The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“They’re tipping the scales right now toward there being class warfare. What everyone seems to be ignoring is the fact that central bankers are exaggerating the trends of rich and poor via their monetary policy. This is not the rich getting richer of their own merits. Do you know what they’re doing? They’re living off the fat of the land, and the fat of the land is actually monetary largesse.”
– David McAlvany
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Kevin: David, it’s good to have you back. I saw the pictures and it seemed possible that you weren’t coming back (laughs).
David: Well, you know, swimming with sharks is not all that dangerous as long as you watch the sharks very carefully. What I learned in Hawaii is that sharks behave a lot like dogs, and you can watch their body language and tell when it is, in fact, time to get out of the water.
Kevin: Yeah, I saw the picture with the one shark, but then later I saw a picture with four. Now, just as with dogs, one dog you can handle, but when they group up, when they pack up, it’s a little different, isn’t it?
David: The constant triangulation of trying to figure out where they are – where they are now – where they are now – as they constantly move, certainly added to some stress and strain.
Kevin: Right.
David: But it was a successful hunting trip – I say hunting because we were spear fishing – and we had delightful dishes of Ono and Mahi-Mahi night after night after night, after we had been spear fishing.
Kevin: And for the listeners who didn’t hear last week’s program, David and Don got a chance to just sit and talk and philosophize about the world, and we have that captured on last week’s Commentary. You know, we got a lot of great comments after that Commentary, Dave. You should do that more often.
David: Hawaii is a place where we can meet with my parents a little easier. It’s not that easy – my dad turned 75 this year, he probably wouldn’t want anyone to know that, but…
Kevin: He doesn’t look 75.
David: So traveling six time zones versus 12 time zones to gather and meet and spend time with him is actually quite a bit different. So, meeting somewhere in the middle of the Pacific makes sense since they are permanently located there in the Philippines. I will get to see them in August. I was invited to speak at an economics conference in Singapore, so we will see them in Singapore and in the Philippines.
Kevin: Dave, before we get started, then, on all of this, because I know you are going to see them again, something was edited out of last week’s show that I think you need to talk about.
David: (laughs)
Kevin: Because the idea of a storm warning was part of the show, and while you guys were recording, and of course, the listener didn’t get a chance to hear this, but while you were recording, apparently there was a tsunami warning that was not just a test, was it?
David: Well, the siren went off, and we looked at each other as we were recording, and of course, this was, as you mentioned, edited out, but we looked at each other and thought, “We’ve got the largest south swell the Island has seen all year long, there is a tsunami warning, and it’s probably the better part of wisdom to load in the car and move since we are right on the water.” So, we did that, and we got out of town, stopped at one place and said, “You know, there doesn’t seem to be very many people moving, or moving as if they are concerned. What’s the deal with the tsunami warning?” And they said, “Oh well, you know, it’s the first of the month, not to worry, they always check the equipment on the first of the month.” And they said, “Nobody pays attention to it.”
Kevin: Okay, so it was something that was expected if you were a local.
David: Exactly.
Kevin: But what was funny was, you guys were talking about storms, and concern, and you know, “The prudent see danger and take action.”
David: Well, and so this alarm goes off and we look at each other and like, “This is just flat strange.” So we took the kids and got ice cream, had our ice cream, and then went back and finished the recording. All of that was, again, sort of nicely edited out, but that’s what actually happened. And that interesting piece about Hilo, which is on the other side of the island from Kailua-Kona getting hit by a tsunami on April 1st, which was the first of the month, and you are supposed to be able to ignore those warnings, but on top of that, of course, it being April Fool’s Day, everyone thought it was a joke that it just kept on going off.
Kevin: I remember you guys talking about that. It’s just so easy to start to become comfortable with what people call the new norm.
David: And that’s about when problems arise is when you can write it off, ignore it, no longer take it seriously. I’ve seen many people say, if you get the timing right, you’re just right, and if you get the timing wrong, you’re just wrong. I think, quite frankly, there are reasons to maintain insurance policies regardless of whether you are in head-on collisions, or your health is falling to pieces, because things happen, and sometimes they happen on an unexpected basis.
Kevin: And I think it’s important to point out, because oftentimes you and your dad talk about some of the concerns worldwide, but you don’t live your life in fear. I think back to your spear-hunting, the spear-fishing that you were doing. You could have been in a fearful situation, but actually, well-managed, it’s actually an exhilarating situation, right?
David: It feels a lot like trading that we do for our clients on the Wealth Management Platform. There are certainly things to fear that can create anxiety, there is the need for mental and emotional control, and there are environmental issues which can certainly raise your heart rate. There are a lot of things to keep in mind and bear in mind, but you have one focused objective. So, actually, I enjoy it, in part because it is similar to what I do every day, but it is also very, very different, and I cannot think about anything that I do every day in the world of investing when I’m there because it requires 100% focus. To dive 70-80 feet without a tank, keep your calm, line up a decent shot on a 40-50 pound fish, and then fight the fish – (laughs) it’s what I enjoy doing.
