Podcast: Play in new window
This week, David McAlvany looks at the extreme valuations driving today’s stock market and why history suggests caution when markets get this expensive. The conversation covers the migration from Mag 7 momentum into blue chips, the warning signs that often appear near market tops, and the fire storm dynamics that can follow when confidence breaks. David also explains why gold will play a critical safe haven role if the bubble finally pops.
“I think what the markets are failing to do is look far enough forward. And some commentators are saying, oh, they’re seeing past this issue in Iran and assuming that this is going to be resolved on a fairly quick basis. But the increased profits, they feed the beast. And that’s what investors love. Decreasing profits end up starving the beast, and you begin to see animal spirits dissipate. So market psychology here is critical, but performance depends heavily on profit momentum continuing. So while it’s possible, I think the economic impact of the Hormuz crisis is likely to be more fully reflected in Q2 and Q3. If that’s right, then safe havens will move from unwanted, unneeded, to most needed as the year progresses.” —David McAlvany
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Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany.
David, you said something in the meeting today that helps simplify this standard deviation talk, or basically the sigma talk in the market. You just basically said less than 1% of the time is the market this expensive when we look back at history. Less than 1% of the time is the market this expensive. Would you explain that?
David: Yeah. 99.7 is the exact number. So yes, less than 1% of the time is the market this expensive. And that’s captured on the Gaussian curve. You can look at it in terms of standard deviations or sigmas. So mention that we have a three sigma market, three standard deviation market, currently. Statistically a two sigma market happens every 44 years.
Kevin: And this is a three sigma market.
David: Correct. So a three sigma market is rarer yet. And we discussed how valuation metrics act as a guide, indicating approximately where you are on a journey from undervaluation to overvaluation. What neighborhood are you in? Are you in the range or the region of under- or overvaluation? It’s not a tool for timing the market, as momentum tends to take on a life of its own, but valuation metrics are helpful signposts. So the further out you move from one to two to three, the market is basically as stretched as you can get. Yes, theoretically, you could move to a four standard deviation or a four sigma market. But the greater your immediate returns on capital— And this is what’s so enticing. As the market momentum carries you higher and higher, it’s much more compelling. You say, “I want some of those returns.” Right?
But the flip side is also the case. The greater the standard deviation is today, the less your future returns on capital are likely to be. Statistically, you’re now looking at a decade or more of zero returns, unless you have a major bear market, in which case you get the correction, you get the undervaluation, and that’s the point where you classically want to deploy capital because now you can compound returns off of a low basis. Statistically, you’re stacking the odds against yourself by coming into the market at these kinds of levels.
Kevin: You know what it reminds me of, Dave? In this area, the thing that we have to worry about every year is forest fires. And I remember I was with Civil Air Patrol years ago when one of the Mesa Verde forest fires was burning. We flew over that fire, and that fire was making its own weather. And it was actually building a lot of moisture up, believe it or not, in the clouds that we were flying in. I remember how turbulent it was. Lightning was coming out of the clouds, it was building moisture. But what it was really doing was sucking all the moisture for the future out of all those trees. So that’s what this is talking about. It’s making its own weather.
David: Price acceleration is like a firestorm, creates its own reality, its own weather patterns. Liquidity feeds the fire, begets more liquidity, which further feeds the fire. And the patterns of liquidity creating a self-reinforcing dynamic in the market, that self-reinforcement works in both directions. So liquidity creation begets liquidity creation, just like liquidity destruction begets liquidity destruction.
Kevin: Okay, but it also is sucking out future returns, right? That’s what you were saying. If you’re getting a lot right now, you may not get much later.
David: Very true. So just as an example, you take the crypto bro that has turned $100,000 into $2 million. The increase in paper wealth, it improves his balance sheet, and it in turn feeds that consumer’s confidence. Stepping out to buy a flashy car or bigger house. Bigger house needs amenities like art, furniture, definitely need an espresso machine to nurse yourself along in the morning.
