EPISODES / WEEKLY COMMENTARY

Not A Bankrun, Just A Rapid Walk

EPISODES / WEEKLY COMMENTARY
Weekly Commentary • May 10 2023
Not A Bankrun, Just A Rapid Walk
David McAlvany Posted on May 10, 2023
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  • Bank Woes Scapegoat Is The Short Seller

Not A Bank Run, Just A Rapid Walk
May 10, 2023

“Gold sitting here near all time highs. Do we go higher? I think ultimately we do. Nobody knows on what kind of timeframe, if it’s this week, next month, next year. I would make the case pretty strongly that we break out above the old highs within months, maybe even within weeks. Chinese demand, very strong. We have the numbers for the first quarter in, 228 tons of gold compared to 1,087 tons of gold for last year, significant central bank buying, and so that continues to be there.” —David McAlvany

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

Well, what a week, Dave. Gold tapped a new high just briefly, and the bank run—I mean the bank walk—continues. And Charles, who just can’t wait to be king, actually now really is, much to the chagrin of a lot of people, actually. And like Bed Bath and Beyond and GameWorks, I guess the failing stocks are the ones that you want to buy because of course we had PacWest—if you could buy the bottom of PacWest, you made a nice, what was it, an 81% gain last week.

David: Not a bad day.

Kevin: Yeah. Yeah.

David: Not a bad day. Well, not a bad day, but it was still a bad week because even up 81% on Friday, it was still down 43%.

Kevin: I guess they don’t tell you that part. Yeah, yeah.

David: Not a bad day in the context of a really rough week. I woke this morning to a Financial Times article, “Wall Street Subdued as US Regional Bank Rally Loses Steam,” and this is really all that happened on Friday. It was indeed a rally Friday after a week of extreme pressure. The relief came, and it was one part rumor of a short sell ban and two parts short covering. Even with an explosive move to the upside—in some cases up nearly a hundred percent—there was still ample red left after the moves lower throughout the week. 

So PacWest, as you said, recovered 81% by the end of trading. It was still down 43%. And the American Bankers Association, a part of the cause— Non-farm payroll was certainly a contributing factor, but the American Bankers Association on Thursday wanted Federal regulators to investigate short sales that they said were, “disconnected from the underlying financial realities.” The group took aim at social media engagement as problematic, and was basically saying that this down pressure in the banks, it’s not reflective of actual industry conditions.

Kevin: Isn’t it amazing who they picked to blame when they’ve created their own problem? It reminds me of that Monty Python scene in the Holy Grail where they’re like, “She’s a witch. She’s a witch. Burn her.” And he says, “How do you know she’s a witch?” And they’re like, “Well, she looks like one.” And one said, “She turned me into a newt.” And it was very obvious—

David: A newt.

Kevin: And he says, “Yes, but it got better.” So what we’re doing is we’re blaming short sellers, which, Dave, sometimes you’re a short seller, you have to hedge a position, and if you’re told that you can’t sell short, then why would you want to own long and take that kind of risk?

David: We do a non-talent show once a year as a family. I mean, it’s a talent show. I’m the one that shows up with the non-talent, and that was actually that Monty Python skit. My daughter was the witch and my son and two of his friends—

Kevin: Dressed up with a carrot on the nose.

David: Oh, absolutely. Absolutely. That was—

Kevin: They put this on?

David: Yeah. Well, I think it’d be misguided, or I think you might be amongst the misdirected if you were assuming that short sellers are the problem in the banking sector.

Kevin: She’s a witch.

David: The problems have been years in the making, and then we had the Covid fiscal largesse, which provided a natural element both in the economy and in the financial markets, and of course a lot of it trickled into banks, five trillion in extra cash.

Kevin: Five trillion.

David: For the financial sector, and it’s like, you remember the whole, Dr. Bruce Banner’s exposure to gamma rays?

Kevin: All that cash is—

David: Yeah, yeah. Is there a scenario where everything is normal going forward? Banks are in this phase shift where they’re no longer in control. It’s like the Hulk on the loose. Destruction is in his wake, and that’s what we had. Between monetary and fiscal policy largesse, the financial world’s been overexposed to gamma. And now in the language of the options market, I think you can expect more gamma problems in the months ahead.

Kevin: Let’s go back to 2008, Dave, when we started actually doing this show. We had the financial crisis, and of course they had created their own problem, and then, didn’t they stop short selling back in 2008 as well?

David: Yeah. Great final point on that. September of 2008, the massive short squeeze in those names, I mean it was like 799 names, that were banned. Massive short squeeze in those names as a result of the ban on short selling. And once the short covering was over, financial market fundamentals drove investors to liquidate. Quite reasonably so. Once the squeeze ended—we’re talking about the KBW Bank Index just as a proxy, that index collapsed 40% in 14 trading sessions.

Kevin: Wow.

David: When you look at shorting, you’ve got to remember that, on the one hand it’s a speculation on lower prices, but on the other hand it can be a means of hedging risk in a portfolio. If you cannot follow that second course and hedge your risk or a position in your portfolio—

Kevin: Why would you even own it? Yeah, why would you hold on—

David: And typically—

Kevin: If you can’t insure—

David: Derivatives, options, what have you, are a way of doing that, you may then reasonably consider liquidating the position.

Kevin: Sure.