Kevin: (laughs) And you know, you enjoy, from the aspect of vacation, going ahead and doing things like that. But you really dig in, too, and study for the next economic adventure, and I know that you are going to be speaking for the Hayek group here this week and you have been preparing for that. I would like to talk a little bit about that, because Hayek is not someone who is talked about much in the schools anymore. Keynes, his counterpart, is. But Hayek is almost dismissed even though he is a Nobel Prize winner, isn’t he?
David: During the first world war, Keynes and Hayek were contemporaries and writing about the same issues at the same time. Bertrand Russell once said that there was one person that he simply would not debate with, because he was afraid of what would happen, and that was with John Maynard Keynes. And I explained this to my kids that it is interesting that both of these men had good minds and they wrote well.
Kevin: And Hayek was happy to debate John Maynard Keynes.
David: Absolutely, and Hayek actually won the Nobel Prize in 1974, the Nobel Prize in Economics. This is a man of high respect in the field of economics, but it is interesting how few in the field, and certainly just outside the field, even know who he is. And so, required reading in the McAlvany household is The Road to Serfdom.
Kevin: That is an all-time classic.
David: My kids looked at it and said, “Serfdom. What is serfdom?” I said, “Well, it is slavery.” What are the many steps that you take to ultimately arrive at being a slave? And I have asked them, “Would you want to be a slave? Knowing what you know of Greek and Roman history, would you want to be a slave?” They said, “No.” “Well, then what are the steps that you want to avoid to not inadvertently arrive at being in some form of soft or hard slavery?” And his book does a marvelous job of that.
When I was in college I was a teacher’s assistant for U.S. History. I had an hour each week to teach and give my own assignments in addition to what was there for the U.S. History class, and The Road to Serfdom was one of the things that I had as required reading (laughs). No one liked it because they didn’t like the extra work, but I thought this was an opportunity for people to be exposed to something that, in terms of public policy, is very important. When you are looking at issues of public policy, and you don’t connect where a particular choice, a particular piece of legislation takes you in the future, you are failing to see the gravity of that particular piece of legislation.
The steps that you take toward serfdom are the most important steps, because by the time you arrive in that state of slavery, there is very little that you can do. You have already abdicated power, and so, you really do need to mind the Ps and Qs, so to say, watch the steps that you take, to avoid that. You and I have re-read Jacques Rueff and his book, The Monetary Sin of the West. I have read it so many times I feel like I can almost imagine having had conversations with Rueff.
Kevin: Yeah, you know, I feel the same way. It is almost as if we have interviewed him on the program, but he has been dead for a long time.
David: Right, and the same with Hayek, getting ready for the speech this week in Reno, Nevada for the Hayek Society, I thought, “I know this man well. No, I don’t know this man well.”
Kevin: But you grew up with him, I mean, literally, reading him.
David: Right, and if you looked in the margins of my copy of the book, The Road to Serfdom, there is a conversation. There is, at points where I disagree, combat (laughs) – verbal combat – and points where it just makes great intuitive sense – his conclusions.
Kevin: You bring up serfdom and slavery. There are multiple ways to be a slave. One can be a slave to debt. You can get so far into debt that you can’t find your way out, and you can be a slave to whatever tyrannical government or fascist government that you are under, as well. I think about how we don’t want to be slaves, but we want to look at who are our masters. If we’re in a country that has too much debt, that government is going to do everything possible to stay in power. If that means more debt – and I think of Larry Lindsay’s quote, he said, “Because the government will not voluntarily let itself go out of business it will use all of its powers. I’m not talking about just our government, but any government will use all of its powers in order to fund itself. Not only will it use its powers to fund itself, but it will use its power to control and manipulate the perception of the people.” Dave, I’m thinking of the jobs report for May.
David: Absolutely. And it was impressive on the surface, at least. At 280,000 jobs for May, what I found curious, and you probably get tired of my saying this, but what I found curious was the 213,000 jobs which were infused via the birth/death model.
Kevin: Which is a made-up number.
David: Right. Well, I mean, it is a helpful number in this case because if you netted out the birth/death-modeled input you would have had a 67,000 job gain instead of a 280,000 job gain. And what is interesting is just where creativity can take you. When you begin to create out of nothing, jobs ex nihilo, do you know that you’re doing? Again, this is where the science of statistics becomes art, a real art form, because those numbers have been assigned to a category.
For instance, you have fictitious jobs which are assigned to the hospitality segment. You have fictitious jobs that are assigned to the manufacturing segment. And there are actually some hospitality jobs that were created, and some manufacturing jobs which were created, but the BD model, the birth/death model, tells you what the statistic should be and then you have to recategorize and shuffle them around. And I am fascinated how those determinations are made. I don’t know, I would love to be a fly on the wall, because I wonder if there are guidelines for believability.
