In PodCasts


The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

October 17, 2018

“The dynamics that these guys are describing, and the chaos that, whether it is Druckenmiller or Bianco, or others described – it makes sense to me. And at the end of the day, what is valuable to you is going to be answered on a very subjective level. Grant has answered that in terms of gold. Druckenmiller has answered that in terms of gold. Bianco didn’t say gold, he just said, ‘We have inflation coming and everything is going to go down.’ But guess what? Gold is in the catbird seat to do very well in that context.”

– David McAlvany

Kevin:Well, your wife, Mary Catherine, did a fabulous job playing the lead role of Eleanor in Sense and Sensibility. I couldn’t believe the emotional input that went into that. You told me she did nine shows, so she deserved a getaway.

David:As it turned out, we had the Grant’s conference on the calendar, and a friend’s wedding on the East Coast, so it was the perfect segue from a very busy schedule, lots of late nights for rehearsals and then ultimately, the productions that she did as Eleanor.

Kevin:So you took her to New York.

David:That’s right, and we were able to squeeze a lot into a few days.

Kevin:It is interesting that Jim Grant, who obviously has been guest of ours in the past, his 35thanniversary of writing the Interest Rate Observerwas being celebrated up in New York. You have gone up to that conference before and there are a lot of heavy-hitters that talk, but what interested me was, last week when you were there you got to hear those heavy-hitters talking about a return of volatility to the market and a return to maybe some of the old-fashioned market forces. Before they actually hit, the conference was over, you were doing the Grant’s conference the first three days of the week, and then of course we had the large moves in the stock market on Wednesday and Thursday.

David:I think I will just mention the 2018 Third Quarter Tactical Short conference call. That is this week. And if you are interested in our views on not only market volatility here in recent weeks, but what has been set up here in the fourth quarter by activity in the third quarter, we will do that. Market Contagion Is Backis the presentation title and Doug Noland and I will be doing that on Thursday, 2:00 p.m. Mountain Standard Time at the market close. For those that orient their lives to the East Coast, 4:00 p.m. Eastern Standard. You can register by clicking on the link.

Kevin:At You can also register on the link in the show notes. You can just click right there after listening to the show or during listening to the show.

David:We will highlight the shifts in the credit markets over the last quarter. We will look at emerging markets, and of course, the U.S. domestic equities markets, as well.

Kevin:And Doug talked about how this bubble will be popping from the periphery, from the outside, into the core, and he is looking at mitigating that risk with that in mind.

David:Yes, periphery to core risk migration is unfolding on a daily basis here in the fourth quarter and I think it is setting the stage for epic market volatility in the months ahead. So on the call we will look at the trajectory that we set in Q3 for year-end and consider in detail a number of the players that are already suffering from tightening of financial conditions. So if you want to register for the call we would love to work with you to create a reliable hedge for your existing portfolios.

Kevin:You just now said existing portfolios. I think sometimes people imagine that they have to move all of their money to us to do this, but actually, this product is designed so that if you already have a professional crew that is working for you just fine, but you are in the stock market, or you have to be in the stock market, this is a way of hedging that position and not having to worry as much about a downturn in the market.

David:There are many people who turn to us for comprehensive investment management, but there are also those who operate with an existing team of investment professionals and what we do in complement to that is utilize the tactical short to create a complement, to reduce overall volatility, to increase liquidity in the context of a market decline. So if you are curious how that particular offering may complement your existing wealth management team, you should listen in on the call. Again, register at I just can’t help think about last week because Bloomberg has this quote from October 4th: “Jerome Powell is essentially saying that the business cycle has been repealed.”

Kevin:“This time is different.” They always love to say that, right before this time isn’tdifferent.

David:I know. It had this echo of Irving Fisher days before we entered the Great Depression in the 1930s – “We’ve reached this permanent level plateau in the markets.” And I’m thinking, “Do you know what you are saying? Do you realize what this has an echo of?”

Kevin:And he is not the only voice who is saying that things are going to be just fine forever into the future. But you have voices, also, like John Hussman, who even before the volatility last week, is looking for a downturn greater than 50%. I mean, what is he looking for?

David:Right. Alan Newman refreshed and reaffirmed his view that based on valuations and sentiment extremes we are likely to see a 50% market decline. John Hussman, another analyst, looks at market volatility on the horizon and a decline in U.S. equities of as much as 64%. Nobody knows precisely how it will unfold, but we certainly don’t have any price-specific forecasts. I think what we agree with is that when you have periods of overvaluation in the market, that leads to long periods of underperformance in terms of investment returns.

Kevin:And that is why the recommendations of sticking with cash and gold cash.

