The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: David, today, our guest is Tom Hudson. He is on PBS, and speaks about the news every night.
David: Kevin, it will be an interesting conversation today. We are looking forward to discussing a whole broad range of issues, whether it is the role of media, the impact of dot.frank, dividend-paying stocks, versus the interest rate environment we are in today and tomorrow. We can go a lot of different places in conversation with Tom. He is used to asking the questions, actually, so our roles are a bit reversed today.
Tom, thanks for joining us. Most of our viewers would know you from the PBS Nightly Business Report. You are in an interesting position. You are in touch with a broad cross-section of investment analysts and professionals. Rarely do you get to explore issues extensively on air, given the time constraints of programming. It is particularly interesting, with that in mind, for us to get your perspectives on a variety of issues, with time being less of an issue. You sit in a sort of information nexus, with access to a broad array of these investment experts. How do you filter the data that you have available to you? What particular matrix? Are there chief influences that you have, intellectually, which allow you to organize all of the data that flows your particular direction?
Tom Hudson: That is a great question, David. First of all, thank you for the time and the opportunity to talk. I am really looking forward to our conversation. I am certainly humbled, and lucky, to sit at exactly the unique position which you describe, which is a nexus, a kind of crossroads of information coming my way and my true privilege, really, to present that to people, on a national and international basis every night on Nightly Business Report on PBS.
One of the things that I start with every day is that the market is not wrong or right, it just is. And price matters. And price action matters. That tells us, really, what is going on. Everything else – geopolitical talk, politics in Washington, local politics, and state capitols – all of that kind of talk is great for flavor and color, but the play-by-play is on the ticker, itself. I usually try to let the market tell me what is going to be most important, in terms of price action, and in terms of volatility. Those are the places, really, that I begin every day when I prepare for my program, to really let people know what has happened today in the market, and perhaps most importantly, begin to let them know about how tomorrow may be shaping up.
David: It sounds very similar to Charles Dow, Hamilton, Rhea, and the modern practitioner of Dow theory, Richard Russell, who would say, absolutely, price action is all that you have to go on. That is the language of the market.
If we want to dive in on that particular point, Russell has mentioned recently that should the Dow break below 11,823, that he would consider a confirmation of a long-term bear market, that being the context that we are in. But he is agnostic at this point, because we are not there. Again, he is looking at price action and saying, well, we will have a confirmation of a further downside move. Do you look back at history and use some of those kinds of ideas?
Tom: I do. I think history, obviously, is a great guide for what is going to happen in the future. It clearly does not have a monopoly on what is happening in the future, but we clearly have to know where we have gone to hopefully get a better idea of where we are going.
Throughout my career in financial journalism, I will be honest, I have tried my best and darndest to explain to people why the Dow Jones Industrial Average is probably the least important of the major equity averages and indices to pay attention to. But I might as well be talking to a brick wall, because people always want to hear about the Dow Jones Industrial Average, always want to measure the mood of the market by using those 30 stocks, even with all the shortcomings of the Dow – it is price-weighted, it is somewhat actively managed, not on a daily basis, but clearly, there are stocks that come in and out of that.
The Dow 30 today is very far from the Dow 30 that hit the recession low back in 2009 and is still a very different index than hit Dow 14,000 in the fall of 2007. It is a much different index today than the one that we are going to be talking about, perhaps in the next couple of years, be that either a Dow 11,000 or below, or Dow 15,000 or above.
David: So you are looking for a broader cross-section and something that is perhaps a more adequate sample size.
Tom: Exactly. I think sample size is interesting, and Dow Theory is clearly one of those ideas that does come into play in the market, because it is just that. It is a theory, but it is one that has been time tested, and there is a lot of literature on it, and a lot of acceptance of it. But clearly it is not the only market theory that we have when we prepare our broadcasts every night, nor is it the only market theory that folks use when trying to prepare their portfolios.
