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Chris Martenson: Welcome to this Peak Prosperity podcast, I am your host, Chris Martenson. Well, if you want to know where you are headed, you have to know where you are, which means you have to know where you have been. And to that end, continuing with our annual tradition, we’ve got the best year-end review in the business today, thanks to today’s guest, Dave Collum. For those of you unfamiliar with Dave, he is a professor of chemistry and chemical biology at Cornell University, my alma mater for my MBA. And in addition to his academic interests, David authors an annual macroeconomic assessment titled: "The Year in Review." It is hands down the best synopsis of anything that mattered during the previous twelve months.

His latest "Year in Review" can once again be found in full, in all its glory, at peakprosperity.com. I am excited to have him with us now live in order to expand on his excellent insights. Dave, thanks for coming back and being with us again this year.

Dave Collum: You know, I love coming back. I like these podcasts we do, and just for you and I to chat for an hour is for me a treat. We are somewhat like-minded. A lot of confirmation bias, but once in a while that kind of helps you out, doesn’t it?

Chris Martenson: I love a big heaping of confirmation bias, so let’s get right in there. How can you not have confirmation bias today though, because you’ve got these broken markets, these wild things that all the central banks are trying, and now, if you look carefully, you know what I’m seeing? Dave, I am seeing lots and lots of big banks starting to come out with their own little tentative, "Hey, this might turn out badly," assessments—a little CYA report writing from some of the bigger investment houses. You’ve got the big giants, many of whom you collected quotes from, Paul Singer et al, saying "hey, this whole thing looks a little goofy." If you were going to give this… your "Year in Review" this year, if it had to have a title, what would it be this year, do you think?

Dave Collum: Well, it actually did have to have a title. In the intro, I actually tell a little anecdote where I sent an e-mail off to a friend of mine who your readers would all know quite well. In April, I said that I’m losing track of the theme this year. And he said, "well, this year is still young dude." But there really was a deeper angst in what I was saying, and as the year went on, it didn’t go away. I became sort of less convinced that I understood what was happening. I have never been fully convinced I knew what was going on, but for example, last year I talked about Ukraine and the Saudis and the oil crunch, and stuff like that. I thought I had a pretty good narrative on it. And this year, I have probably twenty-five pages of notes on the middle east, and I’ve pretty much punted the ball because I just couldn’t figure it out. And of course, that’s so central to where we’re heading in terms of global terrorism. So the title as you know was "Scenic Vistas from Mount Stupid." Mount Stupid is a pinnacle on a curve that says willingness to talk versus your knowledge maxes out early.

And I realized I just was losing my cred. I was losing my sense of where we are. So that’s been the theme for me this year, is disorientation.

Chris Martenson: Yeah, I was thinking of that as the subtitle, "Scenic Vistas from Mount Stupid." I don’t know, I would have put something like FUBAR up top, or I don’t know what. This has been the craziest year ever, but I said that last year. So I’ve been saying this, Dave, increasingly for six years now, because the distortions, the deformations, the dislocations, the three big Ds, that the Fed has basically… the small politburo of appointed individuals has taken it upon themselves to know what the best price is for everything by mispricing money itself. And they got a lot of help. The Bank of Japan is in the mix, the Bank of England’s in the mix, the ECB is in the mix. Everybody is doing this, there is nowhere to go, nowhere to hide, and that creates a very chaotic landscape. But how do you even analyze something like this anymore?

Dave Collum: I don’t know. And then you’ve got the war on cash, you’ve got all sorts of things going on, and they’re trying to shut us out of our sort of normal defense strategy. We talked about confirmation bias, and I put a little piece in there that said I rely on confirmation bias. I embrace it. I’m well aware that it says be careful, you might be confirming something that’s wrong, but what’s also true is when you’re feeling kind of crazy about what you’re doing, you’ve got to find some likeminded people to keep your hand on the rudder steady and to not lose sight. And so, yeah, I’ve been working on an exit strategy, an exit from the situation we’re in in terms of viewing the world ever so darkly. This is by no means time to exit, in my opinion. I think we are actually topping out in the world of absurdity. But at some point we will be in a position where there will be bargains to be purchased.

