Austrian Economics and the Financial Markets

0:00Well, Kevin Duffy, it's a pleasure to have you here from Houston, Texas. I'm in Dallas now. You're in Dallas now. What happened? I moved to Dallas about a year ago. Okay. You're happy with the move? Yeah. So far. Okay. We moved the whole firm there. Okay. And your firm analyzes companies and you run a hedge fund? We run a hedge fund from an Austrian perspective, a global macro, long-short hedge fund. Yeah. So you're very much in touch with daily, hourly, minute-by-minute market happenings.

0:47I remember in October 2008, we had this wonderful conversation. You were at the airport talking on your cell phone. Out of breath. Yeah. It was exciting. The Market was starting to assert some discipline on the system. I think you and I were both kind of excited to see that cleansing start to take place. You could see it take place with, especially in the private sector, companies that had had expanded, I mean, retail square footage was growing at 8% to 10% throughout the 2000s, and that stopped, and capital spending got cut, and you could see how companies were just being very conservative, free cash flows going up, and the strong were surviving, the companies like Linens and Things were liquidating, and their competitors like Bed Bath and Beyond were doing well.

1:50So that part of the process worked exceptionally well. Within the banking system, though, they arrested that with the bailouts. I think we probably discussed that as well. We did. And I think we talked at the time. The prevailing attitude was that the world was falling apart and would completely collapse. The entire world financial system would come tumbling down unless the Federal Reserve intervened and the Treasury intervened. And I recall Well, it was your view at the time that this was just lots of hysteria, really. Yeah. And I guess we'll never know because now we know what they've accomplished. I mean, they have intervened in a massive way, not just the bailouts, the expansion of the Fed's balance sheet by $2 trillion, the national debt, essentially not allowing the GSEs to be liquidated.

2:45So those implied liabilities became explicit to the taxpayer. So the Fed's balance sheet increases by $2 trillion. The debt, the total debt, if you include the GSEs that got brought on, about $6 trillion. I mean, we've thrown this wild party, so we just... And what have we accomplished for all this? I mean, we've gotten the biggest rally in the stock market, the biggest two-year rally in something like 64 years. And we've created a lot of the discipline that was being imposed back then has been removed. And now we're bringing back the old bad habits that we had during the bubble, the housing bubble and the credit bubble.

3:32Now near the end of the credit bubble, there weren't too many people warning that it was coming to an end. You were among them, but there weren't that many. Well, I think within the Austrian community, there were a lot that were warning about this. There's no question. I think the GSEs, there was an article written, it was in the free market newsletter, I think back in 2003 by Christopher Mayer about mortgage market socialism. That was a fascinating article, and we still have that on our website, and it really laid out the case for us to short the GSEs. We started our fund in the middle of 2002, and we shorted Fannie Mae and Freddie Mac that entire time.

4:17It took until 2007 before the wheels started to come off, and then, of course, 2008, the shareholders were wiped out. Despite all the QE1, QE2, all the intervention and everything, there's still downward price pressure on real estate markets. Yeah. This is what's so fascinating is that they have thrown the kitchen sink at this. They've bailed out the crony capitalists. They're still around. They have engorged the government. They've engorged the private sector. They've harmed the... The real economy has suffered through all this, but it's been the political economy that's done well. It's also been... You can see it with beef prices versus poultry prices. You know, the average person is suffering. The poultry business is not doing well, but beef is doing well and high-end restaurants are doing extremely well.

5:10But the prices on the real estate with the continued downward pressure, every few days it seems like there's more news that, look, we haven't fell on this one, it seems like a demonstration of the limits of government power. Well, I think it's also, it's exactly, it's limits on the power. They don't have control. And it's this idea that they're in control of things, they're printing all this money, they're creating all this money and they're trying to expand credit, they're not able to Do That. They're not able to just siphon money wherever they want it to. And I think the lesson, that's one of the lessons, and another lesson is that the old balloon, the old bubble, once it bursts, that balloon has a hole in it, and it will not take the new money. So look at, I mean, QE2 is a great example.

