We're excited to have a brand-new guest for this week's Stansberry Investor Hour episode. And Dan has long admired him for his keen macroeconomic insights...
David Cervantes, the founder of New York's Pine Brook Capital Management, joins us today. Before establishing his firm in 2015, David already had roughly two decades of experience in the financial industry with Wall Street heavyweights like Wells Fargo, JPMorgan Chase, UBS, Bank of America, and Morgan Stanley.
Given the carnage in the markets, an uptick in inflation and volatility, and sky-high mortgage rates, Dan says, "We're on another planet versus a year ago." It's a big moment for macroeconomics... and that's exactly why Dan brought David on this week. He shares his expertise in understanding and explaining large-scale economic factors and gives his take on what's next for the markets.
David also covers the debate between a cyclical versus secular bear market, the Federal Reserve's No. 1 fear, and whether he's in the soft-landing camp. As for his take on the future, it's one heavily colored by the Fed's true nature...
The long-term picture... the next calendar year... it doesn't look good. It's an economy that's slowing, and policymakers are responding with the usual lags.
It goes to the nature of what the Federal Reserve is. [...] That adds another layer of complexity to their decision-making. It's not like they're just these technocrats following formulas. They've also got their finger on the political heartbeat of the economy.
Founder, Pine Brook Capital Management
David Cervantes, of New York's Pine Brook Capital Management, has over 25 years of experience in the finance industry. Prior to founding his firm in 2015, David worked with some of Wall Street's best, such as Wells Fargo, JPMorgan Chase, UBS, Bank of America, and Morgan Stanley. You can follow him on Twitter at @pinebrookcap for more of his excellent market insights.
Dan Ferris: Hello, and welcome to the Stansberry Investor Hour. I'm your host, Dan Ferris. I'm also the editor of Extreme Value, published by Stansberry Research.
Corey McLaughlin: And I'm Corey McLaughlin. I'm the editor of the Stansberry Digest. This week, Dan talks with David Cervantes, founder of Pinebrook Capital Management.
Dan Ferris: And for our opening rant this week, I'm going to correct a mistake I made. We're going to talk a little bit about Cathie Wood. We're also going to talk about all the warnings I've been giving people for the past year or two. And we'll finish up with a little tidbit about the situation in the U.K.
Corey McLaughlin: No mailbag this week, but remember, you can e-mail us at [email protected] or call our listener feedback line, 800-381-2357 to tell us what's on your mind.
Dan Ferris: That and more, right now, on the Stansberry Investor Hour. OK, Corey, so you have to indulge me here. I need to fix a mistake. It was in a recent Stansberry Digest, and I misinterpreted the prospectus of the new ARK Venture Fund from the people at ARK Invest run by the famous Cathie Wood. And I said that you couldn't get all your money out.
Most ARK Invest Funds are just ETFs, right? So this ARK Venture thing is a totally different animal. It's called an interval fund, and you can only get your money out once a quarter. I misread the prospectus and thought that there was an individual limit, that you could only get 5% of your money out each quarter, but it's 5% of the total, and as long as everyone in the fund doesn't want to head for the exits you can get 100% probably most times.
So, you know, mea culpa. Made a mistake. You can probably get 100% of your money as long as everyone isn't headed for the exit, so I got that wrong. But I have to tell you, the more I thought about this the more I thought, "OK, well I got it wrong technically," but I promise you, Corey, man, the venture-capital and private-equity worlds, they mark their assets to whatever they can get away with, right?
They're not marked to the public market prices. And I think what's going to happen, OK, is that Cathie Wood's going to pull in all this money, and you can get into this ARK Venture Fund with as little as $500, OK? So everybody can get into this thing. And I think what's going to happen is that because you can sort of, what they call, "delay and pray" when writing down the assets. She'll get people into this thing, delay and pray with the asset write-downs, keep them in as long as possible, and collect... how much a year?
Four percent. She estimates the funds and expenses at 4.22% annually, and the management fee alone is like 2.75%. I'm like, "Whoa, you're going to take $500 and charge me 4% a year?" I mean, people with $500, they shouldn't be charged 4% a year. It's just ridiculous. So I think she's luring in a lot of unsuspecting, naïve people with small amounts of money, and she's going to put them into like the illiquid version of all the stuff in the ARK Innovation ETF that's down 76% or whatever it is this week.
So yeah, I did make a mistake – like I said, mea culpa, you know? I welcome all mistakes as opportunities to show you that I'm not hiding mistakes, right? They're great opportunities. But man, I just think people are going to get bludgeoned when they finally start writing this stuff down. That's it.
Corey McLaughlin: Yeah. First off, good job mea-culpa-ing. I've done the same thing myself once in a while. [Laughs] But this reminds me of – it's not the exact same mechanism, but about a month or two ago weren't you talking about, what was it, AMC Entertainment doing something similar, kind of luring in these small investors?
Dan Ferris: Yeah. I mean, there is like the luring aspect of it because of all those APES, they call themselves, don't know what they're doing. But the mechanism is different. I'll tell you what it is like, though. It is just like, to me, Lehman Brothers early 2008. They had what they call level one, level two, level three assets. Level one is marked to public market prices, public stocks, public bonds, whatever.
You can't fake that one. Everybody sees that one. So you better mark it to where the market is, right? But level two, level three, I looked in early 2008, I was like, "Hmm, everything else is getting bludgeoned." Level one is marked down and levels two and three are like flat or up. What are the odds of that?
And the exact same thing has happened recently. Blackstone reported their results – you know, private equity – and they reported their private credit, last quarter, was up 9%. Worst bond market in the history of everything. Worst credit market in the history of everything, but these guys made 9%.
I mean, come on. [Laughs] You know, Treasurys are down 33%. No, private credit up 9%. Yeah. Sure. Delay and pray, huh?
Corey McLaughlin: Yeah, no. It's definitely concerning... the ARK. I mean, I keep going back to that Digest that you wrote in February of '21, which was, I believe, the day before, the day after the ETFs topped, pointing out the T-shirts, sweatshirts, baby onesies ARK was selling at the time.
