Larry McDonald - Global Macro Series - 25th July 2020

[00:00:06] Larry

When my book came out, Charlie Munger invited me to Omaha. I went out to see the annual meeting and it was incredible. There were just so many people, about 30,000 people in Omaha, Nebraska, in the stadium. Then he invited me, on Sunday, we went into the Marriot Hotel and there was one room that was Buffet with the pension funds and in another room, there was Bill Gates.

I’ll never forget, I’m in the room waiting for Charlie Munger and in he came and I introduced my wife and he said, one thing that he said to me that I will never forget, he said, “Larry, the toughest thing in the world to do is stare at a screen all day and do nothing. He was talking about… This was a couple of years, this is several years ago, he was talking about how Berkshire will sit there and wait.

Then I look at the last two years and this has just been incredible. They have one hundred and thirty-six billion in cash and they didn’t buy any stocks in the drawdown in 2018 when there was a 20% drawdown. Then in 2020, we had a 36% drawdown and they didn’t put any money to work. So it tells you that they’re sitting in their boat and they’re waiting for better values.

[00:01:20] Introduction

Our guest today is someone who looks for the unexpected instead of focusing on the obvious as he analyses the intersection between politics and markets which is a relationship that is, perhaps, more important than ever before in our lifetime and where politics could well be the key driver of markets. On top of this, he’s a New York Times Best Selling Author with his book, A Colossal Failure of Common Sense, which is about the collapse of Lehman Brothers. So, I’m absolutely convinced that you will have your eyes opened from our conversation with Larry McDonald of the Bear Traps Report.

[00:01:59] Niels

Larry, thank so much for joining us today for a conversation as part of our series into the world of Global Macro where we relax our usual systematic, or rules-based framework, to provide you, with a broader context as to where we are in a global and historical framework and, perhaps, discover some of the trends that may occur in the global markets in the next few months or even years and, ultimately, how this will impact all of us as investors and how we should best prepare our portfolios.

We very much look forward to diving into a few different topics in the next hour or so, not least because in your work you look at the unexpected instead of focusing on the obvious as you analyze the intersection between politics and markets which is a relationship that is perhaps more important than ever before in our lifetime, where politics could well be the key driver of markets.

Larry, you also wrote a very important and popular book titled A Colossal Failure of Common Sense which is about the collapse of Lehman Brothers. But to me, this title could well be used about what is going on in the world economy and many of the markets today. So, tell me how you see the world when you look at it right now.

[00:03:17] Larry

Well, there are some incredible opportunities because of the politics and there are also some just blood-curdling risks that are just… I think we’re very close to a big move down in say the Tech sector. But there are just so many opportunities and there is so much divergence between asset classes. Because of the fifteen trillion of fiscal and monetary juice that is rolling around the planet, there are just so many asset classes that are mispriced and prices are going to change a lot in the next six to nine months.

[00:03:50] Niels

Yeah, absolutely, just out of curiosity, when you look at the world (and I’m sure we’ll dive into many of these asset classes as we go through our conversation today), but many of the commentators and actually some of our guests in this series have drawn parallels to say 1929, or the Japanese Bubble in the late ’80s, even the Tech Bubble, and the Great Financial Crisis. Of course, on top of all of this, we have this pandemic floating around the world. Do you look at any of these past periods as playing out again, right now, or is this really different this time?

[00:04:29] Larry

Well, you know, every crisis (at least in my opinion), every crisis over the last one hundred years there is a metamorphosis, there is a kind of a serpent that turns into another beast. I think this one will be very much like that.

Think about twelve years ago today, the Lehman crisis, there was a giant hole in the banking system that central bankers had to fill and they filled that on the back of, really, taxpayers, voters, in Europe and the United States. That brought on a lot of this populous rebellion that’s now with us.

Today, with the Covid Crisis, instead of having one big hole that the central banks are trying to fill there are thousands and thousands, maybe hundreds of thousands of holes that the only way to address that is with a shotgun approach versus ten years ago it was much more of a surgical strike. When you get into a shotgun approach (in terms of fiscal and monetary) where they’re trying to identify the holes, the problem with that is that it’s going to have a big impact on prices. I think the complacency around inflation and the certainty of deflation (in so many people’s minds) and the fact that inflation is not being taken very seriously is really discounting this whole shotgun approach to what central banks and governments are doing. So, I think that’s the biggest difference between now and 2008.

[00:06:02] Niels

Right, what’s on your mind today, Rob?

[00:06:04] Rob

I hardly know where to start. There is so much we could talk about. Let’s rewind slightly and think about the beginning of this crisis and compare it to the beginning of the previous crisis. I think it’s probably more interesting to talk about the previous crisis because, obviously, you were right at the center of it. So, we were all working the markets at the time, but I guess the three of us were a bit more on the periphery whereas you really were in the bear pits.

One thing that I found interesting about that crisis at the time was that in terms of the things that I was looking at on a day-to-day basis, in terms of worrying about the risk and stress in the markets, most of the indicators that we were looking at by the time we got to early 2009 were things that eighteen months ago almost no one was looking at.

So, I’m talking about things like LIBOR-OIS Spread; CDS prices, which only CDS traders cared about and all of a sudden everyone was like, “Well, these are a key measure of potential defaults, both in the corporate and in the sovereign world.” What are the indicators, updated today? What are the things that could have, perhaps, given us an early signal in maybe January or even late last year and what are the things that we should be looking at now as an indication of the fact that something big (in terms of market moves) is going to be coming our way?

[00:07:21] Larry

Well, we have… What’s really helpful is that we have a Bloomberg chat with five hundred institutional investors that’s live. Out of the five hundred, there are probably fifty or sixty contributors that help us analyze the cross-asset indicators that develop. We do it live. What we were seeing last February versus what we’re seeing in, say, the last ten days, there are a lot of similarities.

