The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“This is the nature of central banks creating targets. The targets aren’t for them, the targets are for us. The targets are for us to know that someone is in control and on track, and that allows us to live with a sense of progress and perpetual growth, and just leave it alone, the experts are in the house, they’ve got it under control, I can go about my business. What is my business? Oh, it’s to spend, spend, spend.”
– David McAlvany
Kevin: My how things change over time, Dave. I remember growing up. Like most people, we had LP albums all over the place, and we had, of course, our turntable. In fact, my parents had quite a bit of money invested in something that, really, virtually nobody even owns now. We’ve been through CDs since then. Now my kids are like, “Why do you have CDs?”
David: “Why did you skip over cassette tapes and 8-tracks?”
Kevin: I hadn’t even thought of that.
David: (laughs)
Kevin: Taking it to the financial field, the Dow Jones Industrial Average started in 1896 and it really was the choice stocks that would define a generation or an era. Charles Dow and Ed Jones decided that looking at the whole stock market was a little too hard so they put this group of stocks together, and they said, “These are what really represent the strength of America.” But today, I think there is only one of those stocks still in existence.
David: Things do change. It doesn’t matter whether we can imagine them changing or not, they do. The largest tech giant of the day in the early 20th century was RCA. RCA is no more, obviously, going back to your issue of turntables.
Kevin: Phonographs and turntables.
David: They’re gone. When you look at the composites that were put together by Charles Dow, lo and behold, there are very few left that were a part of that original mix.
Kevin: I think General Electric is the only one left.
David: That’s the only one remaining.
Kevin: If you’re not in stocks – we’ve all heard when you move from the risk of stocks, you move into the security of Triple-A corporate bonds. You move from stocks to bonds, that’s really the way we were taught. Those two markets were supposed to represent the whole thing.
David: Corporate bonds, obviously, have more risk than government bonds, I guess, depending on the government in question, but there is still within the world of bonds a pecking order of good, better, and best.
Kevin: Twenty-five years ago there were 98-100 companies that had Triple-A ratings that you could choose from, which means they were likely to be the strongest companies for many years.
David: That’s right. That was your best category. The best category was your Triple-A category. They were the venerable companies. As you said, in 1992 you had 98 of those, and today only two of them remain. It’s interesting, this is from Thomas Waters, an analyst with S&P. “One thing is clear,” he says. The trend away from financial conservatism that began in the early 1980s continues to this day.” If you think about that quote for a second, Kevin, you have the trend away from financial conservatism. Of course, corporations managed themselves very conservatively when the cost of capital was very high.
Kevin: Which is the cost of borrowing.
David: That’s right. When interest rates – or the cost of borrowing, the cost of capital, as it were – when they are high you really have to watch every penny, because when you’re paying 10%, 12%, 15%, even 20% on your debt, you can get eaten alive very, very quickly. It is interesting that he notes a shift in financial management, and basically, the ethos within corporate America as rates have come down since the 1980s and money has gotten easier, credit has gotten cheaper, lo and behold, conservatism is out the door.
Kevin: It’s almost free to borrow right now, so why not borrow far more than you would ever be able to repay?
David: Right. So corporate execs have taken the liberty to add more debt to their balance sheets since, really, from their standpoint, if you’re looking at things from a cash flow standpoint. You may have more debt, but it’s at a cheaper interest rate, so it has a similar cost to the older days when debt was more expensive, again, because of the higher rates, and you simply couldn’t have as much on the balance sheet. But in theory, you can improve a company’s growth rate with a little, or in the case today, a lot of leverage. And so ratings, really, those Triple-A ratings, double-A ratings, single A, down to junk status, they tell the story in the clearest way possible.
Kevin: Who are some of the big guys that are starting to be downgraded? If we’re down to two, obviously, there must be big names that no longer provide security.
David: Imagine falling down stairs, because each one of these major stair steps down represents the loss of 20, 30, 40 of these companies. We began the year 2000 with, let’s say, 80 of them, and by the time we got through with the tech bust, half were gone. We’re still in the 40s by the time the global financial crisis of 2008 and 2009 rolled around, and now we find ourselves at 2. Between 2008 and the present we’ve gone from 40 to 2. That’s a lot of downgrades. And all that are left are Johnson & Johnson and Microsoft. Exxon Mobile lost its Triple-A rating last month, which it had held since the great depression.
Kevin: I can sort of see Exxon Mobile – it’s got the double hit. The energy prices, of course, are very, very low, and they probably took that debt out before the oil fell.
