Lance Roberts: This Market Is Like A Tanker Of Gasoline
Lance Roberts, chief investment strategist of Clarity Financial and chief editor of Real Investment Advice has authored a number of impressive recent reports identifying potential failure points in today's financial markets.
In this week's podcast, Lance explains how the massive flood of investment capital into passively-managed ETFs, along with record amounts of margin debt, has the potential to set the markets afire:
Fundamentally, there’s nothing different in today's markets because, at the end of the day, they are about evaluations, earnings — those types of things. Technically, the market is very different today because of quantitative easing, computerized trading etc.
What we see are two things happening, in particular, that people should be paying attention to. One is that investors are herding into passively-managed ETFs now, which is creating a dislocation between the underlying realities of individual stocks and their prices, because the piling into ETFs is requiring stocks like Facebook, Amazon, and Google to be bought in much greater volumes than they otherwise would. And people are making an assumption that there will always a buyer for every seller in the market.
Now that’s absolutely true. But it's often argued by the mainstream media that "For every buyer there’s a seller, so it doesn’t matter when the market turns. You’ll be okay." But you won’t, because, yes, at some point there is a buyer for every seller, but it always begs the question: At what price? And because of all the piling into these ETFs, when the market eventually breaks, yes, there will be a buyer; but that buyer could be at many percentages lower than where prices were before. We could very well see a vacuum appear in prices, with a gap down so sharp and so fast that it not only paralyzes most investors who may be hoping to get a little bit of recovery to sell into, but then will start triggering margin calls.
There’s been numerous articles written about margin debt: "margin debt is not a problem; don’t worry about margin debt." Well, margin debt is not fine. We’re at record levels of margin debts. It’s like a can of gasoline. If I set a can of gasoline in the middle of a room and nobody touches it, it's fine. But drop a match into that can of gasoline you have a different story.
So, the only thing that’s been missing up to this moment right now is the herding of individuals into a specific type of investment. But just like with real estate in the past, we have now people herding into ETFs. And now, with all these computers basically acting on the same set of information pushing stocks in the same direction because they’re all working off the same set of information, the market is like a tanker of gasoline. And somebody’s going to put a lit stick a dynamite into it because when this all reverses, you have these passive indexers become panic sellers. And then that beings to immediately trigger a reversal in the algorithms, which all feed on themselves in a negative direction. And the gap that opens up between the bid and sell prices will be staggering.
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Lance Roberts: This Market Is Like A Tanker Of Gasoline
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Chris Martenson: Welcome to the Peak Prosperity Podcast. I am your host Chris Martenson. It’s May 25, 2017, and today we’re going to be talking with leading market analyst and commentator, Lance Roberts. As this is being recorded. Stocks are powering to move all time highs signaling well what exactly. That’s what we’re here to find out today. CNBC and the Wall Street Journal and other market cheerleaders want you to believe that everything is awesome, but are things really awesome. So, let’s find out. Lance, hey he’s one of my favorite market analyst and commentators. He has a background of 25 years of private banking and investment management.
Lance is currently a silent partner for an RIA in Houston, Texas. The majority of his time is spent analyzing, researching and writing commentary about investing, investor psychology, very important today, and macro views of the market and the economy. His thoughts are not generally mainstream and that’s why I’m going to love talking with him today, you’re going to love him as well. He is also the chief of strategist and economist for Clarity Financial, editor of Real Investment Advice dot com and the talk show host of the Lance Robert show at KSEV 700. He publishes regularly in Seeking Alpha as well. Real pleasure to have him on. Let’s welcome you, Lance. Welcome to the program.
Lance Roberts: Absolutely, happy to be here.
Chris Martenson: First, is there anything else about your background I might have missed that will help our listeners know who you are and where you’re coming from.
Lance Roberts: Well, it’s interesting. I started my entire career as I was managing a deposit CD book for a bank in Austin, Texas and I started three days before the crash of ’87. My boss had me entirely convinced the entire crash was my fault, and so after that our bank eventually got bought by NCNB, which was North Carolina National Bank, eventually became Nations Bank; and we were bought and closed down along with the rest of the acquisitions and I wound up overseas managing money for high networth investors out of Monaco and several other countries. And what I learned there was it set a lot into my overall background and thought process about managing money which is not losing it: the conversation of principle, the management of risk. Well markets can do things that are totally illogical at times. Th ere is one thing that’s always the same which is this time is never different and once again I hear way too much right now because of central banks, because of this because of that this time’s entirely different but it’s not.
