Podcast: Play in new window
- Hyman Minsky’s Financial Instability Hypothesis coming to you soon
- Gold hits record high levels in most currencies
- Group think & momentum – Forget accurate analysis to your own peril
- Minksy’s Instability Thesis: Click Here
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Delaying Panic With Hypnosis (Ponzi Finance)
May 27, 2020
Is there enough money running through the system? Is there enough velocity of dollars coming through the system such that we don’t end up with banks with a very large portfolio of boats and houses and office buildings and all kinds of things? I think it just points to how critical it is to have incentives aligned. Otherwise, you end up with operational imbalances and unhealthiness.
– David McAlvany
* * *
Kevin: Well, we had a three-day weekend, so I got a chance to do a little reading. And when we first moved down here, Dave, in 1992, Fort Lewis College is the college that we have here in town, and I would go down to the library at lunch or after work, and I would just pull books off the shelf that looked interesting, and I found one that was written in 1958 called Panic and Morale, and honestly, it was a book written by people who had been through major panic after World War II. These were doctors, psychologists. This was a conference that got together, and these were papers that had been presented, saying, Okay, this is how we dealt with a loss of morale and panic.
David: That sounds similar to my brother’s experience in Banda Aceh if you go back to December 2004 and the tsunami. He happened to be living in Indonesia at the time, and he hopped on a military transport to help the survivors of the tsunami. He was there two to three days before any medical help arrived, and the difference between hope and despair were just a few words of encouragement, and so morale, being something that can be very tenuous, and literally people lived or died on the basis of what they thought. And their ideas, the words that were presented to them, it was almost like they were in a hypnotic state where whatever was said, you’re not going to make it, and they were dead within hours, or you’re going to be just fine and against all odds, even with complete sepsis, they ended up being fine because of maintaining hope and holding on to a strong morale.
Kevin: That ties into the thesis of the book, they said good morale impedes panic, and poor or bad morale favors it. Just a couple of characteristics when people are in fear, they said that it’s sort of an infantile kind of reaction. They become children, and they either become paralyzed or they start having temper tantrums. When I look around me right now, that sort of seems to be on a minor scale, not necessarily a country being invaded scale or a big bomb going off, but I mean this COVID thing, people are either paralyzed or they’re having temper tantrums. There are very few people who are even keeled at this time.
David: This weekend, as we usually do during the summer months, we got out and did some rock climbing. And so the kids, we get to experience fear. They get to experience fear and we always talk through it like this is normal, what you’re feeling is very common. What you do with it next is your choice. And so, learning how to manage that versus going to that infantile place of paralysis and temper tantrums and panic. It really is interesting. I think these are things that if you have not learned how to handle fear, which is a total normal thing to experience, then you can be dominated by it.
Kevin: One last thing about this book, these doctors were talking that people who are in active fear are much easier to hypnotize. And one of the one of the topics of the book was how do we handle? Because they were talking about entire countries like France being invaded by Germany. How do you handle, with a mass treatment, how do you handle people? And they had two suggestions. One was hypnosis. The other is catharsis. And so I think as we look through these things, everyone has their opinion on the markets. They have their opinion on the debt. Obviously, everybody’s got their opinion on COVID-19 because I hear it all the time and we’re getting YouTubes and all that other stuff. But I think it’s important for us to do exactly what you do with the kids when you climb, and that is, you talk through it, talk through it and say, okay, now this is normal. How am I reacting at this time? Am I using factual information, or am I afraid of something that might happen in the future?
David: Clearly, key to the central bank community is managing perceptions. And if that is creating a success story in the context of the bond market and the stock market and rising values, that really does positively color people’s views of what is going on and what the ultimate outcomes will be.
Kevin: And as long as that keeps working…
David: Right, then it’s fine. You know, last week we commented on Moderna’s limited vaccine trial. The big bump last Monday, all equities were moving higher and Moderna had reported eight out of the 45 that were in the group for the trial. There were the additional 37, which the trial completely ignored. They didn’t give any comment to that at all. So they had great results, right? Talking about the eight. You could say that differently. 83% of the trial participants were not worth commenting on, and out of that, we got a great rally in the stock market.
Kevin: Okay, see the thing is, it goes back to money.
David: Well, it was particularly shady because right after the market closed, Moderna announces, and of course Moderna’s stock skyrocketed during the day on the sort of thin veneer of good news, but Moderna announced an additional $1.25 billion stock offering at the end of the day.
