Karl Denninger: Watch for Market Dislocations

Interviewed by Louis James, Casey International Speculator

Louis: Ladies and gentlemen, thanks for tuning in. We're here in Carlsbad, California at the Casey Research Navigating the Politicized Economy Summit. We've been talking a lot about politics and about investments, and here with us is Karl Denninger. Karl, for those who weren't with us here, can you give us the thirty-second version of your talk this morning?

Karl: Okay. The presentation this morning was intended to focus on how we got into the mess that we are in, where the distortions are, and more importantly, where the most important elements of what is likely to come in the next couple of years are going to emanate from. So if you wanted to look at it in thirty seconds, it is in two places. It's in the household sector which everyone says has de-levered and has not, factually, and it is in the explosion in medical care spending, which is the most unappreciated area within the federal government's realm. Although everybody talks about it, nobody actually looks at where the underlying problem is within that realm.

L: Wow, that really was thirty seconds. Okay, let's take the housing one, because I think that will surprise people a lot. The housing bubble has popped, people think. Why are you saying otherwise?

Karl: Well, because when you look at the facts, which unfortunately economics ultimately devolves into–

L: Darn those facts.

Karl: Yeah, darn those facts and darn mathematics. What you find is that the total amount of outstanding mortgage credit has declined by a little less than 10% from the peak. Unfortunately, the value of homes has declined by about 30% from the peak. And what this means is that the overall leverage in the housing sector has actually gone up instead of down. So when people say that the housing market has de-levered, what they're really saying is that the notional value of home mortgages has gone down by some small amount. But it was at levels that were utterly ridiculous before; and when compared against GDP, it is still 50% too high. So we have another 50% decline, approximately, in the price of homes in front of us – or we have a doubling of GDP. The latter is not likely to happen anytime soon, so you take a look at what you think is the more likely outcome.

L: Okay, no argument. It makes sense. Kind of scary. What about on the medical side?

Karl: Well, this is the part of the economic picture that nobody wants to speak to, especially within the Republican and Democrat parties, and even within the Libertarian party. This is a little surprising because Gary Johnson, of course, has talked about cutting 43% of the federal budget. The problem within the medical system is that medical spending has gone from approximately $53 billion – and this, again, is just the federal government, not private money – to $850 billion last year. That's from 1980 to today. That's approximately a 9.3% compounded annual rate of growth. That means that the rate of spending doubles every 7.7 years, which means that again, in fifteen years we will be spending approximately $3 trillion by the federal government on all medical services provided.

No we won't, because the entire federal budget is $3.8 trillion. So the real question here is not, "Can we fix Social Security and Medicare?" (And all the politicians like to conflate these two things to scare seniors.) Social Security is very easy to fix. You simply index it to longevity, and the problem goes away. Medicare and Medicaid can't be solved. You have to attack the medical system, not Medicare and Medicaid, and until we do that we are faced with the realities of exponential credit growth. Unfortunately, that means that somewhere in the next four to five years there is a hard wall that we are going to hit at the federal level, and the government is going to come apart if we don't do something about it.

L: And the underlying factor there that's causing these cost increases? Is it the bureaucratization of medicine, is it… ?

Karl: It's the monopolization of medicine at all levels. Medical providers of all forms – whether they be hospitals, physicians' practices, advanced technologies such as MRI practices and things like this, or pharmaceutical companies – all have protections in place at the federal level and at the state level to some extent, that give them the ability to do things that would be felonies if they were committed by anybody else. Just as one example, you have to have a license to open an MRI in a new facility, a new business in thirty-some states. This is under state laws that are called CON laws – "certificate of need"–

L: [Laughs]

Karl: Con is probably the better word. The board that makes this decision is made up in the majority of people who have a great interest in seeing the price of these services remain very high. So if you come in and you say, "I want to open an MRI center, and I'm going to charge $200 to scan your knee," where the current price is $2,000, you will not be given a license.

We also have the crazy distortions that show up in situations like what happened out West recently, where a lady recently got stung by a scorpion. She got an $80,000 medical bill from the hospital for two doses of antivenin. The problem with this is that the antivenin was made in Mexico. The factory is there. It costs $100 in Mexico; so it was marked up some 4,000% by the provider of the drug, the distributor, in the United States, and then marked up another ten times, so you have a 40,000% markup by the time you get from the manufacturer of the drug to the patient. The question that arises is how can that happen, and the answer is, the same way that you can't go into Canada, buy up a whole trunk full of Viagra at $2 a dose and bring it back across the border, destroying the $25 market price here in the United States – and that is because it is a felony and you will go to prison.