David: But the interesting thing about that company is they’ve been through so many cyclical downturns that I think they are not unfamiliar with the price of oil going up and down. So there are some interesting things happening across the spectrum, and it’s not just energy companies that have come under pressure. As rates have declined, everyone has gotten in on the refinancing and expansion of debt on their balance sheets.
Kevin: So it’s not necessarily the oil or the profitability of what is being produced, it’s just too much debt.
David: Too much debt. Four trillion dollars in new debt has been added by U.S. corporations in the investment and the junk categories since 2008. Because everything in life is cyclical, we would remind you that the hubris that is inherent to the central bankers’ belief that they can hold rates indefinitely at a low level – that hubris, too, runs in a cycle.
Kevin: While pride cometh before the fall, so any time you start to hear the pride of the central bankers you realize that it’s not going to last long. “We will do this,” as opposed to, “We will try to do this.”
David: There really is no qualification anymore, and the real culling of these companies, as I mentioned, began in the year 2000. And then again, it just was a wipeout in terms of the top rating 2010, 2008 to the present, to remaining. To me, it’s a little bit like a story from National Geographic. If you were to step back in time and say, “We were looking at this feature in National Geographic about the financial dinosaurs and the environmental factors that wiped them out, the cycle of financial conservatism from one end to financial creativity on the other end of the spectrum, it really has run its course.
I realize we’re probably getting ahead of ourselves because, of course, Johnson & Johnson and Microsoft are still very robust companies. They can finance very inexpensively. But keep this in mind. Even those who are now in the junk category can finance inexpensively. Here in the office we were talking about this morning, Steve Wynn’s recent comments where he said, “Look, I don’t quite understand it, but I’ve been able to refinance all of my debt. I’m in gambling, I’m in casinos. This is not medical products, this is not boxes of cereal, this is not Microsoft selling a software package and putting it on everyone’s computer. I’m in casinos and I’m financed at less than 4% on my entire debt structure. While I like that, this won’t end well.”
He says it won’t end well because 4% for casinos doesn’t adequately represent the risk in the equation any more than the entire spectrum of debt that we have out there. And we’re not talking about just the 4 trillion, but it’s now into the tens of trillions here in the United States just in terms of corporate debt.
Kevin: It reminds me of the incredible real estate boom that occurred with so much free debt that was given early in the 2000s. When we look at existing home sales now we’re seeing an increase in buying. When you say 4%, people’s mortgages now are 3-4%. We also know there is no wiggle room in a lot of those people’s budgets.
David: Yes, so a 15-year mortgage is under 3% and a 30-year mortgage is just a skosh over, maybe 3.5% or 3.75%. It was interesting to see April existing home sales – they increased month-over-month by almost 2%, 1.7%, and year-over-year by 6%. The leader in there, what drug the numbers higher, was a 12% surge in the Midwest. Once again, the details matter. Since when has a boom in condo sales in the Midwest – that little segment was up 10% and it raised everything nationally overall – since when has a boom in condo sales in the Midwest been evidence of a healthy real estate market?
Kevin: Isn’t that normally the sign of the end of a real estate market?
David: Sure, because when you’re talking about a migration of value, when people can no longer afford a single-family home, they end up moving to condos, townhomes, apartments, things of that nature. And basically, it is the sign of the end of a cycle, not the beginning.
Kevin: That takes me to something, honestly, Dave, I don’t like thinking about or talking about the replacement of people with automation. When you see these states that are going for mandatory raises in minimum wage, what we’re starting to see is a wave of replacement. If we’re going to have a minimum wage, granted, it’s a living wage, they call it, but a minimum wage that is going to be high enough to actually make the bills, we’re unfortunately going to have to lay you off because we have a computer, or we’ve got a screen, a touch-screen, that will do exactly what you do, and probably more efficiently.
David: Right. The fight for 15 is what it has been called. It is really in that category of “be careful what you wish for.” More money? Well, frankly more money is not always the right answer, it’s just the easiest answer. The Fed has come up with that, and corporations, in borrowing more money, have certainly tried to do that in terms of papering over weakness in their business growth. And you see this, too, with the political solution. I grant you, there is a case to be made for a living wage, but the easy answer of “just give them more money” is not necessarily the correct answer. Wendy’s, this week, is announcing that they are replacing not one or two, but all, of their cashiers with ordering kiosks at 6,000 locations.
Kevin: That’s a huge hit to employment for all those people who would normally be taking orders.
