Sing the Asset Bubble Song: “Don’t Worry… Buy Happy!”

Weekly Commentary • Oct 18 2017
Sing the Asset Bubble Song: “Don’t Worry… Buy Happy!”
David McAlvany Posted on October 18, 2017

About this week’s show:

  • Volatility (worry) Index sets new record for complacency. VIX this month is most complacent in history!
  • Are stocks too high? The same question was asked 30 years ago before the October 19th, 1987 crash
  • Pre-Crash indicator: Shiller P/E at second highest level EVER!

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

“On today’s program, does unlimited liquidity, call it synthetic liquidity, from the central banks necessarily mean unlimited growth and prosperity in the asset markets, or should you have a backup plan?”

– Kevin Orrick

“Maybe catastrophic declines are a thing of the past. Maybe we’re learning to manage crisis in a way that the human element is taken out and you can bring sanity back into panic. The VIX staying in single digits last year – what it implies is a brave new world, and it suggests to me that maybe keeping a little powder dry still makes some sense.”

– David McAlvany

Kevin: Something that is very difficult when we’re looking at rising markets – if the market doesn’t seem real to us there are ways to bet against the market. The problem is, Dave, I’ve watched this for 30 years now, when I have bet against the market, when I’ve shorted the stock market because it feels like it’s just a little too toppy, if my timing isn’t exactly right, which by the way it never has been exactly right, I end up losing money in the interim. That market continues to go up. Maybe it doesn’t make any sense to me. Maybe it doesn’t even make sense to the markets, but if the market continues to rise and you’re riding a short position, you can really lose your skin.

David: We’ve taken a different approach and that is to have that kind of short exposure managed tactically. That means that you don’t have to stick around for all of the losses. As the market continues to move higher, of course, when you have a short position, you’re losing if the market is moving up.

Kevin: Right, because you’re betting on it going down.

David: That’s right, and you gain if the market goes down. But in a managed tactical position you have the ability to move your exposure, limit your exposure to nothing or to something. But it means that, for instance, here in the third quarter we have outperformed all of our peers.

Kevin: When you’re talking about we, what you are talking about is Doug Noland and our tactical short product.

David: This Wednesday we have our third quarter update conference call. For anyone who is interested in the tactical short strategy and wants to know how we executed on that this quarter, if you have questions, if you would like to share your thoughts, this is an absolutely extraordinary market environment, and Doug is going to be sharing some of what he sees developing and we will look at a broad range of factors from what is happening in China, an unprecedented amount of liquidity that is being created there, to what the Fed is doing and not doing in the present to create a certain bubbly environment here in the United States. But 4:30 Eastern Standard Time, Wednesday, October 18th – you do need to register in advance because there are a limited number of spots for the call.

Kevin: What we are talking about is Wednesday, October 18th. That’s today at 4:30 p.m. Eastern Standard Time. How does someone register for that?

David: You go to the Wealth Management website, which is mwealthm.com/register. On that main page you will see a place where you can click and register.

Kevin: It’s a great time to hear the thoughts of Doug Noland, who for decades has been the person to listen to as far as, not just tactical short, but Dave, credit flow. This is probably one of the foremost experts in the world on just watching credit flow.

David: I went home last night and sat around the dinner table with the family and said, “Do you know how fortunate I am?” I said, “On a Friday I get to read Dave Burgess’s comments as the wrap-up, and we look at what’s been happening in our maps portfolio strategies and the things that are taking place around the world that impact them. And on a Saturday morning I get to read the distillation from the week from Doug Noland.” And I just thought to myself, “These are men that I learn from every day. These are men that I respect immensely for their professionalism and acumen,” and I get to call them co-workers, which is fantastic.

Kevin: You get to interact any time you choose to.

David: I feel like my life is incredibly rich by the people that are in it, so I’m grateful for that. We get to spend time with other people that we enjoy, here, coming up with the conferences. And as you know, we start in Overland Park on November 3rd.

Kevin: So we are encouraging you, please, as a listener, try to find one of these conferences to get to. You can hear David McAlvany, and Don, your father. It’s a rare occasion. We haven’t had that for a decade.

David: It’s a fun dynamic. We’re kind of yin and yang. Although we share the same DNA, we’re different enough that we approach things in a way that complements. Overland Park is November 3rd. The Twin Cities up in Minnesota is November 7th. We go to Philadelphia on November 10th, and then head to Charlotte, North Carolina – that’s November 14th. Austin is on the 17th, so after the holidays we’ll meet up in Naples, Florida November 28th. And the final on this particular cycle is December 1st in Orlando, Florida.

Kevin: And we are asking you to please give us a call so that we can register you, not only for the conference, but if you want to speak with David or Don McAlvany personally, you guys are staying an extra day for private consultations.

David: That’s right, and unfortunately, Overland Park is already booked up for that, and the Twin cities is almost already booked for that. So I would not hesitate in terms of putting that on the calendar.

Kevin: Get those times booked. Give us a call at 800-525-9556. Call us any time and get that booked. It’s well worth the effort. I traveled to five of the six conferences when you all were in the West Coast and working your way across, and frankly, I enjoyed myself more and more every conference.

David: We had a ball (laughs).

Kevin: Yes, we really did. Dave, we were talking about shorting the market, but I’ve got to tell you, we meet on Monday nights before we record this program, and I was asking you to play a game with me last night. We know the markets are overvalued, but it doesn’t feel like anything is every going to change. The Volatility Index is just at zero almost. So what I asked you imagine for me, Dave, was what if the central banks can continue to print credit and cash, and somehow feed it into the market forever. What would be the long-term ramifications of that? And we were also talking about, what are some of the other long-term secular bull markets and how did they end?

