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The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

“That is what we are about. That is why we have an offensive coordinator in the form of wealth management strategy, a defensive coordinator in terms of the best folks in the industry in the gold and silver space, to help with this major transition ahead. Two years from now, three years from now, five years from now? I’m willing to be patient because the numbers involved are almost unimaginably large.”

– David McAlvany

Kevin: David, again we’re talking remote. I’m here in the studio, you are in the airstream. I got a chance to sit with your family the other night when we were in Austin at one of the conferences, and just really enjoy the fact that your four kids are getting to spend time with you and Mary-Catherine on the road. It makes me think of the things we have to be thankful for, being on the road with you guys and doing the conferences, meeting with some of our clients that have been with us 30 or 40 years. It is a week to be thankful, isn’t it?

David: It is. Five of the seven conferences we have done now, over and over again, there is a sense in which not only are they grateful that we have come out to their areas and neck of the woods to spend some time with them and to give them an update. But we are just as grateful because we understand that with the nature of our business we wouldn’t be in business if it wasn’t for people transacting with us and extending to us the opportunity to serve them. And so, we’re in our 45th year of business as a metals brokerage company and asset management firm, and it is a real privilege for us. We certainly feel that gratefulness, that gratitude for the opportunity to partner with families inter-generationally.

Kevin: Dave, when I was sitting with you in the airstream the other night before we went to all those food trucks in Austin – we just sort of had a progressive dinner, you, your dad, your family, the kids, and some of the other people who work at the company. It was really an amazing thing, and when you told me, it gave me back the memory that I had forgotten that this was something that you did with your father, going back 35, almost 40 years, where you guys were in a Winnebago when your dad was traveling and talking about the economy. It’s sort of a full circle. You talk about things in your legacy book, but this was truly seeing legacy replayed.

David: Yes, it’s definitely at a different life cycle or time in our family. I learned to walk in the Winnebago, whereas we don’t have any kids that young. But it was my mom and dad, my older sister, our German Shepherd, and the road – the road before us, the road behind us. It was an adventure for all, and a few points of near insanity, I think, probably for my mom, just dealing with kids and dog hair and all things practical. But, in the end, great memory-makers. And so, we’re super grateful to have this time together as a family and it is good for them to see what it is that we do on the road, and to get to do that all together has been super rewarding.

Kevin: One of the things, too, that our clients are getting to see if what you have written about in your book, Legacy. I just want to mention for the listener, that is a book that has gotten almost exclusively five-star ratings on Amazon since you came out with it. That Legacy book is talking about things far more important than just financial legacy. It is talking about deliberate family action and redemption in a family.

So I would just like to encourage listeners, at these conferences you are selling out of the books that you bring, but I would encourage any listener who is interested in reading your book, Legacy, to get on Amazon, order the book. If you like the book, or if you don’t like the book, go ahead and put a comment there on Amazon, but I can tell you, after working with your family for 30 years, the things that you write about in the book I can say are true. The stories that you have told about your family, the ups and the downs, and the redemption that is there, definitely makes for a great Christmas gift for a person who is trying to add value to their family relationship.

David: Kevin, we got to spend time with clients who have read through it, poured through it, shared copies with siblings and with their kids and grandkids, even, and that has been one of the things they have commented to me. The reason they ordered a book or half a case, or whatever, was so that they could stuff stockings this year, and continue a conversation, hopefully engage a conversation across generations on the topics that are most vital to extending legacy, the legacy that you want, from one generation to the next. So I’m pretty excited about that, pretty excited to see how it has been received, and the impact that it is having on people’s lives, because frankly, the big surprise for me is that it is not just content and ideas to chew on, but there are some things in there that people are finding really transformational and something that represents a hard stop in terms of the way they thought about life prior to, and an enthusiastic way of looking at things differently moving forward.

Kevin: I think you are even surprised because a lot of the things and the takeaways that are happening with people are really bigger than what you had in mind. You were just simply telling a story, but it is amazing how people can start to relate and start to utilize that type of thing.