I think that, getting back to the idea of this nexus of information that I am able to sit at every day and have the pleasure to take all that information and make it meaningful, accessible, and useful and actionable for people, the Dow is one of those, clearly, that we always have to watch, probably more out of habit than necessity, but I think the broader S&P 500, or the Russell 2000, gives us a much clearer picture of what is really going on within the equity markets.
David, I began my financial journalism career on the derivatives floor in the options exchange in Chicago and the Chicago Merc and the Board of Trade, and that is why I always get back to that price action. The futures guys and gals that I began covering would always want to look at the book, look at the liquidity, look at the depth of the book, and look at the transparency of the book, to really get a feeling for where the market is headed.
David: Then, if it is not equities – obviously that gets the most attention in broadcasting, that is probably where people have most of their money tied up, and to some degree, bonds as well – but today, derivatives dwarf the size of the traditional investment markets by a factor of 3 to 5, and if you have, globally, roughly 200 trillion dollars worth of paper assets, on the derivative side you have somewhere around 600 trillion. If we can even conceive of the number, a quadrillion, at one point I think they said about 1.4 quadrillion. It is a lot less than that now.
Tom: But those are usually nominal figures, and we can explain nominal figures away by saying those are the numbers on the papers. Perhaps all of those things do not wind up with that kind of value out there, but I agree with you, David. I think that the media pays attention to the equity market, in part, because there is a physical place for it, in lower Manhattan, and in mid-town Manhattan, both the New York Stock Exchange and the Nasdaq. So that is helpful for a lot of people, because we are able to put these concepts into a physical space into our physical 3D world, whereas the derivative space, while there is plenty of action on the exchange-side derivatives, much of the derivatives space, including FOREX, is all over the counter, and it gets to be much more conceptual, and, quite honestly, concepts are difficult to put on television, David.
David: Does it tell you anything when the side bets, again, coming back to the relative scale of the derivatives market, far surpass the underlying assets, both in terms of the revenue importance to, for sample, an NYSE, and foreign exchanges, as well. The scale is different. Revenue importance – derivatives are now more important than the underlying assets.
Tom: Right. More important in terms of the size, perhaps, but those derivatives clearly would not exist without the underlying asset. Maybe it is a chicken or the egg kind of argument, but the underlying asset clearly has a lot of importance, and needs to exist in order for the derivatives markets to exist and flourish like they are.
When I would bring visitors in to the derivatives exchanges in Chicago where I began, they would look at them and they would say, this is one, big, loud casino, with no slot machines. I would consistently say, no, the big difference between the derivatives market and a casino is, the casino is creating risk where there was none, and the derivatives market is merely pricing risk that already exists, and allowing folks to mitigate it, to trade it, to profit, and to lose from it.
David: It brings in, certainly, the concept of counter-party, because on the other side of every transaction is the assumption that the counter-party can stand up to the requirements to pay. If you have hedged out the risk and that has been passed on, that person who has accepted it has to be able to maintain liquidity sufficient to pay. Is counter-party the big risk in the derivatives market?
Tom: It is over the counter, but it is not when it comes to the exchanges. Think back to the spring of 2008 when Bear Stearns essentially collapsed, and then fast-forward from March to September of 2008. We had Lehman Brothers collapse. We had AIG collapse, which was a counter-party risk, to some degree. We had a number of investment banks wind up becoming bank-holding companies so that they could have access to Fed liquidity, so that their capital structures would not collapse under the pressure of counter-party risk.
But we did not have exchanges. Derivative exchanges have those same financial problems, because they step in as the intermediary between the buyer and seller, to guarantee, on exchange-traded derivatives, that the two sides do have the liquidity and the depth of capital, to put up the capital necessary in order to make a transaction complete.
One of the things that we can look at in the derivatives space, we need to separate between those derivatives that were contributing to the problems that happened in 2007 and 2008, which were over-the-counter derivatives and those that were happening on an exchange, and we did not have counter-party risk, we did not have clearing problems, there were not exchange-traded derivatives in 2008, and even 2009, at the height of the financial collapse. That got busted, because counter-parties were unable to fulfill their obligations, as long as they were trading on an exchange.