Kevin: It makes me wonder, though. Okay, Ponzi scheme thinking is, you know, and I hate to say it, but there’s an awful lot of, let’s say, multi-level businesses built on Ponzi scheme type of thinking where it’s like, okay, you too can be wealthy. But the problem is, it’s like a chain letter. That letter may work until it doesn’t, and when it doesn’t, what happens to morale and does it turn to panic?
David: Right, so the first in is usually the best off. The last in is what we would categorically call the bag holder. It was 28 years ago this month, so May of 1992, that Hyman Minsky wrote his instability thesis.
Kevin: The economist, yeah…
David: And so he wrote then that the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation amplifying system. The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable and financing regimes in which it is unstable. The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system. So, I mean, a lot of people would say, right, stability begets instability is kind of the thumbnail sketch of his instability thesis. But there’s Bard College on Levy Institute, 1992. We’re going to put the link to that if anyone’s interested in reading, and it’s not a long paper, but it’s worth reading from the standpoint of history. May, 28 years ago this month. This is what he was hatching, and it’s been a very, very important thesis.
Kevin: So does the Ponzi scheme, though, create a hypnosis that really doesn’t solve the problem. And, you know, we’re talking about hypnosis and morale, panic, that type of thing. I mean, if it could go for forever, then why wouldn’t we just do it?
David: Yeah, well, when you get to the last stage, where he describes his Ponzi financing, in the stage of Ponzi financing, systemic stability is ultra-sensitive to asset prices, and so you can’t tolerate any decline in asset prices. Crisis is always very close by because if you get anything of a downward shift in asset prices, it reveals the unsustainable nature of the Ponzi finance. So there’s the necessity of central bank interventions globally. We have that today. It’s tied to the nature of finance. In this stage of the business cycle, there’s too much leverage in the system to allow for price weakness. Otherwise, problems beget problems.
Kevin: I think the big problem there is that you have to create that stability or that sense of stability with debt that someday has to get paid.
David: And that’s exactly what happened in 2008 and 2009. Following the global financial crisis, the recovery was debt-financed. The recovery was dependent on a series of money printing commitments that they called QE. We’ve come to known it as quantitative easing, just that monetization, that’s all it is. But today too, also in this context, we have ample debt financing. We have another round of QE yet again. And these monetary and fiscal escapades, they’re necessary to avoid a collapse in asset prices. But as we’ve seen in the past, debt is both the cure, and it’s also the cause of financial instability.
Kevin: So in reality, the global central bankers who used to just be guys in the background, they really have become, they have to be, the guys in the foreground to continue to keep this Ponzi scheme going.
David: Well, right, as we have moved along in time, they have come from the basement to now they’re standing on the stage in the spotlights like rock stars. And so the more active the global central banks are in a concerted effort to reflate financial asset prices, the more suspect the value of each and every one of their individual currencies become.
Kevin: Look at last year. I mean, last year gold started hitting all-time highs in all the major currencies except for the dollar. And we’re close…
David: And even if you just did a one-year look at where gold was 365 days ago, we are talking about a 33% increase in US dollar terms and in some currencies even more. I mean, this is not magic. The price of gold moving higher in a dozen currencies reflects the fading confidence of constituents. This is global constituencies, these are savers and investors who are looking at the undertaking of the central bankers and beginning to say, is this really legitimate activity or just the necessary activity to kind of keep our morale engaged?
Kevin: And it’s not that they have a thousand different tools. I mean the playbook. It’s a little like watching checkers. Once you learn the rules of checkers, there aren’t many rules. There’s not a lot going on there.
David: Well, it’s right. I mean, so the playbook’s fairly transparent. The bad news? That’s the good news. The bad news is, the final outcomes are pretty clear as well. Because not all debt is created equal, some debts are more likely to be repaid, others never going to be repaid. That’s just the reality. When the Federal Reserve or other central planning organizations, when they sweep up and buy an asset class indiscriminately, there’s both good debts in the mix and bad debts in the mix. I’m thinking of the ETF purchases they’ve been making recently, so the bad lives on when in the normal course of events that debt would die. The system as a whole would be healthier for the purging of the batch.
But then so you’ve got this intervention. Intervention blurs the lines of natural market differentiation, and the market is always is separating out the good from the bad. And to following a major market intervention, the markets are no longer differentiating, it’s just one ginormous, singular bet. Very interesting right now because you’ve got the pocket of purchases that the Fed is making today, which is impacting ETFs and fixed income ETFs. But if you look at the CLO or CDO markets, this is where they don’t trade actively, but that’s where you’re beginning to see real problems. This is almost a repeat of what we had in 2008 and 2009. Structured financial products, which are very opaque, don’t trade easily. And it’s in this realm that all of a sudden, yes, there is a differentiation because, no, the Fed hasn’t figured out how to intervene and buy up that garbage too.