Dave, I’m going to go ahead and move to the events of the week because talking about a replay full circle, we’ve been seeing manipulations in the gold market. We saw a replay day before yesterday of what we talked about last week. If you recall, you talked about four billion dollars’ worth of gold being dumped into the market all at once to purposely push the price down, for whatever reason. And then day before yesterday, on Monday, we saw the same exact thing. It was just about half that size – 15,000 futures contracts were dumped on Monday. It was about two billion dollars’ worth of gold just instantly dumped into the market. Now, of course, the market has recovered since then, but what are your thoughts on that? Is it that they are afraid of $1300 or is somebody just trying to buy at a cheaper price?

David: I think Volcker made it clear that the importance of the gold price is it signals a no confidence vote within the system, whether that is relating to our system of debt, or the stability of our currency. Where you see traffic into the metals people are basically saying, “I don’t like what I see. I think I’d like to opt out, and I want to do it in a way that gives me some insulation.” Historically speaking, this is an asset, a currency form, which has never gone to zero, and it makes sense to just sort of step aside for a while. So, that’s what an increase in the price of gold is really signaling, and why Volcker was so emphatic that his one mistake in the 1970s was not hammering the gold price.

You might say, well that’s discouraging because it just means it is more of a target now than ever before. What is encouraging to me is that with each intervention in the market you see less and less impact. So, $100-150 dollar decline circa 2013-2014. Fast forward to 2015 and it is more like a $50 or $30 dollar decline. And now you can wallop the price $10-15 bucks on the day and it costs you a lot of money to do it – 1.9, four billions dollars, 15,000 contracts – that is what was dumped on Monday morning in a fraction of a second.

And certainly it has an impact on the price. But here we are, buoying back even to those same levels. And what I love to see is that the free markets ultimately have their day in the sun even while manipulators can have, and have had, their day already. So moving forward, I see it as an impact that is less and less significant.

Kevin: We are in an environment of record highs and last Tuesday the utilities surged to record highs. But we have record highs occurring in just about everything right now. So you have this gold manipulation on the one side, and then you have Bitcoin on the same exact day going up to a record high of $8,200. Do you want to talk about some of the record highs and what those are signaling for the future?

David: I’m not complaining by any stretch. One of the things that was shared in the conferences with folks is that we have hit record highs in household net worth, so as the utilities average surged to record highs last week, we have record highs in net worth, we have record highs in the bond market, at least in the last 12-16 months. We have record highs in stocks and other indexes. We have record highs in art, a 400 million dollar purchase for a Da Vinci, record highs in Bitcoin, as you said, over $8,000. I’m sure there is no coincidence in the bubbling up of prices, or there being a reason for caution. You have a brave new world of people shooting the moon in almost every category.

Kevin: Often, Dave, you have talked about not investing with your feelings, and a lot of times when you have record highs going on the feeling is that a person needs to jump in. You mentioned a few weeks ago that the fear in the market is not fear of it going down, but fear of missing out. So people quickly forget that there is a market feeling that permeates and influences the prices.

David: Yes, and that is the operative feeling which is either bullish – and you might call that greedy – the positive element driving prices higher. Again, I’m not complaining – it is what it is. But I think we know where we are in the cycle of things because the other side of that equation is bearish and where people are more concerned, focusing on asset preservation. But when you recognize where you are in a cycle and you are getting to new highs which represent a certain form of an extreme, what do we suggest? Reducing exposures, raising cash, diversifying into real wealth out of assets with temporary prices that have reached unsustainable levels.

Of course, high can go higher, just like low can go lower. When you are thinking of buying a market low, it can go even lower. I’m not saying sell everything. No. But the future is never what you think it will be, entirely. So hedging your bets is wise. I have routinely circled back around to Rogoff’s comments on the cryptocurrency market. It is an area that has gone high, and will continue to go higher, but Rogoff’s comments on Bitcoin are certainly sobering. He said in a recent Project Syndicate article that the long history of currency tells us that what the private sector innovates, the state eventually regulates and appropriates, and there is no reason to expect a virtual currency to avoid a similar fate. He said that back on October 9th in that Project Syndicate article.

Kevin: It is interesting, Dave, at these conferences when we go to question and answer, one of the first two, maybe three questions, has to do with Bitcoin. I know that the people who are asking the questions aren’t necessarily invested in Bitcoin, but it has been such a phenomenal bubble, if you can call it that, or such a phenomenal rise, that people are intrigued even if they are not attracted. With what Rogoff is saying, it is obvious that the government, at some point, will have to do something about it because the government, itself, is not going to give up the biggest business of any government, and that is printing your own money, being able to borrow in your own money, and pay yourself back in money that you can print. You can’t do that with Bitcoin.