The same cannot be said for over-the-counter trading of derivatives, and to some degree, that is where regulators ought to be focused, and that is why the exchanges really want to grab a lot of that business that has been going on over the counter, bring it onto an exchange, because, clearly, it is very profitable, and the exchanges will point out that they, acting as an intermediary, as a clearinghouse, can essentially step in and protect from that counter-party risk which you talk about.
David: We have had a gentleman named Richard Bookstaber on our program a number of times. He wrote a book called A Demon of Our Own Design, and has been a part of the risk management infrastructure at groups like Smith-Barney, and other groups as well, in Manhattan. In all the Senate hearings that he has done, that is what he has pointed to, that regulation should focus on bringing these things onto exchanges. Do you think that has anything to do with this merger between NYSE and the German Boerse? And coming back to that idea of the physical space, here in the U.S., we think of the U.S. capital markets as one of the deepest, richest capital markets in the world, and yet we are seeing an icon, essentially, shift to another continent.
Tom: Right, to the Germans. Remember the last time the Germans bought an American icon? Daimler-Chrysler, I will bring you back to that merger vehicle in 1998. Let’s hope, for the share-holders, this one does not wind up the same way.
I think in terms of the New York Stock Exchange, Eurex, Deutsche-Boerse deal, while it is not entirely about derivatives, it is a big part of it. The biggest slice of the New York Stock Exchange, Eurex revenue, I believe over 35% comes from derivatives, maybe 30% comes from trading of equities, so it is as much a derivatives exchange as it is an equities exchange, despite its long, long history as the icon of American equities. That is what Germans are after, and it is becoming an international market, clearly.
The challenge that not only U.S. regulators have, but European regulators and other locations have, is the standardization of derivatives contracts. It may be easy to do that for corn. It may be easy to do that for oil, although we are seeing a little bit of split in terms of the different types of global oil markets, between West Texas and Brent and Oman, trying to put a credit default swap, or some kind of debt obligation on a standard basis in order for it to get on an exchange, has been proven very difficult in the U.S., and to do it internationally, has been proven, thus far, pretty near impossible.
David: We have legislative attempts and regulations which are coming out of Washington which are supposed to address the problems which caused the financial crisis in the first place, a monumental effort by Dodd-Frank, at least legislation in their names. I chatted with a gentleman down in the Bahamas, at the same conference you and I were attending, Richard Rahn, from the Cato Institute. He describes Dodd and Frank as fundamentally corrupt. You may not agree with that, but is the legislation actually addressing the issues which played a causal role in the financial crisis, or do we still have a second shoe to drop, perhaps, because the fundamentals have not really changed?
Tom: In terms of the legislation, let me address that first. I think that so much of the legislation has been left to the rule-making bodies. What I mean by that is the legislation directs regulators to write rules that are designed to avoid or minimize the buildup of systemic risk. We will take that as it is, so much of the legislation is going to be written in the regulators boardrooms and their conference rooms.
I think, quite honestly, it becomes a matter of resources, and we have already seen the new Republican House begin to try to take financial resources, or limit the growth of financial resources for the commodity futures trading commission, or even the Securities and Exchange Commission, that could limit their ability to not only write the hundreds of rules that need to be written under the Dodd-Frank legislation, but then, of course, comes the question of enforcement should those rules actually be put into place.
I think when it comes to legislation, whether or not it addresses the systemic issues that came up during the collapse, it is going to be a matter of what the rules are, and then, honestly, the regulators’ financial wherewithal to monitor and adjudicate those rules. I think the final chapter on Dodd-Frank clearly is far from over, and in terms of even the ability to go after the systemic problems, there is a lot within Dodd-Frank that does not really have to do with derivatives, per se, there are some consumer financial protections and those kinds of things, and it does wind up getting to how much we want regulators and rules to try to protect financial markets from not only the ability to profit, but the ability to loss, and I think that is a root question that still remains unanswered on the part of regulators, and on the part of a lot of investors, as well.