Wealth effects are real. When you have these liquidity dynamics take place inside the financial market, there is a crossover into the real economy. And so to have a growing economy in the context of a growing stock market, that’s pretty normal. Wealth effects are real. The real economy is positively impacted by wealth trickling out of the balance sheet that boosted asset values. These financial market bubble dynamics feed into an economic reality which is real. Even if the dynamic behind it is illusory and temporary.
Kevin: Do you remember when the Economist in the last couple of years, they called it the Everything Bubble. Remember that? Okay, from a Gaussian curve standpoint, when would you start to think that we’re in a bubble?
David: Two standard deviations. You’re in a bubble.
Kevin: And we’re at three.
David: And we’re at three. So this isn’t technical jargon, but it’s a super bubble. And so a two sigma market has bubble characteristics. A three sigma market is best described as a super bubble. We’ve had a few super bubbles around the world, and yeah, you’ve got to go global to find them because they’re exceedingly rare.
Kevin: So let’s go back and do that, because I asked you a question in the meeting today. I said, Dave, you were a stockbroker 25 years ago, 26 years ago when we had the dotcom bubble. And are there characteristics that we’re seeing right now from that? Let’s go back and talk about a few of those.
David: Japan in ’89 was one. US tech in ’99.
Kevin: Right. You were there for that.
David: US equities in 2021. If you want to go back before that, Chinese A shares in 2015. Right now, again, specifically in AI and semiconductors, so 2026. And we could go back in time to the ’70s and earlier. The conclusion is the same. You’ve got valuation metrics which are not predictive of a market change. It just communicates when risk and reward have become asymmetric. And it’s deceptive because all you’re feeling is, in that moment, the reward side of the equation. But actually at a two and then a three standard deviation move in the market, the risks are asymmetric.
Kevin: You talked about how concentrated those risks are right now too. They’re mainly in IT or energy. And that makes up almost, it’s like 90 some odd percent of the move in the market right now. You know what I thought of when you said that? Just north of here, the kayakers love the class five waters. But usually what that is, it’s a very, very narrow channel. Things are happening very, very quick in those class five waters, and it’s because that water’s being channeled through such a small, small area.
David: Yeah. I think the common characteristics we have also discussed include concentration of capital, which again could be the Chinese A shares in 2015 or the current concentration in AI and semiconductors in the US. More capital clusters around a small handful of names, with success and enthusiasm being extrapolated from that success too far into the future, to the point where it’s imagination and it’s leverage which end up dominating and driving momentum. So leverage, as you might guess, is the real kiss of death.
Kevin: So let’s contrast, because you’re a value investor, a more patient value investor rather than trying to chase momentum, so what is the difference between being patient or rushing through class five water?
David: Patient capital holds for long periods of time and allows for low basis to compound. Patient capital typically is somewhat contrarian in nature, in the sense that as things are getting better and better, there’s a degree of skepticism that patient capital begins to adopt. And so the patient capital is looking to get out while everyone else is clamoring to get in, playing the momentum trade. And patient capital is typically early, typically early getting out and early getting in. There’s not necessarily catalyst for growth right off the bottom of a market low, and yet patient capital says, “Over the next five to 10 years, I’m going to be able to compound off of this basis and it will be very meaningful in terms of the compounded returns.”
Kevin: It’s the old straw hats in the winter mentality.
David: Leveraged capital is anything but patient, in part because it’s capital on a clock. And I say capital on a clock because you are paying to use someone else’s money, and the hurdle for success rises the longer you let the clock run.
Kevin: Is that why you watch how much of the market is actually borrowed money?
David: Yeah, absolutely. Because that also is one of those common characteristics. If you’re talking about a turn in the market and an expression of speculative exuberance, we’ve measured borrowed money in the market using margin debt as a benchmark. FINRA tracks that. FINRA measures margin debt at $1.22 trillion. It’s down a few percentage points from March. March was lower. And we don’t have the April numbers yet. But it’s likely to be up even more in April, rising with the market indices off of those March lows. But what margin debt does not measure is the quantity of dollars in products which are engineered with leverage in them.