In February it was so clear, and we did make some high conviction calls but when you’re going through… When you’re on the battlefield in the heat of the moment sometimes it’s tough to identify exactly what is happening. But it was clear to us, in February, where you just had a real flattening of the curve; a big bid to Euro/dollars just tracking. (For people at home now, all a Euro/dollar bet is the amount of capital… You can measure the amount of capital that’s being bet on rate cuts from central banks.)

So, those two things were very powerful. We look at the fives/thirties curve or the twos/tens. So, those are Treasury bonds of the United States. All that means is that the curve is flattening so people are buying that long-term bond so the yields are coming down and they’re buying the long-term bond because they think something really bad is about to happen.

At the same time, we had copper collapsing, oil collapsing. We had the two-month VIX future versus the eight-month. That curve was also in a big flattening dynamic. (All that means, for people at home watching us right now, that just means big hedge funds around the world were paying up for that two-month VIX future protection like insurance on the market.) So, we had a number of these indicators. Then on the consumer side airlines, anything consumer-centric, REITs in certain big cities, all these things were really underperforming. So, that was the first batch of indicators.

The second was just you could see very clearly from Asia to Europe the cases in each metric of Covid rates. Back then people were looking at them. We started to look at them around January 15th or so. We were sharing the data in the Bloomberg chat.

So, what we focus on today at the Bear Traps Report are the same indicators. A lot of them are acting up now, but a lot of them are different. I think that speaks to this new inflation dynamic that’s starting to come at us.

I think, first of all, curves flattening over the last ten-day. We saw a lot of money moving into Euro/dollar bets. Once again, people are betting on negative rates. I think, overall, just to the put/call ratio in the Nasdaq. [Thee were] extremely sell signals there: the amount of stocks that are above the two hundred day in terms of the percentages; the cloud stocks, for example, are close to 40% above the two hundred day moving average (So, the index of those stocks is trading close to 40% above the two hundred day moving average.)

So there are a lot of sell signals today. What’s not acting the same is copper and a lot of the commodities. There is a much bigger support system behind the commodity regime today than there was in February. That tells you that investors around the world are worried about price action, looking forward.

[00:10:37] Rob

Interesting, Moritz, over to you.

[00:10:39]Moritz

Hey, great to have you on, Larry.

[00:10:40] Larry

Thank you, thank you, Moritz.

[00:10:41] Moritz

I just want to come back to what you just said about the shotgun. I can actually envision a bazooka because the amount of money that has been deployed has been, thus far, so much more than what was done during the GFC and in so much of a shorter period of time.

[00:10:56] Larry

Yes.

[00:10:57] Moritz

So, I guess what has become evident is that the V-shaped recovery is in the markets but it may not be in the economy. I just want to speak to you a bit about the inflation/deflationary camps. People that we speak to, it tends to be that either they’re on the one side or they’re on the other. I have the feeling that a majority of the people are on the inflationary side but maybe longer-term or medium to longer-term. I guess what we’re seeing is the asset price inflation that people talk about but we’re not yet seeing the Main Street price inflation.

Some people forecast that, because the economy is actually suffering still, there may be a deflationary period ahead with more unemployment, the demographic effect, and all of that type of stuff. So, over what period of time do you see those things playing out?

[00:11:43] Larry

Well, first I think a couple of things have been going on. Number one, the deflation camp, like 30 days ago, actually more like 60 days ago was much more universal. So, expectations for deflation were very high conviction across almost every asset class. Now you’re right, you’re starting to see people really hanging onto that deflationary problem on the consumer side, absolutely.

In the United States, you still have twenty million people unemployed. It’s a tragedy, it’s a big number. Now you have the $600 a week… That’s why this next bill coming out, we had a call this morning with institutional clients with our team in Washington, and most of those important questions were focused on that. What are the Republicans going to do about $600 a week? If you don’t extend that that’s a major hit to the stimulus.

[00:12:37] Moritz

They’re rolling off the end of July, right? (Sorry to interrupt.)

[00:12:39] Larry

Yes, exactly (please do, please do). So, that $600 a week. If you do the math that’s like people are taking home close to $50,000 a year for staying at home. That’s why that question of yours was so perfect for this conversation. If you think about it, the reason why we’re starting to see some inflation is because (in some cases) consumers have had a pay raise. Now granted the savings rate has exploded but there is a lot of money floating around. It’s like a Fiscal Cliff is coming at us again.

All a Fiscal Cliff means is that when you have a big pile of stimulus that’s going to come away in a short period of time, that’s what is called a Fiscal Cliff, and that would cause some type of short-term deflation. The dislocations, globally, on the commodities side, in terms of ability to produce commodities (because of Covid) has been shocking just in terms of the rig count in Texas in terms of shale or if you look at the amount of copper mines in the world that have been taken offline.

So, there are so many moving parts and there is so much coming at us in terms of changes, like with legislation, that that is where there is a lot of… OK, you’re absolutely right, most people are like… The inflation camp, every one of them is pegging it on twelve to eighteen months from now. Whereas, the deflation camp is pretty high conviction that we’re going to have a problem near-term. I would say, if you look at five year/five year forwards, so, that’s one way to measure expectations. Those have been creeping up.

[00:14:05] Moritz

Yeah.

[00:14:06] Larry

Just look at the amount of capital that has moved into commodities. So, here’s my main point and this is so important, so, when you don’t allow the business cycle (and this answer is going to get right to your question) when you don’t allow the business cycle to function over longer, and longer, and longer periods of time, what happens is that more and more wealth is created and asset prices go up.

So, if you think about it, in the United States the amount of money that is in bonds, stocks, and just what the wealthy people own, (Tech stocks and bonds, both corporate – right now there’s ten trillion in the U.S. corporate and there’s another fifteen trillion in Treasuries) then if you take the amount of money in FAANG stocks and Tech and municipal bonds, you’re talking about forty trillion dollars just in those four groups.

