The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“You have to realize, you’re not operating in an objective world. You’re operating in a subjective world. The market doesn’t always respect the subjective. Where you think you are, where you want to be, the market taking care of you today – you don’t always get what you want. And I think that is the danger of presuming that we control the beast. We don’t. The velociraptor is going to eat your lunch.”
– David McAlvany
Kevin: Dave, we talk about the IMF a lot, and the IMF seems to be blindsided every time there is a debt crisis. But Bank of International Settlements seems to be a little ahead of the curve and they start warning the worldwide community before there is a major crash. Part of that, I think, is because they have to be there to help bail either the central bank or the central bankers, and they’re throwing warnings out right now.
David: For perspective, central banks of the world were very loose with their lending leading up to the financial crisis. And then all of sudden they had to save the system, after nearly killing it with too much debt, they added more debt to the system. Now, in the present, we’re managing the cycle using new-fangled tools that they believe give us control over that debt system. And in the future, we are anticipating what they want to do, having a full sweep of tools that will allow them to not relent, never fail, and maintain control over the system. That is what we implied last week when we talked about closure of the system, management of the financial system with tools that allow for the forced behavior of those participants in the system, that is, basically, a financial gun to your head. “You will do what we need you to do.”
Kevin: And that could be a cashless system – what have you. But the Bank of International Settlements is starting to say, “Hey, there may be a little bit too much debt in the system right now.”
David: And that was the same message we were getting from William White over a decade ago. So now it’s Claudio Borio heading the Bank of International Settlements out of Basel, and William White is still there. As an economist, he moonlights with the OECD down in Paris.
Kevin: Yes, he’s been a guest of ours here on the show.
David: The Bank of International Settlements looks at the amount of debt that is in the system today and is very concerned. They were concerned in 2008 and 2009 – even more so today.
Kevin: The BIS, the Bank of International Settlements, even though they warned people back in 2008, no one feels good about, “See, I told you so.” But they did way, “See, I told you so.” It doesn’t repair the issue.
David: This is, of course, the bank to all central banks. These are the guys that coordinate the bailouts and liquidity flows to central banks that are coming under pressure, and channel flows from the healthy ones to those who are weak and under pressure. And the system risk that is infused by the use and abuse of too much debt in the system – that is what they are aware of. You’re right, coming out of the 2008-2009 global financial crisis the Bank of International Settlements was, as it had been prior to the crisis, warning of credit expansion, warning of the risks associated with it.
We mentioned last week the use of collateralized loan obligations reaching almost a quarter of a trillion dollars, while exceeding the kinds of creative structured finance that we saw in 2008 and 2009 – almost doubling it. And they are back on the warpath, warning and warning and warning. Again, we found ourselves in a credit crisis and the BIS was, then, in a position of “I told you so” post 2008-2009.
But since then they are looking at aggregate amounts of debt, comparing it to GDP globally and saying, “How is this safe? You’re 40% higher – 40% more debt relative to the world’s total economy – 40% higher. And if it was an issue prior to the global financial crisis, this is certainly an issue today. We have an explosion in credit creation, the concern is that it represents the opportunity for an explosion into a full-blown credit crisis.
Kevin: Let’s think this thing through for a second. They were warning of a major – and it turned out to be one of the world’s greatest in history – financial crisis. And now we have 40% more debt than we did when they were warning them before.
David: But market practitioners today are more concerned about gains that they have in the financial assets which have benefitted from this explosion in credit. I think this is where you have to focus in. It’s imperative to appreciate where the gains have come from.
Kevin: And can they be duplicated?
David: That’s a huge thing because if it’s just dumb luck – if this phase of asset price appreciation is simply and solely because of a change in credit expansion, what makes you think that it is duplicable? Your process, or what goes into creating wealth from one quarter to the next, one year to the next – if it’s simply based on central bank largesse, understand that the central bank behind the central banks are saying, “This largesse is out of control and not sustainable.”
Kevin: They have no intention of backing away. Last week you were bringing out what Draghi said: “Okay, we’re going to go ahead and taper back to 35 billion in our quantitative easing and we’ll do that, however, until September of 2018.” And then he goes on to say, “And if that still is needed in September of 2018 we will just continue to do whatever we need to do until 2019.” There is no intention of stopping just because the Bank of International Settlements says you have too much debt.
