Stock Sirens Sounding

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About this week’s show:

• Corporate cannibalism is not organic growth
• Basel questions perceived stability
• Lehmans to Lehmanade: Still in trouble

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: We’ve had guests in the past, Dave, that have brought out the dangers of corporate profits if they come by the wrong purposes, and what I’m thinking about is, if they take corporate money and turn around and buy their own shares back, they reduce the amount of shares that are outstanding, and they boost the profitability per share, but they’re not really adding anything to the company are they?

David: No, that really is accounting gimmickry. Financial Times, last week, noted that bankers are growing more and more concerned that there are lots of loans that the banking community is making to U.S. businesses, and the proceeds from those loans are going to special dividends, they’re going to share buybacks, they’re going to acquisitions, but disturbing to them, being in the creditor position, is that they are not supporting organic growth. They’re not going toward growing their businesses via research and development, via CAPEX spending, via the things that you would need to do to take a company from here to there, just on a natural course.

Kevin: In a way it’s like a false high. It’s like taking a caffeine jolt and thinking that you have more energy and that it is lasting and sustainable, isn’t it?

David: It’s exactly what you get when you start connecting the dots between the kind of unhealthy incentivized behavior that corporate executives have with Janet Yellen and the Fed. It is unhealthy consequences and this is what abounds in a low interest rate environment.

Kevin: Artificially low interest rates. Let’s face it. Cheap money is flowing into these companies, but the problem is, it’s not creating any real growth.

David: No. This is what we would call capital misallocation. This is what happens when central banks get involved in determining the course and flow of funds. Rather than markets determining the flow of funds you, end up with a misallocation of capital, and I’ll tell you this. Misallocation is always what comes before capital destruction. Capital misallocation precedes capital destruction.

Kevin: Yellen is on TV right now. It’s the Humphrey Hawkins testimony, so she is being interviewed, and it is interesting to listen to what these people say versus what they do, because she is actually acknowledging the very problem we’re pointing out, yet she’s not changing anything.

David: No, and there is an awareness of what interest rates do. These are very bright people. It’s not that they are missing the implications or the consequences of the actions that they are taking. She said last week, “I am mindful of the potential for low interest rates to heighten the incentives of financial participants to reach for yield and take on risk.” She said a lot of other things in that presentation. But it’s curious that when markets begin to implode, the same Fed officials who created bubble dynamics distance themselves from the cause and effect relationship between the policies that they put in motion and the bubbles that are conceived by them, they love to sidestep that in the moment of pressure. Right now they can say, “Oh, sure, we see that this is a problem, but frankly, it’s a problem that they created, and it’s a problem they’re not going to do anything about until it’s too late.

Kevin: Dave, we’ve talked about noise cancelling out actual true information, and it’s not just happening here. Look overseas right now, you’ve got foreign debt, you were talking about Spanish debt, actually, from an interest rate perspective, looking safer than U.S. debt. When is that going to be addressed?

David: The late 2013 to mid-year 2014 trend in the world of fixed income or government treasuries around the world has been that not only have rates come down, but the difference between European debt and U.S. treasuries has also contracted. The spread has narrowed, so to say. Spanish government debt – is it really safer than U.S. government debt?

Kevin: You have more than 50% unemployment. Anyone who is below the age of 30 has a one in two chance of being out of work.

David: We’re not saying that it is safer, but certainly, you have distorted rates, and those distorted rates are sending a very confused message.

Kevin: Isn’t part of the problem, though, Dave, just the way they label things? Because there are regulations in these banks, and some of this debt has been labeled risk-free debt, which means there are certain regulations that allow them to take more on.

