The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“On today’s program, with 300 billion dollars per month in current quantitative easing by the central banks of the world, will Janet Yellen’s tapering of a mere 30 billion a month really have an impact on our economy? Stay tuned.”
– Kevin Orrick
“If by the numbers the stock market is not where you should be, and by the numbers cap rates suggest that real estate is over-priced, and by the numbers bonds seem a little over-priced because bond yields have been pressed lower by central banks, by the numbers platinum makes sense. It’s one of those simple things that in our industry we look at the ratios every day and we say to ourselves, ‘That’s compelling.’”
– David McAlvany
Kevin: David, we’re hearing so much about the stock market right now, it’s sometimes easy to forget that gold has performed just as well. The S&P 500 is up about 11% this year. Gold is up 12%.
David: That’s right. So we enter this week with a fresh monetary policy backdrop. As you know, we had Janet Yellen and the crew get together last week and say, “Okay, we’re going to contract the balance sheet, and eventually we will take rates higher, but that eventually is not right now.” And what does it mean? Where do we go from here? You’re right, the S&P is up 11% year-to-date. Small cap stocks – the Russell 2000 – up about 7, just shy of that. NASDAQ 100, the big performer, is up 22. Biotech is even more. And if you want more extravagant returns sometimes you have to go to extravagant places. Turkey is up 33%, Brazil is up 25%.
Kevin: Places I don’t normally go to invest, to be honest with you.
David: (laughs) So Gold is at 12%, and that seems boring by comparison, certainly, if you’re talking about the cryptocurrencies. But it leaves us right in between the S&P and the Dow so far this year, silver up 6% currently, in line with the small caps.
Kevin: But look at the dollar, Dave. The dollar has been falling. You would expect gold to go up with the dollar falling, wouldn’t you?
David: And isn’t it curious, we’re a lot quieter about currency manipulation when it’s our currency which is in decline. When everyone else’s currency is in decline, clearly, it’s for a trade advantage, everyone’s working the system.
Kevin: 10% is nothing to sneeze at, though. When a currency goes down 10% that’s big news, and that’s just this year.
David: And actually, the markets we were talking about just a moment ago, they’re perky, when you consider the Fed’s announced change in direction, and when you consider that we’re veering ever close to war with North Korea.
Kevin: You would never know it looking at the market.
David: No, there are no concerns there until you have rockets turning beaches in Guam into some sort of a glass art display. Then, of course, you might have the markets overreact the other direction. But lest we get worried about the world, we do have here on our own shore bread and circuses. We have the gladiator class which is refusing to stand tall for the National Anthem. I just wonder if they’ve forgotten that bored crowds call for lion feedings at certain times (laughs). Don’t let them get too bored with the sport or we’re going to have to extract more from our gladiator class.
Kevin: I think at this point, Dave, it would be worth bringing up that you are now continuing the conference schedule that we first started with the west coast two months ago, and at this point you’re moving the conferences east. We had promised our clients and listeners know that we would let them know that we would be in some of these cities going east.
David: That’s right. We’ll begin just outside of Kansas City – Overland Park, Kansas – November 3rd. Then we’ll head north – Edina, Minnesota – that is the Twin Cities area November 7th.
Kevin: And then after Thanksgiving when everyone is just sleeping on their tryptophan, we’re going to be in Orlando, Florida on Friday, December 1st, and then later Naples. We don’t have that date nailed down yet but we’ll let you know over the next couple of weeks when we will be in Naples.
David: And it will be in between Thanksgiving and December, for that December 1st date.
Kevin: So Naples is before Orlando?
David: That’s right.
Kevin: And Dave, of course, these conferences are RSVP because we do have food and beverages there and we like to know who is coming ahead of time. So please give us a call, 800-525-9556 [ext. 118], if you think you can make one of those conferences. [For more information, see our web page at mcalvanyica.com/briefing.]
Dave, somebody that you have read and gone to conferences of for years is Jim Grant, a brilliant guy. And Jim has brought out the point that Janet Yellen and Ben Bernanke are more than happy to tell you that quantitative easing was very good, and bullish, for the economy. But in the same breath they are now saying, “Well, now that we’re pulling back quantitative easing and actually reversing that, it won’t be bearish, and it won’t be bad for the economy.” Now, how do you get it both ways, where if you bring out quantitative easing you can say that’s bullish, but when you back it away it has no effect? What is that?
