Without Intervention the Markets Will Go Down

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About this week’s show:

• QE triggered a six year run up in stock prices
• Subprime crises 2? Banks brace for energy debt defaults
• So goes the Riyal, so goes the Petrodollar

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

“The Dow-gold ratio is at 16-to-1 today. What that implies is that we are in a period of distrust. It implies that we are in a period of geopolitical tension. It implies that we are in a fiscal and monetary mess. Basically, you already have the ingredients, and you are walking straight into a maelstrom.”

– David McAlvany

Kevin: David, I was talking to a client yesterday and we were just reminiscing, saying, “Wow, here we are already coming into another Olympic year. I was just thinking back from here from 2016, and took me to 2014, and Dave, we started thinking about what’s changed just since the last winter Olympics in Russia.

David: (laughs) Now we have sanctions on the Russians. We were heading over there to compete in Sochi, and of course there was little involvement in Ukraine and Crimea. A lot has accelerated in the last few years, not only in the Russian space, but move further south into the Middle East and you have…

Kevin: Syria.

David: Exactly. Isis, which was a non-entity – it may have been an entity but it certainly wasn’t in the headlines as it is today.

Kevin: And the stock market was still making money in 2014. Not like 2013 when it had made 40%

David: But it still put up a positive number in 2014. QE-3, the last round of quantitative easing, ended in late 2014, and thus began, in our opinion, the topping process in U.S. equities. What we have been witnessing from then to now is a massive topping formation – look at the August declines – which indicates that, really, without intervention, the markets have nowhere to go but down.

Kevin: Right. The central banks had not let them go down, but they still wanted to. Look at the transportation averages – we can talk about that later, but they’ve been going down for a while.

David: And that was the story going back through 2013, 2012, 2011, and 2010. Each time the stock market was ready to go down, a new intervention was introduced. That’s how we got to QE-3. Before it was number 2, and number 1, then you had TARP and TALF and all of the other interventions which were propping up a market that wanted to clear the decks, start over, get rid of the bad debt, get to reasonable value in the equity markets. So we know that without intervention, the natural level of the stock market is well below current numbers.

We also know that with intervention we have only gotten asset price inflation and not economic stimulus. That is a monetary policy failure, because it was intended to translate from asset price inflation into economic activity, and that did not happen. So the hard conclusion of “damned if you do, damned if you don’t” is gradually sinking into the collective investment community’s mind and I think that between now and the end of 2016, any rally we have, whether it is due to verbal intervention or promise of liquidity from, frankly, any global central bank – that’s going to be aggressively sold into.

The reality is that the exits are always smaller when everyone wants out. It’s a volume thing, it’s a bottleneck thing. So I think that any upside volume that we have, any bounce that we have in the U.S. equity markets over the next several months – again, I think you have people who are going to cover their footprints with that volume.

Kevin: You are talking about how we have asset price increases. The stock market seems to be everything in people’s minds as far as what’s real, what’s not real. But the GDP is really what we should be looking at. How much are we actually growing versus how much are just stocks growing? GDP estimates continue to come down.

David: It’s one of those numbers that certainly is important, you do pay attention to it. We also recognize and have talked about this in the Commentary for the last several years. They’re changing the inputs into GDP. There are certain countries around the world that now calculate prostitution and what was illicit drug use and now is a part of the official economy. They count those things into GDP as inputs. We haven’t gone that far in the United States where we are counting prostitution as a part of our GDP or economic calculations, but when you get desperate, everything gets thrown in, and we certainly have changed the way we calculate it through time.

Kevin: Even the last couple of years they added half a trillion dollars to the GDP just out of nowhere. Remember how they just started writing it in?

David: That’s right. J.P. Morgan, on Friday, was concluding that 2015 probably didn’t finish on as strong a note as they anticipated. For the fourth quarter their GDP estimates were at 1%, and they dropped them to a tenth of 1% for the fourth quarter of 2015.

Kevin: Well, let’s face it – let’s go back. We looked back to years to the last Olympics. Let’s look back six years from the introduction of quantitative easing and see what’s really happened.

David: We’ve had QE, which triggered a six-year run-up in stock prices, one of the longest runs of equity prices in stock market history, by the way. And the end of QE marked the beginning of a bear cycle in stocks and already we have many of the components in the equity market which are edging close to technical bear market territory. They were by the end of 2015 and many more have shifted that direction the first two weeks of 2016. Granted, the market is not the economy. The market has had the six-year reprieve. The gift came compliments of the Fed. And 2015, in contrast to 2014 where we did eek out a positive return – 2015 was negative except if you are looking at the NASDAQ, which did eek out about a 5% return positive.

Kevin: Dave, not very long ago you started talking about the breadth of the market, because the index can be deceiving. You can have just a very small handful of stocks pushing an index up, like we saw in the NASDAQ, but the majority of the stocks going down.

