in 1983 when my wife and I got married, we bought a little, I think it was a 570 square foot condo, and I think the interest that we were paying on mortgages was about 15% at that point. I mean it was incredible. Almost everything that we were putting into it was just straight interest. I look at my kids, like I brought up, my kids would like to own a house at some point, but interest rates are skyrocketing right now. We’ll probably see more rises in interest rates here over the next few months. But the affordability of housing during the years that I’ve been married, the dollar’s been destroyed.

David: We’re not in a recession yet, and we have commercial real estate off 22%. That’s prior to getting into a recession. One of the reasons why I’m like a dog with a bone here with this banking crisis issue is because we have yet to see the ripple effects into the banking system from a recalibration of their commercial real estate assets, single family homes, I mean they’re still trading at ridiculously high prices relative to interest rates coming up, doubling from last year to this year. Goldman Sachs housing Affordability Index is now at its lowest level in US history. Affordability is at its lowest level in US history. 

Take the other side of it. In a declining interest rate environment, you get buyers who are recycled buyers, they’re trading up, they’re moving from house to house, they’re rolling their equity into the next newer or bigger preferred neighborhood, and they’re able to do that. And it doesn’t cost them much from a cash flow perspective, because interest rates are basically either favorable or getting more favorable all the time. But in an environment of rising rates, if prices have not adjusted down, to move, you’ve got a major cash flow issue. To move, you’ve got to swap out of your lower rate for a higher interest rate. You’ve got to trade down in terms of the age of the house, the size of the house, the quality of the neighborhood. This is an incredibly tough housing market. I empathize with your kids.

Kevin: I’m seeing that just across the street in our own neighborhood. We’ve had neighbors, we’ve been there 26 years, and they decided finally last year they’re going to sell the place. They’re going to build something up the valley, and they moved up. I mean, obviously they moved up in square footage, because that’s what they wanted to do. They can’t sell the house in our neighborhood right now because of interest rates and probably because they’re asking too much money. They’re still thinking like it’s last year. The problem is, their house, what they’re building right now, is costing more and more and more. They’re in a pickle. It’s exactly what you’re talking about.

David: If I just made a lateral move, if I made a lateral move from the house that I’m in today, sticker price X, and moved to another house, sticker price X again, just a lateral move, same value, I’d double my mortgage.

Kevin: Because of interest rates.

David: I’d double my mortgage. I’ve thought, man, housing prices are so high, wouldn’t it make sense to move? And Mary Catherine wisely says, “And where would we go?”

Kevin: Yeah, well, good. That’s a nice supportive wife. So you would say the tide may very well be turning in real estate at this point.

David: Commercial properties have come down, but it’s home prices that have not adjusted much. Rents are still very high. If we look at recession, unemployment, and maybe some alleviation of pressure on the demand side for housing, there’s your route to improved affordability. It does mean that anyone who owns a home is going to see what was sort of a pie in the sky number penciled in. If you’re talking about relative to houses that have just sold in your neighborhood, you’re not going to keep those values. That’s okay. The tide may very well be turning in the real estate market. In the short run, we still have more demand than supply, but rates and affordability, that’s going to look very different in the context of a recession. The reality of higher borrowing costs—it’s already hit commercial properties, and it will continue to exact a toll in commercial real estate, but it’s barely touched your single family homes. Look, I can’t read the sun, moon, and stars. I don’t have a crystal ball, but I wouldn’t be surprised if the tide is turning.

Kevin: So affordability really does matter.

David: Yeah, and if the labor market shifts, if it begins to deteriorate in earnest, that’s what’ll be what my colleague describes as the long kiss goodnight for real estate. That’s the death of the market. So JOLTS, the jobs number that shows the number of job openings three months in a row, it’s moving lower. And what does that portend? Time will tell.

Kevin: So let’s go back to tides, because for decades we had just the honor and luxury of being able to read a great mentor of the market, Richard Russell, and he would talk about secular markets and cyclical markets, and he had a system called Dow Theory that— He held the baton on Dow Theory. The tide is sort of an analogy. A tide is a long-term secular trend in the markets, and he knew how to analyze that with various markets from stocks to commodities.

David: You’re right, he took the baton from others. So he started publishing Dow Theory Letter in the late 1950s, built his subscriber base by writing an occasional column in Barron’s magazine. And I read him every day for decades. He had the anecdotes of cacti and his brilliant dogs. He loved his standard poodles.