David: This last weekend I re-read one of Jim Grant’s books and was just fascinated to recall – I had forgotten that his undergraduate degree was in International Relations. I knew, of course, that he was a journalist with Barron’s for years, and you had some pretty interesting people writing at Barron’s in the 1970s and 1980s. That was really one of the things that my dad put me onto early on.
Kevin: It was considered a contrarian type of read from Wall Street. Barron’s was read by the person who was suspicious of Wall Street.
David: That’s where Richard Russell got his start. And of course, Alan Abelson was the guy that my dad insisted that I read as I was heading off to Wall Street in 1999-2000. He said, “If you want to understand the markets this is a guy with market breadth. He has an understanding and a real depth to him, and you’ll love his rhetorical flair.” Well, Jim was there when Abelson was there, and of course, as I mentioned, Richard Russell got his start in Barron’s in the mid 1950s. Again, just kind of a walk down memory lane reading Grant’s book. And you’re right, he asked the question with monetary policy being the backdrop, “If quantitative easing was bullish, won’t quantitative tightening be bearish?”
Kevin: Which is what they’re talking about right now.
David: That’s right. So we’ve moved from basically a ten-year period of quantitative easing which has delivered to us stock prices moving higher as quantitative easing drove price higher, drove bond prices higher which, of course, peaked summer of 2016 with yields reaching ridiculous lows at that same time. We have real estate cap rates which are lower than they should be, frankly, which when you add all that together, and when you count it up for households, has brought household net worth to all-time highs, from the newest Z1 report from the Fed – 96.19 trillion dollars is the newest net worth figure here in the United States. In fact, the last year, the last 12 months, has seen that number jump by an astonishing 8.19 trillion dollars. This is a level which is 42% above the 2007 peak.
Kevin: And that’s a form of inflation where you have a perception of more wealth, but you don’t necessarily have an economic recovery.
David: Yes. Doug Noland this last week looked at the latest Fed Z1 report and distilled that for us in his Credit Bubble Bulletin. I still think that is a must read. If you would like to see it on a regular basis go to mwealthm.com, the website, and look under CBB, short for Credit Bubble Bulletin.
Kevin: Why don’t we go back and look at some cycle peaks as far as household income in the past because they have been excellent indicators of a downturn in the economy coming.
David: Right. Doug points this out. Looking at those cycle peaks in the net worth figures, it does tell you where we are, and where we are going, to a large degree. If you look at the size of the economy – GDP – relative to net worth, it reached 435% in 1999.
Kevin: Right before the crash in 2000.
David: That’s right. It reached 473% in 2007.
Kevin: Before the crash of 2008.
David: And again, we’re 42% above that peak level now, which brings us now to 500% of GDP, and an all-time high. So 500% of GDP — so here in the year 2017 we have two 500s to commemorate, both related to paper. One is a piece of paper nailed to the door in Wittenberg, Germany 500 years ago by Martin Luther.
Kevin: You just traced Luther’s steps in commemoration of that 500-year anniversary. But this is a different kind of 500, Dave, that you’re talking about.
David: Exactly. The second 500 is the trillions of pieces of paper today that have boosted asset prices past every conceivable peak in U.S. market history. This is no-man’s land, strictly by the numbers. Prices are out in front of economic reality by five times.
Kevin: And I think we need to stop and slow down here and just talk about this because household net worth is not economic productivity, and GDP is what measures economic productivity. So when you have household net worth five times GDP, it’s exactly what you said – we have a five-fold economic reality above what is economic reality.
David: Right. So it’s important to keep that in mind because we’re late in the cycle. If you’re talking about business cycles, when we’re talking about 435% comparing net worth to GDP, or the total economy, or 473% just a few years later in 2007. These are late cycle peaks and we have now exceeded every late cycle peak – this is every business cycle in American history – we are now at numbers that have never been seen before.
Kevin: And I think I misspoke earlier. I said we have an economic reality five-fold times the economic reality. It’s an economic non-reality – it’s perception.