They eluded us in ’09 for the most part because it never got cheap, but someday there will be and I’ve been trying to plan for that day when I’ll be able to go back to normal investing when no one else agrees with me.

Chris Martenson: Normal investing meaning what to you? You have something where you can identify value and the price is okay? And the prospects, the story makes sense, so there’s some comprehensive story besides somebody’s going to buy this from me for more money tomorrow?

Dave Collum: Well, that last sentence I don’t like. I would rather buy a well-defined revenue stream, and if someone does not want to pay me for it, that is fine, as long as it is a well-defined revenue stream. But there are none of those that I like right now. I was pretty enthusiastic about energy, I knew that the credit markets were a risk for the energy market. I must confess that I did not fully understand that risk. I am still enthusiastic about energy, and the XLE is still up threefold with the S&P is from 2000. But, I’ve had to move the goal post back a little bit in terms of my timeline for energy, but I always want to own energy. I always want to own it, I think we need it; we will use it. but my exit strategy ultimately is going to be, hopefully, to be able to do sort of a sixty-forty kind of portfolio when bonds return, will return, and stocks can be purchased cheap and pay good dividends and the companies have a growth going forward.

Chris Martenson: Well we certainly agree on energy, no question about that. You and I both have some grounding in biology and chemistry as well, so obviously, you know all of life is just a flow of electrons and from one state to another, energy is everything. And so, as I look into this energy space, I loved what you wrote about it because it confirmed for me what I thought, which is that I really think that the initial hit to the price of oil was a political stunt first and foremost, mainly directed at Saudi Arabia and Iran. And I think it kind of got away from them once that ball got rolling. And/or, our political leaders are just so tone deaf that they don’t really care, or are unaware of the amount of damage that’s being currently inflicted upon the U.S. oil industry. But at any rate, I’d love to talk to you about that because here’s when I love to buy things like oil, is it is way below its marginal cost of extraction for a barrel. You cannot possibly get it out of the ground for thirty-eight dollars, or thirty-five. Where are we at today, thirty-four… yes, so thirty-four, forget about it, not happening. You can get existing oil that you already have a drilled well. Of course, you might lose capital because you drilled at a higher set of expectations than you are currently selling it at; that is a different story, but it can come out of the ground, obviously, it does. Surprise to me has been how slowly the shale industry has responded to this. They are still drilling pretty steeply as well, but I know that oil has to go back up to seventy, eighty, ninety dollars a barrel, or we have to admit we’re going to live without oil. That ain’t gonna happen.

Dave Collum: Well, I… so I have some… my wish list, and I intend to buy energy equities again; I don’t buy oil futures or anything like that. That is too rich for me. The one thing I do, and I think your readers ought to consider seriously, at least the ones who are amateurs like me, is that I try to invest in a way where if it goes badly, I forgive myself. So if I bought futures in the oil and started playing around in those markets, and I got busted by it, I would not forgive myself because I don’t understand that world very well. So, I will be looking for energy equities. I don’t think they’ve bottomed yet. I think they’re only slowly responding to the price of energy, and so I’m still waiting, but I’m getting restless leg syndrome a little bit, as I said, and I’m thinking about it.

I want to invest in Russia too at some point, but I am waiting for them to get their tail ends kicked a bit. Maybe I will be waiting forever, I don’t know.

Chris Martenson: You mean kicked economically a little bit more, or…?

Dave Collum: Well, you know if our markets crash theirs are not going to hold up, right? And in fact, the horrifying detail going forward, I think, is in 2008/9, while the equity markets when down, the bond markets went up. And that buffered an awful lot of pensions and 401Ks and endowments and things like that. And so people felt pain, but they didn’t realize that there was an offsetting gain. They did not notice that part as much, but I think the next downturn is going to be concurrent bond market collapse and equity collapse and there will be no slack in that downturn.

Chris Martenson: Explain why you think both turn down at the same time.