Kevin: He was in World War II. He flew.

David: Memories of being a bombardier during World War II, and I think dealing with some trauma from that, too. Of course, the main feature in his letter was Dow Theory itself. Charles Dow ran the Wall Street Journal starting in 1889, and with Edward Jones—thus we get the Dow Jones Industrial Average. It’s Charles Dow and Edward Jones. They created the Dow Jones Industrial Index as well as the Dow Jones Transportation Index.

Kevin: It was partially to tame the noise of all the markets into something that was comprehensible.

David: Right. What are the behaviors taking place, and can we figure out some of the mood swings, if you will? When Dow passed away in 1902 at the age of 51—pretty young guy—William Hamilton continued to develop something—again—we now refer to as Dow Theory. It’s just a system of measuring market trends, gathering data that supports a certain allocation in the markets. After William Hamilton came Robert Rea, who continued to refine the ideas of Dow Theory, and then he passed away. And then upon his return from the European Theater, a very inquisitive young investor by the name of Richard Russell continues to explore and develop various measures and indicators in the same vein. There are several basics which stand out, one of which is I think very relevant to the market action in the last week or so, but it’s a part of the core of Dow Theory.

Kevin: And Dow Theory really is a discipline that came from emotional— It’s emotional to say, “All right, I’ve had these things happen to me in my life. Is there some way of actually bringing order to chaos?”

David: Yeah, structure, process, these are the things that as a team we do on a weekly basis on the asset management side of our business. And the core of Dow Theory is these five or six things. The first thing is that the market reflects all available information. And so Dow believed that the market price reflects all available information, including economic data, earnings reports, and company news.

Kevin: The “price” is almost like a word that comprises all information up to that point.

David: And therefore the price movements of the market can be used to determine future trends. If you ignore price action in either direction, that’s a very significant choice. And it’s worth keeping in mind that the market is not always correct. The market may have all the information and come to different conclusions than you expect.

Kevin: And that’s where the opportunity lies.

David: Yeah, but you still have to watch price action. It cannot be ignored. And in this sense, if you ignore price action in overemphasized fundamentals or doggedly stick to a thesis and ignore the price movements of the market, it will be painful. It will be humbling. And I know that from experience. “The market can remain irrational longer than you can remain solvent” is a very famous quote on Wall Street. It’s a concept that complements this first point: let the market speak. Again, the market reflects all available information. Even if you don’t like it, even if you disagree with what the market is saying when it speaks, the market can remain irrational longer than you can remain solvent.

Kevin: And I love that saying because that’s true. How many people have lost their money when they were right? They were just right too early. But going back to tides and the metaphor with tides being like trends, you can wish that the tide is coming in, but that doesn’t change whether the tide’s coming in or not. And wave patterns are shorter, but the tide going up or down, that’s a real trend, and that’s one of the things that the Dow Theory focused on.

David: That’s the second major thing that Charles Dow put emphasis on, is the market moves in trends. And so here’s this guy making daily observations in the Wall Street Journal and discussing patterns that emerge over time, and concludes that, yes, the market moves in trends. The three phases that he looked at primarily were there being an accumulation phase: people are buying and building positions. The second phase being a public participation phase, where now it’s not just institutions but there’s a lot of popular energy and momentum building. And then the last phase is a distribution phase. 

So you’ve got the accumulation, the participation by the public, and then the last phase is the distribution phase, and these are the trends that make up a cycle. So knowing where you are in the trend, which phase is a part of profit maximization and of course risk mitigation as well. I would argue we’ve been in a distribution phase since the last quarter of 2021. Tops were put in, depending on the index you’re looking at, between Q4 2021 and Q1 2022 and now the primary trend is down. That’s the next point, because he breaks these movements into a primary and secondary trend.

Kevin: So the primary would be like this metaphor for the tide. That’s the longer-term trend.

David: That’s right. It’s the major trend of the market, and it can last for several years. Dow believed that it was important to identify the primary trend in order to make long-term investment decisions. The primary trend is often called a secular trend. And that’s exactly right, it’s akin to the tide coming in, or alternatively the tide going out. My argument, buttressed by the fundamental shifts in inflation and rising interest rates, is that the tide has been and continues to go out. The primary trend is bearish at present.

Kevin: Okay, and so with you thinking bearish, that does not mean that the secondary trend couldn’t kick in and look like a bull.