David: That’s right. So the internal dynamics, what we call breadth, have been very weak and you’re right, what that basically means is that the vast majority of stocks are suffering, while you have a few standout names that are still putting in new highs and are doing it in such grand fashion that it drags the index up. So if you’re looking at the index, it would appear to be healthy, while internally you have a lot more rot, where actually, the prices of the vast majority of shares are heading the wrong direction.

Kevin: And then there is always the cost of borrowing money. The credit markets usually tell the truth more than, say, an equity market will.

David: In the third and fourth quarter, credit markets were telling you a lot. You had spreads – that is the difference between, say, a corporate bond or a high-yield bond, and treasury. Those spreads were widening, indicating that there is a major reappraisal of risk which has begun.

Kevin: Sometimes you’re going to see in junk bonds, in the weakest bonds, your first signs of trouble, but even in corporate debt, we started seeing signs of trouble in the last quarter.

David: That’s right. Last week even more so, where corporate debt joined the high-yield paper market, indicating that trouble is ahead. And of course, if you look back to August and the very precipitous selloff in stocks, I think that was a precursor to, not only what we have here in the first quarter of 2016, but like a tremor, I think in the months ahead, what we had last week, and what our guest described last week, as part two of the global financial crisis – that is what we have in the offing.

Where does that begin in earnest? Breaking below the August levels would open up a range of negative possibilities, all heading in a negative territory, say, 30-40% below the peaks. So you look at where we are now with a downside correction of 10% for the major averages, which is what we have seen year-to-date, and that’s just a good warm-up.

Kevin: Well, you know, this whole thing has been a confidence game. You are talking about quantitative easing, but actually, quantitative easing was a perception deception – that’s really what it was, because free money was coming into the system. But this con game, or confidence game, based on central bank intervention. You have talked about once it breaks down, it is going to be hard to retrieve.

David: Yes, I think tweets and breaking news, and the short-term nature of the markets distracts people from a larger and longer-term context. And if you look at the last 18 months, S&P earnings consensus was 137 and in the last 18 months it has dropped to 106. And yet because people are expecting 106, it’s not as if things are worse than they were before because it’s in line with expectations. But what you see over that 18-month period is that the bar is being lowered – 137 to 106 is a material change in the expectations for the earnings of the S&P 500 companies.

Kevin: But do people really watch that or are they just looking at the Dow to see whether they should be happy or said?

David: And I think that’s really where, as you said, sentiment is tied into some very simple things. Although things have been changing for the last 18 months, no one really cares. I recall from several of our conversations in the last year, talking about how fragile sentiment is, and there is this element where the only relevant number for the general population is the Dow-Jones industrial average. If the Dow is up, everything is well, the economy is good, I’m positive about business, and I think we’re going to take a vacation. And you don’t even have to be invested in the Dow, it’s just a litmus test for how to feel about the economy.

And of course, if the Dow is down, not all is well, and you can hear it in the tone that the pundits take on CNBC and Bloomberg. Literally, the last week of the year, they were talking about how positive 2016 looks, and in the first two weeks of the year they have done an about-face, everything’s negative, everything’s dark, everything’s coming to an end. Why? Because the Dow is down 1500-2000 points! So what changed? Nothing fundamentally changed. Sentiment is that fragile. It ties to one particular litmus. And so, as goes the Dow, so goes consumer behavior, so goes the average belief of our politicians.

You know who is supposed to be immune to this? The folks at the Fed. Janet Yellen and her whole crew should not pay attention to what the Dow and the S&P are doing. Their stated objective is price stability and full employment. Whether you like the fact that they have two objectives or not, price stability and full employment – you tell me what the current status of the S&P 500 or the Dow is. What relevance should have that have to them? And I guarantee you, in any meeting, that is going to be on the table.

Kevin: Dave, sometimes you can live in the past and your perception doesn’t change with the world. We talked about how much the world has changed in the last two years since the last Olympics. But let’s go back to the 1980s. I was a young married at that time, and really, the Dow, the United States – whatever went with the West went with the rest of the world. We were the greater part of the world economy. That’s not the case anymore. The emerging markets that we think of as these little outliers, have become the greater part of the world economy. As they go, maybe now that is how we’re going to go.

David: The success story of globalization is that a tremendous amount of wealth has been created over the last 20-30 years, and many countries which were relegated to “third world status” have been lifted. Average incomes have lifted. If you go back to the 1980s emerging markets were under 36% of global GDP.

Kevin: About a third of the world’s GDP.

David: That’s right – combined. The chief economist at the IMF, [Maurice] Obstfeld, has said, “Look, they were 36% of global GDP. Now, collectively, they’re 56% of global GDP.” So the world economy is driven by the emerging markets in aggregate more than it is the U.S. and Europe. So weakness there is weakness in the global economy. You can no longer say, “We are the big dogs, if you will, and we kind of call the shots.” And to a large degree we do call the shots in terms of monetary policy and its trickle-down effect. But if you’re looking at aggregate transactions and dollar flows and capital flows, 56% is still more than the other side of the equation, right? So what it means is that weakness there is weakness here in the U.S. And we’ve already seen this show up with a number of multinationals. Multinational earnings have signaled a major decline in demand overseas for U.S. products, and a part of that is an affordability hurdle.