David: With a few minutes left to discuss things today, maybe we could talk about interest rates, commodities, oil, Quantitative Easing I and II, and a few other things. Maybe we can give about 20 seconds to each.
Tom: Lots to talk about, certainly.
David: Starting with the big picture, with interest rates. If you step back from the quarter-to-quarter analysis of interest rates, and focus on that big picture, I remember Alan Shaw and Louise Yamada doing an extensive study back in 2004 with Smith Barney, on the duration of interest rate trends. It appears, from a technical perspective, the downtrend in rates which began in about 1980 is reversing. The question is this: Should interest rates adjust higher, are corporations geared for a sustained period of higher capital costs?
Tom: I think that corporations are clearly preparing for that, and we have seen it throughout the downturn, and now the relative up-swing that we have seen since the March 2009 equity lows. Corporate balance sheets have been increasing. Corporations have been launching stock buy-back efforts, and that clearly has an impact on earnings.
You have also seen a lot of corporations continue to issue a load of debt, both short-term, floating debt, trying to take advantage of some of the variations in interest rates here lately because of quantitative easing and some of the other Federal Reserve programs that have been going on, but also issuing loads and loads of longer-term fixed rate debt, taking advantage of these low rates.
We have even seen talk finally surface on the largest issuer of debt out there, the U.S. government talking about a Methuselah bond, of sorts, to try to take advantage of these low long-term rates, almost in a tacit acknowledgment that, yes, the generation-long bull market in fixed income is likely over, and likely to turn itself around. I think the capital structure of companies is prepared, at least in the medium-term, for that, but we are also seeing some private companies begin to turn away from the public markets for some reasons, and part of it may be because of the longer-term concern about the cost of that capital in the next several decades.
David: It has been encouraging to see corporations, CEOs and CFOs, get very serious about their maturity structures. The concern that may remain is at the municipal and at the federal level, where our maturity structure is pretty awful – 36 months, 70% of our debt, nationally, coming due. It is a little bit different because we do have a printing press, we can continue to finance ourselves, if no one else will. But at the municipal level, that is an interesting issue. We do have debt that is going to be maturing, and the question is, how will these individual states and cities cope?
Moving onto commodities, we had a run from 2001 to 2008. We now have the CCI and CRB again pressing higher. Are we seeing inflation, in terms of prices reflecting monetary policy, in your opinion? Or are these truly supply and demand dynamics?
Tom: I think that when it comes to agriculture commodities, when it comes to energy commodities – oil, heating oil, gasoline – we do see supply and demand. Maybe part of this is my upbringing in the Midwest, just outside the corn fields in Iowa, and spending a lot of time at the Board of Trade in Chicago, and watching how these things are priced on a daily basis. But these are global markets for agricultural commodities, there is no doubt about it, as it is a global market for oil, and we are seeing global demand continue to up-tick.
We know that the emerging market, GDP growth, is certainly going to outpace global GDP growth, which is certainly going to outpace developed world GDP growth. So demand is there. The weather has not been behaving too well over the past couple of years in various parts of the world for some of these agricultural commodities, and we have not seen a whole new swath of oil supply come onto the market, even though inventories are very full in the United States and elsewhere. We are not dealing with a supply issue, it truly is a demand curve.
And then I think on the inflation side, if you look at the metals, not only just the precious metals, but even industrial metals, you do have a sense of concern about longer-term global inflation, in part, fed by the Federal Reserve, but also, in part, fed by other central banks, in Europe and elsewhere, and even in China, to some degree, that have provided cheap money to help either keep their economies invigorated, or try to re-spark an economic boom like we are trying to do in the Western World.