David: That goes back to what Richard Duncan called debtism, where we move from capitalism to debtism and we have basically lost the free markets, and he would argue that that is an event that has already occurred. We have already passed from a capitalist free market system, and that’s the migration, or evolution, if you will, that he talks about in his book, The Corruption of Capitalism.

Kevin: It’s no longer capitalism, it’s debtism. How much can you borrow, and how much can you continue to grow? And can you grow quicker than you have to pay back the debt?

David: There is a real-time experiment with that in Japan. When you think about long-term secular markets, extended bull markets, or extended bear markets, what comes to mind for you? For me, Japan – yes, that’s there. The U.S. from 1982 to the year 2000 – yes, that’s there, as well. But for me, it’s the Japanese stock market first, because here in recent weeks we watched the NIKKEI regain the 21,000 market, so this is their publicly traded stock market. And it reached the 21,000 market. It was last at that level 21 years ago.

Kevin: Yes, but that’s only a little more than half of what it was at a few years before that, so it’s never really recovered.

David: That’s right. So 1996 it was at this level, 21 years later it has recovered to that point, but as you mention, it is still 45% below its peak dating to 1989. And it is easy to forget that buying the dips, which is very popular by the pundits on CNBC and others on Wall Street. It sometimes takes not only perseverance, but the patience of Job to have that play out.

Kevin: Yes, but with Job there was a recovery. Dave, I want to look back at what you just now said, because I’ve been part of these markets, and so have you, for a good part of them. It’s been 30 years since we had the stock market crash in 1987. I’d like to talk about that in a little bit. But just looking at the crash in 2000 here, the NASDAQ just in the last couple of years got back to the level that it had crashed from in 2000. That was about 15-year ride. But as you pointed out last week, a lot of the stocks that represent the NASDAQ are new. The ones that actually crashed, a lot of them never came back and a lot of them are out of business.

David: Right, so I think you can still look at those hot stocks, those hot areas of speculation, and on the other side of a peak they may smolder and barely send up a thin tendril of smoke for decades to come, as we saw with the Japanese market.

Kevin: But there are plenty of books on how to analyze a company, and say, “Is this well managed? Is it going to actually earn not just revenue, but profit?” You talked about revenues and profits last week and how you can mess with what profit is for a little while with little fancy accounting tricks, but revenue and profit has always been the reason why a person goes into business. But at this point, it doesn’t seem to matter. At this point it is just how much can you borrow, and can you get something built before you have to pay the debt back?

David: That’s right, because the fundamentals review, whether that includes demographic growth, or improvement in company management, acquisitions which are accretive to the shareholder – that was the question asked – what was the backdrop driving economic growth? It’s not the case today. It’s more of a proximity question. It’s proximity to free money. It’s the ripple effects of central bank asset purchases which are more of the defining elements present.

Kevin: Do you know Janet Yellen? Do you know Mario Draghi? How close are you. How close can you rub shoulders and get that free money?

David: It may be that as we watch the markets over the next few years, those Japanese equities may continue to bubble higher. Why? Well, it’s quantitative easing. It’s artificial buying from the bank of Japan. The Bank of Japan now owns roughly 75% of all Japanese ETFs. It’s fascinating. And it is unlikely to change so long as it is politics as usual in Japan. “Get close to the flow,” might be the 21st century mantra for investing.

And in Europe, too, this is the case. The ECB has said that QE is going to be further reduced, yet Draghi is dragging his feet. Why? He is look at inflation stats, and is not happy yet, and he wants to keep, still, the foot on the gas. So Europe has now had several years of improving economic numbers, but the central bank community is in love with an inflation concept which says, “Not yet, not yet, not yet. Not until we get our inflation number back to normal will we reduce our quantitative easing.”

Kevin: We talked about that last night. Sometimes you can focus so intently on one thing that you can ruin everything else in your life. You can literally die on a hill and lose your family in the doing. And in a way, focusing just on the inflation number when we have these asset prices that are just going through the ceiling, Dave, and it’s not because of profitability. They’re just going through the ceiling because the money is available while they wait for this inflation number to hit whatever level they say they need it at.

David: What is very uncomfortable about this whole equation is that we are talking about two dysfunctional geographies, both Europe and Japan. And we are talking about geographies that are seeing an implosion from a demographics perspective. Yet, the preferred question today is not one of economic growth and its backdrop, it’s what is the backdrop for positive price action? So, as we are living in a world of excessive credit creation, everything becomes a speculation.

Kevin: Right now everything – everything – is a bull market, it’s a speculation. But look at the front of the Economist magazine last week. It said, “Everything is a bull market.” Now, why is that, Dave? It’s because money is free.

David: (laughs) The VIX, as we have noted before, is a picture of the crowd.

Kevin: That’s the Volatility Index.

David: Yes, and they are in anticipation of negative change in the market. So what do they see on the horizon as something that will change the trend of growth? I frame it that way because we have had plenty of volatility.

Kevin: Only one direction.

David: It’s the kind of volatility that investors like. Prices are going up. It’s the negative volatility that has investors concerned and engaged in hedging, which would show up in the Volatility Index – the VIX. When the number is low, it is said to signify a broad-based complacency.

