Welcome back to the Fatal Conceits podcast, a show about money, markets, mobs and manias… not necessarily in that order.
In today’s episode, we’re joined by Bonner Private Research’s macro analyst, Mr. Dan Denning, who’s been monitoring the markets from his “fortress of solitude” up on the high plains of Laramie, Wyoming.
After the worst first six months for stocks in half a century… the worst market for bonds in over two centuries… and the worst for a standard, 60-40 portfolio in… ever, we wanted to get Dan’s take on where he thinks we’re headed from here.
We talk fed hikes, inflation, jobs, housing, energy, BPR’s “trade of the decade” and the looming threat of China’s imploding housing market… and all in (just) under half an hour!
For the less audio-inclined, there’s a full transcript of the show (lightly edited for clarity) below. Otherwise, happy listening…
Cheers,
Joel Bowman
Joel Bowman:
All right. Well, welcome back to another episode of the Fatal Conceits podcast, dear listener, dear viewer, as it were, if you're joining us on the YouTube channel. If you haven't already done so, please head over to our Substack page. That's bonnerprivateresearch.substack.com. By now, you'll be able to catch hundreds of articles from myself, Dan Denning, Bill Bonner, and Tom Dyson, about everything from high finance to lowly politics, and plenty more in between.
There's plenty of research reports up there as well and also many more conversations just like this, which you'll find under the Fatal Conceits podcast tab at the top of the page. I'm delighted to welcome back our in-house macro analyst Mr. Dan Denning, who joins us today from the high plains of Laramie. Dan, how are you doing?
Dan Denning:
Yeah, good. It's been a busy couple of weeks, but still blazing hot summer here, so no complaints.
Joel Bowman:
As I sit here shivering in my sweater at four degrees Celsius. Mate, you and I were just speaking before we jumped on the recording here, we should make a special mention to a lot of new readers who have just joined us over the past few weeks or the past month. Welcome if you're joining us for the first time. I thought we might start with just getting up to speed with where we've been both with the project and with the markets for the first half of this year.
I think most of our readers probably know the basic setup. Worst first six months for stocks in half a century, inflation at a 40-year high, worst first six months for the bond market maybe ever, and likewise for a balanced portfolio. Do you want to just catch us up to where we are now, eight months-ish into the new year? I know we've had a bit of a bounce of the June lows. There's talk about whether or not that's a bear market bounce or the road to recovery. Where do you map us at this juncture?
Dan Denning:
Yeah. I think that's the right question because there's the price action in the market and then there's the big picture. Taking our lead from Bill, we always start with the big picture, which is taking over decades, not just months or weeks or even years. From that point of view, not much has changed since the first half of the year or really since we started in January.
That forecast or that prediction, if you will, is that the markets were extremely overvalued, mostly as a result of interest rates that had been left way too low for way too long. Then we expected lots of inflation because of both the fiscal policy, which is to say the stimulus spending from commerce. Then the support that the Fed gave to markets, which translated into higher consumer prices.
There were a few other complicating factors like the result of the pandemic lockdowns and their impact on the supply chain. That is a really important story for investors ,that the de-globalization that the pandemic has kicked off is probably going to push inflation higher or keep it higher for longer than we think the stock market expects. But it was almost inevitable that after such a terrible first half of the year, you would get some sort of recovery or bounce in markets.
Really the important question is, is that the end of the bear market, or is it a bear market bounce or a rally? I think our view, and I speak for Tom as the investment director and Bill as well, is that it falls pretty squarely within the definition of a bear market rally, which is easy to say academically, because you can look at it and say, "Well, the S&P is up by almost 20% from the June lows." Some of the more aggressive growth-oriented indices and stocks like Apple, the NASDAQ, they're up more than that.
These are really challenging moves for investors looking at the long term, because in the short term you feel like I'm missing out and maybe I'm wrong, but from our point of view, nothing has changed technically or fundamentally to suggest that the primary trend in the markets is still down. So that's what our investment strategy is set up to address is, how do you preserve your capital? How do you avoid the big loss and how do you prepare for this stagflationary environment where you have high prices that are sticky and lower stock prices?