Kevin: Right. The currency moves down for all these emerging markets have got to have an effect on profits for U.S. multinational companies.

David: Yes, so depending on what perspective you take, either their currency moving down or our currency appreciating, our stuff in U.S. dollar terms is losing its staying power in terms of a competitive advantage. So the slowing growth in the emerging markets is not unlike the slowing growth in the developed world. Because look what you have. You have mountains of debt, and those mountains of debt, there and here, require massive interested payments which are sucking away any excess capital that would be used to grow the economy in other ways. So literally, they overspent in the today, and now we’re in the tomorrow, and they’re reaping what they already sowed. So from 2008 to 2015 the Washington Post reports that your corporate debt in the emerging markets grew from 8.9 trillion to 24.5 trillion dollars. So again, with slowing growth and bloated balance sheet, way too much debt on the balance sheet, all the excess income that they would have, whether it is for social programs or growing this or growing that – guess where it’s going? Interest payments.

Kevin: Right. And you know, we’re creatures of conditioning, Dave. It’s like Pavlov’s dogs. For the last six, seven, eight years since the financial crisis we’ve seen intervention after intervention after intervention and it doesn’t feel – we may have signs that it is a bear market in the stock market but for the traders, themselves, it doesn’t feel quite yet like there is fear in the markets. They’re so conditioned to just go in and buy the open, buy the open, because they know the Fed has their back.

David: Yes, Bill King has noted this every day since the beginning of the year. We have nine consecutive trading days leading up to last Friday’s triple-digit decline, where Bill King notes that the stock market opened and traders piled in. Granted, the end of the day was awful. People had lost money. With the exception of Thursday last week people were losing money hand over fist after piling in, afraid that they would miss the rally.

Kevin: The rally.

David: And pundits talk about negativity, but the actions of money managers and individual investors seemed to be rather bullish. The fear in the marketplace of still missing out on potential returns – that does not look or feel like a market bottom. I think we will have a real market bottom, whether it is in 2016 or 2017. This ties directly to what Ian McAvity was saying last week. You get to a Dow-gold ratio of 2-to-1, and you’ve just got to noodle on this if you don’t understand this concept, think about it and mull it over. The relationship between the Dow and an ounce of gold being 2-to-1 implies either a modest increase in gold and a precipitous decline in the stock market, or a modest decline in the stock market and a radical rise in the price of gold to get you to a 2-to-1 ratio. You’re at 16-to-1 at the present.

Kevin: And he brought up the fact that that has happened numerous times over the last 100+ years. So if the traders don’t feel like it’s a recession yet, and they’re still worried about missing the next rally, the true signs of a recession are energy, commodities – those have been screaming recession for while.

David: Right. I think the world being in recession has been confirmed by commodities. This was a 2014 discussion that you and I had looking at the Australian dollar, the Canadian dollar, copper – those three things would tell you just how bad a deflationary recession was. And lo and behold we have the Australian dollar, the Canadian dollar, and copper absolutely on the floor. Oil traded below $29, the Dow Jones Transportation Average has declined sharply here in 2016 after putting in an awful performance in 2015. Biotechnology stocks have started to implode, last week was very telling. The Russell 2000, which we’ve mentioned, covers a broader cross-section of stocks – it’s down 21% from its high, so in bear market territory. And if you look at the S&P 500, the majority of stocks, as we mentioned earlier, are already in bear territory, that is, being below their 52-week average by 20% or more, and it’s just a few bellwethers that are massively outperforming that have propped the indexes up. Again, this is the issue of breadth. The general trend across stocks has been down for some time, with the indexes covering up the poor performance of the majority due to the outperformance of the minority.

Kevin: So when people say these are black swans that you can’t see, that’s just a lie, Dave. You were talking about breadth when the stock market was still looking like it was going to put in a fairly good year. It lost a couple of percent by the end of the year, but the breadth was telling us the majority of the stocks had already turned bear.

David: Ignorance is usually a choice, and when you look at the two elements that typically trade up when you have a robust economy, or trade down together when you are on the cusp of, or actually in a recession, you have oil, and you have the transportation average, and they move in lockstep, depending on the strength of the economy. And you have both of them absolutely on their keisters. And it’s not just oil, because if you look at Bloomberg’s commodity index, granted, oil is one of the components in it, but it finished the year, last year, down 19%.

Kevin: Well, this is a big week because Iran is coming back on line with huge production of oil – huge. They’re one of the major suppliers. How is this going to affect those markets?