David: That’s what happened in 2008. So short covering comes out as a result of the ban on shorting. People cover and then sell—get out.

Kevin: Yeah. Think about it, Dave. If you owned something, let’s say you bought a car and they said, “Well, we just need to let you know, you can’t have any insurance on that car. If you bend the fender, you’re on your own.” Well, actually, that’s going to weigh into your decision as to whether you want to buy that car in the first place.

David: Yeah. And you could see, just go back again to that 2008, 2009 timeframe. When you don’t have the option of shorting in order to protect the downside, and the only way to protect is by selling, you remember what selling looked like with Citigroup? It went from over $30 a share to under $3 a share, actually 97 cents at its low.

Kevin: Because you couldn’t short it. In other words, they had closed down shorting, you couldn’t insure your share.

David: That’s right. So how do you cover the risk? Liquidate the position, period. Now, it looks good if you’re looking at today’s $45 share price, up from 97 cents, but you’ve got to remember there was a one for 10 reverse split. So you’re actually looking at about a $4.50 stock—something that never has recovered after the global financial crisis to anything close to its $30 or $40 share price. Nowhere near its trading highs of ’06 and ’07. 

But my point is that short sellers are a telltale for fundamental impairment. They are not the cause of impairment. Again, they’re just an indication of something that’s wrong. They’re like a symptom. They’re not the cause. They’re not the problem. They’re not the disease. If you look at a balance sheet as that which is plagued and pocked, you want to have shorting choices to mitigate your downside risk. And if you don’t, then you really have one clear choice: exit the position.

Kevin: It’s a little like blaming a band aid for a cut. You know what I mean? I think we’re pointing the finger at the wrong thing. But it’s interesting to me, too, when you’ve got a prominent figure like Jamie Dimon who comes out and says, “Hey, it’s all over. Nothing to worry about here. I just want to let you know that even though we had a gun to our head when we took First Republic over, nothing’s wrong with the banking system whatsoever.”

David: He said a couple of things after the purchase that didn’t really fit the market mood. And frankly, as the week wore on, his words did not assuage the selling energy. In fact, it accelerated throughout the week. “The American banking system is extraordinarily sound,” is what he said on Monday. And then of course the whole system is in freefall the rest of the week. It just made it funny. But another thing he said Monday morning is, “This part of the crisis is over.”

Kevin: Whew. I’m glad we missed that one.

David: Yeah. Well, there is an echo here. He was asked to bail out Washington Mutual, which is the very largest bank failure in US history. This goes back to September of 2008. And now the second largest bank failure as well. So first and second, he’s gotten to play— All those assets go into the Dimon financial melting pot. And just for perspective, Bill Isaac, who ran the FDIC during the Continental Illinois failure, now it’s listed as number seven on the list of bank failures.

Kevin: Isn’t that amazing?

David: It was, once—

Kevin: I remember for decades talking about that as number one.

David: Yeah. Well, he was the one who oversaw the FDIC, and he unwound that bank, and he said, “You make the biggest banks bigger and you have fewer choices going forward.” Very critical of this forced merger, doesn’t like the idea of it. Bad move.

Kevin: And in truth, we don’t have necessarily a bank run going on. I mean, it’s not like a one or two day panic, but money’s moving, big money’s moving.

David: Yeah. And I hate to disagree with the CEO of JP Morgan Chase. He’s a bright guy, but when he says this part of the crisis is over— I’m with Jim Bianco, his observation that this is a bank walk, not a bank run. That supports my thesis that we’re not in a panic from failing institutions, but we’re in a moment of prescient self-interest where depositors are simply walking out to receive 5%, and leaving behind the paltry offers of the bank deposit accounts they’d been in previously. It’s not rocket science, right? 

Last week, the Fed and the ECB both increase rates 25 basis points. Each reinforces the market appetite for greener pastures and a jump from one institution to another. And I think when you look at the smartest institutions, they’ve basically said, “We don’t want to see capital flight. We recognize that this money, which was not originally categorized as hot money, is getting hot as it’s threatening to walk out.” Smartest institutions have geared offerings, like money market funds, to their existing client base to retain those deposits. And so they keep it. It gets to move around from this format to another format, and that may still negatively impact their profit margins, but at least they avoid the “easy come” of deposits inbound in that 2020 to 2022 timeframe as it shifts to the “easy go” in deposits of 2023.

Kevin: Well, we’ve often talked about Jim Deeds and how he likes to look two years ahead and say, “All right, I understand what’s happening today. I’ll see if I’m invested in the right place. But actually what I want to know is, over the next two years what does this look like?” So right now what we see is a lot of money. It might not be a bank run, it’s a bank walk. It’s actually a pretty rapid walk in many ways, but banks have to loan money, and business has to borrow money for things to go forward. So if we were to look at the next year or two, the tightening of credit conditions, it looks to me like that could be pretty bleak.

David: Yeah. Senior Loan Officer Opinion Survey, the SLOOS report, is pretty interesting as it is a group of your top bank managers saying, “Here’s how we’re going to have to navigate the next couple of years ahead.” Deeds, by the way, would say, “Silver and silver stocks, don’t be without them.” If you have a two year timeframe—

Kevin: He’s saying it every day right now.

