The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“Margin debt numbers have begun to decline off of their peak and that feeds a negative cycle of momentum to the downside in stock prices. We are maxed out. The equity market is ready to roll over. If you haven’t already, now would be a great time to raise cash, buy gold, get liquid, choose a good seat for the fireworks show because it’s getting ready to start.”
– David McAlvany
Kevin: David, you’re actually in the studio. I’ve been with you for the last five or six weeks as you have been touring with your dad through Palo Alto; Bellevue, Washington; Portland, Oregon; Scottsdale; Denver; Agoura Hills. You’ve been everywhere, but actually for one day you’re sitting here in the studio with me before you head to Europe.
David: Most of my travel is related to business but on this particular trip we’re going to be going into Munich and then through the Southern part of Germany, up the Mosel Valley and to Herford and Wittenberg. As most people, I’m sure, know, this is the 500th year anniversary of Luther instigating what became known as the Reformation. It was his formal protest – 95 protests – that he nailed to the Wittenberg door and said, “Look, we’ve got to make some changes here.” He was a person who was willing to speak truth to power in a very compelling way 500 years ago this October 31st.
Kevin: And you’re doing it with the whole family, including Don and Molly, so your kids are going to be there, your wife, Don and Molly McAlvany. That’s going to be fabulous. I know that you’re very deliberate in training your children. These conferences, you always had one of your children with you and that’s impressive, because in the room, Dave, as we were in these various locations, you had three generations of McAlvanys. You had Don McAlvany there, you had you, and then of course you had one of your kids, which is your tradition. You try to travel with at least one of the four.
David: This will be a fascinating trip because we will see not only the Eagle’s Nest and Berlin, going by Checkpoint Charlie, but we will also go to the Bach Museum and even Buchenwald, so a wide range of experiences and conversations, and really, something that I haven’t fully processed in terms of the details that I can or cannot share with our kids. We still have some young kids, and so introducing them to the best and worst of humanity but doing so in a cautious way will be the challenge the next couple of weeks.
Kevin: It’s amazing, as we move to the conferences, there were themes that continued to repeat. We talked about that a little bit last week. But the big themes of the conference actually started changing while you were gone. When you first started the conferences, Dave, in Palo Alto and in California, the VIX, the Volatility Index, was at virtually nothing. You could hear a pin drop. That is starting to change. As you were on the road, the things you were talking about, both you and your dad, started actually changing and showing themselves to be coming to pass.
David: Complacency has been the mark of these markets the last several months. And you’re right, one of the big themes from the conference is that we’re here. The end of the Fed and central bank induced asset price expansion is here.
Kevin: Would you repeat that one more time because we have now had nine years of this Fed-induced expansion. You’re telling me that it’s no longer effective.
David: Well, we have the goods, more or less, on credit, but the bill is not yet paid for. So imagine, if you would, some sort of Edwardian era party where credit is extended so that you can throw some grand gala and you serve the finest spread to your fellow socialites. But then after the party is over and the guests have gone home you still have to pay for the goods. The food and the wine still has a debt against them and the party has run its course and it’s winding down and the bill is still owed.
Kevin: Yes, but there is a chart that you showed, all six conferences, Dave. It shows that wealth has increased during this period of time. Granted, maybe the wealth hasn’t increased fairly, or fair is probably the wrong word, but equally distributed. But the wealth, as the Federal Reserve has kept interest rates low and pumped money into the system there has been a rise in household wealth.
David: That’s right – 56.2 trillion in 2008 to 95 trillion today. And that’s good news, right? Except that it was liquidity created by the Fed and the world’s central bankers which was designed to create a wealth effect, and that has increased wealth, but there are two issues. Number one, prices have been hoisted higher by an increase of debt and leverage in the system. And number two, the increase in values was not all evenly distributed. So the distribution of benefits has disproportionately gone to asset owners. That is, the 5-10% of Americans, and those living around the world, that frankly own everything, the 90-95% – I’m really being generous, it’s more like the 99% – that are out in the cold, they own nothing, and they’re beginning to rumble.
Kevin: And the rift between the rich and the poor has truly widened during this period of time. We have one in eight people here in America, maybe it is one in seven, who are actually on food stamps right now. This is incredible. I don’t know that that many people during the Depression were on some sort of handout.