And eventually what goes up does come down there’s a simple thing called a four-market cycle and well we’ve enjoyed a very brilliant first eight years going on to nine years, the first half of the market cycle there will be pay back and those paybacks are fast, swift, sharp and totally unexpected and everything that people are building into their beliefs structure about it, etc. can be reversed literally on a dime when something unexpected happens.
Chris Martenson: Well, now let’s talk about that full market cycle because you recently penned a piece. I saw it on seeking alpha on the five universal laws of human investments stupidity and loved it. I think investors are being especially dumb here. Its context; I follow I know and I agree with pretty much everything John Hussman says. Great guitar player by the way; good voice, too and I’m such an inherent to his views for two reason, one you already mentioned one of them, it’s never different this time. And two, he’s got the data. He’s got the historic rigger to back up what he says. And according to him, investors are not paying very good attention to history here. Do you agree with him on those accounts or have any other reason to think maybe people are being dumb here?
Lance Roberts: Well first of all it's always interesting. I have a great respect for John Hussman, we communicate regularly on different issues. We’ve had dialogues back and forth on particular issues on fundamentals and valuations, etc. People tend to immediately discredit anything that he has to say, simply because they go looking for his performance of his particular fund or whatever it is; or they look at his writings – oh he’s been wrong and say he’s been wrong for so long that he’s just wrong now. The problem is, is that as you stated, his work and his research his based on careful analytical analysis and he goes through the data, he looks through the underlying structure and he makes very well practical arguments as to what is the particular issue he’s covered but most importantly when talking about evaluations and forward returns, the data is clear and this time isn’t different than it was previously. Just lately you always start to see towards the end of a particular bowl market cycle. People coming up with new excuses. If you remember back in ’99 it was well, if you’re trying to invest like Warren Buffett, that’s like driving dad’s old Pontiac. This is all about eyeballs page and we found out – no it’s not about eyeballs per page. It’s about how much dollars you’re actually putting down on geo bottom line.
In 2007, it was different this time because we were in a quote on quote, goldilocks economy. The fed had it all under control prime mortgages were contained. They weren’t. And today what we’re seeing is a very different type of bubble forming that is completely triangular exclude evaluation once again and the bottom line is what we pay for something today is based upon the future cash flows and expectations and corporations over the long term and it’s how we get paid back. Well now it’s, we don’t even worry about that, just buy an ETF, be a passive indexer we’re creating this new bubble inside of ETFs this whole passive indexing mentality. Very similar what we see in the past. This time were making excuses. This time is different because evaluations have been elevated for the last ten years, so the medium long term evaluation no longer matters at fifteen times earnings. It’s now nineteen times earnings. We're really not that overvalued it’s all okay. I’ll be fine just hold on and things we’ll work out, just remember nineteen or twenty or twenty-five times earnings that means a dollar invested today, if you capture a hundred percent of the earnings, there distributed by the company, it will take you twenty-five years to get your money back. That’s the problem, and when your market value is where they are today over next ten years, or twenty years just as John Hussman has shown multiple times, you’ll be close to zero.
Chris Martenson: Close to zero, and of course this time is never really different. But let’s talk about ways that it might actually a little be different. Big article, in the Wall Street Journal last week about the rise of the quants and I don’t know if everybody saw it. But a quant is someone who uses math and writes algorism and computers can do the trading for you and now we all know that the market structure, something I’ve been commenting on for many years, particularly through the work of [?] and others like that that we have a very different market now and its subject to flash crashes and microsecond trading, and colocation servers and all this. Lance, is this market really one where we can historically look back and say here’s how markets should behave, here’s how they do behave or is there something fundamentally different in the market structure now.
Lance Roberts: Fundamentally, no. There’s nothing different because remember the fundamentals are at the end of the day about evaluations, earnings, those types of things. Technically, the market is different today because of all the reason you just laid out in terms of quantitative trading, computerized trading etc. What we see our two things happening in particular that people should be paying attention to is one, as I mentioned earlier that herding into ETFs now has creative a dislocation between the underlying realities what’s happening inside of individual stocks because their people piling ETFs that require stocks like Facebook, Amazon, and Google to be bought. We’re starting to get this attachment between what’s actually happening with the underlying equity of the stocks, experts what happening with the ETfs. There’s going to be ultimately, I wrote I article about this called, about passive and recently that when this break, whenever it breaks it will break that people make an assumption that there’s always a buyer up for every seller in the market.
