Podcast

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Brian Pretti: The World's Capital Is Now Dangerously Boxed In

Creating asset bubbles ready to burst
Saturday, January 4, 2014, 12:22 PM

If you would have told me that we would be in this set of circumstances today ten years ago, I would have told you you were out of your mind.

~ Brian Pretti

This week Chris speaks with Brian Pretti, managing editor of ContraryInvestor.com, a financial commentary site published by institutional buy-side portfolio managers. In their discussion, they focus on the global movement of capital since quantitative easing (QE) became the policy of the world's major central banks.

The ensuing excellent discussion is wide ranging, but the key takeaway is that capital is being herded into fewer and fewer asset classes. With such huge volumes of money at play, very crowded trades in assets like stocks and housing have resulted -- bringing us back to familiar bubble territory in record time.

The key for the individual, Pretti emphasizes, is risk management. The safety many investors believe they are buying in today's markets is not real.

The Housing Market Is a One-Sided Investment Cycle

I think what we have got going on here in housing is we have got an investment cycle, not an economically-driven housing cycle, from the standpoint that really, never before have 40 to 50% of all residential real estate transactions been for cash. We have never seen that in prior cycles, absolutely not. You know, what is driving that? Well, in one sense – and it is not a point of blame, but more a look at the unintended consequences of what the actions of QE are – when you lower these interest rates and you take away safe rate of return in alternative assets. Five years ago you could have got 5% in a CD, a Treasury bond, even a money market fund. Well, for a lot of those people who had been savers and investors in safe assets, they do not have rate of return any more. What do they do? They take their $300-$400 thousand nest egg out of the bank, and they turn around and buy a rental property where they can theoretical get the 6%, 7% cash on cash rate of return. And all of a sudden that becomes their rate of return.

So, I think we are clearly seeing this, where assets are being lifted out of other investments – whether it is Treasurys or CDs or bank accounts – and being used to buy residential real estate. Of course, the issue becomes one of risk, meaning a Treasury bond never really needs a replacement roof, and the water heater does not break, and there are no vacancies. So, we are increasing risk in these asset class choices and investment choices, but it is a forced choice, because there is no other rate of return. And for people who need that to live, that is why I think we are seeing the big cash transaction levels that we have never really seen before.

Second part of the equation, foreign money is absolutely on the move. I mean, we are talking on the first business day of the new year, and one of the things that is in the news this morning and being talked about is, Is there going to be some type of an IMF-driven 10% deposit tax in the Euro banking system? Well, this has been being talked about now for probably two, three, four months. The trial balloons go up in the air. The Euro banking crowd has also talked about potentially negative interest rates. So may be a very simple question, Chris. If you are a Euro citizen and your net worth is caught up in euros and/or you have assets in the Euro banking system, what do you do? You get them out before something like this happens.

And really, maybe we can draw the parallels, too, with Japan, where we have seen monetary debasement and true currency debasement in very violent form over the last year since Abe’s been elected. If you are a Japanese citizen and your net worth is caught up in yen, you have lost 20% of your global purchasing power. What do you do? Capital begins to move globally.

And I think part of what we are seeing – well, maybe one last piece here, too, is, the current leadership in China is cracking down on corruption. So, I know you know full well, moving capital out of China is illegal. There is only one way to get it out. You have got to have serious capital. So, what is it doing? It is hiding in alternative assets globally. It is coming to what it perceives, for now, the perception of safety that maybe includes the U. S. dollar, and if you are coming to the U. S. dollar, what do you do? Well, you can buy bonds, you can buy stocks, you can buy a business, you can buy real estate, and because safe rate of return has been basically taken away, real estate and perhaps stocks, too, are a repository for that foreign capital.

And then, maybe lastly more than not, that global capital being on the move is concentrating in some of these geographic areas that we are seeing. I mean, prices in the New Yorks, prices in the Londons, prices in the San Francisco Bay Areas are just really off the charts here. So this is very much unlike prior cycles where we saw – and I know this sounds a little simplistic and Pollyannaish – but we see younger families getting jobs, making a little bit more money. All of a sudden, they can afford a home; they take on a mortgage purchase application. Maybe they buy your or my house and the food chain moves up. That is not happening this time. So, this is really an investment cycle, as opposed to a true economically-driven housing cycle.

And I just ask myself, is the lynch pin in all of this the dividing line of alternative rates of return, meaning interest rates? And as we saw rates pick up really since May of last year, we saw things like mortgage purchase apps and refi apps just drop like a rock. So as we move forward, these big metrics that are the interest rates that are Treasury rates are very, very meaningful. And will they be the catalyst of change, ultimately, in the housing cycle, as opposed to the economy being that catalyst? We are just seeing something very different this time.

The Box Global Capital Is Now In

The minute the Fed started talking about tapering – I mean, if we roll the clock back to 2009 when the Fed started their QE extravaganza, that money absolutely got into U.S. equities and got into U. S. bonds. But as the money kept being printed, it rolled across Planet Earth. It got into the emerging markets, it got into their bonds, their currencies, their equities. It got into global real estate, it got into gold, it got into commodities. The minute the 'taper' keyword was starting to be used by the Fed, all of a sudden, global investors were anticipating the recission of that tidal wave of liquidity. And all of a sudden, these asset classes started to contract to the point where it is really U.S. equities, the very large blue-chip global equities here that continue to perform well. They offer yields higher than safe bonds, for now, and are also the only place we are seeing rate of return.

But within this, we are herding capital into a very, very small sector of asset classes. And then lastly, fortunately or unfortunately, when we have the global central bankers and the global politicians doing what they are doing – Europe, we may take 10% of your assets in the European banking system. Europe, we may invoke negative interest rates; you bring a dollar into a bank, we will give you back 99 ½ cents. You cause capital to move, potentially, and to me this is a big issue. I think 2013 was driven as much by momentum, and there is no place else to go, and all those other wonderful things, as it was driven by the weight and movement of global capital. Global capital coming out of China, because it was scared of – if we are going to crack down on corruption and you have got corrupt capital, you get it out right away. Japan, the drop in the yen, you have got to move some of your capital to an alternative venue in an alternative currency. Europe, the threat of confiscation, and maybe just the basic question of, What the heck is the euro going to look like in three years? I know if my net worth was caught up in euros, I sure as heck would not be 100% vested in the euro.

So, a lot of this, I think, too, is global capital is hiding in an asset class that it considers to be relatively safe, because all these other asset classes have proven to be unsafe. And for right or for wrong, in U.S. and really large blue-chip globals, they have been very, very good stewards of capital over time. Their balance sheets are relatively clean, and if you are looking for safety, then this is just a very simple question. Would you rather lever your family’s balance sheet to one of the global governments, or would you rather lever it to Johnson & Johnson? Which one do you trust more? Which one is going to take better care of your capital over time?

So I think there are so many different factors that have been forcing capital into these narrow asset classes that basically are equities and real estate. The key issue to me, going forward, is risk management. For people who sat this one out, for people who have said, Hey, wait a minute; I am looking at the Bob Shiller CAPE ratio here, and we are at levels that we have only seen four times in the last 100 years.You have got to be kidding me. I am not getting into this thing. The only way to participate in these markets, in my mind, is to make sure that you have a plan for managing risk, period. This is not throw your money into the equity market and hope for a great 2014, because every year that the market was up like it was last year was followed by a year that blah, blah, blah. It does not matter. It is about making sure that we manage risk. And we need to draw hard lines underneath certain levels of capital.

Very easy to say, but for your listeners, too, I think this comes down to individual families and making an assessment of how much risk they can afford to take. Below that line, they do not allow it to happen. I know it may sound trite:You have every day of your life to get back into the market, but sometimes you do not have a second chance to get out. 

Click the play button below to listen to Chris' interview with Brian Pretti (101m:31s):

Transcript: 

Chris Martenson: Hello, and welcome to the New Year – it is now 2014 – and to this Peak Prosperity podcast. I am your host, Chris Martenson. Today, we are going to focus on the economy and financial markets, especially the degree to which they have become heavily distorted by the most exceptional monetary experiment in all of history. I am talking about quantitative easing (QE), of course.