David: So back to Grant. The monetary tide rolled in, with it all boats were raised, and it seems a simple observation, but if the tide recedes, isn’t it reasonable to see the boats fall back, as well? And Doug drills down on the equity markets in the debt markets, in the CBB this week, and with a very clear take-away. Never before has the U.S. financial market structure been this overextended. There are measures which moderate this. If you want to focus on earnings relative to price, and you are specifically talking about the financial markets, but for every moderating statistic there is one which is even more worrying. We’ve hung out for some time on the prices-to-sales ratio being the real doozy.
Kevin: Right, which is the price of stocks of a company relative to the sales of the company.
David: Right. So sales have been in decline and prices have continued to increase. That ratio has gone absolutely bananas. And it has never been higher in all of U.S. financial history. So the massive growth for monetary policy has centered in the financial sector, and not in the broader economy, and that creates what Doug refers to as perceived wealth.
Kevin: This is something to stop and take an analogy with, because when you have this kind of growth, and when you have perceived wealth, a lot of times you start taking action in a way that it is going to continue forever. Think of a household. Let’s say that you have a varying income, Dave. Let’s say you’re on commission sales, and your income goes up sometimes, and it goes down sometimes. If you go into debt and create future bills based on your best year, and then you have a bad year, that debt stays even though your income drops.
David: Right. Remember Richard Russell’s classic phrase, “Asset prices fluctuate, but debt is permanent.” So if the tide recedes and the boats do fall, the debts remain. And relative to asset values, you end up with the ugliest balance sheets imaginable. And I don’t know if anyone thinks about balance sheet dynamics anymore, but Richard Koo wrote, I think, a classic book on balance sheet recessions which focused on that [Balance Sheet Recession: Japan’s Struggle with Uncharted Economics and its Global Implications]. If you haven’t read him, you should. It’s the long-term cycle of stagnation that you see in Japan, where they have been suffering under this balance sheet recession since the NIKKEI hit 39,000.
That’s 20 years ago. It’s only half that price today. It went from 39,000 down to about 7000, has recovered from 7000 to 20,000, still 50% below its previous peak 20 years ago. So for those who lack an imagination for downside in the market, remember what a balance sheet recession can do to you. And remember that we do have a bit of an issue in our own country with debt. And it’s fine as long as asset prices remain elevated, but that’s when debt becomes really critical in the equation, when you have a lopsided balance sheet and assets aren’t carrying their weight.
Kevin: Look what happens to companies when they do that. Dave, when I was going to college I was a manager for a company called Children’s Palace. They were the number two competitor behind the mega toy store, which of course was Toys R Us. Toys R Us looked like it was going to be a toy store that was unbeatable forever, but just look at them recently. They’re debts outpace their sales to the point where they’re finally having to go into Chapter 11.
David: Right. So Japan, potentially the U.S., in terms of balance sheet construction and anemic growth going forward, and what is it? Whether it is an organization like you are mentioning, or a country, rising debt levels are the killer because in the end, asset prices go down just as surely as they go up. It’s natural, it’s normal.
Kevin: You don’t get perpetual growth all the time.
David: No. This is the nature of a cycle. So Toys R Us is caught in that right now. Chapter 11, five billion in debt, annual debt service of 400 million dollars, and there is not enough street traffic and sales to keep up with it. You can also thank the private equity guys who sucked the lifeblood of the company and left it with too much debt, even as they moved on to the next leveraged buyout target. So that whole business structure of buy, slice and dice, load up with debt, leave for dead – there is a sense in which they’re thinking about dollars and cents, they’re not thinking about the lives involved, the employees of the company. It’s really fascinating to see how, culturally, we’ve accepted the LBO craze.
Kevin: What was the name of the character in the original Wall Street? It was played by Michael Douglas, remember?
David: Gordon Gecko.
Kevin: Gordon Gecko. That’s what that was about. You just sort of empty out the company and create your own bottom line, and then everybody goes home without a job.
David: Right. But you suck all the resources out first. And that’s a part of it, too. But again, they were able to do that because they put all the debt in, business slows, you can’t pay for the debt, and it’s game over.