Kevin: Well, the only solution for the average investor who doesn’t know the good from the bad because it’s all being purchased by the Fed is to somehow exit the system. I mean, why in the world would you be sitting in a stock that would fail other than if the Fed had intervened?
David: It’s those investors who, in the end, are not making a financial bet. This is not an economic bet. This is a bet on political outcomes. It’s a bet on mass responsiveness to and perception of the viability of those interventions. So it really is a bet on, will this be a convincing morale booster, right? How do you assess the value of corporate credit today? It’s very easy. When you’re looking at individual issues, individual bond issues, you can assess the risks. How do you do that today?
Kevin: Dave, you’ve had to hire people to do that, even if it’s not necessary. See, we’ve gone through almost a decade where you didn’t have to assess the risk because the Fed was going to just come up and buy whatever. That’s actually been concentrated in the last 12 weeks, where they’re not just buying whatever, they’re buying everything.
David: Exactly. So can you assess the risks? It’s much more difficult today because the market is one bet and the bet is in the continuation of mass scale intervention to push prices higher to bring yields lower, and you should be able to tell which companies have a better balance sheet and which companies are thriving from an income standpoint and the ones that aren’t doing as well. It’ll show up in the price, but that’s not the case if the Fed is going to buy the LQD. If they’re going to buy investment grade bonds via an ETF. You know, so all of a sudden, investment grade debt, which ranges in composition from Triple B well into the As at the top of the scale in terms of credit. Look, in an age of Ponzi finance, all of it gets the same grade.
Kevin: Okay, so there’s different grades. When you go to grade school, there’s even grading on a curve. What the Fed is actually doing is flattening the curve. I mean literally, isn’t that the case? They have literally flattened the curve.
David: The other flattened curve. Yeah, there’s no differentiation of risk in the context of interventions. So you’ve got investment informed by company fundamentals. That falls apart with the bet, the speculation being that an unlimited amount of capital is going to flow and going to continue to support asset prices. And so the success of that project, if you think about it, is inherently circular. Why are we investing? Because the government’s going to intervene and the prices are going to go higher. And where do you get off of that wheel? You don’t.
Kevin: Dave, I have a microphone for the end of my trumpet, okay? And at Christmas sometimes I’ll bring the horn and will play for the Christmas Party.
David: Do you need a microphone at the end of a trumpet?
Kevin: (laughs) Oh, yeah, it’s never loud enough, never loud enough. But it’s really interesting because it’s hard to stand in front of any kind of speaker where that mic picks up feedback from the speaker and then it loops back through, and then it loops back through. And that’s where you get that huge, really high whining sound. I’m not talking about my playing here, that’s talking actually about a feedback loop with microphones. What you’re talking about here is really a feedback loop. This is what Minsky was talking about back in ’92, right?
David: That’s right. Well, I tell you, there’s been a couple of times where at our Christmas parties you’ve gotten up and played or somebody else in the office who plays the bass will get up and play and scrapple from the apple or what. I mean, it’s fantastic. You’re great. You’re a great player. So I wish everyone could enjoy listening to you, you’re very talented there. But you’ve got the inherent consequences of failure, which become greater over time. And it is like a negative feedback loop, and it requires a matched level of commitment. As things deteriorate, there has to be a matched level of commitment to continued interventions into the future. And once you are on the interventionist hamster wheel, there’s no getting off of it. Unless, of course, you’re comfortable flirting with debt deflation. And nobody, not in this circle. No, no, no, not in an age of neo-Keynesian PhD monetary management, that’s just not going to happen.
Kevin: Fed intervention reminds me a little bit of smoking, Dave, and I probably will offend some of the listeners here who may be lighting up as they’re listening, but I’ve never really understood when you look at the consequences of smoking and you watch how people end up dying because of it, why they do it?
David: (laughs) Can we create a carve out for a cigar here and there?
Kevin: Okay, All right. I didn’t mean to hit too close to home, but here’s the thing. Inflation is like that. Inflation is one of those delayed things where you go, okay, every time we light up and print some money, okay, we’re actually decreasing our life span of our currency by that much. Okay? And I’m thinking inflation is one of those things that you go, well, we’re not going to worry about that today. I need a smoke, you know?