[00:14:53] Moritz

Massive.

[00:14:54] Larry

Massive, and guess what? Two years ago that number was thirty trillion. So, think about those people that have that wealth. Even though there is no inflation right now, if you’re one of those people with a billion bucks that’s sitting in cash or whatever, you’re going to take five percent of that and put it into commodities right now because there is just so much more money that is in deflation bets.

At the end of the day, paper assets that are stocks and bonds and these types of things, are really deflationary bets, especially Tech stocks. They perform really well in deflationary environments and they don’t perform very well in inflationary environments. So, if you’re long these things some of that money is starting to move into commodities even though there is no sign of real inflation.

[00:15:43] Moritz

Yeah, or long-dated bonds – that’s the perfect deflationary bet. The longer duration then the more you benefit from any deflation.

What I found… Just the idea, the thought of it was (and I read this, I forgot who it was). If inflation shows up (maybe when not if inflation shows up), let’s say it’s 4% or 5% per year, something like that. So, it’s not 18%, it’s 4% or 5%, maybe let it rip for five, six years because if you compound it, it’s going to be 25%, 30% over that period of time and that does away with all the debt that’s out there. So maybe, for once, the central bank is not going to be saying, “OK, we are running at or close to 2% (depending on the central bank, whatever the targets are. Here in Europe they say it’s about 2%. I never know why that is but they came up with that magic number of 2%), maybe they’ll just let it go for four or five. So, all of us suffer a little unless you have your money in commodities and gold, and things like that that are positively responsive to inflation. That’s going to be an interesting period ahead.

[00:16:50] Larry

Yeah well, there’s no question. The consensus on the street, now (and all of our clients are institutional clients and hedge funds), everybody is convinced they’re going to let it run hot. The mistake in 2008 (2008 to 2012) was that they really didn’t let it run hot enough and they cut it off too quickly with the taper.

So, the Larry Summers’ camp has been doing a dance in America, this secular stagnation camp. They have been very celebratory in terms of they’ve been right. That camp has been right. So, now there’s just a vested interest in the academic and financial community in America to let it run hot.

The one thing about that is when your balance sheet (think about this), when your balance sheet is seven trillion now; the Fed balance sheet will probably be ten trillion, a year from now; then on the course of two or three years, basically, if things don’t dramatically change we’re looking at fifteen to twenty trillion of just the Fed balance sheet within two or three years. The problem is (and I want you to think about this) in the old days when I was growing up (I lived through the Volker era), I remember seeing days where yields went up two percent a day on treasuries almost.

[00:18:01] Moritz

Wow.

[00:18:03] Larry

So, if you have that type of move today the loses at central banks, in terms of your mark to market on their portfolio, is going to be so large that they’re going to have a real problem at some point and that’s another reason why you’re seeing a move into hard assets.

[00:18:19] Moritz

Sorry to interrupt, guys, but I think that is a perfect question. You’re right, the Fed (or any central bank), they hold those bonds that they’ve purchased as an asset on their balance sheet. So, that asset will be massively impaired. So, in order to avoid bankruptcy, because there are two sides of the equation here, what are they going to do? It’s either going to be a jubilee (I’m not sure if that’s working), or it needs to be transferred into some sort of a zero-coupon perpetual type of thing where we just say, “It’s going to be on our balance sheet but it just sits there. We will be paying it back but at an infinite point in time in the future.”

[00:18:56] Larry

That’s the argument I have heard. That’s one way out of it is that you turn it into a zero-coupon perpetual. In order to get there, the argument is that hard assets… A year ago, even for months ago, commodities were in this bear market because nobody wanted to be long hard assets or commodities. Now, if they go down that road and the amount of printing… Look at the United States, it’s July 15th, they haven’t collected a penny this year. I’m paying my taxes tomorrow for the first time I’m paying last year’s taxes.

So, right now everybody in America is talking about the general account. So, the Treasury general account is upwards of a trillion dollars now. What has happened is the Treasury has printed money through selling bonds and they have paid out some but the amount of commitments that they have to pay, they still have about two hundred billion that they have to parcel out. Then they need approval from Congress to deploy the rest of the money.

So, the Treasury has been selling lots of bonds, even though they haven’t collected any tax revenue. So, that’s pure MMT. That’s why I think the play for the next eighteen months is really starting to take some capital and position it towards commodities. It’s not just gold or silver, I’m talking about commodities across the board.

[00:20:25] Niels

There is so much to unpack having started my own career in the mid-’80s trading Danish government bonds and seeing the Berlin Wall break down and seeing what that did to rates, I can certainly attest that you can lose a hell of a lot of money when yields go up. The frightening thing is that most fixed income managers today, or traders today, they have never been in or experienced an environment where rates go up and likewise with the investors.

So, when it does start to happen it’s going to be uncharted territory for many people. I think also, that a lot of people are not aware of (I think) how quickly inflation can show up. I have been quoting, a few times, on the podcast the difference between the 1% inflation in 1915 and the 21% inflation in 1917. The same happened in 1945 to 1947 and from 1972 to 1974 there were massive increases in inflation when it does happen.

I don’t know if it’s staying on the same point but you do a lot of great work with Real Vision where Raoul has been very vocal about his three-phase view on the current environment, ‘the unraveling hope and insolvency’ (I think he calls it) where I think we’re about to enter (in his mind) the insolvency phase. I wanted to ask you whether, besides having dated the same girl as Raoul, you also share the same view, or maybe I should say ‘taste’ when it comes to which phase of the economy we’re in, in the markets? Again, he’s in the deflationary or kind of negative yield camp on that, but there may be other things where you actually see things more similarly.

[00:22:07] Larry

Yeah, what I love about what’s happening in America and around the world is that we were all at banks and hedge funds, three, four, five years ago, now we’re working with people, like yourselves, around the world. It’s a lot more fun and I really enjoy it. I’m very grateful to Raoul and the Real Vision platform.