David:To me, if the prudent listener would respond that way, raise cash, increase allocations to a, perhaps, more historically stable form of savings in complement to the current greenbacks – gold – the Vaulted program makes that a very simple denomination of savings. And that is the issue. Vaulted is basically just that – a redenomination of savings into gold bars, to get your cash allocation out of the banking system.

Going to the Grant’s conference it was interesting to see a little bit of a re-emergence of concern there with counter-party risk, and the same kind of language used in 2008 and 2009 in the context of the global financial crisis. But when you are looking for reliability and solvency of the counter-party, I think of Vaulted, and it is not only a way of getting out of U.S. dollars, it is also a way of moving savings out of the banking system and really, a financially precarious position in certain contexts.

Kevin:And Dave, the way I use it – of course I have my gold and my silver that I have physically in Toronto, Zurich, in a safe deposit box here – this doesn’t replace that, but the way I use it is, if I have money in savings that I don’t want dollar-denominated, I just move it over directly. I use my phone, I just go onto my account and I move some of my savings into a gold position. It is very, very easy. It is

David:Kevin, to be honest, Vaulted is unnecessary in a world of monetary policy conservatism, but what we have had is largesse in the form of easy money and credit, and savings and investment games which are played on the basis of that easy money and easy credit. And it does require that you, as an individual, play the game a little bit differently in light of that.

I shared a conversation over the weekend with a gentleman that manages derivative hedges for many Fortune 500 companies. His company specializes in structuring trades, and then doing the accounting for those trades. He does work with few financial firms, private equity firms, hedge funds, but many of his clients are non-financial corporations, as well, hedging currency risk and what not. He has 40 of the best derivatives accountants alive.

Kevin:Those are like rocket scientists because how do you value a derivative?

David:Right. They work for him here in the U.S. and in Europe. Michael was a delight to get to know. He is somebody that operates with an amazingly high level of integrity in a world, and in a space, frankly, that often does not. So having this conversation with an expert in derivatives accounting, I did have to jest with him at one point – “What makes for an expert accountant in a world of mark-to-make-believe?”

Kevin:Right. You mark the price to a make-believe value.

David:I guess it doesn’t have something like stock symbol that gets priced to the market, marked-to-market, on a second-by-second basis. And this is specifically the case in the work that he does with OTC derivatives, over-the-counter derivatives, not exchange-traded. You need a legal team to analyze, to understand, to wrap your mind around what the instrument is. And typically, they don’t trade on an exchange, they trade, as some would say, by appointment (laughs). It’s not a lot of liquidity. But I loved his background. As we talked, his youngest daughter sounded like an older version of my own, potentially, the first female president of the United States.

Kevin:(laughs) If you should say so, yourself – the proud dad.

David:(laughs) Yes.

Kevin:Where did he get his background? Where is he from?

David:He started with Chemical Bank many years ago. That is what had me thinking about the Vaulted program. We launched this year with the Royal Canadian Mint. We call it by that name, Vaulted, because as you may know, Chemical Bank, at the turn of the century – the previous turn of the century (laughs) – had the nickname Old Bullion.

Kevin:Right. They were known for keeping money in gold when you put it in there.

David:Right. So a very boring bank in that sense because they didn’t make loans. They charged you a small fee to keep deposits strictly in gold bullion at the bank. That really isn’t the case anymore – Chemical Bank is no more – and it was not the case when Michael was there. He was working on hedging derivative products which, frankly, wasn’t necessary in the days of Hetty Green and Old Bullion.

Kevin:Isn’t it amazing how the name of something can change? It used to be that a bank was a boring place to be, that it was very, very careful with your money. I think of the movie, Mary Poppins. You remember the banker there? They were very prudent and high integrity, and there was a song about that. Nowadays a bank can be leveraged 10-, 20-fold with your money. The money is not there. The same Chemical Bank that had gold for every dollar that you put in back in the early 1900s, now is a Chemical Bank that could be leveraged 20 times.

David:One of our local banks – I sat at lunch with the bank president in 2011 or 2012, a few years after the very worst of the global financial crisis. I asked the bank president, “So tell me a little bit about your leverage ratios. Things are being run a little bit more conservatively, I see the bank had been downgraded during the global financial crisis and they just got upgraded again. Where are you now?” He said, “Oh, very conservative, around 12 times leverage.”

Well, 10 times leverage, 20 times leverage, what that means is that you only have five or ten cents of capital versus the loans outstanding. There was a time when sensible banking was not tied to reserve ratios and the amount of balance sheet leverage that you allowed. Again, 10 or 20 times leverage is kind of the opposite. Sensible banking was marked by keeping a store of value ready for the depositor to put to use toward whatever subjectively driven purchase or investment made sense to them as a value proposition that became obvious.