David: As a percentage of the population it is staggering, 44 million Americans are currently on the EBT SNAP food assistance programs. That compares with just 26 million prior to the global financial crisis. So consider the story about recovery and consider the fact that it was a 33 billion dollar a year line item before the crisis, that is, 2007, and now it’s a 70-billion dollar program per year. That is very interesting, from 26 million participants to 44 million.
Again, this is a big topic at our conferences in the last few weeks, the unintended consequences. What has the Fed ordered up? Well, what are the consequences that follow? And that is what I think we get to reap in the next few years. So the sad reality is that for all the trillions of dollars conjured from out of thin air the Fed only got a little bit of window dressing. There is no real structural improvements that were put in place to aid in future economic growth.
Kevin: So if the Fed intervention is now coming to an end the way we have seen it so far, what does it look like next time? Obviously, if they had unintended consequences that didn’t work, didn’t re-ignite the economy the way they thought with the wealth effect, what does it look like this time?
David: So, you had the asset purchases which have not given us substantive economic growth, that is, below 2%, which is again well beneath the desired goal. It implies the next round of interventions here in the U.S. will have to look different. The next QE from the Fed will be different in character. It has to be due to the unintended consequences of the 2008 to 2014 iterations, that is, the iterations of intervention and saving the markets as we know it.
Delivering funds directly into the economy instead of into financial assets is, and will be, the objective of true helicopter money. And that is where the focus has to be – I’m not saying has to be as in I want it that way, but that is likely where they will go. Ben Bernanke’s early 2000 speech on the subject will find its echo into the present as financial assets are necessarily sidelined and money goes direct to the consumer.
Kevin: Well, Wall Street is not going to be happy about that at all. How many years has it been since Wall street wasn’t placated by the Fed?
David: But they are going to run into political problems if they continue to placate Wall Street, and those political problems are very real. It’s not since William McChesney Martin, that 1951 to 1970 era where the Wall Street frat boys have seen their liquidity limited. That is not entirely fair. I guess Volcker played the unpopular role as well to some degree.
Kevin: But the question is going to come, what is the matter with what they have been doing so far? The stock market is hitting all-time highs.
David: But that’s the issue, isn’t it? Because any more asset price inflation leads to social revolt and radical political swings toward total redistribution of wealth. We have gone through a cycle, a period of time, where capital has benefitted, and if you look at history, you tend to see an oscillation between capital and labor, capital and labor, capital and labor. We’ve just finished a long stretch that has favored capital, and if you press the boundaries any further in terms of asset price inflation, I think you’ll see labor take to the streets in a very significant way. So the Fed is limited in that way. How will they implement their strategies and tactics, monetary policy in the future? If it’s not asset price inflation and wealth effect, then it will be the old-fashioned, just more money sloshing around in the economy, which quite frankly, is good for growth numbers if that’s all you look at, but with some very negative side effects.
Kevin: Well, isn’t that exactly what happened in Germany in the 1920s? The early 1920s it didn’t necessarily go into the stock market. The wealth effect, or the money that they were creating went into the economy and it created hyperinflation.
David: Initially it was very good for stocks in Germany, and initially it was very good for growth in Germany. And then all of a sudden inflation caught up and there was a real wake-up, an aha moment, where people said, “Not even stocks will save me now.” The next Fed intervention will be the sort that rings all of the inflation bells because that is what happens when more money is sloshing around in the economy. Silver and gold will respond quite positively, no doubt. In the economy is the key contrast, because past efforts have had liquidity recirculating through financial markets alone.
Kevin: Right. There are no profits right now. Revenues are way down.
David: Right. So we think of this next intervention and we think of it sooner than later, because if you look at the state of publicly traded firms, you’re right, you have revenues, you have sales. They continue to disappoint. Now, of course, earnings reports have been very impressive. But for anyone who really cares about this stuff, look – revenues are down, sales are down. So you can play games with earnings, but it’s not clear how stock prices are going to continue to be levitated. And when prices fail, and begin to shift direction, market psychology will go with it. The Fed will, in that instance, be back. So looking at the economy, the consumer is maxed out. Creative corporate reporting is just about exhausted, with corporate leverage reaching the highest levels on record. You look at their efforts to buy shares back and add to long-term debt, corporations are leveraged to the hilt, the consumer is leveraged to the hilt. I think current consumer leverage is right around 12.7 trillion dollars. And you would think the consumer would be supercharged and actually willing to take on more debt as he looks at the value of his home increasing. Did you know the average existing home price reached a record $263,000?