5:56Look at what they've accomplished, and I think it's fascinating, you look at the recovery Between the stock market that we had from March of 2009 through April 15th of last year, that was QE1. At the top of that, you had the cover of Newsweek about how the economic recovery is in place. You had Barack Obama on the cover of Businessweek, and he's shooting a free throw, and it's a silver dollar. It was all about Obama-nomics is working, and then it says, and who says so? Wall Street, as if Wall Street were any kind of an expert on this sort of thing. The same people that got it wrong now are saying that this is working.

6:44And so that was right at the top of this rally in the market. And then we get, it all starts to fall apart into the summer of last year. And then QE2 comes along with just, you know, after throwing trillions of dollars at the economy, now it's just a mere $600 billion. And what has happened since then? And it's really fascinating because you see cotton prices are up 150% and you have sugar prices are up 60% and copper is up 23%. And gold is only up 14%, and this is what's kind of interesting, that they've been able to achieve a couple of things, but none of these things were intended.

7:33Right. So they're trying to... They're trying to... What are they trying to do? They're buying the long end of the government bond market. So what happens? Long bond yields go up, and in fact, the worst-performing asset class since August 27th when they announced This is Treasury bonds, down 10%. Everything else is up. Stocks are up over 20% across the board. But then, even within the stock market and within the precious metals market, you're seeing the animal spirits come back. You're seeing they've ignited this inflation. So, for example, in the precious metals market, gold is up 14%, but silver is up 84%. 4% and you're getting the public now is buying coin sales are off the charts.

8:23Right. This treasure can't even keep them in stock. Right. And then even within the gold mining stocks, senior gold stocks are up only 10%. They've actually lagged behind the stock market, whereas junior gold mining stocks are up 30%. And then you have the stock market, which has been completely insane. You now have Jim Cramer, who's on top of the world. So, at the bottom of the market, in March of 2009, he's on the Jon Stewart show. And, you know, of course, this is the Jim Cramer who, in August of 2007, was telling the Fed that they know absolutely nothing and they need to lower rates, which they, of course, did. And it didn't matter. It didn't stop the meltdown from happening.

9:10And this is the same Jim Cramer that said, if you don't buy Lehman, Baer and Goldman here, you're an idiot. This was not at the very top, but close enough to the top. Yeah, close to the end. Yeah. Now, a large part of your job, in addition to analyzing the balance sheets of particular companies and knowing where the best places are to put your money, must involve somehow looking at the present state of things and sorting out what represents real recovery, Which you would expect some of that. Given the depths to which everything sank, you would expect some real economic growth. Separating that from the phony, the artificial, the new bubbles that are being created, how do you do that? Yeah, well, that's what, you know, it's funny. I have a friend who lives in Phoenix, and during the height, I mean, he was at ground zero of the housing bubble. In 2005, he used is to say every day he would just get up and look out the window and wonder what is real.

10:11And that's kind of where we are today, is just try to sort through what is real. So we just stick to very defensive areas, basic necessities, and try to avoid the cyclical companies. But we also do it on a valuation basis because you can see that when you get these bubbles, You get this vacuum effect. So you have this money is pouring into speculative names like the Salesforce.com and Netflix and Lululemon and things like that. Well, at the same time that's happening, there are broad pools of where money is taken out of and this is exactly what happened during the tech bubble. You had during the tech bubble, the six months leading up to the bubble in March of 2000, You had stocks like Procter & Gamble and Abercrombie & Fitch down 40, 50 percent, and it was the old economy value stocks that people were selling so that they could basically buy more lottery tickets.

11:17Yeah. Pets.com and the like. Right. And this is what's happening today. You have the same thing where people are selling Kroger, or they're selling, we mentioned

11:58It's speculative views and it's in lowering interest rates you can see the whole risk profile change and it's amazing when you know you think about the the conversation that we had in October 2008 and people panicking and the risk profile how it how it got brought down and today how it is completely changed as if nothing is nothing has changed whatsoever they've the the discipline that was being imposed is gone and and the speculators are back, it's just like 2007 again. And it's very difficult to assess this going forward. Something like a moral hazard just doesn't lend itself to any kind of serious measurement or evaluation. You just have to kind of watch it play itself out.

12:44Yeah. Well, we can quantify some of these things and we can see, I mean, one of the other things I wanted to add was that in terms of when the Fed lowers rates, there's a saying in in the business, there's more money loss chasing yield than at the point of a gun. People have been crawling out on the risk limb because of lower rates and then they see in the beginning, they're very cautious, but then they see the markets start to move up and we get further and further that all of what happened in 2008 slips into the memory Hall. You've had a huge drop in money market fund balances. Like I said, you can quantify this. You can see that it takes money market fund balances as a percentage of mutual fund plus exchange traded fund assets.