To help us understand where we are economically and financially, and where we might be headed, I am really pleased to welcome Brian Pretti as today’s guest. Brian is the Managing Editor of ContraryInvestor.com, which looks at markets from the perspective of the institutional buy-side money manager. I have been a reader of Contrary Investor for many years, and found a kindred voice there that uses data and logic and history as the means of examining current market events. Contrary Investor is written, edited, and published by a very small group of real-world, institutional buy-side portfolio managers and analysts with at least 20 years of individual street experience.

I have invited Brian onto the program to get a better look inside the minds of those who are managing big money, as well as to discuss a few reports he has written recently that really got my attention for the cautionary tone they are sounding.

Brian, thank you so much for joining us today.

Brian Pretti: Chris, I very much appreciate the opportunity, and my very best to all of your listeners for – and I mean this in order of importance – health, happiness, and prosperity for the new year ahead.

Chris Martenson: Fantastic. I love that ordering. Let us begin at the top and with things that might impact those three things, the effects of QE and related efforts by Japan, Europe, the effects of those on our markets and their structure. That is one of the things I am most concerned with these days. You have written that things are well and truly distorted this time. And you use the term the fingerprint character differences that we are seeing in the current economic and financial market cycles, this so-called recovery we are in, relative to historical experience.

Let us begin with house prices, all in the news because they are rocketing up, particular in some communities, especially those hardest hit by whole, double-digit percentages by the same amounts that we used to see in what we called the housing bubble. But this time I guess it is healthy. Is it?

Brian Pretti: I will tell you, maybe luckily or unluckily for myself, I almost live at ground zero. I am here in the San Francisco Bay Area. So, we are seeing things, at least in the Bay Area proper, that we have not seen for a long, long time. Some of the Case-Shiller numbers were not only double-digit, but I think they were in the 20s. You know, it was a 20, 23, something like, kind of a number, year over year. And here, clearly, not only are we seeing international money coming into this area more and more, but we got the wild tech boom going on the Twitters, and the Zyngas, and all these other wonderful things coming public. So, there is a lot of capital.

And I have been almost convinced that one of the things we are seeing this cycle that is a little bit different is we are seeing the geographic concentration of wealth. If you look at places like London, if you look at places like New York, the San Francisco Bay Area, you would think that the broader economy is just absolutely on fire. But it is really these geographic areas that seem to be so strong, and maybe crazily enough, because that geographic concentration of wealth creates multiplier effects in those areas, it draws even more capital in, you know. So, you are getting an accelerated, if you will, multiplication of wealth in those economies. Those micro-economies look really good.

But when we look at some of the really big numbers, Chris, I think in this day and age, whether it is through our hand-held mobiles or our laptops, or whatever it is, we get a lot of news in sound-bite form, one-liners, you know. Oh, housing this month up, 9% year-over-year the prices were up this and blah, blah, blah. And it is what sounds great, but when we start to dig under the headlines and look at what have been some of the tried and true metrics, especially of the housing industry over time, it paints a much different picture. I mean, over the last two-to-three years, I have never heard a mainstream presenter of fact say something like, Well, housing starts have just recovered to a five-decade low. But that is where we are.

Chris Martenson: [Laughs]

Brian Pretti: There right now, when we look at the real numbers.

Chris Martenson: Yep.

Brian Pretti: And the same thing is happening with starts, as you would imagine. Most of the starts are in multi-family, but it is very, very subdued activity. And it is never really presented that way in the mainstream press, not that that is right or wrong. Mortgage applications, They hit a five-year low a couple of weeks ago. So in one sense, we have got these prices going straight up, but we do not have the underlying metrics that in past cycles would have told us that the housing market is very healthy. And a healthy housing market includes meaningful increases in starts, meaningful increases in new home sales, meaningful increases in new mortgage purchase apps, and also a meaningful contribution of residential real estate construction to GDP. We are also not seeing that at all. In fact, we are very near the lows of prior cycles.

I will tell you, it is just my own interpretation of life, but I think what we have got going on here in housing is we have got an investment cycle, not an economically-driven housing cycle, from the standpoint that really, never before have 40 to 50% of all real estate transactions, residential real estate transactions, been for cash. We have never seen that in prior cycles, absolutely not. You know, what is driving that? Well, in one sense – and it is not a point of blame, but more a look at the unintended consequences of what the actions of QE are – when you lower these interest rates and you take away safe rate of return in alternative assets, it could have been five years ago. You could have got 5% in a CD, a Treasury bond, even a money market fund. Well, for a lot of those people who had been savers and investors in safe assets, they do not have rate of return any more. What do they do? They take their $300, $400 thousand nest egg out of the bank, and they turn around and buy a rental property where they can theoretical get the 6%, 7% cash on cash rate of return. And all of a sudden that becomes their rate of return.

So, I think we are clearly seeing this, where assets are being lifted out of alternative investments – whether it is Treasurys or CDs or bank account – and being used to buy residential real estate. Of course, the issue becomes one of risk, meaning a Treasury bond never really needs a replacement roof, and the water heater does not break, and there is no vacancies. So, we are increasing risk in these asset class choices and investment choices, but it is a forced choice, because there is no other rate of return. And for people who need that to live, that is why I think we are seeing the big cash transaction levels that we have never really seen before.

Second part of the equation, foreign money is absolutely on the move. I mean, we are talking on the first business day of the new year, and one of the things that is in the news this morning and being talked about is, Is there going to be some type of an IMF-driven 10% deposit tax in the Euro banking system? Well, this has been being talked about now for probably two, three, four months. The trial balloons go up in the air. The Euro banking crowd has also talked about potentially negative interest rates. So may be a very simple question, Chris. If you are a Euro citizen and your net worth is caught up in euros and/or you have assets in the Euro banking system, what do you do? You get them out before something like this happens.

And really, maybe we can draw the parallels, too, with Japan, where we have seen monetary debasement and true currency debasement in very violent form over the last year since Abe’s been elected. If you are a Japanese citizen and your net worth is caught up in yen, you have lost 20% of your global purchasing power. What do you do? Capital begins to move globally.

And I think part of what we are seeing – well, maybe one last piece here, too, is, the current leadership in China is cracking down on corruption. So, I know you know full well, moving capital out of China is illegal. There is only one way to get it out. You have got to have serious capital. So, what is it doing? It is hiding in alternative assets globally. It is coming to what it perceives, for now, the perception of safety that maybe the U. S. dollar, and if you are coming to the U. S. dollar, what do you do? Well, you can buy bonds, you can buy stocks, you can buy a business, you can buy real estate, and because safe rate of return has been basically taken away, real estate and perhaps stocks, too, are a repository for that foreign capital.

And then, maybe lastly more than not, that global capital being on the move is concentrating in some of these geographic areas that we are seeing. I mean, prices in the New Yorks, prices in the Londons, prices in the San Francisco Bay Areas are just really off the charts here. So this is very much unlike prior cycles where we saw – and I know this sounds a little simplistic and Pollyannaish – but we see younger families getting jobs, making a little bit more money. All of a sudden, they can afford a home; they take on a mortgage purchase application. Maybe they buy your or my house and the food chain moves up. That is not happening this time. So, this is really an investment cycle, as opposed to a true economically-driven housing cycle.

And I just ask myself, is the lynch pin in all of this the dividing line of alternative rates of return, meaning interest rates? And as we saw rates pick up really since May of last year, we saw things like mortgage purchase apps and refi apps just drop like a rock. So as we move forward, these big metrics that are the interest rates that are Treasury rates are very, very meaningful. And will they be the catalyst of change, ultimately, in the housing cycle, as opposed to the economy being that catalyst? We are just seeing something very different this time, Chris.

Chris Martenson: Brian, excellent summary, and I want to see if I can summarize this, because it was back in 2008 when I first finished the Crash Course proper. And it was probably early 2008 when I was putting together the chapter on what I called what was going to be the most likely outcome, which was printing, money printing. And one of the effects we know from money printing, this idea of seigniorage, that those closest to the money printing are gaining the most benefit.

So, a couple of the dynamics you have put in here. One, investors being driven into housing almost by the financial repression. They have been forced into housing, because that is where attractive rates of return exit. We have heard about the big ones, the BlackRocks, etc., the big private equity firms that have moved in and bought houses by the thousands in certain key districts. But as well, mom-and-pops who do not like the returns they are getting on other so-called “safe” assets. They might have been driven in as well.