For instance, let’s say the Wall Street Journal, the New York Times, etc., are running headlines showing massive layoffs. In those months where there are headlines, do you need to back off the birth/death model jobs that are then being assigned to save the manufacturing category? Again, just looking at the measure of believability, you can make this stuff up, but you have to sort of keep it under the guise of believability so you can’t have too many in this category. I just want to know who is calling those shots.
Kevin: Right.
David: And if there is an actual protocol.
Kevin: Is somebody behind the curtain? You know, I have thought in the past of making a bumper sticker that says, “If the jobs numbers are so great, why don’t I have a job?” There are a lot of people out there scratching their heads, saying, “We’re being told there is a recovery, yet I’m not making my bills. I am spending savings.” It’s not just retired people. We have talked about the retired people for years. Now it is people who actually go to work and work two or three jobs. They are still wondering what is going on.
David: One of the things that seemed a little lumpy to me from last month to this month in terms of the jobs numbers, the vast majority of jobs created for April were for the 55 year and older crowd. Listen to this: 139% of the jobs gained.
Kevin: Were people above 55 years old.
David: Right, and you say, “How could that be? I thought you could have only 100%.” Well, no, actually, 139% of the jobs created in the month of April were from the 55 and over crowd, and then this month, May, 82% came from the 20-24 segment. And again, it seems very lumpy. It seems at the edge, or just beyond the edge, of believability.
Kevin: A little bit of that might be credible because of summer jobs.
David: Well, right. So, if you are a young person in between high school and college age and looking for just a short-term summer job, you’re right, that does make sense. I just want to know, again, who is directing these numbers? And the reality is, you can make this stuff up, and if people will simply believe it, then who cares whether it is true or not? It is a working way of keeping the people going. We talked a little bit about that last week, my dad and I did, in terms of the Orwellian use of language. If people believe it, move on down the line – perpetual war, perpetual peace – as long as it keeps the people engaged and thinking what you want them to think, “Move along, please.”
Kevin: And there are numbers that can be accurately watched, much more accurate than government statistics? And what I am thinking about right now, Dave, the stock market really has not been very impressive this year, yet the margin, the amount of debt going into the stock market – it’s hitting all-time highs.
David: I think that is a very good thing to point out, the comparison between your margin debt numbers, which are now over 500 billion dollars. They were up very significantly, 20-30 billion dollars. They went from, I think, 476 to 506 in one month, a huge percentage increase. And yet, the Dow passed 18,000 in December of last year. We’re a full six months into the year.
Kevin: And it is just about there right now.
David: The industrial average is only up a quarter of a percent. You have the transports, that is, the Dow Transportation Average, which is down 7%, you have the utilities which are down almost 9%. NASDAQ is up, but Apple is doing a lot of the heavy lifting in the average. I just think, this is very curious that you have so many enthusiastic speculators. Think about this. If you look at that 506 billion dollar number in margin debt, you can say this categorically. Speculators have never been so enthusiastic. If you just pause, stock market speculators have never borrowed more money from Wall Street to make money on a sure bet, and yet you are looking at sort of this stalling out of movement, a couple of the averages actually moving toward a 10% decline, the Dow still hanging at sort of a break-even for the year. And the Elliot Wave guys are pointing out that the S&P and Dow had actually just broken down below a four-month supporting trend line. To them, that implies that things could, and are likely to, accelerate to the downside.
What do I see? I see, when I look at the charts, a distribution pattern. What does that mean? Every time the Dow gets above 18,000 – a rally to 18.1, 18.2 – someone out there is selling a massive amount of stock into that strength, and they’re just getting the heck out. And I would like to know who is taking their position in the market, because again, for every seller there is a buyer, and if there are big interests off-loading stock, who is holding the price up? Okay, other than the corporations buying back their own shares, at record high, with money they have just borrowed, I want to know who else – who else other than corporations making a bad business decision? I suppose we will find out in the next 12-18 months, because quite frankly I think we are going to see a rise in bankruptcy filings.
Kevin: And Dave, there is a dirty little secret on Wall Street. You have brought it out in the past because you worked for Wall Street, and unfortunately, you got a chance to see who actually does buy the off-loaded stocks. I would like you to tell that story just briefly, so the people who get a call from their stock broker at certain particular times, that may not be the best recommendation at the time for the investor. It might just be the best recommendation at the time for the company selling it.
David: Morgan Stanley was the company I was working for in 2001, and technology shares were just beginning to bobble, wobble, weave a bit, and move down. They had taken a first major leg down, and there was a pretty decent recovery story – “Are you buying value?” And so, a technology fund, mutual fund, proprietary, in house, was launched, and that was the fund of the week. I remember multiple Wednesdays where management said, “We’re making calls on Wednesday night. We’ll provide pizza, you make the calls. Whoever sells the most of this fund gets free Dodger tickets.” And while that was appealing, I never sold a share, in part, because what I thought was happening, and in fact, what was happening was large clients, mostly corporate clients who had major positions in these companies, needed to get rid of them.