David: That’s right. So this week, the SLOOS report underscores the predicament that banks are still in, and it points to why this part of the crisis is far from over. The Senior Loan Officer Opinion Survey provides confirmation of credit conditions going forward, and it can be a leading indicator of economic activity when you predicate off of it the loosening or tightening of credit access to households and to businesses. And so, the survey says— The survey says that there is more tightening, there’s less available bank credit, and yes, that ultimately is going to tie to a shrinking in economic activity later in the year.

Kevin: So does that mean there’s a change or a tightening of the standards of what a bank will use to give a loan out?

David: Sure. The survey covers lending standards, not only for mortgages, but HELOCs—that’s Home Equity Lines of Credit, credit cards, commercial and industrial loans—both to small and medium businesses, large businesses as well. Importantly, there are both indications of supply, so what the lenders are willing to put out there into the market, as well as demand, what people are wanting to borrow in terms of loans. 

And so the last SLOOS report—it’s out quarterly—it showed that in Q4, that was a period of considerable credit tightening, where senior loan officers went from foot on the gas pedal to firmly foot on the brake. In fact, if you’re just looking at the Q4 numbers, fourth quarter tightening turns into Q1 disaster within the banking sector. Probably not a surprise there, but a real shift in mood. The first quarter Senior Loan Officer Opinion Survey can at best be described as further pumping the brakes. Yeah. There’s no acceleration. Credit demand is now at levels—and this is on the demand side again, so there’s both what the banks want to put out there and then what companies want—credit demand is now at levels not seen since 2009.

Kevin: Wow.

David: Kind of interesting. And supply is tightening, mirroring the loan officer angst and the further raising of the bar. You’ve got to do more than fog a mirror to get a loan at this point. Anecdotally, I spoke with a friend who has a number of businesses and has one of them in expansion mode, breaking ground here shortly, another franchise. And yeah, he expressed to me last week that had he not had his loans organized and locked in ahead of time, he couldn’t get them today. Nothing’s changed in terms of his credit quality, but there’s no longer a willingness to loan on this type of property development. 

So there was a marginal tightening of standards for commercial and industrial loans to large and middle market firms, and that was on par with the tightening for small firms as well. And I think that’s really what catches my attention is the small firms. Because if job creation is primarily in your sub-500 person employer category, that suggests credit driven expansion—economic activity as a result of an expansion in credit—that’s going to end up having reverberations into the jobs market. Jobs expansion is going to be more difficult as we move into the second half of the year. Employment is likely, in the present moment, at an inflection point. We’ll get to employment numbers in a minute.

Kevin: You talked about fogging a mirror to get a loan, but actually, this last year or two, all you had to do was fog a mirror to get a job. I mean, employment has been— Really, isn’t it true?

David: Yes.

Kevin: It’s true. I think we’ve forgotten that a recession is when your neighbor loses his job, and a depression is when you lose your job. We’ve forgotten that completely because all we see are hiring bonuses all over town. I think I mentioned this on the Commentary, but it scared me. My wife said, “Well, looks like the DoubleTree has taken their hiring bonus from $400 to $600.” And I said, “Yeah, but Sweetie, I was driving through Aztec,” which is a town south of us, “and so is the police department.” The police department has a big one of those electric signs that says, “We’re now hiring.” And they have a hiring bonus for the police department. Now, that is fogging a mirror—

David: Does the hiring bonus make reinforced body armor? I mean, that’s not a job I would probably be lining up for right now. Commercial real estate, residential real estate—the exception with residential real estate was the GSE-eligible home loans. So your government sponsored enemies— [laughing] Enemies. Entities. Excuse me.

Kevin: Yeah, don’t change that, government sponsored enemies.

David: If you could offload the paper, then there was still plenty of activity there. But commercial real estate and residential real estate was not conforming, and then you include home equity lines, auto loan supplies, that all tightened. Credit cards were essentially unchanged.

Kevin: People are still spending money.

David: Yeah. So that’s on the supply side. Again, credit that’s available. Demand from consumers was pretty robust, and maybe we’re not surprised by credit cards being higher, autos and mortgages, and it seemed like, through the quarter, the mortgage interest and demand fluctuated. We’re sitting at 6.49% for the 30-year. As it edged towards 6%, then demand would pick up. As it moved back in the direction of 7, things would get a little spasmodic and disappear.

Kevin: But people are still using their credit cards, which means they’re taking money from tomorrow and putting it into today.

David: Yep, take what you can get while you can get it. Credit card debt jumped $17.6 billion in the quarter. This is the second largest increase ever recorded. And given the bank failures in Q1 and now a few bleeding into Q2, you might expect your credit conditions to have tightened even more than they did. But really the big shifts were in the fourth quarter 2022, with marginal tightening in the last quarter. As my colleague Morgan Lewis points out, the levels that we’re at, again, fourth quarter got us there and now they’re a little tighter than they were coming from the fourth quarter. But these are levels that are not common. You don’t see them unless you’re already in a major recession. 

So we’ve already had the tightening prior to any official pronouncement of the R word, and it’s quite common to see another round of credit tightening once recession is declared. And a part of this is because then you’re dealing with credit issues. Bear in mind, the reasons why banks have been in conniptions has been mistakes made with jumbo loans, or maybe it’s your long-dated Treasury securities. These are things that we understand. We haven’t had any credit problems yet. Credit quality has not been the issue. That’s what you begin to see in the context of recession where credit quality is now on the table and you’ve got a further tightening of financial conditions and loan conditions.

