Transcript for Bill Fleckenstein: The Race To the Bottom Will Be Won By the Dollar (Part 1)

Below is the transcript to Bill Fleckenstein: The Race To the Bottom Will Be Won By the Dollar:

Chris: Hello and welcome to another Chris podcast. I am your host and today we have the distinct privilege of talking with Bill Fleckenstein. Bill is the president of Fleckenstein Capital a money management firm based in Seattle. He writes a daily market wrap column for his subscription-based website as well as the popular column Contrarian Chronicles for MSN Money. Bill began writing a daily column on the Internet in 1996 – oh, those were the early days indeed – demonstrating a quite early adoption of the most transformative technology of our lifetime. And from his website we get these words, “Initially the market wrap was a daily recap of market events with an added “yes – but” emphasis. I quickly learned that the contrarian view point was often misrepresented and under reported. Since then my daily column has always called it like I see it. I have tried to write the column in a way that even a novice investor can understand. I believe it’s better to teach someone how to fish rather than just give them an occasional fish.”

He’s also the author of Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve. A classic and a critical look and I think necessary look at the disastrous tenure of the man once lauded at the maestro. Welcome, Bill.

Bill: Hey Chris thanks for having me. Thanks for the glowing introduction.

Chris: Well it’s all deserved. Absolutely.

Bill: Thank you.

Chris: You know you were one of the very first that I’m aware of to voice concerns over the economy, the housing market, the great credit bubble – when virtually everybody else in the profession saw nothing but blue skies. When did you first become concerned and what specific things led you to what was then a contrarian point of view and I guess can now to be referred to as the correct point of view?

Bill: Well I learned early on in the money management business that if you can find the right ingredients on the other side of an argument, oftentimes you get a better risk/reward profile with an investment because you’re taking other the side of what are other people’s emotions. So the contrary investment strategy-type approach was something I adopted early in my career after reading one of David Dreman’s books called Psychology and the Stock Market back in 1979 or something. That kind of explained why it gives you a bit of an edge. It doesn’t make you “righter” it just means that if you’re right you're likely to get to get a bigger return. And more importantly if you’re wrong you’re likely to get hurt worse. In any case, as to when I started to really get concerned was a little bit on the early side and that being about 1996, I had never been a Greenspan fan and I had thought he was a proponent of ridiculously easy money and had nowhere near the acumen that people thought. And in 1996, I set up a short fund because I felt that his policy was going to lead to disaster and that people were going to get badly hurt. Needless to say I was about four years too early in coming to that conclusion. Little did I know that the policies and the ideas and the things that Greenspan did up to ’96 were just rounding errors relative to what he would do in the rest of his career. As the equity problem intensified it became more and more obvious it was going to end in a huge bust. I just didn’t know when, of course. And that’s the way manias are. You can’t know how high they’re going to go or how long they’re going to go. You just know they’re going to end in disaster. And then consequently they bailed out that bubble with the housing bubble and now we’re trying to print our way to prosperity.

The thing that Greenspan, Bernanke and all the proponents and fans of the Feds continually miss is – it’s the bubble that creates the nasty bust. The busts don’t happen in isolation. Much the same if you drink a quart of water and you get up in the morning, you’re not going to be hung over. But if you drink a quart of Vodka you will. And the Fed does not understand that and they continue to pursue the wrong policies to this day.

Chris: So do they really not understand? I understand being caught short once. Twice, and we’re starting to wonder about your mental faculties. Three or four times I mean – they’ve been serial bubble blowers for as long as I’ve been around in the investing world. What’s going on there? Do you have a unique insight to their culture? Is it their institution? What’s going on there?

Bill: Well, I think it’s a couple of different things. First of all, they believe in the infallibility of the Fed. I think it’s probably what draws you to the place and gets inculcated in your viewpoint. Bernanke has been very, very clear that – I’m not going to get his quote exactly right – but he said a few years back that Anna Schwartz and Milton Friedman were right and the Fed caused the Depression and he wasn’t going to let it happen again. Except that they all think the Fed caused the Depression by not pushing the right buttons after all hell broke loose. They do not understand that the reason we had the Depression was partly because of the easy money policies. You know, it was much harder to have easy money policies in those days because we were still on the gold standard, but nonetheless you could do that to some degree. And Benjamin Strong in ’26, ’27 and ’28 – they were trying to boost the economy. And the other thing people don’t understand is when you have a bubble it changes people’s attitudes and the way they behave. In the ‘20s they got leveraged up in bucket shops and we had lots of leverage. In both of our bubbles people abandoned good paying jobs to do something kooky and took on debt. So it’s not just the price action of the bubble that does the damage. It’s the way it modifies people’s behavior when you get misallocation of capital. And that’s part of why bubbles have such long clean up periods. So these guys don’t understand that. They simply do not and it’s not debatable that they don’t. Why they don’t, I can’t get into their heads that far, but they don’t. And thus, their policy response is the same thing. You got hungover by drinking too much alcohol – let’s give you some more.