Kevin: So let’s say that we are going to slow. We were talking about the quantitative easing having a positive effect on the economy, at least according to Ben Bernanke and Yellen. But they’re saying it won’t have a negative effect on the economy. But let’s consider just putting this in perspective with quantitative easing, because remember, when we were at the height of our quantitative easing it was over 100 billion dollars per month that these guys were adding to the economy. Now, they’re talking about pulling some of that back, but I think they are talking about 30 billion a month at this point?
David: Yes, and I just want to make a comment before we move very much farther, because while Bernanke was willing to say that QE was very beneficial, in the last couple of months a fantastic paper from the Federal Reserve Bank of St. Louis argues the opposite, that quantitative easing has done little to no good, and now the question is, seeing what damage is done as you reverse it. So, no it didn’t do any good, and it may have actually done more harm than good, but we’ll have to wait and see. That’s the position that a gentleman by the name of Stephen Williamson has taken at the Federal Reserve Bank of St. Louis.
Kevin: I wonder how long he’ll have his job?
Kevin: Do you have to be yes man when you’re with the Federal Reserve?
David: I don’t know, I don’t know. Maybe they call those black papers instead of white papers when you write them, or pink papers, as you’re writing them on your way out the door. The Fed discussed reducing its balance sheet. That was the big discussion point this last week. And you’re talking about 4.5 trillion dollars of a balance sheet. They want to reduce it by 30 billion a month. And that seems like a big number, but that’s because we are still living in a world of thousands, hundreds of thousands, and millions, and not the rarified air of billions and trillions, like out central bank is. So they took no action on rates. Lots of talk, no action, lots of talk, no action – that seems to be a fairly predictable thing from the Fed.
Kevin: But at 30 billion a month, how long will it take to pull back that 4.5 trillion bucks?
David: About 11 years from now is when they would complete the task at that stated rate. So it’s actually not a lot of liquidity coming out of the system. It’s not a lot of quantitative tightening, if you will. And it’s not a lot of liquidity coming out of the system, particularly when you recall the current commitments of other central banks. At present, you have massive money still flowing in from various central banks. Now, if you look at Barron’s magazine this week, the Bank of Japan has a balance sheet of 4.7 trillion dollars. The European Central Bank has a balance sheet of 5.1 trillion dollars. These are all larger than ours. The People’s Bank of China, the largest of all – 5.2 trillion dollars.
Kevin: The four you just named – let’s talk about our Fed plus the BOJ, plus the European Central Bank, plus the People’s Bank of China – that’s over 20 trillion dollars that they have taken on to show us that this economy is growing. They are still holding that.
David: In the last ten years – only in the last ten years, have these balance sheets ballooned by 20 trillion dollars to create a sense of normalcy in the marketplace, and a tremendous amount of displacement. Imagine a giant whale being thrown into an Olympic-sized swimming pool? Where does the liquidity go? Whoosh! Out of the pool and into other places, and that’s what we’ve seen – additional asset price inflation in other areas, because as the whales jumped into the pool the liquidity flowed other places. So 5.2 trillion from the People’s Bank of China, and while we’re talking about an annual reduction here in the United States, 30 billion a month is just over 300 billion annually being reduced in liquidity from the markets, these other central banks in aggregate are still adding 300 billion, not annually, but adding 300 billion monthly.
Kevin: That’s an amazing thing, what you just now said. So we are reducing, in a year, about 300 – let’s call it 360 billion, maybe, if it’s 30 billion a month, roughly. But they’re adding 300 billion a month.
David: Right. So take ours out of the equation and your net liquidity from central bank activity per year is still 3.3 trillion dollars, a rate that the world has never seen before. Is it any surprise that we have seen asset price inflation when the whale is still flopping around in the pool?
Kevin: So why are we worried, Dave? It sounds to me like we have plenty – plenty – of liquidity coming into this perceived market action. It could go on forever.
David: Yes, well, it is driving global asset prices wild. It is aggravating asset price inflation. And that’s great for the bulls as long as nothing derails confidence. That’s the key – as long as nothing derails confidence. Back to the Fed’s reduction of liquidity. Rather than there being an immediate impact in the market, it’s not likely to be the catalyst for lower bond prices, higher yields, or lower stock prices.