Kevin: Well, Dave, we were in hot real estate markets, and when you are in a hot real estate market like Northern California or Seattle, when you’re looking at that and you’re saying, “Well, gosh, it can never stop.” Any time I’ve ever been in a hot real estate market it has felt like it could go forever. It’s a strange emotion that comes over even a person who knows that it can’t last.
David: We did a consultation with a gentleman in Portland in 2006 and we suggested that this man who had leveraged real estate, 16 different properties, debt on most of them, eliminate as many of those properties as he could and tighten his belt. And this was a life effort, right? But he had gained an exposure to real estate and just wanted to see them paid off, and once they were paid off he would have this tremendous cash flow.
Kevin: And should I say, also, the real estate market had the same feel in 2006 that it did this time?
David: Of course. And he stood up in the middle of our conference in Portland and said, “Just so you know, I took your advice. I sold almost every property.”
Kevin: Back in 2006. He stood up in this conference here.
David: That’s right. He stood up in the conference circa 2017 and he said, “I sold most of those properties. And I’ll have you know that within 18 months bankers were calling me to buy back those same properties for a third of their value. And today I own 100 properties, and I own them free and clear, in Portland. I would not have been in this place had I not taken your advice, gotten liquid, gotten to cash, and gotten out of harm’s way.”
So it was interesting because we look at consumers, they should be super-charged, but the reality is they’re pretty well tapped out. The consumer is not doing the heavy lifting. They’re not the ones who are keeping the required credit growth in its desired range. Again, you have to have net of inflation plus 2% per year credit growth or you end up slipping into recession.
Kevin: So is it the government that is stepping in? Would you say government is spending right now? They’re deficit spending, I know that.
David: Well, certainly. The budget deficit is yawning all over again. It is at plus 700 billion this year. And so, yes, government debt will have to fill huge gaps between now and 2020. I think this is a trend to watch. I think also watch treasury issuance because I’ll bet the actual government debt, not just that budget deficit, but the actual government debt and what they are financing, grows at about twice that amount. I think it will be well over a trillion dollars.
Kevin: It’s amazing to me, talking to people who have six-figure incomes who are still running credit, they’re not saving money. Oftentimes, they’re actually having to go further into debt. And we’re talking six-figure types of incomes.
David: I looked at the chart recently published in the New York Times last week on income growth over the last 34 years, and you can see it. The consumer is unable to engage as a consumer without the use of credit. Because extra income doesn’t exist.
Kevin: They’re not saving.
David: They can’t save because they haven’t seen income growth. So you see, the inflation of the cost that they have, daily living expenses continue to rise, and their incomes aren’t keeping up with those increases. So how do you save? That’s the issue, isn’t it? So the only way that you can spend more is if it’s on credit. So yes, if there is no extra income, then there are no extra savings. Bankrate.com has 57 million people nationwide with zero savings. And that includes 32% of all 53-64-year-olds. Now keep that in mind. This is the group who is quickly coming toward retirement, and a third of all of those soon to retire have not a dollar in savings.
As we said earlier, the consumer is maxed out. You see it in car sales – they’re maxed out. Retail is struggling, as an indication that it is maxed out. Real estate affordability is at its worst and the Fed is now trying to raise rates, making that affordability, both the price and the cost of financing it, even less affordable. Add to that your increases in health care, other ancillary monthly expenses, and those pressing higher are squeezing the consumer further. It is interesting because you look at the Fed engineers and they simply can’t force the consumer to go hog-wild with discretionary income that doesn’t exist! It no longer exists.
Kevin: Dave, flying all that we have flown, it is amazing to me that just about every company – you’ve talked about retail companies only making money at this point, retail stores, by getting people to take out their credit cards and run up credit card debt. Every flight that I was on going to these various conferences, the various airlines were trying to sell you a credit card. That was where they were trying to make their money – that and charging for carry-on luggage. I found that out with one of the airlines. But it seems that credit card debt can’t go any higher. We’re already peaking. Aren’t we hitting all-time highs in credit card debt at this point?
David: I have this picture in my mind of an old movie with Eddie Murphy. He is begging for a sip of water, and they want to charge him for a cup. And he said, “Well, just pour it in my hand for a dime.” (laughs) They’ll charge you for anything. And it is getting to that point when you travel. Yes, credit card debt inched to a fresh all-time high in recent months, and what it indicates to me is that households are filling an income gap by necessity.