David: Well, that’s exactly right. The secondary trend is a correction in the primary trend, and can last for several weeks or even months. Dow believed that it was important to identify the secondary trend in order to make short-term trading decisions. Again, this just brings clarity to the context in which you’re making decisions. Where are you at in that longer-term cycle? Again, the trend of accumulation, public participation, or distribution. And then even getting closer to the market, do you understand the primary trend? Do you understand the secondary trend as it applies to a particular asset class? We could talk about stocks. We could also talk about the primary and secondary trend in things like gold and silver. So when we refer to the primary trend and use a synonym like “secular trend” to go with it, we would, with the secondary trend, match up the word “cyclical.” So a cyclical trend is a little bit more like a set of waves.

Kevin: So primary is secular, secondary trend is cyclical.

David: That’s correct. And so if you look at a set of waves in the larger context of a rising or falling tide, that’s where you’re seeing small movements in a larger context, if that makes sense. And you can generally—and I did a little bit of surfing back in the day, my little brother’s a much better surfer than I am—but the shape and the size of the wave tells you something about the strength and direction of the tide. You can still have a little bit of fun even as the tide is going out, but you have to be very aware of the risks involved and be careful of the shoals.

Kevin: There’s a concept that shows up in scripture about two witnesses, where you have to have two witnesses to accuse somebody or convict somebody. Dow Theory also sort of employs that. Looking at various averages, if one average is going up and one average is going down, that’s considered a non-confirmation, isn’t it?

David: There’s a variety of things like that that, again, we talk about on a weekly basis in our asset management group. We’ll include fundamentals and look at companies from a bottom-up perspective as well as macro level fundamentals from a top-down perspective to understand the context of risk. And this is things like the credit markets and credit default swaps and spreads between various Treasury and bond instruments. These all give us indications. But also we look at technical details, and this would be, again, technical indicators where we may have divergences and different messages. One chart has three different things, a trend, either primary or secondary trend, but then there’s divergences which we should talk about. Or, to use Dow Theory language, confirmation or non-confirmation. Non-confirmation would be another way of saying some sort of divergence.

Kevin: Well, and how many times did Richard Russell say, “I’ve got an inkling that we’re in a bull market right now, but I’m not getting confirmation in the transports.”

David: So that’s right. So the average must confirm the trend. And so Charles Dow believed that the trend of the market could only be confirmed—again, the clarity as to the real direction of the market could only be confirmed—if both the Dow Jones Industrial Average and the Dow Jones Transportation Average were moving in the same direction. 

And this is the point I want to make today. The industrials represent the manufacturing backbone of the economy. Can you imagine a context where stuff is getting made but is not getting shipped? When that’s the case, you have a signal that suggests the current trends in manufacturing are not consistent within demand. There’s something breaking down in the business cycle. There’s something breaking down in the economy. So you watch the Dow Jones Industrial Average—the industrials—and the Dow Jones Transportation Average—the transports—to see if they are moving at the same time or even on a mildly lagging basis with both moving together, confirming or validating the direction of the trend.

Kevin: But when they move opposite each other.

David: If they’re moving away from each other, one up and one down, that’s non-confirmation, and it’s a major cautionary signal. You can look at a variety of indexes. I mean, obviously the Russell 2000, the NASDAQ, a tech-heavy index, didn’t exist in 1889. So originally there was only 10 stocks in the Dow Jones Industrial Average, now there’s 30. So these things take shape differently over time. You could look at the Russell 2000 or the NASDAQ, but I think frankly for the clarity of making stuff and moving stuff, looking at those other indexes just introduces more noise, because sometimes those things can trade on an idiosyncratic basis. You’re looking for a clear signal, and maybe one of a dozen signals, this idea of Dow Theory confirmation. But I like the simplicity of the making stuff and shipping stuff. Perhaps it’s simplistic, and now in the 21st century you could argue it’s time to sort of demote the industrials, but I think it’s still a helpful tell.

Kevin: I have a friend who wrote a book that sold close to 200,000 copies, and he’s got 7,000 reviews on Amazon, and they’re five stars. So that shows there’s a volume of people that think it’s a five-star book. When you look at other Amazon reviews, there may be only three people who have given the review to the book, and yet it’s still five-star. I trust the volume of 7,000 reviews that are five-star. Volume played a big role in Dow Theory.

David: Thanks for reminding me of the number of reviews that I have on my book.

Kevin: Oh no, I wasn’t talking about you.

