EPISODES / WEEKLY COMMENTARY

The Market’s “Window Of Vulnerability”

EPISODES / WEEKLY COMMENTARY
Weekly Commentary • Nov 08 2023
The Market’s “Window Of Vulnerability”
David McAlvany Posted on November 8, 2023
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“Well, the bottom line, from the Hussman Research, the primary drivers of major stock market declines are extended valuations, a sharp rise in interest rates, and growing recession risks, and they’re rarely as elevated in combination as they are today. Even a small “r” recession could lead to a deep market decline, and the bulk of those losses could occur before the recession is even recognized.” –David McAlvany

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

Dave, we live in a day of instant information, and a lot of times instant desire to respond to a text or a Marco Polo or what have you, to where it’s continually consuming our time. I was talking to somebody this morning, and she was saying, “My mom just expects me to respond right away on Marco Polo, and it’s dominating my time.” And I thought, “It’s named Marco Polo,” think of the days of Marco Polo. Okay, let’s go back.

David: It took a little time.

Kevin: Oh my gosh, if you think about those responses, how long it would take—

David: I had this conversation with my mom just three days ago. She’s like, “Well, you finally called back.” And I’m like, “What are you talking about? I’ve been sending you messages on Signal”—she uses a different app, she’s got WhatsApp and Marco Polo—“for weeks now.” And what I didn’t realize is when I got a new phone I didn’t update all of the apps, and so I didn’t get any of the push signals. I didn’t know that she was trying to get in touch with me.

Kevin: And you were having this strange feeling of freedom.

David: Well, from her perspective, it was, “Why doesn’t he care anymore? I mean, he’s usually so prompt in getting back to me. It’s been weeks, I hope something’s not wrong. Maybe there is something wrong with our relationship.” I mean, the time lag allowed for a misinterpretation. It was pretty funny.

Kevin: It is amazing. Yeah. I guess if you were in England, you wouldn’t have known that George Washington had died for what, six weeks? I mean, it took that long to get across the Atlantic. But in this day and age, since we do have immediate information, sometimes we get it wrong on the other side. And you were talking earlier about recessions, and I’d like to talk about that a little bit today because if everybody’s just waiting for the economists to name a recession, from your research, most of the losses have already happened by the time they actually call it a recession.

David: Yeah. Half to two-thirds of the losses in the stock market are already behind you by the time a recession is already announced.

Kevin: That’s like getting news six weeks later.

David: It doesn’t really matter anymore. And it’s funny because the informational advantage is something that the Rothschilds used to pay for. They had their own pigeon carriers, and so between the continent and London, they could trade the markets on the basis of this informational asymmetry where they had this lead time ahead of everyone else.

Kevin: And they knew the outcome of the Battle of Waterloo early, didn’t they?

David: That’s what I was—

Kevin: That’s what you were thinking. But on the opposite side of things, some people are just trading instantaneously everything. It doesn’t matter whether—

David: Without necessarily knowing what’s going on. I mean, I’m fascinated by the events that trigger movement in the equities markets. Last week we had a variety of central banks sounding like a chorus, pausing the increase in rates, that was what they were all singing. Equity traders interpreted this as the end of the cycle. We interpret it just as a pause. So the end of cycle interpretation triggered a melt up in short covering, the S&P 500 moved 5.9%. The Goldman Sachs short index moved 12.9%. That’s a huge move in one week. And obviously these are the most shorted stocks, so an indication of short covering all over the place. The Regional Bank Index was up 10.7% last week, just a further indication of unhealthy speculation. We now have between 46 and 49% of trading in the SPY and the SPX, the volume is now tied to zero date expiration options trades.

Kevin: How do you do that? Zero date expiration, you’re talking about they’re covering stuff for the day.

David: That’s right. I mean literally they’ve got a day to be right, 24 hours to be right. So the underlying companies within the index, you’ve got these series of removals—distance, if you will. You’ve got the companies themselves, the index—which is a basket of those companies, and then the option which trades on the index and all of those underlying companies, and their volatility is being driven by 46 to 49% of the volume coming through zero data expiration options. Wow. It’s Vegas, baby. It’s Vegas.

Kevin: There’s no forethought. Yes. Step right up and gamble. I shared earlier that I bought a few hour glasses of different time, 15 minute, five minute, a three minute, I’ve got them up on my shelf. And I did that purposely to actually force a pause. A lot of times I’ll react to something without actually stopping and pausing. And 41 years of marriage—I’m on my 41st year of marriage—I’ve learned that a pause before a reaction sometimes is a marriage saver. So I can put that three minute hourglass down in front of me when something happens and I can go, okay, let me take a pause and what are my circumstances?