Kevin: But you have all the signals that would normally tell you that a recession is coming and have told us in the past—

David: If the traditional—

Kevin: That a recession is coming.

David: Yeah, if the traditional signals hold, and we assume that these are relevant. You’ve got the Institute for Supply Management Survey. It’s been signaling a recession for six months. Key commodity prices, copper and oil, we’ve talked about this previously, they’re telling you something is coming. The treasury yield curve, steep inversion, suggests yes, we’ve got a recession coming. I was intrigued by Warren Buffett’s weekend comments on declining rail freight. He’s got a signal that—

Kevin: There’s a signal.

David: Yeah. It’s a small but meaningful signal. We talked about it last week. The industrials make it, the transports move it. If the transports are showing a problem, the industrials may be in trouble too. You’ve got to look and see how they’re interacting.

Kevin: Wasn’t it Warren Buffett that made the analogy about the tide going out and seeing who actually has clothes on?

David: Yeah. Well, in this case, it’s the banking sector tide, right? The tide’s gone out in the banking sector only to reveal bank CEOs swimming provocatively underdressed. Each bank problem revealed—hello—is unique and idiosyncratic. Maybe it’s the jumbo mortgages here or the long dated Treasurys or the mortgage backed securities portfolios over there, but the tidal trend is revealing regardless of specific balance sheet differences. 

You’ve got raising interest rates till something breaks. That’s been the story. That was the 2022 modus operandi from the Fed. Maybe they didn’t want to break things, but they certainly were going to raise things until they solved the inflation problem, and now we have higher rates, which are indeed shifting incentives, shifting behaviors, and increasing fragility. These are credit conditions via central bank decree. These are yield curve dynamics set in motion specifically by the central banks of the world, and ironically, it’s the central bank activity that is promoting the bank walk previously described. Not a panic, just a measured move to higher rates and better compensation.

Kevin: And who wouldn’t? I mean, you’re walking yourself right now. You’re going, “Do I want 3% or do I want 5%?”

David: I include myself in that. I’m looking at a corporate account this week, earning 3.6% with no immediate need for those funds. So a 90-day T-Bill at 5% makes sense. That’s 140 basis points, 1.4% difference. Kevin, even a year ago, that would’ve put a smile on anyone’s face. Coming out of years of zero yield, 140 basis points, that’s a beautiful thing.

Kevin: Alone. Yeah.

David: I used to joke that income on a bank deposit wouldn’t even buy you a Starbucks coffee. Yields of zero for years on end. And what we’re finding is that those years of zero yields, they didn’t condition savers to expect nothing forever. Now that they’ve got the option, they’re moving. They may have been yield starved, but the appetite never went away. 

I have this cartoon just outside my office. It’s a picture of two guys sitting in front of a street café, and the name over the cafe is the Interest Rate Café. These are the owners, and they stand proudly in front, and there’s this bubble quote that says, “Ah, nostalgia sells.” And this is the kind of joke that you can make in a zero interest rate environment. Interest rates are back, and with them, market based incentives.

Kevin: Sometimes it’s just best to stop and listen to yourself, and go, “Interest. Why do they call it interest?” I mean, we talk about these things so often. We don’t just stop and go, “Well, no wonder people are walking. They’re interested. They’re interested in higher interest rates.” I mean, it makes sense.

David: The Indianapolis 500 has about 220,000 viewers. That’s what it was last year.

Kevin: In the stands, too?

David: I think on television.

Kevin: Oh, it’s got to be more than that.

David: Viewers. That’s what I found as I looked this up.

Kevin: I think that’s in the stands, Dave. It’s got to be. It’s got to be. Yeah, but you know what? Still—

David: Okay, so the—

Kevin: It’s probably not as much as watching Powell when he’s raising interest rates—

David: The MD 500 has 220,000 viewers. There were no statistics available for viewers of the Powell 500 last week.

Kevin: I knew you were going there.

David: Powell took rates to the range of 500, actually 500 to 525. And general interest, to be honest, is limited. Even though numbers relating to that— The betting related to Powell’s numbers, it’s immense. The world hangs on a few basis points.

Kevin: And you were taking 500 basis points to 525. I just want the listeners to understand your humor here.

David: Yeah, well, the S&P 500—

Kevin: Oh, another 500?

David: Yeah.

Kevin: Yeah. Here we go.

David: It’s losing viewers, too. Volume stats are in steady decline from March 20th to the present. They’ve been in steady decline every day and week since then. It’s been fascinating to see. The “sell in May and go away” adage and the loss of interest in that particular 500, the S&P, seems to be in effect, particularly if you look at the bottom 492. 

And this is what we were talking about last week. We talked about equal versus cap-weighted last week. Outside the top eight names, nobody cares. And that same dynamic existed in the late ’60s and early ’70s. The Nifty Fifty was the can’t-lose list of the day. And like the FAANGs today, like the eight leaders in the S&P and in the QQQs, breadth is the concern. You don’t have a broad-based buying of the market. You have a very concentrated play in just a few names. When you look at that and you look at the volume statistics, you’re really looking at low interest generally. Concentrated interest in only a few names has always been problematic because what it portends is a decline.