So we have in the United States put together a series of laws that effectively protect practices that would be illegal for anyone else to undertake in any other line of work. I ran an Internet company for close to ten years, and if I did any of these things, I would be sitting in prison right now. Until we stop this, the growth in cost will not go away.

And you cannot shift this into the states. For example, Governor Johnson says he wants to block-grant Medicare and Medicaid to the states. Ryan has said something somewhat similar to this with the vouchers that he's talked about within his program. Taking a massive budget problem and moving it from one place to another does not fix it any more than taking a $20 bill out of your left pocket and putting it in your right makes you more wealthy.

We have a series of very powerful people in industries that apply their lobbying prowess to our government, and they get these protections put in place. This has come about over the last 30-40 years. EMTALA is a part of this as well. That was a law passed by Ronald Reagan that says that if you are an indigent and you have a heart attack, for example, as you are walking down the street, they must treat you, irrespective of your ability to pay. So this destroyed charity care within the United States and now, as a result, your care is escalated in price by whatever it is that the hospital has as unreimbursed.

L: That's really interesting. I've always wondered why Moore's law doesn't seem to apply to medical technology. You know, why is it that with technology, everything is faster, better, cheaper every year – except in medicine it goes the other way?

Karl: Because the medical industry has gotten special laws passed to protect them from the forces of competition. This sort of a situation could never arise in a free market, because somebody would come in and undercut whatever was being done. If you could open up all the MRI centers that you wanted, you could go in and get your arm or your leg or whatever scanned for a couple hundred dollars and pay cash.

The nasty part of this is what it does even to routine things that we all understand. Babies are born to millions of people every year, for example. It's a very common procedure, of course. It takes place in a hospital. If you take the 1963 cost of having a baby, including four nights' stay in the hospital, and you inflate it by the Consumer Price Index from 1963 to today, having that baby in the hospital should cost $950. Now, anyone who has actually had a child at some time in the last 10 or 15 years knows that you need to add at least one zero to that price if you are actually going to the hospital to try to have a kid. So the real question becomes how does a hospital get away with this, when there should be another hospital down the road that says, "Well, gee, you can have a luxury suite here for that kind of money. Why don't we just have a really nice room and some very skilled doctors and you can have your child and have that child here for $1,500?" And the answer is because you have all of these protections that make that impossible. The market is not allowed to work.

L: Okay, so let's pull back to the big picture. Consider somebody looking at the US economy today and trying to think about their investments and their life: "How do I plan; what do I do?" You've picked two very special areas from the broad context. Why and how does that fit into the big picture?

Karl: The big picture is this: We have all lived for the last 30 years in a world where we believe that the price of certain things will always go up – houses being one of them, stocks being another. We have also lived in a time when an insane amount of monetary inflation has taken place. Most people look at the Consumer Price Index or some other government-provided thing, or they look at M1 OR M2, the growth of the money supply, for example. But the truth is that your credit card in your wallet spends exactly the same way as do the $100 bills or the coins that are found there. So what you really ought to be looking at for the growth of the monetary base is the total amount of money and credit that is in the system, and add those two together.

When you do that, you find a very ugly picture. We now have $53 trillion approximately of credit instruments outstanding in the United States economy. The growth of that monetary base has been from approximately 150 to 175% of GDP back in the early 1980s, to 350% today. Where has it gone? And the answer is into the S&P 500, which went from 100 in that timeframe to 1,400 today. It went into houses, which have gone up at a massive radical of the Index itself, in GDP.

So, what is likely to come? Well, exponential series only continue – and the trends in the economy that are driven by them only continue as long as you can continue to find a greater sucker to put on ever more debt in this particular case. That is no longer possible. We have already found that out. The only place where that is happening today is in student loans and in the federal government, so you only have two suckers that are trying to prop up all of these asset prices. This will fail, and when it does, you're going to see a massive amount of deflationary credit contraction within the system as a whole. So from an investment perspective, the answer is take duration risk out of your portfolio, because duration is death if you happen to get caught on the wrong side of one of these events. And the second thing is to shorten your swing generally and be prepared to take advantage of conditions where you buy cheap and sell expensive. This is how everyone always makes money.