Dave Collum: I think they are both at ridiculously high levels now. I mean, the bond market can only go down, right? I mean, it can keep going up for a while, but there is just nothing left to be squeezed out of it. Interest rates are at seven hundred year lows, supposedly. I don’t know how they get those numbers, but they’re claiming… they’re certainly at stupid lows. You have a third of Europe at negative rates, so I don’t see where… and I put in a quote, there were some guys saying "you know, if you buy bonds at negative rates there’s a chance you’ll lose money." I am going, "Really? Ya think?"

So I think at some point the bond market’s got to collapse. It will start in the high-yield market, and that is happening right now. Then it will spread. Maybe treasuries will get bid to the stratosphere, but at some point you’ve got to get a real return. And so the bonds have to sell off to get back to that real return, so they’ve got to go; and all crises are credit crises, right? And then equities are going to go once there’s not leverage out there for share buy backs and stuff like that.

Chris Martenson: Well think about… you know my model for this is, remember… I am drawing a blank on the year, but Bernanke was still in charge and it was the so-called "Taper Tantrum." I remember the month, not the year, it was June, and everything sold off. Everything just got clubbed at once, everything. That is sort of my model; remember that was like two or three days of awkwardness? Bonds were down, commodities were down, and stocks were down. Everything was just getting sold all at once.

Dave Collum: It wasn’t too many years ago. You know, there is the fear of twenty-five basis points, and to me, it is… at first, I thought it was just an abstract fear in which people say "Yes, but that’s just the tip of the iceberg, and you know what icebergs do, right?" But Zero Hedge did an interesting analysis and said look, you raise twenty-five basis points, you are going to see the equivalent of a quantitative typing of eight hundred billion dollars. I can’t say I follow the line completely, but I thought it was a credible storyline. So if they start raising rates and they start unwinding these incredibly leveraged positions, there is a problem, right?

Chris Martenson: Well, there is, of course the Fed has a few other tools besides just taking liquidity out. They can raise the rate of interest they are paying on the excess reserves and that would serve as sort of a magnetic attractor to a higher rate without withdrawing any liquidity. In fact, it is actually liquidity additive because you are paying banks more for the privilege of giving them free money that they round trip back into an account that you pay interest on. So they could do that.

There is a variety of things they could do because we know the Fed is deathly afraid of this market going down, and they know they do not want to withdraw a lot of liquidity. So, I think they’ve been doing what they can, and they got, apparently, the rate hike they wanted, only withdrawing, I think, about a hundred and thirty billion so far that I’ve seen. So they got away with doing it with a lot less than that Zero Hedge estimate that came through some firm. I can’t remember who.

Looking at that, here’s the theme I see. I see all the central banks as just being really afraid of the markets they’ve created. I don’t really remember you writing about the psychology of what’s going on in the politburo, or the FOMC, or inside the halls of those power bases. But it seems to me, from everybody I’ve talked to, that the Fed is actually pretty clueless. They don’t really have a good plan. They did not really mean to end up here. They don’t really know how to get out of here. But as you wrote in your article, you summed it up, you said that the dominant narrative, the theme this time that everybody’s running with—like we had railroads as a theme once that supported a set of bubbles. We had Internet, at least that was a credible story you could hang a hat on and say "yeah, I get how the internet’s going to change everything, let’s just go crazy on a bubble." But this bubble is a bubble of faith in a bunch of people who are appointed committee members, just a small handful of them, and that seems a little dangerous.

Dave Collum: Yeah, I am not sure if they’re afraid or if they’re clueless. You used both, and so you kind of hedged your bets there.

Chris Martenson: Yeah. [Laughter]

Dave Collum: I think it is probably a combination. I know Bernanke was afraid of 1938. I actually… I sort of had an epiphany on 1938. Everyone seems to accept the notion that in ’38 the Fed tapped the brakes at the wrong time. After a discussion I had with Mark Spitznagel, which was quite a treat, he mentioned the Tobin’s Q, and I started thinking about it some more, that’s a valuation model that’s really sort of a price-to-book valuation model, and he wildly endorses it as the cleanest of all the valuation models. And I went back and looked at it that night and was staring at it, and I noticed that in 1938 according to Tobin’s Q, the Fed had blown another bubble. And I had never noticed that before, so the Fed, the Tobin’s Q had reached all time highs again, and so the Fed had to tap the brakes in ’38 because they had over juiced the markets.