Now that’s absolutely true and this is often argumentative given by the mainstream media that go for every buyer there’s a seller matter, so it doesn’t matter when the market turns. You’ll be okay. But you won’t because at some point there is a buyer for every seller but it’s always the question at what price. And because of all the piling into these ETFs that when the market eventually break, there will be a buyer but that buyer could be percentages down much way over where that buyer initially appears and we'll see a very rapid break in the market in a vacuum will appear in prices and the gap down will be so sharp and so fast that it not only paralyzes most investors who are now going to start hoping to get a little bit of recovery to sell into but then we’ll start triggering margin calls. And there’s been numerous articles written about margin debt. Margin debt is not a problem; don’t worry about margin debt. Margin debt is not fine. We’re record levels of margin debts. But it’s like a can of gasoline. If I set a can of gasoline in the middle of a room and nobody touches it, it's fine. Nothing happens, it’s a nerve. Drop a match into that can of gasoline you have a different story. So, the only thing that’s missing at this moment right now is this hurting of individuals into a specific type of investment. Just like real estate stocks, we have now people hurting into ETFs. This is now being driven back to your point about quantitative trading; so all these computers are basically acting on the same set of information pushing stocks in the same direction because they’re all working off the same set of information. So, this is like a tanker of gasoline. And somebody’s going to stick a dynamite into it, because when this all reverses, you have these passive indexers become panic sellers and then that beings to immediately trigger a reversal in the algorithms, which all feed on themselves in a negative direction, and the gap that opens up will make the gap in the Lehman crisis appear minor.
Chris Martenson: Now let’s talk about this; this is such a fascinating market structure to understand I — maybe you can help me understand this. I looked at it and I couldn’t believe what I was seeing. it was on Zero Hedge awhile back. It showed that the number of ways to engage with stocks through something like in ETF. So, an ETF, for those listening, is a basket that’s meant to attract the underlying share of stocks. You might buy an ETF in the SNP 500, as the SNP goes up the ETF goes up. And the way they do that is they couple the ETF to the underlying shares. There are not apparently more ETFs and vehicles like that than there are individual shares. Did you see that piece of data?
Lance Roberts: Absolutely, absolutely.
Chris Martenson: So, help us understand that, because to my unsophisticated way of thinking it means that; let’s just make it simple, I’ll make the math simple and work this out in my head. If there are a thousand different shares, types of companies out there, listed with ticker symbols, and there are fifteen hundred ETFs out there, it means there’s basically 1.5 representation. It means that as these people start to sell ETFs, there’ s going to be more selling than there is actually shares outstanding. If I haven’t butchered that too badly, it means that’s their actually leverage on the number of shares that are outstanding. They would all have to be rectified both I guess on the way up and the way down.
Lance Roberts: Well, that’s right, if you take a look at a lot of shares and the market: the individual side. Step aside from the ETFs for a moment, go look at what’s happening at the underlying individual stocks that are in these baskets and you’re seeing more what we would consider more abnormal movements in the stock because of this exactly, as you stated is exactly the right way is that you’re getting this leverage of buyers, because as one buyer goes in to buy an ETF, then at that one marginal buyer effectively buying one and a half time stocks is actually being purchased by the purchase of ETF. Then, you leverage that with the fact that you have a lot of these ETFs that are using option structures in order to leverage those ETFs. So, now you’ve got options on top of the leverage on top of the stock. So, this is back to our original point about this quant driven market. The information flow into the market is all bullishly biased and these algorithm’s, where there looking at political headlines or geopolitical headlines or stock trading headlines, company headlines, whatever is driving these algorithms. All these algorithms are all basically messed up and they’re all trading up information exactly the same way but this is what we saw last Wednesday.