There's a lot involved. There's interest rates involved and real interest rates and things like that. I'd say we got initial confirmation in the first half of the year that our macro thesis was spot on and since then we've seen sort of a counter cyclical reaction in stock markets. You never want to say the stock market is wrong. You never want to say that the price action is wrong, just because it disagrees with your thesis.
But I'd say based on the levels in the stock market right now, we're not going to change our call about where we think things are headed.
Joel Bowman:
You mentioned stagflation there and prices. We've obviously got financial asset prices on the one hand but then prices of everyday goods and services that people consume on the other hand, that's obviously a big part of the picture. What do you say to people who make the case that inflation has peaked?
I heard somebody use the metaphor the other day that the pig had moved through the python, this massive $6 trillion cash giveaway is moving through the system and now we're on the other side of that. What do you say to that argument?
Dan Denning:
Yeah. I mean, I'd say it's wrong. I think there's certainly an element that inflation was exacerbated by one-off factors, but that to me seems like the conventional explanation that it came easily and it will go away easily. History suggests that's not the case, that there's a lot of inertia once inflation gets hold. Part of that is just monetary and then part of it's psychological. If you look at real interest rates, so you look at the Fed funds rate adjusted for the inflation rate, it's still negative.
It's around 6%, maybe almost 7%. Markets seem to have gotten ahead of themselves in saying that inflation will come down and the rate of interest rate increases has probably already peaked as well so they might continue to go up by 50 basis points or 25 basis points. But 3% is probably where the Fed will stop and therefore it's okay to go buy growth assets again at really high premiums, at high price to sales ratios, high price to earnings ratios.
Those ratios are down a little bit from last November, but they're still elevated based on their historic high, so things aren't cheap right now. They're not cheap either especially if you think that we're headed toward either a recession or we've been in a recession, or that we'll have stagflation. You're pricing stocks as if interest rates were going to be lower or inflation was going to be lower and earnings were going to be higher.
To me, that's a very rosy scenario and the risk if you're wrong is that there's still another 30 to 50% drawdown out there for equity prices based on where they normally revert in a mean reverting crash. Again, what I've been looking at lately, Joel, is I've been looking at the credit markets, especially if you look at some of the junk bond exchange traded funds, those have started to roll over a little bit.
I say that because sometimes the credit markets are a little bit better indicator of financial conditions than the stock market. I'd say people who think that the Fed is done raising rates and that inflation's going to come down quickly, are hoping that's the case but the historical evidence is that it's not the case.
Joel Bowman:
You mentioned real rates, i.e. adjusted for inflation, and we're probably maybe something like 600 basis points behind the curve, as they say, where historically I think it was Volcker who jacked up rates to 600 basis points beyond the curve to get inflation under control when it was at roughly this level 40 years ago.
Just sticking with real-world adjusted prices for a little bit, I know you've talked a lot about real wages, for example, and just to get back to your observation then that a rosy outlook necessarily entails increased earnings for corporations, I'm wondering how people who make the peak inflation argument are factoring in higher earnings when people's real, that is to say adjusted-for-inflation earnings, are lower and even going backwards.
Dan Denning:
No, I don't know. I mean, we both read the same people and we try to keep up. I mean, it's an important thing to keep up with data, evidence and arguments that could indicate that you've missed something or that you're wrong about something. But when you look at credit card debt exploding to its highest levels ever, a number of people taking out new credit cards and then the employment figures they vary from month to month, they're volatile. Are they leading? Are they lagging? Are they even correct?
These are surveys. They're not necessarily hyper-accurate accounts of what's going on in the labor market, but if you look at the trends for real wages adjusted for inflation over time, those are easier to understand and they're easier to extrapolate.
That compared to what's going on with energy prices, with healthcare costs, with food prices, with the cost of rent, with the cost of existing homes and new homes, those suggest that it's just harder than ever for normal people on a median wage and a middle class salary, even the rarest of things, a home with two wage earners, a mother and father who are both earning income, it's just the cap is getting bigger and bigger.