Kevin: Okay. So let’s go into that because what we’re talking about is, how much is that—from what we actually see to how much is actually invested—right? So it could be two-, threefold, or more.
David: Right. Yeah, because the ETFs that have been quite popular, particularly with the younger investor set, if you want to own silver, you use 2X silver or 3X silver.
Kevin: Right, you’re leveraging it.
David: If you want to own semiconductors, you don’t own it as a standalone index. You want to own two times the return or three times the return of the semiconductors.
Kevin: Or the loss.
David: Yeah, correct. So current estimates are about 165 billion in capital in those ETFs, leveraged ETFs, two and three time ETFs. That creates a $330 to $420 billion footprint. More if you’re doing times three, taking an average of those.
Kevin: Two to three-fold. Yeah.
David: Yeah. And then you’ve got to keep in mind, lest we forget, a group that borrows to enhance returns as a part of their business model— It’s total misnomer. When you think of a hedge fund, it’s not that they are hedging risk, they are taking leveraged speculative bets using other people’s money to make as much money as they possibly can. 1x is never going to be sufficient. That’s not what they’re getting paid 2% to manage and 20% of all returns.
Kevin: Is that why they have to block the doors on liquidity sometimes, where they say, “You just can’t get your money out right now?”
David: Occasionally. Yeah, occasionally. So the most up-to-date data at financialresearch.gov tallies borrowed money used to enhance long positions from your hedge funds at 7.42 trillion. Trillion.
Kevin: Wow.
David: So you’ve got underlying assets at year-end that sum to 4.83, which, if you’re comparing those numbers, 4.83 in actual assets plus the leverage, you’re talking about 154% on average across all the strategies. Leverage applied is 154% within the hedge fund community. Some, of course, are a mere 20% or 30% leveraged, and some are heavily leveraged, 300%, 600%. Basis trade calculations are upwards of 1,000 or 1,200%. I mean, it’s crazy leverage in certain categories.
Kevin: But you’re talking about professionals. Okay. The hedge funds. What about the retail investor, just the guy on the street?
David: Well, retail speculation is best measured by the margin debt numbers, and we’ve never seen these numbers as high in terms of nominal figures. But as a percentage of market capitalization—again, you’re taking the margin debt number 1.22 and you’re dividing that by the current stock market capitalization—you come in right around 1.7%. Depending on the stock market, we have a sell-off in a given week, maybe it’s 1.9% or whatever, but it’s well below the record of 2.9%.
Kevin: So we’ve never seen these nominal numbers, but we’re actually still below on the margin debt for the retail investor. So there’s more money that could go in before we break any records.
David: Yeah. If you wanted to make the case for added fuel to the market firestorm, you could see margin debt past two trillion from its current 1.22. And markets do melt up, and this is—
Kevin: So we could see higher numbers.
David: Again, we go from two and a half, in terms of the standard deviation or the sigma, to three, three and a quarter, three and a half, and markets are getting more stretched. That’s why it’s a terrible timing tool. If you’re saying, “Oh, it’s overpriced, therefore I’m going to short the market today.” Well, it might hurt you.
Kevin: It can stay high longer than you think.
David: Yeah. And the nimble trader may be able to be in and quickly get out. That’s usually what is assumed. People aren’t assuming that they’re going to get stuck holding the bag. There’s always time. There’s always going to be some indication, they’ll always get out, except that euphoria tends to be dizzying and gains tend to be addictive.
Kevin: Is it reasonable—
David: And traders often overstay.
Kevin: Well, is it reasonable to add up all this? We talked about the hedge funds, the retail investors. What does it look like when you put it all in the same pot?
David: If you add all the borrowed capital together, so you’ve got margin debt plus the implicit leverage in ETF products—that’s the kind of 2x, 3x exposure—plus hedge fund borrowing, brings you to 8.97 trillion.
Kevin: Almost nine trillion. Wow.
David: That takes your total margin relative to market capitalization to 12.28%. So while 1.7 is conservative relative to the all-time peaks of 2.9%, again, this is margin or borrowed money relative to stock market capitalization, that number, 12.28, never been seen before.