Kevin:It was reliable. You could go down to the bank and it was reliable.

David:Right. It was hallmark – reliability, availability. Frankly, liquidity didn’t become a concern in banks until you had over-leveraged balance sheets, too many loans, fractional reserves, being introduced. And gold was the reliable store of valuable. That was Chemical Bank. That was Old Bullion. I guess my bias is, I tend to agree with history on that point, that through time you are better served by real money as a store of value. And what we have simply re-introduced is 19 centuries of banking and monetary experience back into a 21stcentury platform – easy, transparent to use, reduces as many counter-parties as possible.

Kevin:And like I said, use it as a savings alternative. I am not making a long, long-term decision when I put money into Vaulted. I am just basically saying, “Hey, can I put it into gold for a little while because I don’t trust the dollar?”

David:So you have the flexibility to turn on a dime and re-allocate using the best technology available, using a web browser, going to Vaulted, and opening an account basically is shifting savings from the 21stcentury leveraged behemoth we know as the modern bank, to what was as recently as the 19thand early 20thcentury considered to be the only reliable method of banking. So in one sense, Vaulted is Old Bullion, plain and simple, just with a new ease of accessibility and refreshing transparency.

Kevin:Sort of 21stcentury. I can tell you, my cell phone is Old Bullion. That’s what I like. I’ve got it with me, and I can go, “All right, hey, what’s happening here? I think I’ll shift a little bit into gold, or I’ll shift out.” I have shifted out a number of times, too, Dave. I don’t just buy and hold. I shift out so that I’m paying bills with the same thing that I had in gold a week before.

David:I think it is really interesting just to reflect on Michael’s professional trajectory. He started with one of the staid old banks, which through time compromised in terms of risk, taking on more risk to increase profitability through time. Then ultimately he left the bank and saw an opportunity. The opportunity was to enable corporations to “mitigate risk” and to some degree that is what derivatives do. It is an insurance product. And then, to another degree, it enables them to take on more risk, feeling that some risks are already hedged. And so, from a systemic standpoint, it puts that much more risk, in total, into the system. That is what we talked about when Richard Bookstaber was on the program. It is the aggregate numbers that actually do matter in the context of crisis. And when they run their stress tests they don’t think about the aggregate. They don’t care about the aggregate. I thought it was fascinating. Great conversation, great guy, running his business with honesty and integrity. I don’t know if he understands how close to the mechanisms of destruction within the financial system…

Kevin:It’s like working in a nuclear reactor. Everything seems fine until something goes terribly wrong. And what goes terribly wrong is completely unpredictable until it happens.

David:Right. I am just imagining an engineer at Fukushima, for whom it’s just another Tuesday – I forget which day it was, but just another day, and then, “I think we ought to call this one in. Let’s call this one in because it has actually gone past our temperature threshold.” And then within hours it’s all over.

Kevin:One of the men who was there who has been in banking for many years and just wrote a book – Pollock – I’d really like to have him on the program after reading just a few chapters of the book. In fact, the book just came out.

David:Alex Pollock – this week – his book came out this week.

Kevin:Yes, it’s a great book. What he talks about is the difference between risk and uncertainty. If we confuse the two – and as a banker he does not want to confuse the two – but risk is something that has to do with large numbers you can calculate, like an insurance company can calculate the odds of how many accidents are going to occur. Uncertainty is completely incalculable. And he says, about every ten years you can just count on that uncertainty turning into a major crisis.

David:This is one of the reasons why I like to go to Jim Grant’s conferences. Alex Pollock was a guy who was there, signing a few books. He was the President and Chief Executive Officer of the Federal Home Loan Bank of Chicago.

Kevin:He was with Continental Illinois before they failed. How do you get that kind of experience? That was the largest bank failure in world history.

David:And just like I really enjoyed the opening lines of Bookstaber’s book, The Demon of Our Own Design, it warmed my heart to read the first lines of his book, in which he says, “And why is a philosophy major interested in joining a bank?” asked the interviewers over lunch in the big bank’s elegant dining room so long ago. His answer was, “Because I find many things about banking philosophically interesting, like what is risk, what is money, what is credit?”

Kevin:And Why We Are Always Surprised. That is the subtitle of the book. He says there is no possible way to not be surprised by the future.

David:Yes, so I got to attend a wedding on the East Coast this past week. I also got to celebrate Jim Grant’s 35thanniversary of publishing theInterest Rate Observer.

Kevin:He started with Barron’s, didn’t he?

David:He did. And it was interesting, Randy Forsyth walked by and we had a brief conversation. He is still at Barron’s. Alan Abelson, I would say, is one of those mentors for Jim Grant, not so much in the area of interest rates.