Kevin: Last week you told me that you could actually short the VIX. You could sell short the VIX and say, “You know, people are just going to grow calmer and calmer, and more complacent.” That’s an amazing way to make money, to bet that everybody is just going to go to sleep.

David: Right, and actually that is a huge bet at present. We have, today, what is a raging bull market in complacency.

Kevin: How often have we been this low on the Volatility Index?

David: Ed Easterling wrote some on this. John Mauldin pointed it out recently. Ed Easterling’s observation on the VIX was that the number has only been below 10 on its index 41 times since 1990 – 32 of those times have been this year. And 15 of them have been in the last 30 days.

Kevin: Wow. I think it’s important to point out, any time the Volatility Index gets this low it always signals a change is in the wind. It’s just they’ve been able to delay it this year.

David: Right. Abnormal is either the new normal, or we’re on the cusp of real change in the marketplace. I would guess that that change is unpleasant.

Kevin: Dave, one of my favorite times of year is this time, especially as I drive into the office over the Animas River and look down at the beautiful changing leaves. Something would be wrong if it were this time of year and those leaves were anything but yellow and orange. If those leaves were still green, and they stayed green through November, and then December, and then January, that would kill the tree. Ultimately, we need that change. We need those leaves to drop off.

David: I remember coming home from work one day from Morgan Stanley, and Mary-Catherine was crying. You have to understand, I thought somebody was dead because she’s tough as nails. I very rarely see her cry. I said, “What’s wrong?” And she said, “Well, it’s always summer in Southern California, and I miss the leaves changing. There’s something that’s missing from our life, and there is nothing in nature that marks the change and progress of time. And it just leaves me incredibly melancholy. I’m missing the East Coast and right now in Boston the leaves are changing and I’m not there.”

Kevin: Sure, she’s used to four solid seasons. And actually, the markets have to have the same thing.

David: Well, my interest in change is more than that seasonal fancy. I love it when leaves are turning. I love it. It’s my favorite time of the year. But it’s more than that, because when you look at change there is regeneration, there is renewal. There is life that comes out of winter. What do you have in winter? You have darker days, you have shorter days, and a period of rest. And everything needs it.

Kevin: Well, you put that ten pounds on, too.

David: (laughs).

Kevin: Anyway, Dave, you’re right.

David: Not true. This year my training cycle begins in December, so we’ve got a race in June, for anyone interested. There is a half ironman coming up in Coeur d’Alene June 24th. Join us. Be there or be square. That was for you, Kevin, I’d love to have you join in the race.

Kevin: Oh yeah – no.

David: But if volatility is dead, do you know what also is dead? The market is dead because you basically have no way of gaining an appreciation of price. There is no price discovery. That would be a sad state of affairs. For the time being, I think we operate on the assumption that we’re just dealing with something that is on leave, on vacation. And volatility, even though it’s gone at present, it will return shortly.

Kevin: We talked about it being a bull market in everything. The one thing that has been completely ignored, like we have said in the past, gold has been up between 10% and 13% here for the year.

David: Silver 9% to very little fanfare. It’s funny, my eight-year-old buys with ferocity every chance he gets, and price is not really in the equation. Of course, part of the reason he doesn’t care about price is he gets kind of a two-for-one special. I motivate or incent savings, in silver terms, by matching his purchases.

Kevin: Dave, if you only did that for our clients, it would just probably double our business.

David: And bankrupt the company at the same time (laughs).

Kevin: (laughs)

David: But my eight-year-old talks about his long-term ounces. This is a fascinating new conversation.

Kevin: What eight-year-old thinks long-term?

David: These are the ones that he wants to keep forever as sort of a foundational holding. And then there are those that he wants to turn into other things, and he really is kind of our budding entrepreneur in the family. It’s wonderful to watch, in the gold and silver market, what is a stealth bull market. Nobody cares, prices are moving again – 8%, 10%, 12% – but nobody cares and nobody observes that when they are in the shadow of Bitcoin or Facebook or Amazon or the biotechs, now up almost 29% year-to-date. The metal to watch, frankly, if you were just looking at value – I think it was two to three weeks ago I mentioned this, but I’m intrigued by platinum because of the discount to gold and the ratio to palladium. And I think if someone has a three-year time horizon, an intermediate horizon, you can play that platinum/palladium ratio for a big gain in ounces, and it’s worth it. If you don’t understand ratios, I think getting in touch with our team would be well worth the time.

Kevin: Could I just take a moment and tell a story from yesterday, Dave? I have a client who I was talking to about his required minimum distribution in his IRA. We had positioned him in palladium because it was the better buy about eight years ago. He knew that at some point we were going to turn that palladium into two or three times the platinum just by taking the palladium side first, and then moving to platinum. Yesterday we tripled his platinum. He was thrilled. This is a man who has been waiting patiently and he understands the concept. Do you know what he was thrilled about? He wasn’t thrilled about triple the platinum. He got three times the ounces in platinum. No, he’s like your eight-year-old. He is looking long-term, and he said, “You know what? Let’s triple the palladium.” So he’s waiting to now triple again.

David: For the next time.

Kevin: He understood the concept, and this is not a hard concept, but it does require some experience. And I would, like you said, encourage anyone who is interested in this to call us and we’ll show you how to do it.

David: I’m proud of our team. I think unlocking value and exponentially growing ounces is possible if we’re engaged at that level, and we love to be. Don’t get me wrong, I think any position in the metals is interesting, but when you properly allocate and diversify in advance, some of those ratios can play to your favor over time, which significantly improves your total returns.