David: I know, I know. No, but yeah, 50’s not 7,000, but I haven’t sold 200,000 copies either. Volume is your point, and volume confirms the trend. So this is kind of the last thing I’ll say on Dow theory. Volume confirms the trend. Charles Dow believed that volume should increase in the direction of the trend. If the market is in an uptrend, buying volume should increase as the market moves higher. If the market is in a downtrend, then you should see that confirmed by increased volume of liquidations, right? That’ll increase as the market moves lower. 

And so volume is one of these little tells too. Is volume supportive of the major trend? Is it increasing into a bullish trend? If it’s very tepid in nature, you’ve got problems. Volume studies are one of those supporting data points for the intensity of a trend, and it serves as an indication of a trend’s ability to follow through. Is momentum building? Is it waning? Is the trend supported by major institutional accumulation, or is it just a thin layer of volume from retail buyers? Volume stats are a little bit like this. If you’ve ever been on a game trail, you’re going out and you’re looking in the woods and there’s rabbit tracks, little tracks, but you know there’s little rabbits, and then you come across bear tracks. You and I had this happen when we were in Alaska years ago.

Kevin: I do remember.

David: Yeah, it was about nine inches across. It was a big track. Scared the—

Kevin: That was a Grizzly, yeah.

David: I mean, it was huge, right?

Kevin: We had fishing poles, that was our protection.

David: I know. And that fishing guide said, “Well, at least I’ve got mace.” We’re like, “Yeah, that’s called an agitator.” But volume stats are like tracking game on a hunt. You can see the rabbit tracks, you know who’s been coming through. You can see the elephant tracks. You might even be able to see the bear tracks. And it’s just one of those factors in Dow Theory.

Kevin: But volume really only works with the other elements, like looking at averages. You can say, “Oh gosh, well, I just bought Tesla and I just made a bunch of money.” But the point is, if we’re looking at trends, especially primary trends, you really do need to look at the overall picture, don’t you?

David: Oh, well, sure. If we’re talking about averages needing to confirm the trend, we talked a little bit about this six weeks ago. NASDAQ , NASDAQ 100, they’ve garnered primary attention on this move up, because they’ve been the leaders. They were the laggards. They led on the downside in 2022, NASDAQ was down 33%, and now they’re leading on the upside. But very interestingly, there’s only a few tech names leading those indices higher. On some reports, you’re talking five to 10 names are responsible now for 86% of the improvement in the index value, which when you think about it is fairly pathetic. The vast majority of names are not moving up. 

You could look at the Russell 2000’s under-performance. You could look at the New York Stock Exchange, the composite index, which captures 2,800 names. These broader measures, the vast majority of names are trading sideways to down. It’s the concentrated money flows into just a few names that are moving the indices higher, and it happens to be working. It’s great window dressing for Joe and Susie Lunchbox to say, “Hey, maybe I should get back in while I can. Looks like we’re headed into another bull market.” What you see is volume going into a few names, because these indices are capitalization weighted and not equal weighted. Does that make sense?

Kevin: Yeah. Well, would you prefer equal weighting so you can actually just watch the price? Because capitalization weighting, what that’s basically doing is saying the big companies are the ones we’re watching. The little guys we can’t even see.

David: Well, that’s right. In the S&P 500, if it were equal weighted, you’d have two tenths of 1% allocated to each company. So as money flows into the index, it would be proportionally spread between those companies. Cap weighted, there’s an argument for it, but it just means that the ones at the top are getting most of the money. They’re getting the juice. So not all indices are constructed the same. The S&P is capitalization weighted—biggest companies by capitalization get the biggest inflows of capital. Frankly, it’s a little bit like this deal we just did, JP Morgan and the FDIC, where the big keep on getting bigger. That tends to be a theme. 

And by the way, just as a side note, JP Morgan’s $3.7 trillion in deposits puts it at over 10% of the market. And by law, they are not allowed to acquire another bank. So the fact that First Republic and JP Morgan merge, you’re really talking about something akin to a shotgun wedding. And in fact, Dimon’s press release insinuated it: “Our government invited us to step up, and we did.”

Kevin: Hey, you guys have the money. Go buy First Republic.

David: You will be the ones that solve this problem. It’s like, “Oh, kind of like a shotgun wedding. I didn’t think we were able to with the deposit levels relative to the total banking industry. We are the biggest, but it’s okay if we get bigger.” Well, by all means.