So, you have that one big dynamic driving housing, and as well, I wonder if you have looked into the data deeply enough to answer this question. We know that the extremely wealthy, whose money are flowing into, say, the London markets or the New York markets, or even some of the foreign, extremely wealthy people flowing into your neck of the woods in Northern California, specifically Silicon Valley, I am wondering if the propensity to buy large trophy houses is driving up that average sales price to – or to what extent it is that this money that is flowing preferentially to the 1%, to put a number on it, whether that is having an undue influence on the overall statistic of average home price we are seeing. That is, is there sort of a bimodal distribution in the data? Are we seeing it vary, what I would call ‘average houses’ maybe languishing compared to larger/trophy houses for those who can afford them in certain key areas? Is this a place where averages are hiding something from us? Or, indeed, are we seeing a very broad-based increase in prices, which paradoxically may be locking out those first-time buyers that you were just talking about?

Brian Pretti: You know, Chris, maybe there is a little bit of both going on here. And maybe, if I can describe it this way, it will have changed over time. Meaning if we run this clock back to maybe 2009, 2010, a lot of the lower-priced homes – call it $150,000, $200,000 – were really being bought up by, as you say the Blackstones, the Colony Capitals down in L.A., etc. And those home prices really started to move up on a percentage basis. And it is very easy to get a large percentage move off very small basis. But I know you and your listeners know this, Chris. Over the recent past, some of these big institutional players now – and this is really a matter of arbitrage more than not – are starting to issue fixed-income securities against future rental payments. I saw some of the term structures on these things; just absolutely unbelievable from an arbitrage standpoint. They can issue some longer dated bonds here with a buck and a half on the coupon, 1.75%, 2% on the coupon. And they can turn around and put that money to work, mid-single-digit, high-single-digit. So, in one sense, heads I win; tails I win, too, from the institutional side.

But as time has progressed, and I have seen some of this in our local areas, some of the really big institutional investors now are starting to balk. Some of the folks I have known that have been lending the money, or lending some institutions money to do this, have told me that some of the activity has really started to slow down. Because, the numbers now are not quite as attractive as they used to be at the lower end, vis-à-vis cash flow rental, etc. But at the high end, Chris – and boy, I will tell you, San Francisco to Silicon Valley (and it is, again, my immediate area that I see) is very, very different than what we see throughout the country. I grew up in San Francisco and the San Francisco Bay Area. The prices we are seeing today are just off the charts. And it has almost become the trophy-ish type of deal.

One of the things that has happened recently in San Francisco, and this is just a little microcosm more than not, is there is a little bit of a backlash starting to grow against the tech industry. In San Francisco, rents are protected, and you can evict protected renters under what is called the Ellis Act, and there have been many Ellis Act evictions over the last year or so. So, this little outcry is starting to grow a little bit of a groundswell in that investors will come in, buy up these multi-unit places, kick out renters who have been protected at very low rents. And the rents are up two, three, four, five times what these folks were paying.

So I think that does distort some of this, too, because the prices of properties in these areas – and I mean this, and I know it sound crazy probably for a lot of listeners in other parts of the country – five hundred dollars a square foot. Are you kidding me? That could be a starting price. Eight hundred, a thousand bucks a square foot for some of these places; it is not unheard of, it is common.

Chris Martenson: Wow.

Brian Pretti: And that is not what we really see as we look across the breadth of what we call this asset class called ‘residential real estate’ in the United States. But in these areas, such as the New Yorks, and such as the San Francisco Bay Areas, the price per square foot, if we could use that as hopefully a common metric across the landscape, is just so different than anything we see across mainstream or averages, it is not funny.

So, perhaps a number of years ago, it was really pressure on the low end, coming up, price pressure on the up side at that low end from the institutions. But what I have seen locally is they have been backing off recently. But the heavy capital that has come into some of these areas – and some of the big tech money that has been realized over the recent past, especially the San Francisco Bay Area, has really driven up the top end in a very big way – and it is a crazy thing to say, because I grew up in an area where 30 years ago, you could have bought some of these houses for $100,000, and today, they are going for $1.5 million, $1.7 million. The numbers are just staggering when you look across time.

Chris Martenson: Well, Brian, I ask this question all the time. I never get a good answer, because I do not think one exists. How do people who have average salaries, who are filling in the so-called blue-collar, middle-class jobs, how do they survive out there?

Brian Pretti: There is no answer, because I really do not know the answer to that question. What I see happening here is that – and especially in San Francisco, again; I hate to keep coming back to this one specific area, but – you have got a lot of young folks who want to live here. I can remember a few years ago, I have a client whose son was very high up in sales force. Sales force was considering moving to Texas, and their employees basically told them, If you move to Texas, you are moving without us. We are staying here in San Francisco. What ends up happening is, you know, the Google campus is down in the southern part of the Bay Area; the Apple campus is down on the southern part of the Bay Area. But buses run daily from San Francisco down to Google, down to Apple. A lot of the young kids want to live in San Francisco. Culturally, it is kind of a cool thing to do. So, what we are seeing is maybe $4,000 monthly rentals for two-bedroom apartments being filled with four kids or filled with three kids. And I hate to use the word ‘kids;’ these are adults. But it’s very, very expensive to do this.

But that is why we are starting to see this little groundswell recently, of that, let us call it the service-sector economy, who really cannot afford to live in the city in which they work. So, they get pushed out further and further and further. And I have talked to a lot of children of clients, and they have told me that over the past two to three years, they are having a lot of trouble being able to put in a practical bid on a home, because they are bidding against all-cash buyers, etc. I had a client a couple of weeks ago, his daughter was looking for a home. She had been outbid probably five times in all-cash offers. He had to lend her the money to make an all-cash offer and then come back and refi the home and put a mortgage on it later on. It was the only way she could get in.

So, it is really a tough deal for the younger folks, because they are being priced out by the perceived necessity of investment money to move up the rate-of-return food chain. And that really, to me, and I know this is kind of a social comment more than not, really disrupts the economic food chain – not the investment food chain, the economic food chain – that necessarily needs to happen over time. We look at household formations in the United States; they are declining. We look at the homeownership rate, and it is declining. We do not see that in economic recoveries, Chris. We see quite the opposite. So, is this the distortion of QE and what is has caused in terms of changed behavior and how it negatively influences those at the lower economic strata. I think that is exactly what we are looking at.

Chris Martenson: This is a very interesting topic, of course, right in the center of it. And I do want to make sure I have time to ask you the most important question for a lot of people who write into my website, which is, Should I buy a home now? There have been people on the sidelines for a while, and getting antsy, quite understandably. But what you are talking about here is the distortive effects of QE, this financial repression. If we drive interest rates down to zero on safe assets, of course, zero is not an acceptable return, so we have to go out and find it. And we find it in asset markets. And Ben Bernanke, I believe it was op-ed in 2009 or 2010 in the Wall Street Journal, he said this is exactly what they wanted to do. They wanted to see house prices move up, and they want to see equity prices move up.

This is something I critiqued and faulted Greenspan for a lot, confusing rising asset prices with rising wealth. It looks like wealth, tastes like wealth, feels like wealth, but it is not actually wealth. Wealth is the things that, of course, you have been writing about and talking about. It is about real investment in real property, plant, and equipment. It is about adding value somewhere in the chain. As we all know or should know, the so-called wealth that comes from housing prices rising, or from equity prices rising, is potentially chimerical. It could be there one minute and not there the next.

So, asset prices come and go. Real wealth is a durable substance. And so as we widen our view up a little bit and we look at the life blood of our economy, QE or not, looking at the bank loans and bank lending that has been happening, that lending is going to happen for all sorts of purposes, maybe for a home. Maybe it is for new property, plant, and equipment. That is something that I think you have written about, and I have noticed as well, that seems to be completely missing from this so-called recovery, is any meaningful recovery in the increase in bank loans and leases. What is the data telling you there?

Brian Pretti: I know it sounds melodramatic; it’s absolutely anomalous in the current cycle relative to anything we have seen over the last five decades. And right now, the loan-to-deposit ratio in the banking system is where it was in 1983. We have not seen a level this low since that period of time. And we can remember back in 1983, Chris – and you know what banks do for a living. They do one of two things. They take your deposit money and they either lend it out in a spread, or they invest it in what they hope are securities that will yield them more than they are paying out in their cost of funds. Well, back in 1983, they could have gotten what? 10%, 8%, 7%, 6% in very safe Treasurys, let alone corporate bonds or whatever they might have been. So, there was one huge incentive in the early 1980s to invest rather than to lend, so to speak.