Kevin: And that’s not it. There are auto loans, student loans – they’re all up there as far as record numbers.
David: We’re reaching the outer limits of what you can do there. Student and auto loans have reached records and they are now facing problems. For instance, 44 million Americans are carrying, collectively, 1.4 trillion dollars in student loans. And as I’m sure you can imagine, this inhibits first-time home-buying. As Fred Hickey has mentioned, there is a shocking 70% of young people under the age of 34 that have less than $1,000 saved for a down payment on a home. So again, it’s kind of have one or the other. Student loans sort of preclude your ability to dream, imagine, or even get in line for a home. We have 107 million people who are carrying – talking about student loans – an average of $31,000 on a car loan. And you have the number of 90-day plus delinquencies in the sub-prime category rapidly passing six million people. That’s according to the Federal Reserve Bank of New York. What was a small market is no longer a small market. Subprime auto loans were a 2.5 billion dollar annual market, and that was 2009. Now it’s 25 billion dollars a year in the subprime auto loan market. It’s ten times the scale in less than ten years.
Kevin: And Dave, they can actually mask that a little bit because if a person can’t pay their loan, instead of it being a three-year loan, it becomes a four, or a five, or six.
David: So you have stuff that is way beyond that that the average is now 69 months to finance. So when you bring in the last buyer in any market, and we’re going to define the last buyer as the marginal buyer, guess what? It’s time for the trend to change.
Kevin: But I’m going to go back to what I was saying. The stock market is hitting all-time highs, Dave, and just talking to people as we were on the road, most of the people that we talked to were in our camp. They were looking and saying, “We need to do something, and we need to do something before the fall.” If they had stocks, there was a nervousness there. But you talk to the general public, people who don’t come to these conferences, and they are going to argue with you. They’re going to say, “Hey, look, my stocks are doing just fine, and all of my friends’ stocks are doing fine, as well.”
David: Some of these points are counter-intuitive. For instance, Charlie Blayo tweeted last week that we’ve just hit our 33rd all-time high of the year in the major indexes. Again, that’s great news, right? We’re hitting all-time highs. It’s happening over and over and over again. This is a great sort of bullish market jump drumbeat, correct? But there was one other time that we had 33 increases and new all-time highs ever, and that was 1929, which I find very interesting. Again, it’s a little bit counter-intuitive, but sometimes you get the very best news at the end of a market cycle. Where does a market peak? A market peaks at a very high level. In other words, your last input is your best input.
Kevin: Well, it’s the most optimistic, and it’s the one that carries the most certainty of the future.
David: Right. The last positive input being your best input. What you have instead is the market minimizing the importance of a growing list of uncertainties, which are already numerous. And the course of each of these uncertainties is not clear. For instance, what is going to catalyze economic growth in the years ahead?
Kevin: Well, what if somebody says, “Well, Trump is going to get his tax cuts.”
David: Can he actually deliver on those tax cuts? Try this on for size. Evans from the Fed – he is suggesting that balance sheet reduction at the Federal Reserve can commence now. So stimulants, which gave us asset price inflation, and were intended to create that cascade effect from excess wealth to increased consumption, which in turn drives economic growth, we are to believe will not have a negative impact on prices when those same stimulants are removed. Think about that (laughs). It’s preposterous.
Kevin: So here’s a bunch of money and now we’re going to take it away, and we’re not going to have a different effect.
David: That’s right. So Michael Hartnett of Bank of America – he is Chief Economist, has done some good work over there – noted that central bank purchases have fallen from 350 billion in April to 300 billion in May, to 100 billion in June, and in our opinion, you just have to get ready for a show, a real fireworks show, because what has funded the financial largesse of the last several years is being tapered, and there will be a tantrum.
Kevin: So you have tapers, but you also have Janet Yellen actively saying, “We’re going to normalize rates.” We’ve heard this for years. We’ve seen little rate increases. How about normalization?