When that initial headline hit, let me rephrase that sorry. This is what happened a couple of Wednesdays ago, when the headlines hit about James Comey, and the potential that there might have been an obstruction of justice. What you saw was a very rapid decline in the market. Almost one and a half percent in one day and this is the beginning of those reversals. Fortunately, right after that the headlines cleared and algorithms went back to work, but there will be a point to where once these algorithms fit, they will hit major support points. When those support leverage levels are hit, that would trigger more selling and so forth and so on. And as we were talking about earlier, the thing that happens to the individual investor; and this is the difference the individual investors has been lulled into the place of consistency that it's simply, every day is a buying opportunity, and every opportunity for a dip is just something not to worry about and it’s all fine, it’s just this high level by both the federal reserve and by the media and by the market action in and of itself. That at some point when that reverses and that decouples and things begin to run in reverse, it will happen so rapidly that investors will be trapped into a paralysis, where they are simply trying to make the justification if a decision comes back I’ll sell but it won’t come back, it’ll go lower. If things go back to where it was I’ll sell and eventually there where there simply just like oh well I’m here where I am, I’m just going to sell everything now. And typically, that’s the bottom of the market.
Chris Martenson: Now we’ve had a lot of conjecture out there, including recently by Asher Edelman saying, that he has no doubt the PPT is behind the market rally, this and that, but it seemed to me that – remember January 2016, everyone was kind of going bad, emerging markets were blowing up, and the dollar spiking. It was a lot of chaos out there and January was pretty awkward, and February it all turned around and then we had Brexit just a few months later in that same spring. And a few weeks of confusions and then things turned around and then we had what I really thought was a black swan moment was Trump being elected. That was not on my radar screen until 10:30 that night and remember we had the Dow down 8- 900 points and then turned around in a couple hours and went the other way. Would you – do you think those are the kind of moments where, Mr. Edelman’s — I don’t want to put words in his mouth, do you think, is that what he’s looking at, or is he saying more general people are starting to suspect the entire advance of the market at all moments now?
Lance Roberts: It’s not the individual. The individual player is very, very small relative to the markets today. There’s actually a very good article out, just today talk about the number of people and the population of the country. Take a look at the statistics, 80% of Americans have less than five hundred dollars in the bank. The average American 401 K balance is less than one year salary. American consumer debt listed at all time high and the wages are continuing to remain stagnant. People are living, really for the bulk of America, really living kind of paycheck to paycheck. It’s not the individual player that’s in the markets, that’s driving the market in any direction. What we’re talking about here is talking about institutions, we’re talking about hedge funds but most importantly we’re talking about central. I tracked the central bank changes on a four-week moving average for the federal reserve and I’ve gone back and I traced this back over time. You can go back and look at the lows in early 2016 and immediately at the lows we were hitting at the lows in February 2016. Janet Yellen made a call to ECB and to the bank of England. The next day the markets started climbing higher, and that was the end of that sell off.
When we go, and look at Brexit and we go and look at the election of Donald Trump. What we see there is that the Fed's balance sheet hasn’t grown. It’s been flat line; what happens though is that all these reserves were a bondsman sure on the balance sheet. And when the interest payments come in they reserve those in cash and at opportune moments they come in and they redeploy that cash and you can see if you zoom in on the Fed's balance sheet you can see the wiggles from one week to the next week about what’s happening within the balance sheet and they line up almost perfectly with market bottoms. Whenever there’s a market bottom, you’ll see the Fed come in and start redeploying the capital that’s been accumulated on their balance sheet. So, the balance sheet size is not changing that why its flat line. It’s the difference between the cash roll off and the reinvestment of that and that’s one thing they were talking about this week with the Fed minutes, is that coming up later this year, bank of – JP Morgan thinks it’ll happen sometime in maybe September that they’ll start reducing that reinvestment. See that’s extraction through the equity of the market and you couple that with higher interest rates now you’re actually talking about tightening money for the end of the market. Tightening is really started to slow the economy a bit and I’m not sure that work out really well for investors but there’s a direct correlation of what central banks are and the market responses.
Chris Martenson: Well that’s fascinating and I haven’t thought to track the wiggles like that and that makes a lot of sense. And just a piece of information that’s always been odd to me and I can’t go any further with it because nobody will answer, but we know the Chicago Mercantile Exchange has a central bank preferred incentive buying program, which is a program reserve for its highest volume participants. So, apparently central banks are buying enough stuff on the Chicago Mercantile Exchange which are all leverage products for the people listening. These are options in the future primarily and we’re the commodities and we’re in equities and bonds. So, we know central banks are in there. I’ve scoured their balance sheets. I’ve scoured the minutes the foot notes. I can’t find a single central bank that will admit to owning a single CME product but they’re in there, so I don’t know how to put those two dots together but it makes me – let’s just say, curious about what’s going on there.