13:36At the top of every bubble, the technology bubble, the credit bubble, in this stimulus bubble, it's about 20%. At the bottom, we had, I think we got up to 35% at the bottom and 38% in 2008, 2009. It puts Austrians in a strange situation. I think we talked about this in 2008. At the time, your worry was not the recession or the de-leveraging. That was not the thing that was causing the worry. You were worried even then about the recovery. Yeah, we were, exactly. We were worried about the, that they would intervene and not allow to allow this process, this healthy cleansing process to take place. As this continues, then people become ever more risk-averse, or I should say they're adopting more and more risky investments, and we've got inflationary pressure now, and really, we seem to be not on the road to renewed prosperity, but just a replay.

14:36Well, and it's not just what's going on in this country, but it's what's going on around the world as well. It's not like we're in isolation. You have these problems. I think China is a great example of what's going on. Do you have the view that we have a bubble in China? Yeah. I think the Austrian insight, I was listening to Joe Salerno the other day, and he talked about when you get this artificial boom, you see it's overconsumption plus malinvestment as a Result of Excessive Credit Expansion. And doesn't that sum up what's going on in China? You've got, in 2009, credit expanded by 100 percent, you've had, and money supply grew by 30 percent, and now it's growing at about 20 percent.

15:27Just huge, talk about the stimulus, a lot of this has been coming from China, and it's It's a little bit frustrating because I know there are people that consider themselves anti-fed, anti-Bernanke, pro-Austrian that I think have been sort of co-opted by this idea that China is a positive influence and that that's going to just take commodity prices up and gold up and all the rest of it. Well, you have wild speculation in China. I remember the Japan bubble in the late 1980s. You had housewives selling mutual funds door-to-door, and you had million-dollar golf club memberships and just insane valuations of property. Well, you've got a similar thing going on in China right now. You've got in Beijing, land prices are up nine times in 10 years. And they've got, it's the same kind of inflation. The In addition to following the markets as closely as you do, you also spend a great deal of time looking at fundamentals that you read in the Austrian books.

16:40That's why you're here at the Scholars Conference, which is wonderful because you're kind of a practitioner of Austrian economics, but you don't neglect the theory. You're thinking about the theory all the time. How does that work in your own mind? Well, I think a couple of things. One, there's so much that applies. But in our business, Nassim Taleb talks about this, the being fooled by randomness. And it's the survival of the, not the survival of the fittest, but the survival of the least fit. And what we've had here is this last 20 years, kind of this artificial period in the markets, and the survivors and those that have been the most successful have been interventionists.

17:28They've been Keynesians in various strains of intervention. And I think this is where we have a big advantage, just viewing the world through this Austrian non-interventionist lens. And so, you know, our competitors right now are basically, what's the justification for being in the stock market? Well, either the intervention is going to work and we'll get a recovery or it won't work and the Fed will just print more money. And that's the extent of the analysis. So I think it gives us a huge advantage. Do you encourage your clients to read in the Austrian tradition? Well, fortunately, we don't have to because a lot of our... What we know from this business is that a friend of mine, Tony Deaton, who's a big Ludwig, supporter of the Institute, has been over a long period of time, he always says that the problem with this business is when you run it like a business.

18:23And I think what he meant is this isn't the kind of business that you can maximize revenues in the short run. You really have to think about the long run and the problem is that the customer really doesn't know what's best for them. And so you need, you can't just have people chasing a track record, chasing short-term performance. We need to have a philosophical fit. Most of our clients are very patient. What gives them that, because we go through ups and downs, is that they tend to be Austrians, they tend to be libertarians. Either they're in that camp or they're close. We're trying to move them in that direction as much as possible.

19:11Yeah. Well, I hope that we can meet back again maybe next year or maybe in, I don't want to wait two and a half years to see how all this is going to play out, but these are very exciting times, very different times than they were in 2008, and it will be interesting to watch, see what happens and hear your views as we go along. So I'd like to thank you for coming today. Thank you for having me. I enjoyed it.