Chris Martenson: So price to book, is this… how clean is the book? You know we’ve got all kinds of shenanigans going on in accounting these days, so is there a cleaned up Tobin’s Q, or are we still… has that slowly been drifting off into nebulous uselessness like a lot of statistics?

Dave Collum: Well, let’s assume it’s clean. It is at near record highs, with the exception of 2000, but it is above twenty-nine, it is above sixty-seven, it is above the obvious high points. If it’s not clean, then it is worse. So, I don’t need to know… this is like the inflation debate. I no longer need to know how wrong it is at this point, because I’m just… I am not touching it. I talked to some guys who said, "Be careful of Tobin’s Q," and I go, well, I’ll start worrying about the validity of Tobin’s Q when it’s below the mean. Then I will start worrying about whether we are getting a valid read on it. Right now it can be wrong, I don’t care. I am not buying; that is the key.

Chris Martenson: So price to book then, "book" meaning—for those who are not totally familiar with accounting—this is the book value of a company. Meaning, what we have done is we have added up all their assets that we know about and subtracted out their liabilities and say, hey there is an enterprise value here that if you just broke this company up today, what would it be worth. Of course, this is a little bit tricky to estimate sometimes, because Coca Cola… how much is the brand itself worth? There’s a way of valuating that, so I’m not familiar with exactly how all that would get wrapped into the Tobin’s Q because I’m not that familiar with it. But, the idea here is that the amount that people are paying for companies, in terms of their book value, is the second most extreme in all of history, right? It is second only to what, 2000?

Dave Collum: Yeah. What is also true is there’s a bunch of other valuation models. The one that you should be very wary of is price/earnings ratios. That is the one that is toxically wrong. But there is a bunch of others, like Buffett's is price to GDP and the problem is that GDP is now all contorted. Again, assuming it is clean, which is the best-case scenario, Buffett's indicator valuation is about forty percent above the mean. As I said in the write up, I said you not only regress to it, you’ve got to regress through it, because you’ve got to spend half your time on each side of the mean pretty much. That is my freshman math teaching me that one.

Chris Martenson: Good point. Now this has been of course a very frustrating period of time for people who use history, who use common sense, who use fundamentals, who use valuations, things like that. I am thinking of Hussman, great guy, one of the smartest and most astute and mathematically oriented market mavens I’m aware of out there, and it’s just tough sledding whenever I talk to him. And it’s been hard for a while. As you and I were talking about before we started recording, here’s my frustration with all of this, David. I do the same thing, not nearly as comprehensively as you do all at once. But what I do when I’m writing is I start collecting dots and I put them all together. And once I put them in one spot, I’m like… my first reaction is "You have got to be kidding me. How can we be tolerating this?" But we do. And my frustration is that a lot of people still don’t get just how weird and extended things are.

The Fed plays dumb or coy or both, and what I am worried about is when this finally really does break, I have the same fear I think the Fed does. Once the ball gets rolling on this, I think this does go through the mean, and I think it is much worse than 2008. I think the damage is going to be extraordinary, and I am really worried about how my country is going to respond that, because I don’t think we’re going to take it well. My personal projection is that my country will blame somebody, maybe Islamic people, or Russians, or Chinese, it does not matter. That is what I feel.

Dave Collum: Yeah, they do it every time. The good news is there’s very few countries left to bomb. We are already bombing most of them. Yeah, I… here is my fear. One of the parameters in market corrections that is grossly underestimated, is time. And I really try to eliminate time from my portfolio, so I would never buy an option with an expiration date. And if you make the right bet, you want to be able to stay there until it’s either the wrong bet or it pays. And the problem with bear markets and secular bear markets—which I argue we are still in. There’s a lot of bulls saying I’m an idiot, but I argue we’re still in a secular bear market waiting for the third leg down. I am a big fan of the three-leg down model—is time is the killer. So, if you’re a Japanese investor in the Nikkei in ’89, twenty-five years later, you’re not only down seventy percent, you also have given up half of your entire investing life waiting for something good to happen. And if you’re an investor in ’67… You know, in 1981 fourteen years later, you are even on capital gains, but you are down eighty percent on inflation. And you have burned fourteen years of your investment life again. So my fear is they are somehow going to be able to stall this so long that you and I are just going to sit there and we’re just going to—dead cold finger sitting on the mouse waiting to click. And if they don’t wash it out pretty soon, time will start to chip away on all of us.