David: Within 48 hours of Iran bringing online close to 500,000 barrels per day, Russia radically reduces its production by something like 460,000 barrels per day, so the net effect of Iran coming onstream because the Russians were willing to give up some market share means that the price may stay stable and around $30. What happens if Iran wants to go back to their 1970s, 1980s production levels? They can produce 3-4 million barrels per day, and that is not out of the realm of possibility.

Kevin: And they’re no friend of Saudi Arabia anymore, not that they ever were, so they’re not really willing to play ball with the OPEC line of thought, are they?

David: No, they’re not, and I think it is worthy of noting that there are other types of crude – we have Brent crude, we have West Texas intermediate, but there are other types of crude which are already selling at much lower levels. You have Saudi Arab light which is closer to $25 a barrel as we speak. You have Basra heavy which is at about $17-18 a barrel. And the low tick last week was in the Dakotas, this past week, and again, this is due to transportation constraints, but it was actually negative 50 cents for a barrel of oil.

Kevin: So they were paying people to take it off their hands.

David: Right. And it has to do with massive sulfur content, which won’t be shipped through pipelines anymore, I think, because of its corrosive nature, so getting it to market is the real issue. I would say that oil, if you take all that sentiment from a birds-eye perspective, it’s in a full-scale depression. In the oil patch this is not recession. And is amazing to me is, the oil majors, if you look at their stock prices, they do not reflect that yet. And I think that will continue to change as the hedges that they have on current production mature and they roll off those majors and their share prices should suffer, I think, considerably, over the next 6-12 months. So here you have the Iran with the ability to drown the market in oil over the next 6-12 months, and some interesting questions.

Kevin: Petrodollar comes to mind. The strength of the U.S. dollar is oil. You can’t buy a drop of oil without a U.S. dollar. What happens if that changes?

David: Right. And we see these massive devaluations occurring in currencies all around the world and the one standout has been the Saudi real. It has stayed – well, why hasn’t it moved at all? Because it’s pegged to the U.S. dollar. And at some point, the peg breaks. And the question in my mind: Have we at long last said goodbye to the petrodollar era? And the day the real peg to the dollar breaks, I think that is the end note, if you will, the very end of the book, we can close that chapter, we can close the entire book. The petrodollar era will have been over.

We mentioned other commodities. Yes, the Bloomberg commodity index is down 19% last year, but look, copper was down 25% for the year, iron ore was down 24% for the year, coal was down 32% for the year, aluminum was down 19% for the year. Gold, yes, it was down 10.5%. Relatively, let me argue that it was healthy, and here’s why I think it was healthy. It was trending higher at year-end, even as the dollar was rising, which again is just telling you something about the capital flowing into it, and I think, again, of note is this relative difference between gold and the industrial commodities. At the end of the year there was a difference – 10 versus 20 or 30% in terms of losses, but since the beginning of the year it’s been pretty interesting, too.

Commodities have initiated another leg down, a considerable leg down. Almost across the board commodities are lower here in the first several weeks of the year. Gold has held up. Gold is up, so far, this year. In fact, gold is up even as the dollar has been climbing, and we’ve even had the opportunity for it to do something kind of odd. Stocks have sold off and bond prices would have normally gotten the rotation of dollars coming out of the stock market. And what happened to the bond market? Prices were actually declining, interest rates were increasing. That is somewhat counterintuitive, but it suggests that the size and scale of liquidations on the treasury market are larger than anyone expected.

Kevin: This is saying something different about gold and commodities. Commodities have been falling, the stock market has now been falling, but the foreign currencies have also been falling. So if you’re anywhere else in the world – and we have a lot of international listeners – they’re sitting there saying, “What are you talking about gold being down?” It’s only down in dollars, and that’s hard for an American to get their mind around the fact that around the world the emerging market currencies have been falling relative to gold. Gold buys a lot more copper, it buys a lot more oil, it buys a lot more of the things you need to make things – aluminum, what have you. So it is interesting to see gold playing out as a monetary metal, and a monetary hedge.

David: Right. We’re basically almost at the exact levels, slightly below the levels we were in terms of purchasing power, if you’re talking about milk. Gold buys you roughly the same amount of milk as it did when gold was peaking in 2011 and 2012. In terms of maintaining purchasing power and taking currency out of the equation, assuming that gold is the currency, and it’s just the commodities we’re talking about buying, virtually nothing has changed in the ratio between wheat and gold. By the way, this is nothing of my own creation. Charles Vollum – pricedingold.com – it’s an invaluable resource to be able to compare these assets and see what gold is doing relative to the things that we purchase on a routine basis.

Kevin: It’s a little bit like having gold in your wallet. The way he looks at it, he says, “Let’s pretend you have gold in your wallet, not dollars in your wallet. How much does that gold buy of wheat, corn, milk, copper?”