Kevin:I’m so glad we were able to have him on the program before he passed away.

David:Yes, just in terms of his wit and wisdom and the way that he wrote, Barron’sin that era was an incubator for quality writing. So Jim left Barron’s35 years ago to pursue his own publishing endeavors, and that is what he has brought to the paper that he writes – realism and wit.

Kevin:We need to have him on again.

David:Yes, while we were there he agreed to join us again in the New Year – lots of things that I want to talk to him about, market-related. He also is finishing a book on Walter Bagehot, one of the great English commentators on markets and cycles and psychology.

Kevin:Didn’t he start The Economistmagazine?

David:Yes, that’s right.

Kevin:Back in the 1800s.


Kevin:One of the things that I love, when you back from this trip, when you have gone to Grant’s before, and this time as well, is to sit down with you over a Scotch and just ask, “Who did you have lunch with? Who did you talk to? What are some of the insights that you gained that you can’t gain just reading? These are very famous, well-known people that you are sitting down with and actually talking about your kids, you are talking about theater, you are talking about economics and philosophy. Who did you have lunch with? Who did you have dinner with? Those are the questions I always ask, and a lot of times it turns into guests on the show from acquaintances that you make at this conference.

David:Sure. Last time I was there I sat and had lunch with Mitch Cantor and Bill Fleckenstein and had a conversation that was very intriguing about changing dynamics and the structure of the markets. Mitch is a very interesting guy, very quiet, very active intellectually. It is fascinating to see him always double-tasking in the midst of the conference. He will be listening to a speaker and continuing to do research on his iPad. He doesn’t know how to stop, I don’t think. Bill Fleckenstein, of course, is known for being one of those very few short-sellers in the marketplace and has made a name for himself in that area. This go-round, I ate lunch and visited extensively with a renowned value investor from France, Jean-Marie Eveillard. He is now 78 years old and is considered an icon in the investment world.

Kevin:Last time you were there I think you took Declan, your son.

David:That’s right. I was recollecting with Jim Grant, who I sat next to at this conference, the impressions left by my son, who, you are right, attended the conference a year or so ago, and got to listen to the debate between an active hedge fund manager who was taking the opposing views to the passive investment style of Mr. Bogle, himself, the founder of Vanguard, who was there. And you are right, Declan got to meet Mr. Bogle. I got to see old friends in the industry and made new ones, as well. It is always a fascinating conference.

Kevin:We talked about how banking has changed, but investing over the last ten years has changed dramatically from active, intelligent people managing portfolios to this passive investing that Bogle was known for. This modern financial guru that mocks everything but things that are created out of thin air, like debt. Did anybody address that? Because the men and women who go to these conferences are not passive investors. These are people who have devoted their lives to understanding the intricacies of history. Did they address that?

David:I think there are some that are very clued into that. I really enjoyed Anthony Deden. The speakers ranged from philosophically reflective, like Tony, who mused over the modern financial guru who today would laugh at the man who chooses to keep his money in gold. And yet, that same guru would be totally comfortable talking about debt as an asset, and would be applauded for making large allocations there – real assets versus a paper promise to pay in the future. Things have changed through time in terms of the elemental principles of the craft. He echoed, actually, a lot of what is in Alex Pollock’s book in the introduction, which is that there are elemental principles to the craft of investment management.

And you first have to understand and respect, what is money? What are savings? What is wealth? What is risk? What can we learn from history? And if you don’t respect those things, then you can get sucked into modern trends. So we had the philosophically oriented guy like Tony, and a surprisingly simplistic pitch on Starbucks from a famed hedge fund manager, William Ackman.

Kevin:Will Starbucks ever get old?

David:Not a compelling case, in my opinion. He boiled it down to two things—based on improving same-store sales and growth in China, you should go long Starbucks. I think he is only about 20 years late.

Kevin:Listen, your dad spends five bucks a day at a Starbucks, and then he spends eight hours there using it as his office. So he gets a good deal there at Starbucks.

David:Right, but who is getting the good deal? As a business model, this is not like a Regis office, and yet that is what Starbucks has largely become. Somebody spends five bucks and yes, the profit margin on a cup of coffee that they serve is monstrous – 90% profit margins are not bad margins to be working with.

Kevin:My wife likes pumpkin spice latte, so I don’t know that people go there for coffee, Dave, I think they go there for the upgrade drink.

David:Well, that is, I think, one of my issues. I have a different perspective than Ackman. Maybe it boils down to something that is just that simple. There are coffee drinkers, and there are people who drink coffee drinks. And to confuse Starbucks as a place that provides anything for the coffee drinker is a mistake. They do serve coffee drinks to people who drink coffee drinks.