David: Right, that’s right. Because there is this whole issue of presumption. They believe that they can bridle the inflationary stallion, so better attempt to rein in any inflationary consequences that come from propping up asset prices. We’ll deal with that later. Better to deal with reining in the inflationary stallion than dealing with the dead horse of deflation,
Kevin: Right, well, since the Great Depression of the 1930s, they’ve acted like deflation is the worst thing that could possibly happen on Earth to any human.
David: 1929 to 1933 was a period and left such a deep mark on the field of economics and finance that we continue to see practitioners organize their efforts around never going back to that kind of environment. It’s ingrained in some sort of a pain memory, and that’s the way they operate. So regardless of the cost to currency stability, that is a threat that most people do not understand. So it’s a future issue and a future concern that they’re willing to engage with, in part because most people don’t understand currency instability, don’t understand inflation and have a hard time measuring it in real time. Like you can, let’s say, the value of a stock portfolio or bond portfolio. If I said inflation today is 1.5% but your equity portfolio is up five, you wouldn’t know what I’m talking about in terms of inflation being up 1.5% but you can get a statement, you can go online and look at your stocks in the green, your bonds in the green, you say, well, I like that. I mean, so what are you managing? You are managing morale…
Kevin: And inflation is reported by the people who actually create the inflation. It’s a little bit like going to the cigarette companies and trying to figure out what the statistics are for death by cancer.
David: (laughs) The reality of inflation, you’re right, it can easily be obscured by manipulating the statistics, changing the variables, changing the weighting of various inputs in that to support whatever narrative is necessary for financial market stability.
Kevin: Okay, but we were talking about hypnosis. When people are fearful or trying to maintain morale. In a way, groupthink is a form of hypnosis, is it not? I mean, when you’re watching what somebody else is doing, and you know, if the Fed is going to continue to pump money in and all the guys that you play golf with or whatever, their stock portfolios are going up and they’re just laughing at you for worrying about inflation or the possibility of a collapse in the debt or the dollar.
David: Yeah, so at the value of a speculative environment from a central planner’s standpoint is that the judgment of price is replaced by a groupthink dynamic. And so all of a sudden, you’re just going along with everyone else and you must be right, because apparently momentum and price action are compelling, right? So you don’t have to ask any other questions. J.R. McCullogh—he was at, not the London School of Economics, but it was another school in London [University College London]. Economics professor, actually political economy is what they used to call it. It was the early 19th century, and he said in speculation, as in most other things, one individual derives confidence from another. Such a one purchases or sells not because he had any really accurate information as to the state of demand or supply, but because someone else has done so before him.
Kevin: I don’t want to overuse the analogy, but it’s similar to when teenagers start smoking. There is a peer pressure when you see other people doing it, and I’m just wondering if the markets don’t really amplify that.
David: But I think it’s more than peer pressure because you’re talking about almost something that feeds on itself, where a stampede, the dynamic ends up becoming something other than it was at the front end, and now it just takes on a life of its own.
Kevin: Well, you were talking about a feedback loop, and when we flew over the Mesa Verde fire, it was creating its own weather system. In fact, the Missionary Ridge fire was the same way. These fires, they get to be the size where they’re actually creating their own thunderstorms, which is actually creating more fires.
David: Right, Right. So you get market rallies which take on a life of their own, and it can happen on the other side as well in terms of market declines, but you end up in this kind of environment, prices go higher. And according to Bank of America at present, you get, of the 500 companies in the S&P 500 index, there are just five that make up over 20% of the entire index. So five are dominating.
Kevin: Out of 500 companies, you’ve got five that dominate the index. 20% of the index is five companies?
David: Over 20%. And you know, for comparison, in the year 2000, the number never exceeded 18%. And again that was the top five constituent parts. It was a little bit different in terms of who made that short list in 2000, but then in 2008, again, just prior to global financial crisis, the number never exceeded 15%. So you’ve got a concentration of names, concentration of energy and this positive dynamic where again, like a stampede like the Mesa Verde Fire, it’s taking on a life of its own. Higher concentrations in a few names covers the spectrum from, I mean this is everyone from individual investors to hedge funds. It’s regardless of market experience. Momentum begets momentum, and thus you have a Microsoft-Apple-Amazon-Alphabet-Facebook, which are the dominant themes in the market place.
Kevin: So we could possibly substitute groupthink for the word momentum…
David: Or groupthink for those five names.
Kevin: Yeah, well, there you go.