Kevin: Dave, this is a memorable year for me because it is the 30th year of the crash of 1987.

David: That’s the first year you came on board with us.

Kevin: That was the first year that I started here. But I remember the market for the next nine years rallying to the point where Greenspan – and he was partially responsible for this – he said that the markets were getting irrationally exuberant. I remember calling my clients and saying, “Hey, Greenspan thinks it’s about to crash.” It didn’t. 1996 came and went. 1997 the market got higher. 1998, 1999, we know what the tech stock boom was. Now, 2000 ultimately did come, and irrational exuberance did hand people back their heads. But look at what Yellen has said over the last few months about Facebook and Amazon and some of the social media stocks and biotechs. She says that they may be over-valued.

David: We quoted her last week as saying that in her lifetime she didn’t think we would see a correction in the stock market, which has a ring of Irving Fisher – “We’ve reached that permanent plateau in price,” he said in 1929 just months before the market crashed. But Yellen’s concern about over-valuation with social media stocks and biotechs – that was not this year. She was talking about that back in 2014.

Kevin: Oh, I thought it was just in the last few months. She’s been talking about it for a while?

David: Right. If you go back to 2014 she was saying, “Look, things are a little hot and heavy in the biotech and social media space.” And now you have biotech almost 90% improved since then, up in value. And social medial has moved up in price 70% since then. You’re right, it is like Greenspan’s observation in 1996. Markets were rationally exuberant – he was right. They doubled again from those levels anyway. And that’s the nature of speculative markets. You reach irrational levels, unimaginable to most investors, and then they double again. I suspect we are closing in on the end of that cycle where irrational levels were identified three years ago, and now we’ve just about doubled in price from what was considered an irrational level. I’m fascinated to see what happens next. You have technical analysts which point to things like a rising wedge in the S&P 500. You look at a chart like that and it either breaks down and the price begins a long correction, or it breaks out and breaks to the upside.

Kevin: It’s been breaking to the upside.

David: It has. So it’s resolving itself positively, and this in the context of the equity markets being already over-bought, and this breakout to the upside may just ring the bell. We have new highs in all the indices – the Industrial Average, the Transportation Average, the Utilities Average, the Russell 2000, the S&P 500, the NASDAQ 100. And what it really suggests is that there is very little differentiation of the purchases. Just buy the market in whatever form.

Kevin: Just buy anything.

David: And it was interesting. This is kind of a word of caution, going back to CNBC, when you are at all-time highs, and CNBC comments as they did this last week – we had one day where a couple of bank stocks were off 1-2%, they had a decline, so financials and bank stocks are just barely off of their highs. CNBC commentators come in and say, “Oh, you’ve got to buy that dip. This looks like a value opportunity.” (laughs) And I just think, this is the kind of lost perspective that you have at the top of a market.

Kevin: I remember hearing your dad tell people over and over and over through the decades, when things got high, he would say, “Guys, keep your powder dry.” That’s and old comment about muskets and keeping the powder dry, but I have one of those muskets, and you have to have dry powder. If you have any moisture in that powder you have to through it out. It’s done. And what we’re talking about, and what he was talking about on keeping your powder dry is, you can either spend your powder right now on something that’s making money and not have anything when the thing reverses, or you can keep your powder dry, stay liquid, because something is coming. A re-pricing is coming.

David: Yes, I’ve read a couple of asset managers who have retired in recent years, so they no longer are subject to the pressures of client asset management, and it’s just managing their own money. And pretty consistently, the guys who are just managing their own money moving to 25%, 30% — the highest allocation to cash I’ve seen is 60%.

Kevin: But they’re older managers.

David: And they’re not playing the game where they have to keep up with the Joneses, as in, the index, or whatever. They’re now just saying, “On a risk/reward basis, should I be here?” And to me, one of the rarest commodities on the planet today is dry powder, rarer by the day, which is, in fact, why bear markets often get so nasty. There is no one to support the price when everyone is in. You have cash, liquidity levels, which we mentioned here in recent weeks that suggest nearly everyone is in. The BofA numbers and the Merrill-Lynch numbers, J.P. Morgan’s numbers looking at client cash allocations, and in reflecting on percentage allocations to equities – very, very historically high.

So technically speaking, there are these interesting patterns emerging in the indices. Not only do you have the rising wedge where we’ve see a breakout to the upside. That’s positive. And Dow theory, a confirmation of a bull market, with the transports supporting the Industrials to higher levels. But it is interesting because we are also seeing small indications – new highs on a given day, and closes well off the peak of trading levels by the end of that day, and to any technical analyst, that is troubling. You would much rather see strength on display than a tepid probing of the market’s outer bounds. And that’s what it looks like. Tepid probings of the markets outer bounds is not actually confidence in a massive influx, which is saying, “Prices be damned, I’m going in.”

Kevin: Let me ask the question that a lot of people who are listening here are saying, “You know what, Dave? I sold my stocks. I get it. I’m out. I’m in cash. I’m keeping my powder dry. Why should I worry if other people, like my neighbors, are out buying stocks? How will that affect me if I’m not owning stocks?”

David: Ned Davis has a research company and asks a similar question. Why should your neighbor’s stock buying worry you? The answer is, U.S. household equity ownership is near record levels. The only higher period was at the top of the market, the 1990s internet bubble, and at the top of the market in 2007. So what do we have today? If you’re watching your neighbors it’s not a lemmings parade. If everybody is in, and percentage ownership of equities, in terms of net worth, again, you’re ringing the bell in terms of what people do at the end of a cycle.