David: Yeah. Well, I mean in the military they do the OODA [observe, orient, decide, act] loop, which is their opportunity to pause and recognize what’s going on around them before they choose an action.

Kevin: So you would consider this just a pause?

David: Well, absolutely. As it pertains to the central banks and what they’re doing, we do interpret it just as a pause. So the economy, domestically, here in the US, is too strong to reduce rates, and yet that’s how the market wanted to interpret it. Well, if they’re not raising them, we’ll soon have lowering rates. And again, the economic strength doesn’t justify it. Unemployment is too low for the Fed’s dual mandate to move to a more accommodative stance, 3.9% unemployment as of last week’s uptick, and that’s alongside the third quarter GDP growth figures, which annualized at 4.9%. Good numbers. That still argues for maintaining rates at a higher level. To accommodate to lower rates today, it would not only damage Fed credibility, it’d damage the US dollar, and it would take us into a second wave of inflation, a very significant wave of inflation.

Kevin: One of the things that we can do while we’re pausing in life or what have you is, we can take an evaluation and say, is there any anomaly? Is there something going on that isn’t going to be going on down the road? And I think right now about the inverted yield curve, people are being paid more for shorter time risk than they are for longer time risk.

David: Yeah. There are still adjustments that need to flow through the financial markets on the heels of rates increasing as they have over the last 12 months. And a lot of the adjustments we’ve seen have been proportionately at the short end of the curve. An inverted yield curve has placed short-term cash and cash instruments with a similar income profile to longer-term bonds. Both are about 5%. So cash at 5% doesn’t have any duration risk to it, and bonds at 5% have duration risk. And that doesn’t make sense because you’re not being compensated any more for taking duration risk. So bonds will ultimately need to reflect that and yields will need to compensate according to where they’re at on the yield curve.

Kevin: So the anomaly to me would be, okay, either short-term interest rates are going to have to fall below long-term rates or long-term rates are going to have to rise above short-term rates. And you’ve talked about an awful lot of refinancing that’s coming up here. Do you think that’s where it’ll happen?

David: Well, and that’s what I’m getting at because the higher-for-longer is the state of affairs that we have, in part because inflation is not to target, and to accommodate the markets at this point would be to reinforce the inflationary dynamic and bring back a second strong wave. When you look at that yield curve, that gradual differentiation across the curve prodded by the higher-for-longer policy choice and the investor’s expectation of a better deal in the face of a refinancing tsunami, that’s what you would expect. It will end up exerting increased pressure on other areas of the financial market, not just long bonds, but you have yet to see that pressure show up in other places.

We’ve seen the pressure in the commercial real estate market, so there is evidence of where have financial conditions “tightened.” We’re only now beginning to see it in residential real estate, and its volumes that have dropped, but it’s not prices. They have not yet popped. So we have commercial real estate, we’re in limbo land with residential, private equity players have been unable to exit portfolio companies at the pace they grew accustomed to in the previous cycle. And in some cases they are now looking at refinancing because these are really heavily indebted deals that they put together, but they’re needing to refinance, and they’re paying between 12 and 18% rates to finance these deals. And what it’s showing is distressed levels today which were not evident six or 12 months ago.

Kevin: I sometimes have to remind myself that when the Fed is raising or lowering rates, they only have control of the short side of the stick. I mean, they don’t control the long rate.

David: That’s right. So a pause in rates is a pause at the short end of the curve. That does not imply that a bond bear market has ended. It only implies that monetary policy has moved swiftly and will now take a breather. The lag effects of previous actions taken, they’re in the system without being fully evident at this point, but they do have an ETA theoretically established. They will be arriving soon.

Kevin: We were talking about getting news too late and how that might not help. We actually gave news too early last week, and we need to amend that.

David: Sure. Yeah. The Treasury auction I discussed last week is in fact this week. The announcement of the scale of issuance was last Wednesday. My mistake. As anticipated, there is more emphasis on the short-term debt, and they alleviated some pressure on the long bond, 30-year Treasurys. The other thing that they did is they reduced the total scale a very significant amount. Instead of 114 billion, it’ll be 112.

Kevin: You think that was a message to show, “Hey, we don’t need as much money as we thought?”

David: A little gamesmanship there. But the Q4 number, so if you’re looking at what we will have through all of our debt issuance in the fourth quarter, 776 billion in new issuance, that’s a fourth quarter record. And then we’ve got 816 billion which is anticipated for issuance in the first quarter of next year—also atypical for size. So this week’s auction 112 versus what the market had expected, 114. Yes. That’s gamesmanship. And it’s as if to say, “You see, we really don’t need to borrow a ton of money after all.”