Again, you were talking about a relevant factor, but not the catalyst. Number one, you have massive excess depository reserves from banks that are still sitting around, about 2.2 trillion dollars, and that’s likely to be adjusted as that balance sheet is reduced at the Fed, so again, there is plenty of liquidity in the world, it’s just a question, really, of either endogenous weakness, or exogenous shocks – endogenous meaning internal to the market, itself, where we have actually put in systemic frailties.
And if you look at the structure of credit and the structure of financed capital, you will find those kinds of endogenous problems. The exogenous shocks would be something like – oh, who knows? A missile from North Korea? Greater conflict or trade conflict with China? It could be any number of things.
Kevin: And have we forgotten the definition of inflation? Inflation is creating money. So the quantitative easing that is going on right now worldwide, even though we’re tapering back, supposedly – that is inflationary. If you listen to guys like Warren Buffet, he made an amazing statement recently. He said, “I can see the Dow at one million points. Now, that sounds great – over the next 100 years the Dow at a million points. But what does that mean relative to inflation?
David: It means that Buffet, to some degree, is thinking and dreaming like Havenstein (laughs). We’re going back to Germany, where inflation is a big component part of that. And that is a big number. It is an interesting forecast to think of the Dow at a million. But he is also saying, “Look, this is just the basics of compound interest. If you look at the next 100 years, you just compound at 3.7% per year, and you get to a million points. That assumes a 3.87% growth rate every year, uninterrupted, which isn’t really reasonable. Compare that to the 5.5% that we have seen over the past 100 years and you say, “Well, maybe it is reasonable. Maybe it’s actually quite reasonable.” You had a Barron’s Roundtable guy, Mario Gabelli, who is one of the permanent bullish guys on that roundtable, and he said, “Why is Buffet so bearish?”
Kevin: (laughs) Because he is only predicting 3.87.
David: Yes, exactly. So on the one hand, it’s a realistic number when you consider the nature of compound interest, if that were the only factor. The driving growth in the last century – you have had a massive population boom, you have had a productivity revolution from things like electricity, internal combustion engine, indoor plumbing, running water, the use of petroleum, chemicals. And all of this has been known as the second industrial revolution. You might argue that tech has been revolutionary and I think the response to that is, yes and no. Revolutionary in some sense, but not in the ways that radically increased productivity in the last century.
Kevin: You talked about population growth. Demographically, things are shrinking at this point. Look at Japan, look at China. Some of the larger countries, they’re not growing, they’re shrinking, and their population is getting older.
David: Right. The headwinds we face are actually similar to Japan’s. We’re below the replacement level demographically, so in terms of fertility or birthrates, we’re slipping, not increasing. And obviously there are places in the world that are worse than we are here in the United States, Japan and China being two of them. But we also know that productivity growth has not been positive to the degree necessary to drive economic growth here in the last 10, 15, 20 years, and we don’t see that changing any time soon.
Kevin: Well, I brought up inflation. What about inflation? Because you could have that 3.87% annual expansion, but what do you take away with the cost of the dollar dropping?
David: I think he is assuming that half of the growth comes from inflation. So that’s not 3.87 in real terms, that’s before you subtract 2% or whatever the actual inflation rate is. Now, in the last 100 years, inflation was 3% per year, on average, so you had spikes that were double-digit, and then years where it was flat to negative. But on average, it has been a 3% inflation rate from the year 1916 to the present. Now, consider this. If that is the case, and we just repeated it all over again, three out of the 3.87% would be coming from monetary policy instead of economic growth, so a measly 0.87%. Less than 1% growth (laughs), which again, is not that impressive. I think what some of this neglects is the cost of inflation, the cost of losing purchasing power by 2% every year – year-in, year-out. So quite frankly, what has driven a part of Buffet’s success is a coincidence in timing. He was lucky to be in the United States at the time that he was in the United States, and there have been some things that have been massively growth-oriented, again, sort of the second industrial revolution, on his watch. That is not likely to take place again, and I don’t think we can, or should, forget that the last 100 years of growth carried with it a cost. In that 100-year period, what used to cost $100 dollars now costs $2116. And again, that is at an average rate of 3% which we talked about earlier. It seems benign until you frame it differently because it is 96% of your purchasing power which is gone. So in the next 100 years, if we’re 2%, maybe we just go back to the old average of 3% inflation. That’s targeting two. Maybe they end up with three accidentally. We’re back to the same kind of thing – losing another 96% of our purchasing power from here. Much of the wealth we have today is perceived rather than actual.