David: That’s just it. Historically, raising rates has acted as a brake on lending and other economic activity, but somehow this is not going to have a negative impact on markets today. Again, what I am saying is, I think we’re ready to roll. I think we’re ready to roll over. That characterizes where we are in the markets today, but the markets continue to minimize the importance of these uncertainties. There are no answers to the consequences of a rise in interest rates. There is a real concern – we had the most recent inflation numbers out – Neel Kashkari is out in two seconds saying, “Oh, see, that’s why we should not raise interest rates. We’re not quite ready yet.” Any reason to not raise them – and again, this is back and forth, speaking out of both sides of their mouth. “We will raise them – we’re not going to raise them – we will raise them – we’re not going to raise them.” This is one of those uncertainties the market it just flat ignoring.
Kevin: It has always bothered us, Dave, that they say, “Oh, well, we have to have 2% inflation.” That’s a little bit like saying, “We have to steal 2% of the buying power of your dollar every year so that we can see whether there is economic growth. But it is the indicator that they use to see whether the economy, itself, is growing. And according to them, it continues to disappoint.
David: Add that to the list of uncertainties. Right. Inflation continues to disappoint. That’s why Kashkari is instantly dovish. And what is it suggesting? That the Fed, in spite of its best efforts, can’t stoke enough economic activity to matter. Do you see what I mean? There are a few significant unanswered questions which the market has chosen to simply ignore.
By the way, it is not as if we think, you and I, or I think any common-sense American, that standard 2% inflation target is healthy. Even my kids recognize it as theft. You take a penny or two from others, and the general public seems not to care. Take the whole dollar and now people squeal like pigs. But in principle, it’s the same thing. It doesn’t matter if it is a threshold of two cents, five cents, ten cents, or the full dollar. It is all still theft. And they think they’re legitimized in doing it because it’s “normal monetary policy.”
Kevin: Well, I’m going to shift then, because we’re seeing that the Federal Reserve has been relatively, if not massively, ineffective with the amount of money that they have printed, and the low interest rates, but the hope that came into the market last November, at least into the market, was that the government would be able to do something about health care, do something about taxes, do something about the economy and infrastructure spending. But whether a person voted for Trump or not, I’ve never seen a president so attacked, as far as the press goes. He has been vilified, Dave, so the Beltway is probably not going to say this.
David: Right. So the markets gave him a free pass. We went from 18,000 to 22,000 since November, and it was on the basis of new ideas, it was on the basis of him coming in to drain the swamp, it was on the basis of him coming in to cut taxes, and thus, stoke the economy.
Kevin: Call it the Trump rally, yes.
David: But this is the challenge. What he is discovering is the high levels of dysfunction which have always existed in the Beltway. And I don’t think they have gotten any better. In fact, they may have gotten worse since he has gotten there, with the daily ups and downs, including McConnell stone-walling on the Obamacare repeal and replace effort, because the constant mainstream media barrage of attacks on Trump, which from the media’s perspective, makes him the most vilified president in history.
I think to describe the White House interaction with the Senate, with the House, and even with its own staff as anything other than dysfunctional, would be to miss the fact that his agenda is very effectively being sabotaged by petty concerns which look like they’re multiplying faster than rabbits. And the positive market contribution has been the idea that, yes, he is going to bring significant tax cuts. That is going to gin up economic activity. I stand back, you stand back, we compare notes with others, even those living in D.C., and does it look like everyone in D.C. is going to play ball with the Trump administration on anything?
Kevin: Oh, it’s amazing. And all we have been talking about so far is the Federal Reserve, the U.S. Federal Reserve, and the U.S. government. Look at international relations, Dave.
David: Well, sure, but this is just one more point. The political dysfunction here in the United States is completely ignored by the markets as if, “No, everything’s fine. He’s still going to be able to deliver on time and under budget.” You’re right, international relations issues all but ignored by the markets – Iran, North Korea, complex changes in the Middle East, pressures in Europe – if I take all of these or any one of them, I conclude that from an insurance standpoint, if you want to create a hedge against calamity, gold makes more sense today. It makes sense like few other times in history, again, because you have the international relations deterioration, domestic political dysfunction, interest rate normalization, or if they fail and can’t do it, a fast track to negative rates – again, if raising them fails – a stock market that is ill-prepared today – again, you look at VIX and you look at other levels of complacency – most investors are not ready for even a normal 20% correction, let alone the more likely 40-50% decline that we expect as soon as this fall. And gold is marching ever closer to 1300, and I think we will take out that number the next few months.