Chris: Well you know, it’s mysterious to me though. It’s not a central banking defect, let’s be clear. During the housing bubble run up, the head of the New Zealand Central Bank was famous to me for noting that they were having a property price bubble – he called it as such, undertook policies to limit it because they saw asset inflation as a form of inflation. They saw bubbles developing. So this is, I think, something that was unique potentially to the Greenspan Fed and maybe that’s been continued along. But I remember being shocked: there was a paper that came out in 2007. It was from a couple of Fed staffers, very bright gentleman, PhDs both – and they basically asked the question “Is housing in a bubble?” and said “no”. And they’d compared it to income and all kinds of things. And I was just wondering – at that point in time I was one of the people that was writing pretty caustically about the housing bubble. – it seemed so obvious to me. How did they miss that?

Bill: That’s one of the things about bubbles and human nature is that they grow to the point where everyone thinks that it can’t possibly be a bubble. Hell, Greenspan made a speech and said real estate specifically couldn’t experience a bubble because it wasn’t fungible and you couldn’t arbitrage: Portland, Maine isn’t Portland, Oregon. They had a whole bunch of reasons all of which I debunked in my book, but it’s just – they start with a false premise, I believe, and that is "We can’t create a problem of this nature and thus it has to come about some other way." And let’s be clear: psychology has an important role to play. The individual has some culpability here. But when you have these back-to-back bubbles and you have the appearance of free money and people thought they learned a long lesson from the equity bubble they decided, “Oh geez, we shouldn’t have bought those crazy dot coms. We won’t do that again.” And then real estate came around and they didn’t realize anything; they just thought it was peculiar to the dot com stocks and they forgot all the other crazy things that they did. And then they did they did the same sorts of crazy things only this time they used leverage . How anyone could miss the real estate bubble, Chris, I don’t know. In fact, I think any supposed investment professional that did not see that coming and act to protect their clients shouldn’t be allowed to practice the art of managing money. I mean, how could you miss anything so huge?

Chris: Well you know: a flood of liquidity, bailouts, backstops, Greenspan puts, bubbles, all of that – it creates this overly-optimistic atmosphere, which you described using your words here: “Psychology gets deranged and nonsense passes for knowledge.” So I think we did have a lot of that derangement. The visible manifestation of that is we saw – “Okay, we can all identify the malinvestment in housing”: okay there are strip malls we shouldn’t have, maybe too many square feet of retail. We’ve got all these developments were maybe we shouldn’t have them. That’s all the obvious stuff. Can you talk to me about what’s unseen in a bubble? What else gets mispriced out there?

Bill: That’s a very good point. So behavior gets modified. So let’s say that your housing is always going to appreciate in price. You’ll always be able to take your money out, so you don’t really have to worry about saving money. And therefore you buy a third car, a ski boat, maybe a vacation spot – and you start to take more vacation. And everyone seems affluent so somebody else starts a business that walks dogs and plans parties. And there’s an incrementally extra number of restaurants and those people have employees and they get to go to things. So the knock-on effect and the piling up of jobs and things like that that really wouldn’t exist were it not for the bubble is why the job creation mechanism – we haven’t been able to really create any this time – because we had a illusionary economic recovery last time in that it was fueled by debt and equity extraction and the creation of jobs that would never exist but in a fairy-tale-like economic environment. So those are some of the things that occurred and they’re not readily obvious, but if you stop and think about it for a second and say, “Oh gee that makes sense.” So those are some of the consequences of having a bubble. In my view I have always believed that to call something a ‘bubble’ you really need that market to get so crazy that people modify their behavior such as I just described. In the equity bubble people quit jobs to day trade and do other things. The word ‘bubble’ gets tossed around all the time now. Bonds are a bubble, gold’s a bubble. This is not true. It’s the people – and the people that are using the word are the ones who tend to be the people who missed the really big bubbles. They say that pejoratively because the big price gains are in commodities and they don’t like that fact. It doesn’t fit with their bullishness on paper assets. That’s part of the reason why I think they say that.

Chris: Right. So a bubble then is technically something I’m not personally invested in.

Bill: Exactly, exactly.

Chris: I understand. I think I’ve seen that quite a bit. I’ll tell you – one of the things that I’ve been noticing looking across the world of investments is just how frighteningly correlated everything has become. I mean, especially for people who are looking for safe harbor. You want to have some money that you can put in places where it’s not all going to go up or down in the same stroke. Unless you’re playing the short side, it really feels like most of the risk assets out there are highly positively correlated. They’re trading off of dollar/Yen/Euro. They’re trading off of paper, flicking around kind of maddeningly. Where do you fall in that? I mean – those are my thoughts. I would say investing is out. I think we’re speculating. So what do you think?