Dan Ferris: Yes!
Corey McLaughlin: It's like these are so blatantly obvious signs of the top in retrospect, but you were writing it at the time, so this is obviously a little bit different when you're talking about investment mechanisms, you know, luring people's money in that way. But it's the same thing as selling merchandise, really. I mean, it's all signs of the same concerns.
Dan Ferris: And the guy who wrote in and pointed out the mistake, he said I was doing the world a disservice. He was really slightly snide about it. He said I was smearing the whole asset class of interval funds and not at all. I just think in this case it's inappropriate. It's also inappropriate to – well, I won't go off on this. Let's just say it's inappropriate to lure people into an illiquid thing and charge them 4% a year.
You don't charge people with only $500 – 4% a year. It's just not done. So there's that, but then there's the fact that it's the illiquid version of the thing they've already gotten killed in. It's like, wow. It's like a crowded theater that's already on fire and people are still coming in the door. [Laughs] Anyway, yeah.
Corey McLaughlin: On the other end of it, your 4% comments have just reminded me you can probably get 4% interest on a two-year Treasury today.
Dan Ferris: That's exactly right.
Corey McLaughlin: More than that. So maybe you could balance it out that way.
Dan Ferris: You know, it's funny because ARK lists the estimated fees expenses at 4.22%, and I just checked quotes – I mean, the 10-year and 30-year are flat, they're a basis point apart or something at this point. So on either one of those you can get almost exactly your ARK fees and expenses back. So yeah, maybe that's the trade.
Corey McLaughlin: Yeah, there's the trade.
Dan Ferris: You put $500 in – yeah, that's right. [Laughs] But that's the thing too, like when I was a kid I had a savings account that I had $5 in, not $500, and I'm pretty sure I was making like 5% or something. When people give you $500, you pay them 4%. You don't charge them 4%, you know?
But hey, they're adults, right? They're making their own decisions. Whatever. Got that off my chest, anyway.
Corey McLaughlin: Well good, yeah. And you've been – I mean, you've obviously been warning people about these sorts of anecdotes and instances, and you did that in a big way this week. I know I was watching myself, and I think even if people don't necessarily agree with what you think could happen, I think the warnings itself is useful to hear in general, to just basically see what's out there. Like, wake up, people. I think you said, "Wake the hell up" –
Dan Ferris: I did.
Corey McLaughlin: – in your presentation on Wednesday, and I agree. In general, we have to see what's going on out there and research these things for yourself. I don't know. I really think your message was a welcome one. I think it should be to a lot of people.
Dan Ferris: OK. So right, even if you don't think, as I said, you know, that we've got 70%-plus more downside, you know, if history is any guide, and high likelihood of a decade or multidecade sideways market coming our way, disagree with that all you want to, but we know the history and we reported a lot of good facts in that presentation. I did, I should say. I was the only one there.
Myself and my cohost, Amy. You know, I agree with you, man. Disagree all you want, but hear me out because I believe it is very obvious that this was the mega-bubble of all mega-bubbles, and if you agree with that, you tell me how we get out of this one better than we got out of any of the others, all of which ended the same way – huge drawdown, decade-plus sideways market after. I don't know.
Corey McLaughlin: Yeah. And one of the things I forgot about that you pointed out was, you know, at the late stages of a Melt Up is when a lot of the big gains are made, the biggest gains you can make are made. And I didn't realize the last third of a bear market or a Melt Down is when a lot of the biggest losses can happen. And we've been talking about this the last couple of weeks, like have we reached that capitulation moment yet in this bubble popping?
Dan Ferris: Right.
Corey McLaughlin: You know, it doesn't seem like we have yet, and we're already down 20%. So if we haven't seen that yet and we're down 20%, then what happens next? These are just things you have to think about I think, just like at the beginning of the year when we were warning about 60/40 portfolio is going to be in trouble because of the inflation situation, and stocks, how expensive they were, and nobody was really – I didn't see many people talking about that, and it's happened.
It's the worst performance like ever for that portfolio. So I don't know. My point is anyone who hasn't seen Dan's presentation should check it out and just – you know, the more information – even if you disagree with it, I think the more information you have in this environment and independent information the better.
Dan Ferris: Yeah. I would say independent, different sources, and varied perspectives, right? Prepare yourself for a wide range of outcomes, and by definition, the outcome I'm talking about is pretty extreme. So if you can fill in with other outcomes in between that one and the very best one that's a wide range of outcomes, and then you can make your own decision. It seems like every day there's a new insight that makes me just more concerned.
I've been noticing, thanks to Michael Gayed, former podcast guest, and a couple other folks on Twitter, it seems to me over the past, I don't know, maybe since August or July or so, it seems like the bond market is kind of calling B.S. on the stock market, because the TLT, like the long-term Treasury Bond ETF, it keeps underperforming the S&P 500. And these are Treasury Bonds. These are supposed to be the safest thing in the world, and it's debt.
Like equity is the bottom piece of the capital stack in the world, right? That's the risky piece. And it's outperforming the worst performance ever in the safe piece above it. [Laughs]
Corey McLaughlin: Right. Yeah, no –
Dan Ferris: That feels weird.
Corey McLaughlin: Yeah, no. That's something. I think you're spot on with the bond market. I think the bond market hasn't been buying what the stock market has been selling when throwing those rallies in the summer when you had that kind of big bear market rally, which is more obvious to people in hindsight. But at the time, the bond market wasn't behaving any differently than it has all year, and it still isn't even this last week or so.
You know, rates are going relatively through the roof compared to where they've been in the last 15 years. People are excited over 4% interest again, or if they've ever known it – you know, a lot of people have never known an error like that, which tells you a lot about the market we're in and a lot of people are not prepared for what could happen and have never been in a bubble like this before or anything like that. You know, I'm thinking of like younger traders and the Robinhood users of the world and that group.
You wonder how much of these rallies within the downtrend are because of that kind of behavior and just inexperience generally. Nobody's fault. You're not prepared for it.