Kevin: And so there is this ignorance, Dave, of any kind of risk, and some of the top market practitioners that we’ve talked to over the last six to seven months have said that there is just absolutely no price discovery in the market at all. That price discovery, of course, is being covered over by government intervention, central bank intervention, and so what it does is, it removes the threat.
What it makes me think of is, my daughter has an electric stove, and we have a gas stove. So when I stayed with my daughter at one of these conferences down in Scottsdale I had just used the burner. Well, there is no real sign that there is a risk after you turn that burner off. You know, it’s one of those flat-top stoves. And I had to remind myself over and over that there was still a risk of being burned even though there was absolutely no flame. The risk of being burned on my own stove is a flame.
David: There is no cognizance of that in the financial markets today, and when I say investors today are ill prepared this is not just in the United States, it is around the world. They are ill-prepared for a correction. Look, investors across the globe are simply ignoring risk. Increased risk-taking is always indicative of a late cycle issue. Ignoring risk is never wise, but particularly the later you get into one of these cycles. Italian junk bonds now yield less than U.S. treasuries.
Kevin: Italian junk bonds. Now, Italian government bonds – government bonds used to be a joke, Dave, because you couldn’t trade them without sitting down with the family.
David: The government currency before it became a part of the euro was a joke.
Kevin: Yes.
David: Italian finance – everyone knows that they know how to celebrate life and fix fabulous family feasts. But the reality is, they don’t know how to manage their budget, and that shows up in the way that the markets price debt. Except now because Italian debt would say, “No, there is more risk in the U.S. bond market than there is in the Italian market.” That’s preposterous.
Kevin: Well, it’s crazy, Dave. If you were going to tell a bond joke to somebody, what would you say? It’s a little bit like telling a real estate joke.
David: (laughs)
Kevin: You say swamp land in Florida right off the bat, right? Well, a bond joke would always be told with Italian bonds. Now, what we’re saying is, Italian bonds are at least pricing themselves in the market as safer than U.S. treasuries.
David: Right. We’ve lost our reference points. We referenced the ten-year German bund and the Bank of America European junk bond index as we traveled up and down the West Coast and we were talking about yields being disproportionately low in the junk paper debt. And that was before the Italian junk bond market sunk below the U.S. treasury market. What does this tell you? Thanks to the ECB for the distortion in prices. But there are other consequences, because what happens is, all of your other central banks who would ordinarily buy government paper are now squeezed out of the market. The ECB has this massive footprint in the market. What does the Swiss National Bank do when yields in Europe are virtually nothing?
Kevin: What would normally be considered a very conservative banking community – the Swiss National Bank.
David: They are currently speculating in the U.S. stock market. They are buying U.S. stocks like there is no tomorrow. They have basically crowded themselves out of the market, and now are moving from fixed income as a preferred allocation within their portfolios to stocks. What is my point here? Adding risk late in the cycle – what could go wrong?
Kevin: Remember what Bookstaber talked about – systems change based on what is going on. That is that whole adaptability or complexity in a system. Well, the system, as it starts to recognize that there is no more risk, starts taking more risk without actually knowing it. That was his point from his first book.
David: So are we wrong in thinking that these risks are actually there? Are we in a brave new world where we are, as he might have said, fighting the last battle? Or is it fair to say that we can still learn something from the past, and that you do have a return to higher levels of volatility and a return to appreciation of credit risk? Or are we in the new period of time where these things simply don’t matter?
Kevin: Well, could it be the end of history? Because the end of history would basically tell us that at this point we have no consequence for our action. What in the world would be the problem with more debt if debt has no consequence?
David: Right. From a political standpoint I know what that book was about, The End of History, written by the guy from the Rand Corporation. But Robert Kagan’s response, The Return of History and the End of Dreams, I think, at least in terms of political instability, hit the nail on the head. You can go through a phase in time where you can convince yourself that all will be the equivalent of nirvana. But in fact, we see a cyclicality in all things, whether it is, again, political relationships, or ups and downs in the financial markets. So just because we don’t see any volatility today doesn’t mean we don’t have volatility tomorrow.
Kevin: Well, you’ve been bringing that up. We didn’t have volatility, but we’re starting to see an increase in volatility sneaking under the carpet right now.