But as interest rates got lower and lower and lower over time, we saw a lot of banks really increase loan-to-deposits, and at one point in time, Chris – and this is really late 1990s/early 2000s – the loan-to-deposit ratio in the United States was actually above 100%. And what that really meant was banks had borrowed money, largely from the federal home-loan banking system, and had lent out above and beyond what their level of deposits was. That is how confident they were at that time in making corporate loans. Well, today, we just do not see it, and I think part of what is going on here – and I would say most folks are fully aware of this – starting in 2009, what the Fed did is it told the banks that if the banks had excess capital, excess reserves, it would pay them a quarter point on that money.

So, in one sense, we created a closed-loop cycle here. The Fed prints money, it buys or creates electronic digits (whatever you want to call it). It buys bonds back from the financial system, but largely the banks. The banks now have capital, they turn around and put that money right back with the Fed at a quarter point. Might as well earn the rate of a two-year Treasury or a three-year Treasury, whatever it may be, and not take any risk at all. And so it never gets into the system itself.

And part of what we are seeing is, the number of credit-worthy borrowers has declined in this environment. But the second part of the equation is that banks would rather use this capital to do something else as opposed to make loans with it. And at least, until, let us call it May of last year, the Fed had basically guaranteed that they would keep their foot on the neck of the long end of the bond market. So, all a bank had to do was raise deposits and turn around and buy ten-year Treasurys, and as long as they stayed in control, they would earn a spread and they never had to work or take any risk all day long. They would just – again, I am convinced it was part and parcel of the Fed’s modus operandi to re-capitalize the banking system without the banks taking on additional credit risk, and that has been happening. But now all of a sudden we have got a little bit of a changed environment with the interest rate markets. And it is a little bit different for the banks, but we still do not see the type of credit creation that we have seen in the past.

And maybe one last tangential issue, Chris. When we really look at this thing from a long-long-term perspective, let us call it three, four decades, what we have really lived through is – and I used to ask this question all the time, largely for myself for the last 12 years – are we living in a business cycle or a credit cycle? A business cycle or a credit cycle; which one is it? Well, from my view of the world, it had really been a credit cycle. I mean, what was the huge buildup in household mortgage debt pre-2005, 2006? Well, that was a credit cycle. What was Greenspan lowering interest rates to one and all these other wonderful things, and even Bernanke lowering rates? It was to incite a credit cycle again. That is the horse that brought us in this economy over the last three, four decades.

The tough part in this one, this cycle, is that the private sector has to de-lever. It has got too much leverage already, and it needs to contract that leverage, either through debt paydown and/or just halting the rate of credit acceleration. Well, somebody has got to be the borrower in a system heavily dependent on credit. And that borrower has been the U.S. federal government since really the end of 2008. Federal debt since the 4th quarter of 2008 has doubled, and it is really easy to do when the Fed pushed interest rates down to zero; your cost of capital is basically nothing. And we have got a one-year Treasury here at 1/10th of a basis, or 10 basis points. You cannot even feel the interest costs when you take on that kind of leverage.

So, in one sense, the whole thing has been flipped on its head in this cycle, in that the borrower has become the government. And this is not just the United States. Look what is going on in Japan. Look what is going on in the European community; the broader Asian community. It is the governments that have become the key provocateurs of the credit cycle, and it is the private sectors that are really trying to heal. But given that, you just do not get the type of economic acceleration that you get in normal economic cycles, because the governments are horribly inefficient allocators of capital. And if they are the ones borrowing the capital, not a great deal. That is why we are ending up with 2% GDP growth right now.

Chris Martenson: So, this is a really fascinating topic. This is one that I have been focusing on for a while. So, let us take long bond interest rates in 1980, from which they began a very long descent downwards in yield. And so that is a long bond bull market, and it was right around that same time that our country and much of the developed world departed from what we might call normal debt-to-GDP ratios. We got on a cycle of borrowing at a much faster rate than even nominal GDP growth.

And so that is the system we are addicted to. That is what I believe that Greenspan, that is what I think Bernanke, that is what I think Janet Yellen is going to be in charge of trying to get us back onto is something that I think any grade-school child could tell you, you cannot do forever. So, we might title this podcast, Where Do We Go from Here? Because from 1980 to current, we basically ran interest rates as close to zero as you can. There is not a lot of room left to go, unless you are willing to entertain negative interest rates. And the Fed is busily trying to get us back onto this idea of growing credit at roughly twice the rate of real GDP growth.

And obviously, that you cannot do that with your credit card compared to income. You cannot do that as a business; you probably cannot do that as a state. You cannot do it as a nation. But here we are, and so the question then becomes, starting 2014, we are now going to be in our 5th full year of QE. And by every measure, say GDP growth or employment rates, things like that, we might say it is not really working. Where does the Fed go from here?

Brian Pretti: Chris, sorry to maybe make this a pandering comment. That is absolutely the question of the moment. And that is the key as we look into 2014 here. And I will just throw this out as a question: Is the beginning of Fed tapering? But let us back up for two seconds. When we started QE 3, year-over-year rates in change in payroll employment growth, and year-over-year rates in change of GDP were not much better than we see today. Now, admittedly, we recently had a 4.1% GDP number, but I think you know and I know 1.7 of that number was inventory accumulation. And look, if you are a business person, inventory accumulation is not a good thing; it is a bad thing. So, you strip 1.7 off that and then the final revision of the GDP number included an increase in both – well, it was personal consumption expenditures, but it was personal consumption expenditures for energy and healthcare, you know. That is not for building new plant and equipment. So you strip those things out, and we are really still back down to about a 2% kind of a GDP number here.

So in one sense, has the economy really done what the Fed wanted it to do when we started QE 3? You know, we want better payroll employment growth. Now I get it. You got the unemployment rate down, but that is really because of the distortion of the labor force participation. Did you really spark GDP here, even though that last little headline looks nice, if you only looked at the sound-bite headline number? Sure.

I tell you, I think what is really going on here is, the Fed knows it has reached its limits. And here is the deal. They, at $85 billion a month, they were printing 30 to 35 cents of every dollar the U.S. government spends. I mean, when does the capital market wake up some day and go, Hey, wait a minute. We are an unsustainable path here, you know? And the second part of the equation is that they were basically huge portions of the mortgage-backed securities markets and really the ten-year Treasury. In one sense, these are really sacred-to-me traffic lights. I know that is a Jim Grant characterization for the economy in terms of pricing risk. I mean, what is the capital asset pricing model that Bill Sharp participated in Nobel Prizes for? It is all about the pricing of risk relative to that risk-free rate. And when you distort that darn risk-free rate, you are really distorting prices across the board.

So, I am not trying to say that the Fed woke up one morning and came to some incredible revelation that they are distorting the financial markets, but they know the level of distortion that they have created. And if they continue to do this, they know that this distortion is ultimately impacting real economy. So, I will tell you, I think they are going to back away from this because they have to. They know they have to. Otherwise, the logical extension here is that within, let us call it two to three years, maybe four years, would the Fed own the entire Treasury market? Well, yes, they would. They cannot go there, they just cannot, without destroying the integrity – and I use that word loosely these days – of that market.

And then maybe lastly, really quick and tangential, when you look at some of the real data here, the one thing that we are absolutely missing in this cycle is, we are missing investments. When we look at capital expenditures – and I do not care whether it is small businesses or large businesses – we are looking at a level of nominal dollar capex that we saw in 1999. I mean, come on. This is what allows economies to grow over time. This is what allows economies to flourish, and that is investment that ultimately produces income somewhere down the line. When we are doing QE, and companies are choosing to take their cash and not increase their businesses, not have it go into plant and equipment, but having it buy back their stock.

And I understand why. The numbers arbitrage is as clear as a bell. I would be doing the same thing, borrowing at next to nothing and buying back my stock. But that does nothing for the long-term economic viability and growth potential of any economy, U.S. or otherwise. So, are they getting to the point where they are realizing these things and saying, You know what, regardless of what the ‘numbers’ look like ahead whether it be payroll or whether it be GDP, we got to knock this off? I think that is where we are.