And frankly, the mutual fund ended up being a dumping ground, and yes, the man in the street ended up – he got caught holding the bag. What we saw is a technology fund launch at $10 a share that within three months was selling at $2 a share. And yes, it did provide liquidity for someone, but it hurt someone else. And I guess that is what I am saying – right now we are seeing people hit the exits, large block trades. Again, other than the corporate buyer who is literally taking the treasury and manipulating earnings per share statistics, it is unfathomable to me who would be stepping into the market at this point.
Kevin: At the risk of sounding like a broken record, this margin debt is so important because any time it hits levels anywhere close to this it always turns into a crash in the stock market.
David: Categorically. The crash in ’29 was preceded with record high margin debt. We had a major market blow-up in 2000, of course. Fast-forwarding to something more current tense, the highest numbers ever, in fact, in terms of margin debt and a major crash to follow – 2007, new highs in the stock market. What were we doing? Putting in records with margin debt. What are we doing now? New highs in the stock market, records in margin debt. It’s really no different. You say, “Well, how can you make a comparison to the 1920s?” If you look at it as a percentage of either GDP or as a percentage of stock market capitalization, today’s number exceeds it. Of course, in nominal values they are going to be higher than they were in the 1920s and 1930s, but as a percentage of stock market capitalization or GDP, we are at record levels. That should communicate. If it doesn’t, I’m afraid you have already been lobotomized.
Kevin: Dave, let’s move to the metals for a moment, because most of our listeners invest in the metals, and let’s face it, if you are an American investor in gold and silver this year, it has been a yawner. I mean, it’s very, very boring. But if we were to look – let’s say we were European or Japanese, gold has risen very substantially against the euro, it has risen substantially against the yen.
David: I’m okay with it doing nothing here (laughs). Honestly, I look at it in perhaps a different way than most. I made certain assumptions three years ago about ounces that I wanted to own, and when I set out to achieve a goal I generally do, whether that is physical competition, or holding my breath – I wanted to get to 3½ minutes, and I have done that – for the sake of spear-fishing. And I want to reach a certain ounce level, both with gold and silver, and my assumption in 2012 was that it was going to be very difficult to get to my lifetime goals because the price was continuing to march higher.
Kevin: So thanks to the central bankers, and whoever was manipulating the market…
David: And the perception of normalcy today where the stock market is going to go to 50,000, or what have you, and we’re all clear, sans the 200 trillion dollars in unfunded liabilities and things of that nature, which only the nay-sayers would still point out, if you have a negative gene in your gene pool, and you tend to fixate on those things – fine. I look at it and say, “Hmm. Gold and silver are cheaper. I get to buy more at cheaper prices than I had expected. That means I am going to get to my ounce objectives sooner than I had anticipated.”
I had assumed that it might be 30 years from now that I would get to my goals because I’ve got to go through another cycle, another cycle of not only boom, bust, but boom again, where in that bust phase I would be able to buy, again, cheaply. We haven’t had another bust. We have not. We have had a significant cyclical correction. And in that context it has given me the opportunity to add to a significant number of silver ounces, and a healthy number of gold ounces, as well.
This is what I look at, frankly, Kevin, right now, and find encouragement in, and this is a little bit like someone understanding the currents and tides. I don’t – I have to be with an expert to figure out where to go to get fish. And you can do that. In the markets, these are the currents and tides. Silver has outperformed gold year-to-date. That communicates something significant to me. And mining shares have outperformed the metals year-to-date. These are typical precursors to a move higher in the metals. And when you watch those indicators, when silver is weaker than gold, you can expect the metals, both of them, to continue heading lower. So, it works both ways, and in this case, we have seen the gold-silver ratio contract from 75 or 76-to-1 – we’re at about 71-to-1 – and that says silver is out-performing. We have seen the XAU, that is, the gold share index compared to gold, that ratio, improve pretty considerably.
Look at shares like Newmont, which are up over 40% from the beginning of the year. Now, I’m sorry, last time I checked, for the Dow Jones Utility Average and Dow Jones Transportation Average to be down 7-9%, and people to be ignoring it, and to completely set aside a trend change – Newmont has been blistered for the last four years. But something changed January to the present. And a lot of people are not looking at those things. I happen to be, and I think they considerably change the direction of the markets.
What I would anticipate is, this summer we may even retest the lows. I would love to see it – love to see it. If you are looking at the daily sentiment index for gold, you are at a very disinterested level at about 15% of investors who are bullish. And for silver it is lower than that, about 12% bullish. I would love to see those get down to a single-digit number, and at a single-digit number I think you basically have people say, “Look, gold and silver are never going anywhere.” And do you know what happens when people start operating in hyperbole? They are usually wrong.
Kevin: And as your dad always likes to say, “The majority, in the end, is always wrong.”