Dan Ferris: Right. Folks under 40, professionals, Wall Street professionals who have never seen this. Absolutely. And who maybe have never seen a real crisis in their careers as investors, even if they lived through one as a child or something, but never been alive during bad inflation. That's the one.
They have no reference point whatsoever. It's a bad time to be young, to be a young investor, or maybe a good one because then you'll have the rest of your life to recover. I don't know. [Laughs] Take it either way.
Corey McLaughlin: Yeah, yeah. If you have the really long term, you're good, yeah.
Dan Ferris: That's right. You will be a long-term investor whether you like it or not, right?
Corey McLaughlin: Yeah. You'll either be very short term or if you stick with it, yeah, you're right. It could be a good thing for the youngest.
Dan Ferris: Yeah. So speaking of safe debt instruments that kind of blew up a little bit recently, let's turn to the U.K. now because that was a really, really – it's been an interesting – well it was an interesting 44 days for Liz Truss, the prime minister who recently resigned, who I think is technically still in office, but she'll be out as soon as they pick a new one. There was a little timeline in the Wall Street Journal, and I was like, "Wow, that really sort of went bad in a hurry."
Corey McLaughlin: That escalated quickly.
Dan Ferris: As soon as – yeah, that escalated quickly. The Bank of England raised interest rates, raised what they call their bank rate by half a percentage point to like 2.25%. OK, fine, everybody's doing that. The 23rd, the chancellor, Kwasi Kwarteng comes out and announces a plan that they were – Liz Truss was elected to do this, and the main features of what he announced were tax cuts and energy subsidies, which everybody should've known was going to happen.
But the bond market hated it, the British pound hated it and sold off, and then because it sold off, the pension funds hedges got creamed so they had to sell British bonds. So that made the bond route even worse, and I just don't get it because she was elected to do this stuff and she did what she was elected to do. It should've been in the market, everyone should've known. It makes me wonder, like, there must be something worse underneath that really caused this. But I was shocked that the market was so shocked, put it that way.
Corey McLaughlin: I think you're probably right, that there's something more to it underneath based on the couple of stories I was reading about just what's gone on in the Parliament there in the last couple days. Obviously for a prime minister to lose support of her own party in 45 days is actually unprecedented. It's never happened before. She's going to be the shortest-serving U.K. prime minister ever. That said, there are a few interesting things about this.
One, of course, this whole thing revealed the leverage of these pension funds to begin with, which we talked about a couple weeks ago. And ironically, trusts – I wrote this yesterday or this week in the Digest – is she is eligible for about $130,000 equivalent essentially pension fund for being a former prime minister in the U.K., which is insane. These things that happen –
Dan Ferris: Awkward. [Laughs]
Corey McLaughlin: Yeah. You know, and it's supposed to be – obviously, it was put in place – this funding, post-term – so you can carry out public duties as like a former prime minister, but obviously that was not – I don't think anybody wants her carrying out duties as a former prime minister. This is the stuff that just happens in these situations. You see just how absurd things turn out.
Maybe in a different economic environment, where inflation wasn't such of a big issue, she'd still be the prime minister. You could cut taxes easier and nobody's going to be – and of course the war is going on. In a different situation, she could do these things, but it shows you just how the economy, the global economy, can affect politics directly.
Dan Ferris: Right. And then, of course, the Bank of England is coming in, intervening, and trying other moves to basically support the currency, support the bond market, and then that has ripples around the world. You can see guys posting charts on Twitter of like the yen was the one I saw earlier. It was like really over a short period of time, just practically looked like a crash basically, and the question was, hm, is this the Bank of England screwing up my yen trade here?
So the ripples, right? The ripples around the world, when you start messing with sovereign bond markets and currency markets, that's maybe like the next thing that I'm just going to go on ranting and raving about for the next several months as I have been about stocks and bonds, especially stocks, for almost two years now because I don't think folks understand – like we had Brent Johnson on and he's got his theory and it really holds water. Yields are spiking all around the world because countries, they have to service dollar debts and they have to sell their own currency to get dollars to service the debts.
Eventually, I think the dollar just goes to the moon and then our government has to intervene and weaken it on purpose, and that's when you better be hanging on to some gold, I think.
Corey McLaughlin: I agree with you there totally. Yeah, what's going on with currencies today, a lot of people frankly just don't even pay attention to them. You think more of casual investors don't really see the influence of it. But if you look at the trends this year, the obvious trends are stocks down, bonds down, dollar up. That's pretty much what's been going on.
And you see how this is affecting the rest of the world... we talked about the UN warning, which we weren't fans of, but what they're saying is true as far as what a stronger dollar is doing just to the global economy. You're not making any friends either around the world with the dollar leading the way. But, you know, I've said this before, it's our fiat-manipulated currency, you know? So the U.S. is in a good position overall from that perspective. But you're right, when things turn around, you're going to want to be prepared, and gold obviously should benefit from that.
Dan Ferris: Yeah, it's funny, you started off by saying people don't even think about this – $7 trillion a day in currency trading. It dwarfs everything. We had George Gilder on the program. He called it the hypertrophy of finance, and I couldn't agree more. Finance has like taken over everything. Everything has been financialized to death, and yet nobody thinks about it, nobody knows about it.
You hardly ever see like the Wall Street Journal and Financial Times and all that – stocks and bonds, stocks and bonds, stocks and bonds. That's it. That's all you see.
Corey McLaughlin: Right. Over the last couple of years I've started to think about how you should really pay attention or try to pay attention more to the closer you get to the central banks and the people who are creating the money or pulling the levers on that, make sure you know what's going on there first before you get into tiny stock picking because you could have the greatest stock in the world, or company in the world, but if it's in a bad environment that doesn't help it at all it's going to be hard.
Dan Ferris: Right. And for a long time, this was a concern about emerging markets only. You never worried about the U.S. or developed economics like this, right? You worried about emerging markets. You're like, "Is the government going to change? Is the currency going to tank? Are they going to initiate whatever, currency controls, are they going to kill the prime minister?"