Bill: I would agree with you. I think most investment specialists would agree that there seems to be – well in fact, Jim Bianco of Bianco Research was here in town and he and I had dinner. And he had done some research and it is actually a fact that the correlation between the average stock and the market is at the highest it’s been in about sixty years. It kind of fluctuates between twenty, twenty-five percent of the return is correlated with the market, and say eighty percent now. And so it’s very, very high now. I can’t say exactly why that is. My sort of lame answer is in a money printing environment – who knows what sort of relationships will take hold especially when you’re printing money as brazenly as we are now or have been and still are? The other part of it probably has something to do with the proliferation of quantitative investment techniques – computer-driven this, that, and the other thing – some combination of the two. I don’t think it’s a trend that will be with us forever. I think it’s a mindless thing that will end in tears and a debacle. Sort of like the flash crash with maybe a wake up call. I wouldn’t be a bit surprised to some variation on that theme again somewhere down the road. Don’t know when. Don’t know what would cause it, but I think it’s probably a high probability we would see something like that again.

Chris: Well that high frequency trading possibly being the culprit for that flash crash – I’ve been really disturbed with what I’ve seen. Not just in the HFT algos that are outrunning and doing these little penny pinching routines in front of all the orders, but the fact that the SEC has chosen to essentially look the other way. They need to gather information. They’re not really biting down on it. As far as I read the rules and laws – as far as I understand – maybe this is incorrect  – but it’s kind of not legal to put a quote in that you have no intention of filling. And so these guys are trading on non-public information using quote streams that seem to bend the rules, if not break them.

Bill: Yes. I haven’t really paid close attention to the gory details because I don’t care that much. But it doesn’t seem quite right. Having said that, about the SEC: they were sound asleep at the switch for a very long time. Post the 2008 catastrophe – finally, they seem to be getting after all manners of things, so perhaps they’ll address that. They have a pretty full plate I think and I’m glad they’ve finally woken up. I hope they don’t take it too far and create witch hunts. But basically it was almost as if we had no SEC for fifteen years so things got really carried away and I don’t really understand this whole purpose of high frequency trading. To me it seems like portfolio insurance did. Can’t possibly work in the end, but in the meantime it all it seems to. And I look at all of these high frequency quant trading strategies as something that will work for a moment in time – or appear to work for a moment in time – but won’t over time.

Chris: Yeah it feels like it’s not really a strategy that adds a whole lot of value to the situation. In fact, it just scoops money off the trades. I think the ultimate payees on that are probably the pension funds and the retail investors and other people who are getting front run.

Bill:  Well either that or the HFT guys all picking each other’s pockets – who knows?

Chris: Yeah that could be true too. All right, so let me shift back to the Fed a second. It feels like a lot of what we’re expecting about the future hinges on us sort of tossing a coin and guessing what the Fed’s going to do next. Luckily we know what they’re going to do for the next six to seven months and that is they’re going to monetize a hundred percent of all new incremental federal debt. Can they keep doing that? I’ve been surprised that they’ve been able to get away with it this long without the world rebelling, but they have. And our custody account keeps growing by leaps and bounds. So where do you see this going? How long can this go on?

Bill: You know, Chris, I wish I knew. I am just like you. I know it can’t go on forever. I’m a little surprised that we’ve been able to continue along this path as far as we have. And I don’t really know when it will stop – and it will stop. And I expect at some point the bond market or the currency market will revolt and we’ll have a weak dollar and bond rates will back up despite what the Fed wants. My nickname for that is the funding crisis – kind of like what the Greeks went through, but on a slightly different scale and for slightly different reasons. A lot of people may not know this, but in the late seventies we were forced to issue a bit of debt in yen and also in deutschemarks. I wouldn’t be a bit surprised if we get to that point. I mean – there’s obviously no way that you can print your way to prosperity like we’re trying to do. It’s mind-boggling that so many people seem to think that it’s okay and it’s going to work and the Fed is ever going to exit any of these strategies.

So – I mean, it’s similarly mind-boggling that people discuss deflation when you look at the prices of most everything with the exception of housing really – increasing in price. And yet, people still talk about deflation as though it was an imminent threat. But we saw in the housing bubble – people were delusional for years – same with the equity bubble. The collective crowd – once they get a silly idea in their head – seem capable of rationalizing it for a very long time. And thus, we just can’t know. I think we can know with the same degree of certainty that the equity bubble would burst and be a big problem, and that the real estate bubble would burst and be a big problem. This printing money is going to lead to huge trouble. It’s going to lead to higher interest rates. It’s going to lead to more inflation and at some point there is going to be a train wreck an the currency and the bond market, I think.

Chris: Right. So how did Herb Stein put it?