David: Well, the momentum charade, I mean, it continues at all costs, and that’s really what you have. This is where a savvy investor says you either get on board with the momentum charade, or you at least hedge your bets. And, you know, this is where I think you’re beginning to see intelligent investors say, this is why gold is already up. This is why gold has already begun to move because enough people have said, yeah, fine, so, you want to play the stock market and play the upside that’s great, but you better hedge the bets.
Kevin: Back when we started in 2008 with this program, Dave, you were even talking at that time that we’ve got sort of a blind spot in our adult lives. And that is, the only thing we’ve ever known is falling interest rates. That’s all we’ve known. I mean, I was a teenager when the interest rates were spiking up and early married, early twenties. You know, we paid 15% for our first mortgage, my wife and I, a little 550 ft2 condo, and we were paying 15% interest rates. But since then, since the early eighties, interest rates have been falling and we’ve been waiting for interest rates to come up and artificially now, they continue to fall. So my question would be, you know, the interest rate cycle you’ve brought out many times is about a 30 to 35 year cycle. Roughly, I think that’s right. So it’ll rise for about that and then it’ll fall for about that. We’re on the late, we’re late for dinner, basically, as far as the turn on the interest rate cycle, are we not?
David: Yeah, you know, this will date me, but Salomon Smith Barney, before they merged with Morgan Stanley, Salomon Smith Barney had a great technical team: Louise Yamada, Alan Shaw, they had probably some of the best chart work done in the industry. And they did a bunch of studies on interest rates, one of which was showing interest rate trends, the shortest of which was 22 years in length, longest of which was about 36 years. And so they would come up with an average of right around 28 to 30 years again, again, with the longest being something that now we’ve exceeded here in the year 2020. We started this trend in 1982. Rates have been coming down since then. We’re in the 38th year of declining interest rates. So if you look at that sort of historical perspective, if you look at a chart of interest rates, you’ll notice that one of the oddities, if you kind of focus in on the more recent years, one of the historical oddities of rates being kept virtually at zero from 2008 to 2015. You’ll never see that, not in interest rate history in the United States, not an interest rate history in any other country, but it basically flatlines between 2008 in 2015. Then you’ve got the Fed funds rate, which was finally lifted to a very low historical number of around 2.5%, that range between 2015 and 2018.
David: The increase, that little bump from 0 to 2.5-2.75%, the increase was sufficient to reveal just how far we are into the era of Ponzi finance.
Kevin: So my question is, can interest rates rise? With the amount of debt that we’ve accumulated, I mean, never in history in this 30, you said 38 years, never in history have we accumulated this kind of debt. We still have interest to pay on that if interest rises.
David: Well, the answer is yes and no. The outstanding quantity of data obligations is too large to allow for normalization of rates. If you go back to the fourth quarter of 2018, the market went into freefall. Fourth quarter of 2018, stocks fell 20% as a result of a marginal tightening of financial conditions. That is, as interest rates began to rise at the behest of Jerome Powell. And guess what happens? We start to see that, yes. No, Ponzi finance does not work. It doesn’t work unless rates continue to decline, right? So, yes, they should rise because that’s the nature of things. But no, they’re not going to be allowed to rise, and so they will continue to be pressured lower until market forces rip those controls from the hands of the monetary mandarins of our day.
Kevin: So the Fed continues to buy. I mean, the balance sheet is growing to what number at this point? We used to say four trillion was huge after the global financial crisis…
David: You know, it started to shrink to about 3.63 or 3.7 prior to this last little episode. And now, as of last week, we’ve surpassed seven trillion, 7.037. So just above seven trillion on its way to double digits. And you know Bloomberg is telling us that by year end 2021, if you’re looking at the G20 economies, that’s us and the other big boys, that’s an additional 13.1 trillion in debt that’s going to be added. This is a debt problem that’s not going to shrink. And this is one of the reasons why interest rates have to … because there’s no way we can or the G20 can afford an additional 13 trillion on top of the 40 trillion that we’ve added since the global financial crisis. We have direct asset purchases in the debt markets, in the investment grade markets, in the high yield markets, in the mortgage backed securities markets, in the Treasury markets and the stock market reflects today a disregard for the frailties built into the financial system. And today you’d say, okay, it’s indicating confidence that the Fed and the Treasury gambit that’s going to be a success. This is going to be a success.
Kevin: Okay, but if we feel like things are normal and they’re not, it seems to me like that’s the formula for panic right there.
David: But that’s Minsky’s wisdom, right? That’s what he said, distilled down to, the more normal things appear, the more likely crisis is near…
Kevin: That sounds like a Dr. Seuss line, doesn’t it?