David: So, if you want a guarantee of being right in the market, line yourself up against the majority…
Kevin: And wait…
David: And wait. And where I feel most comfortable doing that is with a single-digit sentiment number. So, let’s say silver slips into the 15s, even the mid 14s, you are going to see sentiment get to those single-digit numbers, you will have basically put in what I think will be, historically, once we can look back a year from now, a double bottom in the silver market, maybe even a double bottom in the gold market if we slip another 30 bucks or so, and I think we’re off and running. I think the next two years for the gold and silver investor are going to be the most exciting, actually more exciting than anything we saw 2001, 2002, or 2003, and more exciting than what we saw in the period of 2008-2012 – massive increases. But again, when does that happen? It happens when people least expect it.
Kevin: Even the mainline media, sometimes, and the mainline big banks, will publish something that you just scratch your head and you go, “How in the world is it that Deutsche Bank said that?” Even Deutsche Bank has come out and said, “Wake up and smell the coffee. Something is wrong.”
David: Yes, and this is from an important research piece put out by Deutsche Bank. It is worth reading to you now, just here in part, the highlights. This is from the piece: “Not only are debt loads rising (this is talking about corporate debt) – not only are debt loads rising, but EBITDA (that is earnings before interest, tax, depreciation and amortization) levels are also falling and have dropped for two consecutive quarters.” I’ll just editorialize there. Two consecutive quarters decline in earnings. Again, that is significant, you should be paying attention. The fact that equities are holding up, but not advancing as we are seeing a decline in earnings says something. You should be listening.
Now I’ll go back to the article. “A third measure of deteriorating balance sheets, interest coverage, captures balance sheet deterioration best. Interest coverage (as shown in this chart and graph) is as weak as it has been since 2009, and lower than pre-crisis levels. Again, the energy sector is not the only culprit. Weak global growth and a low interest rate environment play an important role in understanding how balance sheets got to where they are. Issuer debt loads, even on a net basis, have been growing at an annual rate of roughly 10% as companies take advantage of cheaper borrowing costs to finance acquisitions or repurchase stock to support earnings per share growth. With in-demand still tepid globally, company management teams can crank up leverage to boost return on equity.”
Kevin: It sounds almost like what you’ve been saying, Dave – the share buy-backs to boost earnings per share. And they are doing it with margin. That says they’re going further and further into debt every year.
David: Right. And for the short-term investor, return on equity may be important and for the long-term investor, leveraging up as fundamentals are deteriorating – when has that ever been a good idea?
Kevin: Right.
David: Again, it is only a good idea if you suffer from short term-ism. If you are a long-term investor, or frankly, a long-term manager of a company, not expecting to be there very long explains your behavior today. If you wanted to be there as a career guy 20-30 years from now, you wouldn’t be making these decisions. So, if fundamentals are deteriorating, do you know what it is wiser to do? It is wiser to batten down the hatches, it is wiser to raise cash, it is wiser to sell off low-yielding assets and take your lumps, develop a war chest that allows you to purchase assets cheap. Instead, what we see is, zero interest rates are helping enable behavior of prettying up the numbers, encouraging merger and acquisition, and buying assets, frankly, at premiums instead of discounts. Again, you have window dressing today, which makes tomorrow an even harder reality to take in stride with the added strain of increased debt.
Kevin: You said, and we titled the program, actually, a few weeks ago, you just need to have cash, gold, and patience. And if that is the case, then what you are not doing is actually increasing your debt. There is a great quote: “Asset values fluctuate (they go up and down, everything does), but debt is permanent.”
David: Right. So today you look at the investor who says, “Thank you, Mr. CFO, for buying back several billion dollars’ worth of shares. You have just increased the value of my remaining shares. Thank you for doing that.” But what happens when the value of those shares drops by 20%, 30%, or even 50%, and yet you still have the debt to pay, because in order to purchase those shares you took out a loan to buy them back. Does that make sense? That’s where that quote – Richard Russell said this years and years ago in one of the first issues that I ever read from Dow Theory Letters, maybe 1999-2000 when I started reading them, “Asset values fluctuate. Debt is permanent.” So, I think that CFOs have forgotten that that is an issue that they will have to address later on.
Kevin: Speaking of earnings per share, because that’s what, really, a person should be focused on with their stock portfolio and where those earnings are coming from, if it is actual productive business growth or if it is in the reduction of share quantities by purchases of the shares by the companies themselves. At different points in the growth cycle, is there a disconnect between the earnings per share and the actual economy?
David: Yes, and again, you have to dig in to corporate numbers to figure this out, but Bloomberg, on June 3rd, in a Michelle Davis article, wrote that there is a dark shadow lurking behind the happy façade of rising stock prices. U.S. companies are borrowing money faster than they are earning it and they’re doing it at the quickest pace since the aftermath of the financial crisis. Instead of deploying the debt to build factories, hire new workers, or expand product lines, companies are funneling more of their money to shareholders or using it to fund deals.