David: Do you eat bread? I do. Except for Tess, she’s gluten-intolerant. But we do eat a lot of wheat in the house, so it’s relevant that one of these measures of relative value is wheat. And in gold terms, it’s virtually unchanged since 2011, 2012. Gold peaked then, it’s down by X percent, unless you’re looking at what it purchases. And what is purchases – it’s got virtually the same spending power. So it’s just kind of interesting, same with copper. Copper is down, gold is down, but from 2010, 2011, virtually the same kind of behavior.

Kevin: Dave, there is a movie out called The Big Short that talks about how you had all this sub-prime material that was on the market and it was bound to collapse. You had a huge amount of debt based on bad real estate loans – this was back in 2007, 2008 – and of course it did crash, and everyone said, “Oh, we didn’t see it coming.” But the movie is about how, yes, you could easily see it coming, there was just denial. I’m wondering, right now, if we’re not possibly going to see something very similar to this based on the debt and this huge margin that has been created in the energy sector. We talked about two years ago, the last Olympic year, the United States was super-excited. We had oil near $100 and we had fracking going on. We had a huge amount of leverage and margin going into the energy sector from the big banks. Now they’re holding those loans that they can’t possibly pay.

David: Right. It’s what they call redeterminations, and it typically happens in the spring and fall. Banks reappraise the value of collateral and that secures the gas and oil loans they’ve made. So, if prices of a commodity are down, then reserves and resources are given a new market value and then there is an adjustment made to the credit facility or loan, typically lower, so liquidity begins to dry up, credit begins to tighten, and the redeterminations, typically, again, are in the spring and the fall. Rumor has it that banks are being encouraged to forego this exercise and not mark the assets to market.

Kevin: Boy, does that ring a bell? Do you remember talking about not marking assets to market back in 2008, Dave?

David: That’s exactly right. And in this environment, if they were to mark it to market, here’s the implications. It further pressures the whole sector. And in a somewhat circular manner, it ends up pressuring lenders at the same time. So, no surprise, then for us that the Dallas Fed is encouraging forbearance.

Kevin: In other words, “Hide it.”

David: (laughs) “Well, listen, don’t force bankruptcies. If you need to liquidate some assets do so, but try not to bring this into the light of day. Just kind of keep your heads, things are going to get a little rocky, but that’s okay, we’ll make it through.” And I guess what the Fed doesn’t like there is Dallas is, they don’t like the default daisy-chain that they see within the banking community where you begin to see weakness in one bank, and there is a cross-contagious effect to other banks. Wells Fargo has reported numbers here recently, and it was interesting to see that they have about 17 billion dollars in energy loan exposure. And so oil is now at levels we haven’t seen since 2003. Should they increase loan loss reserves since they have 17 billion dollars at stake? And they did. But only by about half of one percent.

Kevin: So, like nothing.

David: They are assuming that they made all the best loans and nothing bad can happen here. And my assumption is that the only way they can operate on that basis is either in sheer stupidity and ignorance, or because they don’t have to mark those loans to market and the piper will not be paid within the banking community. Why? Because ultimately, the Fed, which is the central bank to whom? Who are the major clients of the central bank? Regional banks. Ultimately, we know who is buttering whose bread.

Kevin: This is a replay, Dave, of the bad mortgages. They were told not to mark to market on those bad mortgages, as well, and we had to have a huge 4 trillion dollar government bailout.

David: And then in the aftermath, you have these things like Goldman settles their Department of Justice case this week with 5.1 billion dollars. The civil penalty was just about 2.4, you had an 875 million-dollar cash payment, and then consumer relief to the tune of 1.8 billion dollars. And the amazing thing is that Goldman was setting the records in 2010!

Kevin: Yes, when it was half a billion.

David: That’s right. New records set with SEC judgments – $550 million is what Goldman had to pay. 550 million – and now it’s 5.1 billion – we’re up nine, almost ten times. What changes in five years? Surely, not the value of money. Now, it seems almost insignificant that the SEC is at the same time fining Goldman-Sachs 15 million dollars for their involvement in naked shorts.

Kevin: Selling something you don’t own.

David: Yes. When you sell something short you have to go into the market, borrow that, and ultimately give it back. But if you sell something short on a naked basis, you’re not actually taking possession of the shares, you’re not in possession of the shares and you can short, basically, an infinite number of shares, if that’s the case. Considered illegal, considered highly manipulative, considered dangerous, and ultimately destructive to the capital markets. That’s why the SEC is slapping their wrists for 15 million dollars, but I will remind you, one of our conversations six years ago was with the CEO of overstock.com and he was basically saying, “Look, I know that this is happening, I can prove it, and I can tell you three or four of the big banks that are absolutely abusing the capital markets and abusing investors, with the ability that they have using this loophole we call naked shorting.”

Lo and behold – again, does anyone care about Goldman-Sachs’ misdeeds? What happens to their reputation? Think about this – 5 billion dollars in fines. Granted, these are civil penalties and not criminal, and that was probably why they signed off on paying 5 billion dollars, but I feel like watching Goldman clients today is like watching a replay of Patty Hearst. This is the Stockholm Syndrome all over again.