Kevin: Wow.
David: So if retail margin numbers have headroom, if you’re talking about aggregate margin, it’s never been this high, and you’re truly playing with fire.
Kevin: Okay. So we talked before about bubbles, you used the term super bubble. We’re in a super bubble, right? I mean, isn’t that what you’re saying? We’ve never seen margin debt as high when you put it all in the same pot. The other metrics that you look at, I’d like to, sometime in the show, talk a little bit about the cyclically adjusted price earnings ratio, some of those, but we’re just tooling along right now. And how’d you say? You said less than 1% of the time throughout history has the market been this expensive.
David: Yeah. And over the last 15 to 20 years, there’s times where I’ll reference GMO, which is not genetically modified foods. This is an organization that manages money, a hedge fund that was started by Jeremy Grantham. And he’s—
Kevin: You just read his book.
David: I did, and it was a good book. Many of his articles sent to clients have been made available publicly through time, and he’s the guy who’s not afraid of being early. And it does mean that he’s sort of swimming against the stream at times, sitting in cash when others are still making money.
Kevin: They call him a permabear, right?
David: Yeah.
Kevin: And that’s not endearing, the people who call him that.
David: No, but I think one of the things that he reflects on is that ultimately I’m going to be right, but I probably won’t be right with the same set of clients. In other words, he’s familiar with what happens. People get greedy at the end of a cycle. And if you’re under-performing the market, you pull the plug.
Kevin: It reminds me of Andrew Smithers. Remember when he told you, he says, “Look, the market’s just too expensive. I know I’m going to miss something, but I’m going to keep my cash.”
David: Yeah. And I’d rather be in cash and I’ll take an inflation hit, but I can define the inflation hit in low single digit terms and a market loss is high double digits. And at my age, I’m not interested in trying to make it back, and I don’t have the timeframe to allow the market to mend. The patience game is not a game that I can play, therefore I’m going to be more conservative.
So Grantham’s definition of a great bubble is apropos as we work our way through this particular earning season, where over 80% of companies have beat expectations on an earnings per share basis.
Kevin: Wow.
David: Profits are great.
Kevin: Yeah. Wow.
David: And he says, “A great bubble is excellent fundamentals, euphorically extrapolated.” That’s a great bubble. That’s a super bubble. Add to this a common feature of super bubbles, which he describes as “an acceleration in the rate of price advance toward the end to two or three times the average speed of the full bull market.”
Kevin: So that’s that class five water we’re talking about where it sweeps through a very narrow channel, but you better know what you’re doing.
David: Yeah. So if you go back to Jeremy Siegel’s tome Stocks for the Long Run, he would argue that you can expect somewhere between a 7%, 7.5% return in equities over time. Better than bonds, better than many other asset classes, and you should just own stocks for the long run. Well, that’s an average number that includes drawdowns of 30% to 50% and years where you may see 30%, 40%, 50% in gains.
What Grantham is getting at is, if your normal expected rate of return is, let’s just say 7% to 10% in an average year, if you’re seeing 30%, 40%, 50% rates of return, those are dynamics which he would describe as an unhealthy rate of change, or an acceleration which is two to three times the average speed of a normal bull market, and that should be a cautionary signal.
Kevin: But there is this concentration that you talked about. This is just a few names. I mean, these are just a few sectors that are just skyrocketing.
David: Right. And this is familiar territory for our listeners. Breadth is a technical term, which is just how many companies are participating in this move. If it’s a market that has a very wide breadth, it’s really a broad-based market move. Those are the characteristics of a really healthy bull market.
As you get towards the end of a bull market, breadth narrows. In other words, the number of names participating, benefiting from the upswing, they diminish. So there’s a clustering around a few names, breadth narrows, rate of change increases dramatically, then a handful of investors begin to note the crowding effect and you start to see relative value on offer, so they lead the move.
You’ve got a few investors who are starting to say— And this has been the case in the first quarter. I think very important to note, they’re moving from the leaders to the laggards. That was a notable first quarter characteristic, money moving from tech to the Dow transports and the Dow industrials.