I don't find it credible to think that there's going to be a huge rebound from the consumer in the second half of this year that justifies paying higher prices for stocks right now. Now, you talk about the stock market, we still look at individual companies where the setup is more favorable.
I think that's an important point to make is as an asset class, our view on stocks is mostly bearish, but part of our strategy is to own some of them anyway, as part of a diversification approach and to focus on companies that have pricing power, companies that don't have debt, companies who for various reasons that are particular to their industry or to their management seem to be bucking the trend.
That doesn't hedge your risk that when you own stocks in the bear market, most stocks go down, but Tom's actually been really... I say, actually. He's been doing it his whole career. He's been pretty good at finding these little pockets of opportunity. For new readers, or I think who would like to be more aggressive, we're simply not going to do that. We're not going to be aggressive on the short side because we're bearish and we're not going to try and surf these rallies and time the market perfectly in and out.
I think Tom's going to continue his bottom up balance sheet analysis of companies that have a favorable setup and then trade them. I say trade, I mean, these are not long-term holds. We have one long-term hold, which is our trade of the decade, but the other stuff is not meant to be held for years. It's months or longer, but he'll be clear about all that when he sets them up.
Yeah, it's difficult because we all have to do something with our money and it's hard to sit there and watch the market go up and wonder if you've missed something. I think we're on top of the macro trends and nothing has changed in the first half of the year that would cause us to think we're missing the boat on this.
Joel Bowman:
Right. Well, let's make that transition then for readers who are following along from what you've outlined then as Tom's tactical trades. They're these little pockets of the market where he sees perhaps an asymmetrical risk or favorable winds blowing, given a particular set of circumstances, but over the longer timeframe, which is to say the remainder of the decade, we've set up the /trade of the decade' as Bill has called it.
This is essentially long conventional energy sources and there's a particular play on that for our readers. Do you want to set the backdrop there and maybe just talk about the slight correction in oil prices that has manifested over the past couple of months. Where we are with that?
Dan Denning:
Yeah, sure. I mean, that's an important one because if you want to do something, that's the simplest one to do. I would encourage people to read that report, which we'll probably update before the end of the year, because when we put it out at the beginning of the year, it was really based on two or three important ideas, none of which have changed. In fact that they've all gotten stronger and to extent that data has come out since then, I think it's confirmed what we said.
The first one was just purely driven by the price action in the energy sector over the last 10 years. Anyone who's familiar with the idea of the Dogs of the Dow, that if you buy the worst performing Dow stocks from the last year and they tend to be not always the best performing, but they rally, or you can buy the best performing stocks from the previous year.
The momentum investors would tell you to buy the best performing stocks from last year because they're probably going to be the best performing stocks this year. Contrarian Dogs of the Dow approach is to look for stuff that's done so poorly that it can't get much worse. When it gets worse in the Dow, they just kick you out of the Dow anyway. That's actually what happened with ExxonMobil.
When we were looking, we looked at both the size of the S&P energy sector as a percentage of the entire S&P 500 and the performance of that sector relative to things like financial stocks and tech stocks, especially, and it couldn't have gotten any worse. Well, I mean, I suppose it could have gotten worse, but worse would've been the death of the coal industry and the death of the oil industry, which funnily enough, some people were calling for at the end of last year.
They were saying, "That's it. Oil's never going to reach a hundred bucks again and it's uninvestable." I think Jim Cramer at one point said oil stocks are uninvestable.
Joel Bowman:
That's a great contrarian indicator for you right there.
Dan Denning:
Yeah. The magazine covers as well. The Economist had a lump of coal in a bell jar saying... I don't remember what it said, something like the end of coal. But those are cultural indicators of what's going on with liquidity and asset allocation and investor sentiment. It was underinvested in from that point of view, but that was the first point that it was bound for a rebound over the next 10 years, compared to the previous 10 years.