Kevin: I have wondered that, Dave, because you see Goldman Sachs not only making money all the time, themselves, but a lot of the clients losing money most of the time, themselves, yet they still want to be a Goldman client. And I’m thinking, what is it? Is it prestige? Is it just, do they want the punishment? Or, you brought up something interesting. Like the Patty Hearst thing, maybe they think that Goldman-Sachs actually is out for their better good.

David: I mentioned 1.8 billion dollars in consumer relief. That’s not going to Goldman clients who actually were fleeced by Goldman. It’s going to the people who are behind the mortgages which Goldman was selling, and the CDOs which Goldman was selling, which is interesting because, actually, Goldman had no contact with those people, whatsoever. They happened to be buying and repackaging. And they bought an already securitized package and just repackaged it again – financial engineering, if you will. But it is interesting, this Stockholm Syndrome on Wall Street. Confidence gets abused, Goldman clients take pride in being abused, and it’s almost like (laughs) maybe the vampire squid is just misunderstood. “You just don’t understand, he’s really a nice guy.” I don’t know, it doesn’t make any sense to me.

Kevin: In contrast to Goldman-Sachs, who obviously is virtually always bullish in the market, the Royal Bank of Scotland said something that was just bone chilling a few days ago. They basically said, “Get out of the stock market, get into cash.” Did they say into gold? I don’t remember.

David: It’s funny, Abby Joseph Cohen over at Goldman says that stocks are the best place to be right now. “Stocks are the best place to be.” RBS says, “Sell everything except high-quality bonds.” They are saying, basically, that global trade – and when they look at loans and how they are contracting – there is going to be a major negative effect on earnings in corporate balance sheets. And their credit team is suggesting that markets are flashing the same kind of stress signals that we saw in the months leading up to the Lehman crisis.

So keep that in mind, and then put this into the grid. We’ve just had four consecutive quarters of corporate revenue and earnings to clients.

Kevin: That doesn’t sound like an expansion to me, Dave.

David: How likely is it that stock buy-backs set a new record in 2016? We had 2000, we have 2007 – these are when you saw the buy-back peaks. They were desperate measures at the end of a cycle. And I think 2015 was the end of the cycle.

Kevin: And these buy-backs – what you are talking about is companies buying their own stocks to keep them buoyed up.

David: Yes. Looking at the General Accepted Accounting principles, non-GAP earnings were off 5%, plus or minus. If you are looking at things from a GAP accounting standpoint you have earnings down 13-15% heading into 2016. Where is the new driver of growth? Are we counting on the emerging markets, which are telling you they’re hemorrhaging? Are we counting on China, which is disappointing in terms of its GDP growth? Are we counting on Japan? Good luck with that, demographic winner. Are we counting on Europe? Major issues still there. The U.S., to quote Ian McAvity last week – our merits are simply being the best looking horse in the glue factory.

Kevin: Well, Dave, somebody has to be out there. There has to be some genius out there that made a bunch of money last year. The geniuses are the ones who run the hedge funds.

David: Thirty-three out of 36 hedge fund indices were down last year.

Kevin: Thirty-three out of 36 of the hedge funds, the indices, were down.

David: Last year.

Kevin: Yes. So there’s nobody figuring this out right now unless you’re on the inside.

David: And in part it’s because you have to work past the blather and the advertising and the promotionalism that Wall Street has ingrained in it, and look to some of the hard facts. Why is Walmart laying off 16,000 people? Why are they closing 269 stores? 154 of those stores, Kevin, are here in the United States. If there is not a bellwether like Walmart in terms of retail sales – we’re talking middle America!

Kevin: Yes, but somebody would say, “No, no, no, that’s just Amazon Prime replacing Walmart. But actually, if you look at December retail sales, that’s not Amazon replacing Walmart. December retail sales actually dropped.

David: The growth rate was 2.1%, which was the lowest we’ve had since 2009.

Kevin: So that’s not the replacement of Walmart with Amazon Prime, that’s just people not buying as much.

David: Or looking for the cheapest possible deals, and imagine anything cheaper than Walmart. But I think it is absolutely telling – 269 stores worldwide, 154 of those stores here in the United States closing. Do you realize the decline of Sam Walton’s empire is telling you something about the decline of our empire. I think it’s very interesting. And of course, we’re not alone. Europe is still struggling. Europe has major issues. Their debt is still off the charts, over a trillion dollars in nonperforming loans in the European banking system.

Kevin: And let’s face it, they have a whole new group of people moving in who are not necessarily bringing productive jobs.

David: Exactly. This is, again, where debt begins to be crippling. We’re not even talking about the aggregate amount of debt which they have to pay interest on. Right here, 9% of European, euroland GDP, is a nonperforming loan. 1.02 trillion dollars throughout Europe, those nonperforming loans in the banking system – just in Italy, alone, it’s 17% of GDP, 216 billion dollars in nonperforming loans. And so, yes, you still have the same debt issues we had in 2011, the same debt issues we had in 2012 – they’re lingering.