Chris Martenson: Well it has been chipping away, and of course, I am thankful… oh my gosh, I am praying right now… I am thankful that I am not a pension fund who—those guys and gals have just been getting cleaned. Can you imagine being responsible for the retirements of millions of people potentially, and you need seven and three-quarter percent in this particular environment? I don’t even know where I would begin. I am very frustrated at my own portfolio returns, but I cannot even imagine how bad I would feel if I was responsible for thousands, maybe millions of people.

Dave Collum: Well, if you integrate your… I know what you have done through the years, and if you integrate your returns over the last fifteen years, I bet you beat the S&P.

Chris Martenson: Oh I did, yes.

Dave Collum: Right, as did I. Now, for the last five years, you and I have been getting browbeaten by the bulls, but you have to integrate over a long period. So, we had a huge lead on them in 2009. We were just rocking at that point. And we’ve given up some of that lead, but we still have a comfortable margin, a factor of two or three for me, relative to the ’09 crowd who somehow were smart enough to jump in, although I don’t think many did, actually.

Oh, I don’t know… hopefully this will eventually equilibrate and eventually cause the carnage that’s necessary. The seven and a half to eight percent return crowd, that gets back to the bond market. If the bond market returns zero—which it is priced to return zero or worse, right? It is priced to pay you nothing in dividends and hold up, or to collapse. And if that pays nothing—and I’ve got to do sort of back the envelope in my head… sixty-forty portfolio, you get nothing out of the forty, you’re going to have to get about twelve percent on the sixty. I don’t think equities from this level could possibly give you reproducibly twelve percent a year. I don’t think it’s even theoretically possible, unless of course, inflation’s above twelve percent.

Chris Martenson: Yeah, so on that front, people vary a little bit on where inflation really is, but obviously, it is… so I don’t really go by prices as much as I do looking at credit and money and watching the collapse in M2 velocity, and looking at the fact that the Fed did get some credit out the door. But boy, we must be scraping the bottom of the barrel. I think the last person who wanted to took out a tuition loan for an online university, and I think the last person who could buy an eighty-four month subprime auto loan has been found and rounded up and given a loan. It really feels like we are… I don’t know how much further we go. Can people really continue to extend the housing market in San Francisco? The signs say maybe not. We see a lot of things that look like topping signs here.

So, where is the story that says here’s where we’re going to get this inflation the Fed keeps yapping about? Where does that come from, except a war that accidentally causes oil prices to spike? Which isn’t the inflation they need. They need monetary inflation, not necessarily price inflation. One is a symptom the other is the cause.

Dave Collum: Well, I’m not… okay, so, hat tip: Several years ago, a number of years ago, there were a half a dozen deflationists on the planet, best I can tell. I happen to have realized I should have given Mish Shedlock a hat tip. He was a diehard deflationist, and I thought he was nuts, and other people thought he was nuts, and he’s looking pretty smart right now. I think we are going to have a hybrid model here where I think we are going to get the worst of both scenarios. Where we are going to get inflating prices and deflating assets. And I don’t know what to call that. For years I have been railing on the idea that something so complicated as zillions of prices moving around could possibly described in a binary language of inflation or deflation. That just strikes me as nuts. So I think we’re going to have price of veal and beef going up, and the price of your equities going down, and the price of bonds going down, and possibly the price of houses going down again. I think we are going to end up with a credit crisis because, while energy high-yield bonds continue to tank, liquidation from the funds start, you are going to start having to sell the ones that are not tanking. So, other high-yield bonds that maybe weren’t such a crazy idea will now get crushed. And then lesser risk bonds will start to get sold from portfolios, and it just cascades. I think we will have an inflation/deflation hybrid combo. All the bad things rolled into one. I know it sounds like a doomsday scenario.