David: This is confusing to me, quite frankly, Kevin, because on the one hand you have the Basel Committee on Banking Supervision, which now says they see problems with the current practice, which, in fact, was encouraged by the Basel III agreement of including government bonds in the category of risk-free assets. So, the Committee on Banking Supervision says, “We think there is a problem here.” The Basel Committee on Banking Supervision is a subdivision, if you will, of the BIS. They are either not talking, or they go ahead and set a policy in motion, and then only after the fact see that there is a negative consequence from it. But again, they are now saying, “Yes, this is a bad idea to have all government bonds treated as a risk-free asset.” Because what they have seen, what they have witnessed, is a flood of bank assets go into government paper, and I think everyone knows, including the Basel Committee on Banking Supervision, how destabilizing it can be when you have a re-emergent credit crisis in Europe, which is still on the table. Or, let’s say on a broader scale, you have a rise in interest rates on a global basis. That is going to impact the assets on those bank balance sheets, and again, you can treat them as risk-free, but when interest rates start to rise, they are anything but risk-free in terms of what happens to the mark-to-market value of those assets.

Kevin: I think that’s the thing that is bothering me so much right now, Dave. All the markets, not just the interest rate markets, but the stock market, we can talk about that in a little while, but the volatility in these markets is actually spelling out the word “certainty.” Certainty that interest rates are going to stay low, certainty that the stock market is going to continue to rise, certainty that any kind of European debt crisis like we have had before is behind us, but certainty turns into panic when people find out that they are wrong.

David: In our conversations, we have always talked about low volatility being an indication of a certain future outcome, and that’s what we have today, a low-volatility environment. Whether you are looking at the volatility index, or any measure of volatility, it is incredibly low, and it does imply that there is certainty about an outcome.

Kevin: Sort of a perceived stability.

David: And that’s exactly what it is. It is a perceived stability in the Eurozone, and it’s just that. It is a perception. Not that it is any different in the U.S. We have a perceived reality. What does 50-100 billion dollars a month in money-printing and monetization of assets get you here in the United States? It gets you perceived stability, which is apparently good enough for most of today’s market practitioners. Again, what you see, though, is not necessarily what you get. In recent days I think we have seen a more rational judgment in Europe. All of a sudden interest rates are rising. Why? Banks have suffered another round of pressure, particularly in Portugal, even though European banks have been recapitalized, it is becoming obvious that they still have high leverage exposure, they still have derivative exposure, they still have off balance sheet exposure, which was just sort of swept under the carpet. Just because they have access to a little bit more capital doesn’t mean that they have fixed the problems that led them into crisis, the peak of which was 2011, and we are beginning to see, again, cracks within the European banking system. This notion of perceived stability – you know how quickly it can come undone.

Kevin: Dave, I think about measuring things. If I had a yardstick and somebody asked me how many yards a football field measures, or how many yards is this tennis court, or the office here, if I had a yardstick that was accurate in size, I could give you an accurate measurement, but if you look at the variability of Federal Reserve decision-making, or central banks in general, there are really very few rules or transparency that is there so that we can measure how well they’re doing. They say, “We’re going to taper,” or “We’re thinking, possibly, of raising interest rates next year, or the year after that,” or “We’re going to continue to do this or that,” where are the rules, Dave, for the Federal Reserve?

David: Speaking of rules that are pending, we have the Federal Reserve Accountability and Transparency Act of 2014. Just think about that. Can you imagine a world in which we had the Federal Reserve and there was accountability? Can you imagine a world in which there was the Federal Reserve and transparency? And all of this could be delivered to you in 2014. Granted, that’s just the title of the legislation, but there are some interesting details in the legislation. Our guest, John Taylor, from Stanford – with the proposal of this legislation he is ecstatic, because it is the first measure of accountability given to the Fed, or proposed, anyway, in decades. If you recall our discussion with him probably a year-and-a-half, to two years ago, what we discussed with John was the need for rules-based policy measures instead of the current discretionary orientation. What we mean by discretionary is, make it up as you go along, learn as you go, the kinds of things that we have heard from Greenspan and Bernanke as literally being an unscripted play-by-play, it’s going to come, not quite like jazz, where there is some sort of organizing principle. There is no organizing principle when it comes to Fed policy. It literally is flying by the seat of your pants.

Kevin: It’s a little bit like chaos. When we talk about transparency, what I am hoping for is transparency in what their plan is and what rules they are following, not necessarily the transparent gold that we think maybe Germany is starting to wonder if it is truly transparent.