Kevin: One of the foremost experts at valuation of stocks, and one of the better stock buyers through the years is a guest of ours. We’ve had him on several times, and you actually flew out to Scotland to meet with him – Andrew Smithers. Andrew Smithers looks at several things like Q ratio, but the Shiller PE is one of the key instruments on his flight panel that he looks at, and he says, “I know when it’s getting over-valued.” The Shiller PE right now is signaling that there is a problem.

David: It’s interesting, both he and his co-author – I can’t remember his name, but they were both professors at the University of Edinburgh class that I took – they looked at a variety of things including that cyclically adjusted price earnings ratio which was popularized 20-30 years ago by Robert Shiller, so they call it the Shiller PE. The Shiller PE, or CAPE – that, according to Andrew Smithers, is the best way of valuing stocks, next to another ratio which he discusses in his book called the Q ratio. Again, you have a ten-year rolling average of price/earnings which is the CAPE. And what has it done? It has just surpassed 1929 levels. In his book, Valuing Wall Street, he proves the value of these two measures above all other markets metrics, and he looks at all market metrics, and basically gives you the data about how accurate they are in terms of giving you some sort of predictive insight into the market. He’s not looking at it as a timing mechanism for trading stocks on a day-by-day basis. But if you’re saying, “Where are we in the seasons? Is this a season of growth and renewal, or is this a season where we are going to see decay, destruction, death?” The beauty of bear markets is that they are the precursor to bull markets.

Kevin: Sometimes you just have to wait. I remember that conversation that you had. I’ve listened to the recording, Dave, with the harp music playing in the background when you were sitting in Scotland talking to him, interviewing him. And he told you, “You know what? The stock market may have further to go up.” This was just a couple of years ago. And it did. The stock market continued to go up. But he said, “You know, I’m an older man. The downside risk is not worth it to me. I’ve moved to cash.” Now, this is one of the foremost stock valuation guys in the world, and he says, “I’ve moved to cash.”

David: By the way, he wrote the book Valuing Wall Street, and it’s a must read for any student of market history. He wrote it, published it in 1999, and was making the case that between CAPE, or the Shiller PE, and the Q ratio, that these were irrefutable evidence that there in 1999 they were at a market peak, and that we would have sub par returns over the next decade. And lo and behold, gold does well for the next 10-12 years while stocks suffer for the next 10-12 years and he was exactly right. You had a low rate of return environment for equity investors, and a high rate of return for gold investors in that period of time.

Kevin: Isn’t the Shiller PE higher now than it was even in 1999 when he sounded that warning?

David: No. In fact, 1999 was its all-time high.

Kevin: So what are we worried about?

David: 44 is what it was then, 31 is what it is now. 31 far exceeds any of the other bull market phases that we have seen in the last 100 years, the exception being 1929. Again, 1920s, the Roaring ’20s – massive speculative boom followed by a massive bust. And we got to about 30 – we’re past that now. We’re past the numbers that we saw in 2007.

Kevin: So before every other crash we’re higher than what we were, except for 1999.

David: And part of that is because of the way earnings blew out in 1999. Price continued, in its speculative blow-off phase, late 1998 and early 1999, and earnings had already begun to recede. So you had this strange snap where overnight – boom! – the price earnings number goes up, and that gets factored into that ten-year average. So the implication is pretty significant, because just as Andrew Smithers would have said, I don’t like a post-1999 world, which is why he wrote the book then, and why on our commentary just a few years back he said, “I don’t like this market. It’s too expensive.” And at the time he said, “Basically, I could expect less than a 2% return.”

If I recall, the cyclically adjusted price earnings ratio, when he was on our program, was closer to 26. Now it’s 31. What had changed? This is really the implication. It implies that we have a decade of average returns in equities at right about zero. You still have a whisker’s breadth to the positive, but we’re talking about, basically, zero returns for the next ten years for the equity investor.

Kevin: So Mr. Jones, go ahead and take a risk in the stock market and expect zero return. But the mainstream media sees no bubble. They’re there for entertainment, first and foremost. But the financial media, they’re talking about this not being a bubble and that this could continue to go for many years.

David: It’s interesting, because if you look at the global stock markets, add them all up, the combined capitalization of the world’s stock markets is right around 87 trillion dollars. We tacked on an extra 2 trillion last week.

Kevin: Wow! What is global GDP? What is that in comparison to what we actually create?

David: It’s not 87 trillion. So again, you have the prices of a speculative vehicle exceeding what you have in terms of the productive engine, if you will. Again, you look at the global stock aggregates of 87 trillion compared to global GDP and you come up with about 111% ratio. That is a bubble. And why do I say that? Because that ratio has never been higher – not 1999, not 1929, not 2007, not 1968. Pick any period where the stock market was peaking relative to the economy, both domestically here in the United states, and globally – this number has never been higher. Yet the mainstream media folks, as you say, see no bubble.

Kevin: Let me ask you a question. Day before yesterday, it was interesting, gold just all of a sudden dropped $10 or $12 based on the fact that they brought up a guest of ours in the news, a guy named John Taylor, who believes in the Taylor Rule – the thought would be that he would keep interest rates at a certain percentage higher than what the inflation is. Of course, gold started to come down. But one of the things that is fueling this market is the expectation that interest rates will stay low.