David: Let’s just say three cashiers per location and it’s probably more than that if you’re talking about running the clock for 12- to 14-hour days and serving food during those timeframes, at least 18,000-20,000 people. And this is in response to the mandated $15 an hour minimum wage in New York City, and the $10 an hour level in California. If you push too far, what is the response? Whether it’s robotics, or AI, or computers, it wipes out employment for an entire swath of the population. And quite frankly, this is an at-risk segment of the population anyway. It’s not swath that can easily be retooled, retrained. To a large degree, it wasn’t tooled and skilled in the first place.
Kevin: That brings up a point. Sometimes a person would say, “Gosh, if they’re being replaced here, maybe they’ll be able to take on a higher level job, something that actually would be more than a $15 an hour job, and I’m sure that’s the case. But educationally, are these people ready for it?
David: I think the folks at Investor’s Business Daily point out the real problem here, because when you force someone out of the labor force in this segment of the population, IBD points out that 50% of high school grads do not have the skills needed for technical training programs or for college. The idea that they could go to a tech school, or go back to school and get a degree – they’re not ready for it. These are high school graduates who are not going to be able to, because they didn’t get the skills they needed in high school.
And so, the retraining effort – there is really not something that can fix this particular problem. Pushing for higher wages, in all likelihood, builds out the ranks of the permanently unemployed. So you see an echo of this. Like health care, our public schools don’t seem to improve the more money you throw at them. And apparently, improving wages doesn’t improve the plight of your average Wendy’s employee, either.
Kevin: Staying on the line of debt, because we talked about housing debt, we talked about corporations getting to the point where they are taking out too much debt, they can no longer be rated as Triple-A bonds because they’re no longer secure in their payments. The Federal Accounting Standard Board has new requirements. Let’s look at the other side of debt, the people who loan. The people who loan money out, the banks, if you look at the bank rating sheets over the last 6, 7, 8 years since the global financial crisis, Dave, their ratings have improved quite a bit. I think that we have to take into account some of the leniency that they have had getting through this crisis. It seems like that is probably going to be tightened up, maybe at the wrong time.
David: It is interesting, when we were in the Lehman Brothers crisis days we were dealing with organizations that had, in some instances, 40-to-1 leverage, that is, company capital of $1 for every $40 in loans. So if you ended up seeing an impairment in those loans, if the value of those loans dropped at all relative to your company capital, it was very easy to get wiped out. So the greater the leverage, the greater the risk.
Kevin: Unless you were the chosen few who were too big to fail.
David: Too big to fail, or conveniently knew the priest who could performed the forced shotgun wedding (laughs). If you were Merrill you were fine because Bank of America was waiting there for you with open arms. Moynihan, the CEO at B of A might have a very different retelling of that tale. But you’re right, the Federal Accounting Standards board in 2008-2009 was in the process of changing rules right in middle of a chaotic period.
Kevin: And they were tightening the rules.
David: They were tightening the rules. And the problem is, you find regulators doing the right thing at the wrong time, almost all the time. When things are going well you should be tightening up the rules and tightening up the standards. It’s almost like, was Joseph setting aside grain in the lean years for the lean years?
Kevin: He was seven years too early.
David: He was. And he was tightening up, and he was extracting a 20% tax from the very profitable and productive fields so that the coffers could be filled for the seven lean years. In other words, he was operating on a counter-cyclical basis. The problem with most bureaucrats is they respond to crisis and feel like they now have the impetus and the permission to do something when they wouldn’t have been able to get anything done politically when things were not going against them. The problem is, when you start putting in new standards, higher standards, in the context of crisis, it can exacerbate the problem.
And that’s what was happening with the bank standards by the FASB in 2008 and 2009. They were requiring that assets be marked to market instead of marked to model or marked to make-believe. In other words, mark-to-market is you have to actually come up with a real price for the assets on your balance sheet as opposed to figuring out some sort of a model in your mind. Again, you may say, “I think it’s worth $75.” Well, how do you know? “I’ve run the numbers, and it should be worth $75 or $80, maybe $60.”
Kevin: We talked about this during that time on this commentary, how they were just making up the numbers. Something you can’t really make up is the reserve. A bank has a certain requirement for reserves. The higher the reserves that they have to hold, the lower their profitability.
David: And this is the FASB rules that are coming into play right now. They are discussing this now and I think that by the time that it becomes reality I think we’re back in the middle of another crisis. So if you’re looking at these things sort of slow motion, the crisis is just around the corner and FASB is now having the conversation again about mandating higher loan loss reserves. Currently, they are at about 1.3% of total loan book value, and they will, in all likelihood, be required to come in at about 3%.