David: Now we face a risk in the marketplace. Do you want the risk of missing out, or the risk of missing some part of your net worth that is not replaceable with some catastrophic loss.
Kevin: Like you said, the fear of missing out. Not the fear of losing, but the fear of missing out.
David: So if this central bank largesse is not going away, maybe the logical, if not very dangerous, conclusion is to ignore the implicit risks of an over-leveraged system and invest like it’s 1999. This is a credit mania. We know that. We can see it in asset prices, and you mentioned having a long list of things that show that credit mania in terms of objective mile markers. I’ll be happy to share some of those today. And we’ve shared some of those 30 points with the folks that we’ve met with already in Kansas City, and in Minnesota, and we’re looking forward to seeing the folks in Pennsylvania and North Carolina next week.
What we see are the massive dollar flows into the marketplace. What we talked about last week is classic hot money. Hot money chases returns, and it doesn’t know how to weigh risks. In fact, sometimes it just flat chooses to ignore it. The defining characteristic of hot money is that it is only there for returns, and if the returns are good the money stays put. If returns are disappointing it leaves.
And this is the dangerous aspect, and is, I think, why the Bank of International Settlements is so keen on the nature of growth in the global economy, and what is driving misallocation of funds. When funds pull – when hot money leaves a market – it is invariably destabilizing to the asset class in question, and quite often, to the geography in question. We’ve seen hot money flows wreak havoc in Mexico, we’ve seen hot money flows as they pulled out of Thailand, destroy the country and create what was the Asian Contagion in the late 1990s.
It’s never disruptive for money to come in. Nobody minds the disruption as money comes into the market because it boosts asset prices and everyone is happy. It’s when they come out in fast fashion that they end up gutting a market, and end up creating not only a market crisis, but sometimes a currency crisis, as well.
Kevin: It creates almost a macro flash crash. You’ve talked about flash crashes where there is money going in, everything seems to be normal, the rises seem to be normal. And then all of a sudden something happens where everybody leaves at the same time. It creates a vacuum, and it’s the “Where did everybody go” syndrome. When you were talking a few weeks ago about the flash crash that happened five years ago, that flash crash – you had assets that you said were selling for hundreds of thousands of dollars on the bid side, but there was no buyer.
David: Right. I think particularly fascinating at present is the melt-up dynamics across all asset classes, because when you think of hot money it is usually from a select source and to a select destination, and in past manic phases you would see a single asset go wild. But today you have this broad cross-section of asset price appreciation. It could be junk bonds, it could be corporate credit. It can be government bonds. It can be specific sectors in the stock market. It can be the crypto-currency universe. I mentioned government bonds, but they are truly one of the greatest bubbles. These are of epic proportions and across the world it’s a global hot money issue. We’ve never seen central banks act in concert this way, create as much hot money as they have, and it’s flowing into everything, which doesn’t really give us a framework, historically, for what happens when or if that hot money comes out, because you’re not talking about going from one asset class into others, you’re talking about exiting the asset classes which are affected. And these melt-up dynamics are across all asset classes!
Kevin: But the central bankers themselves are not concerned. It is interesting that the granddaddy of the central banks, the Bank of International Settlements, is the one that is concerned. It is the older voice that is saying, “Hey, listen boys, you need to understand something. This is huge.”
David: This is maybe me going to a dark place, but the scale of all the all-in bets leads me to this sort of strange conclusion – I hope I’m wrong – that the central bank community actually believes their own B.S. and is throwing caution to the wind because they see themselves as the masters of the universe, they are the alchemists of old resurrected. And what do you have? People who believe that they can do things that no one else has ever been able to do.
Kevin: Let me ask you a question, because I wonder about this. When we interview some of these people, Dave, they have a human level of concern. Carmen Reinhart had a level of concern. When you interviewed Otmar Issing, he had a level of concern. White – they all had a level of concern. I wonder if they really do lose sleep and realize they’re just so far into this that they can’t back out.
David: I think we’re talking to two people – not that all academics are schizophrenic, but I think what you have is the person who makes decisions for their family and they feel a certain way about the topics on the table, and the academic who looks at it and more pragmatically says, “There is only a certain number of conclusions here. We’re boxed into a corner and there are only a few things that we can do.”