Kevin: It’s only three quarters of a trillion for what? October, November, and December.

David: That’s right. Only three quarters of a trillion. So 48 billion is what this auction will be in the three-year category. Forty billion of 10-year Treasurys, and 24 billion for the 30-years.

Kevin: Why would anybody buy a 30-year right now and you can get the same rate in just cash?

David: Rates are always a bet on what happens next and how bullish or bearish you are on the economy. Somebody who wants to invest in long bonds might be assuming that rates are going to come down. Rates would come down if the Fed was forced to accommodate. If we moved into not a small “r” recession, but a significant recession, a depression, a global financial crisis, these kinds of dynamics would precipitate a decline in interest rates—Fed policy-driven decline in interest rates. And on that basis, rates come down and the value of those bonds goes up and the long bond holder makes a ton of money. What we’ve seen is that the long bond holder over the last three years has lost 60% of their principle. Because rates have gone up instead of down, it’s been one of the greatest bond carnages in US bond market history.

Kevin: So it sounds like a dangerous bet right now.

David: It’s a very dangerous bet. The farther out you go, the more risk you’re taking, the more interest rate sensitive it is. That relates to inflation and duration, and right now credit’s not even factored in, but all eyes are on the bid-to-cover ratio. This is Wednesday this week, the bid-to-cover ratio, that is the dollars of demand compared to the size of the offering. So again, we’re talking about 112 billion. We’d like to see if there’s 200 billion in demand or if there’s 100 billion in demand. Comparing the ratio across the spectrum of maturities will also tell you a few things about investor preference. As I was noting earlier, the differentiation across the curve has yet to occur. Again, this goes back to what kind of demand there’ll be for the short stuff or the midterm stuff, the three-year or for the long bonds, because we haven’t seen an un-inverting of the curve.

Twos-tens, this is the two years and the 10 years, and the difference between them. July of this year, 2023, this was the most inverted they’d been since 1981. That extreme inversion has diminished a bit, but the twos are still at 4.95%. The tens are still at 4.64%. So you can see about a 30 basis point inversion. We’ll talk a little bit more about the un-inversion process later, but just remember, the longer date of the paper, the more you should be compensated in yield for the unknowns like inflation risk. The fact that they have not reflected that, there’s an adjustment process that has to take place in this higher-for-longer backdrop.

Kevin: Morgan was talking this morning in the meeting and he was talking about— There used to be mechanical demand by a lot of buyers for Treasurys where it just didn’t matter what the rate was. It just would automatically renew, buy bonds, hey, this is how much we’re going to renew in bonds. Now what you have is price-sensitive buyers. You have different demand from different areas, but the automatic or that mechanical demand is dropping at this point, you seem to have price-sensitive buyers. And then there’s the reverse repo market, and I think that’s a source of demand as well. So we’re changing tires on this car, and I’m wondering how they’re going to perform.

David: Yeah, the price-insensitive buyer was a sovereign wealth fund. It was Japan, it was China, it was the Mid East buyer, and they were dealing with balance of payments concerns. They weren’t really concerned about the interest rate. It was a question of recycling currency and proceeds from trade to make sure that that continued, that volume of transactions continued.

Kevin: That was a nice regular thing to count on if you were the United States government trying to go into further debt.

David: Yeah, that’s right. So a government, a central bank, sovereign wealth fund, these are the ones that are price-insensitive. They are dissipating interest in the Treasury market and we’re coming up with more price-sensitive buyers, which is why, again, how this auction and other auctions down the line are so important because it now matters what you’re being compensated over any particular period of time.

Back in September, the folks at Bridgewater made the case that ample liquidity had flowed out of the reverse repo market into T-bills, which sufficiently funded the Treasury’s short-term needs and allowed for rates to remain calm despite starting with the quantitative tightening, the Fed’s exiting from their Treasury market positions. And of course at the same time you had significant T-bill issuance. So this is where we have yet to see any fireworks in the Treasury market in large part because liquidity that was needed to make those purchases came straight out of the repo market, reverse repo market.

Sure, the curve seems to be well covered in terms of demand. But those funds were and are moving from short-term instruments, reverse repo—this is an overnight lending facility for financial firms and institutions banks and whatnot—they’re moving from short-term instruments to short-term instruments with no loss in yield. I can get five, five and a half percent in 30, 60, 90 day paper, same as I can get in overnight paper at the Fed for the reverse repo arrangement.

Kevin: So how does this affect the longer bonds?