Kevin: And the masters of perception are the central bankers. They use fancy numbers and fancy mathematics to make you feel stupid enough that you can’t really see where it came from.
David: That’s right. So inflated by wanton monetary policy. This is really the central bankers’ understanding, that the general public is too stupid to appreciate how they arrived at their success in terms of monetary policy.
Kevin: “Yes, but let me show you an equation that makes it all work.”
David: Sure. But again, we think of the Dow as 30 companies. It wasn’t 30 companies, it was 12 companies, and then it was 20 companies, and then the master list of 30. But that master list has changed through time, so not only do we not have the same list, believe it or not, there is only one of the original Dow 30 that are still on the list – General Electric. Most went under, a few were merged. I guess what I’m suggesting is that autopilot is not an option over the next 100-year period.
On our way to a million-point Dow reading, we not only have hiccups and interruptions and panics and crises, but we also have entire industries which will simply go away. At some point, someone is going to realize that, as Bill King mentioned a few weeks ago, Facebook is nothing more than a bulletin board. Why do we spend so much time on a bulletin board? And why is it worth billions and billions and billions and billions and billions of dollars?
Kevin: It doesn’t really increase productivity. And that 3.87% can be a little bit deceptive, what Buffet was predicting over the next 100 years, because you can go through periods, Dave, as you know – 7, 10, 12, 15-year periods – where you have zero to maybe 1 or 2% growth. I’m thinking of what John Hussman was projecting over the next period of time.
David: Love his comments. I think one of the things that is crystal clear to me is that with Dow one million, that progressive inflation rate has an impact on other things in the world that we live in, too. And if we looked around and said, “What does Dow one million look like?” You’re talking about $30-40 for a Starbucks coffee. If you wanted to look at what the monthly mortgage would be, your average housing cost on a monthly basis? $11,000 to $13,000 per month. And if you bump up your average household income by 2% per year, which by the way, does not happen. It happens if you are in the upper echelon, but the vast majority of people do not see it – they do not keep up with the rate of inflation. If you did keep up with the rate of inflation your average income 100 years from now would be $360,000. Maybe it’s $362,000 (laughs) – it’s up there. A one-day park-hopper pass at Disney, instead of being $150 would be close to $1500 — $1250 to $1500 – for a park-hopper pass at Disney.
Kevin: So a Dow one million doesn’t necessarily say that we’re all going to be millionaires.
David: It just means that a millionaire doesn’t really mean anything.
Kevin: There is no middle class anymore.
David: No, there is no middle class anymore. That’s one of the things, if you’ve read Doug Kass – he’s an interesting guy – a recent essay he wrote, Screwflation of the Middle Class. It’s no longer inflation. He would argue that incomes don’t rise at the same rate of inflation. If I’m borrowing his ideas for our purposes, in that next 100-year period where Buffet thinks, “Don’t bet against America,” what we’re describing is the second century of monetary recklessness. We’re talking about there being a complete elimination of the middle class. The sad truth is that if Buffet is right and we see Dow one million it signifies a return to feudalism, and extremes of wealth disparity perhaps never seen before. You were talking about John Hussman, and this is the reality. I think this is what comes closer to the truth, certainly in a period more relevant to our timeframes. I’m not going to be alive 100 years from now, but I sure hope to be alive ten years from now. And John Hussman projects that over a 10-12 year period immediately ahead of us, that the stock markets will deliver, at best, 2% rates of return per year, more likely closer to zero.
Kevin: And those, a lot of times, come with shocks – major downturns. Look at what we’ve seen back in the last few crashes. You’re talking 49-50%, 55% losses, or more.
David: And I think everyone knows this, but you end up with the most exuberant calls for stock market pricing at the end of a cycle.
Kevin: It’s at the market peak.