Kevin: Wow. So before it was Mag7, FAANG stocks, that type of thing. And now, what you’re saying is it’s starting to move toward the blue chips.
David: Yeah. So you had the Mag7 sexy, they’re out, move to mega cap, boring, they’re in. And your year to date performance in the transports in particular and the industrials has been impressive. In the last couple of weeks, we’ve had a rip snortin’ move higher, with semiconductors and tech and Mag-7 back. And in fact, if you look at the profit expectations, the big beats have been in those names. So the rotation is serving as confirmation, in my mind, of a market top. This is how market tops play out.
Kevin: So they go from the high-risk like Mag-7, then they go to blue chips, then they step out at some point.
David: Yes. The music is still playing, investors continue to dance, but they shift from blue chips to de-risk while still dancing with the devil.
Kevin: So let me ask, because we’ve been talking about a bubble, super bubbles, that type of thing. How long would you say we’ve been in what would be considered like what Grantham’s talking about, a bubble?
David: A bubble since 2020, with a modest decline in 2022—of course we had the everything bubble there, 2021. Then 2022 rolls around. Bonds have the worst performance since 1873. It was a terrible year for bonds, a terrible year for stocks, terrible year for real estate, terrible year for everything.
And of course, we had interest rates make the turn and start moving higher. And you find that actually the cost of capital is one of those key components that stitches together all asset classes. If there’s something that correlates them, brings them together, it’s a move in interest rates.
Move lower, everything booms. Move higher, everything gets crushed. So the US equity market’s been in a bubble since 2020, modest decline in 2022. Animal spirits quickly revive thereafter, and introduced into the equation as the AI bubble within the preexisting bubble.
Kevin: Which really reminds me, that’s why I asked you about the dot-com period of time while you were a stockbroker back in 1999, 2000, right in that area. We got to a price-earnings ratio of almost 43, didn’t we? The Schiller PE got up a little bit above 40. We’re getting close now.
David: Yeah. I mean, the setup is fantastical. You’ve got the extrapolation, which is precisely what’s baked into the market today. 40.7 is where the CAPE sits today.
Kevin: That’s only the second highest ever.
David: Second highest ever. And I’ve seen one other measure that puts it at 39.8 or something like that, but it’s in that 39 to 40 range. So yeah, the Schiller PE, another way of framing it, Robert Schiller popularized the CAPE, cyclically adjusted price earnings. Same thing.
The Schiller PE is saying that market participants expect not 10 years of comparable growth, not 20 years, not 30 years, but 40 years of growth comparable to today.
Kevin: Right, So it’s the earnings of those companies.
David: It’s strong fundamentals extrapolated indefinitely.
Kevin: You can get online and type in “Schiller PE,” and it gives you a chart that you can just move your cursor on, and you can actually just see how accurate that chart has been throughout history—it goes back into the 1800s—how accurate it has been as a predictor of a major market downturn.
But I almost hate to ask you this because I think I already know, but what is this saying to you when we’re above 40?
David: Yeah. What it says to me is that markets are, as they always have been, an expression of aggregate psychology. And while you don’t want to ignore the wisdom of that aggregate data, you do need to reflect on it and make sure that it’s not mad, as in misguided or manic, and frankly near the turn—and that would be a turn towards mean reversion.
Kevin: So with the Strait of Hormuz being closed or relatively closed right now, I’ve heard how dire the circumstances are getting in Europe, some of the places that require that kind of energy, but isn’t this energy shock going to affect the earnings? Because we’re talking about earnings of companies that need energy.
David: Yeah. The profit metrics, the earnings reports that are coming out, you’ve got January, no issues. February, no issues. We only get into this issue with Iran in March.
Kevin: Right.
David: So you’ve got the last part of a quarter, maybe the last two weeks, which negatively impact corporate numbers. And where you’ll really see it show up is in Q2.