Again, this is how FASB times things. The requirements are going to be in place by 2020. That is the effective date. Banks are right now trying to wrap their minds around it, trying to model for it, trying to figure out how they can do this. Increasing reserves, as you just said, has the effect of lowering profitability because it is lowering your leverage ratios. And so, they’re not wanting to do it too soon, but they also can’t wait until December 31st, 2019. It has to be eased in.
Kevin: Even though the banks have been given a lot of leeway, and this doesn’t go into effect for a few years, we’re already seeing big, big banks getting squeezed. Deutsche Bank has been in the news several times this year. I remember, Dave, it hasn’t been too long ago that Deutsche Bank, their billboards, they were bragging that they were the bank of Krispy Kreme donuts, and they were the ones who got behind that whole fad and craze at the time. The crazy thing is this – where are Krispy Kreme donuts now? There was one on every corner for a little while.
David: And where is Deutsche Bank going?
Kevin: Where is Deutsche Bank?
David: It’s really a systemic issue, it’s not just one particular bank. But when you exist in a zero-rate, or negative interest rate environment, the net interest margin for banks gets squeezed. You already have suffering profitability amongst banks on that front. If you’re going to lower your leverage ratios by increasing your loan loss reserves, it’s almost like a double whammy. I’m going to hit you with the right fist – that’s negative interest rates. I’m going to hit you with the left fist – and that is, again, an increase in loan loss reserves. Which is prudent. It’s prudent. Actually, loan loss reserves, going back to that idea of financial conservatism, it should be 5%.
Kevin: Sure. Which means if you put $100 in a bank and they keep $5 and loan out $95…
David: That still seems pretty conservative, but for the average banker today, it’s like, “Oh, well, I’ve got to have those last three bucks.” Five? No, let’s make it two, let’s make it two?
Kevin: Reminds me of Jimmy Stewart in It’s a Wonderful Life. It’s in Ethel’s house, and it’s in – but okay, the banks, however, I don’t have too much sympathy for. Honestly, Dave, I’ve watched financial crisis after financial crisis, especially the last one, the big one that we went through, and the banks seem to always be given favor. Now, here’s what we need to do. We need to actually listen to what Draghi is saying. Draghi is saying it’s really not the debt problem, it’s not the banks, it’s not borrowing too much money, it’s this stupid savings glut. These people are not borrowing and spending.
David: Which suggests that he thinks that banks have a totally different role than maybe we on the street think they have. Your relationship with the bank is that you have an account with a bank, probably one or two here locally, and from your income you save and deposit at that bank. And what he is suggesting is that, actually, it’s not savings held that is the primary function of the bank, but it is credit extended that is the primary function of the bank.
And as such, the real problem – this is Draghi’s point, and he’s just echoing Ben Bernanke – he believes that there is a savings glut. And that the savings glut, not a central bank credit glut, he won’t go there, but he is suggesting that it is a savings glut – again this is straight out of Bernanke’s, it’s almost like they’re reading from the same hymnal – that is the cause for global financial crisis, that is the cause for nearly every version of instability over the past decade.
Kevin: It’s that darn piggybank.
David: It’s the savings glut.
Kevin: If you think about the piggybank that we always saw as the iconic picture of saving, that’s actually the nemesis of the current economy. We need to break those piggybanks and start spending that money.
David: I think that is so much hogwash. But academics prefer this explanation, in part, because it complements the Keynesian penchant to force more domestic spending.
Kevin: Right. Don’t they call that demand management?
David: That’s right. When you’re looking at aggregate demand, looking at forcing up aggregate demand, too much savings and, according to the cult followers of dead Englishmen, Mr. Keynes, there is not enough spending, there is not enough end-demand for finished goods. And I think that it is forgotten by Draghi, I think it is forgotten by Ben Bernanke, who is, of course, retired and on the speaker circuit, that it is liquidity that central banks have created and have thus far failed to get into the economy to create healthy growth. It’s not getting into the economy.
Honestly, and maybe this is a bit of a stretch, but I can’t help but think of Draghi and his global colleagues a bit like befuddled water board specialists at Guantanamo (laughs). And here is what they are doing. They are failing to recognize the impossibility of a body taking in a forced, gargantuan amount of liquidity. Rather, they would stand back and say, “Look, I know where the problem is. This prisoner has a water bottle. And he hasn’t used it.” The whole process of excess credit creation, so much credit that normal individuals, normal firms, companies, private businesses, they don’t know how to react.
Kevin: I’ll tell you who does – the speculators. “Yeah, yeah, let’s see that spending go more.”