Kevin: We have to do what do when we’re at work, but we have to do what we do at home. Do you remember – and I won’t name the name of the person because it wouldn’t be fair – but after you had talked to a person that was very deep into the central banking community who understands financial repression very well, after we finish the program, oftentimes after you interview a guest, for the listener, a lot of times the conversation continues to go on after we sign off.
David: We’ve not been given permission to include this but…
Kevin: Exactly. Do you remember what the person said that they were doing with their own…?
David: “I’m raising cash, I’m buying real assets.”
Kevin: “And I’m thinking about some gold.” This was a central banker.
David: Yes. It’s fascinating because the question to that person was, “Have you ever thought about gold before?” “Oh no. No. But I’m getting out of debt, I’m raising cash. I am thinking about buying gold for the first time in my life.”
Kevin: This was a person who was actually doing what you are talking about on the central banking side.
David: But there is another option. And again, this is kind of me going to the dark place, but is it possible that they know full well that the asset price inflation, as great as it is today, is inaccessible to most people, and that what it is doing is further consolidating wealth into the hands of the few? I know that may sound conspiratorial…
Kevin: But that’s what is happening, Dave. The rich are getting richer.
David: Let’s just say I’m wrong, they didn’t know that that would be the consequence, they thought that everyone would benefit and there would be greater economic activity. I’m curious what happens in the midst of consolidation? What happens if they cannot, as per my first suggestion, maybe they’re controlling the whole cycle and they don’t believe they can run amok, they don’t believe they will make a mistake, or can make a mistake. The alternative is, what if they don’t care, and in the context of a market decline they anticipate consolidation of power?
Kevin: One of the videos that you play during your talk, you and your dad, is chilling. It is just a short three-minute video by Bill Gates talking about the unbanked poor and how concerned he is about the unbanked poor, and how important it is to get that system digital and get rid of cash as quickly as possible so that the unbanked poor – I keep saying it because that’s what you are going to hear – the unbanked poor can then be in the system and no longer be in poverty.
David: Kevin, you have read a lot more about string theory than I have, and in physics and math this is a world that you love. I know that the string theorists today are looking for the big toe – the theory of everything (laughs). I call it the big toe when I’m talking to the kids because they’re like, “The what?” “Yes, yes, scientists are looking for a big toe.” But the theory of everything includes multi-dimensionality, as many as 11 dimensions to explain activities and behaviors that otherwise math and science can’t explain.
Kevin: Right. And so they add those dimensions so that the math actually starts working.
David: This will be the craziest I’ve probably ever sounded on the Commentary, but looking at the possibility of other dimensions that we don’t know, this idea that there is a conspiratorial nature to it – is it possible that the great central bankers of our day have no idea what they are complicit to? That there are things that happen in layers and dimensions which we can’t fathom or understand?
Kevin: Dave, I’ve wondered the same thing with the Tower of Babel.
David: I mean, we’re just pawns in a game and we have no idea the role. Sometimes we associate a dark nature to people that is not accurate. They’re good people doing the best they can with the tools they have, and they have no idea that they are merely pawns in a game.
Kevin: Dave, were there good people who were building the tower? You had the brick-makers, you had the guys scaling it out. The Tower of Babel in Genesis 11, you always think of as something evil that occurred that God broke up. So yes, I think you’re right. I think what you have is individuals all around the world who are doing their best, for the most part, to do the best for their family or for their future.
David: Or for their country. There is a part of me that does get very cynical when I think about Mario Draghi and Janet Yellen and Kuroda, who will get another term in Japan. I don’t know that they are a part of some dark cabal trying to…
Kevin: So you don’t think they’re doing deep, dark incantations when they’re not at work?
David: No, and you and I use that language of a central bank priesthood, but really, what we’re getting at is people who believe they have a certain knowledge which is special, and through every time and race there have been people who have that, and they have been considered the wizards or the weird ones, or whatever.
Kevin: It’s the elite.