The one thing that people need to keep in mind is that the best investments are the ones that cannot be deflated, inflated, or taxed; and what are those? Those are the ones that are sweat-equity based things. So if you are able – everyone has a skill; let's say that yours happens to be that you're a very good CNC machine operator. You know how to make parts of a CNC machine, but a decent CNC machine costs $500,000. If somebody gets in trouble because they over-levered themselves buying one, you might be able to pick that machine up for $10,000-$15,000. During this time period, that gives you a tremendous advantage over everybody else who is then going to try to sell those parts into the economy. This is how you build real enterprises and real wealth, because at the end of the day, the only way that we build actual capital – which is what wealth really is when you get down to it – is by mining something, manufacturing something, or growing something. Everything else that we do – all of the leverage that we pile upon leverage – is just claims on paper.

L: It's a shell game.

Karl: Yes; you're just moving things around.

L: Okay, but most of our audience are not machinists, they are investors.

Karl: Right.

L: Can you give us some examples of how as an investor you would play this, given what you see unfolding?

Karl: You look for special circumstances. You look for instances where companies have been beaten down or sectors have been beaten down far beyond their intrinsic value, and that is when you try to pounce. If you are not able to actually go out and set up your own business because you don't want to – if you are a passive investor in other people's businesses, for example – then you want to look for those opportunities. You want to look for things that are mispriced. Right now, everything looks expensive relative to value. This is one of the problems today. I can look at a dozen different industries and I can say, where is the real value, for example, in Amazon? It's a company that has a sky-high valuation, a couple hundred times earnings, and it is all predicated upon the exponential increase in growth of their sales. Well, that's a very nice premise, but it is eventually going to fail. The problem, of course, with trying to short a stock like that is that it can go up far longer than you can remain solvent. You get margin-called out, then you end up being proved right, which doesn't do you any good at all. So trying to be on the other side of–

L: Sorry, do you ever short?

Karl: Oh, yes. All the time. During '08 and the early part of '09, I was massively short a lot of things, including banks. Washington Mutual was a great example: they were paying dividends out of money they didn't have. When you identify companies that are doing things that cannot continue, then that is an excellent opportunity on the short side. But what you need to be realizing there is that money management is the key to success no matter whether or not you are right or wrong, because timing is extremely difficult to get accurate. From an accuracy perspective, you don't have to be right all the time, you just need to be right half the time, but your money management has to be excellent, because otherwise you will find yourself being vindicated – but after you have been forced to exit whatever it was that you were trying to do. Right now, it's very hard to find examples of companies that I think are undervalued on a relative value basis compared to their equity prices.

There was one example very recently, though – Sprint, which everyone thought was going bankrupt. I wrote several articles and said that I believed they had to break the glass, which is what happens when you're the underdog and you're being shredded. You need to look at what you can do that's different, how you change the paradigm in the marketplace. And they did exactly that. They went to a true unlimited-data pricing model, they brought the iPhone and other high-end smartphones into their prepaid service – which nobody was doing at that point in time – and it has been rewarded by not only the change in their stock price, but they were also able to refinance a lot of long-term debt that threatened to damage the company or perhaps take it out of business. The bankruptcy risk is now essentially – or at least from my perspective – off the table, and the stock price has gone up dramatically. So there's always an opportunity in these kinds of dislocation events. You just have to be very careful that you don't jump on a bandwagon. Facebook's another example. People thought Facebook was going to be the second coming of Jesus, and of course it has cratered.

L: 800 PE. [Laughs]

Karl: I looked at the S1, and then I looked at my own experience. I have an online trading forum. I run a blog. I run advertising on those things. I looked at the advertising and the number of clicks that were coming in from both the desktop users and from mobile users. As the world is transitioning more towards the handheld, the person with their cellphone, I said, "Okay, how are these guys ever going to make any money in this second paradigm when I can see that I'm getting 3% of my revenue from 30% of my use on the handheld side?" And the answer is, "How are they ever going to monetize this?" If they can't turn this into money, then all the great plans in the world are worth nothing. And I also look at the fad factor there, because look what happened to MySpace, just as another example. Another teenage fad scheme that seemed to be working out very well for the people who ran it, and now nobody even knows what that name is.