David: But it’s the wrong meme to continually blame excess savings for slowness of economic growth when rational minds can’t absorb the utilization of, they can’t think of the long-term burden of more debt layered on top of an already large stock of existing debt. So a reasonable person would say, “Look, if I’ve got $50,000 in debt to pay off, maybe it’s a combination of student loans, credit cards, and I’m not even including the mortgage, do I really want to add to that existing burden?” Because we’re talking about the burden of interest, interest on existing debts.
Do individuals and firms opt to stash some cash in anticipation of repayment of debt? Absolutely. And you see that this week in the headlines, everyone is talking again about corporate cash getting above 1.8, 1.7 trillion dollars. It’s a lot of cash. But guess what? Look at the rest of the balance sheet. They have more debt than they know what to do with, and if you’re looking at repayments that corporations have to make in just a few years, it’s going to suck dry every bit of that cash.
Kevin: And you’re talking about stashing cash because of too much debt, but frankly, it’s also because of lower interest rates. You’ve brought that out in the last few months, especially the Asians are saving more and more and more as interest rates drop further and further. Why would you even save it in the bank, necessarily? It’s not just not taking out debt, it’s also the incredibly low interest rates. And the Keynesian way would say, “Let’s just lower them further.”
David: I think it’s one thing to attribute expertise to Draghi and our central bankers here in the United States, and they do have a certain professionalism and expertise given their job titles, job descriptions and job requirements. But this, I think, is really important. When these central bankers criticize savings, you need to check the source of the criticism because they’re not just professionals, they’re central bankers. They are in the business of extending credit and ensuring that banking and financial firms do the same, ad infinitum. Their reason for existence is pushing credit, pushing, pushing, pushing, pushing.
And they don’t know what limits are. And that is evidenced by the expansion in central bank balance sheets. Look at the Fed balance sheet. Look at the ECB balance sheet. The ECB balance sheet is now back above 3 trillion, and so far they haven’t generated growth. We’ve redoubled our efforts, we’ve seen 90 billion dollars a month in purchases by the ECB, and this is to re-liquefy the system, again, a central bank encouraging bankers to do what bankers do best, not encouraging savings, but encouraging higher and higher and higher levels of debt. You just think, “Gosh, where’s the glut? I know exactly where the glut is. The glut is in central bank credit, not savings.”
Kevin: I’ll tell you what, let’s go ahead and look at this, because I’m going to say, au contraire on no growth. I think you’re wrong on that, Dave. I work for you, so I have to be careful when I say, “I think you’re wrong on that.”
David: (laughs)
Kevin: But actually, the Federal Reserve is saying, “Oh, we do have growth, and we’re adding it to the dot plot. We’re going to use, as part of our analysis as to where to put interest rates, how to manage by how the stock market is growing.” Now, talk about an incredibly artificial way of looking at growth. You said it yourself, the speculators love this. The speculators are in the stock market. The stock market has been either growing or holding, and now the Federal Reserve is saying, “We don’t need to look at economic statistics, let’s just look at the stock market.”
David: Yes, and that is a reality. The dot plot matrix that the Fed uses, the various data points which all tie together and give them a comprehensive picture of what decisions needs to be made on the basis of the evidence on a weighted basis, and believe it or not, the Fed is relying on to shape their monetary policy, more and more, the stock market.
Last week we discussed the Labor Market Conditions Index. We have had the last four readings which have been negative. And this week, the reminder is that a very significant, a growing number in terms of its significance to the Fed, schematically, is how the stock market fits in to this total picture. Why is it more prominent? Why is that role being given a more prominent position in the Fed’s thinking and direction? I think a lot of it has to do with public perception, because it is the litmus that everyone in the economy looks at. More than wages and home prices and everything else, these are things that move on a turtle’s pace.
But if you can give someone, in real time, a confirmation that they’re okay – I’m okay, you’re okay, we’re okay – the stock market does that. Or it communicates something very differently. So loosening policy, if stocks are falling, that’s what we’ve seen over and over again. In theory, they would tighten as things improve, but that has yet to occur. A sweet white wine, a couple of weeks ago – it was a Riesling from the Rheingau region, and I think it was made by Dr. Lusen. And I thought, “I wonder if this is what they serve at Fed soirees.
Kevin: Yes, it’s a nice, sweet, white wine, but it will make you punch drunk with the wrong information. I want to go, since we’re still talking about the Federal Reserve, to a quote that Yellen made just recently. It seems so far off the mark from what we would actually think is true. Remember the guest, Tomas Sedlacek, said, “There is almost a religion these days amongst the central bankers, and that is the religion of continuous growth.” Yellen, one of the high priestesses of this religion said the other day, “I think it’s a myth that expansions die of old age.” Is she talking about forever growth?