Kevin: Yeah. You can’t just run an entire market on eight stocks. But is it possibly that people are looking ahead and saying, “Well, if Powell’s right and he’s just going to keep raising interest rates, things will tighten.” Is that part of the lack of interest in the stock market right now?

David: Will tighten or will loosen? In the Q&A, Powell last week suggested that rate cuts were not in the Fed forecast.

Kevin: And that’s what I mean. He said, ‘We’re not going to loosen at all.”

David: Well, that’s right. So from his perspective, and this is where you’ve got a disagreement. The Fed policy is, “Nope, not going to happen.” Inflation is the focus at the central bank, and it’s going to take time to bring it down to target. And he’s right about that, it’s going to take time. This week, we’ve got CPI and PPI, the two standard measures here in the US. And with that data, the markets will make some minor adjustments. More interesting to me this week is the Chinese CPI number. That’ll be out in midweek as well. We’ve highlighted the massive credit stimulus in China in recent months, and we’re looking for clues.

Kevin: Was it a couple of trillion?

David: Exactly. Over 2 trillion in credit infused into the Chinese banking system in just the first couple of months of the year. So where’s the evidence of where the money’s gone? We’re looking for clues as to where the credit is being channeled. Is it to the consumer? You might see a meaningful uptick in consumer prices. Alternatively, is it to the financial markets? Maybe the next PBoC-induced asset rally is in the early stages. We’ll see. 

We look at some peripheral indicators. Maersk, the container shipping line, has noted a significant drop in freight demand, and we’ll see if China can buck the trend of declining Asian exports as the year progresses. Yeah. I want to say one more thing about the Maersk comment because a part of it is volume related, but a part of it, too, is, during Covid we had this big increase of “We need stuff and we need to get it here. How do we get it here? We’ve got to solve the supply chain.” Well, we put in motion the building of fleets upon fleets of shipping vessels, and they come to market end of this year and into 2024. So shipping rates are likely to crash next year regardless of volumes because they’re oversupplied. You’ve got too many boats. There’s no way we need as many as it will be on the market.

Kevin: So there’s little things that happen where you go, “Gosh, this is absolutely the worst time to do this.” Right before the real estate collapsed back in 2006 and ’07, Purgatory Resort, if you remember, built all this real estate and then were selling all these condos. And they couldn’t give them away for years. Now they’ve finally recovered. But wouldn’t it just be perfect right before a major recession or depression that you have an entire fleet of ships that are just meant to carry all the goods that are not going to be delivered coming in—

David: Harbinger of de-globalization. “Things have never been better.” “Right. We don’t need you anymore.”

Kevin: But a guy who looks at the markets, he’s buying bonds and he is looking ahead and he’s going, “All right, what does the bond market tell me going forward?” Powell may tell me that interest rates are going to continue to rise all through the year, but the bond market is shaking its head. You call them the bond vigilantes, Dave. The bond vigilantes are shaking their head and going, “No, there’s going to be a radical shift before the end of the year.”

David: Yeah, it’s interesting because in the short run versus the long run, very different trends in play. In a short run, inflation can come down. We fully expect official measures of inflation to come down in the next few months, but quite intriguing is the Fed forecast of no rate decreases this year. That’s what they’re saying. There will be no rate decreases this year.

Kevin: But what do the vigilantes say?

David: The markets are pricing in between five and six cuts before year-end. What does that mean? Means that the bond market is suggesting that there will be a sufficient catalyst between now and year-end to motivate a massive loosening of financial conditions. Now, is that a victory on inflation? Doubtful. What does it look like exactly? Major financial market trouble on the horizon. 

This is from Doug Noland, last week’s Credit Bubble Bulletin. He says, “An assumption of a 50% probability for a crisis eruption between now and December which would force the Fed to slash rates 150 basis points”, 1.5 percentage points,” gets close to current market pricing.” So the bond market is assuming that we’re going to have to cut rates by 150 basis points. Or another way of looking at it, as Doug said, is there’s a 50% probability of a crash.

Kevin: So either the market’s way wrong or Powell, one of the two.

David: And Mohamed El-Erian wisely councils against validating the market’s expectations of rate cuts in the months ahead. He’s like, “Do not say you’re pivoting. Don’t do that.” This is the game of knowing your audience and knowing why they want to know what they want to know. So in this case, the audience is the equity investor. An accommodative Fed lowering interest rates, pivoting to easy money policies, is like getting a social media text or tweet or Instagram announcement that the frat party kegger is starting, and it’s just a block or two away. It’s time to get over there. You got to get there. Better get there as fast as you can. There’s so much enthusiasm for the equity investor. 

And it’s funny because lower rates for the bond investor is, “You don’t get it. There is a 50% chance of a market collapse, and that probability grows by the day.” And the equity investor is like, “Oh, goodie, we’re going to have a party. This is going to be great.” It’s such a strange divergence, where the equity markets—they really do look like idiots compared to the bond markets, who are like, “Don’t you want return of your capital?”

Kevin: But the equity guys always think it’s a party until they get spanked and spanked and spanked and spanked. And then there are people who, once that’s happened a couple of times, they’re like, “I’ll never buy a stock again.” Alan Newman’s dad said that. Remember that? He wouldn’t even look at his stocks.

David: No. He went through the Great Depression and he took his stock certificates, put them in a safety deposit box, and then gave the keys to his son. In the 1950s or ’60s, Alan went to the bank and looked at those stock certificates for the first time in 30 years.