Chris Martenson: Well, this is interesting, this idea that capex is really low, capital expenditures by businesses, because they are really being treated to – as far as I can tell – a once in a, not just a lifetime, but several lifetime low in corporate financing costs. So, they have got really, really cheap money, as you mentioned. And that would be a great time to plow it back into property, plant, and equipment. And it is not just slightly anemic. I am looking at a chart here that shows that in 2005, 2006, 2007, they were plowing in anywhere from, say +7% to +20% year-over-year growth in capex. That is what a boom period feels like. And 2013 is going to clock in at -1.5%. Based on early reports, looks like 2014 might slip a further five from there. So, those are percentages points. So, capex just really is not there, and the federal government is also not investing in a similar fashion. They have got, I believe, some of the lowest investment stances we have ever seen at least in several decades. I believe we have to go back to the early 1990s.

So, we are not investing in property, plant, and equipment; public or private. We have all this really, really cheap money. It is definitely flying into asset classes. We are all supposed to feel good that we see all this money flying into various asset classes. And of course, one of the things the stock bulls like to say is that corporate profits are really high relative to GDP, all-time highs. And wages and benefits are really plumbing some historical lows. Is that not a bullish set up?

Brian Pretti: Chris, you hit the numbers exactly on the head. I mean, right now, corporate profits as a percentage of GDP are resting near all-time highs close to about 11 to 12% of GDP. The crazy part is – and I know you probably know these numbers; you know, I went back and looked at these – in every single economic down cycle, and there are no exceptions to this all the way back to the beginning of the GDP numbers in 1948, the lows were 5 to 6% of GDP, corporate profits 5 to 6% of GDP. So, number one, based on historical averages and based on historical experience, we are as overextended now as we ever have been before, profits relative to GDP.

And the ‘headline’ bullishness of something like corporate profits, I understand, and I get it. But as you said, these corporations have been treated to a once-in-a-lifetime drop in cost of debt capital. So, number one, even very marginal corporations have been able to live. And very healthy corporations; any CFO who has not been borrowing to buy back stock in the last three years should have been fired three years ago, so to speak, because the arbitrage numbers are huge. And if we were to strip buybacks out of last year’s S&P earnings per share numbers, we would not have a hell of a lot of earnings growth.

And I know this is tangential, but the one thing that has really caught my eye recently, and I think, hopefully, is a characterization of that dichotomy between the real economy and the financial economy is long-cycle activity in mergers and acquisitions, private equity, and, to a point, venture capital. But really M&A and PE, because I go back to this and say, Okay, look, when most of these corporations are involved in some type of M&A, they aren’t just issuing new stock. In fact, in an environment like this, I would be issuing as little new stock as I possibly could in an M&A deal and borrowing as much money as I possibly could at near zero interest rates.

Same deal on the private equity side here, you know. And quote unquote, and I do not mean this in some monumental way, but the M&A community, the VC community, the PE community, they have really been characterized over time, rightly or wrongly, as the smart money, Ohh, these guys and girls really know what they are doing here. That is where they the hotshots are. Okay, great. We are seeing M&A activity and private equity activity today as subdued as anything we have seen at the lows of the last ten years.

Chris Martenson: Really.

Brian Pretti: And this is in nominal dollar M&A volume as well as PE volume, and also on a per-deal basis. So, again, these folks have been treated to a once-in-a-lifetime low in debt financing costs. We should be seeing an M&A boom. We should be seeing a private equity activity extravaganza at these kind of numbers. I mean, the arbitrage between cost of debt capital and theoretical rate of return in a real economy should be absolutely huge. Why aren’t we seeing this? Why aren’t we seeing the ‘smart boys and girls’ putting money to work like there is simply no tomorrow? The only answer I can come up with is, they do not see rate of return in the real economy. We are seeing rate of return in the stock market, we are seeing rate of return in financial assets. But we should be seeing boom times in M&A and PE, if we were in a healthy economic – an economic environment that looked like prior cycles. I do not mean to say it is unhealthy. We are getting growth; it is just small growth.

But if the economic outlook ahead was very, very bright, we would be seeing M&A deals every five minutes, and we are seeing none of that.

Chris Martenson: Well, that is really fascinating. I just recently read that private equity was going to return a record amount to investors. But the Wall Street Journal did not cover the other side of that, which is, why are they returning so much? And I guess the answer is because they are not plowing it back into new deals quite as much. I will have to look into that. Very interesting.

So, here we are, we are starting 2014. I know a lot of people I mentioned before, some of whom are writing and saying they have sat on the sidelines around housing. They are wondering what to do. Other people have sat on the sidelines with respect to the equity markets, and many are starting to feel a little foolish for having stepped aside. Let us talk about, what does somebody do going forward from here? Let us start with housing. Is this a time to buy, for somebody? Tough question, I know; a lot of variables, but generally speaking, would you be patient here or would you think we are in a new structural, this-is-the-way-the-world-works kind of moment?

Brian Pretti: I will tell you honestly, I am guessing more than not, and just as a little context and a little background here, both you and I sold our homes in the last decade, and we rented for a number of years.

Chris Martenson: Yep.

Brian Pretti: And then we bought homes back. And I think it was really because of the silliness that we were seeing in the mortgage credit markets at that time. So, I think it depends, number one, on the individuals, where they are in life and what their financial circumstances look like in life. And to me, to be able to lock in the cost of long-term housing at some interest rate level and/or you put up an amount of your cash out of your net worth, all you are doing is locking in a cost, and that is that, you know; I personally would not be – and I do this with clients all the time when we are looking at their finances – do not count your house as one of your assets unless you are going to monetize that thing. And for most people, they are not. So, if it works for them in terms of their own specific set of circumstances, by all means. But what they are doing is not making a huge investment; they are locking in and hopefully freezing what would be a future cost. And we all know that real estate appreciates over time and that we are going to have to put money into it to maintain it. So that needs to be factored into it, too.

For the bulk of the country, real estate prices have not done what they have done in New York. They have not done what they have done in the San Francisco Bay Area. And yes, some of the lower end here has been influenced by the institutional money. But I think on a rate-of-change basis, that upward price pressure being driven by the institutions is now starting to fade a little bit, because rate of return is not what it was in the last two to three years. So, that segment of the market is starting to look a little bit better, or let us say more appetizing, from the standpoint that prices are not going to the moon. But in some of these geographic areas that have been attracting capital, like the New Yorks and the San Franciscos, things are very expensive. Again, I wish I knew what lies ahead here.

The only other issue that we are going to have to deal with in the housing market is, once the investment demand is satiated, then what? Do we have a group of younger demographic that can come up, that is getting better jobs, getting better wages, and able to buy homes? Well, right now we are not seeing that. We are not seeing very significant job growth, or let us call it the 16-to-28-year-old section of life, and we are not seeing the wage growth at these levels either.

So, I’m sorry, I know I kind of spun you in circles here and did not give you a good answer. But I think individuals need to look at their geographic areas, they need to look at their own financial circumstances, and answer that question based on themselves as opposed to the market as a whole.

Chris Martenson: Well, I certainly answer that question for myself non-economically, just having to factor out the idea, Am I going to make or lose money on a house? Because I think it is very wise to tell somebody, When we look at your net worth, we are going to strip the house that you live in out of that, because that is not part of the equation. For me, the decision rested on time variables. I wanted to own my own place so I could make certain improvements that take a lot of time and investment of money as well as time. So, for me, it was that sort of a decision. I would say to somebody who is in one of those hotter markets that my personal advice would be, It might not hurt just to sit a little bit and watch. I have seen the roll-over in housing markets follow a fairly predictable pattern. And the first thing you see is sort of a slumping in activity, maybe the mortgage purchase apps are a beginning of that, at least on the non-cash institutional buy side, regular folks. And then you see inventory start to build and then prices roll and then eventually everybody says, Uh, oh; we had a bubble again, and we are going to have to go through some downturn. I am not sure yet, but I am seeing some early signs that say, mmm, a little caution; if you can wait, maybe you wait.

On the equity side, you said this is a TINA market. What do you mean by that?

Brian Pretti: Ah, Chris, in one sense as we look at – and last year was a poster child for this, you know – if you were in bonds, you lost money. If you were in gold, you lost money for the first time in many, many years in that bull market. If you were in emerging markets, you lost money.