David: The same liquidity shift, repo to T-bills, is not likely when you’re talking about extending the term 3, 10, 30 years. And not only extending the term but for less interest. So less compensation for more risk, not generally something that the price-sensitive buyer is going to say yes to. The reverse repo in this case is the overnight lending facility for financial institutions, mostly banks, sometimes money market funds. Overnight repo is pretty close, in terms of short-term, to 30-day, 60-day, 90-day—all in the short-term category. But think about overnight lending arrangements compared to 1,095 nights.

Kevin: I like overnight better.

David: There’s your 3-year or 3,650 nights or 10,950 nights.

Kevin: That’s your 30-year.

David: Compared to overnight, one versus almost 11,000, not remotely similar. So maybe events dictate that you don’t sleep well at night at some point during those extended timeframes. What has changed in the last 30 days? Well, obviously a lot has changed. If you look at the events of the last 30 days in the Middle East, 31 days ago, you didn’t anticipate it. And now in 30 days the Middle East is extremely upset. What might change over the next 10,950 days? Again, this is why you should be compensated more.

Kevin: Well, look at the last 30 years of your life.

David: I know, you have to be compensated more on loans that extend through time. There’s more unknowns, just not right now. That’s not the way the market is priced with an inverted yield curve. There is less compensation for more time involved, and that will change, and I think that’ll change almost immediately.

Kevin: So what you call the bid-to-cover ratio, it’s really the demand for this debt that’s coming out.

David: That’s exactly right. It’s just demand compared to the supply being on offer. So your 112 is the targeted number, broken into those three categories. You’re going to have a positive number if it’s 113, 115, 150—if you’re basically “oversubscribed,”—more people demanding than there is supply available. A low bid-to-cover ratio would be where you don’t have as much demand relative to supply, and all of a sudden it starts to be repriced in the market.

Kevin: Which is a rise in interest rates. And so this takes me to what we were talking about. We can either see short-term rates fall at this point and come back down over the long rate, or the long rate is going to have to rise. I would imagine that’s what you’re going to be watching this week.

David: Well, that’s right. Whatever monetary policy tightening we’ve had, and obviously it’s been there, but thus far it has been led, it’s been led by short-term paper. It’s likely that with the central bank pause, additional tightening will now be led by long-term rates moving higher. So the yield curve un-inverting and moving higher.

Kevin: Sometimes this time is different. And this time is different, isn’t it? Because we are more in debt compared to GDP than we’ve been in I don’t know when.

David: Yeah, that’s fair. I think that is a part of it. I think the other part of it is it’s not different this time. The yield curve does invert and then it un-inverts, and then things happen after it un-inverts. But to your point, Bank of America charts US government spending as a percentage of GDP and just for perspective, they go back to 1791 to see the big instances where government spending has increased considerably. They bring it up to 2023, and then they even speculate as to where, on the basis of CBO estimates, these expenditures will go out to 2033. And it suggests that, if you look at that chart, only once in US history have our expenditures relative to GDP been higher than they are at present.

Kevin: When was that?

David: During COVID. So we’re spending today—deficit spending, mind you—as much as we did during World War II relative to the size of our economy, nearly twice as much as we did during World War I, and three times as much as we did during the Civil War.

Kevin: We’ve got to borrow. We’re spending so much.

David: We’re expected to remain on that course. Again, going back to the CBO projections through 2033, the CBO projections in terms of deficit spending do not include any recessions along the way, which could obviously increase deficit spending many times. I mean, you can add 1, 2, 3, even $4 trillion a year to our debt, and at 3 to 4 trillion would be in the case where we have entered recession. Maybe that’s a 2024 event, probably in my view. But we’re adding this amount of new debt without driving rates higher. What’s the likelihood of that?

What’s the likelihood of adding this amount of debt without driving the US dollar lower? And again, seeing sort of a blowout in terms of expenditures versus GDP. We routinely run current account deficits. We buy and import more than we produce, and then export, but the capital account balances that out. Essentially, we finance our spending and the two areas balance. If we’re unable to finance and thus balance out the current account deficit, the currency is at risk. And this is where, if you had to take sort of a macro view, we’ve got immediate risk in terms of the US dollar strengthening and putting pressure on the emerging markets if there’s pressure within the financial markets that is expressed. On a longer-term view, from a macro perspective, we are losing our financiers, and as we lose our financiers, we are closer and closer to an acute currency risk. And again, it comes back to the capital account and our inability to finance deficits.

Kevin: Is this what we’re seeing modeled in Japan right now, where they’re having to come in and buy their debt? I mean, it’s been seven or eight times now in the last 30 days where they’ve had to step in and become their own consumer of debt.