David: (laughs) Obviously I still have kids. But the Fed this last week bought $1.5 billion in ETFs. And so, again, go back to your high yield your mortgage backed securities. If it trades in the form of an ETF, they were able to sort of smooth, create a smoothing effect and boost prices. Bring down yields. What is this? In the grand scheme of things, it’s an informal nationalization of the economy. New York Times, May 19th, quoted Luigi Zingales. He’s a professor of finance from the University of Chicago. He said the too-big-to-fail that existed for banks has now extended to a lot of other firms. He went on to say the Fed’s actions are far more sweeping, and it essentially propped up the entire financial markets with the bottomless ability to buy assets with freshly created money. That is our new reality.
Kevin: Well, and the new reality creates, you were talking about how it creates its own storm system, okay, and creates its own new reality. If I’m a speculator and I know for a fact that the Fed’s got everybody’s back, it’s going to change my behavior. You know, there are terms that are used for this, moral hazard. If you know you’re going to be bailed out, why in the world…when you were climbing Dave with the kids, if you guys knew that you were roped in and you had a pad underneath you, you’re going to behave very, very differently than if you have no rope and you have no pad.
David: Right. In any organization, whether it’s a family, a company or a nation, having incentives aligned is critical to the balance and operational health of that group. And you may think, on the surface, you’re doing something that’s really smart when in fact you’re warping or twisting an incentive or misaligning various groups within an organization. And now all of a sudden you can create conflict. Whereas you might have been trying to do the right thing, but you end up creating conflict and chaos. When there is a less-than-thoughtful appraisal, in terms of incentive alignment, unhealthy behavior emerges. In the markets, you’re right, that’s what we refer to as moral hazard. And we had a fascinating example of this over the weekend, over the long weekend, with our kids. So our pine trees drop cones like crazy, and I don’t know if you’ve ever been running through the grass barefoot and hit one of those things…
David: (laughs) They are sharp.
David: So we asked the kids to help pick them up, and we created a little competition out of it. We said a penny apiece for pinecones, and, you know, we knew they were going to make a couple bucks each. And I mean, there was a lot of pinecones out there, and they keep on falling. Then we said that sticks needed to be picked up too, and that was a mistake.
Kevin: So you were paying for sticks as well?
David: That was a mistake. Because have you ever seen one stick turned into 15?
Kevin: Ah, yes, a moral hazard. The behavior changed.
David: That’s right. So incentives were created that fostered a backyard derivative product play. They took one product and turned it into 10 or 15 and we paid for it. Granted, it was only pennies, but it was fascinating to watch nonetheless. We created an incentive and they changed, very cleverly. They said, okay, we can do that. We’ll get you the sticks.
Kevin: You know, and not to be insensitive to the people who have lost their jobs, my wife and I had our 37th anniversary on Thursday. Where you and I meet, well, we went down to pick up our meal because we decided we’re going to have the whole shebang for the anniversary. And the people who were working, we recognize, it was very exciting to see them again. You know, it’s been a couple of months. They brought us out our food. They had a little tent set up, but actually, they told us that they were making less than the other employees in the restaurant that were on unemployment. They weren’t complaining, but it was ironic that they were working and the ones who weren’t there at the time were actually making more, and, you know, again, I’m not trying to take anything away from these people. We love them. But how in the world does that not create moral hazard or a change of incentives over time?
David: Yeah, I mentioned the restaurant owner last week in the commentary from Arizona who was struggling with that problem, and this is a misalignment of incentives. Economists from the University of Chicago, a whole group of them, put some numbers to it, calculated that 68% of unemployed workers in the U.S. are eligible for payments that are greater than their lost wages. Right? So on average, the benefits are running at 134% of the workers’ original weekly salary, so they’re being paid like an extra third to not come to work, right? So if anyone is counting on the U.S. Workforce sort of getting back to work quickly, there might be a reason that it doesn’t. So how do you spell extended summer vacation?
What’s really interesting about this is if the economy…they have an incentive to not get back to work, right, and that’s a totally separate issue as to whether or not, you know, mayors and governors are allowing it. But there’s a reason for them not to. And where this comes up against real hard numbers is your 90-day forbearance by a lot of banks who basically said, look, whether it’s mortgages, commercial mortgages or home mortgages or credit card payments we’re willing to just wait and not require anything, we’re not going to take any actions for 90 days. Well, guess what? The unemployment benefits are going to bump us up against that, and now all of a sudden it’s a question of is there enough money running through the system? Is there enough velocity of dollars coming through the system such that we don’t end up with banks with a very large portfolio of boats and houses and office buildings and all kinds of things? I think it just points to how critical it is to have incentives aligned. Otherwise, you end up with operational imbalances and unhealthiness.