Now, Trump is interviewing different guys. You have Warsh and Taylor and Powell, and these guys bring something different to the table. But I thought back to one of our guests, Dave, who was in the Reagan administration the first couple of years, and he said, “We hated Paul Volcker. Reagan would have never picked Paul Volcker knowing what he was going to do, which was raising interest rates to the degree that he did.” Do you think that someone in the Federal Reserve will step in and possibly pull a Volcker – like a John Taylor?

David: You have Warsh, you have Taylor, you have Powell, and there are a few other people interviewed. I think Yellen has been through the interview process, as well, but these are the explorations for the next Fed chief. And it’s all very interesting. Taylor, as you know, has been a guest on our commentary before, and frankly, in my opinion he is the least likely to be appointed.

Kevin: Because they don’t want to see interest rates rise? Is that what you are thinking?

David: According to the Taylor Rule, which he popularized, developed from his post there at Stanford, it applies that the Fed Funds Rate should be north of 3.5%. I think it is 3.5% or 3.75% right now. What that means is that markets would be very unhappy. If he was brought in, the implication is, “Uh-oh. If he applies the Taylor Rule, that’s really going to change the rate structure and change asset pricing as we know it.” So speculators would not like it. When I say markets, what I really mean is speculators would not like that.

Kevin: But let’s face it, that’s what we need. Volcker brought in what was needed at the time. We had high inflation back in 1979, 1980, 1981.

David: Even if the experience of it was not enjoyable, you’re right, that’s what we needed. Powell has establishment sponsorship and is the least likely to rock the boat. Warsh is a Fed QE critic. He was not a fan of QE 1, 2 or 3. So again, Taylor like rules, his own included, which again, doesn’t really fit the central bank community today, which is an ad hoc world of accommodation and money printing. That leaves Taylor and Warsh, to a certain degree, outside the acceptable envelope.

Kevin: Could it not be political suicide for Trump to come in and say, “Hey, I’m going to put somebody in who is going to raise rates.” Look at his reaction when he was told to trim Medicare and Social Security. That wasn’t even on the table.

David: That’s right. We think of Republicans, generally – well, some of us, some people out there (laughs) – how should I say this? Some people out there think that Republicans are fiscally conservative.

Kevin: (laughs) Years ago maybe that was true.

David: Please introduce me to one. That would be helpful. That would be like a field trip (laughs). We could look at the monkeys in the cage. “And here is a Republican who believes in fiscal conservatism.”

Kevin: I think Jesse Helms was a fiscal conservative.

David: (laughs)

Kevin: He’s been gone for many years.

David: Right. The Office of Management and Budget – Mick Mulvaney – advised Trump this last week, “Look, this is not going to work. You have to trim Medicare benefits, you have to trim Social Security.” We’ll probably see a 2% bump in social security payments, so we’re moving the opposite direction. Trump did not take his advice, did not like his advice. What’s the implication? The implication is that we’re heading for a fiscal blowout. We have rising costs – health care and actual living costs on the rise. We have increased demand for services, which is a demographic-driven thing with the Boomers retiring in one mass glut. You have shrinking demographics to support the payouts.

Kevin: Let’s talk about shrinking demographics because we’re told that we have very, very low unemployment, yet if you lined up everyone across America like we did before, one in three would be unemployed.

David: This is where NILF matters – the Not In the Labor Force number is nearly 95 million. Not in the labor force – that’s 25-30% of the population not in the labor force. So the issue in the end is that debts will rise, and that Trump is no different than the Republicans that preceded him, is no different than the Democrats that preceded him. Debt is the problem, and it rings of our conversations with Bill King where he constantly says, “It’s the debt, stupid.” When you think about central bank commitment to inflation metrics – again, why do they want 2%? Why do they have to have 2%? Why are they fixated like a dog with a bone? Why will they not let go of that 2%?

We have Draghi overseas who is probably willing – just in the next couple of weeks, I think it’s the 26th or 28th of this month, he’ll let us know if he is going to continue the QE program in Europe. What is he holding out for? Higher inflation rates. Why is it important? It’s because we already have too much debt. And we’re on the way to adding more on top of it. The only way to manage our debt burden is the twin approach of inflationary pressure reduction, that is, inflate it away, pay it off with cheaper and cheaper dollars, and control the rates that you’re paying on that debt by suppressing interest rate levels, as they have effectively done – what we call repression.

Kevin: I brought up Reagan. I’m thinking back – I’m starting to go back and get a little nostalgic, Dave, because it is my 30th year here, but that first year that I was here, it was a great learning experience. As painful as it was for people it was a great learning experience for me because on October 19, 1987 – we’re coming up on this – we had a very black day. I remember, we were sitting in a meeting. We looked at the stock market – it was crazy – and Don said, “Well, we’re still going to have the company meeting.” So we sat for an hour-and-a-half and had a normal company meeting while the stock market fell hundreds and hundreds of points, and a lot of those companies never recovered.

David: Over 500 points. It was interesting, it was one day. Thursday and Friday the week before were pretty rocky, so leading into it, on the weekend, they had time to kind of fester. And then in Europe and the Asian markets things were looking pretty nasty, too.

Kevin: Back then it was about 20% of the market, though. 500 points was nothing to sneeze at.

David: No. That was over 20% down in one day. What you had was the collapse of portfolio insurance. What that was is a derivative construct meant to reduce portfolio risk.

Kevin: Remember Richard Bookstaber. He was part of the design of that.

David: That’s right. And his famous words, to me, in his book A Demon of Our Own Design, where he says, “I might not have been responsible, but I was right there.”