Bill: If something can’t continue it won’t? Except he forgot to say to say, “But it might go on a hell of a lot longer than you think possible.”

Chris: Which is absolutely true. I’ve been absolutely shocked watching. If you took me three years ago and said, “Chris is there any chance that the Fed could – and then you showed me a mock up of their current balance sheet – I would have said no way, no way, not a chance. The dollar is going to be toast.

Bill: And that. was my thought. At the end of the equity bubble if we had talked about it I would have said, “Well gosh take me here back here in time.” I would have said it couldn’t go here. But what was really surprising even more so was how long the real estate/credit bubble continued on. And I used to keep wondering who the suckers were that were buying all this bad paper. Little did I know it was Merrill and Lehman and all the big banks and brokerage houses buying this ridiculously worthless paper simply because the rating agencies were dumb enough to think housing prices would always go up.

Chris: These are the smartest guys in the room you’re talking about.

Bill: Yeah, those guys.

Chris: Those guys, right. I remember I was in the uncomfortable position at one point of being short a mortgage insurer at the same time that Merrill was buying it. We saw things very differently.

Bill: Yeah. I was short them also when that occurred. And it was just madness. It was utter madness. I mean – and so, but if you look back then you know what you knew, which is why you were short those things. And then you saw Merrill buying them. You think about the disconnect that had to take place. That was really monstrous. So for the currency markets to be a little slow on the uptake to get after disciplining the Fed and all that is not surprising given the level of disconnect before that got overlooked, if you see what I mean. And I think also one thing that has helped the dollar is: there’s a lot of people that think the Euro is binary in that they might wake up one morning and it might not exist or some variation of that theme. I don’t think that is going to be the outcome. But they’re probably going to up the size of the bailouts to get all the pigs at the trough past this point. Well if people can conclude the Euro won’t cease to exist or will exist in a way that is similar to what it is now then you can start to restart the race to the bottom between these two pieces of paper, i.e. the Euro and the dollar. And I think that just because of the way they are in Europe and the fact that they’ve got different countries not wanting to do this, but being dragged into it – they are being more disciplined. So if we just said okay, “Which one of these two currencies is going to race to the bottom the fastest”, I think would be the dollar. But what gets the dollar bid up is people say, “Well, God, the Euro might not exist.” So once we get past that point in time, Chris, then we might have to start thinking about, “Okay maybe the dollar is really going to come under pressure.” That’s my theory. I don’t know if it will work out that way.

Chris: It might not. I share that theory. I’ve heard a lot of people talk about currencies and relative positions. So they – I think it boils down to this statement: the dollar is the best horse in the glue factory. And so they’re looking at the relative proportions and where you want to be. But on an absolute basis it’s pretty clear that the United States is printing like crazy. And what’s been interesting to me is seeing that everybody fights their last battle. So deflation is ours – the thirties. We’re not doing the thirties again.

Bill: Exactly.

Chris: But what’s Germany fighting? Well they really don’t want to repeat the thirties as well. . . 

Bill: Exactly.

Chris: . . .but from an inflationary standpoint. So they’re going to fight that battle. And that’s just going to continue to increase the strain and the stress across those two relative currencies until I think people are going to see the absolute difference between them, which is, “Gosh, one is being created in unlimited quantities. And this other one is being managed – if you want to put. . .

Bill: Right.

Chris:  . . .value term on it: maybe more sanely or rationally.

Bill: Well, I think that’s exactly right. And the perversity of it all is we get rewarded for using a printing press rather quickly and we believe we don’t have to make many changes. Europe is struggling to fix things and raise retirement ages and all that sort of stuff and yet they get penalized. So I totally agree with you. It’s that German mentality versus our mentality. And in the end if the Euro doesn’t facture, which I don’t think that it will, then the race to the bottom is going to won by the dollar, which at some point is going to cause a huge problem.

Chris: Well on that note what I want to do is draw this portion of the podcast to a close and thank you very much for your participation and note that we’re going to continue this conversation in an area for enrolled members because I really want to find out how does that play out and what would that look like knowing that timing is unknowable, but I think that if we at least understand what the breadcrumbs are that we’re going to be looking out for and what you’re looking out for in particular in your head would be a fascinating conversation.

Bill: Great.

In Part 2: Outlook for 2011 (for enrolled members – click here to enroll), Bill gets specific about what he predicts will happen in the bond and currency markets, as well as his specific outlook for 2011. 



William Fleckenstein is author of Greenspan's Bubbles: The Age of Ignorance at the Federal Reserve and the president of Seattle-based Fleckenstein Capital. He also writes a daily Market Rap column and a weekly Contrarian Chronicles column and has his own website. In 1980, he left the computer business to become a stockbroker. He founded a money management firm in 1982, and has been bullish (and bearish) on almost every industry group, commodity, and asset class at one time or another during his investment career. His time horizon as an investor is long-term (three to five years).