What Q1 earnings, as impressive as they are, they don’t reflect the supply shocks and the inflationary impact of what is our generation’s greatest energy crisis. So as we advance through towards the end of 2026, there is a strong case to be made that Q1 profit margins were the record levels.
Not that we can— Maybe we set new [records], but I can’t see it as we’re facing the headwinds from macro factors which are way outside the control of the C-suite. And so if margins compress in the remaining quarters of 2026 and profits revert towards the mean, that’s when you begin to see risk repriced.
Kevin: Well, and I was thinking about that because if we’ve got a price-earnings ratio right now that’s over 40, 39 or 40, whatever you want to call it, okay? And yet we had the kind of earnings we had in Q1, that should have affected that PE ratio and knocked that thing down.
So obviously the stocks are going up. In a way, the earnings are fueling this market right now. People are like, “Hey,” like you said, I mean, this firestorm, it makes its own weather. And because the Schiller PE should have come down if the earnings spiked, that’s how the ratio works.
David: Yeah. I think we’re seeing it come down a little bit because we were a little bit higher, and by the time they recalculate the number it wouldn’t surprise me to see it at 37, 38 as earnings put in a peak.
Kevin: Nosebleed.
David: Mm-hmm.
Kevin: Yeah.
David: But I think what the markets are failing to do is look far enough forward. And some commentators are saying, oh, they’re seeing past this issue in Iran and assuming that this is going to be resolved in a fairly quick basis.
Kevin: Wouldn’t that be nice?
David: Yeah. But the increased profits, they feed the beast, and that’s what investors love. Decreasing profits end up starving the beast, and you begin to see animal spirits dissipate.
So market psychology here is critical, and it’s getting what it wants, it’s getting what it needs, but performance depends heavily on profit momentum continuing.
So while it’s possible, I think the economic impact of the Hormuz crisis is likely to be more fully reflected in Q2 and Q3 and the numbers that are reported in those quarters.
So if that’s right, then safe havens will move from unwanted, unneeded to most needed as the year progresses.
Kevin: So it’s not just earnings though, because it’s borrowing as well. This goes back to how much money are people borrowing to do the things that they’re doing.
David: Yeah. And borrowed money is an expression of confidence. Not only do you want to make a bet with what you have, but you’re so confident that you’re willing to borrow, pay interest on that loan—or on the collateral that you borrow—and increase your bet.
So borrowed capital, that’s a speculative expression of confidence. And I think that borrowed capital will be a force multiplier in the markets; just as they are in the upside—inflating performance in the indices in individual companies—but it can also be a force multiplier as the year progresses in a not so pleasant way.
My fear is that correlations between equities and bonds will once again move towards one, strong correlation. So remember the hedge funds that we mentioned earlier. Remember the fact that what we discussed last week, that hedge funds are the largest holder of US Treasuries, leveraging them as collateral for other speculative bets.
The pecking order: you’ve got Japan, which holds about 1.2 trillion in US Treasuries. The UK, about 900 billion, China is third at about 700 billion, and then [hedge funds] in the Caymans, they registered over 400 billion, but there’s many that believe that is understated significantly. The total in the hedge fund community in terms of Treasury exposure is actually understated by 1.4 trillion, with a total being closer to 1.8 trillion. They’re the number one holder.
Kevin: Okay. I’m going to back up here. When you talk about the correlation of stocks and bonds getting near to one, what you’re talking about, the old model is if you think stocks are going down, go into bonds. If you think bonds are going down, go into stocks.
But what you’re saying is when that correlation hits one to one, whether they’re rising or falling, they’re doing it together.
David: Yeah. The lead in the investment committee, we talked about this last week and some of my frustrations with the investment committee conversation last week from the Wall Street crowd.
But the lead on the investment committee asked a question about what happened in 2022 when stocks and bonds both moved lower, and that’s not supposed to be the case? Well, cost of capital moves higher and all of a sudden both assets are tied at the hip. They’re moving for the same reasons.
And his question was brushed off. Again, the frustration that I was expressing last week. It was a very good question. It’s a very important question. What’s different this time? And if we’re trying to manage risk in the portfolio, do we have more correlation of the portfolio rather than having a balance of assets and something that creates sort of a derisking, a hedge, if you will?