David: Well, this has been the story, the case for a long time. The Bank of Japan already owns 60% of the entire Japanese government bond market.

Kevin: Wow.

David: So buying at the edges—hardly. They’ve been the buyer of first resort, not last resort. There’s some concerns about not only the value of the yen, but to what degree can they continue with yield curve control. That’s one of the things that was modified last week is the 1% cap on their debt. We’ll see. I mean, fascinating. Actually this month, what we just are witness to is the last piece of government debt with a negative yield. We were at, what, $16, $18 trillion of government bonds with negative yields.

Kevin: Oh, that’s been wiped out. We have no negative yields anywhere?

David: I think December 2024 JGBs were the last bit that just went positive.

Kevin: Really.

David: So it’s kind of like end of an era or very close to an end of an era.

Kevin: Gosh, I’m going to miss those negative rate eras.

David: I know.

Kevin: Or that era is— Okay. So this week, though, let’s go back to this week because we don’t want to be the guy who finds out six weeks later that George Washington is dead. We want to look at it and say, “Where do we find clues right now for something that might happen in the future?” I would imagine this auction is a place of finding clues.

David: And that’s why I was drawing attention to it last week. I just got a little ahead of myself with the auction announcement versus the actual auction itself. So Fed tightening may be taking a pause, but there is a tightening feedback loop at the long end of the curve. So the tightening feedback loop at the long end of the curve, when it’s initiated, will differentiate not only duration, but ultimately, credit risk as well. And we have yet to see any real increase in spreads to differentiate between fixed-income products on the basis of credit quality. So the credit market solvency concerns have not been a part of the, “bond bear market” to this point hardly at all.

So if you think about the moaning and groaning of the bond bears, it’s only been affected by a rise in rates at the short end of the curve. It has yet to be transmuted or changed into something at the long end of the curve, and there’s been virtually no impact into the high yield or the investment grade markets. It’s hard to imagine that that remains the case, remains the same. In fact, what we are seeing, Kevin, is that bankruptcies year to date are 516, this is if you’re counting publicly listed companies. And these are the zombies, the zombies are starting to drop. The ones who can’t get financing, they’re done. The ones who can get financing, but at a higher rate, I mentioned private equity firms who are now having to pay as much as 12 to 18% to refinance.

Can you imagine if I had said that 12 months ago? I would’ve been laughed out of any room. Investment-grade high-yield debt remains as yet unmoved. But commercial real estate, private equity, those are two areas where spreads are leading what should be an expansive trend in the financial markets. Higher for longer at the short end of the curve will permeate and will transform the fixed income across the spectrum. Bloomberg reported on the 2nd of November how a growing number of private equity companies are not making cash payments on their debt. They’re reserving their cash liquidity and instead they’re paying debt with debt.

Kevin: It reminds me a little of the bail-in program that we saw overseas a few years ago, “No, you can’t have your cash, but we’ll give you more debt.”

David: I’ll give you another IOU and we’ll call it good. And that’s called payment in kind, right?

Kevin: Oh, there you go.

David: That’s how they refer to it. With an interest rate of 16%, the offer of an IOU as payment on an IOU.

Kevin: Wow. I’d gladly pay you Tuesday more debt, basically.

David: Yeah. Enjoy the rally in bonds while you can because we’re already to the stage where pressure is emerging. The higher-for-longer is beginning to permeate and spread out, and there’s no way that we won’t see the long end of the curve begin to move higher, the yield curve un-invert completely, and credit quality, the great sorting machine of the markets, figuring out who will exist and who will no longer exist.

Kevin: Well, and if my debt is getting paid with more debt, I’m going to demand higher rates than what I was being paid in the first rate.

David: Oh, absolutely. So by the end of 2024, I think the bond bear will be, again, sorting the solvency winners and losers. You’ll see more equity risk premium having fully adjusted to that higher-for-longer regimen. In other words, look at an equity portfolio today and it will have to reflect the impact of higher rates at the long end of the curve and across the credit spectrum as well. What that translates to, for the autopilot portfolio today, is between now and the end of 2024, you’ll find more encouragement by taking your statement to the paper shredder.

Kevin: Well, and we’ve been talking mainly about debt, but you were telling a story about yesterday you were walking through the office and one of the guys was talking to a client and he said, “You took out a home refinance to buy Tesla?” Now let’s shift to stocks just for a second. What did he say? That’s a bad—

David: Wait a minute, you took a home equity loan out to buy Tesla stock?

Kevin: Yeah.

David: That’s a bad financial decision.

Kevin: Well, up to this point, you just buy the FAANGs, the magnificent seven, right? But that’s starting to reverse. That’s a bad decision.