So yes, I’ve been trying to work my arms around the differences between where Raoul is and there really are two camps. There’s the immediate deflation camp. The problem with that argument (if you think about the dollar), is that there are three legs to the dollar stool: there’s the United States and a second wave there in terms of second wave, how dangerous it is, how bad it is relative to the rest of the world; then there’s the political uncertainty; and there’s deficit spending and this left-wing shift in the United States towards more fiscal, so that’s going on.

So, that’s dollar negative because investors, the last four or five years… The problem with the dollar bull crowd is that they’re coming out of Brexit, trade war, and the first round of Covid. All those things were incredibly supportive of the dollar and really forced global investors into the United States – hiding out in the U.S. assets; hiding out in U.S. stocks; hiding out in U.S. bonds. During that period you really didn’t have that much political uncertainty. Now you have an election where you’re really going to go, potentially, to a… If it’s a blue wave it’s going to be a very, very Congress’ going left wing. You’re talking about that brings a lot of uncertainty.

[00:23:45] Niels

Yeah.

[00:23:46] Larry

You can say whatever you want about Trump but, at the end of the day, the Republicans have controlled the Senate and the White House. The Democrats have the House for the last two years. That balance (no matter what people say about Trump), that balance gives investors, globally, a lot more certainty.

So, the three legs of the dollar stool, that part of it is shaky. Now, the other part (let’s go to Europe), so, fragmentation Europe, this whole thing with this recovery fund and the fact that we’re in a Kumbaya moment where the Europeans, even the most fiscally conservative, there is a period where, OK, for at least one year people are going to try to work together. So, that’s supporting the Euro. Whereas, like we saw in 2008 (it’s the same thing I talked about in my book (A Colossal Fear of Common Sense), when I talked about Europe you had a period there where, after Lehman, Europeans stuck together for about a year, year and a half, two years, until, finally, the financial stresses in Greece started to rear their ugly head.

So, in Europe, you probably do have another six months before the Italians, Mr. Salvini, starts making some real noise, or the Dutch or the countries in the North really start to, potentially, pull away. So, that’s supportive of the Euro for at least six months. I’m not saying this is a firm part of the stool. This could easily start to break down towards the end of the year. But that’s very dollar negative.

Then there’s China. One thing about when I spend a lot of time on The Hill, we take clients around The Hill, meet with people from Treasury. We have spent a lot of time, not so much, going down there this year because of the Covid but a lot of calls. I can tell you right now, the people in the White House, as much noise as Trump makes, it’s just noise and I think behind the scenes there are a lot of backdoor agreements that just say… Just similar to what Mr. Obama and Mr. Medvedev, you know that moment when he said, “Let’s talk after the election.” I just don’t think that the White House really wants to have a problem with China in the last two, three months before the election. So, once again, that’s very supportive of the Yuan. That’s negative for the dollar.

So, if the U.S. went into this Covid situation last, which it did and it’s going to come out last, and those other two legs of the dollar stool are firm, for the first time in five years those two legs are firm, for the first time: the European leg and the China leg are firm for six months for the first time in five years. There’s no Brexit, no trade war, no Mr. Salvini running around making threats. So, that tells me that the dollar could really have a hardcore down move here. I think Raoul is going to be right but I think that crowd has underestimated the near-term or the short-term impact of the election and the political implications. Then, Raoul’s theory will probably play out next year.

[00:26:47] Niels

Yeah, interesting. It’s interesting to hear your view about what you hear from the White House because I did notice, I think it was actually Grant Williams who wrote about this and mentioned it on another podcast I was listening to. I did read the first part of this memo that came out from the White House in, I think the 20th of May of this year. When you read it, it really sounds like a declaration of war, de facto, against the Chinese. I don’t know if you have read it but it’s worth a read. But maybe it’s, as you say, it’s just postulating and not really wanting to do anything more than that.

[00:27:24] Larry

Yeah, here’s the scary thing. In the election, both Biden and Trump are going to position themselves as anti-China in terms of trade, in terms of bringing jobs home. If you take a ride to upstate New York, upstate Pennsylvania, upstate Ohio, the decimation in America. I have taken long rides and my next book is more about this populous rebellion in the United States. It is just incredible the Opioid deaths. You’re talking about life expectancy, in some of these states, gone from 82, 83 years to 61, 62 years. You are talking about a 15, 20 year drop in life expectancy in some communities all because of Opioid addictions.

This is all related to the lack of hope. The financial crisis was the hit and then the drain of jobs out of the middle of America and it’s a real serious problem. That’s why you do hear a lot of this noise but I just don’t think the White House will act on it until after the election.

At the end of the day people forget. I wrote about this on our website and in client letters, I’m convinced that Janet Yellen with that promising the world in 2014, 2015 eighteen months ahead of the election, they were promising the world, pounding the table that they were going to hike rates twelve to sixteen times, and every bank bought into it. Every bank thought there were going to be twelve to fifteen rate hikes in the two years before the election.

At the end of the day, so the dollar ripped 82 to 104 and that moved crushed middle American jobs and really, I think it partially cost Hillary Clinton the election. Trump won Michigan, Wisconsin, Pennsylvania, but one hundred and ninety thousand votes. So, that dollar move was so vicious and I think the Trump camp has learned that you really can’t have a runaway dollar heading towards an election. You really want that dollar down and that will help whatever is left of middle America.

[00:29:32] Niels

Just staying on that topic, you mentioned that you had taken these rides and you have seen how the U.S. is challenged in many of these States. I believe, from your work, that you believe in cycles of different sorts. Of course, certainly, the three of us have discussed on the podcast Neil Howe’s work and the Fourth Turning and it kind of all fits into us going into a really, really, difficult decade as the last stint because everybody may believe that the big crisis was the TFC, but actually, when you read the book and the work that they have done, actually, the real big crisis is at the end of the Fourth Turning which is really what they predicted to be the next ten years from now. Frankly, this is something, going back to the inflation discussion, inflation expectation often really take hold when there is a big geopolitical shock, typically a war. Fourth Turnings tend to end in a war. So, there are a lot of things that point in the same direction, frankly.