Chris Martenson: Yep.

Brian Pretti: If you were in so many different – hey one of the things I have even told the clients, I said 2013 was one of the worst years for diversified portfolios that I have seen in many, many, many years, maybe decades. So I think what we are seeing is a narrowing of asset classes and a narrowing of capital decision-making, if you will, to just what the Feds want.

Chris Martenson: Yeah.

Brian Pretti: Equities and real estate, so to speak, for large diversified portfolios, they had one heck of a really tough year. So, what we have been hearing in the TINA characterization is that There Is No other Alternative except stocks. Okay. Again, I am speaking for myself solely. In an absolute sense, that is not a good enough investment rationale for me, you know. Somebody said, Hey, look, you have no alternative except to jump off the building here, and everybody else is doing it, you know. Just jump.

Chris Martenson: Yep.

Brian Pretti: And that is not a good enough rationale; no way. But for capital that is forced to get rate of return, and maybe one of the poster children for this at the current time is the pension industry; the pension funds. Not only are they coughing up blood, meaning they are very, very underfunded, but in large, well-diversified portfolios, they are not earning the assumed rate of returns that they need to earn. So, increasingly, and maybe this is just a little anecdotal example, the largest pension fund on Planet Earth happens to be the Japanese pension fund. And if I am not incorrect, it is about $1.2 trillion in equivalent monies. 80% of that darn fund was holding Japanese government bonds, yielding what, 59 basis points. That just is not going to do it, especially when implied inflation rates and real inflation rates in Japan are going straight up right now, especially for energy, food, and things like that.

Chris Martenson: Right.

Brian Pretti: So, about three months ago, these guys hired five domestic Japanese equity managers and they hired five U.S. equity managers, and they are going to start to reallocate money toward equities. Now, again, this is after the Nikkei had its greatest year since I do not know when. And this is after some of the other broader global markets, the equity markets have gone up. But they are being forced into this for survival. You know, I mean they know they cannot get rate of return anywhere else. So, it in one sense – and this is not sour grapes, and I am not trying to say this is all the Fed’s fault, and see what you get for doing QE – but in one sense, see what you get for doing QE? You pushed rates of return down to zero in very safe securities.

The minute the Fed started talking about tapering – I mean, if we roll the clock back to 2009 when the Fed started their QE extravaganza, that money absolutely got into U.S. equities and got into U. S. bonds. But as the money kept being printed, it rolled across Planet Earth. It got into the emerging markets, it got into their bonds, their currencies, their equities. It got into global real estate, it got into gold, it got into commodities. The minute the keyword was starting to be used by the Fed, all of a sudden, global investors were anticipating the recission of that tidal wave of liquidity. And all of a sudden, these asset classes started to contract to the point where it is really U.S. equities, the very large blue-chip global equities here that continue to perform well. They offer yields higher than safe bonds, for now, and are also the only place we are seeing rate of return.

But within this, we are crowding, we are herding capital into a very, very small sector of asset classes. And then lastly, fortunately or unfortunately, when we have the global central bankers and the global politicians doing what they are doing – Europe, we may take 10% of your assets in the European banking system. Europe, we may invoke negative interest rates; you bring a dollar into a bank, we will give you back 99 ½ cents. You cause capital to move, potentially, and to me this is a big issue. I think 2013 was driven as much by momentum, and there is no place else to go, and all those other wonderful things, as it was driven by the weight and movement of global capital. Global capital coming out of China, because it was scared of – if we are going to crack down on corruption and you have got corrupt capital, you get it out right away. Japan, the drop in the yen, you have got to move some of your capital to an alternative venue in an alternative currency. Europe, the threat of confiscation, and maybe just the basic question of, What the heck is the euro going to look like in three years? I know if my net worth was caught up in euros, I sure as heck would not be 100% vested in the euro.

So, a lot of this, I think, too, is global capital is hiding in an asset class that it considers to be relatively safe, because all these other asset classes have proven to be unsafe. And for right or for wrong, in U.S. and really large blue-chip globals, they have been very, very good stewards of capital over time. Their balance sheets are relatively clean, and if you are looking for safety, then this is just a very simple question. Would you rather lever your family’s balance sheet to one of the global governments, or would you rather lever it to Johnson & Johnson? Which one do you trust more? Which one is going to take better care of your capital over time?

So I think there are so many different factors that have been forcing capital into these narrow asset classes that basically are equities and real estate. The key issue to me, going forward, is risk management. For people who sat this one out, for people who have said, Hey, wait a minute; I am looking at the Bob Shiller CAPE ratio here, and we are at levels that we have only seen four times in the last 100 years.

Chris Martenson: Right.

Brian Pretti: You know, You have got to be kidding me. I am not getting into this thing. The only way to participate in these markets, in my mind, is to make sure that you have a plan for managing risk, period. This is not throw your money into the equity market and hope for a great 2014, because every year that the market was up like it was last year was followed by a year that blah, blah, blah. It does not matter. It is about making sure that we manage risk. And we need to draw hard lines underneath certain levels of capital.

Very easy to say, but for your listeners, too, I think this comes down to individual families and making an assessment of how much risk they can afford to take. Below that line, they do not allow it to happen. I know it is very trite comment to say, Oh you have every day of your life to get back into the market, but sometimes you do not have a second chance to get out. The key issue is managing risk to be heavily involved in these markets at the moment.

Chris Martenson: You know, the old maxim is, Don’t fight the Fed, and the Fed has been very clear that their interest is seeing the equity markets go up. So, in many ways, it is just siding with the Fed. But when it comes to the emerging market and the rest of the world, the Fed has been more in, I guess, the vein of Marie Antoinette. They have said to the rest of the world, Let them eat cake. So, Brazil cannot print like we are printing, and I am sure Argentina is heavily envious of our ability to monetize 40, 50% of our federal debt. I am sure Mexico is as well. I am sure Greece would be very, very happy with that ability at this moment in time.

But we have afforded ourselves that, that one – well, Japan has got the same sort of privilege as well – but we have afforded ourselves that exorbitant privilege, and it has been fantastic. The question really is, how long can it go on? I had arguments with people who said the Fed balance sheet could never get to $3 or $4 trillion, and here we are. Could it go to $40 trillion?

Brian Pretti: At this point, I guess anything goes. If you would have told me that we would be in this set of circumstances today ten years ago, I would have told you you were out of your mind. And here we are. We have crossed so many imaginary boundaries, it is not funny. But if you do not mind, I am going to come at that from a little bit of a different way in terms of how far can this really go. Okay, I may sound like a raving nutball, but here it comes. If we look at what has been going on really from a much, much, much broader lens, and we look at it over a multi-decade time period – and this is me, and it is a little bit of the Austrian economics – that we have been living in a multi-stage credit cycle. If we go back and look, this is the 1960s, this is the 1970s, we are at the very, very beginning of the acceleration in household credit that really went to blow off proportions in the middle part of the last decade; okay, fine. The U.S. financial sector and the U. S. corporate sector in the United States also levered up, and they levered up over a multi-decade time period. The financial sector ultimately blows up, the household sector ultimately hits its comeuppance with residential real estate and way too much leverage. Okay. Since 2006, 2007, 2008, the key provocateurs of the continuation of the credit cycle have really been governments. And the U. S. government has done this in spades, but so have really global governments. Okay.

But I think the box we are in is this one. When you double U.S. debt from 2008 until now, but the Fed artificially suppresses interest rates, and you can borrow in one-year Treasurys at 1/10 of a basis point, you cannot even feel it. You can go on taking all the debt you want, until the capital market tells you it is over. Right now in the United States, every one of your listeners can do this. Every single month, the Treasury reports all U. S. government debt outstanding on their website, and they give you an average cost of capital for the United States. In the last couple of months, some of the numbers we were looking at are as follows: The interest only cost on total U.S. debt right now is about $350 billion. For every 1% increase in interest rates, we are going to tack on another $170 billion.

So, it does not take too long in terms of interest rates, call it 300 basis points on the up side, and you are pushing what, $800, $900 billion a year in interest-only costs, maybe a trillion a year in interest-only costs. So I tell you, this is what I think the real issue is: How can the Fed get out of this? Because they know they are distorting the capital markets, yet not cause a huge increase in cost of capital for the U.S. government. And really, this is an issue again for global governments. I mean call up Kyle Bass and he will talk to about Japan for the next five hours and tell you what he thinks. But conceptually, it is the same kind of a deal. They cannot allow cost of capital to go up, because all of a sudden the interest costs for the governments mushroom. And what is the capital market going to do when it sees that?