David: Right. It’s just the issue of – we’ll do whatever it takes. And that’s a blanket that includes everything under the universe, includes things that may be morally reprehensible, not that it would include them, but it doesn’t exclude them. When you open up discretionary monetary policy, it literally is that you can do anything, any way you can, preferably not breaking the law. But what you have with a rules orientation is some level of accountability: Here’s how you can expect us to operate, now you can judge us by our own yardstick. We told you we were going to do A, B, and C. How did we do? Did we measure up to A, B, C? How did we measure up against our own standard? That is really what is proposed in the Federal Reserve Accountability and Transparency Act of 2014. You are going to hear a lot of talk, I think, about how terrible that is, because look how hog-tied our officials would have been in the context of dealing with the 2008-2009 crisis. And yet you talk to central bankers with more historical reference and what they will tell you is, actually, the market does very well if they understand what rules we are playing by. If the game is established and we know the rules, it is a lot easier than the kind of environment we’re in now, where literally, everything changes with one utterance from the Fed, because the whole game can change, the rules can be different tomorrow than from today, and so you’ve got an entire market, both fixed income, bond investors, equity investors, stock market investors, who are fixated on Fed language and what is the next utterance, because from their mouths to God’s ear – that is exactly what is going to create reality, instead of stepping back and saying, we understand what they are going to do, we understand how they are going to do it, and there is no way to game them, or to somehow take advantage of others in the marketplace by being two seconds early, and not one second late in the race to take advantage of the newest utterance from the Fed. It just means that the investment markets in a discretionary environment have become nothing but a casino.

Kevin: And the disconnect is amazing to me. June’s retail sales figures seem like they were gaining, but if you talk to the guys at Walmart, if you talk to the guys at Family Dollar Stores, container stores, what have you, they were saying, “Uh-oh, it was not a strong seasonal winter that caused the contraction. We have a major contraction. It looks like retail sales have fallen back to 2008 levels.

David: June retail numbers bumped, in part, because of food inflation. That’s something relevant to keep your mind on. Just let that sit in the back of your mind in future months. When we look at retail sales figures, one of the inputs that you have to factor in, or factor out, as inflation increases: What is an increase in consumer spending, and what is just a reflection of the higher costs of goods and services, where people aren’t necessarily increasing their spending, per se, but they are increasing what it takes to buy the old goods and services? We did have a little bit of that in June. But you are right, we have the folks that run the Family Dollar Store say, “Listen, we’re in a retail funk.” When you have an earnings call and you basically say, “Yeah, this last quarter there was a real retail funk. The problem was, we didn’t have enough bodies coming through the door.” And then you look at Walmart. Listen, we’ve had five quarters of declining sales. Walmart, to me, is something of a bellwether. You can look at other retailers like Amazon and look at their stock share performance of the last several months, and you have a similar story, but far more compelling to me is Walmart. Folks, if we have a recovery in the economy, the middle class should be throwing off their fears, they should be getting out there for a little retail therapy. They should be in Walmart, buying like there is no tomorrow. In fact, five quarters of declining sales – that is very significant to me.

Kevin: All of this is well and good. You can keep interest rates low, you can actually even endure slowdowns in retail sales as long as the dollar stays the reserve currency of the world. But we’re looking at China right now, Dave. It’s about to surpass 4 trillion dollars in their own reserves, and they are looking to other countries. They are saying, “You know, the dollar probably is not where we are going to be in the long run.” That’s 4 trillion dollars. It may be more.

David: Let me just suggest something to you. We just mentioned Walmart. It is not that Walmart captures all of the imports in the United States, but it is a decent litmus for our trade with China, because frankly, 98% of the products in Walmart come from China. So how is it that we have declining sales in Walmart, and yet we continue to see Chinese foreign currency exchange reserves go through the roof, 3.99 trillion. My guess is that we finish above 4.25 trillion dollars by the end of the year. One of the things that this suggests to me is that they continue to increase their foreign exchange reserves, but the irony is that there is a reorientation away from U.S. dollar trade, import/exports with the United States, and a much broader audience the world over, that is interested in buying Chinese goods.

Kevin: So they have more reserve money, but it’s not necessarily ours, it is not necessarily the dollar.