Kevin: There was so much emotional pain to the loss. But it is nice to have friends that are in their 90s, Dave. I brought up Jim Deeds, and you talked about Jim talking about silver. Jim is 90 at least. And his wife, Barbara, same thing. They’ve had this long-term, one of those dream things where you’re like, “Gosh, I get to get old like that with my wife.” But when we talk to Jim, Jim has wisdom because he has been spanked. He’s been spanked and spanked and spanked, and Buffet has sort of that advantage. Warren Buffet spoke this weekend, but who did he have with him?

David: Well, so Munger’s 99. Going back to El-Erian’s comment of not validating the market’s expectations for rate cuts in the months ahead, it’s because you get into an even more dangerous zone. From our perspective, further inflation of asset values as a consequence of people getting really excited, adding further—

Kevin: Fuel to the fire.

David: You’re just raising asset values and increasing the probabilities of market crash. Certainly that prolongs the pain of underperformance if you’re talking about going from overvalued to even more overvalued. If you’re a long-term investor and look at the next decade, anything to increase asset valuations and prices is going to prolong your pain. I think that’s—

Kevin: Isn’t Buffet talking about prolonged pain?

David: Exactly. Well, that’s—

Kevin: He’s basically saying underperformance from this point forward.

David: That’s right. Their weekend contribution was interesting. The Oracle and the 99-year-old sidekick spoke at the Omaha soiree, and of course they were primetime—competing with the crowning of the new King of England. Now, I have to confess, I watched Buffett and Munger. And that’s not because I have a problem with the monarchy, but I just wanted to see how the duo treated cash and dealt with their Q&A. That’s usually an interesting session. What I gleaned from it was both were sour on growth prospects, and one significant takeaway was: prepare for a long period of lower returns. This is, again, Munger: prepare for a long period of lower returns. And that was kind of the extent of positivity.

Kevin: It’s because they understand how expensive things still are. I mean, when you buy something for a high price, you’re not going to have the same kind of returns as if you bought it for a low price.

David: Overvaluation leads to underperformance, like undervaluation leads to a period of over-performance. What you pay for an asset determines your long-term rate of return. Pay a little, make a lot, pay a lot, make a little. 

So when we look at the cyclically adjusted price earnings—this is the 10-year rolling average of the PE. It takes out what CEOs and CFOs do to manipulate the number for their share benefit—there’s compensation usually attached to short-term PE volatility. So the CAPE takes out that noise and gives you a clearer signal. Cyclically adjusted price earnings, that’s the CAPE. It’s at 29 today versus—

Kevin: What’s the average? What’s the normal historic average on that?

David: 17. And so it’s an improvement from where it was in the mid to high 30s.

Kevin: Yeah, but it’s almost twice the average.

David: It’s still above the average, and averages are never where corrections stop. But that current number is fully 70% higher than the historic average. If you’re starting your investment prognosis from this point forward and say, “What does the next decade hold?” From these levels and this valuation, you’re talking about a 3–5% annual return—and that’s inclusive of dividends. So basically you get a goose egg with a dividend. And frankly, we think there’s a better way to approach the financial markets.

Kevin: Hard assets.

David: Yeah. And in that sense, we’re not looking at a 10-year goose egg with dividends. I think there’s some significant opportunities there. But for Buffett and Munger, adjusting to a low-return environment is because we’ve only seen a correction—and now we’re in a little bit of a recovery—but there was never a capitulation. A capitulation is when investors quit the market—cold turkey. Quit it. This is why we discussed cyclical markets last week. And I wonder if Munger is a little impatient at this point.

Kevin: Oh, you think? He’s 99 years old. He’s healthy.

David: Well, yeah, maybe, I don’t know. But will he live to see the next great buying opportunity? There’s a little bit of cash burning a hole in his pocket, sitting on top of $130 billion in cash.

Kevin: And they want to invest it if they can, in something valuable.

David: They’re waiting. They’re anxiously waiting. But they do that. They wait. Bargain hunting is what they do. And just coming back to banks, banks are of no interest to the Berkshire duo. They’ve got a few shares left of Bank of America. That’s all they have. At one point, they had a lot in financials, and today it’s just a sliver.

Kevin: Well, and they’re seeing an awful lot of money in the US markets. With all the stimulus money and everything, there’s been an increase of investment in the United States, not just for us, but worldwide—money coming in.

David: If you step back and look at the last 20 years or so, I remember when I bought a bunch of German bonds back in 1999, and reasonable yields and prospects for growth in demand for those bonds—and actually they were very good investments, ’99 to probably 2002, if I remember correctly. But that was a period of time where it looked like the dollar was going the way of the Dodo bird, and the euro was going to replace the dollar. And you could see that argument gaining traction. And then by the time we got to the global financial crisis, what started as a domestic issue here in the United States became a European and global issue. And then all of a sudden the EMU, European Monetary Unit, shows that it’s actually what Ian McAvity used to call the franc and stein monster. It’s just this collection of national interest, and it’s not very well sorted. It’s not well organized.

Kevin: You interviewed—remember, 2008, 2009—you interviewed the guy who really would be considered the granddaddy of the euro.

David: Longest standing member of the European Central Bank.

Kevin: He knew there’d be a problem. He told us that.