Kevin:Orange mocha Frappuccino. Yes (laughs).

David:He was actually trying to make the case that modern medicine is showing us that coffee is really a healthy thing for us to be drinking. So based on same-store sales increase in China and the health benefits of coffee, I’m thinking to myself, “Wait, wait, wait. Wait a minute. Most of the people who are ordering drinks at Starbucks are getting the 5000-calorie latte with whatever it has in it – everything and the kitchen sink. When my dad orders a Chai tea it is with six pumps of whatever that mystery brew is, and I guarantee you, there is enough caffeine to raise a dead horse, and there is enough sugar to turn somebody who is not a diabetic into a diabetic with one single cup (laughs).

Kevin:For those who know and love your dad, he is a great paradox, because he used to walk around the office eating popcorn telling everybody that he was allergic to popcorn. And the same thing with the chai tea. He drinks the chai tea for its health benefits, but actually, the amount of chai tea that he drinks, like you said, the caffeine is off the scale.

Going back to the conference, you don’t agree, necessarily, with what is being said, but it does keep you actively engaged. Who would you say was one of your favorites?

David:Stanley Druckenmiller – Duquesne Capital Management started in 1981 and was one of the original traders for the Quantum fund because the trading, I believe, was outsourced to Duquesne. He affirmed a long-held bias of mine that the next five years are going to be very different than the last ten years. The big changing variable is shrinkage of liquidity. The last ten years has been floated on the basis of free money and the prices going up.

Interest rates are the price of money, right? And so the price of money is going up. We had ten years of a free lunch and that is no more. There is a knock-on effect from that. He also noted that the free money which has been a boon to passive management – we’re talking ETFs and back to the Bogle complement.

Kevin:That’s the Bogle plan.

David:Yes. That’s changing rapidly. I think it is very easy to reflect on what Bogle has had as wind in the sails, particularly over the last ten years.

Kevin:He was in the right place at the right time, Dave. They just gave him money.

David:Assets under management. If you look at a chart of assets under management at Vanguard, it looks like a hockey stick over the last ten years. And lo and behold, Druckenmiller makes the case that you don’t need a brain to manage money when you have free money floating around. All boats rise, and in fact, the harder you work, the unluckier you get in the context of free money. So when the trend of easy money goes away, or is lessened to any degree, you also have real pressure put on that passive asset management thematic. Druckenmiller compared the interest rate environment, as we have, to the game of Jenga.

Kevin:The wooden block game of Jenga where you build the tower, and then you pull piece after piece out.

David:Right, where each rate increase is like removing a piece from the tower of wooden sticks. And you don’t know which one matters. His point is, the central banks don’t either.

Kevin:They act like they do because you have to keep the perception going, but they really don’t.

David:Right. But at some point you raise interest rates and it is one step too far, and there are cataclysmic consequences to that.

Kevin:We have discovered this, Dave, interviewing central bankers here on this program. They have this perception in the news of being masters of the universe. When you actually get them talking as just normal people, they are like, “Man, we really have no idea what is going to happen next.

David:I loved our candid conversation with William White because he spent, I think, 15-20 years with the bank in Canada, and then moved over to the Bank of International Settlements.

Kevin:I sensed that he had been humbled a few times.

David:(laughs) I think he was just realistic. He said, “We’re artists, we’re not scientists. Just because we work with equations doesn’t mean we have calculus backing our play. We’re creating models that are explanatory, not predictive.” That is the problem. We assume that the model somehow gives us an insight into the ultimate trajectory of the market, as if there is determinism in the model and in the math, and that is just not the case.

Kevin:So Druckenmiller really has been ahead of the curve many times. What was his thought on gold? If he doesn’t think the free money is going to continue to flow, my question would be, what is his thought on gold?

David:Well, I think he sees a step sequence. He would say that the big moves for gold are still on the horizon, and it’s not going to happen tomorrow. His justification for that is that he sees QE coming back into play, Powell bringing QE back.

Kevin:As a reaction to a crash of some kind, a market decline?

David:Right, yes, as a response to a significant market decline, QE is reintroduced and gold goes absolutely bonanza-like. Two other points that he made – corporate profits cannot stay at these elevated levels, and his exhibit A was 10 trillion dollars in corporate credit growth. When you have taken on the amount of debt that corporations have, and then you start tinkering with the interest rates, he makes the case that the profit cycle is in the upper 1-2 percentile. It’s at the end of the line.

Kevin:It’s topping out.

David:Yes. And lastly, something he said – again most of his thoughts related to a liquidity shrinkage thesis, which not only impacts the cost of capital. Rising rates also impact the ability of financial entities to roll over their debt. Again, less available credit, high replacement costs, things of that nature. But also, if you are talking about higher interest costs, you are impacting profit margins. We mentioned that earlier.