David: They may continue to buy treasuries, they may not continue to buy treasuries, but the source of the funds, and the problem, in terms of the import and export imbalance, what I am suggesting to you is this is not being exclusively driven by the U.S. dollar. They are trading a lot regionally, and with other trade partners around the world, and to some degree, what you are seeing is diminishment in the importance of trade with the United States.

Kevin: It’s not just China. All of the BRICS are echoing concerns about a dollar-centric world. They are looking at alternatives. They have been talking to the IMF and the IMF has been talking back, actually.

David: Of course, we had the World Cup recently, and Putin is down there at his meeting with Dilma Rousseff and discussing these things right now. Are they in a dollar-centric world? Yes. Do they like it? No. And they are exploring the alternatives, a replacement of the IMF, a replacement of the World Bank. Real plans, frankly, have yet to emerge. They are in the discussion phase, they are not in the implementation phase. But when they get to that phase, I think you are looking at being so far downriver, so far downstream, that it is shocking to us in the United States. What we will see as an initial trickle from dollars will, I think, very quickly become a flood, as the world over recognizes that the old monetary system is a has-been system. And the BRICS are certainly interested in breaking out of dollar hegemony, that is, our control of the entire monetary system. Talking to Benn Stiel it was very clear, we’ve had the privilege since 1944, and it’s not something that we get to hold onto by default. We may hold onto it, but it’s only going to be by very sagacious policies put in place by those in Washington.

Kevin: I think it’s interesting, too, Dave. These countries that are dissatisfied with the dollar are the same countries that are showing major gold purchases – physical gold purchases, moving away from the dollar. Isn’t it interesting that you can pretty much define who is not happy right now, and who probably is not going to use the dollar, exclusively, as a reserve currency.

David: Yes, you’re right. Last year, 350-400 tons of gold, purchased by central banks, and this is the 5th consecutive year of net purchases by central banks. It’ a very subtle, but let me tell you, very powerful contrast with the last 30 years, of central bank liquidations of gold. Now you see a radically different kind of behavior. And as you mentioned, it is countries that have a beef with the U.S. dollar. They are not content with the dollar-centric system, and those are the ones that are accumulating the most gold.

Kevin: You have to look, sometimes, behind the curtain to see what is going on elsewhere. We were talking about certainty, the lack of volatility in the stock market. It just continues to quietly rise. I was looking at interest rates. And of course, we’ve talked and talked about the artificiality of interest rates and how they don’t really relate to what true risk is. You cannot measure risk in this environment. I just wonder, Dave. The stock market continues to rise. We’ve talked to Andrew Smithers, we’ve talked to Napier, we’ve talked to these guys who watch these markets, and they’ve made a lot of money in the stock market, and they’re saying, “Get the heck out of Dodge, get out of stocks, get into cash, because it’s going to fall.”

David: Again, we don’t have information in the marketplace, because real information via interest rates and other measures of risk, is being muted by the central bank footprint in the marketplace today. But we are at or near an inflection point in equities. Although we’re lacking information, I think there is evidence that we are at an inflection point. For instance: Short-selling. Short-selling is at the lowest level since the collapse of Lehman Brothers. What this means is that bears, those who are thinking that the stock market is going to go down instead of up…

Kevin: They’re nonexistent.

David: They’re nearly extinct. Frankly, the only species living on Wall Street today is the bulls. They are the ones saying, “Hey listen, sky’s the limit, there’s no place but up.” And the belief is the market only goes one direction, and of course, that is supported by central bank pumping of money, and standing ready to intervene in the markets to prop up prices and perpetuate these bubble dynamics. Linger on this for just a moment. There are normally a multitude of opinions about a given outcome in the marketplace.

Kevin: Sure. That’s what the market is – a multitude of opinions.

David: Yes, and that is expressed by trading positions, that is, people put their money down and say, “I think this is going to grow, or I think this is going to drop in value.” So you have these opinions expressed by trading positions which profit from one outcome or another.

Kevin: But you have virtually no one who is saying it is going to go down. That’s what the short position is, isn’t it?