Stock buy-backs reached an all-time high last year and the volume of global mergers and acquisitions announced so far this year would make it the second busiest ever. The debt undermines future growth and could dent company income when borrowing costs rise. The consequence – profitability, buoyed by cheap money since rates went to near zero in 2008, will sink. Companies have said, “We don’t have an ability to grow organically, so we can distract shareholders instead.” And that is exactly what is happening, a distraction of shareholders using the earnings per share figures as a way of saying, “No, we’re actually helping you.”
And there is a great measure which Russell Napier, a friend of ours who has been on the program a couple of times, has pointed to. At different points in a growth cycle, there is a disconnect between the earnings per share and corporate profits, and we have that radical disconnect now. Napier draws from the Bureau of Economic Analysis, their NIPA series. NIPA stands for the National Income Product Accounts. And he says, “Okay, wait a minute, from 2011 to present, the corporate profits have improved by 2%. In the same timeframe, earnings per share figures for the S&P 500 are up 23%.
Kevin: That just doesn’t make sense, does it?
David: Right, so he’s basically saying, these numbers typically run in a parallel track, with the NIPA numbers being far more stable, and the earnings per share numbers being far more volatile. And the data that he is looking at, where the NIPA comes from, are corporate tax returns (laughs). And that’s a place where it is more difficult to lie. Nominal GDP – you can lie about that. Listen, we’re at 13% in that same timeframe, 2011 to the present. And how do we lie about that? Well, listen, we introduced – what was it? Intellectual property. So, we’re including things now in GDP stats that we didn’t include before.
Kevin: Right.
David: Well, for earnings per share figures we are just shrinking the number of outstanding shares, we are increasing debt to do it, etc. So, you can manipulate those numbers, but what you report on your tax return is a little bit more difficult. And so, what Napier points to, and what he is highlighting in this separation of realities between the NIPA series and the earnings per share numbers, one from another, is that looking at the last several full business cycles, these numbers have been an excellent guide for actual growth in earnings versus the financially engineered growth that you see show up in the earnings per share. The same divergence occurred in the run-up to the peak in 2000, and of course, they came back in sync as the market crashed.
Kevin: Just like margin debt is a signal, this same signal showed up in the late 1990s, didn’t it, from 1995 to 1999 before the crash in 2000?
David: That’s right, so you had the BEA corporate profits which increased 15% – again that’s that NIPA series from 1995 to 1999 – and then you had the reported earnings per share numbers grow by 52%. So 15 versus 52, 2 versus 20 – again, it moves and there is a stretch, a gap between the numbers, and the gap closes.
Kevin: That is a signal.
David: Very important, because from a timing perspective the BEA series begins to decline six to twelve months before the earnings per share number gets pulled down, in spite of the best efforts to prop it, or drive it higher. So, to bring these numbers back in line with each other, which occurs consistently at the bottom of a business cycle, the S&P earnings per share number would need to decline between 45% and 57%. Now, think about that. If earnings per share stats drop by 45-57%, what do you think is happening in the stock market?
Kevin: It is coming straight down.
David: That’s painful for the investor in stocks, but it is particularly painful for the leveraged investor margined to the eyeballs (laughs).
Kevin: Speaking of margin, then, because we keep bringing it up, I mean, is there a limit, do we reach a saturation point where corporations can no longer continue to borrow and just buy back shares and play this game?
David: They are going to continue to borrow as long as the market allows them to. This is the nature of market loans and borrowings. So, yes, we have had the management of earnings via share buy-backs and other tricks of the trade. They are reaching their natural limits. And I think a part of the reason for that is that you have corporate executives who are beginning to look and say, “Listen, if the Fed does, at some point, follow through and raise rates, what does that mean for our ability to continue to roll over that debt at higher rates? What is that going to do to our earnings?” So, yes, that’s why I think there are some natural limits there. But Jim Grant points out that, year-to-date, of the hundreds of billions of syndicated business loans, about 177 billion this year, 67% of those loans are what they call covenant light.
Kevin: There is nothing behind them.
David: And that language should stir not only memories, but a little bit of heartburn.
Kevin: Subprime? Is that what you’re trying to say?
David: A little bit of a repeat of the story from 2005 to 2007. Once all your best borrowers have borrowed, you keep the lending game going by lowering the qualifications and thereby expanding the potential list of borrowers. Covenant light essentially means low to no collateral, and on negotiable terms if the debtor comes under pressure. So, these are the kinds of loans you would want to pass on to unsuspecting investors rather than originate and hold on to.
Again, just go back to the old-school banking where the banker sits across the table from you. He’s known you since you were six years old. He has watched you succeed. He watched you get Dean’s List through college. He has looked at your business plan, he knows you’ve got some skin in the game, and he says, “I’m with you. I’m going to loan you this money, and we’re going to hold on to the loan. We like you.” Compare that to the 2005 to 2007 model of home lending where it was, “Fog a mirror – we’ll originate the loan, we have no intention of keeping it, we’re going to capture 1% and move it on down the line. All we are is an origination factory.”