Lance Roberts: I don’t think there’s any great secret or any great conspiracy. We know that jus since the beginning of this year, central banks have injected more than a trillion dollars into the market, just this year. The differential between the federal reserve and the European bank and bank of Japan is that without a congressional charter change, the Federal Reserve cannot buy stock, they can only buy government guaranteed insurances which our genuine bonds and US treasury. But of course, when they buy those bonds how that money winds up into the market is basically they’re crediting the reserve accounts banks and then take that capital and say well I can either loan Chris money for 30 years at three and a half percent and maybe he’ll pay me back on a mortgage or I can just go invest it into highly liquid commoditised investments at a huge amount of leverage, oil future and demonized bonds etc. trade and that flows immediately into the financial markets and that what we get discontinued with.
Back to our original point that brought this up is, if you will notice there’s always a very interesting pattern that exists will break a major level of support that historically if when you break a 50-day moving average you break a previous bottom of support in the market; generally markets will fall to the next support level where you may find some buyers; and what we’ve seen in particular of over the last several years, is that the markets will break a level of support and magically will just buying coming out of nowhere at points where normally you would not see that happen; and I think the example of the election night is really key, because I was down at Fox during election coverage that night on Fox and we were watching the futures as more and more states fell in Trumps favor, but I don’t really believe this is going to happen. More and more states fell to the favor of Trump. We were down 800, 900 points I’m thinking man, tomorrow morning is going to be a bloodbath. By the time I got up in the morning we’re almost to even a will positive right out the gate and it was a flood of equity, where normally you would have not expected that to occur and normally it would not have happened in those circumstances, had you not had the influence of central banks coming into support markets to keep the deterioration from happening.
Chris Martenson: So, lets – I can actually put myself in their shoes and say, I get it. So, they can’t afford a big downturn at some point in time. There’s been a lot of commentary about how the fed and other central banks have really got themselves into a corner if they don’t market to such a level they can’t afford to have them fall so they can’t let them fall. But under that strategy there has to be some sort guiding principle, and that I think was always was, hey, growth is going to come back at some point. Let’s be honest. We’re friends here. Growth is missing. It’s missing in action it has been on the global stage for more than a decade at this point we are sub-par, sub-trend full capacity however you want to measure it and it doesn’t seem to be able to get off the market at this point in time and the United States were always looking at we’re going to have a first half recovery and a second half recovery and I guess a third half recovery. They keep going and every time we keep pulling in these weak returns, where is there – is there a point, Lance, where there’s central banks go, this isn’t working, we have to try something else or lost in this regime until – where beatings continue until morale improves.
Lance Roberts: I think it’s a nail in the head. One of the best examples to look at as far as the country and people quickly dismiss this. I think it’s wrong. Let’s look at Japan. Japan’s been trapped in this low growth rate recession type environment with subprime interest rates now for over 25 years. But what similarities do they have versus the United States. And this is where people quickly dismiss the Japan comparison, it’s an island, it’s over there have nothing to do with us. But they have an aging demographic problem. They have very low birth rate. They massively underfunded pension system where maximum amount of people that are drawing off it and you take a look at every economic environment that they have in Japan and we have very many of the same things here. We have the lowest birth rate since the 1940s of new children coming into our economy. We have an aging demographic with the baby boomers. We have more multi generation families living with each other since the great depression, 30% of the millennials are still living with their parents after graduating college.
You have these, all have an impact on economic growth and so to your point we continue to lug along here at 2% growth and very interestingly, Bariatrics of Economics Analysis has tried to rejigger under calculate economic growth in the first quarter they keep adjusting first quarters economics growth and it still comes in week we have cold weather during the winter. They keep adjusting for cold weather which we already have existing and then we have this recovering the second and third quarter, then we roll off again in the fourth quarter and the first quarter and this has been the cycle and it had been a very impendent sticking cycle to get through the next two couple of quarters and then we start this whole process over again and it’s been this consist abend flow really ever since 2009 and that hasten changed and we take a look at the employment numbers and yes we’ve created tons of jobs but with clearly jobs weave the lowest jobs claims since the 1970s, and yet we don’t have any real type of wage growth, and you take look at the consumptive side of the equating where people were buying 70% of our economy is personal consumption expenditures, yet that really isn’t showing any track of growing on a strong basis fight the fact the very body supposedly has job wants a job. But of course, we get into the real numbers we start looking at the number of people they’re the prime working age, between 25 and 54 that should be working, only half those people are working.