And as a final comment here, and I am not saying the U.S. is Greece; far from it. But conceptually, it is not too far away. Everybody and their brother knew that Greece was living beyond its means. Everybody and their brother knew that they were digging a hole that they probably could not get themselves out of. Well, one day we woke up, and it mattered for the capital market.

Chris Martenson: Right.

Brian Pretti: And all of a sudden, 2% interest rates went to 4%, 4% went to 6%, 6% went to 8%, then all of a sudden no one would lend them any money more except the European Central Bank. Okay, fine. Are we going to hit that type of a moment in the major developed economies like Japan’s, like the U.S.’s, etc.? And in one sense, I am just asking myself, here we are back in May at the all-time lows of a buck forty-five on the 10-year Treasury, and we were over 3% at the end of the year. Is this the very beginning of global capital starting to question the balance sheet veracity and the ability of the large global governments to repay their debt?

And maybe this is a little bit punctuated by the fact that we just need to remember over the last six months, nine months, the Fed has not been printing $85 billion dollars buying stocks. They are buying bonds, and yet the 10-year Treasury yield has doubled. Ultimately, the free markets are bigger than the central banks. And I know, this may sound crazy and lot of people have said this already, we are just not there yet. The capital markets are bigger. And ultimately, in the long run, the global capital markets are going to control and set rates. Are we at the very beginning of that change right now with the inability of the 10-year Treasury to come back down in yield? Is this the very, very beginning?

Okay, and one more crazy comment where I blow all credibility, I promise you: Is the final act of the multi-decade credit cycle the deleveraging of global government balance sheets? I will tell you, I think that is exactly how it ends. Because the capital markets will force it, and the further the Fed goes, potentially the more violent the forcing it may be. And I think they realize this. I think what they would love to do is tiptoe away from QE. They have convinced themselves that all they need to do is wordsmithing about how they will not raise short rates and tapering is not tightening.

Chris Martenson: Yeah.

Brian Pretti: Well, come on, when you were printing money, you told us it was loosening, because it was the equivalent of negative interest rates. But now, tapering is not tightening? In the end, the capital markets are not stupid. They just are not, and that is what I am really looking for, is, will the capital markets lose trust in the central bankers? Forget the stock market for a minute. Because, you know this, the bond market is for dough, but the equity market’s for show. And I guess what I mean by that is, the credit markets are all about the numbers. The equity markets are about greed, and they are about emotion. A lot of different things drive them than just the numbers. So, it is really the credit markets where I think our focus really needs to be, because that is what is going to call the tune on not only the central bankers, but ultimately, the global governments and their ability to continue levering up their balance sheets.

Chris Martenson: I am certainly keeping my eye firmly on the 10-year rate, which has been poking at the 3% level there and has a little battle going on. But I am convinced that that is doing it despite the Fed’s best intentions and efforts at this point. So, that is really where my attention is going to be focused for a while. Because I agree, this will happen in the capital markets. And I do have a bit of the Austrian economist in myself as well. I believe, there is one quote I actually have taped over my desk by Ludwig Von Mises that goes along the lines of, There is, when you have a credit expansion, you have only two options. You either voluntarily abandon it, or you face a collapse of the currency system involved. That is the risk that I see us really facing.

And you talked about controlling risk. I believe there are some micro risks within portfolios. There are some macro risks here, too. This has never been tried before. We have been talking about four or five decades of data, sometimes seven, eight decades, sometimes more. And we cannot find anything to guide us here. We just have to rest on the idea that if it was possible to print your way to prosperity, I am reasonably confident the Romans would have worked it out, or somebody earlier. And otherwise, we have to have confidence and faith that the particular cast of characters that sit around the FOMC table, and the equivalent in the ECB and Japanese Central Bank, that somehow they have managed to find a new way to permanently manufacture prosperity from a mahogany board table, pressing ones and zeros that sent out off an enter key on a keyboard.

If you believe in all that, I guess, it is smooth sailing; it should be a great 2014. Otherwise, there could be some bumps along the way.

Brian Pretti: Chris, I think you are exactly right here. And again, 2013 was one fun year. You see those kinds of years in terms of rate of return, especially in the equity market, and maybe two, three, four times if you are lucky, over a career. Those things do not happen every day. But this grand experiment that we are living through here, I think you are exactly right. So far, the capital markets and at least the equity market have given the Fed the benefit of the doubt. But at some point in time here, the party just does not last forever.

And maybe it is even that mindset of, Well, they said they are going to print money, so we know stocks go up. They are going to print money, then stocks are going to go up. Well, I am waiting for the, “Well, we are still printing, but stocks go down.” Well, no, no, no, no, we said we are still going to print. It is okay. No, but stocks go down. And it is that divergence that we are ultimately looking for here. But first, all the capital that either must play or is absolutely starved for rate of return gets forced into those asset classes first.

Very, very simplistic question, Chris: After that happens, who is the next buyer?

Chris Martenson: It is a great question. And Brian, I am very cognizant of the fact that I have already personally chewed up big portion of your entire 2014 on a percentage basis. You have been very generous with your time, and I could keep this conversation going a lot longer. I really want to thank you for your insights here. I think the right way to go is to keep our eye on the macro trends, to really understand what is and is not different in this story. And there are very few voices out there running counter to the mainstream narrative, which wants us to believe that all is well and all is mended. But I think a quick peek under the run tells us there are a few rotten floorboards down there, and thank you for helping to see those in a really fun, entertaining, and enjoyable manner.

Brian Pretti: Chris, I cannot thank you enough for allowing me to be part of this at the very beginning of the year. Like you, I could go on for hours with it, and I very much appreciate the conversation. My very, very best to your listeners for the year that lies right ahead of us.

Chris Martenson: Thank you. And thank you for that. I hope we can do this again sometime.

About the guest

Brian Pretti

Brian Pretti is the managing editor of ContraryInvestor.com. Contrary Investor is written, edited and published by a very small group of "real world" institutional buy-side portfolio managers and analysts with, at minimum, 20 years of individual Street experience. Our credentials include CFA, CPA and CFP, as well as the obligatory MBA's in Finance. We are all either partners or employees of institutions with at least $1 billion under management.

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12 Comments

Arthur Robey's picture
Arthur Robey
Status: Diamond Member (Offline)
Joined: Feb 4 2010
Posts: 3936
Thanks

That was hard to follow for a nuts and bolts sort of brain such as mine. I do not have an intuitive grasp of the concept of "Capital" or even Money.

To misquote Adam Smith (I have lost the reference)

A house is no more an investment than is a pair of trousers.

And another quote from one J.Christ

Birds have their nests, foxes have their dens but there is no pillow for the Son of Man. Make yourselves a warm bed.

So what's a poor boy to do? Orlov and I have independently come to the conclusion that a sailboat side-steps the entire train-wreck of the real- estate bubble. I am on the hard right now. I have to get out the sander and sand the hull. I would have a complete failure of resolve if the boat were an inch longer- so a boat is not without it's down-side.

The white South African government knew that it was in serious trouble and pinned all their hopes for stability on a middle class of home owners. Perhaps this is what the FED also wants, but by printing money the toothpaste came out the back end of the tube. What happened was that the big end of town priced the middle class out of their homes.

No stable middle class has some serious consequences. hence the hollow-point rounds.

Got to get out the grinder-catch you all later.

pat the rat's picture
pat the rat
Status: Silver Member (Offline)
Joined: Nov 1 2011
Posts: 125
intrest

 $350 billion is half of the deficit of the budget, rates go up to about 1.5 percent it should eat  up all of the deficit.

This is about $ 700 billion, sending the treasury department and the fed of to own orbit. The budget will now stand on it"s own, can you spell failure!

AKGrannyWGrit's picture
AKGrannyWGrit
Status: Gold Member (Offline)
Joined: Feb 6 2011
Posts: 498
Bring Him Back

Thoroughly enjoyed this podcast I hope you will have Brian as a regular guest. Listened to the podcast twice just to pick up bits and pieces I missed the first time. What a great way to start off the new year!