L: It's interesting the way you describe your views in what you see coming. It sounds an awful lot like Doug's Greater Depression – "the rock and a hard place; there's no real way out." The reality of politicians embracing the harsh medicine they would need to, to change something significantly just doesn't seem to be there. Is that right, or is there a way out of this?

Karl: Not an easy one, no. And one of the problems you have is that because of the way geometric series work, if you wait another doubling time, you have to double the amount of damage you have to take. Back in 2000 is when I first started looking at this stuff and started writing about it. I had given a couple of interviews during the late 1990s after I sold my Internet company. I had said I thought Amazon was a $2 stock. It actually bottomed at $4 during the depth of the tech crash. And I also pointed out that these companies had claimed the gross domestic product of the world in their S1s – something like 60 times over. That meant that essentially all of them were going to end up zeros because you can't have more than 100% of anything, right? That of course turned out to be true as well, but the real question there was what was the structural imbalance in the economy at that point in time? And the answer was about 10%. So at the 2000 point in time, we needed to be willing to take about 10% off the economy, off GDP, in order to correct this, and about 10-15% off the size of the federal government in the budget. Fast forward to 2007 after we, instead of doing the right thing under George Bush, did the wrong thing and blew another bubble, and now the correction that had to be taken was about 20%. Well, 20% is approximately equal to the decline that you saw during the Great Depression in the 1930s from top to bottom, and it's a horrific contraction both in the size of the government and also in the size of the consumer economy. Now let's put four more years on this. Today, the imbalance is closer to 40%.

L: Whoa.

Karl: So how far do you go before the market gives up on this? I can put a mathematical number on where we hit the wall from a standpoint of federal revenues and federal expenditures. What I can't tell you – and nobody can tell you – is exactly how long does this go on before people in the bond market in particular say, "We're not going to play this game anymore." Look at where the positioning is right now. The Federal Reserve, through Operation Twist, has essentially dumped all of their short-term securities. So they own no short-term Treasuries at all for all intents and purposes, but they are 70% of the long-term market from 10 years on. That's a serious problem, because now the liquidity's been destroyed in there from the standpoint of the investor. If you end up with a market that is not really a market anymore, then you end up in a situation where somebody has all of the levers and can push and pull them. But what people have to realize and understand is that when you emit more credit into the economy – which the banks did during the 2000s and which Bernanke is doing now – you are not actually gaining anything. It is a hidden tax on everybody in the economy – on all of the capital that has previously been produced and reduced to money, all of the assets, and on all of the people and their earnings, because you are deflating their purchasing power. And by doing this, you make it less possible for them to pay taxes in the future – and at the end of the day, only employed people pay taxes. So the sustainability of government comes down to "Can people afford to be hired?" It's not just a question of whether or not you can go out and you can find a business case to hire another employee. It's also a question of whether or not the person can afford to take the job.

L: Okay, well these are different specifics, but it sounds very much like Doug. On the other hand, I'm not hearing anything about precious metals from you. Does that fit into your picture?

Karl: Yes and no. The problem with precious metals – I would like to separate them into two groups, okay? Silver, for example, although it's considered a precious metal, also has an industrial purpose.

L: As does platinum.

Karl: As does platinum – well, platinum particularly, because of the catalytic converters and everything else. Silver, however, is used in all kinds of electronics. Gold to a small extent, but for the most part, gold is either a numismatic metal or is conceived as a store of asset value as opposed to something that is used in manufacturing.

The problem with metals is not that they are not in and of themselves a stable store of value. A one-ounce gold bar in your hand will never be anything other than a one-ounce gold bar in your hand. However, unfortunately, what we've done is financialized the trading and the execution of all of these things. So the value of a one-ounce gold bar in your hand is no longer set by the number of one-ounce gold bars that exist. It is now set by the number of futures contracts that happen to trade over the CME every day. And because we have financialized these things, it is impossible to discern what the actual value is of the underlying asset that sits behind these contracts.