Kevin: I wonder if the shotgun from the government wasn’t promises that would make JP Morgan very happy down the road.

David: Well, okay, so back to the indexes, equal weighted indices spread the money around evenly. Then you’ve got a third version, the industrials and the transports, they’re price weighted, just to add a little bit more confusion.

My point here is frankly a little bit of a distraction from the bigger issue of confirmation or non-confirmation. I’m going to work my way back to that here in a second. But you’ve got Apple, you’ve got Microsoft, you’ve got Amazon, you’ve got Nvidia, you’ve got Alphabet, you’ve got Meta, Tesla. These are the market movers—as in largely the only market movers. It’s the same big names in the NASDAQ 100 and in the S&P 500 on a cap-weighted basis. 

Think about Apple. Apple is over 7% of the S&P 500 versus if it were equally weighted it’d be two tenths of a percent. S&P is doing pretty well measured as it is, and it skews to the few larger names. But if you look and measure how they’re doing on an equal weighted basis, it’s not that great. How different on a year-to-date basis? The cap weighted S&P 500—the way everyone normally looks at it—is up 9%. Granted, it was down 19% last year, so it’s not quite back to half of its losses. But anyways: cap-weighted, up 9%; equal weighted, up 2%.

Kevin: Quite different.

David: So you can tell there’s a huge skew in terms of a few names doing well and everyone else just kind of suffering through. The rally since October has been driven by a handful of techy names. It’s not the broader market, and it’s not the broader economy.

Kevin: So most people, when they turn the news on, they’ll see what the Dow Jones Industrial Average is doing. It’s a little like looking at something through a telescope. You just see the one thing. What you’re saying is maybe it’s better to look through binoculars, because you’re talking about confirmation—not just one view, but also looking at the transportations. They need to confirm each other.

David: Well, that’s right. And so back to this notion that prices of these tech names, they may be telling one story, but if you’re having a divergence between the Dow Jones Industrials and the Dow Jones Transportation Average, it’s worth paying attention. US Bureau of Economic Analysis gives us our first quarter GDP numbers annualized at 1.1. It was a disappointment.

Kevin: Morgan said that that’s recession.

David: Right. So transports may be telling you something, and may be sending a signal to the rest of the stock market. And again, if you’re not used to thinking in terms of processes and the ways of understanding the market through some sort of structure, you’re going to miss it. You’ll just be hip, hip, hooray, prices are up. Let’s do this thing.

Kevin: So a person would say, “But my Dow Jones Industrial shares are up right now.” This year we’re up almost 3%.

David: Right. So I’ll get to the main point. The industrials—not a particularly strong number year-to-date relative to the other indexes. The industrials are up 2.9%, and so it does suggest that something’s going on on the production side, whether it’s 3M or Boeing or Caterpillar or Chevron or Merck or stuff being sold at Home Depot, just a few names in that 30. However, the transportation average, after leading out of the gates in Q1, is now trading lower while the industrials are trading higher. If that trend or that divergence continues, you can reasonably say products are getting made, but they’re not getting moved. Would that come as a surprise—that products are getting made, but they’re not getting moved—if we have tightening credit conditions, corporate expenditures which are being curtailed as we discussed a few weeks ago, consumers still trying to figure out how to digest the higher cost of living? No surprise, no surprise. So the confirmation or non-confirmation is something Richard Russell spoke of all the time. He had some other things which were really neat, the proprietary primary trend index, which I found interesting.

Kevin: One of the things, though, I wonder, because emotion and perception really play a huge role in the markets. You’ve got these disciplines, primary trend, secondary trend, the averages confirmation, but you also have the emotional swings that a lot of times can be far more extreme than any number can show.

David: Yeah. So in the end, just like our team constructs a vast mosaic of indicators to help us make thoughtful and data-driven decisions, they are ways of appreciating context and current momentum without losing yourself to an exaggeration of emotion. When things are bullish, people just get really excited. When things are bearish, people turn so dark and sour. It’s difficult for them to do anything but, again, extrapolate trends. Extremes are driven by emotion. This is what we described a few weeks ago, the danger of hyperbole.

Kevin: Well, and when you’re managing someone else’s money— When you’re managing your own, that’s one thing. When you’re managing everybody else’s money, you better be careful that emotion doesn’t swing for you. This is where the discipline makes so much sense.

David: Well, it matters if you’re managing your own money as well. It’s just as consequential because you can make the same mistakes and it matters to you.