Kevin: (laughs) And he’s a regular guest.

David: So what they ended up doing, instead of reducing portfolio risk, they exaggerated it instead. This week, we think of Bookstaber. Today, it’s a little different. We don’t have the same kind of portfolio insurance, but we do have a massive amount of money being managed, according to quantitative and rules-based systems, which are now all the rage.

Kevin: Back then it was billions of dollars, now it’s trillions of dollars.

David: That’s right. You would have the pig in the pipeline, proverbially, if you had three, four, five, ten, 16 billion dollars coming through of a particular product, and no one to buy on the other side. Now, we have 3.933 trillion dollars in assets in this quantitative, rules-based system. This includes your quant hedge funds and your ETFs, all of which are in that rules-based category. The problem here is, you have assumptions layered upon assumptions, which in a nanosecond world of trading triggered off of news feeds, I think more in the public consciousness today is this idea of fake news. What about news and the headlines being the determining factors of how algorithms trade, either buying or selling? And this is stuff that we make up. It doesn’t have to reflect reality. This is the creativity of an editorial board.

Kevin: And the editorial board might not even be an editorial board. It might be an algorithm, itself. These algorithms literally write stories. Dave, I remember when it was announced – I was in New York City when I heard that Bloomberg, which is the news franchise, actually was creating the algorithms and selling to Wall Street the algorithms that trade on the news stories. What a world. What a world, when you can create the news, and profit on the news stories, using the key words that are built into the program.

David: (laughs)

Kevin: Unbelievable.

David: I know, and it’s all in real time. But the crash, again, 30 years ago, 22% in one day, left its mark, 30 years ago this week. Frankly, if you’re new to the market, not much is remembered, which is why we do find cycles repeated through time. Differences between now and then? Yes, the proliferation of derivatives has been huge. What was a market in its infancy and what they called portfolio insurance – now we have so many more kinds of derivatives out there.

There are lingering concerns, even after 2008 and 2009 and the global financial crisis, over high levels of institutional risk that remain, even if you have off-loaded that risk onto someone else in the broader market. What has happened, though, is that derivatives become the opportunity to off-load risk and take on more leverage, so you feel like you don’t have as much risk on any single bet. But in aggregate, not only do you have more risk, but the whole system does, too. So what derivatives have served to do is provide an excuse for leveraging beyond numbers that you can imagine.

Kevin: But there have been changes through the years. Sometimes it is a small technical change that’s mathematical, so you would say, “Why would that make a difference?” Remember, they used to trade stocks in fractions.

David: That’s right.

Kevin: In fact, I think when you first started as a stock broker they would trade in fractions, and then they changed that to decimals, and that actually caused convulsions in the market.

David: We’re talking about big shifts in terms of derivatives, but the smallest shifts are, in the end, maybe some of the biggest. This is what I would look at as a two-part devolution for market-makers. We have been restructuring the role that a market-maker plays since 2001. And you’re right, the first would be the move from fractions to pennies – that’s the decimalization of shares. You used to be able to buy a stock and it was quoted at 32 dollars and a quarter, or 32 dollars and an eighth. Whatever it was, it was a fraction instead of a decimal, and that decimalization, basically, gutted market-makers starting in 2001, from what had been a healthy margin. It crushed transaction costs, it began to squeeze the margins for market-makers, and dis-incentivized people playing in that role in the market, facilitating liquidity.

Kevin: Dave, just to give a person an analogy who doesn’t follow this very closely, the difference between turning it to decimalization – you could go as many spaces behind that decimal as you wanted, whereas the fraction kept the trades within some sort of a workable boundary.

David: Yes, so that was the first crushing of the market-makers. Now you have the Volcker rule, which Bookstaber talked about when he was on our program.

Kevin: That de-incentivizes anybody to buy stocks – the big market-makers.

David: That’s right. They solved the problem in terms of creating an alignment between clients and the folks who were holding assets for them. But one of the things that they crushed was the incentive for market-makers to hold an inventory. So the Volcker Rule further guts the market-maker. And this is, I think, a very curious market evolution, or as I mentioned, maybe devolution. Here are the implications that I see. During the last decade we have been in the process of distributing shares to investors. Meanwhile, the plumbing on the street has been shifted to accommodate more of a unidirectional flow of distribution.

Kevin: Think about it from your house’s perspective. If water only flowed in and you had no way of flushing…

David: That could be a problem.

Kevin: That could be a problem, and flushing would be the liquidity side of things.

David: (laughs)

Kevin: All markets have to have a buyer at some point. In fact, we try to drive that into our clients’ heads. “Don’t just think about when you’re buying gold. Where are you going to sell it, and when do you want to sell it?”

David: Yes, there is buying and selling which occurs every day. I’m not suggesting that there is not liquidity today. But it’s more the question of when trades cannot be matched up, who is willing to step in and hold an inventory when the incentive to do so has been destroyed through decimalization and the Volcker Rule?

Kevin: And automation.

David: What it suggests is that you don’t have the kind of liquidity that you might have assumed in earlier generations. Because we haven’t had many downside tests we really don’t know what happens next. We got rid of the Uptick Rule, which was one of the things that slowed the downward progress in a market decline. Maybe we replaced it with something that was as good or better, it depends on your perspective, I guess. But we do have kill switches along the way, circuit breakers which will halt trading at a 7%, a 13%, and a 20% decline. But again, we have these factor and rule-based automated management systems which are now in control of just shy of 4 trillion dollars in assets.