And now you layer in immigration. Who doesn’t want to leave – let’s say you lived in North Africa, where you are commodity-rich or commodity-poor, depending on the price of commodities. So that makes you, today, commodity-poor. Where are the jobs? There aren’t any. Where do you want to go? Europe, where you can have everything for free. You think the immigration tidal wave was a story for 2015, wait until you see the majority of North Africans get the first Western Union wire transfer from their friends who made it into Belgium and Hamburg and Paris.

Kevin: I hadn’t even thought of that. If you think about Europe being a mess, and we’ve already talked about our tending toward recession right now is probably an understatement. China has been the driver of growth – we know this for the last three to four decades. And China right now is putting in growth figures – obviously, they re lied about often, but we’re not seeing growth in China like we did before either.

David: No, we’re not. Again, if you listen to the narrative that’s been woven over the last two, three, four years, any time we had a bad economic figure here in the United States, it was, “That’s okay. Emerging markets look like good value. They’re going to bounce back.” And of course, it was the linkages between the emerging markets in China, so the emerging market recovery story was really a Chinese growth story, and as it turns out Chinese growth is not occurring, therefore the emerging markets are in an even worse position because of the linkages.

I just want to say one more thing on Europe before we move on because what we conclude there, as well as what we conclude here in the United States, the bottom line is that temporary relief, the cessation of panic brought about by central bank monetary policy activities – they have not changed the core credit problems in Europe, any more than we’ve changed the core credit problems here in the United States, to go from 9 trillion to 20 trillion, in terms of our national debt – that’s not to speak of an increase in corporate debt – in the last eight years we’ve doubled our debt. We’re not going to go from 20 to 30 trillion during the next administration. It doesn’t matter if it’s Republican or Democrat. We are in the doubling cycle and the timeframe is shrinking. We go from 20 to 40, not 20 to 30. Thirty is like a yellow light. You might want to consider slowing down, or just speed up because you’re going right past it.

Kevin: Yes, and let’s face it, Dave, we haven’t really felt the effects other than just keeping the pain away. Okay, so you double the debt. Then you double it again, no big deal. China is going to see that, and the People’s Bank of China if their growth is slowing down, they’re just going to add stimulus, as well. Why not? It works.

David: Right. And I think that’s an interesting idea. Francis Fukuyama developed it. In an article for Project Syndicate, he argues that the economic arms race has begun, with the Chinese choosing fiscal stimulus in its one belt, one road initiative. And they are attempting over the next ten years to redraw the economic map. The economic map of the 21^st century, according to the Chinese, will move Central Asia directly to the center of the map. That was the point of launching the AIIB.

Kevin: I think we should define terms, because we’re talking now about fiscal stimulus. You and I were talking just a few minutes ago about monetary stimulus. The Keynesian model is both. You stimulate by growing the money supply, or you build buildings and projects, and you do Mount Rushmores, and you do Hoover dams. And you do it for the people, and you spend and you spend and you spend. There is a question that I have though. You still have to borrow the money from somebody. Who pays for it?

David: I think this is where the People’s Bank of China is counting on a level of opacity which doesn’t exist here in the United States. I guess there is the opaque nature of the Fed never having been audited, but still there is some degree of accountability between the Fed and Congress. The PBOC and the Politburo – they can do whatever they want, and it’s just going to be a question of who finds out, and what the consequences are to the value of the currency.

Kevin: “You vill buy this bond, you vant to buy this bond, we don’t have to tell you what it’s for.”

David: Right. So now we have direct competition with the IMF and the World Bank, Joseph Nye’s notion of soft power, which is just, they are trying to create influence. The one belt, one road initiative is designed to connect all of China with all of Europe. Think about the development that has to take place all in between. And their approach is to create new jobs in this thoroughfare, this connection, from Europe to China. And in the process of creating those jobs you are increasing the net worth of individuals who live there, creating income streams where income streams didn’t exist before. And essentially, what you are doing is you’re creating a new market for Chinese goods.

The infrastructure project serves two purposes: One, it is money spent now in economic activity put in motion today, but it is also to create in Pakistan, and Afghanistan, and all of the “stans” – just look at a map sometime and look what connects Poland to Shanghai – everything in between needs to be developed. That’s China’s new market for goods to be sold, and they’re going to create that market through this infrastructure spend. That’s their goal.

Kevin: In the past we interviewed a very interesting man named Robert Higgs who wrote a book called Crisis and Leviathan. He said, “The more crisis you have, the greater the leviathan grows.” And part of this is this fiscal stimulus, this fiscal spending that you’re talking about. We saw this in the public works here in America back in the 1930s during the depression. We’re going into an election year. We have Bernie Sanders, we have Hillary, we have Trump, we have Cruz. We have this mix of people who will be Commander in Chief and making decisions for the United States after this next November. My question to you would be, is there any difference between any of them as far as this fiscal stimulus, or is this something that just happens no matter what the administration is.