Kevin: How does your gut feel?

David: Yeah, but it does matter when you have a fiduciary responsibility. I understand what you’re saying. The world is never all good, which is kind of the conclusion you might come to if you’re in the manic phase. And it’s never all bad, which is the conclusion you might come to if you are on the depressive side of that emotional mood swing. People are never all good, which is what we are looking for in hero worship. And they’re never all bad, which is what we tend to do when we throw someone to the dustbins of history.

Kevin: It reminds me a lot of sailing, Dave, because really if you go get a sailing simulator and put it on your computer, you can simplify things where the wind is always blowing from one direction, and you can actually work quite well if you always know exactly where the wind’s blowing. But you know, and I both know what— we co-owned a sailboat many years ago, okay? Wind is never always from the same direction when you’re sailing on a lake. I mean, it’s continually changing. That’s the one thing you can count on. So you’re always having to balance and adjust. You never have the all good, all bad, like what you’re talking about.

David: Well, and it’s easier to model on the basis of these very binary outcomes. I would say science is never all good or all bad. Market trends are never all good or all bad. There is this variability you’re speaking of, and it goes against the grain for many of us because our preference is for black and white. We love the definitive.

Kevin: I’ve made up my mind. I’ve counted to three.

David: We love certainty.

Kevin: Right, sure.

David: Even if that certainty is false and a fictional projection of our subconscious. The movements of the markets are just a reminder of how fluid things are. The same as sailing. You’re going to have to let out a little bit of sail or bring it in. You’re going to have to control and continue to feather to get the optimal results. 

Nothing is a stationary data point. I mean, if you’re thinking not just the markets, but in a family relationship, you can’t take things for granted. You have to engage in a nuanced fashion every day with fresh data. It’s not static in the markets. It’s not static in science—although it’s funny. If you look at the history of science, everyone who’s in control of science in that moment has settled the matter, but they haven’t been around long enough to experience the next revolution in which there’s a little bit of embarrassment that they didn’t really have all the facts. They were onto something with the assumptions that they were working with, and it was good science then. But things change. 

History shows that whether it’s science or the markets, change is the constant. So measuring change and knowing the direction of flows is imperative. The caution even there is not to extrapolate too far, as we said a few weeks ago. Extrapolation of the trend to infinity starts to look like the parabolic curve if you’re looking at a chart. The parabolic curve is only one equation, which does not exhaust reality.

Kevin: You feel like it’s always going to be that way, and it never is.

David: Right, because the exponential function, pictured as the parabolic curve, is resolved, as you mentioned, by the logistics equation. Something happens. Something always happens. And it’s just something. What is it? I don’t know. But something happens that smooths the curve. 

Kevin: And it’s usually a surprise. Dave, back in the 1950s at Bell Labs a brilliant guy named Claude Shannon came up with Information Theory, and what he showed was you’ve got signal and you’ve got noise. Now noise, there’s no surprise in noise. Signal is a surprise in information theory. And one of the analogies he used was, think about being in a library and everything’s completely quiet, and then all of a sudden somebody sneezes. That’s a surprise. In information theory, that actually has relevance because it’s something new. You had talked about fresh data. You have to look for fresh data, and a lot of times you have to be able to maneuver based on a surprise, something you didn’t expect.

David: Yeah. And I think that’s what I’m really getting at today, is how are you going to adapt to surprise? New information? Go back to Dow theory and the first point about markets reflecting all available knowledge. That’s right, all available knowledge. Surprise is knowledge that was not available and must now be factored in. It must now be adjusted to. We are surprised every day in our work. There are things we believe will happen, and often that is what happens, but there’s many days that there’s new information. There’s surprise and a forced adaptation. We either adjust or the market runs us over. This is why money management is best as an active and engaged process.

Kevin: And it is active and engaging. But you talk about Doug bringing so many disciplines to the discussion, and the other guys you talk to as well. I think the same thing with the triangle. The base of the triangle being preservation, the left side being growth and income, the right side being cash, what you would spend. About seven weeks ago or eight weeks ago when Silicon Valley Bank failed, my wife, it was a Friday, and she said, “What do we need to do different? This is a surprise to the market. What do we need to do different?” I told her, I said, “Not much, because we’re already obeying the triangle, we’re obeying disciplines that keep us from having to overreact.”