David: Exactly. You profit when the stock price goes down. The lowest numbers of people who are short the market now since the collapse of Lehman Brothers. Of course, that was a big surprise. Everyone thought that everything was great in the real estate market. No one expected it, everyone called it a black swan. The market believes that these trees grow to the moon.

Kevin: You’ve talked over the last year or so, but especially the last half-year, about how margin debt, in other words, not only people going in and buying with what they have, but borrowing to buy more. Margin debt has been hitting records, hasn’t it, for the last 6-8 months?

David: Through the month of February we had six successive all-time record numbers. They blew past the records that were set in the year 2000 with the tech boom. They blew past the record numbers we saw in 2007, which were even greater than what we had in the year 2000.

Kevin: And those were both preceding very substantial crashes. Now we’ve had three months of a minor contraction in the margin debt numbers, which in the past has been prelude to not only a massive decline in the margin debt numbers, but obviously, and this is of greater significance, really, pulling the plug on the market advance. So the bull market trend that we’ve had in place for five years, when you begin to see margin numbers get to high levels, why is that importance to us? Because high levels usually come before low levels. When you get to new record numbers, there is mean reversion, and that is what we saw happen in 1973 to 1974, that is what we saw in 1987, that is what we saw in the year 2000, that is what we saw in the year 2007. When the margin debt numbers begin to contract, it coincides with stocks moving considerably lower.

Kevin: How much lower would they – typically, what do they lose when you have that happen?

David: In those four historical reference points, you are talking about 20-50% declines in equities. Again, that doesn’t mean that has to happen now, or next week, or happen at all, in terms of a 20-50% decline, but I’m telling you, when we get to new margin levels, all-time highs, and those numbers begin to roll over and move down again, you are basically pulling the plug in terms of speculative investment in the marketplace, and you begin to see a cascade effect. Maybe there are exceptions to this, but this is the way it rolled in the bear market of 1973 to 1974, the bear market of 1987, the bear market of 2000-2001, the bear market of 2007-2008.

Kevin: I can remember, three of those four bear markets, just working here – 1987, 2000, 2007 – each time I remember talking to clients who continued to stay in the stock market. Granted, a lot of our clients had moved out by then, but I talked to the people who were still there and they said, “When I start to see it come down, I’ll get out. I’ll start moving out.” It’s really more like a game of musical chairs when the music stops, isn’t it?

David: I looked at the long-term chart of margin debt yesterday on a Bloomberg terminal, and if you look at it, it rises and rises and rises, over a long period of time. And then, do you know what it’s like? It’s like stepping into a crevasse. You step into a gap where there is nothing but air underneath you, and you’re going down. There is nothing to support you, there is nothing substantive underfoot; you are free-falling. This is one of the reasons when we are in the mountains, and we are mountaineering in areas where there are crevasses, we are always on a rope. Why are we on a rope? Because things happen so quickly there is nothing that you can do. Unless you have a safety rope, there is nowhere you are going but down and to your harm or demise.

Kevin: Those questions that occurred before were in markets that didn’t have volumes nearly as low as we have these days. We have rising markets, but actually, volumes are incredibly low.

David: That is a critical point, because what we are talking about is the structure of the market today – lower and lower volumes. And this isn’t just the normal summer doldrums. Classically, you see lower volumes in equity trading during the summer months. That’s not what we’re talking about. We’re talking about a trend in volumes which has been in place now for about five years, very significant in and of itself, not just a short-term, but a long-term structural trend. And then you have this, again, declining volumes. But much of the existing volume is not from investors or analysts, we’re talking about high-frequency traders scalping pennies from the exchanges, literally, computer black box trading models, buying, selling, buying selling – hoping to capture a penny or two of gain.

Kevin: And when a person wants to sell their stock, let’s talk about that crevasse. Let’s say you say, “Okay, today’s the day, it’s a crash. I’m going to go ahead and call my broker and sell.” Those high-frequency traders are not going to be the trades that come in and buy those stocks.

David: There were a few shares that I wanted to sell in 2008. There were a few shares that I wanted to sell on a particular day in 2008. With Charles Schwab, I stayed on the phone for three hours, and never got through.