What's going on in this little country? Can I put money there? Because the stock market's so cheap or something, whatever your thesis, and you've got to ask those questions about those markets, but people really – this is another thing that nobody in our lifetime really gets about the United States. Asking questions about currency and bonds, the U.S. Treasury market? Well, it's down 30% so worst performance since the 1780s, so I'm just saying maybe yes this time.
Corey McLaughlin: I wonder how many people we've already turned off with this conversation about bonds and currencies.
Dan Ferris: You know, the turning off is a good thing I guess to a degree, but hopefully we turn them on to find out more, right?
Corey McLaughlin: Right.
Dan Ferris: That is the business we are in, turning you on to find out more. Maybe that'll be our new tagline.
Corey McLaughlin: Yeah. Save that one somewhere.
Dan Ferris: Yeah. All right. Well, I think that we've done it again, Corey, we've started out sounding like two guys who just want to talk about stuff and ended up talking about the end of the world, practically. [Laughs] We just keep coming back here, and we keep agreeing too much. We've got to find something we disagree on.
Corey McLaughlin: Yeah.
Dan Ferris: One of us needs to be an optimist about something.
Corey McLaughlin: All right. I'll do my best moving ahead.
Dan Ferris: Yeah, it's got to be you.
All right. I can't wait for you guys to hear our conversation with David Cervantes. He's a really smart guy. He's never done a podcast before, so I feel really lucky that we're the first one to get him. Get a pencil, get a pad, get a piece of paper. Take notes. He's going to throw a lot of data at you, but I want you to listen to the way this person's mind works.
It's awesome. That's why we wanted to have him on the show. So without further ado, let's talk to David Cervantes. Let's do it right now.
Wake up, Stansberry Investor Hour listeners because a major market event is right around the corner, which will take most Americans by surprise and likely ruin millions of retirements. I'm stepping forward to expose exactly what's about to happen and how it could change everything you know about investing. You might not know this, but I'm the longest-tenured analyst at Stansberry Research, and over my 20-plus years at the firm, I called the Lehman Brothers collapse five months in advance, the bitcoin crash, even the top of the Nasdaq last November to the day. But what I'll be sharing with you is by far my biggest and scariest prediction ever.
In short, what I think is about to happen has the potential to destroy everything you spent your life working for and will require a totally different investing approach going forward. To find out more, go to www.DanMarketPrediction.com. Again, that's www.DanMarketPrediction.com. Oh, and just for tuning in, I'll give you the names of two well-known stocks you've definitely heard of and might even be holding, which I think you need to sell immediately. These are two of the most popular widely held stocks in America right now, so there's a really good chance you really do own at least one of them.
And if you do, I think you need to get out immediately. To get the names of those companies, again, sign up for my free event by going to www.DanMarketPrediction.com.
David, welcome to the show.
David Cervantes: Thank you. Glad to be here. Thanks for having me.
Dan Ferris: Yeah. I'm glad that we got you on. It's funny, David, we were interviewing another guest and he apologized at the end for only talking about trading and for not talking about the Fed and inflation and interest rates and all kinds of things. And I didn't say this to him, but I wanted to say no worries, I have a guy for all that.
And I was thinking of you. So, you know, maybe the first question I should really ask just to give our listeners a sense of who you are and what you're about, I normally start out with asset managers and I say, "Hey, if we were in a bar and we just met and the conversation turned to finance, and you said, 'Hey, I'm in finance,' and I said, 'What kind of an investor are you?'" What would you reply?
David Cervantes: Yeah. So I would say I'm a private investor. I don't run outside money. I don't have a committee of people I'm reporting to or anything like that because I'm a private investor. My background is – I started in the business on the emerging market, fixed income side back in the mid-'90s. Actually, I came right during the vortex of the Russian ruble crisis in 1998, and it was trial by fire. At that time, dot-com was just getting really on fire.
I was a young kid, recently out of college. I didn't know a lick about bonds, but I spoke Spanish, and they said, you know, can you pick up a phone and speak? I said sure. And I had a job.
Dan Ferris: [Laughs] Nice. That's great.
David Cervantes: So yeah. I was – they call it now a flow trader, but I was a sales trader for the JPMorgan private bank. Then I went to UBS and joined a team there. It was called a middle market institutional sales role, so we were covering on the offshore side small, mid-sized banks, insurance companies, hedge funds, a couple of ultra-high net worth individuals, but the role was institutional in nature. Then I went back to grad school and got an MBA at the University of Wisconsin-Madison with a stopover in Singapore at NUS, National University of Singapore, for some graduate work there.
Then I went back to the same team. Ultimately we moved to Morgan Stanley and I started focusing on Latin America. So as a salesperson, I spent a lot of time, about a quarter of my time, in South America, pretty much the whole continent, which was fine when you're a younger person with no family, but right around then I got married and started having kids and the job just became incompatible – I'm sorry, the family situation became incompatible with the job lifestyle.
Dan Ferris: I see. Just for our listeners' sake, I know David as one of those smart macro guys on Twitter, and that's why I invited him on the show because this is how – I don't know how else to put it. It's simple-minded sounding, but it's a big macro moment I feel like. And actually, macro, in lots of sort of active strategies and things, really got ignored. I'm a value investor myself, or have been, and we were all getting ignored for a long time, and these are like the topics that don't matter until they're all that matters, and I feel like macro is one of those topics.
So the real reason that I got you on here today is just maybe to let us know what your outlook is, let us know what you focus on as an investor, and where you think all this is going. Markets have been bludgeoned, the bond market's been bludgeoned, inflation has ticked up. If the CPI numbers mean anything to you, mortgage rates are suddenly 7%. I mean, this to me is like – I feel like all of a sudden we are on another planet versus a year ago. But I really want to talk to you and see what you think.