What if your hedge ends up working against you?
Kevin: Right.
David: And so—
Kevin: And these guys were like, “Ah, don’t worry about that. That’s an anomaly.”
David: They didn’t even say that. It was like the question wasn’t asked. And so here’s your daily thought experiment. Just work through this because I think this is a pretty reasonable potential sequence of events. Leveraged equity bets, for whatever reason, go south later in this year, sell off.
Kevin: Okay.
David: Hedge funds unwind forcefully. Interest rates creep higher as a consequence of inflationary pressures—and that’s from elevated oil and gas, but also supply chain disruptions and more importantly because there are too many IOUs. There’s just too much supply of IOUs and not enough demand.
As rates increase, bond prices drop. For the hedge funds this is significant because it shrinks the value of the hedge fund collateral. At the same time, their speculative equity bets are souring. That forces degrossing by the hedge funds. They’ve got to limit, they’ve got to shrink back their balance sheets, and that acts as a negative feedback loop, adversely impacting stocks and bonds at the same time. Again, correlations across assets increase, just like in 2022.
With the next dominoes to fall being credit related. Low quality credit gets repriced. Credit spreads widen. That puts a tremendous amount of pressure on corporate America. Default insurance costs increase. Insolvency begins to be factored into the market. Insolvency hits the lowest quality borrowers first because they’re unable to refinance. Or if they are able to refinance, they can find the liquidity. It’s at rates that are not manageable. All their pro forma numbers get blown out. Typically, you’ve got Treasuries which act as a safe haven.
Kevin: Yeah. That’s where people go when they’re worried about everything else. Treasuries and gold.
David: But with hedge funds being significant players in that space, and basis trade being absolutely massive, your leveraged equity bets in the hedge fund community being aggressively unwound, you could have a decline in Treasury prices.
Kevin: You’re talking about longer term.
David: Yeah.
Kevin: Not short-term Treasuries.
David: Well, exactly. T-bills are a totally different animal. But as you get into notes and bonds, that’s where you’ve got greater risk. So typically, Treasuries act as a safe haven, but with basis trades and leveraged equity bets in the hedge fund community being aggressively unwound, this dynamic of a decline in Treasury prices may in fact discourage the normal migration. It’s now trending down. Do you want to move to Treasuries if they’re in a downtrend?
Kevin: So where does gold factor into this? Because that’s also a safe haven.
David: And that’s the point is you’ve got safe haven scarcity, a growing awareness in this context, this thought experiment of counterparty risk and the desire, the need for liquidity, devoid of solvency risks or interest rate or duration risk. And that draws an investor crowd into gold.
ETF demand for gold increases, over-the-counter demand increases, that’s for physically deliverable products. Central banks continue to do what they’ve been doing since the dollar was fully weaponized in 2022, add to gold and let some other sucker own their previous holdings of US certificates of confiscation.
Kevin: Bonds. Yep.
David: Relative value flows increase, and foreign capital moves to greener grass. And this is a really key risk because we see any dollar pressure and equity pressure at the same time— We’ve got so much foreign capital in the US markets. Roughly a third of market cap today is from foreign invested capital.
So where do you go for greener pastures? You go to the UK, you go to Brazil where PEs are approachable and instead of playing the momentum game in a three sigma market, you go shopping in markets that are already fairly valued. And no, you don’t get the same growth benefits of exposure to AI, but if that trend is played out or if it’s too crowded, now, again, it’s a relative value question.
Just like we’ve already seen in the first quarter migration from tech to transports and industrials, you can also see the same value migration out of the US market altogether, and that is very consequential because we’re talking $20 trillion.
Kevin: Wow. So if the foreigners leave— Now, okay, so this was a thought experiment. It’s not happening right now. You were just thinking through what the rest of the year might look like. What would you say you want to be in? It sounds to me like you want to keep your powder dry right now and have liquidity in safe things so that you can jump in and buy the value.