Kevin: I remember, Dave, reading an article back in 1987 in the Wall Street Journal. It was a two-page article in the middle of the paper written by a guy in Europe talking about the need for 12 people, the illumined few, to run the world, get rid of this democracy, and let’s just go ahead and put it into the hands of the people who have your best interests in mind. I know that sounds conspiratorial, but I read it in the Wall Street Journal.
David: There is a fascinating conversation I had with a gentleman who spent about eight years as an attaché for the Treasury someplace in the world.
Kevin: Right. That was just a couple of weeks ago.
David: That’s right. Our conversation was interesting because partway through the conversation we both looked at each other and we said, “We should be the ones directing a conspiracy, because if the folks at Treasury and the folks in the State Department don’t understand the nature of losing reserve currency status and what the implications of that is for us projecting power into the world, somebody has to do something to save the Union.” Literally, we were two people saying that, from our vantage point…
Kevin: So the question comes in, Dave, if you could save the world, would you?
David: All of a sudden you see this repeated theme through history and through literature.
Kevin: You see the motive being good because you think you’re going to save the world.
David: Right. And Gandalf the Grey says, “No, I won’t take the ring because I know that I’ll start with a good motive, I’ll believe that I’m going to change the world having this infinite power.”
Kevin: That goes back to Plato. You taught me that years ago when you were a Philosophy major.
David: Of course. It’s book two. You have the Ring of Gyges. This innocent shepherd boy finds a magical ring and it gives him invisibility, and ultimately that gives him power. And he figures out how to use that power, and he basically dethrones the king, takes the queen as wife, and sets himself up as a tyrant.
Kevin: I read those books and I watched those movies, Dave. What you are talking about ends with a lot of bloodshed before it would come out the other side.
David: We all believe that we will do best if we have power, and we’ll do the best for other people and for ourselves. I know that’s a bit of a diversion.
Kevin: I think we did divert a little bit, but let’s just say, the masses right now – we’re talking about if this is a conspiracy, or even if it’s not – the masses are buying into it. Look at margin debt right now in the stock market. The margin debt is hitting all-time highs. What that means is, people are not only buying the stocks they can afford, they’re buying the stocks that they can borrow to afford.
David: Right. When you run out of money, and you still consider the stock market to be a sure bet, then borrow some more, and buy the same thing you already own. That’s remarkable. Margin debt as a percentage of GDP is now 3.1%.
Kevin: Every time it gets up in this range it crashes.
David: Except that we’ve never been in this range. Let me correct that because we have never had that number higher in all U.S. market history, and it’s important to look at the percentage of GDP because if I give you the nominal number, 551 billion dollars, you say, “Well, look, the stock market capitalization is bigger. Of course we’re going to have more money borrowed.” But when you look at it relative to the size of the total economy and realize that the speculative dollars coming into the stock market today have never been higher – not at any time in U.S. history, what you are defining is a mania.
Kevin: Where were we back just before the tech stock bubble popped?
David: Just above 2%. We reached just above 2% in 2000, the tech boom. We reached just about 2% in the 2007 real estate mania.
Kevin: And now we’re at 3.1.
David: Which, in percentage terms, we’re at levels 50% higher than we’ve ever been before. And apparently investors are happy to ride the momentum with zero concern for risk.
Kevin: What happens when people need to sell, when this needs to be unwound?
David: What we know is that when these margin numbers get out of whack it represents forced liquidation, it represents the trigger-happy finger that finds the mouse and says, “Well, I’d better close that out as quick as possible.”
Kevin: Have you ever gotten one of those calls, Dave, called a margin call?
David: Of course I have.
Kevin: “You need to sell part of your position, or all of it.”
David: And price doesn’t matter. You have to. Or they will choose what gets liquidated for you.
Kevin: That is painful.
David: So I just wonder, does anyone have a memory of leverage being unwound? Does anyone recall that in reverse the dynamics are not equally powerful? There is not a symmetry here. In fact, it is exponentially more powerful than anything you could experience on the way up.
Kevin: It’s like tsunami.
David: Right. But I don’t know that people recognize that leverage brings an unhealthy market asymmetry on the liquidation side. Unwinding leverage is the most dangerous and violent, uncontrolled financial experience imaginable. And when you look at margin debt at 3.1% of GDP, it represents more of a landslide, more of an avalanche, than potentially we have ever had in the history of U.S. markets.