The second point was because of regulatory action, which was mostly hostile to fossil fuels that the oil and gas company majors especially had dramatically reduced their capital investment in exploration and in production so that if demand recovered from the pandemic drawdown, which you would expect it would recover at some point, then the industry was not in a position to rapidly increase oil and gas supply to keep up with recovery demand.
Our idea there was that demand would grow. It would resume, and it did quickly. You had the added complicating factor of the war in Ukraine with Russia and how disruptive that has been to energy supplies. That's a big story, which we probably can't get into here, but the idea that energy is being de-globalized or it's being politicized in a way that it hadn't before.
The basic argument was just supply and demand, that the case that fossil fuels were dead was overmade, and that even if you believed that we were moving to renewables in this energy transition, it would be probably decades, not years and certainly not months and it wouldn't be seamless. That was a favorable setup.
The third, which is probably a little more controversial is the very idea that we're moving seamlessly to an energy transition where the internal combustion engine will be replaced by electric cars and wind, solar and renewables, hydro, will all eventually replace coal and gas and we won't need nuclear is a pipe dream. It's a thermodynamic pipe dream and we're already seeing that.
We didn't expect this at the time, but I saw this morning that Germany has two months of natural gas reserves, thanks to its dispute with Russia. That's a country and an economy that set themselves up as if they would always be able to get cheap fossil fuels, but switch miraculously to renewables. You and Byron King have had a lot of really productive discussions on why that's not true and what will happen if you make policy based on those assumptions.
On the investment side, our conclusion was that for those three reasons, the underperformance in the previous 10 years, the underinvestment in the capital required to increase supply and the overemphasis on the energy transition and the idea that everything would be green and electrified, that over the next 10 years it would be hard to find a sector that's going to do better than oil and gas. That you can probably ignore the short-term price fluctuations.
We get that a lot from new readers saying, "I didn't get into the trade when you made it. Is it too late?" What we say is we'll revisit it from time to time to look at when is an attractive time to enter the trade, and that means there's going to be drawdown. We were up by over 130% at one point, and then it came down, then it goes back up. The whole idea... Bill's idea of a trade of a decade was you just didn't have to pay attention to any of that over 10 years.
Find yourself an attractive entry point to the trade, put as much money in as you're comfortable losing, and then forget about it. Don't agonize. If you can't sleep because you've made an investment that's supposed to work over 10 years, then probably it might not be the right investment for you. We'll update that report. I think those three points are still in our favor, and if anything, I think the decline in the oil price has been overdone.
That's an interesting issue, which I'll get into in a weekly update in the next couple of weeks, but I wouldn't worry too much about the price action in the oil market.
Joel Bowman:
I should mention there that we recently unlocked a transcript that we recorded back in late December of 2021 with Bill's longtime friends, Rick Rule and Byron King. We had a really great discussion. This was when we were just getting going with Bonner Private Research and they were generous enough to give us their insights on what was happening in the energy markets.
Of course, nobody could have foreseen the events in Eastern Europe unfolding as they did, but that served really just to exacerbate the situation that they had seen there. You can go onto bonnerprivateresearch.substack.com and check out that unlocked transcript. I'll put a link in the notes below this show, but Dan, we're almost out of time here, mate. I've just got one little black swan type question.
A few of our readers have written in asking possibly off the back of one of Tom's observation, he's been writing a little bit lately about the slowdown in China and the bursting property market there. I think he noted that the Wall Street Journal had called the Chinese property market the single biggest asset class by value on the planet and that's something in the order of $53 trillion or some absolutely mind-boggling number there.
Given what's happening over there in China, are you at all worried about being dragged into a global recession? What that knock-on might look like with regards to oil prices? How does that impact the thesis? I know it's kind of a big question to end on, but...
Dan Denning:
No. It's a great question. I mean, those are the things we're paid to think about and try to figure out ahead of time. I think it sort of graduates in scope. If you want to start with the oil markets, if China's in a recession or if they're locking down cities or if the property market collapses, or if there's disruption in their property market that causes slower economic growth, then that's going to impact their demand on oil.