There are a number of people who will argue that all of this is a manipulation game that is played by the large banks in order to hold down the price. The truth is that any producer that has a single scintilla of intelligence will sell forward all of his expected production over the life of his mine the minute he determines what that expected production is, as long as it is above his cost, because it locks in his profit. So If I have a cost of production of $500 an ounce out of a particular mine for gold, and the current price on the market is $1,700 an ounce, I'd be out of my mind not to short all of the contracts that I expect to deliver over the next two years into those contracts, because I have guaranteed myself a $1,200-an-ounce profit. Why would I take the market risk that the price may collapse in the meantime? I'll take the $1,700 right now, thank you very much. So the question to ask for people in the mining business in particular is, "Does your balance sheet reflect the pretax operating margin that you have from your claimed cost of production versus today's price in the open market? And if the answer's no, please explain why." [Chuckles]

L: Okay, two different directions here – the mining and the metals themselves. Do you see gold as a means of protecting wealth in case of serious crisis? Or is it a barbaric relic?

Karl: I don't think it's either. I think that gold is probably a means of stable return measured against real things. In other words, if I look at the economy not in terms of dollars, but in terms of the number of miles I can move in my car with the fuel that I put in the tank or the number of loaves of bread I can bake with bushels of wheat or the amount of corn that I can use to either eat or feed animals or whatever have you, then yes, I believe there is some stability there. And if you look at history, I think that you will find that that bears out fairly well – that when you compare against actual things, there is a decent correlation of protection. What I think people are a little off the ball on is that they are all using gold – and other precious metals to a lesser extent, ones that have industrial use – as a means to try to hedge what they see as a potential hyperinflationary scenario. And the problem with hyperinflation is that in a fiat-currency realm – where all money is debt – somebody has to take the debt up in order to be able to hyperinflate the currency. The only way that that doesn't happen that way is if they were to change – well, if Ben Bernanke was, for example, to send everybody a $500,000 check unbacked by anything, which under current law he cannot do. Congress could change the law and allow him to do this, and that is exactly what happened in Weimar Germany. The German government decided to just start issuing unbacked bills. But what happened immediately after that was that all lending ceased, because one could no longer price the time duration value of money. And so you have to be very careful with that kind of an expectation, because if you look at history, history says that the hyperinflation for all intents and purposes, very high levels of inflation already happened. What would you call something going up in price by a factor of 14 over the space of 25 years? I would call that a hyperinflation, and yet if you look at the S&P 500 from 1980 to today, that's exactly what occurred.

L: Okay, but I'm still not sure I have an answer. In the Weimar Republic, you could buy things with gold that you couldn't buy with wheelbarrows full of marks. So it did provide protection for the people who had it.

Karl: Yes, but not in nominal terms, and see, that's the important factor. If people are looking at the price of gold in dollars as a means of protecting their wealth, there's a huge problem there that is likely to arise because government – well, we saw what happened in the 1930's. Government just made it illegal to own gold, so you protected your wealth, but you couldn't touch it for 40 years. Well, you're likely to be dead before you can get to it again if something like that happens. The other problem is that government can always put a confiscatory tax on any kind of alleged capital gains, and then if the currency was to collapse, we would probably end up with entirely electronic [money]. That would mean that you wouldn't be able to perform any kind of exchange other than through barter without it being able to be attached to the tax system. So if you're looking at it from the standpoint of protection of assets, then I think it does have a place in a portfolio. If you're looking at it from the standpoint of price in nominal currency terms – you have to be very cautious.

Just as a lot of people expect gold to be $5,000 an ounce, $10,000 an ounce, $20,000 an ounce, it could be $200 an ounce. The difference is that if it's $200 an ounce, the price of a house that was $500,000 is probably $50,000. So the relative value change is the same, but people will look at that and say, "Oh, my God, I lost 75% of my money." No you didn't – you didn't lose anything in purchasing-power terms. I think you have to be careful as to what purpose you are putting to this. And the miners are just simply a way to put a leveraged bet into the market in that regard.

L: Right. What about other commodities? How does energy fit in to your picture?