Kevin: So this takes us back to the motivation of these people. Let’s call them good people in a bad system. You were talking about, do they know that there is a conspiracy, or does it just happen because of the system? If I was a central banker right now and I could see the other side of this unwind, I think I would be tempted to say, “Well, maybe I need to continue with quantitative easing.”
David: That’s where the conversation has gone with our friend, Richard Duncan. He has basically said, “Look, you don’t want to count the bodies, you don’t want to count the chaos. You have no idea what happens to the system, and you don’t want to find out.”
Kevin: He doesn’t think it’s survivable.
David: The central bank community – maybe that’s the deal. They have preferred to pile on more leverage – postpone, prevent, eliminate that kind of unwind. I don’t blame them, but I’m not going to excuse them either.
Kevin: No, there’s no excuse for it. It’s wrong.
David: We will tend to exaggerate, in our own lives – and, I think this is what they do, too – the fear of the unknown. In the central bank community they’re not any different. They’re not sure we could make it out of a full blown deflationary collapse, so they’ve engineered a world that they believe to be impervious to it. And maybe it is looking at the boy maintaining the poise there standing on the burning deck. He knows it’s burning, he knows he is in trouble, and he is just choosing courage.
I don’t know – are they evil? Sometimes when people do things that are not good, they themselves are not evil, though they are complicit to a crime. And I think that is more or less what we have today. Prices are continuing to increase. They are dependent on the increase in leverage today, in large part because we have a limit on the true quantity of capital. When I think of capital, I’m thinking of what has been saved. I’m thinking of what is readily available for investment in the old model of capitalism where you save from your income, you set it aside, you invest it, and hope to grow not only your wealth, but the economy and jobs, etc.
Kevin: But what if you can harness debt? If you can harness debt…
David: Instead of capital.
Kevin: Yes, exactly.
David: Then the limits of growth are, theoretically, as limitless as the debt that can be created. This is the model we’re working with. And it works until it doesn’t. This is the real challenge for any investor. It works until it doesn’t, which means you’re right until the moment you’re wrong. And it means that you have to own that.
Kevin: You brought out that interest rates are the price of risk in the market, the price of borrowing in the market. You have to manage the perception of the people to think that there is no risk so that interest rates don’t rise. The price right now of money is close to zero. People are able to borrow with virtually no interest payments back. So I guess you would say the lynchpin is going to always have to be, to continue this, is to suppress rates.
David: We have the language game being played by the world central bankers. We talked about Draghi last week who said, “You know, look. I’m going to trim back what we’re spending on assets.” At the same time he’s promising the sun, moon and stars and guaranteeing that rates will not go up until 2019 at the earliest, and he’s going to do everything that it takes, just as he promised back in the summer of 2011. So, the lynchpin has been, and always will be, if they are following this strategy of infinite growth built on limitless debt – the lynchpin has and must be suppressing rates.
The game of infinite growth based on an expanding stock of liabilities only works if you control the interest portion, sit on it, so that the liabilities are manageable from a cash flow perspective. God forbid the markets ever reassert themselves and roust the planning community. But this is the deal. They have to get in a bluff with the old bond vigilantes, let them know, “No, no, no. You don’t understand. We’ve got big guns. We’ve got infinite guns. We’ll print as much as it takes, and you will lose.”
Kevin: You said something that gave me a thought, Dave. I love the first Jurassic Park movie. I don’t know why. There are so many quotable lines by Malcolm and all these guys. But the point that these guys who were looking at this dinosaur island were trying to make was that you cannot tame these dinosaurs. They are meant to hunt, they are meant to kill. They are from a different time period. I think, of the market, Dave, as something for 4,000 years plus, has always won. The market, basically, is coming in and saying, “No, you know what? We’re going to get back to real prices. The velociraptor is actually going to eat you.” In Jurassic Park they tried to cage up the velociraptor. They tried to cage up Tyrannosaurus Rex. If you think of those, in an analogy, as the markets, at some point those fences are not going to work. And the fences right now are the central bankers with their hubris. “We have caged the animal, we can tell you that a T Rex can be fed this little goat that is chained up right here.”