Kevin: The market kept going down while you were doing it, right?

David: The computer trading system was not taking trades, it was overwhelmed by volume, and we could not input trades online – this was me, personally. This is one of the reasons why, as a firm, in our Wealth Management Group, we don’t use that company. (Laughter) I found the frailties of their IT, and it scared the snot out of me. And then, you think, “Gosh, well if I can’t put the trade in online, I’ll just call.” That’s right. Three hours, and guess what time it was by the time I got through? After 2 o’clock Mountain Standard Time, which is after the market was already closed.

Kevin: So you get next day’s market price.

David: The thing is, with high-frequency traders, you are talking about volumes which are, if you want to define it with one word, fickle. They can go either way, it doesn’t matter. Today they’re buying, but they can just as easily sell. Again, you have people out there gambling, speculating – based on Fed promises, not economic fundamentals. You are listening for the voice of the Fed, you’re not reading the economic tea leaves, as literally, what is Janet saying today, because that’s the only thing that I care about, that’s what is going to move the markets.

Kevin: Think about it, Dave, What compounds that is this margin debt that you are talking about, because once it goes down a certain amount, you get what they call a margin call, and it just compounds on itself. It forces the sale.

David: You’re right, because you layer in what is a speculative investment, margin borrowing from individual investors, and that, still, is north of 430 billion dollars. The peak was just above 450, we’re still sitting at around 430, and it has started to decline. You may say, “Well, that’s healthy, it’s declining.” No, actually, when it begins to decline, these are the siren songs, these are the things that are telling you, you don’t understand what happens next. This is the only thing that was propping up the market, except for the high-frequency traders. If you aren’t moving to the exits right now, you’re not going to squeeze through the exits when everyone else wants to. This is the challenge you have: In addition to this 430 billion dollars, you have, say, year-to-date, an extra 100 billion dollars of actual investor money. These retail investors are chasing 2013 increases in price, buying equity mutual funds. This, to me, is the making of a nightmare scenario, because remember, it is the individual investor that tends to pile in at the end of a rally. And you may say that 100 billion is not much compared to all the other numbers. Yes, but year-to-date mutual fund inflows – do you know the last time we had 100 billion come in, in this kind of a time frame? The first quarter of the year 2000. Literally, you have the lemmings coming right up to the edge and saying, “Isn’t this going to be fun?”

Kevin: David, I have to bring up, you do have sort of a morbid sense of humor. A few years ago, you and some friends went in on making some wine. The label still cracks me up, because it is a nice big, fat turkey. There was more than went into that label than just picking out a picture.

David: Well, what is the happiest day in a turkey’s life? His last day is his happiest day. He is being stuffed and fed, right up until the end, but all he sees is the present. All he sees is the past. All I’m suggesting is that prices are driven by liquidity, and ample liquidity has done its job. We’ve gotten to these levels because of the liquidity created by the Fed. The Fed’s liquidity, yes, it can continue to flow, because if they so choose, they can run the printing presses ad infinitum. But the investor dollars are not constant. The high-frequency trader dollars are anything but reliable, and the margin money has a hurdle. Do you know what the hurdle is? Those dollars are actually loans which bear interest and will have to be paid back, which means that everyone who has a position in stocks, with borrowed funds, is watching not only the value of the stock market, but they are watching the clock, as well. And they know at some point they are going to have to pull the plug. If prices begin to get twitchy at all in the equity markets, guess what happens? You go ahead and pay back, while you can, and hopefully, you are above and beyond your original investment. What precipitates the payback? It could be any number of things.

David: And I wonder, because the Federal Reserve is doing what they said, as far as tapering. They are taking a few billion off every month, and it is October or November that they are talking about actually ending quantitative easing. Could that precipitate what you are talking about, Dave?

David: Yes. This is an interesting, very coincidental time frame, but it speaks to me of the absolute ignorance at the Fed. I’m not meaning to belittle or undermine who these men are – very bright academic men, but we’re talking about, just looking at the seasonality of the stock market, if any one of them picked up a Stock Trader’s Almanac, do you know one of the things they would glean from this?