[00:30:43] Larry

Yes, I did a sit-down with Niall Ferguson and Niall Ferguson made that point. In the ’60s you didn’t really have the inflation until the Vietnam War ended. So, Neil Howe’s work, I think, is incredibly… The foreshadowing is just very, very disturbing. It is all lining up that way. Populism, there’s a leftwing part of populism and a rightwing part of populism globally. We’ve seen both in Greece. You saw both the leftwing and the rightwing.

Now, in the United States, we went right with Trump. It’s just a matter of time before we go left. When we go left you’re talking about people that have no respect, really, for austerity and you’re talking about real spending and whether that leads to war or not, maybe the fact that both the Biden camp and the Trump camp are going to continue to pound home on China, more so after the election to try to bring some jobs back to the U.S. So, it’s all lining up for a very, very big move in asset prices over the next three years and it is the Fourth Turning. I am a buyer of that kind of cycle.

[00:32:00] Rob

What’s the cross-country picture like, then? So, you talk about currencies, obviously. If I look at valuations in fixed incomes and equities across the Atlantic there are huge differences, right? So, the U.S. market, particularly the Tech sector, looks ridiculously overvalued compared to Europe and compared to the U.K.

The U.K. is just super, super cheap. We’ve had this Brexit discount for a long time now and I guess that’s not going away any time soon. That’s not going that well, to be honest. Then in the fixed income markets which, obviously, is your background and my background and Niel’s background as well, you think that U.S. ten-years are like 63 basis points, or whatever they are today, you think that that’s low and then you look at bonds, which are at -85 basis points, or something ridiculous. So, how do you see those valuations playing out? Are those differences here to stay or could they even get worse or are they going to narrow? How do you see those flows?

[00:33:00] Larry

Well, this gets back to the Neil Howe Fourth Turning in our last discussion in terms of Tech. So, the largest hundred companies in America, the largest hundred companies in the 1960s and 1970s, anywhere between 55% and 65% of the profits were in the largest hundred companies. Then in the ’80s and ’90s that number went up to like 75% to 80%, maybe 79%. So, that’s in terms of the largest hundred companies percentage of the profits.

Now we’re up to 89% to 91% of the profits are inside the largest hundred companies. So, you’ve gone from the 65%, 62% up to 90% where the largest hundred companies just have so much of the profits. I’m talking real profits.

So, it just sets up that if you get a blue wave or even if Trump is re-elected, the probability of a destructive anti-trust phase in America is so high, and the probability of real (not laws but) restrictions on stock buybacks. Since Lehman, we’ve done six trillion in buybacks, six trillion. Everybody knows this and it’s funded by debt. So, the companies are issuing the bonds and the central banks are buying the bonds, and then they’re buying the stocks.

The whole thing is just so setting up for such incredible inequality. It’s really central planning go mad and gone bad. It’s setting up for real populous rebellion which means that a lot of money, I think, once there’s a response to this (which should come in the next six months, nine months) the money is going to really flow out of the U.S. and into some of the other parts of the world. Like you said, European equities, the U.K. equities are trading at twelve times earnings, and the U.S. are trading at twenty times earnings. It makes no sense but it’s because of the buybacks. It’s because of the concentration of profits.

[00:35:06] Rob

The other thing is that it’s not just about concentration but, I think, if you look at U.S. corporate profits divided by GDP I think that number (certainly before the crisis was at a record level) it had gone past what it had been in 2007 and before that in 1999. So yeah, there’s clearly a concentration of wealth. You can really see that in that figure as well.

[00:35:30] Larry

Yeah, the more time I spend on The Hill, we’ll take the clients around The Hill we’ll do calls, we’ll meet with Senators, we’ll meet with members of the House of Financial Services Committee. When you go down there every year, for almost ten years now, you definitely see a tone change. The tone change that I have seen in the last year, year and a half (on these trips and on these calls) is just much more (even from Republicans), much more populism, much more anti-trust incentivized and you’re going to see a big reaction from Senate leadership, House leadership next year and the year after.

Another big trend too is income. So, you want to look for sectors in America, new sources of revenue. One sector where we’re spending a lot of time is the Cannabis space. So, you get a blue wave, more left-leaning, House, Senate, White House, in the United States. Even with the Trump win, these States are bankrupt. You’re talking about a default, potentially, in New York City. You’re talking about New York State and Illinois. Illinois, (I think) has a 100% probability of default within the next two or three years.

So, you’re going to have a massive shortfall of cash at the State level. You need another trillion dollars for the State. You need another trillion dollars for the infrastructure to replace all these service jobs that have been wiped out. So, it just sets up for a dynamic where new sources of revenue like the Cannabis space. You want to look to Green Technology like the next infrastructure builds. Right now there is a three trillion dollar plan in the House, which won’t get passed, but the House and Senate will probably meet in the middle, for say a trillion, and Democrat’s plan is much more Green. There is much more of a Green infrastructure. Whereas Republicans have a more traditional infrastructure. So, these things are going to have a massive impact on asset prices, especially for European investors. You really have to have your ear to the ground in terms of what’s coming out of Washington.

[00:37:30] Moritz

I think that’s what we heard from the Biden camp probably today or maybe yesterday, that they are going for the Green Deal, which is something that we didn’t really hear that much about in the United States in the U.S. prior. What I really want to say is that you could say that, at any point in time, there is always stuff going on in the financial markets and the world. There is always risk. That’s certainly true, right?

[00:37:49] Larry

Absolutely.