David: And those seven are entering the cull, and that cull is exactly what I mean. Those seven names have held the market up while the majority of names are already in a bear market. And maybe we get a rally to take hold, building off of last week’s short covering. And that’s great. Those dynamics exist where a big rally becomes a bigger rally. But we’re talking about the generals already getting shot.

Kevin: The magnificent seven.

David: Yeah. And that’s not good for the foot soldiers. So when you think about the smaller companies relative to these large market cap leaders, they are now going down. Tesla reported net income down 44% year-over-year, shares sold off 22% in less than two weeks. So this is what has been guiding the market higher, and now we’re seeing evidence that they can’t move the product. And then out of that group of seven, Google beats on its revenue and earnings estimates, but still manages to give up 12% in three days because it disappointed on its cloud revenue. You’re beginning to see cracks emerge with the leaders, and that means that the ones that have been lagging, you could say, “Oh, well, they’ve already given up.” Oh, they’re going to give up. No, that’s not the way this works.

Kevin: They’re not all down yet, though, right? Amazon is still holding its own.

David: No problems on earnings, just a super-rich valuation at a P/E of 67. Apple, on the other hand, down 15% since its summer peak, massive insider selling. You get Cook, almost everyone in the C-suite, ditching Apple shares—and we’re talking about multimillion-dollar liquidations. Cook’s most recent one, 41 million, just another liquidation of 41 million. Buffet reported his first quarterly loss at Berkshire Hathaway after taking a hit in his stock portfolio. Apple is a huge portfolio holding, and one of the big losers—again, a part of that quarterly loss.

And Berkshire, that’s a quarterly loss despite selling tens of billions in stock since the beginning of the year. Berkshire’s gotten their cash levels up to records of $167 billion, and they still, with a large cash position and tens of billions in liquidations, took it on the chin. NVIDIA has yet to report, should be stellar. Big backlogs and huge demand given that AI has been the thing since the beginning of the year. So, like Amazon, price is what you pay, value is what you get for it. And NVIDIA at 98 times trailing earnings is not a great value. It’s pretty darn expensive.

Kevin: And when you say the word expensive, this isn’t just a gut feeling. When you talk about 98 times trailing earnings, what you’re saying is, the company as it runs right now would take 98 years to break even for the stock price at this point.

David: Exactly. You’re paying for 98 years worth of earnings up front because you think that it’s worth 200 years of earnings or 300. The greater fool theory of investing is where you’re paying for those things in advance. And you’re probably less of a fool buying a company where you may pay up for it and pay for six years worth of earnings.

Kevin: Well, if you’re buying a business, yeah.

David: The other way of looking at this is that you expect earnings to increase dramatically, making the price and the price earnings ratio somewhat irrelevant.

Kevin: It’s still expensive. It’s expensive. Yeah.

David: Well, speaking of expensive, William Hester, who works for John Hussman, talks about the stock market’s four horsemen. They are extended valuations—in other words being overpriced, interest rate pressures, recessions, and sudden destabilizing events. And he looks at recession easily getting added to the first two, which are already present.

Kevin: Okay, so—

David: Rates pressure and extended valuations.

Kevin: Extended valuations, rate pressures, recession is coming, and then sudden destabilizing events. That’s not happening, is it?

David: Well, as far as the market’s concerned, no. Yes, we’ve had destabilizing events, but they have been largely ignored, if you’re talking about the Middle East. Valuations are not up for debate. The current Buffet ratio, measuring market cap to GDP, exceeds the market peaks in 2000 and exceeds the peaks that we had just prior to the global financial crisis, 2007, 2008.

Rate pressure, as measured by the intensity of the move higher, not necessarily the absolute level because we’re rising off of very low levels and have yet to get to points where you would say historically we’re at pretty high levels of interest rate. No, actually, it’s just the intensity of the move and the speed at which it’s happened. The intensity of the move is on par with the rate increases in 1980, in 1987 and 2000. And that’s, again, the intensity measurement is sort of the measure of zero to 60. This is one of the most intense.

Kevin: I like that four horsemen, that’s interesting, but which one leads to the most radical downturn?

David: The biggest market declines in equities tend to start from the highest levels of overvaluation.

Kevin: Okay. So we’ve already got the first horseman.

David: Yeah. And that’s been in place since the end of 2021, early 2022. But second, and not surprising, he finds that a sharp increase in rates often provokes the bear, and that can take place whether the market is highly overvalued or not. So back in 1980, markets were not tremendously overvalued, but we had a big rise in rates and, boom, there we are into a recession.