But my exit strategy is I think the next recession is going to be a barnburner. At the point where everyone is talking about the recession, I intend to start averaging in. And if Tobin’s Q is at the mean, I will start there. Last time I did, but then it jumped. And I will start averaging in and hopefully I will average all the way down to stupidly low levels of Tobin’s Q and wish I had not done it. But I really would love to get to sixty-forty. I would like to get back there, but I am not doing it until it is a bargain.

Chris Martenson: Well, this is going to call for more patience, right? So a lot of patience so far. I am running out of patience, I have to admit. You say you have restless leg syndrome. I have frustrated eyebrow syndrome. I just keep squinting at my screens going "how are we still here? How is this still this dumb?"

Now what I would love to get your take on—because you and I both have the opportunity from time to time to rub e-mail elbows with, or even face to face some of the big money names out there who are in this. And I’ll tell you Dave, you know, I’ve been at a few major, sort of heavy duty wealth conferences, both presenting and attending, and when I talk to these people who are running these big giant funds, they’re nervous. They are nervous. People… I was talking with a guy who has a giant real estate portfolio, unloading it as fast as he can. It’s in New York City. I asked him why. He said, "You know, our metric is once we see around seven to ten thousand units with a minimum square foot price of three thousand dollars a square foot, we just start running away from this as fast as we can." Three thousand a square foot, right? That is like at the low end. They have apartments there that are going for four, four and a half to five thousand a square foot, and the people who are managing the assets complain that there is really nowhere to look at this point in time; not within sectors, and not across the globe. Nobody can find price, nobody can find value, and everybody is concerned that they are over paying. And here’s the fun part: Everybody thinks they are a little closer to the exit than the next guy and will be able to protect their clients in the next downdraft. What are your thoughts there?

Dave Collum: [Laughter] They are nuts. I think the reason the third leg down model works is because everyone knows when it starts. I think the fear of "not again," it gets so compelling, so overwhelming. I believe that when the secular bear market is over, people will swear off asset classes in their entirety and they will say "I am just never, ever, ever again going to buy that. That is just a piece of garbage and I am not buying it, I have been duped three times." Last night I had one of my business school colleagues tell me to buy real estate… commercial real estate… and she said "that has been a really great investment." I am going "yeah okay; I will put that on my wish list. I will buy something that has boards on the windows." The reach for yield is going to kill people. They sold hundred-year Mexican junk bonds, I mean… "Mexican junk bond" is redundant in my opinion, but they sold hundred-year bonds in Mexico. Nestle got negative interest rate bonds… a corporate bond that is a negative rate. This is certifiably nuts. And it will just drive us nuts. Then one day it will crack and the ice under our feet, you’ll hear it crack and you’ll go "that was it." I remember when it did it in ’07. I know you and I were waiting for it, and waiting for it, and then it finally did in ’07 when you heard a crack and the internal Bear-Stearns hedge funds went down, and they were supposedly little things, and you go "no, no, no… Something is going on in there." And Tonta, that woman writing from inside the system—we’ll hear that again, I think. I think we will get that.

We kind of got it in August, right? The markets started to break. They started to dysfunction in August, and then somehow they pulled off a stick save. I don’t know how they did it. Guys like Eric Hunsader said he could see the markets breaking. There was complete air pockets, malfunctions, everything was wrong and will do that. They saved it, but you can only save these things so many times before one gets by you. It is like a hockey goalie.

Chris Martenson: Yeah, so in terms of how they saved that one, now there were a couple there, in August and also an October save. What are your thoughts there?

Dave Collum: Well, I don’t know. I really have not a clue how they saved it in August. They couldn’t drop rates, I didn’t see any evidence of huge influxes, although maybe I’m forgetting that Draghi dumped some money in or something. They somehow have the psychology, they have the leveraged speculators not willing to run for the exits yet. They were able to head them off at the pass. The fact that the system is fifty percent more leveraged than it was in ’07 is just so staggering. And you’ve shown charts with the little blip and the leverage and the damage it did and how it’s just gone exponential since then.

This is one of these when Dave and Chris get together and lament how crazy the world is moments. At some point, when it finally is true and we are shown to be correct, it is not going to be satisfying. We are not going to be sitting there partying in party hats and noise makers,