[00:37:50] Moritz

When I look at today, the things that are happening, all at the same time, it may be the most decisive economic point in time in our careers, be that the South China Sea (which we heard about this morning) or tariffs (nobody talks about the tariffs anymore), it’s yesterday’s Tweeting news but it’s still happening. You have the Covid crisis, you have Iran, you have failing pension systems, you have States at the risk of bankruptcy (probably California and Connecticut), you have the Brexit, you have a failing Euro (potentially), North Korea, this, that, and the other thing. It’s countless – all the amount of debt. When I step back from that picture and you put that all on the canvas, I think, well, let those equity prices go as high as they may. We have seen that picture before. Yes, there’s a massive stimulus going on. Maybe, probably, they will crash.

I would rather be exposed to things such as gold, or assets that give me an exposure to positive convexity or positive skew, trend following strategies, whatever the case may be (pick your poison in a sense). Particularly, I’d be interested in the outlook for gold because that comes up all the time so we have to ask you the same question. You spoke about the commodities but gold being the primary monetary commodity where do you think that thing is going?

[00:39:17] Larry

Well, a lot higher for gold for sure. I just think that what happens with gold is that it’s like a stadium. Picture in your mind a stadium with, say, fifty, sixty thousand people. The amount of people that care about metals, in the world, relative to Tech stocks, relative to corporate bonds, relative to government bonds, it’s a very, very small pond. That’s what makes the convexity so sexy and exciting.

At first, what happens is that as people come into the stadium (and this happened in the ’70s, it happens throughout all the cycles), as people come into the stadium the first thing that they buy is gold. That gets to be a crowded asset class. That’s why we monitor the gold/silver ratio, copper/gold, these ratios were really skewed two months ago towards gold because, once again, the first 40,000 people in the stadium that are interested in this space are going to buy the granddaddy – the gold.

Right now, at this part in the cycle, with the amount of printing out of the central banks I would much rather be long silver, to some extent even copper, but definitely silver because, as we’ve seen throughout past cycles, as more people come into the stadium, gold is higher and higher, $1,800, $1900. It becomes very expensive and it gets silver down there at $18. The silver pond is so small and so your risk-reward with silver here is 300%, 400% up, and (depending on where you stop yourself out), 20% to 30% down. Whereas gold has had so much of the love the last year with people coming into the stadium that it does look a little bit crowded. I guess, if I was looking at gold and silver, I’d be long two-thirds your silver ratio and one-third gold.

[00:41:12] Moritz

Interesting, it’s a great analogy with that stadium. I thought there were more people in the world, actually, looking at the gold markets and actively investing in them. We’ve heard a couple of news items, probably around the turn of the year that the physical gold stores, for instance in Germany they ran out of metal. This was pre the Covid mint crisis where the refineries couldn’t produce enough gold. It had to do with the year-end change and stuff like that. Apparently, a lot of retail people had run into physical gold stores and then they bought everything that they could. So, there is, at least here in Germany, there’s a little bit of hoarding going on where some are very, very afraid of inflation.

[00:41:51] Larry

I’m just talking about the… Yeah, Germany, after what Germany went through in the ’30s and ’40s I guess the ’20s, was it twenty the Weimar, what year was that?

[00:42:00] Moritz

Yeah, in the ’30s, mainly in the ’30s.

[00:42:03] Larry

I’m just talking about these FAANG stocks, talking about two stocks now are worth three trillion. So, in other words, the amount of money that’s in the bonds is so big relative to the amount of money in metals. So, if just 5% of this capital that’s in, really, paper assets, moves over you’re just going to have a much bigger move in silver because silver is so small relative to gold.

[00:42:21] Moritz

Smaller, yeah. And much more volatile.

[00:42:25] Larry

Yeah.

[00:42:28] Niels

I thought they were all moving into Tesla, that seems to be… (Laughter)

[00:42:35] Moritz

Also, a fun thing about Tesla, I didn’t verify, but we have all heard the news about Tesla trading north of $1,500, and Tesla being worth more than Toyota and Volkswagen and all those car manufacturing companies combined, the latest company that they overtook in terms of market cap is JP Morgan. I found that surprising because JP Morgan is a damn big bank, paying an annual dividend yield and having a solid business, kind of like every year, and Tesla is now being worth more than JP Morgan. So, here you go. Thank you, Robinhood.

[00:43:06] Niels

Yeah, and you know what was odd about the whole thing and I don’t know whether anyone of you has read up on that, is that some people, at least, speculate that people are front running the fact that Tesla could be, at some point, included in some of these indices. The problem is that they have to, I think, produce three years of actual profits before that happens which is probably not anytime soon.

[00:43:27] Larry

Well, I have a little color on that.

[00:43:28] Niels

Yeah, OK, cool.

[00:43:29] Larry

So, we wrote a blog this weekend, and we’ve had (on our Bear Trap Reports website) twenty-thousand people on the website over the weekend reading this – a lot of people were reading about this blog. Here’s what it comes down to. So, there are a lot of conditions…

So, you’re absolutely right. Tesla has never had its three consecutive (it’s really four consecutive quarters of profits). So, they have had three. So, if they produce results next week, and the theory is that they wouldn’t go on the S&P right away. But it is a lot of gamesmanship because you have never had this, in the history of America, or the S&P, or U.S. Capitalism.

Typically, the way it would work is that a company, in its early stages, would go into the S&P, not early, but when they become a large-cap company. You’re talking about 30% through its lifecycle.

Here, Tesla hasn’t been around that long but because of the central banks and because the amount of money and they have been really keeping the capital markets wide open for a long period of time, they have just developed this huge market cap, close to 300 billion total enterprise value, about 290 billion of equity market cap, and you have just never had a company like that come into the S&P. It’s normally that you come in at twenty, or I guess 60, 70 billion, 25 billion of market cap.