David: Design flaws. The reason I mention it is because there was a phase where the euro was going to replace the dollar. Then after that, where all of a sudden that ended up being a myth, from the time of the global financial crisis to the present, the dollar and dollar-related assets became even more important than they had ever been before. So think of this, we leave the global financial crisis, and the US stock markets represent roughly a third of total stock market capitalization. Today we represent half of total stock market capitalization.

Kevin: Worldwide. This is worldwide?

David: Yeah.

Kevin: So we’re about half.

David: For the last decade, US investment markets have moved from one third of total global equity capitalization now to half. The cycle that fed foreign interest and investment in our markets was first of all the strong dollar, and all of a sudden we could see weakness in the euro relative to the dollar. And this soon-to-be replacement for the dollar, that idea foundered, flamed out. So number one, you’ve got a strong dollar driving foreign interest and investment in our markets. Number two, you’ve got the asset performance. It almost becomes a self-fulfilling prophecy. A little bit of money coming into the market drives positive performance. That positive performance attracts even more money, and the performance continues on a momentum basis. But underpinning that was reasonable economic growth. 

Now it’s likely that over the next few years we could see all three of these things work in reverse. Weak dollar, underperforming; US indices, underperforming; slow to no growth, another form of under performance relative to the rest of the world. And so investors are going to have to continue to drive overvaluations to new and unreasonable levels, or they’re going to have to look at this and say, “We’re already priced for perfection. We don’t have a perfect model. The dollar’s not helping our returns. Once we do our currency exchange back to our currency, do we really want to be long the dollar, long US assets, long US economic growth?” If the answer’s no, then I think it’s going to be very difficult for us to maintain that 50% global equity market share. Does that make sense?

Kevin: Well, it does. And I still have to think. More and more, especially over the last few years, we’ve had to learn to think for ourselves. You can’t really trust the numbers. You can’t trust what you’re being told. You can’t trust that something’s safe when maybe it’s not. You really have to do your own homework. So you talk about the signals. Look at what we talked about with the bond market saying, “You know what? We think something’s going to happen in the fall. We think interest rates are going to fall.” You look at the employment reports, Dave, and they don’t smell right. I was joking about fogging a mirror to get a job, but actually the numbers, aren’t they just giving us good numbers and then changing things when nobody’s looking?

David: Yeah. One more thought comes to mind as it relates to foreign interest in our markets, and it’s very similar to what we’ve seen in the banks. You operate on the basis of self-interest, and you’re constantly balancing risk and reward. And if you think there’s reward on offer, then perhaps you migrate. And we’ve seen a migration to the US markets. Again, the three reasons why foreign capital has moved to US markets: strong dollar, US asset outperformance, and economic growth. All of which can, I’m not saying they are, but all of which can work in reverse. And then the question is, does the money move? We know there’s a lot of money that’s moved because we now are the largest market share in terms of global equities, US indices, bar none. So can we attract more capital? Well, it’s going to take a stronger dollar, greater economic growth, and asset outperformance. But I think that’s going to be hard to accomplish in a rising interest rate environment. So the problem’s been hiding in plain sight with these banks, correct?

Kevin: Sure.

David: And it is just this. Money’s going to move on a self-interested basis, and when it does, you’ve got assets that are impaired as a result. Why would that be any different at a national level? You look at the US dollar as a proxy for the US, almost like the stock of this country. And why would someone be moving into the dollar at this point unless you had a global crisis and then all of a sudden it catches some sort of a safe haven bid?

Kevin: So let me restate what I think you’re saying. What we’re seeing with the banks, basically they’re like caught in wet concrete right now. They cannot liquidate all this money that came in. What you’re saying is that happened on a worldwide scale. Money came into the US dollar, and now that money may be ready to migrate.

David: Well, and asset managers look at this. Where is the valuation more attractive, more appealing? Well, US markets are overpriced. Everybody knows that. The PE tells you what you need to know. We’re certainly not underpriced. And as we move closer to fair value, you can certainly make a case for staying put. Then maybe there’s upside. But again, relative to the rest of the world, emerging markets and others, valuations are far more compelling elsewhere. If you give people the motivation to move, might they move? You look at the wranglings over the debt ceiling. Is there any reason for foreign creditors to say, “These guys can’t get their act together. Let’s just move on.”

Kevin: So in other words, money may migrate because it gets a better return somewhere else, or it might migrate just because of fear that something will happen to the dollar—

David: Right, because problems are hiding in plain sight, and that’s looking at our national debt. Tell me that’s not obvious. We’ve got 31 trillion, we’re on our way to 50, interest on the national debt is double digit, and it’s going to be a bigger, more significant chunk of total government revenue going forward. How does this not appear to be problematic if you’re talking about dollar stability? You already have a flow problem. You look at the Chinese holdings of US Treasurys, they’re in decline. It once was over 1.2 trillion, now coming in at close to 800 billion. This is a significant decline. There’s already money leaving. And what does that shift in capital reveal in terms of cracks?

Kevin: When the tide goes out.

David: When the tide goes out, you get to see not only which commercial bankers, but maybe even what central bankers have been playing in an underdressed state. So funny, listen to this interview, this Frenchman, he was talking about a monokini. I’d never heard of a monokini. Oh, well, I have, if you think about what a bikini is—

Kevin: Oh, there you go.

David: And then you back into it. So there’s that thinking about the word.