Kevin: Well, we’ve been talking about normal, and if normal is normal, and, you know, things are paying for themselves, that’s one thing. But if it is artificial, and at some point it’s going to end, that goes back to this book Morale and Panic. Okay, panic occurs when something that is normal is no longer normal and you’re threatened. And, you know, we talked again earlier about how the reaction is either paralysis or a temper tantrum. But it’s an infantile state. We have another wave coming, Dave, I was just reading Bill King’s letter, and July is the wave that we probably ought to be looking for the wave of companies that we have known all of our lives are going to be declaring bankruptcy. Okay, as you start to run out of this. Like you said, the 90-day period or whatever period it is, anything that’s artificial ultimately will be shaken away.
David: Central bank asset purchases, what are they doing? They’re taking rates lower, and it’s created an incentive. Again, the proper incentives are being undone and misaligned. Debt issuance from corporate America has exploded again, with corporations getting as much capital as they can, while the Fed is loosening financial conditions and creating artificial demand for paper. So again, before they step in and start buying ETFs, everybody who was not going to get a loan couldn’t access the financial markets because of a tightening of financial conditions now all of a sudden can get the money they need. And I’m not saying, look, there’s good businesses that should stay alive. But there’s also businesses that were on lifeline to begin with, and this is where again there is a certain unspeakable and politically incorrect brutality to the capitalist system, and this is what Schumpeter was describing in terms of creative destruction. It’s okay for some people to fail because it does, in fact, create a process of regeneration within the business community. It allows for new ideas to flourish and eliminate stagnation.
Kevin: And, you know, just to use the Durango example, when we moved here, we love the hummingbirds. My wife hangs flower baskets up and the hummingbirds come. But if you keep a hummingbird feeder out past a certain date, it becomes cruel because that hummingbird won’t migrate. That hummingbird will keep coming back and eating. And ultimately, you are dooming that hummingbird to an early death because they will not leave for winter. And so, in a weird way, this artificial supply flowing in reminds me of keeping the hummingbird feeder there when you know you shouldn’t have it there.
David: Well, it’s artificial demand from the Fed which allows for an extra artificial supply to come to the market from corporations that shouldn’t be getting their debt needs taken care of. So the asset purchase program, just like lowering rates creates a perverse incentive to increase balance sheet liabilities. And that’s exactly what you see. If you look at your small to medium size businesses, take the Russell 2000, these are not as large as the S&P 500 companies. It’s not as large as your Dow Jones industrial companies. These are again sort of your smaller medium size enterprises. If you look at their debt compared to earnings, specifically EBITDA (earnings before interest, tax, depreciation and amortization), very typically, if you look back over 20-30 year period, it will be 1 to 1.5 times. Debt will be 1 to 1.5 times EBITDA. Now it’s three times. So it’s the corporate version of cleverly increasing the stick count. They can do what my kids did. It’s just no big deal. They are incentivized to add debt, incentivized to! Reuters last week covered the companies which are issuing debt, these are riskier names that weren’t going to get debt and then all of a sudden, Fed starts buying ETFs and those who couldn’t raise any money in the markets all of a sudden could. And just since, just in the last 30 days, a lot of those bonds are already trading at 80 cents on the dollar.
Kevin: Wow, in that short period of time.
David: Yeah, so who gave them money? The people who gave them money were investors that presumes that the Fed was buying, so they should too.
Kevin: It’s hard to believe, Dave, that it’s been about a month since West Texas Intermediate crude oil actually went negative. That was an incredible period of time. It doesn’t feel like it’s been a month, but now we’ve got the June contract coming, and we talked a little bit about that this week. But oil? Let’s talk about oil just for a bit.
David: Yeah, I mean, you could cluster these together and say something’s going on. That’s not particularly healthy when you have negative oil, negative rates and negative GDP growth. But it’s been about a month. We managed to avoid the same events for the June contract. In that month’s time, 20+ exchange traded funds, these are energy related financial products, have either started the death spiral, reverse splits or they’ve been delisted already. And this is an example. This is an example of a deflationary many collapse even as the rest of the world marches on without skipping a beat.