David: The book written on Dow 36,000, which projected that the Dow would be at 36,000 in the year 2004, was written in 1999 at the market peak. And people get bold with their predictions – very bold with their predictions. I remember the Aden sisters. The Aden sisters got very bold with their gold prediction — $3000 gold – when gold was $800, in 1979/1980. Everybody moves the goalposts in a moment of exuberance, and now we have Buffet talking about a million points. Great. Wonderful. Going back to John Hussman, I think this is a worthy quote: “At the October 2002 market low the S&P 500 stood 49.2% below its March 2000 peak.”
Kevin: So within two years it lost almost half of its value.
David: 48%, if you include dividend income. The NASDAQ 100, having lost more than 82.8% from its high, on the basis of both price and total return – the loss wiped out the entire total return of the S&P 500, in excess of treasury bills, all the way back to May of 1996. The bull market that followed would bring the S&P to a fresh high by October 2007. “Unfortunately,” as Hussman says, “In the face of historically extreme valuations, that victory also proves temporary, and the S&P 500 collapsed by 56.8%.
Kevin: And if you include dividends, it’s a little less than that.
David: 55.2% Good mathematician. Key distinctions. And that was by March of 2009, with the NASDAQ losing 51.9% in that decline. “The loss wiped out,” says Hussman, “the entire return of the S&P 500 in excess of treasury bills” – this is 2007 again – “all the way back to June of 1995.”
Kevin: That’s what I’m saying. You reset the clock backward, Dave. You’re not moving forward, you’re moving backward. And unless you’re really, really good, like you brought out before, a lot of these companies go out of business during these downturns, so you can’t count on the index, necessarily, keeping you up on top of things.
David: He goes on to say that, “presently investors,” presently as in right now, September 2017, “appear to have entirely ruled out market losses on the order of 55% in the S&P, as in the 2007-2009 collapse, and the 82.8% loss in the NASDAQ 100 during the 2000-2002 collapse.” In his words, “This is a mistake.”
Kevin: Right. Well, of course, because you’re talking about the mindset that always reappears near a market top.
David: Where Hussman shines, in my opinion, Kevin, is that he connects stock market valuations with future returns. In other words, when you are at, or near, records valuations, and arguably, at the mature end of a business cycle, you can expect future returns to be low, or even negative. In layman terms, you buy cheap and the potential gains are greater. You buy at premium prices, and your returns, subsequently, are going to be sub-par. While we consider the sage of Omaha’s one million Dow projection, you have to bear in mind that there can be 10, 20, 30-year periods where the market does you no favors at all. And right now Hussman is assuming a 62% decline in the S&P 500 as we finish this cycle. And hand back all the glee and all the glory that investors have gained, essentially, being on autopilot mode since 2009. And particularly, I want to correct that, because it’s not really 2009 that Wall Street has checked its brain at the door. 2012 is when fundamentals went out the door across Wall Street and central bank credit creation started driving asset prices far in excess of economic justification. So again, we’re talking about the economic justifications of sales and revenue, and if you’re looking at GAAP results, Generally Accepted Accounting Principles, you realize that most of the numbers that people look at, including Wall Street today, are numbers that are produced on a non-GAAP basis. In other words, they have all kinds of exceptions and all kinds of exclusions, expenses that are not considered expenses.
Kevin: It’s funny accounting, is what it is.
David: That’s right. Imagine if I paid you in stock only and no cash went out the door. And I paid everybody on staff here stock only and no cash went out the door. Now, I can, actually, on a non-GAAP basis, I don’t have to count that as an expense, which means I had no expense for compensation. What does that mean, exactly?
Kevin: That means that the person who is buying that stock who didn’t see that happen has no idea that they’re buying something that has been tinkered with.
David: And on a GAAP basis, Generally Accepted Accounting Principles, that should go through as an expense, and it is not considered so on a non-GAAP basis. Most of Wall Street reports on a non-GAAP basis. Again, Hussman’s conclusion – 62% decline in the S&P 500 as the cycle finishes and hits a peak. What’s the peak? Is it 2500? Is it 2700? Is it 3000? Maybe we’ve already hit the peak at 2500. You know in retrospect. But what he knows clearly, and I think what we started out by saying today is that you have already gotten to levels, in terms of asset prices – look, we’re talking about a stock market, in toto, which is pressing 41 trillion dollars in valuation, a bond market, in toto, which is pressing 41 trillion dollars, 82-83 trillion dollars combined in those financial markets.