Kevin:It’s like having an ARM – an adjustable rate mortgage. As that rate goes higher it gets to be more and more difficult to service that loan.

David:Yes, it’s fine on the front end, but there are knock-on effects across most asset markets, and so, an across-the-board bull market in everything, in the context of liquidity shrinkage, turns into an across-the board bear market in just about everything.

A big point he wanted to make on the debt structure was that by 2025 here in the U.S. our debt structure is terminal – his word, not mine – terminal. But the problem is, that is seven years off. So you can see this slow-moving train wreck and the problem is, making a bet on that, you can accrue lots of losses in the next seven days as you wait for impact over a seven-year period. So he was very keen to point out that the markets today are about three times what they were at the end of any other cycle, so he said that are really no historical analogs here. He said it is just flat craziness.

I guess the way I would summarize his ending comments was, “Systemic stupidity on steroids.” You can try to borrow from the 1930s, you can try to borrow from some other past financial crisis, and most of the financial crises that we have had were teed up by massive excess, perfect sentiment, a booming market, ebullient spirits – and then boom! We had the crash. He said we have all of those things times three today.

Kevin:One of the things we see toward the end of the cycle is strange accounting. You are talking about profits, but a lot of times profits can be played with. I know forensic accounting is something that you have been very, very interested in. There was a speaker at the Grant’s conference who is an expert at forensic accounting. First of all, define forensic accounting, and then tell us what she said.

David:There are occasionally other speakers at the conference who specialize in something like this. Francine McKenna spent most of her life as a forensic accountant and has since joined Market Watch. She had some very interesting comments on Berkshire Hathaway. Her words, not mine – “Berkshire Hathaway is a roach motel.” Again, forensic accountant, in recent years has taken to journalism, and she sees Buffet’s baby as a work in accounting subterfuge. She gave many illustrations which I thought were interesting. It might surprise some of our listeners to hear – Enron, Herbalife, Symantec, Valiant, Berkshire, Tesla, and Alibaba, all put in the same context of misrepresentation of financial realities.

Kevin:And she included Berkshire in that.

David:Yes, and they do that via non-gap earnings releases and purchase accounting wizardry, and things of that nature. So, it just is what it is. Purchase accounting is something that they use, and it is a way that they can game the system. Non-gap earnings releases are a way that they can say whatever they want, and then in the 10K or 10Qs later on, make the revisions and full disclosures after the fact when there is no audience for the real numbers.

Kevin:And this is where forensic accounting becomes important because you have to be able to see behind the accounting curtain to understand that. One of the things that I love about Jim Grant and the books that he has written, and his newsletter, is that he has a real focus on economic and political history. Obviously, we can’t predict the future, but if you can look back in the rear-view mirror, you can see what has happened before, and I would imagine that they had a historic perspective, as well.

David:Other speakers on China, which I didn’t learn anything new, in particular, from that presentation, just to say that there are problems brewing, and significant implications within the banking system there, given the amount of debt that they have to control. Again, nothing new in terms of there being huge amounts of nonperforming loans which are all chickens that haven’t yet come home to roost. John Law, and the History of the Mississippi Bubble – that was an interesting presentation. Jim Bianco is great. He reminds me of Bill King. Bill King brings a lot of energy to our program a couple of times a year. Jim Bianco is like Bill King from the Midwest, just focusing on technical analysis.

Kevin:Just a plain speaker. He says it plain, and you love it.

David:Yes. He loves technical analysis. And what he concluded is that there is really nowhere to hide. We are moving back toward asset classes being positively correlated, and he gave some great scatter graphs which showed what the transitions have been, and why he holds to that view. If he is right, frankly, I like the idea of gold, maybe cash, as well. But what he sees us transitioning back to is an overtly inflationary concern. In that context, positive correlation between assets occurs pretty consistently. He gave us ample evidence of that. I guess his caveat was, even if inflation does not reemerge, you have the inflation mentality, the perception, and it is being pushed by the Fed.

He did a word study of Fed language over the last several years. Actually, he did a word study of all of the Fed releases in all of history, and then through an algorithm, looked at the frequency at which they were talking about inflation, and in the last 18 months, it was just going nuts. The way he ran his algorithm, it is almost as if the only thing they care about anymore is inflation. It is not necessarily the case, but again, it is just interesting that their tone has changed.

Two things, going back to the presentation, historical, John Law and the History of the Mississippi Bubble. Two things stood out to me on the History of John Law. First, Richard Cantillon was John Law’s contemporary in the 1700s. He wrote then about this and I think it seems just as applicable now, as well. He wrote that most of the money created at the time, during the Mississippi Bubble, did not get into the economy, but rather, it inflated asset prices. So on a very lagged basis, you saw consumer goods inflation which was an afterthought.