David: Yeah. It’s a series of scenarios becoming more plausible every day. And the conclusion is simple. And we’ve said this repeatedly throughout the two and now three sigma market, healthy amounts of cash. Yes, that’s in Treasuries, but not bonds, not notes, talking specifically about short-term T-bills. So healthy amounts of cash, that puts you in a position to own a one sigma or a negative sigma market.
Kevin: That’d be the left side of the chart, right?
David: That’s right.
Kevin: Yeah.
David: So the journey from overvaluation, it’s never to the mean. When we talk about mean reversion—
Kevin: It swings.
David: —markets overshoot in both directions, and you may have a shot at owning companies for less than their replacement value. Again, for those of you who’ve listened to the Commentary for many years, we’ve talked about the Q ratio. If you just add up the land, plant, and infrastructure of companies—
Kevin: That’s what Smithers loves to watch.
David: And he wrote the book on the Q Ratio.
Kevin: Yeah, exactly.
David: And I think if you want to become an astute investor and are thinking about, “How do I do this throughout business cycles and even across generations? What are some of the tools that I need, and what’s the information that needs to be transferred?” Not just the wealth.
Kevin: Q Ratio, Shiller PE.
David: Get Andrew Smithers’ book on the Q Ratio [Valuing Wall Street] and you will have some bona fide metrics that will help you manage money across generations. So there is a point where you can, according to the Q Ratio, buy companies for less than their replacement value. Today, you’re paying high premiums, land, plant, and infrastructure, plus, plus, plus. That gets you to the right side of the Gaussian curve. You’re one, two, three standard deviations.
Kevin: And you want to buy on the left side of the Gaussian.
David: But on the left side of the Gaussian curve where actually you’re getting the company for less than it’s worth.
Kevin: Right.
David: So today, we are at the outer right edge of the Gaussian curve, three standard deviations, AI and tech in particular. And it’s the part of the curve that you sell. The far left side of the curve is where you buy.
Kevin: So you want to be selling tech right now because it’s on that side of the curve.
David: Yep. John Authers is a guy that I read, Bloomberg article comes out a couple times a week. And in his recent note, he says, “The boom in profits is very much centered on technology and the unprecedented AI data center build out.” Other sectors are playing catch up, and he refers to a Société Générale chart. “The rise in profits is concentrated almost entirely in the prime beneficiaries of this capital intensity.” And it’s semiconductors and equipment, it’s tech hardware and storage. And then a third would be oil and gas, consumable fuels. No surprise. We’ve got an energy crisis, and there’s been some out-performance and capital flowing there. But he goes on to say, evidently, this helps justify the near hyperbolic rise of the Philadelphia Stock Exchange Semiconductor Index, up almost 50% in April alone.
Kevin: In one month?
David: Yep.
Kevin: Yeah. Up 50%.
David: So go back to Grantham’s idea that, what’s a normal rate of change? If you’re doing two to three times normal annual rates, yeah, that’s exuberant, but the picture becomes less reassuring once you unpack it to look at concentration risk. I mean, Kevin, we’re not the only ones sitting here talking about breadth.
Kevin: Or the lack of breadth.
David: Or the lack of breadth.
Kevin: Yeah. Concentration.
David: 43% of the increase in 2026 consensus profit comes from semiconductors alone.
Kevin: Wow.
David: Add IT hardware and energy, he says, and you’re close to 98% of this year’s extraordinary profit upgrade.
Kevin: Class five water.
David: This is the concentration of capital we spoke of earlier. Semiconductors, IT hardware, oil account for 98% of the increase in profits. At least two of these are stretched—really, really stretched.
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You’ve been listening to the McAlvany Weekly Commentary. I’m Kevin Orrick along with David McAlvany. You can find us at mcalvany.com and you can call us at 800-525-9556.
This has been the McAlvany Weekly Commentary. The views expressed should not be considered to be a solicitation or a recommendation for your investment portfolio. You should consult a professional financial advisor to assess your suitability for risk and investment. Join us again next week for a new edition of the McAlvany Weekly Commentary.