Kevin: Right, just those two.
David: And these are numbers that exceed every previous market peak. What is different this time? Has the Fed figured something out that radically reshapes the world as we know it, that is going to generate the kind of economic growth that we can only dream and hope for? Or are we at the end of a business cycle? And at the end of a business cycle, if you have paid too much, you can expect sub-par returns over the next 10-12 years. I think Hussman has hit the nail on the head.
Kevin: Dave, let’s just go ahead and pretend that we have four bowls in front of us. We have some money, and we have four bowls in front of us. Let’s say the first bowl is the stock market, which we know is at high valuation right now. The second bowel is the bond market. The bond market can be great when you have high confidence and you have high interest rates, but we are at very low interest rates right now. You have cash – cash can be another bowl. And then finally, the metals – gold and silver.
As we look at those four bowls, it looks like we really don’t have a lot of options. The stock bowl is at high valuations, the bond market is at high valuations ready to reverse. Cash – the U.S. dollar has lost 10% of its buying power relative to other currencies just this year. Gold is up 12%. Where do you go? I know that sounds like a question that I already have the answer for, but we really don’t have a lot of options, do we?
David: Well, I think bonds also do well in a period of low confidence. The question is, is there very much room for them to move when the central banks have already pressed rates this low?
Kevin: That’s a good point. Well, how can you go much lower on interest rates, which is a boost for bonds?
David: Right. So there are some limitations in terms of growth, but maybe an argument for some bond positions. It’s not where I would go. It’s not where I would allocate money. But there is an argument for it. Stocks – yes, reading Doug Kass this last week, it was interesting to see him, as a hedge fund manager of 30-40 years, say, “I have to tell you, categorically, I am 100% out of the stock market. I own not a single publically traded company.” Okay, note to self – this does happen, but it only happens at market extremes where a few people say to themselves, “I can’t make sense of it, it doesn’t make sense. The risk/reward is not in balance and I want out.”
Kevin: Well, then, that takes the cash side. I would imagine most of what he has, then, is in cash.
David: And in short positions. So I think establishing short positions intelligently, as we have done through the tactical short, makes sense. Cash, I think, makes sense. Gold and silver, I think, make sense. Real estate makes sense as a real asset, you just have to be aware that its value has been bumped up by the amount of funny money that is around. And so, there is some downside vulnerability in real estate, too.
Kevin: So, own it with no debt. You want to make sure that you don’t have debt on it.
David: Yes. And at least it’s a real asset. You may lose 50% of the value, but real estate is not going to go to zero. Stocks and bonds can. Gold and silver doesn’t. Here is a carve-out which is really interesting within the precious metals and I would encourage anyone with a metals portfolio to think about this. Platinum, today, sells at a 39% discount to gold, which is the largest discount it has ever traded at relative to gold – ever. That is worth noting. As a value play, does platinum makes sense? Yes.
Now, as it relates to palladium, the other metal in the group – platinum and palladium have almost the same uses from an industrial standpoint. They are considered almost the same family of metals. We look at those two metals and look at the price, one relative to the other, and see an arbitrage opportunity trading back and forth between them. And right now it is almost a 1-to-1 ratio. That’s actually the best ratio – there has only been one other time in 40 years where the ratio is exactly what it is today, and it was the most compelling opportunity to own platinum in that cycle. Of course, you can own palladium at a later point in the cycle as you’re trading back in.
So relative to gold, and relative to palladium, platinum is one of those things that is real, not likely to be confiscated, has industrial demand, is a precious metal, and is on sale. Again, I realize we’re in the business and maybe it sounds like it is just a self-interested plug. You do your own history, you do your own research, in 50 years you will not see a better relative relationship with platinum and gold, a better relative relationship between palladium and platinum.
And I’m just telling you by the numbers, if by the numbers the stock market is not where you should be, and by the numbers, cap rates suggest that real estate is over-priced, and by the numbers, bonds seem a little over-priced because bond yields have been pressed lower by central banks, by the numbers platinum makes sense. It’s one of those simple things that in our industry, we look at the ratios every day and we say to ourselves, “That’s compelling.”