Kevin: Call it a robot.

David: And that number is climbing. But you take your risk parity models, as an example. It is a very popular way of managing money using a combination of fixed income and equities, and leverage. And low volatility, going back to what we talked about earlier with the VIX, low volatility in the market translates into a broader asset base for the strategy because they can leverage up in a low volatility environment, and that raises the level of assets that they had purchased for their portfolio.

Kevin: But what happens on the other side when people are actually selling, not accumulating?

David: Play that in reverse. If you have an increase in volatility it leads to a required rules-based reduction in assets in order to scale back balance sheet leverage. Now, not on a whim, but we’re talking about a rule, forced selling occurs in that environment, and it’s all handled by computers and code. And sometimes that automatic forced selling gets out of hand. We have had these unexplained flash crashes which have happened in recent years, and they are happening with greater frequency and severity.

Kevin: Yes, we’ve been talking about volatility being close to zero, but every once in a while you have this flash crash that occurs and they say, “Well, it was a fat finger.” I had a good friend who, actually, is not in the brokerage industry, but he was trading their entire retirement, and he got wiped out. A big part of his gains, years of gains, was wiped out in a flash crash that occurred back in 2010. He looked at me and he said, “You know what? There was no reason for that to occur. I just lost everything.”

David: Right. And it’s happening with greater frequency and severity, in part because of these forced selling rules. Again, it’s factor-based, it’s rules-based automated management, which is, I think, going to, in the end, exaggerate some of the price declines that we have in the future. But it’s not as if we haven’t had a forecast or preview of things to come. August of 2007 there was an implosion in quant funds, Renaissance Technologies being one of those quantitative funds. Goldman-Sachs was also a big loser. We’re talking about 9-20% losses. Those are big losses in a very condensed period of time.

Kevin: And if you’re leveraged, it can be everything.

David: You mentioned May of 2010. I think that might have been on the 6th of the month if I remember correctly. The market dropped 7%, and it did that in 30 minutes. Why? Nobody knows. But you had bids on shares that were selling for 10, 20, 30 dollars. You had bids at a penny. And you had the asked price for many of those same shares at $10 to $100,000 dollars per share. Something went haywire. It was like temporary insanity. It was like literal wires had been crossed.

Again, August 24, 2015, the Dow opened up, and five minutes later it was down 1100 points. 1100 points in five minutes. Most recently, I think of the Brazilian stock market. Again, people love these exchange-traded funds. But on the day the Brazilian stock market traded 19% down in one day, closed, I think, down only 16%, that was driven by ETF liquidations. Now we have massive strategies that benefit from low volatility, and in fact, load up on leverage, when volatility is low.

Kevin: With the assumption that it will never, ever get higher.

David: Yes. It implies, as we mentioned with risk parity, shrinkage of portfolio holdings to eliminate leverage when volatility returns. So if you’re looking at things as they are, just recognize that’s not the way they stay, because volatility, unless it’s dead, means that there is a massive shift that occurs and forced selling is a part of that.

Kevin: So the Korean missiles flew over Japan. People called and said, “How come the markets aren’t reacting at all?”

David: This is what drives you crazy. It drives you crazy because there is no explanation for the moves that we just talked about, but there is also no explanation for news that would ordinarily drive higher levels of volatility. North Korea. Hello. Does that matter? Turkey is making closer and closer alliances with Iran and Russia. The market does nothing. And frankly, it’s absurd. The Korean Peninsula is, as we speak, practicing war games. North Korea, in just the last 10-20 days has hacked the South Korean military installations and obtained South Korean counter-measures to a North Korean attack.

And who cares? Nobody cares. Nobody cares. And that’s what you get when you have a central bank-controlled universe. You get the South Korean stock exchange, which is up 22% year-to-date. South Korean stocks shake it off as if the brink of war was a total fiction. It’s amazing.

Kevin: I’ll never forget, 1987, I was eager to learn anything I could, being my first year. I remember getting the August issue of Fortune magazine, and it said, “Are stocks too high?” And it said, “No, new methods of valuation say that they can continue much higher.” Now, it was six weeks later that the stock market just cratered.

David: New methods of valuation – that’s like straight out of the Bureau of Labor Statistics, Bureau of Economic Analysis.

Kevin: “This time it’s different.”

David: (laughs) Our market crashed 20% in October of 1987. What people forget is that it doesn’t always help to be diversified across geographies. Japanese stock futures were down 50% at the same time. Taiwan, South Korea and Hong Kong exchanges were down nearly 50%, as well. So, does going international reduce your risk? Really? Probably it does not, but I think that is a popular ploy to keep people in the markets – “Shift your geography.”

And I agree that from a valuation perspective, emerging markets are cheaper, but sometimes cheap gets cheaper still. And now, we have, as I mentioned a minute ago, circuit breakers which exist which will shut the market down – trade halts which come in at 7%, at 13%, at 20% declines. The Uptick Rule went away, I think, in 2007.

So maybe catastrophic declines are a thing of the past. Maybe we’re learning to manage crisis in a way that the human element, the human factor, is taken out, and you can bring sanity back into panic. The VIX staying in single digits the last year, and as we mentioned earlier, 15 times in the last month getting below 10. So over the last 30 days what it implies is a brave new world.

And I’m open to things changing, I’m open to the idea that perhaps there is progress on Wall Street and in the world of structured finance, but it remains to be seen how much bravery we’ll need in this new world of ours. And it suggests to me that maybe keeping a little powder dry still makes some sense.

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