David Cervantes: Well again, thanks for having me. Yeah, as you said, it's a big macro moment, and I think the big question is, is this bear market secular or cyclical? As you know, in a cyclical bear market, stocks, will recover their losses in a year or two and continue on a growth trajectory that generates real positive inflation-adjusted returns over time. They might be painful, but that's part of the growth process.
Versus a secular bear market, stocks and other financial assets generate negative real returns over time, and a secular bear market tends to be associated with an economic environment characterized by secular stagnation or stagflation, which real economic growth is low or even negative for long stretches of time. So think of the Japan syndrome, lost decades of economic growth and output, living standards stagnating or even declining. It sounds kind of abstract, but these are real consequences, real issues. There's a whole spectrum of life choices that revolve around this, everything from household formation, birth rates, homeownership, educational funding, retirement.
These all suddenly become front and center as we try and determine where this is going because it really does have an impact on not just your investment but on your life choices. And lost decades can also impact, on a broader level, social stability, it could lead to political upheaval. Politicians will use policy leverage to deal with a shrinking economic pie, and that's just always a painful adjustment. And then finally for the U.S. in particular, as a secular stagnation of lost decades really puts things like the dollar as reserve currency of the world, puts that at risk. And along with the rules-based order that the dollar underwrites and enforces with military muscle, you know, that's just kind of thinking broadly about macro and what this question of a cyclical bear market means.
So that's kind of – you're absolutely right. It's a big question and this is where we are. Unlike other – well, I shouldn't say that. I was going to say unlike other bear markets, but every bear market is really something that the Fed does and takes out, shoots the economy in the head by lifting rates. In that regard, this is no different, the Fed lifting its policy rate to levels we haven't seen since 2005, so that's 17 years ago, which is a long time. A lot of investors, a lot of careers haven't seen this kind of rising rate environment.
And just to some listeners, just to put some context in this – I'm very big on context. I think without context it's hard to have a real meaningful understanding. So during the pandemic, GDP collapsed by an annualized rate of over 30%. It's crazy... 22 million jobs were lost in the first two months of the crisis. Unemployment went from a 50-year low at 3.5% in February 2020 to post-war peak of almost 15% by April 2020.
I mean, we're talking Depression-era levels of change compressed in two months. The Fed and also the fiscal policy as well, they got a whiff of this during the Global Financial Crisis, but that was really kind of a banking crisis, and Ben Bernanke put on his Depression hat and threw the kitchen sink at the problem. I think this really was different in the scale of unemployment and collapse in GDP. I think both sides of the policy spectrum, fiscal and monetary, came in and just went nuclear here and they threw the kitchen sink at the problem.
Over the course of 2020, 2021, Congress passed three separate fiscal packages totaling $5.8 trillion. That's about 20% of U.S. GDP.
Dan Ferris: Wow.
David Cervantes: And the Federal Reserve was equally aggressive, deploying its conventional arsenal of tools such as cutting the policy rate, QE, using its statutory authority to calibrate regulatory and supervisory practices to support the flow of credit to households and businesses. So who am I to judge was this right or wrong? I don't know. But I think they saw a problem and they did the best they could and attacked it.
Now what we're looking at here with the inflation is the collateral consequence of that, and it's front and center with inflation. CPI and core, we haven't seen these kinds of numbers in, in 40 years. Core is at around, gosh, about 6% – I can't remember offhand – it's about 6.75% roughly. Headlines have touched 9%. It's come down a little bit.
But these are inflation numbers we haven't seen since the early '80s, and this is why it's a big deal. So I think a lot of investors, even if they didn't experience this kind of inflation due to just their age, it's a narrative that we grew up with. It's a story we grew up with that inflation caused a lost decade in the United States, the '70s. We had stagflation, gas shortages, we had mortgage rates in the high teens, and I think there's a real and legitimate fear of that repeating again.
So that's where we are, I think. We're wondering, OK, great, where do we go with this? That's kind of the background for that.
Dan Ferris: Right. That fear of repeating, I feel very strongly that that is one of the primary motivations behind the pretty aggressive stance that Jerome Powell has taken. I remember there was this one moment at I think it was the last press conference, and the first question was something like "how do you see the end of this?" You know, when do we stop hiking rates and all of that? His answer, to me, amounted to get that out of your head. We're not anywhere near there. I heard that fear of repeating the '70s.
David Cervantes: I mean, that's a real fear for the reasons I mentioned. It affects people, it affects the economy at large, and it affects us globally, and by extension, the world, since we are on a U.S. dollar standard. But moving on, I want to go back to the historical inflation. We've had high inflation before, but I think what really is different this time is the volatility of inflation, the second-order effects of inflation. In the '70s, this thing played out for over a decade, and we're seeing this play out. Similar to how the crisis compressed Depression-era levels of panic into two months, we're seeing inflationary pressures compress in a short time frame.
The way I get a feel for the volatility of inflation is just that it's simple. Look at the standard deviation of inflation. Back in the '90s, the standard deviation of inflation was annualized 0.99% a year, and through 2009, that became 0.37%. Then the decade after the financial crisis, 2010 through 2019, that became 0.35%. So we had three decades of not just disinflationary pressures but three decades of lower volatility within inflation and inflation expectations. In 2020, that number jumped up to 1.23% on a standard deviation.
Dan Ferris: Wow.
David Cervantes: In '21, that just went parabolic to 4.71%.
Dan Ferris: Whoa.
David Cervantes: We didn't even see that in the '70s. In the '70s, '70 through '79, the standard deviation of inflation was 2.15%. So we're looking at, you know, double the volatility in the inflation in the '70s in a span of one year.
Dan Ferris: Wow.
David Cervantes: And that's, I think, what terrifies people. Don Rumsfeld, you know, his little quip, "There are known knowns, there are known unknowns, and there are unknown unknowns," and I think that kind of volatility puts people on alert for the unknown unknowns and the second order effects and third order effects of inflation. Markets can price inflation. Market changes and prices. That's fine.
They'll deal with it, they'll discount it. What they have trouble with is uncertainty, and that second order effect of inflation volatility is what has markets really off kilter right now. Just to mention, that number has come down. We're at so far year-to-date around 0.86% standard deviation. So it's come down quite a bit. I can say '21 was a very spiky outlier, but that's where we are.