Kevin: Right. Just don’t think too much about the word.

David: No, I’d never heard of a monokini, and I was like, “No, actually I’ve seen plenty of monokinis. It’s just a one piece.” But is the central bank community in that naked state? Whoops. Swimming naked. We shouldn’t have done this, but it takes the tide going out to reveal cracks in the system. Cracks in the system.

Kevin: No pun intended.

David: Oh, gracious. No, I’ll try to move on.

You asked a question about the employment numbers, and I think this is just worth noting because what you see is not always what you actually got. The headline number last week certainly created some energy in the stock market. We had a strong rally, banks went crazy, part of it was short covering, part of it was the suggestion of the ABA, American Bankers Association, that they go after the shorts. But a part of it was this headline non-farm payroll number, at 253,000. It was decent. It was above the 185,000 that was expected. That lands us with an unemployment number of 3.4%. It’s a great number. It takes us back to, I don’t know, 1960. It’s a great number.

Kevin: Now, nobody watch what happens over the next couple of weeks or months.

David: Things are not always what they seem. The game is to print a great number and then in future months when no one pays attention, revise them lower. For instance, March was revised from 236,000 down to 165. Well, 165 would’ve disappointed, and there would’ve certainly been a market reaction to that, a very negative market reaction. But you can run with 236 and deal with the reality of it later.

Kevin: Sure. We’re the BLS, we can be trusted.

David: Who cares? The news cycle is over. People have moved on. February was revised lower by 78,000 jobs. It’s window dressing in the current month, and then in future months, just garbage removal after the fact when no one’s looking. The administration is crowing about strong labor market and the economy’s great. And I think the irony here is that the number, strong non-farm payroll number, it actually serves as an impediment to the Fed loosening financial conditions. And the White House would love to see loosening financial conditions, but they also want to crow over really strong economic figures. It’s like the right hand at the White House doesn’t know what the left hand is doing.

Kevin: Contradictory. Self contradictory statements. We just talked to somebody last week about that.

David: Oh, wait a minute. The right hand at the White House doesn’t know what the left hand is doing.

Kevin: Right. Well, and it’s the BLS—

David: Oh, and the seasonal adjustments.

Kevin: Bureau of Labor Statistics.

David: The seasonal adjustments are another factor. April, 2023, factor in 336,000 jobs. Again, this is a statistical aberration. They do this every year. So what’s the difference between 2023 and 2022? This year is 336,000. Last April was 229,000. So the magical difference is 107,000 jobs one year versus the next. The Bureau of Labor Statistics should be a division of Disney. Magic pencils. It’s amazing what you can do with statistics.

Kevin: Yeah, Dave, the BLS, they probably have one too many letters. If you take the L out, it’s just BS.

David: What’s not BS is the continued increase in demand for gold from central banks. We get another month. We knew that last year was strong, we knew that the first quarter was strong, and April continues to be strong. So you’re talking about numbers that for this timeframe represent a record. Lower than the fourth quarter, but clearly from the World Gold Council, numbers that are still pretty staggering and in demand—

Kevin: So that’s a signal too, when the central bankers are buying a lot of gold.

David: Many of these stories take time to really come together. And gold sitting here near all time highs, do we go higher? I think ultimately we do. Nobody knows on what kind of timeframe. If it’s this week, next month, next year. I would make the case pretty strongly that we break out above the old highs within months, maybe even within weeks. Chinese demand, very strong. The World Gold Council, again, pencils a lot of this out. And we have the numbers for the first quarter in, 228 tons of gold in the first quarter compared to 1,087 tons of gold for last year. Significant central bank buying last year. Very significant. And so that continues to be there. 

One of the things that’s lacking is widespread financial investment in gold. In fact, we saw in the first quarter liquidations in exchange traded funds, outflows in the first quarter, roughly 29 tons. Not a whole lot. 

Kevin: So the public’s not there yet. 

David: Public’s not there. There’s a difference in the public that’s buying physical gold for delivery. They probably are a little bit more skeptical of the outcomes of the system. Maybe they visualized the cracks in the system.

Kevin: But this is the paper gold you’re talking about. This is somebody going in with financial investment.

David: There’s a lot of investors that will just allocate to gold as an asset class, don’t necessarily care to take physical delivery of it. We’ve seen these trends for 50 years because that’s been our bread and butter for 50 years. But when you look at the ETF volumes, it does tell you what the appetite of your typical investor is. It’s not there. Net outflows in the first quarter. 

So in aggregate, if you’re looking at demand for gold across the board, 1,174 tons in the first quarter. Pretty strong. Pretty strong. Central banks, pretty strong. Not at records, but pretty strong for this time of the year. Continued buying from the Chinese, the Russians, and Middle East entities, and waiting in the wings is when does the investor say, “I think it’s time.” They don’t have a lot of gold to sell. We know that. So they don’t represent a threat to the market as they did in 2013—

Kevin: But they do represent a price increase if they all of a sudden jump in. See, this goes back to, what happens this fall? Is the bond market actually telling us that the public might be very interested in gold this fall?

David: Well, that’s right. And might be dead wrong. The general public, who’s still investing in equities and is giddy about the notion of a pivot, might they be the ones who are coming a little bit late and are driving the price well into the 23, 24, $2500 announced range even by the end of this year? That is a growing probability.

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

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

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