So, there’s the real issue economically and to you point and to your question which is yes, this whole premise behind quantitative easing and this easing, this kind of ejection of capital supposed to do one thing and one thing only. They were supposed to lift asset prices temporarily to get consumers confident about the economy when they get confident about the economy they’re going to start spending which is going to create the virtue of cycle in the economy creating demands for business, then businesses need to hire more and deploy more capital to meet the demands that put more people to work in this virtuous cycle of the economy, the Fed raises interest rates a little bit, gets off to zero and that’s supposed to happen after two years of doing this. We’re now nine years into this program and we are in no better position than we were nine years ago; and here’s the danger – is that there is an end point to this where the economy is going to start correcting regardless.
Economic cycles are not indefinite. They are finite and we may be very well seeing signs of economic deterioration and the end of this economic cycle; and with the Fed still near zero in terms of their interest rate policy and then of course with their monetary policy already running full speed ahead. Globally, there’s really a lot less ability, a lot less efficiency in these quantitative programs from what we saw previously, so the bang for the buck after the recession may be very limited, which allows the recession to be much worse than if they backed out of this program four or five years ago. Let the economy have a secondary recession like we did in the late 70s. We had back to back recessions. Let the economy work through its debt revulsion. Get the economy back on track and then help along the way. Now the problem is they’ve gone so far for so long there’s no option to exist when the next recession comes.
Chris Martenson: What a fantastic answer. It makes me think immediately that some of the — there are certain economist I do like to follow. One of the is Steve King and he makes a point that, hey look it’s one thing to measure this side of the equation but there’s two sides on a balance sheet and maybe you should look at debt as well. So, you mention some of these components before that household debt now at all time debt now all time new recorded even though we’ve got median wages, real wages that are fairly staged and if not declining on a real basis. But corporate debt, also is at all-time highs and margin debt, all-time highs and so everything seems to be fully stuffed with debt at this point and time and it feels to me that it needs to be accounted for as well. Because at least we look at corporate earnings, and people say oh well look at corporate earnings. Unless you adjust that for the debt that corporations took on to retire shares, you’re not really apples to apples in this comparison. And when, not if, but when that down turn comes that debt is now the preverbal in a mill stone of the neck of corporate health and profitability and all that other stuff going forward. How do you – when you’re looking at these things, are you factoring the increasing debt has stability and maybe is?
Lance Roberts: Well, absolutely, of course. This kind of goes back to some of the fundamental questions we were talking about earlier when we were looking at the markets; and you take a look at the amount of debt the corporation has relative to its debt assets ratios are at an all time highs. But we shouldn’t be there, the company’s like apples we were flushed been loading up on debt like buy back shares pay dividend, it’s been a very, very efficient use of capital I can borrow so cheaply for 20 or 30 years. Why not borrow money at 1% and pay out a 2% dividend? That works really well over time. Well, the problem is though we are leveraging up all these companies. If we take a work, and I did a study this recently, we combine household debt, corporate debt, government debt. Combine it altogether we’re eleven hundred percent of GDP. And the important thing to remember about debt is that when you have debt it requires service. So if I have a dollars’ worth of revenue growth coming into my company so at the top line I earn a dollar. Well, I’ve got to service that debt, so that takes away from my dollar that I earned by having to service that debt. So, that interest payment goes out. So, that mean less money as an investor or consumer to go reinvest capital to something productive for economic growth, and this is the big difference.
Just recently Donald Trump introduced his budget and he says okay so here’s our budget and over the next ten years, mind our we’re already nine years into an economic cycle. Over the next 10 years we’re not going to have a recession, and economic growth is going to grow to 3% and interests rates will remain fairly flat. Sounds fantastic. But the problem is you can’t get to 3% economic growth because back in the 60s and the 70s and early 80s when Ronald Reagan which is what ev
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