1987 is a case where a sharp rise in rates contributed to the Black Monday crash, and then, of course, hedges prove to be anything but hedge-like, as you had portfolio insurance kind of massacre itself. But when the market is overvalued, it does not have to have an increase in rates in order to decline. But we do, in fact, have those two already.

Kevin: I was blessed, actually, to have had my first year here be 1987, so I do remember that the stock market wasn’t rolling over at all, even though it was overvalued. You’ve had Richard Bookstaber on several times because he was there for several crashes, and the remedy, supposedly, for crashes— He basically says that remedy actually makes them worse. But the S&P 500, Dave, it reminds me of the 1987 stock market. It hasn’t rolled over yet. You may have the FAANG stocks going down, but you don’t have the S&P 500 index going down.

David: You mentioned 1987 as the year you started, and it was a good year to start. The year 2000 was when I started with Dean Witter, Morgan Stanley. And I talked to Jim Deeds the other day, and he said, “Dave, do you realize I started at Dean Witter when there was only four of us in the office?”

Kevin: Really?

David: It was a small company when he started. I may have misunderstood him. I haven’t even looked back to see—when did he start?

Kevin: I don’t know, but he was a stockbroker in the ’60s.

David: Still, does it make sense that— I don’t know.

Kevin: He’s been through a lot, though, and he still pays attention.

David: He has been through a lot. Well, one of the leading economic indicators that has not rolled over is the S&P 500 index.

Kevin: Yeah.

David: So you’ve got consumer expectations which have been in decline, you’ve got new orders in the ISM index which have been in decline, and at least five other leading economic indicators, which similarly have been negative. New orders of consumer goods buck the trend, and the stock market has thus far bucked the trend. So you’ve got a couple of non-conformists, if you will, in the LEI index.

Perhaps the most intriguing bit of commentary from Hester is what he describes as a window of vulnerability, where the yield curve un-inverts, the inversion of the curve preceding recession, that’s a common topic amongst Wall Street practitioners and it has been the case since the New York Fed wrote a paper on that topic back in 1996, yield curve as a predictor of US recessions. He instead argues for the more timely signal of recession derived not from an inverted yield curve, which you generally say that precedes a recession by 6 to 12 months. He would say no. If you want something more precise in terms of timing, it’s the un-inversion. He says that’s the most reliable clock on recession expectations, and it has only just started.

Kevin: Well, and this goes to how we started the talk today, that you don’t want to be late for that news. By the time they actually call it a recession, you’ve already taken your losses.

David: Yep. So here comes the killer. Most people lighten up on risk exposure when a recession starts, but in the last six recessions losses were accruing for 60 to as much as 375 days prior to an official recession call being made. So you’ve got losses of 6.7% to as much as 24.7% which are already being inflicted on your portfolio. More losses still to follow, but big losses already taken.

The key takeaway: be early and, yes, you may miss out on potential gains. Be late and you’re going to miss out on principle.

Kevin: Yeah. Well, and that makes sense. Okay, after a recession is announced, how long do the recessions usually last?

David: As short as 50 to 100 days. More of them last between 100 and 220 days, and some can last 350 to 600 days. But keep in mind, you can have already been losing for 30 to 300 days before the recession starts. The recession then lasts 50 to 100 at the short end, as many as 600 at the long end, with a cumulative loss of 49%, 48%, 56%, 36%, 17%. These are kind of your worst percentage losses of the last series of recessions.

Kevin: So let’s pretend you’re the guy who just waits to hear about recession before you start selling your stocks. What does that look like?

David: Well, 11 out of the 15 recessions that have happened in recent decades—and go back 100 years—11 out of the 15 recessions have already hit their worst and their lowest declines by the time the National Bureau of Economic Research, the NBER, announces that the recession has begun.

Kevin: There’s your delay. George Washington died six weeks ago.

David: Oh, well, I guess we should do something. But better late than never, which is fine if you’re an economist, they’re used to that. But if you’re an investor, it feels a lot different. It’s not just a reputational hit, this is a balance sheet hit. Again, loss of principal. What about the return of my money, right?

Kevin: Yeah. Will Rogers.

David: Exactly.

Kevin: That’s right. My principal.

David: So economists reaching consensus on recession or lack thereof can be very expensive for you. 11 out of 15 recessions hit their worst and lowest declines in terms of the equity market performance by the time the NBER announces the recession. Okay, you can wait. That’s fine.

Kevin: What good are they? What good are they? Yeah.

David: Well, bottom line from the Hussman research, the primary drivers, he says, of major stock market declines are extended valuations, sharp rise in interest rates, and growing recession risks, and they’re rarely as elevated in combination as they are today. Even a small “r” recession could lead to a deep market decline, and the bulk of those losses could occur before the recession is even recognized.