David: I think that’s actually one of the purest expressions of humanism, where they have faith in themselves, that’s what is on full display, where a central banker says, “I think it’s a myth that expansions die of old age.” Why? Not only is The Economist magazine attempting to frame this whole discussion, but the chief economist here in the United States, if you will, is arguing the same thing.
Kevin: When somebody says, “This time it’s different,” you almost always need to take cover. Remember Francis Fukuyama when he was saying that we’re really done with global war?
David: That’s right. In the 1990s he wrote his book, The End of History. And it was the end of history, because for Fukuyama it was obvious that world peace had emerged, and that a new and permanent age of global prosperity was upon us, that globalization had united us economically, and this idea of international relations volatility was a thing of the past. And that is basically where our chief economist, Janet Yellen, and the economist magazine are going. They would say, expansions don’t die of old age, which is to say, the current business cycle at seven plus years is not long in the tooth, we’re just getting started, and what you need to understand, fundamentally, is that we will just change the composition of growth, but expansion will continue.
The cycle is, in essence, a thing of the past. We don’t have any cycles anymore. It is perpetual growth, just like Fukuyama suggested, perpetual peace from this point forward. Again, we go back to that notion of, everything runs in a cycle, including the hubris of central bankers, who put themselves at the center of the faith scheme. And in this case, Janet Yellen believes in herself almost like Donald Trump believes in himself, only she’s not quite as obnoxious.
Kevin: You were talking about perception, or faith management, that’s what they’re really doing. After the Depression, governments and central banks directly fought pessimism by pumping money into welfare and unemployment programs. So they can manipulate interest rates, they can keep growth on track, they can manipulate the stock market. If that’s the perception that they can give to the person who is either making a decision to spend money, borrow money, or to save money, they want to manage that perception. But it doesn’t last. It’s a false high. It’s like that glass of white wine. If you have too much of it, you’ll feel good for a while.
David: Of course, we have a few analogies these days from our triathlon training. Our event is coming up in less than ten days. We will be floating, we will be spinning, we will be rolling down a hill or two, perhaps.
Kevin: And we’re hoping that we’ll be surviving.
David: Yes. And in the process of getting ready for this, one of the things that I think we both experienced is that there are days when it is really good to do nothing, and the body needs to do nothing.
Kevin: Yes, you want to listen to your body, if it’s too tired.
David: And there are days when you can get on your bike and just spin. You don’t have to put any resistance on, and you can just spin, and it’s very, very good to just spin and go nowhere, to not feel like you’re getting the best exercise, making the greatest progress toward your goal. Actually, sometimes the greatest way to get to your goal is to not pursue it directly, to not push it. I think that’s one of the things that central bankers have forgotten. Of course, they’ve changed their mandate from simply being price stability, to price stability and controlling unemployment. Now it’s price stability, controlling unemployment, and making sure that the global economy is functioning, and the U.S. stock market never implodes.
So the mandates continue to expand, and what you said is absolutely critical. After the Depression, it was governments and central banks that assumed that they could fight pessimism, and that they could basically, through manipulating interest rates, keep growth on track, and by doing that, they could create public expectations of perpetual prosperity. And this is the nature of central banks creating targets. They targets aren’t for them, the targets are for us. The targets are for us to know that someone is in control and on track. And that allow us to live with a sense of progress and perpetual growth and just “Leave it alone, the experts are in the house, they’ve got it under control, I can go about my business. What is my business? Oh, it’s to spend, spend, spend.”
Kevin: If you’re in politics, or you have a past in politics, that’s a dream come true. But the people who have the experience in politics – I’m thinking of David Stockman, a guest of ours in the past, he says perpetual growth is an illusion. He just tears it to shreds.
David: Fire-in-his-belly Stockman. Every time I hear an interview with him, I just think, “Man, he must have strong coffee in the morning. There is something churning in his gut today.” But that’s the idea that he is after shredding, this idea that after seven years of prosperity, maybe what we have is a perpetual growth cycle. Because one of the things that he does is, in a recent blog post he calls into question the industrial production numbers which would suggest that the quality of our growth has been far most suspect than we would want to admit. The industrial production numbers have been revised downward recently, and they were revised downward so heavily that the case for economic growth from 2012 to the present is all but gone.