David: No kidding. How about last week? Finally, some movement in the VIX. It was up 50% last week. A question for us all – will greater volatility be the theme of the third quarter? I would say, in all likelihood, yes. Another day or two of pressure like we saw last week, and you could have the bulls getting slaughtered with a very lengthy shift in market psychology. The VIX went from sub 10 to 15 in a matter of two days. In the fullness of time, it will triple or quadruple from those current levels. Again, indifference to risk has been a growing trend. I guess what we’re saying is, trends do reverse. So if you’re suffering from the problem of extrapolation, which is easy enough to do, and you say to yourself, “Low volatility means no volatility. Rising stock market means booming stock market forever.” Again, keep in mind what extrapolation is, and what the dangers are inherent to it.
Kevin: Well, and you know, there is something that is deceptive, and if you’re not really watching it, you can think that a lot of people are buying stocks as they hit new highs when, actually, the volume of buyers, when people are actually leaving the party, that has been happening the last few days.
David: Nine straight days on the lowest volume in years. So the Dow is rising, and yet on lower and lower volumes. The futures market, if you’re looking at the S&P E-minis contracts – lowest volume since 2001. And again, low volume, with a rise in price, is always suspicious because the crowd of buyers is getting thinned out. And just like we talked about the marginal buyer being the last buyer, you begin to look at those volume statistics and they do tell you about who is in line because you need a big fat long line to continue to drive prices higher.
Kevin: And when you have dropping volumes in the stock market and prices rising that is one thing, but these companies that are represented by these stocks, these are companies that actually have to have revenues, and when you have dropping revenues as well as dropping volumes and prices rising, you’re getting a double indicator.
David: And some would argue, “Well, look, you can see massive positive volume on the New York Stock Exchange because at these levels somebody has to be shorting the market and hedging positions,” and it is just not so. You look at the standard products that are used for shorting the market that have traded to billions of dollars, and they are a few hundred million dollars. And literally, there is no one shorting the market. So this idea that somehow you will see a nice pop in terms of a short covering frenzy – it can’t happen. Nobody is short. All the bears are dead. Well, except for the one that we know and love.
Kevin: Yes, there’s Doug Noland.
David: (laughs)
Kevin: I’m sure Doug Noland is champing at the bit at this point.
David: Absolutely. No, this is an absolutely fabulous and fascinating time to be in the market and shorting the market, but doing it intelligently in a way where you can engage, where there is pressure emerging and cracks beginning to spread, and disengage as and when the market moves higher and the Fed indicates that it will throw everything including the kitchen sink at the market. So you have to be able to strategically posture that way.
Kevin: And I think it would be worth repeating the difference between revenues and earnings, because you can gain the earnings simply by buying your stocks back with borrowed money, but the revenues of the company, say the Macys out there, and the Amazons, and the Apples, and you name it – the revenues have been dropping.
David: Yes, let’s say for earnings sake, let’s say I make a $100 and I have a 100 shares. Well, that’s a dollar per share. Pretty straightforward, right? But what if I buy back 50 of those shares? $100 earnings. Now I have $2 per share. It looks like I’ve increased my earnings 100%.
Kevin: Even if you haven’t sold a thing.
David: On a per-share basis. But what if, in fact, earnings were in decline, and I lowered my expectations, and then beat those expectations by a few pennies, to say, “We’re always winning, we’re always winning, we’re always winning?” And you try to distract and take people’s attention away from the fact that sales are down. You don’t have the same revenues that you had last year, the year before, and the year before that.
Take IBM as an example. We now have 21 sequential quarters of decline in revenue. How’s that for size? And who cares? You think, 21 disappointments on revenue for IBM, certainly their shares would suffer. “Oh, no. Oh, no. How naïve you are. That’s not how assets behave in the context of an asset price inflation induced by central banks around the world. You don’t have to make any money to succeed.”
Now, when the tide goes out, as Warren Buffet said, then you get to see which of the players have been swimming naked. And you’re going to find the executives at IBM – they populate the nudist colony. The reality is, you have a bunch of people who have been playing games with earnings and distracting from a significant decline in revenue. Price-to-revenue, if you take that as a ratio, last week for the S&P 500 it was the highest ratio we’ve seen in the history of the U.S. stock market.
Kevin: That’s called over-priced.
David: That reaches beyond the extremes that we saw in the year 2000. That reaches beyond the extremes that we saw in the year 2007. I repeat—revenues in decline, while prices climb higher. What could possibly go wrong? How many times does it need to be repeated? Earnings are gamed and manipulated constantly so that executives can get their bonuses. Revenues and sales – they tell the tale. And now you have all the data you need to be selling stocks right now.