David: I think someone could fairly present the case and argue for index investing being a contrary approach. And no, you don’t have to take it a day at a time. No, you don’t have to actively manage and engage a process. Over enough time you’ll be fine. And you could look at the last several decades, which have delivered healthy returns for a generation of investors, and I think that’s a fair case to make. I would say you were fortunate enough to be playing in the waves as the tide rolled in and as the primary trend lifted all boats. So it’s possible that under certain circumstances you might be right. Reasonable returns can be garnered with an autopilot approach, but when the tide turns and the shallows are revealed, everything you do becomes more dangerous.

Kevin: We were talking about a sailboat. I remember getting a call one afternoon, Dave, and this wasn’t the tide going out, but the lake was draining. We had the boat tied up to a dock, and John Fry called me and he said, “Kev, we’ve got a couple of hours to get the boat out of the water, or”—it was the equivalent of the tide going out. That was a surprise to us. And you’ve seen the pictures of sailboats with keels where they’re laying on their side in a dry lake bed.

David: No, but I think that is an important thing. That is what we have to do. We have to take it a day at a time because we have these ideas of the way things will unfold, and we have good reason to believe them, whether it’s based on data or economic theory or historical precedent or the basis of cause and effect.

Kevin: But you have to be humble. You have to be humble enough to say, “Maybe I was wrong.” Think about Richard Russell, okay? He was a lifelong learner. He was continually curious. You come from a curious family. They’re continually asking the question, “are we looking at this thing right?” But again, you will be humbled, and you have to be able to accept that.

David: That’s one of the things that I like about his idea of: don’t ignore price action because, regardless of what you thought, there may be a surprising aspect or element in the market which you’re not appreciating. If you don’t respond, you will get run over. So Russell was a student of the markets. He was a student of history. He was a student of psychology and of himself. He was relatively indifferent to the market trend, whether it was bullish or bearish. He wanted to know what was happening. He just wanted to be the investor who respected the flows either into or out of various assets. And so he studied things, not from a predisposed standpoint where I think things will be bullish because I’m bullish on America, or I think things are going to be bearish because of all the terrible things that are happening from a policy perspective.

Kevin: But he always owned gold. He told everybody, own gold.

David: That was one thing that he was unwavering on, that the value of gold as a store of wealth— He had many wealthy readers, but always reminded them that 3,000 ounces of gold was what any wealthy family should have. I don’t know how he came up with that number, but when I was reading him in 1999, in 2000, 3,000 ounces at the market price was less than a million dollars worth of gold. Now, 23 years later, it’s more than $6 million, right? The adjustments in value are shifting all the time.

Kevin: Dave, I remember reading him in 1990 and not liking him very much, because I was in the gold market at the time, working with clients, and he said, “Based on trends…” Now he was unwavering as to how many ounces to own. He was always about the ounces, not about the movement, because in 1990, he said, “Just looking at the charts, looking at the theory—“

David: The primary trend for gold is down.

Kevin: For the next 10 years. He called the number. He said, “I think for the next 10 years, the primary trend on gold will be down.” From 1990 to the year 2000, the bottom on the gold market was 2001. He was right, but he continued to say, “Get those 3,000 ounces, build those ounces. It doesn’t matter whether it’s rising or falling.”

David: So you’ve got the adjustments in value shifting all the time. The climate that we’re in changes, whether that’s the business climate or the actual climate. You’ve got business cycles which ebb and flow. You’ve got riches which are created, in another context destroyed. And so the questions of what lasts, what endures, what is timeless, what is priceless, what is worth more than gold? And don’t you dare say Bitcoin, because that’s not my point. 

My point is that we engage with the world like we engage with the markets: sometimes more and sometimes less. Sometimes we’re fully engaged and fully invested, and sometimes we’re not very invested at all because there’s no reason to be. Sometimes people never learn to read the markets. What you don’t recognize as truth today will be revealed, and it may be painful. You’d be wise to learn. You’d be wise to add what you learn to your cache of perspectives, and have humility be a part of that. We think we know more than we actually do. We think we control more than we actually do. Just to engage a process that requires humility, that respects surprise, and that adapts in real time, I think that’s enough. There’s actually a redemptive theme in that.

Kevin: You’ve been listening to the McAlvany Weekly Commentary. I’m Kevin Orrick along with David McAlvany. You can find us @mcalvany.com, M-C-A-L-V-A-N-Y.com. And you can call us at (800) 525-9556.

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

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