So, the problem is that all the indices that have to buy the stock (it’s really like an evil genius thing because Tesla, typically, if they do produce the profits this quarter and the results next week) probably deserves to be in. Therefore, the amount of buying that would go into that…

The University of Pennsylvania did a study (there have been a number of studies) that show that a lot of the earnings results, going into the S&P, are in the eighteen months to two years before and then a period of normalization. So, what happens is companies and boards of directors are just dying to get into that S&P. They’re gaming it, they’re gaming it, they’re gaming it, they’re juicing their earnings up, you get in and then the earnings either fall off or the index is left holding the bag.

So, it’s fascinating because that’s clearly what is going on here and then it’s going to be very disruptive to the index. You’re right, right now Proctor & Gamble is at number ten at three hundred and nine billion. Tesla is at close to three hundred, so Tesla would come in at anywhere between twelve and ten in terms of the S&P 500. So it would come in, basically, in the top twelve companies which has never happened before.

[00:46:15] Niels

Yeah, staying with Tesla for a second, I’m not an equity specialist in any way shape or form, but it’s quite interesting for us as systematic managers where our core philosophy is ‘knowing what you don’t know’ because nobody can tell the future and, so, we just follow price, essentially. But then you have something like Tesla which is such a prime example of how analysts have completely different views as to whether stock should trade and I don’t know if anyone has been right at all. But it’s just a really classic picture of having no clue, really, about…

[00:46:53] Larry

I’ll end my Tesla comment with this one stat.

[00:46:54] Niels

Sure.

[00:46:55] Larry

If you measure the spread between the analyst price target and the stock? This is one of the widest spreads that we have ever seen and it’s just an incredible chart. We have the chart. It’s up on our website, TheBearTrapsReport.com. It’s $790 is the average to median target and the stock, as you said, hit $1,600, $1,700 this week. So, $780 is the average target. Most of the analysts on the street have a sell. Goldman went to a sell maybe two months ago or more of a hold. But the bottom line is that the Street is looking incredibly silly here.

I want to remind you, this is one of the most important parts of our talk today, this is just what happened in the ’90s. In the ’90s we sold our company ConvertBond.com to Morgan Stanley, so I was a dot-commer. What happens is that the froth and the mads, the serpent in the market, that mad mob just bids up stocks so aggressively (and we saw this in 1999, 1998), the analysts can’t keep up. So, that’s what’s happening now with Tesla, the analysts are down at $780, the stock’s at $1,600 and this is what we saw in 1999 all over the place.

[00:48:17] Rob

Can we take a more optimistic view and say that the analysts in the late ’90s were a little bit too optimistic and aggressive, in fact, putting buy ratings on a lot of companies that, frankly, were total dog shit.

[00:48:27] Larry

Yes, for sure. (Laughter)

[00:48:30] Rob

So, maybe some of the legislation and regulation and the changing culture actually helped a bit. It is interesting, isn’t it? There were a lot of companies around, in the late ’90s, which wouldn’t have gotten into the S&P either because they had no earnings at all. But you’re right. It’s funny thinking back that none of them were as big as Tesla.

The Big Tech companies that were in the S&P were real companies that made profits like CISCO, INTEL, I think Microsoft, I think they were the four biggest tech companies in the S&P. We didn’t have all of the fluffy internet kind of .com this complete… Pets.com and all of these things we can laugh about now. They were sort of overvalued, in terms of market cap, but none of them were, as you say, the sheer size of Tesla. It is pretty unique, isn’t it?

[00:49:28] Larry

It is. Think about yesterday, between yesterday’s high and the after-hours price, there was a closer to 20% swing in Tesla’s stock. You’re talking about a three hundred billion-dollar company with a 20% swing. This is like madness. This isn’t like some biotech, like you said, a Bets.com.

[00:49:44] Rob

Yeah, penny stocks.

[00:49:46] Larry

This is a lot of money moving around here. This can be extremely destructive. It’s setting up for a pretty ugly mess in the next couple of months.

[00:49:59] Moritz

So, that’s a 60 billion dollar swing between the high of the day and yesterday’s after-hours price. I didn’t know about the ranking of Tesla, if it came into the S&P tomorrow, which you say is between ten and twelve, position ten and twelve, which is a very high ranking. Then if something like that happened then, you are long the S&P and people trade the e-Mini futures contract and all that type of stuff and Tesla goes down 50%, what does the S&P do? The S&P is left holding the bag like you say. It’s introducing a ton of volatility to an index that everybody got accustomed to. We’ve seen the VIX trading up ten, now, this is a pretty behaved index. So, maybe that thing becomes like a mini Nasdaq.

[00:50:45] Larry

Yeah, we got a taste of this last year when Facebook missed the earnings, they were extremely high market cap at that time, I think probably close to four hundred billion, and they missed the earnings. There was about the same thing, about a 20% drop in like one or two days. The problem with the S&P is that everybody knows now that it’s really ten stocks that have a very large portion, 30% to 32% of the value, in ten stocks, and most of the profits. So, if one or two of those stocks make a big move it can really take the S&P down much more than they could before.

[00:51:31] Niels

Another kind of interesting, maybe hidden consequence of this massive rally that we have seen in these Tech stocks is something that I picked up this morning which I certainly was really surprised about, it was to read about how Warren Buffet, who preaches diversification, invests in all these companies. Right now, Berkshire Hathaway has a 43% allocation to Apple. I mean, crazy.

[00:52:01] Larry

When my book came out, Charlie Munger invited me to Omaha. I went out to see the annual meeting and it was incredible. There were just so many people, about 30,000 people in Omaha, Nebraska, in the stadium. Then he invited me, on Sunday, we went into the Marriot Hotel and there was one room that was Buffet with the pension funds. In another room, there was Bill Gates.

I’ll never forget, I’m in the room waiting for Charlie Munger and in he came and I introduced my wife and he said, one thing that he said to me that I will never forget, he said, “Larry, the toughest thing in the world to do is stare at a screen all day and do nothing. He was talking about… This was a couple of years, this was several years ago, he was talking about how Berkshire will sit there and wait.