But I think when it comes to the inflation side of things, we also have to keep in mind that the developed world, the U.S., especially, has still lots and lots of utilization, lots and lots of aggregate demand to pick up from. So, while we are seeing commodities move here, and we saw a move from 2001 to 2007 and 2008, as you mentioned, I think similar to the generation bull run in interest rates, the generation bear run in commodity prices that ran through 2001 or 2002, and seeing that bottom, we seem to be continuing that general up-trend over the past 6 or 8 years, due, in part, to supply and demand, but also, fed more recently by inflation concerns.
David: If oil today was at $175 a barrel, it would be the talk of the town. Notable, in recent weeks, has been silver at a 31-year high, and gold also closing at an all-time high. It seems that it is lightly discussed, and I am wondering if the public conversation about gold is something like Eeyore showing up at a cocktail party. Nobody really enjoys the negativity. What does the price of precious metals imply? Is that, perhaps, why The Financial Times, The Economist, and other notable news venues, remain somewhat dismissive of the metals? Is it just kind of a downer?
Tom: You have hit the head of the pick in the goldmine, I guess, David. I think you are absolutely right. The implications of the rise in gold prices, just as the implications of the drop in gold prices that we saw throughout the 1980s and 1990s, will continue to be debated, but the fact is, holding a mirror up to that rise in the gold price, especially, and silver, as well, portends concerns about monetary inflation, concerns about geopolitical risks, no doubt about it, and real worries about the value of the paper currencies that the world has embraced over the last generation-and-a-half. None of those things are real happy-go-lucky conversation starters, no doubt about it.
David: It seems there is a little bit of a disconnect between the stated inflation rate, and the implied understanding of inflation by the guy in the street. If you go back to the Summers-Barsky thesis, Gibson’s paradox, Larry Summers writes that in a negative real-rate environment, that is when people opt to take risk off the table and move to precious metals. It tends to outperform in a negative or low real-rate environment. But if you look at the official numbers, we are not in a negative real-rate environment. We have really tame inflation, the cost of living adjustment has not been raised the last two years, signaling that CPI and inflation does not exist, and yet, the man-on-the-street says, “I am wondering if that is balderdash!”
Tom: Right. They use stronger language than that, by the way.
David: Yes, of course. So this is an issue. We do have a drive toward the metals as a preservation tactic. We saw QE-I come around. Mortgage-backed securities were the primary effort there, and that was deemed acceptable by the U.S. and international market. Then you have QE-II, and the market has judged that intervention in the treasury sector unacceptable. You have had yields which have moved aggressively higher since its announcement – the opposite of what was intended. This is an issue. QE-II, monetization, quantitative easing, these concepts all wrapped up in one, spell inflation to somebody.
We certainly have seen a move by David Einhorn and John Paulson into the metals as a currency position, not a commodity. Transitioning from our original conversation about commodities, supply and demand, inflation impacting gold and silver, we actually have a number of fairly significant investors saying, “I am just looking for an opt-out, I am just looking for a currency that is not tied into the fiat world of either the euro, the British pound, or the dollar, where monetary policy makers are going to determine my ultimate outcome of success or failure.” What do you see with QE-II? Do we carry that through to June? Do they cancel it because inflation becomes a concern? Is QE-III even an option?
Tom: Ben Bernanke, last week, when he was on Capital Hill, as part of his semi-annual testimony, was asked just that question about QE-III, by a congressman. He essentially ducked the question by saying that would be a decision by the Federal Open Market Committee. That is clearly a firm grasp of the obvious, but not really an answer to the question, Mr. Chairman.
I think that the Federal Reserve is being more transparent now about its ultimate strategies than it ever has been, and part of that is because the market is still on tenterhooks. It is still very sensitive. Certainly, the interest rate market is, let alone the metals market, and the equity markets, and real estate all tied in here together. I think that the Federal Reserve has drawn this line in the sand about June winding up its Quantitative Easing II program about buying U.S. government bonds. Should the Fed decide that the goal of that program needs to be retained, or has not been met and needs to continue, I think we would begin hearing some talk about that from the Federal Reserve regional presidents, let alone the Board of Governors, in speeches and elsewhere, really, now, to get the market prepared for that.