David: This outside of their control, for the simple reason that they will be, in their first year in office – doesn’t matter if you are Republican or Democrat – responding to the same kind of crisis. And you have limited options. We have just stated, and I think over the last year or two have proven, that the monetary policies have not created what needed to be created.

Kevin: Right. Now you have to go build things in the name of public betterment.

David: The only other levers that they control, in terms of spending money, if it’s not dropping money from helicopters à la Ben Bernanke, then it is spending money, and it’s going to be government work programs. So you do end up with this direct competition. The Chinese are trying to spend 8 trillion dollars in a matter of ten years. What will the U.S. government spend to create economic activity, and still keep ourselves in the pecking order in terms of global prominence? Are we going to spend 8 trillion? Is it going to be 10? Do we need to match and raise them by 10? We could find ourselves, in 2018, 2019, in the middle of a spend fest we haven’t seen since the 1930s.

Kevin: Right. But a person would say, “How is that bad?” How is that bad if the monetary stimulus hasn’t brought about a change, we haven’t had growth, what is bad about the government coming in and taking over and just doing it themselves?

David: Kevin, the shift is really in who’s making the decisions and who is calling the shots. You and I, as individuals within the economy, every time we get a paycheck we make a certain number of votes. How are we going to spend every dollar? And we’re voting about the things that we like or don’t like. We like candy bars, we like organic apples. And we get to vote with our dollars. When the government takes over a larger and larger portion of total GDP spending they start to crowd out the private sector. And they like the fact that they have control over how things are spent.

Kevin: But you lose your liberties, you lose your freedoms in the process.

David: You have two avenues toward funding government spending. One is either an increase in taxes, which is directly taking the dollars that you would have spent and spending them in a way that they think is better.

Kevin: It’s their vote, not yours.

David: That’s right. Or, they can deficit spend, or a combination of the two, of course. But the deficit spending is saddling a future generation with the obligation of paying it back. This is something that we have done on, I say a small scale – we’re up to 20 plus trillion dollars by the end of this year. But we’re talking about blowing it out. We’re talking about 2016 to 2018 being a new era of fiscal blowout.

Kevin: And Margaret Thatcher did address this issue with just a simple phrase: “The problem with socialism is that sooner or later you run out of other people’s money.”

David: Yes, so one of the dangers that you have is that in a context where individual countries are focusing on domestic spending agendas, you start to focus less on global trade, you start to focus more on domestic fiscal policies. And globalization suffers. Global cooperation suffers. It sets the context for geopolitical tensions. It immediately conveys that what is important is me, not you. And it sets the context for a decrease in trust.

Kevin: So for a person who is looking ahead and they are saying, “I know it’s an election year, I can’t predict right now who is going to be in, but I want to look at the next five years. What do I do? And again, this shows is about taking positive action toward future events. What does a person do to get themselves through this next five years, and maybe preserves assets, but then also positively gain?

David: I think Ian McAvity gave a little gem last week, which is worth holding onto. It describes the next two to three years and also what comes after that. It absolutely dictates what you should be doing right now. The Dow-gold ratio is at 16-to-1 today. The idea that it could reach a 2-to-1 ratio, or a 1-to-1 ratio which it has hit three times in the past – what that implies is that we are in a period of distrust. It implies that we are in a period of geopolitical tension. It implies that we are in a fiscal and monetary mess. Basically, you already have the ingredients, and you are walking straight into, a maelstrom (laughs).

What do you want to own in the context of an economic, political, and geopolitical firestorm? Do you want to own some cash, you want to own some gold, you want to limit your exposure to high-risk assets? If you have real estate that happens to cash flow, that’s great, too. A diversified portfolio could be three or four different little buckets. But at this point, you want to limit your exposure to the asset classes that have benefitted the most from monetary policy. So those areas that have been exaggerated? Retail properties (laughs) have benefitted greatly. Commercial properties have benefitted greatly. There are only a few pockets of real estate that probably makes sense and it is strictly on the basis of cash flow, which beats the socks off any other cash flow that you could find.

And the point is not just weathering the storm, because a 2-to-1 ratio, compared to a 16-to-1 ratio, implies that your purchasing power of equities is anywhere from 8 to 16 times improved. If you can imagine going out and buying stocks today, like an Abby Joseph Cohen at Goldman, what I’m suggesting, what Ian McAvity suggested last week, is that you could own anywhere from 8 to 16 times the size of your portfolio compared to putting money to work for yourself today. So why sit back and weather the storm? Because value is going to come to you. All you have to do is preserve your purchasing power through what is a fiscal and monetary nightmare. On the other side of that, you’re in the catbird seat, for putting your money to work for you.