Then I look at the last two years and this has just been incredible. They have one hundred and thirty-six billion in cash and they didn’t buy any stocks in the drawdown in 2018 when there was a 20% drawdown. Then in 2020, we had a 36% drawdown and they didn’t put any money to work. So it tells you that they’re sitting in their boat and they’re waiting for better values.

[00:53:08] Niels

Yeah, absolutely.

[00:53:10] Larry

That’s why Apple is such a big part of it.

[00:53:16] Niels

Right, sure, sure, sure, also I wanted to ask you… Moritz brought up a great list of things that we all hear about, we read about, all things that can blow up and we’re aware of them but it seems like we’re kind of complacent about it. In my introduction, I talked about that you are one who looks for the unexpected. So, what are we missing, what are we not focusing on and what are you most worried about that maybe a lot of people aren’t paying attention to?

[00:53:52] Larry

Well, in the U.S. Dodd-Frank forced the banks to move a lot of assets off their balance sheet. So, the private equity space is filled with a lot of the things that the banks used to have on their balance sheet – the CLOs the CMVSs. A lot of these loans, these secondary market loans, are in private equity hands, they’re in CLOs that are in these…

What’s fascinating now is U.S. CLOs relative to Europe are dramatically underperforming. It tells you that, once again, the U.S. is having a little bit more difficult time with Covid. The secondary market for lending, and the amount of capital that is over there, if there’s a problem there then some of those assets will make their way back to the banks and/or those assets get marked down and that impacts the value of the banks.

I think that’s why the Fed was so aggressive because the Fed knew, even though the banks are very well capitalized and JP Morgan today, their reserves are incredible, but if those assets are marked down because of… Think of double ETC loans on airlines. So, there are billions and billions of dollars in these airline double ETCs, which are loan portfolios that backup the airlines, and this is just one aspect.

Take commercial real estate, so, every part of CLOs has its baskets of these loans and there are just so many airlines that have put their planes in the desert, so, there are no cash flows now to back up. So, a lot of these loans with small businesses and all kinds of business loans are in private hands and it will take a while for this problem to really… (It’s not going to take a month were the Covid thing has only really been around, what, five, six months now.) In about a year and a half, two years, if these loans start going bad, then the banks have to really mark down their books and that’s what I’m most worried about in the U.S. is that.

The second thing is just Italy and the amount of… Italy has total debt coming due the next couple of years, close to eight hundred and fifty billion, over the next three years. Once again, that’s another slow-moving problem because you have the recovery fund, you have the whole period, but then, toward the end of the year, they’re going to have to start, as they do in September, they’re going to have to start doing the numbers. Once again, politicians have been running the show and doctors, not financial people. So, they’ve been very aggressive around really constraining economic activity and Italy is going to go hat in hand, in the next eighteen months, to Europe and it’s going to be a lot bigger than the recovery fund, unfortunately.

[00:56:45] Rob

Do you think that Madam Lagarde will put her hand in the German taxpayer’s pocket and… Moritz is looking concerned.

[00:56:48] Larry

You guys would know better than I. (Laughter)

[00:56:52] Moritz

It doesn’t concern me anymore. I think that is almost a given. It’s either going to be, do we want to keep the Euro as a currency? Do we want to keep that, let’s just call it, “union” which is on paper but, in reality, it really isn’t, do we want to keep it intact and give it a chance or not? I guess this is exactly what it comes down to. If you want to give it a chance and want to preserve it then you just have to put the thing together and spend the money on it otherwise it’s just going to fail because Italy and Spain and all of the other countries, they’ll just drop off.

[00:57:26] Larry

Yeah.

[00:57:30] Rob

So, the ECB is going to save the Italians, but why wouldn’t the Fed just buy out these CLOs and just keep that particular part of the system afloat?

[00:57:39] Larry

OK, so right now the Fed, I think that right now they can buy triple-A CLOs. Right now, if you’re looking at the Fed’s tools, they have been pretty aggressive but they haven’t been that aggressive, I believe, on the derivative side. So, the lower quality CLOs, yet I don’t think that that’s on the menu yet, which it probably will be. It’s a real, complicated problem for the Fed because you’re talking about hundreds of counterparties and hundreds of bonds in these slices, and slices, and slices, so far they’ve avoided it. There is usually stress and tension before the Fed takes major actions.

[00:58:25] Niels

It’s listed under dessert on the menu, actually. (Laughter)

[00:58:31] Moritz

Maybe it’s the cheese course.

[00:58:34] Larry

I think right now, I think they can buy triple-A CLOs.

[00:58:36] Niels

Any final thoughts Rob and Moritz while we have Larry and also trying to be respectful of his time?

[00:58:43] Rob

No. It has been a very interesting conversation. There’s nothing else from me.

[00:58:47] Moritz

It’s been great, Larry. Thanks for joining us.

[00:58:48] Larry

Thanks and I would just say, as we look towards the election, you can go to BearTrapsReport.com. Anybody that would like a free look over the next month, we’re going to be sitting down with the team in Washington every week and then producing reports and we’re coming up with sector rotation calls. As we saw with the Trump election there is just incredible sector rotation in the months before and after the election. So, that’s what we’re going to be focused on in the U.S. and we’re happy to help there.

[00:59:14] Rob

Perfect.

[00:59:18] Niels

Absolutely. Larry, thank you so much for spending some time with us. We really do appreciate it, as I’m sure all of our listeners do. By the way, as Larry said, make sure that you subscribe to Larry’s work on Twitter and TheBearTrapsReport.com and, of course, also the Larry McDonald series on Real Vision.

As you can tell from today’s conversation we’re living in a true global macro driven world. It is, perhaps, more important than ever before to stay well informed. From Rob, Moritz, and me thanks so much for listening and we look forward to being back with you as we continue our Global Macro Miniseries. In the meantime be well.

[00:59:56] Ending

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