Kevin: One thing that you’ve brought out, Dave, is that there is a small clustering of stocks that are pushing the major indexes up. But when you look at the broad index, when you look at the Russell 2000, there is a divergence. You don’t have the same kinds of gains that we see in these more clustered types of indexes.
David: Right. You compared the Russell 2000 small caps index and they led out of the gates. As Trump came in, again, a lot of enthusiasm and energy in the markets. Usually it is the small caps that, either at a cyclical market turn, or a business market turn, are the first out of the gates. Well, they’re also the first to turn down, oftentimes in lockstep with the financials, and we’ve got the small cap index today which is diverging massively from the Dow and the S&P, that is, the Dow and the S&P continue to move higher. Small caps are already selling off. What does it mean? That investors are already reining in on their speculative bets, and there is a broader market liquidation which is occurring and it is being masked by the big indexes which are being driven higher by a few big-name stocks, and by the ETF blind buying which is happening in the marketplace, which again gravitates toward the largest companies within those cap-weighted indexes.
Kevin: And of course, you have the high-frequency trading where the algorithms are all focusing on the same stocks. We could go on and on. Let’s go back to the way things are measured. We’ve talked about inflation being measured and that changes over time. One of the things that has changed dramatically over time is the way we measure employment and when unemployment looks bad with one index it seems that the government just starts looking at other indexes that might tell the story a little bit better. Last week I think they retired one of those plug-in indexes that they had been using – the LMCI.
David: The what? The LMCI? The what? It doesn’t exist anymore.
Kevin: In 2012, though, wasn’t it 2012 that they plugged that in because they liked it better than another one?
David: (laughs) It’s been around for a long time, long before 2012, but it has been sort of their internal measure. Listeners know that this has been the Fed’s internal employment gauge which has been considered by them a better indicator than U3 or U6 numbers. And this has been their preferred yardstick, preferred for years, but according to their recent release, it’s no longer a good summary of job market conditions. That’s what they say. Well, what’s wrong with it? What’s wrong with it is that it’s sending the wrong signal. It’s sending mixed and opposite signals to the accepted narrative, the story of labor market recovery. And amazingly, any number that doesn’t support the promoted narrative gets 86ed. For years we talked about the LMCI and how it has often sent a mixed signal to the market. Again, the employment number can be coming down, but the LMCI, the Labor Markets Conditions Index, is in fact pointing the other direction.
Kevin: But it was always used when it was more favorable for their story.
David: Right. But now they’re cleaning up the story altogether to say no incongruency, the propaganda tools need to be constructive, they need to be supportive, they need to be consistent. They need to be – well, and maybe this is harsh for us to say – but 100% bravo sierra.
I’ve told my youngest son who likes to push the boundaries in terms of language, “You can’t say B.S. anymore. You’re eight years old and I don’t want you saying B.S.”
Kevin: But he say can bravo sierra?
David: He can say bravo sierra. I’m okay with that. (laughs)
Kevin: (laughs) Well, Dave, we may have had the end of history. We may have had the end of consequences for debt. We may have the end of any kind of consequences for an economy that doesn’t restart. That is possible, but not probable. Let’s go ahead and go back to the way we started this program. It could be that the Fed has run out of bullets and we’re going to start seeing something change as early as the next couple of months.
David: Actual bullets? Yes. I think they are already out of them. But this is a little bit like the older brother game with the younger brother. I have a younger brother, and I know that my little brother can now kick my butt. The only bullets I have left in my arsenal are psychological bullets. If I can somehow bluff my way through, then maybe, just maybe, I won’t get my ribs broken again, (laughs), but that is a risk that I have to take. In terms of actual strength and wherewithal, I’m no longer a match for Scott. I’m not. And I think the reality is, the Fed is out of ammunition. If they choose to bluff the market, that is the best that they could hope for.
We could go on, but I think we’ve conveyed the point. Central bank asset purchases are shrinking. Margin debt numbers have begun to decline off of their peak, and that feeds a negative cycle of momentum to the downside in stock prices. We are maxed out. The equity market is ready to roll over. If you haven’t already, now would be a great time to raise cash, buy gold, get liquid, choose a good seat for the fireworks show because it’s getting ready to start.