So, asset price inflation came first, consumer price inflation came later. We have discussed that on the Commentary before as the Cantillon effect. Like honey migrating from the center of a plate toward the edge, it takes time to spread.

Kevin:Before you go to the second point, for the person listening who is not familiar with the Mississippi Bubble, there was a great book that talked about it called, Extraordinary Popular Delusions and the Madness of Crowds. It was written in the mid 1800s about this very thing.

David:It is a must-read, I think for everyone.

Kevin:You have to have it on your shelf.

David:Oh, absolutely, it needs to be read and re-read in terms of understanding crowd dynamics, social dynamics, and panic dynamics, particularly, because panic typically follows a major rise in any particular asset class, and this is one of those, literally, for the history books.

Kevin:Not understanding this is a little bit like not understanding the American Revolution. You have to understand certain things to understand what happened. Or the Communist Revolution, as well.

David:The second thing I thought was interesting from that presentation was, there was a foreign exchange crisis which began as soon as people started taking gains and moving out of the French livre.

Kevin:So after that huge, huge bubble and all those asset prices expanded, those who were getting out were also turning around and getting out of the currency.

David:Yes, and so it started to have a negative impact on the currency. And that was a fresh insight for me.

Kevin:I don’t remember reading that. That is an interesting insight.

David:Yes, so livre problems after massive excess, intoxication within the financial markets.

Kevin:I wonder if that could ever happen to the dollar?

David:Well, what was a fresh insight for me is exactly that. You say, “Wait a minute. What does the dollar look like in the event that assets are sold?” Let’s take, for instance, from now until year-end. Foreign investors taking gains note that we are less and less popular internationally, and whether it is a tiff with the Saudis this week, or a tiff with the Chinese the week before, or next week, foreign investors have played a significant role, not only in the fixed income markets, but also in the stock market.

Kevin:Look at the Russians. Jim Deeds brought that out last week, that the Russians have really reduced their treasury holdings to almost nothing.

David:Right, so if you begin to see a migration, not just out of stocks, but particularly if foreign investment dollars don’t flip from stocks to bonds, but instead head for the exits and come out of the dollar, do you develop a livre problem following too much liquidity and a frat boy-style party?

Kevin:So that would be called cirrhosis of the livre.

David:(laughs) That’s right. Thank you (laughs). So the issue comes into high relief when we think about rapidly rising deficits. Not only do we have problems politically and geopolitically, but geopolitically is what we will talk about here in terms of international relations and how the treasury is viewed, how the U.S. dollar is viewed, from more of a political calculus, not just an economic one. But bring the economic factor in, we are running an over trillion-dollar deficit. The last 12 months, Jim point out, 1.2 trillion dollars. I think, actually, the number is a little closer to…

Kevin:That would be 8100 dollars per working person in America.

David:1.4 trillion is what I count for borrowed funds in the last 12 months. It raises the question about foreign support for the treasury market. Very interestingly, we got to see the government bond offerings last week, which were, should we say, disappointing. And these were all short-term paper, this is not like long-term debt where people might say to themselves, “I’m concerned about this or that.” Very little interest in in 2, 3, or 5-year treasuries, which I think was important. I don’t know if that is going to be a trend moving forward, but we didn’t seen the kind of interest that we generally do, and a lot of that paper just went back to the dealers.

Kevin:We saw that vulnerability a couple of days ago when Saudi Arabia just mentioned the possibility of not trading oil in dollars. We know how vulnerable the dollar is if oil wasn’t traded in dollars, and we have protected that, really, since 1971 when we closed the gold window. We have to have those foreign investors.

David:So where you are beginning to see, I think, interesting behavior, is from the White House. Not interesting, as in, a new version of the old comb-over or anything like that. That would be really interesting. But political, as in, he is starting to put a ton of pressure on the Fed, and saying, “Wait a minute, what are you guys doing raising rates so fast? This has got to stop, this is nonsense. You guys are a bunch of crazies.” And you know what he’s doing? He is defending the political arena that he exists in. He is defending legitimacy, because it isabout the economy, stupid. And as you raise rates and begin to see an impact in the financial markets, dominos in the financial markets end up falling into the economic sphere, and it is not very long…

Kevin:Before it’s in the political.

David:Before there are political ramifications to what is done at the Marriner Eccles building there at the Federal Reserve. So that, I think, is worth developing. The language that Trump uses directed toward Powell will be very, very important to keep in mind. But I think there are a couple of other areas which are absolutely vital to keep in mind, and this will sound familiar, but margin debt has been a big theme of ours the last couple of years.