Someone who owned those assets again, all 20 of those ETFs, and we’re not talking about huge money, but those products had anywhere from 50 to $250 million in them each, and they’re gone or shrinking again according to the reverse split and death spiral. That’s usually an indication of things to come. It’s like getting a negative cancer diagnosis, a reverse split is never good. So you’ve got selective asset price implosion and it tied directly to derivative market dependencies. And I think that’s a really key thing for us to, as an organization, any of our listeners to as well understand an asset prices interconnectedness to the derivatives market. And to the degree that there is an interconnectivity or dependence on the derivatives market, you need to understand that’s going to play into that asset class’s volatility and any behavioral anomalies going forward.
Kevin: Okay, but let’s go back to the interest rates because they have been falling all of our adult life, and interest rates, if they continue to fall and if borrowing money is easy, like you were talking about corporate debt, government debt, what have you, then that’s just fine. But interest is a measure of fear of the future, okay, or risk if you don’t want to talk about being fearful. If we’ve eliminated risk completely, then interest rates can stay down. But it sounds to me like risk is everywhere. It’s just being artificially covered, and we’re being hypnotized with rising markets. So what happens? What happens when interest rates rise?
David: Yeah, this is a little bit like me giving Skittles to the kids before they go climbing. There’s a different kind of energy when they hit the rocks and they feel like they’re indomitable. They feel like they’re supermen…
Kevin: But they can’t eat it all the time. You couldn’t give them three meals a day of skittles.
David: No, no, no. And that’s actually not my primary tool. But there can be some, again we’re back to that word incentives.
Kevin: Yeah, there you go.
David: There can be some incentives. I love what the guys at Epsilon theory said. It relates to interest rates. Ultimately, interest rates are financial gravity. I love the way they say that: “Interest rates are financial gravity. When rates are high and gravity is strong, valuation multiples collapse. When rates are low and gravity is weak everything floats.” And the longest duration stuff either falls or floats the most. They’re talking about, you know, being way out on the interest rate curve. But what I like about that quote is a suggestion that when gravity is suspended, since when you get abnormal behavior. That’s what emerges. And you know. Then, of course, yes, you’re ignoring the laws of nature at your peril but everybody is doing it, right?
Kevin: Right.
David: 10 years ago, the 30-year Treasury was at 4.5%. Okay, 10 years ago, 4.5%. 5 years ago, it was sitting at 3%. On March 9th of this year, the 30 year was priced to yield less than 1%.
Kevin: Could we go negative?
David: This comes at the end of a 38-year decline in rates. Less than zero is an option, yet you listen to Jay Powell and he says it’s not a consideration today. But we live in an era where the powers that be want everything to float. They want everything to float, and they prefer that weaker gravitational force. Forever. Not just now, not just tomorrow, but forever. That’s what they prefer.
Kevin: Wile E. Coyote also wanted everything to continue to float. If I remember right in the road runner, ultimately gravity caught up.
David: It worked well for that split second before he could turn his head to the camera, and you could see his eyes pop out of his head just before he made…
Kevin: The fall. Beep-beep.
David: Yeah. Well, I read this weekend in The Economist that are our weekly commentary guest Carmen Reinhart was just selected for the chief economist role at the World Bank. Congratulations to her. I think what she’d say here is that suspending the gravitational forces in the markets, floating all assets higher, as she would describe it, that is a part of financial repression, which is a policy choice. It’s a policy choice to select winners and losers. This is not by accident that we find ourselves near zero or even negative in rates. For the first time, the Bank of England, in their history, this is a 300 and…I don’t know, 40-something year history, they’re considering negative rates. Bank of England is not working with a lot of evidence here that negative rates actually generate economic activity, but that may not be the point. Maybe it’s gravity that they’re playing with, and not economic activity. If we go back to Minsky, if we go back to what he said in May of 1992 on that paper, which we know as the instability thesis, he said, in particular, “the much greater participation of national governments in assuring that finance does not degenerate, as in the 1929 to 1933 period, means that downside vulnerability of aggregate profit flows has been much diminished, however…”
Kevin: At what cost?
David: Exactly, “however, the same interventions may well induce a greater degree of upside inflationary bias in the economy.” So we have Bloomberg last week that reports that some of the world’s most prominent investors are raising alarm bells over the looming threat of inflation and are turning to gold for protection.
Kevin: So the surprise, the cost, is inflation.
David: And Bloomberg last week reported the same. They said some of the world’s most prominent investors are raising alarm bells over the looming threat of inflation and are turning to gold for protection. Our question is, still, should you be doing the same?