They've also shut down a bunch of factories in different places, so I think it has impacted oil demand, which has shown up in the oil price, which was something frankly I had neglected to pay attention to because you just talk about the global oil market and you forget that there are some components of it that drive the price more than others. That I think is something worth keeping an eye on.
I think the two other... To be concise, there are probably two other things we'd look at. One is the financial stability in China and how that plays into whether China has an alternative to the dollar or the truth is China's capital market is still mostly closed to the rest of the world so they could have a property collapse and their banks could collapse, but the government would absorb those losses or they'd transfer them to someone else in the system.
That doesn't mean it wouldn't have a domestic impact. When people have money that they think is in a bank account and it turns out that it's in an investment product and they can't get that money, then that makes people upset. We see some of those stories, probably not as much as we should, but I think that's also a cautionary tale for investors in the West and the United States is that money in the bank. Yeah, I mean, it's FDIC insured so I don't want to suggest that it could be seized like that, but that's what can happen.
China's capital markets aren't ready for prime time. It's not going to replace the dollar or the U.S. bond market anytime soon, but I think the highest level about instability in China economically is how it plays into their strategy with regard to Taiwan and challenging the United States militarily.
We didn't talk about those things because basically from when China entered the World Trade Organization in 2000, until the beginning of the pandemic, there was what we called the symbiotic relationship between China and the United States where China exported goods to the U.S., generated huge trade surpluses, which it reinvested in its own economy to build its infrastructure to re-migrate about 500 million people from the countryside to the cities. That's done. It's not entirely done.
In fact, it may have been overdone in terms of the amount of investment they made in real estate to resettle those people. But if you have an economy where voters... Well, they don't really vote, but if you've got people that are unhappy because they're not sure their money is safe anymore, and you've got a conflict with Taiwan, and you're trying to decide whether the Russian war and Ukraine gives you an opportunity to conduct a military operation that the U.S. might not be able to resist, those are all things that... They're not black swans, because we can talk about them.
A black swan would be something we just didn't even think about and weren't prepared for. We know that there's a possibility for military conflict in East Asia. We don't know if it'll be the North Koreans. We don't know if it would be the Chinese. We have no idea if China would suddenly say, "You know what? We're not worried about our economic situation anymore. We're going for territorial acquisition maybe as a way to distract our people from our crashing economy."
As you said, China's property market is something like 300% of GDP. It's a massive sector which has suffered from massive inflation. It's one of those you have to keep your eye on because when you take your eye off it, that's when it's most likely to blindside you literally because we're all paying attention to semantic debates over what a recession is or over where interest rates will top out.
In the meantime, you've got this giant lumbering economy that may be in crisis mode, and they're making noises about a conflict. Yeah, it's an excellent question and we'll be covering it more for the rest of the year, for sure.
Joel Bowman:
Excellent. All right. Well, just on the subject of recession, obviously, Dan, the correct definition is a recession is that it's only a recession if it comes from the recession province in France, otherwise it's just a sparkling economic gut punch. Mate, your readers, our readers, Bonner Private Research readers are going to be able to catch all of your weekly updates every Friday.
Tom writes to our readers every Wednesday, so please be on the lookout, members, for those twice weekly updates. Again, as I said, it's bonnerprivateresearch.substack.com. Check out the dollar report, the strategy report, trade of the decade report and all the transcripts that we post from our special private summits, the latest of which Bill convened a round table to ask our panel, nine guests, two very simple questions, that is to say, what is going on in the markets and what are you doing with your personal money?
We had a bunch of newsletter veterans, many of whom our readers would recognize. Alex Green, Porter Stansberry, Doug Casey, Byron, yourself, Tom, Rick Rule, and others besides. I'm sure I'm forgetting some. Jim Rickards.
Anyway, it was a really all-star lineup. Obviously not everyone agreed because we had nine different people looking at different sectors of the market and trying to keep their eyes on this huge, complex global setup. Anyway, lots and lots of really interesting thoughts there. Again, head over to the Substack page where readers will be able to check that out. In the meantime, Dan, keep safe up there in Laramie, mate, and we'll catch up again very shortly.
Dan Denning on Where to From Here?