Kevin:Alan Newman, especially – he puts it in every one of his letters.

David:That’s right. We hit the peak in margin debt in May at 669 billion – not quite that high now, I think it is in the 650s.

Kevin:But it’s still higher than ever, as far as the other pre-crash highs.

David:And that is why it has been on our minds for the last couple of years, because as a percentage of GDP, and as a percentage of stock market capitalization, and as just in nominal figures, we have blown away every other peak in terms of borrowed money. Why is this a key element to us? Because it tells you how over-confident investors are.

When you are confident, you go out and buy stocks because you think tomorrow is going to be better than today, and on that basis, you see growth and reward for the risk that you are taking. Over-confidence is expressed when an investor says, this is such a guaranteed layup, two-point shot, I’m going to bet not only my money, but I’m going to borrow money from the house and double down on that bet so that I can make even more money on something that is a riskless bet.

That kind of over-confidence is in the market, on display, in ways that we haven’t seen since 2000, since 2007. Before that you have to roll the clock back all the way to 1929, again, where borrowing, margin debt versus GDP, was getting above 2%. Now we are not above 2%, or 2.5%, or 2.8%, we are at 3.2% of GDP.

Kevin:We have never been there before.

David:No, we haven’t. So you could look at things from a valuation perspective, which we often do, so the Buffet indicator tells you that the stock market is overvalued. You could look at things according to the Shiller PE, and that would tell you that things are overvalued – 31, 32, it’s pretty high.

Kevin:It has never been higher except for once.

David:Right. So from a valuation standpoint, from a market sentiment standpoint – and this did not come out at Grant’s conference, but I have been reflecting on this the last couple of weeks because Doug Noland and I talked about this quite frequently of late – there have been a number of significant hedge funds that have decided to close down. Maybe one or two of the smaller ones it had to do with performance and it’s been a tough row to hoe the last couple of years. They have been under-performing the S&P or what have you. But there is a bunch of others that have just quietly disappeared – 10, 12 billion-dollar hedges.

Kevin:Contact the investors, send them their money.

David:Yes, just sending your money back, deciding we’re going to go do something else. Again, nobody is saying the market is going to crash, get out of the way, and yet the smart money is doing just that. They are returning investor capital, they are converting to family offices where they have a lot more opacity. They don’t have to report any of their holdings, necessarily. It depends on how they structure themselves, I guess.

But I think capital is about to get quiet, and the capital markets are about to get crazy. And smart money knows it. When Jim Bianco says the specter of inflation is here and we’re going to see greater and greater correlation amongst asset classes and there is no place to hide, what that translates to me is, we’re in the catbird seat.

Do you know what we do? Yes, we’re in the money management business, and yes, we run the Tactical Short with Doug Noland, but our business since 1972 has been brokering gold and silver. And while it has been a low light and very uninteresting over the last five to seven years for investors who have been watching the price decline from $1900 to $1050, and we currently sit just below $1250 on the ounce price, with the dynamics that these guys are describing, and the chaos that, whether it is Druckenmiller, or Bianco, or others described, and certainly Jim Grant is right in there amongst them saying, “You know the place to be?”

Tony Deden shut down his management business, and now it is just a holding company. He is not managing money for other people, and a part of that is, he says, “I don’t want people asking me questions as to why I own gold, and if I want to allocate money to gold then I want to do that without being questioned. It makes sense to me, and at the end of the day, what is valuable to you is going to be answered on a very subjective level. He has answered that in terms of gold. Grant has answered that in terms of gold. Druckenmiller has answered that in terms of gold. Bianco didn’t say gold, he just said, “We have inflation coming, and everything is going to go down.” But guess what? Gold is in the catbird seat to do very well in that context.

Kevin:And Dave, this is why you go to New York. This is why you go to the Grant’s conference.

David:It adds perspective, It challenges my thinking. I get to listen to the best explanations given for what is next by a number of investors, and sometimes I agree with it, sometimes I don’t. That is just the reality. But here I am watching Well Fargo and Bank of America and Goldman-Sachs and some of the financials come under significant pressure, and no one seems to really notice or care. And this has been happening prior to last week’s volatility. But what are the financials telling us? What has copper been telling us? What are the credit markets telling us?

I think if you’re interested in hedging risk, understanding risk, understanding cracks within the credit system, by all means, join us for the conference call with Doug Noland this Thursday, 2:00 p.m. Mountain Standard Time. Register for that ahead of time.

But if nothing else, at a minimum, stay engaged, because this is going to be an absolutely fascinating, 3, 6, 12-month period of time.

Recommended Posts

Start typing and press Enter to search