Kevin: October is not a good month for the stock market.

David: October is, classically, the worst month for the stock market. Of any period in time, where you have market crashes, October is it. Why they are pulling liquidity out, leading up to, and plan on being finished at this time – they’ll be down to roughly 15 billion a month in money-printing and asset purchases by October. The Federal Reserve, yes, they still intend to take their maturing securities and re-invest those in treasuries and mortgage-backed securities. Call it 15-16 billion a month. Does that make sense? You have individual debt, it is paid off, and then they essentially take the proceeds and recycle it back into new debt.

Kevin: It’s almost like quantitative easing, but it is at a much smaller scale than what they have been doing?

David: Right. But it will still enable a drip feed to the mortgage and treasury market, and in theory, that will help contain rates. On the other hand, we know Bernanke’s introduction of QE was intentionally, in his words, “to loosen monetary policy.” So it follows logically, that if taking QE off the table is the reverse action, it is, in fact, going to have the same consequence, in the stock market and in the economy, it’s the equivalence of tightening monetary policy. Can that have a negative effect on investor sentiment? Sure. Does it sort of constrain the willingness to speculate in equities? Maybe. If you give it the backdrop we’ve just described, it’s just not unreasonable to suggest a September to October decline in equities.

Kevin: Dave, it’s interesting looking back to the crashes that you named. I’m thinking of 1987, 2000 and 2007. There was always some precipitating “black swan” event. Even though you can talk about it, see it ahead of time, and say gosh, all the factors are in, there seems to always be what they call a black swan, and they say, gosh, we just didn’t see it coming. Sorry boys and girls. But in reality, they’re only controlling interest rates. They can only control the flow of money. Last week you and Chuck talked about ISIS. It sounds like they have a little bit of nuclear material at this point. Is that a black swan possibility? What are things that could trigger?

David: But see, this is what I don’t like about the concept of the black swan, as if it’s some surprise. Right now, utilities, the Russell 2000, consumer discretionary stocks, home builders – these are all categories that are diverging from the Dow Industrials and the S&P 500.

Kevin: So they are signaling also.

David: They absolutely are signaling that something is not quite right. Again, if the economy is strong, wouldn’t you expect consumer discretionary [spending] to be strong? Wouldn’t you expect, if you were looking at the retail stocks, for them to be doing very well, and for the expectation to be doing even better, if in fact, we are coming into a period of economic recharge and growth. And yet, again, retail and consumer discretionary, Russell 2000, utilities, home builders – they are all giving you an indicator that something is not quite right. And even though the S&P 500 and the Dow have been gamed to higher levels, there is this unhealthy divergence. For anybody with their head screwed on straight on Wall Street, I think this is a time to be eliminating positions, getting into cash, increasing a gold position at low numbers. You should be retrenching, not riding the wave, because honestly, this wave – guess what happens? Guess where it lands? It crashes on the beach. It crashes. Again, is this a permutation that we think we could see in the next two days? No. In the next two weeks? Maybe not.

Kevin: You can’t predict it.

David: What Smithers said in November was absolutely telling. He said, “Listen, valuation metrics don’t give you any insight in terms of timing.” We could look and say that according to Tobin’s Q, or the cyclically adjusted price earnings multiple, that we are somewhere between 75, and now 95% overvalued in the major indexes, but that doesn’t mean that they don’t go from being overvalued to super-overvalued.

Kevin: When does the bridge collapse? I think about that bridge in Minnesota. It was a tragedy, but the bird poop had built up and built up and built up, and the chemicals had gotten underneath it, and finally, that was your catastrophe. Somebody, unfortunately, was under the bridge and on the bridge when it occurred, but it was going to happen.

David: You mentioned Smithers when we started off the conversation today, and I think, yes, that’s right. For the trader, there is still money to be made in the stock market. For the investor, your better days are gone, you should be on the sidelines. Follow Smithers’ advice, increase your percentage to cash, if not move to cash entirely, if you are an over-committed equity speculator. What do you have in your favor? You have Fed intervention in the marketplace in your favor. That’s the primary wind at your back. Will it continue to work? Sure – up until the point where it doesn’t. What you have is a growing numbers or factors, whether it is margin debt, whether it is the fickleness of high-frequency traders, there are all kinds of things that you could say, “You know, I should probably be a little bit more cautious here.”