Let me just read a little bit from his site. “As with many other economic accounts, we find of late that the Fed was serially overstating the level of economic activity, and therefore the whole recovery. As noted with last month’s benchmark revisions, the whole industrial production series was revised downward, largely erasing the acceleration and recovery economists thought they saw in 2014, and even into 2015. That meant the contraction portion of the slowdown is now calculated to have begun earlier in 2015, but more importantly, the data series, itself, has been forced to belatedly recognize the whole slowdown from its start in 2012.”
Kevin: So we have had virtually no growth since 2012.
David: We’ve referenced the folks at the Economic Cycles Research Institute, and how in 2012 they were calling for recession. Oops – no recession. In 2013 they were calling for recession. Oops – no recession. After a while you begin to say, “Are they the boy that cried wolf?” Apparently, they’re not the boy that cried wolf.
Kevin: There was a wolf there the whole time.
David: That’s right, just a wolf in sheep’s clothing. You have the Fed massaging numbers, and you have, basically, collusion amongst the top statisticians here in the United States, to pretty up this picture of economic prosperity, growth and recovery. And it doesn’t exist. Where do you look for supporting evidence that, yes, the economy is, in fact, in recovery and growing? Where do you find evidence that, in fact, it’s not? Well, certainly, the industrial production numbers are part of that. We’ve talked about the industrial recession, which has been with us for at least 12 months, maybe 18, and Stockman would say, could date back to 2012. And we’ve talked about the retail recession which is already here.
And you could look for other confirming evidence. If you want to look south of the border, exports from Mexico to the United States are on the decline, specifically, automotive exports, and we are their largest trade partner. We are 80% of the Mexican economy, ex oil. When they are struggling, it’s a good indication that there is something wrong under our own hood.
So it seems to me that Stockman is onto something here. People have been living a lie, living with a delusion. But actually, it’s not something they created for themselves, it was something handed to them by officialdom, handed to them by the same folks who would say, I think it’s a myth that expansions die of old age. They never have to die. Why do they never have to die? They never have to die because we’re in control of these things now. The central planners have it well in hand.
Kevin: You say people have been deceived, but honestly, Dave, I think we need to get a little bit more specific than that, because the person who doesn’t have enough to make their bills, or the person who doesn’t have enough to maybe go out to the nice restaurant on the weekend, that person is not deceived. I’m going to give you an example. My wife and I had our 33rd wedding anniversary and we went out to one of the nicer restaurants in Durango. We were sitting there, and it was great service, incredible food, there was absolutely no reason why on a Saturday night the restaurant shouldn’t be brimming, and usually is, but it was only about a third full. My wife looked at me and said, “You know what? Things are not booming, things are not expanding.” We don’t talk much about economics when I’m home. That’s just not the topic of conversation between me and my wife. But it was interesting. Her observation was, “There should be more people here. Something’s wrong.”
David: Let’s assume the Fed is looking at the same thing, and they’re saying, “Look, we have certain internal variables that suggest that the economy is not robustly in recovery. That’s on the negative side. On the positive side we still have the stock market hanging out a few percentage points below its all-time highs. That’s on the positive side. So we have something positive to advertise, and we don’t want to create some sort of a self-fulfilling prophecy with negativity breeding more negativity breeding more negativity. So we’re going to have to speak positively and that means we’re going to at least speak to raising rates.”
One of the things that they’re doing, Kevin, is they’re assuming that everything is in the price, and everything technically is in the price, but it’s not that everything is appreciated in the price. Let me give you an example of what I mean by that. The stock market is priced well. Does that mean the economy is doing well? No, but that’s the assumption. So everyone is assuming that because it’s priced well at high levels, that all is well.
Kevin: There is the efficient market hypothesis, this is what you’re addressing, Dave, which assumes that all information is built into the price. But we know, almost always, the only way a person makes or loses money in any market is because all information is not built into the price and you’re trying to look ahead.
David: Right. In the last two to three months we’ve seen a massive increase in volumes traded, whether it is cotton, iron ore, oil, and specifically, contracts in commodities in China. And there was a migration of investor interest in speculating in stocks on leverage to that leverage, the margin accounts being curtailed, and those speculative dollars migrated over to the commodities exchange. And the commodities exchange is seeing volumes – get this. A single day’s volume – a single day’s volume in iron ore – there was enough iron ore traded to build 178,000 Eiffel Towers.
Kevin: In one day.
David: In one day, on the Shanghai exchange. On one day, cotton contracts traded enough – there was enough cotton traded – buy, sell, buy, sell, buy, sell – on margin – a tremendous amount of debt, tremendous amount of leverage, to outfit every human being on the planet with a pair of jeans.