Kevin: Sometimes you have to recognize things by looking outside of your own room. I’m going to shift to gold here for a moment because gold is hitting all time highs. While we’re talking about stocks and bonds, Dave, and the overvaluation of stocks, possibly the overvaluation still of bonds because we have higher interest rates probably in store for us. We’ve got gold actually hitting all time highs in a number of currencies while we see a minor correction here in the dollar.

David: This is fascinating because if you said 2023, what are the marks in the market that are important to pay attention to? At this point we can say equities have had very little volatility. If you look at the VIX index, it’s like equity non-volatility. That’s just one sort of mark you need to put down on paper.

Contrast that with currency volatility and bond volatility, and those are the two have been off the charts. Currency volatility and bond volatility, this is where I think comments of late of Japanese yen and the RNB. This is really important, but it’s not just those two currencies. If you look at other currencies, gold closed at record highs in October, new all time record highs in Sweden, in Norway, in Thailand, Taiwan, Japan, China, Europe, UK. Tough currency pressure both for the Aussie dollar and the Canadian— Is it loonie?

Kevin: Well, it is now.

David: Well, and there’s a couple more currencies where gold in those currencies is at all time highs. Central bank buying has been a part of the strength in the gold market for 2023, but also for 2022. Central bank buying has migrated from 10 to 15% of annual consumption to 25%.

Kevin: That’s significant.

David: Sequential years are on pace to set records for tons purchased by central banks. And I think back to the way a US investor is reading the marks in the market and trying to understand what signals are being sent. We now have a momentum trade in the Scandinavian countries, in Europe—

Kevin: In Asia.

David: In Asia. And the US investor is busy selling IAU and GLD and getting out of metals positions. We have had a tremendous volume of liquidations in our physical metals business. Now, ironically, not so much in the Vaulted program. We’ve seen quarter on quarter growth since the beginning of that program, quarter on quarter growth in terms of assets in the program. And I think with the institution of silver here recently, and the pricing that we have through HSBC being second to none, second to none in the US, it’s shown that the market has a strong appetite for value.

But if I step back from the Vaulted program, if I look at the gold market overall in the US, we’re close to $6 billion in liquidations from GLD and IAU year to date, the US investor could care less. And the story is one of disinterest, really, in the West.

Kevin: You think they’re going into stocks? You think they’re going into bonds? You think they’re attracted by the 5% T-bill rate right now?

David: I think it’s a little bit, Kevin, like the client that our colleague was talking to. I just can’t pass up Tesla 22% lower than it’s all time high. Come on now.

Kevin: Take a second loan out on the house.

David: Time to get a HELOC and buy Tesla. I think there really is a buy-the-dip mentality.

Kevin: But you don’t want to be the dip.

David: Well, that remains to be seen how this plays out.

But the story is one of disinterest. I think it’s a story of faith in the Federal Reserve and the Treasury remaining intact—remaining intact for now. And then, as you look at the strong interest everywhere else, gold held in IAU and GLD continues to be sold off. 862 tons is what you have in Western ETFs today, last count, down from the COVID peak of 1,268 tons. So while we’ve basically said the crisis is behind us, we’re no longer concerned about COVID, we’re going back to normal. It’s business as usual. The rest of the world is buying gold hand over fist. The years since COVID, we’ve seen record-breaking demand in China, in India, with global central banks. We’ve got Poland who’s in the process of doubling their position in gold from 300 to 600 tons. Everybody wants to own more except us. And the question is why?

Bold market dynamics are gaining momentum around the world, and they’re largely ignored as Western investors— I mean, I think what it is, and this goes back to what we shared with our clients on the conference call, the Wealth Management Conference call. Western investors fail to appreciate a new set of rules that are in place. They’re living by the old rules. Equity traders interpret the Fed pause as the end of the cycle in terms of rates increasing, and they’re just going back to normal. We interpret it as just a pause.

Kevin: Dave, instead of us thinking of a Fed pause, I go back to Hester, the window of vulnerability. Is this a pause or are we actually entering the window of vulnerability?

David: We’re in the window of vulnerability. The biggest implications going forward, at least in terms of gold, is that US and Western investors are going to arrive late to this global market, and only after prices and equities have moved considerably lower, gold considerably higher. And what is that context? Well, in that context, I think you find the credibility of the Fed and the Treasury considerably diminished. But yes, we are squarely in the window of vulnerability.

*     *     *

You’ve been listening to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany. You can find us at McAlvany.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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