Dan Ferris: It's not a fun place.
David Cervantes: It's not. And again, going back to the ramifications of this, financial assets don't do well with uncertainty. They don't do well with an uncertain inflationary path. We saw P/E multiples back in the '70s just get annihilated to the single digits, and then once this inflation kicked in, once the volatility of inflation kicked in, P/E multiples expanded. I mean, they got a little crazy during the dot-com in the mid-'40s, and they obviously have since come down, but that just gives you an idea of the impact of the volatility of inflation on asset prices. It's a very direct impact.
Dan Ferris: So David, I have to ask. It seems like a lot of people want to say inflation is peaking. They want to keep saying it and keep saying it, and it keeps not quite being true. You don't sound like you're in that camp, but you can speak for yourself.
David Cervantes: You know, let's take a step back and disaggregate the big moves in the 10-year, right? We've seen yields go up. And I like to use a model that the New York Fed uses. It's called the ACM term structure model, and that helps break things out between not just real rates but also Treasury risk premiums, and then from there we can calculate a real risk-free neutral rate, which is kind of a pure rate that takes out risk premiums, and that gives a better profile of what's happening.
What's interesting is this move in nominals is hands down being driven by the move in the real rate. The Fed does not control real rates. They control nominal rates. They control the policy rate. The market sets long rates. The Fed controls the short overnight rate, the policy rate. But reals have been on a tear.
Reals have been – pre-COVID, they spent a lot of the post-financial-crisis time period in negative territory, and now they have moved, I'm looking at my graph here, easily 200 basis points from the bottom of the COVID crisis to now. That's a big move. That's a very, very big move.
Dan Ferris: In a short time.
David Cervantes: In a short time. But getting back to the inflation question, so there's a few different ways to look at it. You know, Michigan Inflation Survey Expectations, they actually peaked right around April. They've come down. I think they peaked around 5.4%-ish.
They are now at roughly a mid-four handle, so they've come down. And then if we look at break-evens – let me get my other spreadsheet open. One second. So break-evens peaked right around April 28 at three handle. They are now at 2.4%, 2.5%.
Dan Ferris: So maybe tell our listeners what break-evens are. They might not know that term.
David Cervantes: Yeah. So the break-even is basically – I mean, there's a few ways to define it, but the simple rule of thumb is the nominal yield at which you would have to be paid to adjust for inflation and break even. I mean, I can get into more mathematical definitions of that, but that's effectively what it is. And then you also have five-year forward inflation expectations, which is what do investors expect inflation to be in 10 years, five years from now?
In other words, fast forward to five years, what do investors five years from today will think inflation will be five years after that. And that's actually a common metric the Fed follows. Five-year forward inflation expectations have also come down. Those peaked also around mid-April, 2.67% roughly, now roughly 2.3%. So market base indicators are suggesting we've hit peak inflation, it's priced in, along with consumer-based survey measures as well.
I posted a few items on Twitter. It looks like I think what's driving inflation or our view of inflation is what's called owners' equivalent rent. So basically, you know, the Fed has this – or I'm sorry, I believe it's the BLS – but they have a wonky definition of shelter cost, and it's rent for renters, housing shelter for owners, and some combination of everything else. It's called owners' equivalent rent. Owners' equivalent rent typically lags house sale prices by about 12 to 18 months.
House sales prices peaked back in July of 2021. They've since obviously come down with the increase in mortgage rates. Owners' equivalent rent will lag that, and the reason is rental contracts and shelter contracts are fixed in nature. So you lock in a rate to pay rent or shelter. If you're a renter it's typically a year or two at a time... if you're a homeowner obviously it's different.
But that measure is still climbing, kind of an echo lag of the runup in home prices after the COVID pandemic. That OER, owners' equivalent rent, is about 40% of core inflation. So that is really what's driving core inflation, which by intention drives headline inflation. But I expect that number to start flattening out in about three to four months. In about three or four months, owners' equivalent rent will start taking into account the decrease in home prices that had started in July of 2021.
Dan Ferris: Oh, wow. OK.
David Cervantes: Now – go ahead?
Dan Ferris: No, no, no, I was just saying that – just an oh, wow. That's all.
David Cervantes: I mean, it's a lot. It's a lot. And if we were at a bar hanging out, your head would be spinning and you'd say, "My god, it's just too much."
Dan Ferris: Yeah.
David Cervantes: But let's not get so granular. Let's zoom out a little bit. Where are we now? So I track a series of real economic cycle indicators, the long-leading indicators, the short indicators, and the coincident. So 14 long-leading indicators I track, 10 are negative, three are positive, one is neutral. Of 14 short-leading indicators, six are negative, five are neutral, three are positive.
And on the coincidence side, meaning what's happening today, it's kind of a mixed bag. Six are neutral, five are negative. So my view on today is I don't think we're in a recession. Expected inflation appears to have peaked. The economy is clearly slowing. Of the four metrics that the NBER, National Bureau of Economic Research, they are the official business-cycle daters, they look at income, production, consumption, and employment. Employment is doing OK.
It's slowing down. But as we see every month, employment is still strong, so we can't have a recession with that kind of employment. Production, yesterday, we got industrial production, which I call the "Mack daddy" of coincident indicators, and that hit an all-time high. So the production and employment side of the economy are still pretty strong. The income side and the consumption side are lagging and real aggregate earnings are declining.
When I say "real," I mean "inflation adjusted." And on the consumption side, real retail sales are also declining. They've been declining since around April of this year. So I don't think we're in a recession right now, but at the pace that the Fed is tightening, and what's happening in the housing market, I think it's pretty much a near certainty we will be in a recession likely in the first half of next year.
Dan Ferris: OK. So it sounds to me – you know, I heard when you were going through your indicators, and then what you just told me about a recession, I heard a lot of negatives in this indicator.
I heard you say negative a lot more than you said positive or neutral.