Kevin: In one day.
David: Right. So you say, “What is in the price of crude oil? What is in the price of copper? What is in the price of iron ore?” There are actually a lot of things behind the scenes that are driving prices that are not real. In this case, it’s a trillion dollars of speculative money that the People’s Bank of China put into the system, and it found its way very quickly into the commodities space after being told to go way from the stock market space.
Kevin: And it has nothing to do with the underlying commodity.
David: It has nothing to do with it. Same thing – look at oil. We still have a glut. And you might think that as the price of oil has been rising off of its first quarter lows, that the glut of oil has been relieved. That would be incorrect. Bloomberg reports that the OECD, the Organization of Economic Cooperation and Development, the commercial inventories which they track, have grown now to 67 days’ worth of inventories. That is five days more than what was seen in the depth of the global financial crisis after global oil demand had collapsed.
Kevin: In this particular case, oil has been rising.
David: Right. So if the price action doesn’t fit the model, sometimes the model for understanding the market begins to shift. And in my opinion, this is dangerously so. So there is now a rationalization and this is how it goes. Because Saudi Arabia has given up the role as the swing producer in the oil market, the market’s response is to house more oil for security purposes. And so there are changing dynamics in the world oil market, or have prices been driven in the futures market instead? Again, because of speculative flows, have prices been bumped without regard for the short-term supply and demand fundamentals?
I think the argument favors developing a cushion to absorb a spike in demand, and I guess I would take the other side of that argument, suggesting that the shock that needs to be prepared for is not a spike in demand, but rather, preparing for demand leaving the oil speculator rather exposed to a drop in the price. And in the end, we see this, as with all investments, fundamentals of supply and demand actually do matter.
Kevin: I think we need to jump to gold for just a moment because we’ve talked about this for years, especially in the last couple of months, how the actual supply of gold is now 1/500th of what is traded. At some point, supply and demand do matter, and we likened it to musical chairs last week in the show. But that is exactly right. There is one chair – there are 542 ounces of gold being traded for every one contract that can be delivered. There are 542 people playing for the same chair, they just don’t know it.
David: Right. So you have a price anomaly with oil and it doesn’t match the supply and demand fundamentals.
Kevin: Right. There is too much oil right now.
David: Right. You have a similar price anomaly with gold, only there is not enough gold, so it’s kind of the opposite end of the spectrum. But what you have with the news media is the demands of meeting real-time deadlines, publishing deadlines, and you have to come up with an explanation that meets the momentary press deadline. So you rationalize away fundamentals if it doesn’t fit your press deadline. And the variable lacking in this, in the shifting of models to explain the price action, the variable lacking is patience.
Forcing an explanation because of short-term pricing and consistencies – I think you just wait around. Either the global economy comes roaring back, as the Fed suggests that it will and is doing, contrary to what David Stockman and industrial production numbers would suggest, or we have Saudi and U.S. over-production. And inventory levels really will have an impact. Demand may, in fact, drop, and take prices lower, reflecting not only that deterioration, but the glut that remains a growing issue.
Kevin: So like you were talking about with the training, there are times when you lay off the training, when you sit back and say, “As hard as this is, because we have a big race in front of us, I’m going to rest today.” We were talking about central banking, but we should probably look at this even on our own and say, “All right, if the conditions outside look like things are overstressed, why wouldn’t we just wait and watch things come into more order so that you can make a good decision?” It seems to me like right now you want to stay cash liquid and stay out of the speculative markets that may be very overpriced right now.
David: I think that makes a lot of sense, if you can practice patience. Most people can’t. It’s the missing variable in the long-term success of most investors to manage assets like an endowment manager manages. What an endowment manager looks at is multiple generations, not multiple quarters, multiple weeks or multiple days. He is expanding time out as much as possible, which requires a patient view, which requires a different perspective altogether. And I think it is very important to bring that into the mix and not allow the news media and their requirement of publishing deadlines to determine your information flow and distort your understanding of what is actually happening.
Kevin: So think like an endowment manager, multiple generation. It’s a much calmer way to live anyway. The opposite of that would be, say, a day-trader, drinking coffee, continually taking Tums and living on Pepto-Bismol.
David: Investing is not a sprint. For those who try it that way, I can give you a laundry list of people who have shot themselves in the head treating investing like a sprint and not like an endurance race. The performance requirements and the insanity that goes with it is enough to be mind-numbing and maddening, and that’s usually what happens to those, even the best, who approach it from the short-term view only, and don’t embrace a longer-term perspective.
Kevin: So, patience.