Kevin: That reminds me of the song, “Hello, I love you, won’t you tell me your name?” Because literally…
David: (laughs)
Kevin: They’ll give the loan, and then they tranche it up into pieces, repackage it, and immediately sell it on the street. They don’t keep that loan. And they know they’ll get paid back if any of those loans go bad. They know they are going to get paid back by the government or someone coming in to bail them out.
David: Again, for anyone thinking that this time is different, just remember that a high percentage of loans that are covenant light – that’s a signal to you, it’s an indicator to you, that we’re at the end of a cycle. Napier concludes that the current business cycle expansion has already lasted over 20% longer than any post World War II expansion, and the Bureau of Economic Analysis numbers have already turned down, so what does that tell you? It tells you that we are simply watching the clock for a considerable decline in earnings per share and therefore significantly lower stock prices. Is that the next six to twelve months? Emphatically, we would say yes.
Kevin: So, again – cash, gold, and patience.
David: (laughs) Well, yeah, sure. Raise cash, add to gold positions. A few weeks ago, we had Alan Newman discussing with us the merits of owning a small percentage of precious metals miners. That also makes sense. Charles Vollum, a past guest on the program, recently noted that mining shares have only traded lower relative to gold on 34 trading days in the last 20 years. If you are looking for value, if you are looking for something that is dirt cheap, that has, frankly, had its nose rubbed in the dirt for some time now, they are at a low ebb. They are at a low ebb.
Kevin: That is amazing. Let’s repeat that. Okay, so only 34 trading days in the last 20 years have gold shares been lower relative to the price of gold.
David: That’s right. So, are these areas that deserve attention? Cash, gold, a small percentage to mining shares? Yes, indeed. Yes, indeed. Last week, Don and I discussed the universal nature of credit expansion, on a different topic. This credit expansion feeds asset price inflation, and ultimately it hurts more than it helps. The danger of asset price inflation, and that’s what we are talking about, with a blow-off in stock prices we are currently witnessing, and margin debt – part of the reason why people are adding to margin debt is because it is pretty cheap. 5-6%? There are some brokers where you can borrow money for less than 3% and go speculate in the stock market. On a good day you could make that much and more. So, listen, it is the artificial pumping up of the stock market and the real estate markets which is so dangerous, because it creates the illusion of wealth like Mountain Dew gives you the illusion of energy.
Kevin: Right.
David: So, you have this short, unsustainable, artificial – and when it runs out – minorly catastrophic reality. Have you ever had that happen? Because it’s kind of a double goosing on the downside. Not only do you have the sugar blues, but when a double caffeine boost runs out, you have the caffeine blues and the sugar blues and you just feel like a pile. It’s awful.
Kevin: You’re dating yourself, Dave, because these days it’s Red Bull and Monster Drinks (laughs). And you watch people come down off of that, and actually, that’s not a bad analogy, if you think about it. The current stock market is on Red Bull and Monster Drinks.
David: Unless you do things that are sometimes irrational – I mean, I’ve seen guys at the Red Bull Competition up here north at Silverton Mountain. Great mountain. But I’ve see them, and this is the description given by the commentators. Have you seen someone huck their meat off a cliff like that before? Where somebody is literally doing a triple back-flip off of a 120-foot cliff, and you’re not supposed to do that. But you can on Red Bull.
Kevin: (laughs)
David: There are amazing things that happen when you’re on an artificial stimulant, and that’s essentially what we have, and this is where, again, you go from thrills to chills when you are dealing with asset price inflation. And the chilling side effect of an asset price inflation, according to the Austrian school, is that busts follow boom times, and these periods bring about a tremendous amount of upheaval. And this is where I think it is naïve to think you are only talking about financial and economic upheaval, because social and political upheaval get brought into the financial and economic mix.
Kevin: And you know, you talk about the Austrian school saying that busts follow booms, and you have a number of other schools that would counter that, like we have talked about, Keynesianism. But actually, in the end, it is always Austrian.
David: In the end.
Kevin: The Keynesians can be right for a while, but in the end it is always Austrian. In other words, you get the bust after the boom.
David: And the Austrians are wrong for a long time, until they are very right, which is one of the reasons why, as you look back to Hayek, he was not in the glory days, he was actually sort of hiding out in an intellectual closet for the better part of 50 years. You would have been more at the fringe to read him and think that he was a respectable economist. And then in the 1970s, late in his life, when Keynesianism was not answering the questions of the day, the crisis questions of the late 1960s and early 1970s, somebody said, “Well, who has any explanation for what is happening to us?”
Kevin: They dusted Hayek off.
David: That’s right.
Kevin: And then gave him an award.
David: His theory had the best explanatory power for the day. And we are moving into that period of crisis where I think Keynes does not have the explanatory power, and the experimentation with massive credit creation falls flat, bringing us to what happens only once in a blue moon – a very Austrian moment.