David Cervantes: I mean, the long-term picture – and long-term I mean, you know, next calendar year, it doesn't look good. It's an economy that's slowing, and policymakers are responding with the usual lags. I think this goes to – you know, a little off topic here, but it goes to the nature of what the Federal Reserve is. We all know they set the policy rate, but more fundamentally what they are is they're an agency of the government, right? So they are a part of the government apparatus.
And like any government agency, they have political imperatives. They have obviously their statutory objectives – full employment and price stability – but they need to manage things, right? They need to manage optics, they need buy-in from – first of all, from financial markets, but also from the population at large, and that adds another layer of complexity to their decision-making. It's not like these technocrats are following formulas. They've also got their finger on the political heartbeat of the economy.
Dan Ferris: Yeah. Right. So to me, that's a really complex set of inputs, and it makes their actions really kind of unpredictable.
David Cervantes: It does, you know? After the stimulus that we discussed earlier was put in and we started seeing inflationary pressures start bubbling up, you know, the Fed says, "Oh, no, no, we're fine. We're going to use average inflation targeting. We're going to let it run hot just so we can recover the jobs, and then once we do that then we'll cool things down."
Obviously, that didn't work out as expected, but I think that sheds light on this notion of that they're just technocrats. They're not. They're reading the tea leaves. They're looking at their statutory mandate, they're looking at what's happening, and they're kind of spit-balling in the dark to a degree trying to manage these different complexities.
Dan Ferris: So you don't sound like an ardent Fed critic. You sound very understanding of the position they're in and the difficulty of the task that faces them.
David Cervantes: I wouldn't want the job, that's for sure.
Dan Ferris: No. No, we wouldn't want the job, but some folks think the job shouldn't exist, right?
David Cervantes: Well, you know, reasonable people can disagree, but they are here and neither I nor you are getting them out. So it's not so much that I'm sympathetic or not. It's more of just a part of reality that – you know, it's kind of like shouting at the moon. It's not going to make the moon go away.
Dan Ferris: Exactly. Yeah
David Cervantes: I'm better off understanding the lunar cycle and what goes with it. Similarly with the Fed, I'm better off trying to understand what they're doing and how I can make money off them.
Dan Ferris: It reminds me of that book, David, that was called Men Are From Mars, Women Are from Venus. The Fed is from the moon and the rest of us are on earth.
David Cervantes: There you go, there you go. So, you know, there are political institutions. No one's going to come out and say it, but they know the election – they're in tune with the election cycle. I'm not necessarily saying that they are partisan and biased – maybe they are, maybe they're not – they're human. They're an institute run by people. But they're certainly aware of the political cycle and the changes in fiscal policy that might bring and what their reaction function is going to be toward that.
So anyway, getting back to the Fed being a political institution, they are held to somewhat of a political standard, right? They don't want to upset the public, and they also don't want to upset their oversight committees, and I think generally they mean well so I'm going to give them the benefit of the doubt that they're doing the best they can. But they're doing the best they can with limited information. They don't have a crystal ball.
They have a reaction function. They react to things. They can forecast all they want till they're blue in the face, but we all know those forecasts don't really mean a whole lot, and that's why they focus on the reaction function. They need to react to the data and not be – it's kind of an institutional drawback.
It's by design. They're kind of handicapped by design. It's a feature, not a bug, so to speak.
Dan Ferris: I see. Yeah. Limited information and under extreme conditions. I mean, it's been decades and decades since some of these conditions were in place, and having limited information is one thing, but having extreme conditions on top of it is just, you know –
David Cervantes: Sure. And after they botched the average inflation targeting, after they botched that, you know, they got some egg on their face, right? Inflation blew up in their face. They said, "No, we've got it under control, it's fine, it's fine, it's transitory and then it's not." Now you've got the inflationary black hole of the '70s looking at you.
Now you've got inflation volatility going parabolic. And I think they are institutionally terrified of having this happen on their watch after they screwed up the first time, and I think that's driving – look, inflation is what it is and they have to attack it, but I think there is an institutional bias toward going a little overboard because they already screwed up once and they just don't want it to happen again on their watch, at least not Jerome Powell, right? He doesn't want to be – go ahead.
Dan Ferris: Yeah. Well, I was just going to say going overboard, that's an interesting idea, isn't it? Because for a long time, it seemed like going overboard meant, you know, allowing – well basically going overboard went in one direction, and now going overboard means fighting inflation at all costs, whereas before, going overboard, well, we're much more worried about stimulating growth and keeping rates low. Now the going overboard, the worry is in the opposite direction. I find that interesting.
David Cervantes: So I don't think a soft landing is in the cards for the economy and the Fed, and the reason is the Fed is hiking pretty aggressively into a horrific housing market. If you think about the term – the housing cycle is the business cycle that was coined by Ed Leamer back at the Jackson Hole Symposium that the Fed organizes in Wyoming. He pointed that out to participants there, that the housing market really drives the economy. The economists are looking at all the wrong indicators.
The business cycle is driven by the housing market. The Fed is currently hiking into a market that has mortgage purchases at a six-year low and refis at a 20-year low.
Dan Ferris: Wow.
David Cervantes: It's just not going to happen. If the Fed wanted a soft landing, they'd have to do a hard pivot now going into November and pivot and say, "Look, we're not doing anything, or we're doing this because it's priced in. We don't want to let you guys down, and we're done and we're going to wait. We're going to see how things pan out. We're going to see how – we're going to watch inflation, we're going to watch owners' equivalent rent and see how that impacts Core, see how that impacts headline, and see what happens with the rest of the business cycle." But they're not going to do that because they already screwed up average inflation targeting. They're held to do this out of institutional inertia.
Dan Ferris: Wow. It's incredible to me the disconnect, like every time Powell talks, he points out the – he said monetary policy, the effects will lag and so forth, and yet at the same time we are utterly committed to 2% CPI. I mean, there's a disconnect there for me.