We have not been hearing that. Instead, what we have been hearing is quite the opposite, that Federal Open Market Committee members seem to be more and more in tune, that they are going to stick to their guns, that they are going to continue with this quantitative easing program until it is due to expire, and at that point they will begin to assess the relative success or not. But let’s not kid ourselves here, David. The Fed is assessing the success and failure of this program on a daily basis, and clearly, on a monthly basis, they need to see unemployment rates come down, and the real unemployment rates, not talking about the 9% that we see printed almost every month.
We need to see the real unemployment go down, the U5, The U6 numbers. We need to see jobless claims continue to move lower, and they would love to see the official inflation number being to tick up, and to your earlier point about the man-on-the-street, and the woman-on-the-street, their real inflation does continue to pick up. There is a program called the Billion Prices Project at MIT. It is bpp.mit.edu. This follows hundreds of thousands of products that are sold online in many different countries, and you can drill down to specific geographical locations. Over the course of the past couple of years it has been seen to be a leading indicator to the CPI, and it is beginning to go parabolic, and that becomes, I think, a big concern for the Fed. But does inflation become a bigger concern than unemployment? I honestly do not think so. I think the bigger concern is unemployment, rather than price stability, at this point.
David: It seems like we are in that classic stagflation scenario. It is interesting, though, coming back to the interest rate environment, because with record, unprecedented funding requirements, you have rollover risk in the treasury market, on top of current deficit spending – a trillion was projected by the CBO, it ends up it is 1.65 trillion for this year, on top of 1.5 trillion last year. Maybe they can rein in spending, maybe there are cuts, but the reality is, we have both the rollover of existing debt, with new debt being piled on. It seems a safe assumption to see rates going higher. That is not to say, moving parabolic, but certainly an adjustment higher, if nothing else, because of those market constraints.
Tom: Yes. And let me add kind of a macro concern on top of the accounting that you talk about from the federal government level. For generations, the U.S. has been able to grow itself out of these really awful debt-to-GDP ratios. We are beginning to hear continued talk about the U.S. needing to grow at 3.5%, 4%, maybe 4.5%, to really begin to make a dent here. But at what point are we going to have a realization on the part of our federal government and voters, for that matter, that a 2.5%, even a 3%, or 3.2% annual GDP growth, may not be enough in order for us to grow our way out of this debt-to-GDP ratio, let alone begin to work down that debt load that we have incurred over the past 60 years?
David: Well, we will tune in tonight to listen to the PBS Nightly Business Report with great interest. The only thing we have not discussed, and maybe we can end with this, is that there seems to me to be a difference between commercial broadcasters and what you do at PBS, and maybe it is just the nature of why commercial broadcasting exists. What is their reason for existence versus the venue that you professionally participate in? Is there a different tack taken because of the audience constraints and business model?
Tom: Yes, there is. There absolutely is a difference in the business model, and there is a big difference in our audience. We have the privilege of being able to be on the air in millions of homes every night and have a half hour to tell the story of business, finance, and money, to America each night. Some of my colleagues in financial broadcasting journalism have eight hours to fill, or twelve hours to fill, and it becomes much more of a play-by-play, and much more of a focus on the box score scenario than what we are able to do with The Nightly Business Report, which is clearly, always keeping our eye on the prices.
To wind up our conversation where we began it, David, price action does matter, but we are able to distill out of that, hopefully, some larger trends in how some of these policy discussions that are going on in the nation’s capitol and in state capitols, wind up impacting either the paycheck that you receive, or the prices that you are seeing at the store, or the portfolio that you have to save for tomorrow.
David: Tom, thanks for joining us. Great to be in touch with you again. We look forward to it in the future, and we look forward to your insights nightly.
Tom: It has been, really, my pleasure, David. I really appreciate the time and the opportunity to speak with you and your audience.