AK Granny

 

cmartenson's picture
cmartenson
Status: Diamond Member (Offline)
Joined: Jun 7 2007
Posts: 5974
Re: Bring him back
AkGrannyWGrit wrote:

Thoroughly enjoyed this podcast I hope you will have Brian as a regular guest. Listened to the podcast twice just to pick up bits and pieces I missed the first time. What a great way to start off the new year!

AK Granny

Well, I share your views on Mr. Pretti; he was a real pleasure to talk to.  I only wish our before and after conversations had been recorded, too.

Much more was shared when the mic was off.  

So if he's willing, we'll have him back.

flintdm's picture
flintdm
Status: Member (Offline)
Joined: Feb 6 2013
Posts: 1
Excellent podcast

I thoroughly enjoyed this podcast. His perspective and insights from a capital markets and finance analyst currently in the trenches was excellent especially regarding the question, What is next? Just great stuff.

His critique of the sound-bite nature of financial news was such a breath of fresh air. It seems so much of financial news these days is meant to deceive rather than inform. I will be listing to this podcast a few more times for sure!

I did notice one beginning of the new year glitch in that the presenting date on the youtube part of the podcast was January 4, 2013 rather than January 4, 2014. It is always tough to make that year change transition when it comes around!

Thanks to Chris and Brian for taking the time to share your knowledge, experience, and insights!

gbcm's picture
gbcm
Status: Bronze Member (Offline)
Joined: Sep 3 2009
Posts: 36
That which Chris dare not mention ??

Well, nothing new here, and of course the 'gold' word was uttered once , but the subject wasn't discussed (as in the last OTC with Mish), probably because the 'pre talk'  made it clear that Brian doesnt see gold going anywhere price wise, except sideways or down, as he believes along with Jim Puplava, whose interviewed him many times, deflation and a strong US$ will continue to be negative for gold , and the US is the only game in town till the flock of black swans appear. So gold it appears remains a very expensive insurance policy especially when wrapped around the 4th finger of the left hand (sic). For those with a weird sense of humour, watch the latest interviews with Sprott predicting $2000 by the end of 2014, $5000 thereafter  - LOL.

Happy NY , GB.

Woodman's picture
Woodman
Status: Diamond Member (Offline)
Joined: Sep 26 2008
Posts: 1028
Arthur Robey wrote: So what's
Arthur Robey wrote:

So what's a poor boy to do? Orlov and I have independently come to the conclusion that a sailboat side-steps the entire train-wreck of the real- estate bubble. I am on the hard right now. I have to get out the sander and sand the hull. I would have a complete failure of resolve if the boat were an inch longer- so a boat is not without it's down-side.

Same here Arthur, I've got my wooden sailboat hauled out in the driveway, awaiting some new varnish and paint this spring.

Enjoyed listening to Brian Pretti.

Hrunner's picture
Hrunner
Status: Gold Member (Offline)
Joined: Dec 28 2010
Posts: 256
Unlimited is bigger than Limited

Chris, Brian,

Highly articulate and thoughtful podcast.

I have just one question, and it comes up over and over.

Brian Pretti said:

"the Fed has not been printing $85 billion dollars buying stocks. They are buying bonds, and yet the 10-year Treasury yield has doubled. Ultimately, the free markets are bigger than the central banks. And I know, this may sound crazy and lot of people have said this already, we are just not there yet. The capital markets are bigger."

The Fed has an unlimited printing press.  They already are buying 30% to 90% of new UST issuance.  With thin-air money.  That is unprecedented and historically massive.

If they are going to go that far, why not 100% of all new UST?  Why not 100% of all UST, new and rolled?

Why not 100% of stock market?

They are already, IMHO, setting prices of all major markets at the margin, by unprecedented purchases, and indirect purchases via futures and derivatives.  I repeat.  Their checkbook is unlimited.  The counter-parties is limited.

Our checkbook, our savings and that of pension funds, investment houses is limited.

Why can't the Fed set the price exactly where they want it, forever?

I think that is the scenario that plays out in 2014.  Immoral people keep doing something immoral, if it benefits them personally, until something or somebody stops them.  Lord knows, our government and business leaders will not stop them.  The asset holders, and the people themselves must stop them.  Bank runs, strikes, protests, societal shutdown is what it must come down to.  But clearly there needs to more pain to motvate the folks.

But Brian, do you think a few pension fund managers with limited capital throwing a temper tantrum will stop an entity with unlimited money-printing power, who thinks it is in charge of the world?

(I realize the nominal price setting game comes to an end eventually, when oil stops pumping and food is not grown, but those are physical and human limits, not monetary ones).

Thanks again,

H

jcat3022's picture
jcat3022
Status: Bronze Member (Offline)
Joined: May 9 2012
Posts: 78
Is it possible...

for you to make a post and not bash Austrian economics or those influenced by its school who are partial to gold or alternate currencies?  I've come to the conclusion that PP has a rather intelligent crowd that can critically think on its own and form opinions.  For me, there is no need to constantly be lobbing grenades at those who have differing opinions.  I'll even lend my ear to the Paul Krugmans of the world to hear what he has to say even though I agree with almost none of it.

As for the interview, it was excellent.  Very well put together.

Mark_BC's picture
Mark_BC
Status: Platinum Member (Offline)
Joined: Apr 30 2010
Posts: 522
Hrunner wrote: The Fed has an
Hrunner wrote:

The Fed has an unlimited printing press.  They already are buying 30% to 90% of new UST issuance.  With thin-air money.  That is unprecedented and historically massive.

If they are going to go that far, why not 100% of all new UST?  Why not 100% of all UST, new and rolled?

Why not 100% of stock market?

That's what I say. If they can buy bonds then why not stocks? Especially since it's a smaller market and as they said, the stock market's for show, the bond market's for dough. I'm not holding my breath waiting for a crash. But who knows, maybe we'll get one.

But just because the Fed can buy all these things doesn't mean it can go on doing this till the cows come home until there is mass social unrest which forces it to stop, because the Fed has to deal with the international community as well. There will come a point where the rest of the world won't tolerate it anymore. I think we're already there, and the other factor is coming into play: when will the world's gold run out, which I consider to be the more likely scenario triggering the end. China and India are in competition to buy the gold while it remains; their citizens know exactly what is happening.

What this means is that if the rejection is brought on internationally rather than domestically, the US will enter hyperinflation directly without having to go through a deflationary crash first.

This is also why I don't really buy into these bail-in concerns. The entire financial system is a ponzi scheme based on CONfidence. As soon as the average person loses confidence then it's game over. The best way to get the average person to lose confidence is to lock up the banks in a holiday and take a portion of depositors' money. Then it's basically game over and the elites lose control, at least financially. And I would guess the amount of depositors' money they'd have to steal would be many times what depositors actually have, since if confidence is lost and the banks have to fess up, then they are going to face their derivative obligations and there's no way they could bail-in 100X global GDP, or whatever it is! I can't see these bail-ins doing anything but hastening the ultimate demise of the banking system, not helping it lurch even further along. Sure they might work in tiny Cyprus, but that's just a little country "over there in the Middle East". Try it Europe- or USA-wide and it's a totally different ball game.

westcoastjan's picture
westcoastjan
Status: Platinum Member (Offline)
Joined: Jun 4 2012
Posts: 575
interst rates and liquidity

I second the request to have Brian back again. This was a great podcast for me because it was informative without being overly technical for the layman (woman). More like this please.

To underscore the importance of some points made, here is a link to another article that also reiterates the importance of interest rates, and how low rates have been so enabling to the wrong crowd.

http://www.acting-man.com/?p=27788

I also remain a fan of Dimitri Orlov, and his hypothesis that it will be another liquidity crunch that leads us into the collapse. The two combined - increasing 10 year treasury rates and decreasing liquidity will be a strong tell in this big poker game.

Jan

Cornelius999's picture
Cornelius999
Status: Gold Member (Offline)
Joined: Oct 17 2008
Posts: 381
I'm beginning to warm to your

I'm beginning to warm to your and Orlov's boat idea a lot Arthur. Despite the saying that you only get two good days with one - the day you buy it and the day you sell it!  And there's also the trend amongst smugglers to go as far as submarines. Of course the wind does't blow underwater.

Cornelius999

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