David Cervantes: Which I don't even think we're going to get because what I think will happen is, the way things are going is if we have a hard landing, it's going to sneak up on them, and the inflationary echo – or I'm sorry, the disinflationary echo will be a lagging indicator. It'll show up later. So they're going to get hit in the head with a hard slowdown and they will have to start cutting rates, and that will be stimulative. And depending on the rate at which they cut, that could provide an inflationary impulse. So I don't think we're headed toward an inflationary supernova.
I do think that we're going to settle higher than we were pre-pandemic and post-global financial crisis, meaning after the financial crisis, the Fed could never hit their inflationary target. They're actually always under it, and they could never hit their target. Go ahead.
Dan Ferris: So, you know, one, two-ish before, what, three, four-ish afterward? That's a 100% or more difference. That sounds pretty big to me, maybe, if those numbers are OK.
David Cervantes: I think the real risk is in – as a macro investor, the real risk always lies in what's priced in the growth and inflationary mix, right? So if growth is priced high and comes in below expectation, then that's a real problem. Ditto with inflation. That kind of leads into my next topic, in having this macro conversation about where are we going? What's priced? Where are we going?
Dan Ferris: David, I'm going to interrupt you real quick. I want the answer to this – I want what you're about to say to be the answer to my final question, which is normally if you could leave our listener with just one thought today, what is it? But if it turns out to be five thoughts, that's cool. But it sounds like you're headed to where have we been going in this conversation and what listeners are interested in, like what's next? So David, what's next? [Laughs]
David Cervantes: Sure. Well, quick context, as I say. So at the end of 2021, the equity risk premium was around 4.25%, all right? The 10-year Treasury was 1.5%. So you had a total equity return of 5.75%, all right? Now Treasurys are at 4% ballpark, the equity risk premium is at around 6%, and expected equity returns are now 10%, which means – you know, it's a fancy way of saying things have gotten cheaper.
In other words, there's more value there. OK? Now the big question is inflation, and as I was saying, this issue with the growth of inflation mix. I'm looking at earnings, what earnings have been expected by the market – by analysts, all right? So expected earnings in 2022, they haven't changed much. They've come down a tiny bit.
And at the beginning of 2022, really at 223 and change for the S&P, now looking 225. So they've actually gone up a tiny little bit. All right? But '22 is a done story. The market is looking at 2023 now, right? Earnings estimates have only come down by 60 basis points.
At the beginning of 2022, 2023 earnings, we're looking at 244, 45 roughly, now they're 243, 46. So the question you've got to ask yourself as an investor is, fine, the Treasury market has done what it's done, inflation could be leveling out, but earnings haven't budged. They haven't budged one bit. I mean, if you want to count 60 basis points a bit. So I guess as an investor you've got to ask yourself, what's going to happen to earnings and what typically happens to earnings?
Personally, you know, this is nonsensical to me. You don't have this kind of slowdown without a corresponding offset in your earnings. So if you were to adjust earnings, mark them down, say, 15%, leave bonds roughly where they are, let inflation come down a little bit, the market is not looking good. It's looking roughly 3,500-ish in a good scenario. And if you want to get aggressive and start cutting rates even more – I'm sorry, not rates, earnings and look at different scenarios between earnings and Treasurys, you know, if you're lucky it could be maybe low 4,200s.
If you're very unlucky, you're looking at 2,400 and change. And what I want to leave you off with, is this whole inflationary vortex that we've experienced, it's filtered through the bond market, it's filtered through credit markets. I don't think it's filtered through the equity markets yet.
Dan Ferris: Boom. Wow. David, thank you so much for being here, man. I hope listeners are as kind of fired up about everything they've just heard as I am. I was on the edge of my seat here listening to you go through everything. I really enjoyed it. I really did.
David Cervantes: Thanks for having me, and I hope it wasn't too much data. What I probably should do is circulate some of this stuff so readers can have a look on Twitter and judge for themselves if this stuff makes sense or not.
Dan Ferris: Hey, that'd be great. Yeah, I'll send them to you. What is your –
David Cervantes: It's @pinebrookcap.
Dan Ferris: There you go.
David Cervantes: @pinebrookcap.
Dan Ferris: All right.
David Cervantes: All right.
Dan Ferris: Thanks again, man.
David Cervantes: Thanks for having me.
Dan Ferris: I really appreciate you coming on.
David Cervantes: Cheers.
Dan Ferris: All right. Bye-bye for now.
David Cervantes: Bye-bye.
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I say wow a lot at the end of the interviews, but wow. I really want you to think about what you just heard. Did you hear just the mountain of data that this guy sifts through his brain? He really wants to get it right, he really wants to be careful, and he's not like me. I sort of let emotions and politics and things filter through my head. But he is so focused on – like you heard the discussion about the Fed.
He's like, "Well, you know, we're not going to get rid of them, they're doing the job that they're doing and I take it as it is." Right? He's really focused on assessing things exactly as they are, and that's hard to do. Did you hear the number of indicators that he was talking about when he said, "You know, 10 are negative, three are neutral," etc., etc.? I mean, there must've been 30 of them. And he's constantly watching those 30 things in addition to everything else that he was talking about.
I thought the discussion about housing was particularly interesting. I've tended to say that housing is like the number one leading indicator, economic indicator, and it sounded like, you know, he was sort of in that camp. He was quoting Ed Leamer, saying that it drives the economy. It's extremely important. It is the cycle.
I really hope that you maybe listen to that again and take notes this time, or maybe we'll – yeah, maybe we'll take some notes and discuss David's points as things play out in the economy. We'll see. But there was a lot in there, and I hope that you can sort of encapsulate it for yourself and make some notes and keep an eye on this stuff. Great stuff, great stuff.
That's another interview, and that's another episode of the Stansberry Investor Hour. I hope you enjoyed it as much as we did. We provide a transcript for every episode. Just go to InvestorHour.com, click on the episode you want, scroll all the way down, click on the word "transcript," and enjoy. If you like this episode and know anybody else who might like it, tell them to check it out on their podcast app or at InvestorHour.com.
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