Kevin: You know, during that transition time when Hayek became in favor again, right before they gave him the Nobel Prize, that was that period of time when the United States, which had committed to keep the dollar on the gold standard, reneged on that. Nixon reneged on that, of course, in August of 1971. And there’s a problem – once you remove gold from the dollar – your dad saw it. Your dad was a stock broker, and he saw that happen, and it was like, okay, the time bomb is now ticking. “I have to not only get gold for myself, I have to get gold for my clients.”
David: You know, the social unrest we have seen here in the United States this year, some have compared it to Paris in 1968, and there was an undercurrent, socioeconomic in nature, of discontent, and we see that growing, certainly here in the United States, as they did in Europe in the mid to late 1960s. And it is when you combine economic stagnation with massive credit creation because what you end up with is low economic activity and high asset prices. The New York Times pointed this out this last week. In terms of the divide between rich and poor – this was a poll that they had done. I don’t know how many people they polled, but six in ten polled thought that the government should do more to reduce the gap between the rich and the poor.
So, you are tipping the scales right now toward there being something akin to class warfare, and what everyone seems to be ignoring is the fact that central bankers are exaggerating the trends of rich and poor via their monetary policy. This is not the rich getting richer of their own merits because they came up with a new and better business model and they are making fortunes doing X, Y, and Z. Do you know what they are doing? They are living off the fat of the land, and the fat of the land is actually monetary largesse. It is monetary largesse which is driving asset prices, which is driving balance sheet expansion. It is the central bankers who, with the best of intentions – we’ll just assume that they have the best of intentions – have tried to reassure the masses that all is well, and will be on their watch. But in the process, there is dry rot occurring in the pillars which support our economy – quality of jobs, quality of income.
This brings us back to the very impressive 280,000 jobs number that we saw. Actually, when you look at it, and test for strength, you have 67,000 jobs created, not 280,000. The last time I checked, a difference of over 60%? That is statistically significant. Those jobs don’t even exist.
Kevin: Dave, we have interviewed central bankers on this program and I do think oftentimes they are best intentioned, but this machine has grown so big to this point, that if they stopped lying about the statistics, I think they are afraid of what could happen. So, I’m wondering, was it Junkers who said that sometimes you have to lie?
David: Yes, it’s absolutely the case in Europe where they are willing to fudge the headlines and they are willing to fudge the press releases if they think it is going to gain them some traction in the process of keeping Europe together.
Kevin: And they’re doing it to save the children. So, Dave, what we had talked about before – it always goes back to the Austrian bust after the Keynesian boom. So, with that being said, again, like a repeating record – cash, gold, and patience. It is the impatience, when a person looks at their portfolio and they say, “I have waited three years and gold has done nothing.”
David: And that’s okay. It’s okay to wait. It is okay to wait. Where it becomes insufferable is when you have your own personal timeline infused in the marketplace. “I’m 62, and I’m retired, and I need the money now.” The need for the money now can hurt very badly. The market will do what it is supposed to do. It is never going to do it on your timeframe. It doesn’t operate that way. It’s not particularly sensitive to personal prerogative.
And I just continue to look at the things which around the world suggest right place, right time. Saudi Arabia’s foreign currency reserves are dropping rapidly. You have Venezuelan currency problems. Their currency has lost half its value since the beginning of May. These are things that, when push comes to shove, politicians in Venezuela aren’t going to take responsibility for what has happened. They’re going to blame someone. And when you blame someone, sometimes bad things happen, of a military nature. What is China doing? They are offering another swap, another trillion yuan swap, about 161 billion dollars, to swap bad paper for good. Basically, the People’s Bank of China is becoming a bad bank. They’re becoming China’s special purpose vehicle. What do you do when you have excessive debt in a country and are on the verge of implosion?
Kevin: You just buy back the bad debt, and charge the people.
David: Exactly, and it’s just shifting responsibility. Bad actions are taken, bad choices are made, responsibilities, before they are fully meted out, which may actually have a domino effect, you anesthetize and sterilize by creating a special purpose vehicle. I just never imagined that the People’s Bank of China would become the special purpose vehicle for toxic Chinese paper. But how insane is the market? Petrobras is embroiled in a scandal down in Brazil.
Think of this for just a second. The Brazilian government is financing short-term debt at over 13%, which is about 3% higher than Greece. Why isn’t anyone talking about the catastrophe in terms of the economy in Brazil? If the global economy is in recovery, why aren’t the goods – this is physical materials which drive the economy, commodity goods being sold all over the world from Brazil – why is their economy in such a bad place? Why is it costing them 13% to finance government debt when it only costs about 10-11% in Greece?
Do you see what I’m saying? And here Petrobras, the state-owned oil company, which is in the middle of a massive scandal, just issued paper and outsold, over-subscribed their debt offerings. This is 100-year debt. 100-year debt! It’s insane. And do you know what you should do when things are insane? Practice patience, move to the sideline. Get out of the way. When bad things happen, you really don’t want to be there.
Kevin: You don’t want to lose, and you want to be able to take advantage of the discounts.
David: That’s right.