Karl: Energy is a huge problem. And it links with defense, and again, this is an area that the government doesn't like to talk about. We spend $750 billion a year approximately on defense. About half of that is spent outside the United States, and we do it because we have this problem with Saudi Arabia and other Arab oil sources. And oil – like every commodity that comes out of the ground or is grown – gets priced at the margin. In other words, the last barrel of oil that you want to burn is the price you will pay for all of them. So if we were to lose access to that oil, oil would likely be $500 a barrel in an afternoon. And that would, of course, do what to gas prices? It would also be terrible for things such as food prices because, of course, the trucks have to bring the food to your grocery store. So the real question here is how do we link these things together in a way that works? And the answer is long term, we have to stop being stupid about energy policy. We have spent 40 years with our head in the sand on this. There are solutions to this problem. We knew how to fix this in the 1960s, believe it or not, and we refused to take those actions. There is a nuclear technology called thorium that has the ability to provide all the energy that we need for the next 10,000 years in the United States. We built one of these reactors at Oak Ridge in the 1960s, and we proved that it works.

L: But it didn't make a good weapons byproduct.

Karl: That's where the problem came from. You see, you can't make nuclear bombs out of the byproducts that come out of thorium reactors. So we shelved it in favor of the uranium fuel cycle, with all of the problems it has, including the drastic dangers that we saw played out at Fukushima and almost at Three Mile Island. But the other side of this is that thorium happens to be somewhere we really wish it wasn't. It's in coal, and it is responsible for almost all the lung cancers that are caused by coal-fired power plants because thorium is an alpha emitter, and alpha emitters, when they get into your lungs cause lung cancer.

We could very easily – and I've penciled this out on the back of an envelope, and it works – we could take the thorium out of the coal, use it as a power source, and then turn the coal into synfuel. The Germans perfected this process, and there is actually now a commercial plant running in South Africa by a company called Sasol. It is in commercial production, and it is producing synthetic diesel fuel at a blended cost. Now, they're not using nuclear power as the power source for it, just conventional power of about $60 a barrel. Now that happens to be 30% cheaper than what oil is going for right now. Why are we not doing this when we have 400 years' worth of coal reserves at present rates of consumption? The answer is that if you were to try to transfer petroleum into this, we would have to double the amount of coal that we use. That's uneconomic for a lot of reasons. I mean, how much strip mining would you like to do? But what if you could take the thorium out of the coal, use that for the power source, and thereby use the same amount of coal that we use today, and replace all of our foreign petroleum requirements? And the answer is, you can do exactly that. We just have this fixation with dual use when it comes to nuclear energy. We demand to be able to get bombs out of what we do, and that's why we're on the path that we are on. It's foolish.

L: And not likely to change without things breaking first.

Karl: We won't change it; but interestingly enough, the Chinese are already working on this, so we are going to get leapfrogged again. India is also working on thorium as a power source, but they're intending to use the fuel in a more conventionally designed reactor than a liquid fluoride salt. The liquid-fluoride-salt design has a number of advantages, both practical and from an energy perspective. One of the problems with conventional nuclear power is that the heat that it produces is very low quality. That's why you have to put the plants near oceans and big rivers and lakes, because you need huge amounts of cooling water in order to keep the thing under control. Liquid-salt thorium plants run at 650° Celsius internally, which is a much higher-quality heat source, so your thermodynamic efficiency is better. Only about a third of the energy that comes out of a nuclear power plant actually ends up as electricity. The rest is thrown away, and that's a result of the fact that the quality of the heat that it makes is relatively poor.

L: Okay, we've covered a wide range here. Any closing thoughts or main takeaways?

Karl: I think the key takeaway is that the government and the politicians are not going to do the right thing until they're forced. This means that you have to always be on guard for a potential dislocation event. We are in an especially dangerous time right now, because we have total gridlock in Washington, DC. That's going to persist through the election, and as a consequence, as it was in 2008, this is the time when a flock of geese can go flying into the engine of your plane and cause severe problems that you don't have any tools with which to combat. I look at the next two to three years as being the most likely time for a massive dislocation event that comes out of the markets, because I don't believe that our politicians are going to do anything effective about those two areas that need to be dealt with – specifically, the medical-cost issues and the energy issues. And if we don't fix those, we're in big trouble. But the possibility of something coming out of Europe, in particular, over the next 60 days cannot be discounted. And if it does occur, it's going to be especially ugly, because we're just not equipped to deal with it right now.

L: Thank you very much. Words to the wise.

Karl: Thank you.

Karl Denninger was one of 28 financial luminaries who offered timely market commentary at the Navigating the Politicized Economy Summit last September in Carlsbad, California. You may not have been there, but you can still hear every minute of all the presentations – which include actionable investment advice – with the Summit Audio Collection (over 20 hours' worth in all).