David: “The training program has gone well.” It’s interesting, because what were the very best days of trading? If you look back in time, prior to earlier crises, the best days of trading were those days immediately prior to the crashes that followed. Sentiment was best, trading volumes were very intriguing. You had market internals and maybe advance declines. The internals were telling you something. But the general public wasn’t looking at the internals, they were just looking at nominal pricing and saying, “Happy days are here again.”
When we look at pension fund cash never having been this low, when we look at the commitment to stock funds, mutual funds and ETFs, versus money market funds being 5-to-1 today versus 1982 when they were 1-to-5, the exact opposite mirror. 1981, 1982, no one trusted the market. Everyone wanted cash. Today it is the exact opposite. No one wants cash, everyone trusts the market.
You have the American Association of Independent Investors, a group of professional investors, with their lowest cash levels since the late 1990s. This is like pretending that we’re controlling the beast because things have never been better, the program has gone so well. This is a common thing for us to talk about here. The S&P price-to-sales, or revenue, ratio – it’s the highest ever at 2.5. The last go-round it was 2.1.
Kevin: These are some of the points that you make at these conferences, Dave. Any one of these points would be a reason to be worried. You have 25 or 30 of these things that you go through and people are still “Ho-hum, let’s just go ahead, I like my target date fund. I have no idea what I’m buying, but I know that I’m going to be able to retire in 2030 or whatever.”
David: I ask the question. “How many of these would convince you that, objectively, we are in a topping pattern in stocks?”
Kevin: Yes, when you were in Coeur d’Alene. That’s right.
David: Would it take three? Maybe it’s pension fund cash, maybe it’s the commitment to stock funds, and no one committing to money market funds. Maybe it’s the price-to-sales ratio in the S&P 500. Maybe it’s what we talked about before, the cyclically adjusted price earnings ratio, the second highest every – that’s the Shiller PE. What does it take? Three? Ten? Twenty? Thirty? There is a point at which you have to realize, you’re not operating in an objective world. You’re operating in a subjective world where you’re going to get what you want. The market doesn’t always respect the subjective. I guess that’s my conclusion. Where you think you are, where you want to be, the market taking care of you today – you don’t always get what you want. And I think that’s the danger of presuming that we control the beast (laughs). We don’t. The velociraptor is going to eat your lunch.
Kevin: But the person who has listened to the conference, or the Commentary, and says, “You know what? I hear you, but I don’t know what to do. I throw my hands up. What in the world do I do because the markets have all gone crazy, the whole world is upside down and I’m standing right-side up. What do I do?” And I know we repeat ourselves, but Dave, let’s end the program with a little positive. What do you do with your money while you wait?
David: This is the private advice of someone who consults with all the major central bankers, from Claudio Borio at the BIS, to the IMF, the OECD.
Kevin: This is the unnamed person who talked to you after we hung up from the interview, right?
David: And I will give you that person’s advice, and you should take it to heart. “Eliminate debt, raise cash, buy gold. If you own real estate, make sure that it is not leveraged.” It really doesn’t get any more simple.
Kevin: That’s not complicated.
David: No. And if somebody says, “No, but I have to own stocks because I’m collecting dividends and that is a part of my income component. I have to have it.” Fine – hedge them.
Kevin: Dave, let’s repeat that because it’s a four-step process. Eliminate debt, raise cash – you need liquidity – buy gold. And if you own real estate, just make sure it’s not highly leveraged.
David: Yes, there are more complicated things. This is a back-of-the-napkin conversation with an advisor to a central bank. You can make it more complicated, but if you haven’t done those things, then don’t make it any more complicated. Get those done first, then we can have a more complex conversation. Do I think shorting the market makes sense? At a certain point, absolutely. Do I think that there is going to be value in the long side of the stock market? Absolutely, at a certain point in time. There are a lot of things that strategically can be put in place. That’s what we want to explore on a one-on-one basis at our conferences, at our one-on-one consultations following those conferences.
Kevin: I’ll just repeat that if you’re listening to this program right now you still have time to join us in Philadelphia, Charlotte, North Carolina, Austin, Texas, Lake Buena Vista in Florida, and even Naples, Florida. So there is still time if a person wants to come to the conferences that is listening to this Commentary. Just give us a call, 800-525-9556.