You mentioned Iraq. Their UN Secretary just communicated with the U.S. that ISIS, or ISIL, took 80 pounds, equal to 40 kilos, of radioactive material from a University Research facility. The primary concern is that you have a dirty bomb that could be constructed. No, not a full nuclear weapon.

Kevin: Sure, a dirty bomb is just nuclear materials that are blown up with conventional explosives.

David: So, it’s a device that could be, nonetheless, disruptive, given the lingering effects of contamination from the radiation. How do we think about these things? We categorize these types of issues as low probability problems with very high-risk outcomes, which obviously can be exaggerated, or exacerbated, by general market panic. That is exactly what we had with 9/11. I remember watching the twin towers. I was at work at Morgan Stanley, usually the first one to open the office, and with television on, watched the planes fly into the towers. Then I also watched 500, 600, 700-point declines in the stock market the next several days. There was general market panic as a result of this low-probability high-risk outcome. Right now are we directly threatened by what ISIS or ISIL took from the University? No. But you never know what circumstances might align themselves for a surprise. And of course, today – this is the awkward part – the markets are priced for a perfect, and perfectly functioning world.

Kevin: Certainty. It’s what we talked about before. They have certainty toward certain outcomes.

David: This is what is interesting to me. ISIS doesn’t cooperative with the central bank community, so you have to be aware of markets freaking out when they discover that central bankers don’t actually control the universe, they merely control interest rates, and of course, they do their best to control investors’ short-term perceptions of reality.

Kevin: Speaking of that, it is still a great time to continue to accumulate gold. I think of periods of time like now, Dave. Gold continued to go up over the last couple of weeks, and now the profit-takers have taken a little bit of a profit. Isn’t this expiration week? This is usually a good time to pick a little up.

David: Yes, options expiration, any month. You can usually look at volatility the week of expirations in the options and futures contracts, and what you are going to find is that people start targeting a particular number. In this case, we are close enough to 1300, or sub 1300. That jives with a trader’s self-interest. So we have temporary gyrations, not a big deal. What we usually see, seasonally, is that gold reaches its low point sometime between May and the end of July. I think probably we’ve already had the lows in early May. The implication is, if you wanted to look at, say, 19 out of the last 21-22 years, as a sample size, prices are up 15%, 20%, 25% from those lows by the time you get into September, October, November, and it is no coincidence that sometimes the high point in the gold market is actually in a period of time when there is a lot of pressure in equities. So there is some seasonality here. You can tie it to Ramadan, you can tie it to the Indian wedding season.

Kevin: Or just technical. David Gurwitz just looks at the technical charts. We had him on about 2½ to 3 months ago and he said, “I think, just from the charts, the end of June is probably the bottom on gold,” and that’s not too far from what has seemed to be the truth.

David: I would look at these temporary gyrations and say, “It’s not a big deal. If you are adding to ounces, this is the timeframe to do it. I wouldn’t be waiting until September or October.

Kevin: Well, what would you rather have, stocks, bonds, cash or gold? Those are your choices, really, if you are not counting real estate.

David: Yes, if I’m heavily exposed to stocks, then I’m moving to cash first, and then the question is, how comfortable am I with the Federal Reserve managing my cash assets? I have the feeling that over the next several years they will do anything to keep the banking system alive, even if it costs them the stability or value of the dollar. Really, a catch-22, at this point, as an investor. I think you look at stocks, bonds, and they are overpriced. Real estate, in most places, is overpriced. Moving to cash? Sure, that makes sense. But then you have to balance the risk that you have with those resources being managed by Yellen and Company. What’s my sense? My sense is that at the end of the day, you’ll be “yellin’.” You would rather have some balance, you would rather have some ounces to offset the unintended consequences of well-intentioned, but poorly executed monetary policy. At the end of the day, that’s where we are. It’s the middle of the summer, prices are getting better, and would I do something? I would. I’d do something right now.