David: That’s a pretty valuable franchise and currency monopoly status is not something that governments in the past have given up without something of a fight. So if a technology fixation causes you to ignore the history of monetary monopolies, to ignore warring states, to ignore the nature of governmental control, then I would say that you are not at the cutting edge of the future, but probably on the knife’s edge of the past. Government’s routinely gut their citizenry like fish. Of course, if it serves their interests, that’s when it happens. We should always remember that as valuable as the distributed ledger and the blockchain system is, it is not the private sector that is in control of the kill switches on the Internet. Ultimate control of the Internet is in the hands of governments. So if bits are private today – that is the part where you can keep it offline – their movement is anything but private. Cumulative since 2011-2012, you have 980,000 bitcoins which have been hacked and stolen. What makes you think the NSA or some other governmental group can’t completely coopt the cryptocurrency universe, just as Rogoff has suggested?

Kevin: It is interesting, the people that I have talked to who absolutely don’t want to hear about Bitcoin being anything but a valid market, usually don’t have much market information or history. They are looking at a new technological boom. Dave, it reminds me a lot of talking to people in 1998 and 1999 about the dotcom bubble, when stocks got to be so ridiculously so overvalued – the price earnings ratios were to the moon. People were saying, “Don’t you understand, this is the advent of the Internet. This is a new world. It is a new means of valuation. It’s not a bubble.” Of course, we learned differently in March of 2000 in the NASDAQ. Really, many of those companies never recovered.

So, it is interesting that you have a technology that you will see – and you have pointed this out in the conferences – this blockchain technology is an amazing technology that the government will use to their advantage at some point. It’s like a beta test, like Tesla when they are beta testing the models that drive themselves. In a way, bitcoin is being beta tested for something further that probably will be government controlled.

David: Yes, the blockchain is incredibly valuable, it’s just the iterations which, today, we see them growing in popularity, various tokens and coins which may not exist five years from now. That is the big question.

Kevin: Right. Talking about government monopolies, we’re seeing this Senate tax plan coming through, and it’s strange that the monopoly of – let’s call it government incorporation, which is a monopoly unto itself. You could even call it fascism, where big business is favored by the government and small business is not. The Senate tax plan is making the individual, you and I, tax breaks temporary, but the corporate tax breaks – it sounds like they are going to be permanent.

David: Who are you working for? That is the question that comes to mind. It is the question that comes to mind when I think about our representative form of government. Times have changed since the original formulation of an idea, whether it is Jefferson, Madison, Hamilton, Washington. Because the answer today is not We the People. From the L.A. Times, the Senate tax plan, they report, makes the individual tax breaks temporary, while corporate tax breaks would be permanent. And so, who are they working for? That becomes obvious.

It is a combination of democracy/kleptocracy. The demokleptocracy serves corporate interests over individual interests. And that really is because K Street lobbyists are the voice our representatives hear, and I would love to see the electorate express disdain and intolerance for that sort of corporatist – what classically was defined as fascist – where you can’t tell the difference between big government and big business – that corporatist system that we are perpetuating. It is fascinating to me that Republicans actually make the best fascists because they can’t see the difference between governmental and commercial interests, and they are only too happy to blur the lines.

Democrats make no bones about being anti-business, and even amongst the elite within the Democratic party, the Clintons proved that they can work for themselves, which is not necessarily anti-business, it is just kind of pure corruption (laughs). That’s a different kettle of stinking fish, where business can be co-opted for personal gain, even while in public office.

Kevin: Dave, I would say that I’m a conservative. I am a conservative because I believe in free rights, I believe in small business. But it is embarrassing at this point, in many ways, to call myself a Republican because the Republican party has turned into a fascist party, like you are saying. The qualifications of a conservative, years ago, really was a benefit to the individual, and now the individual is being ruled out for the corporation, so the party really ought to be renamed.

David: Yes, that’s right, because there is this sickening element within the Republican party, and certainly this does not represent all Republicans, but that sickening element within the party is that big business has co-opted big government Republicans, and then gone on to abuse the small business and entrepreneurship language as if they are actually for the little guy and champions of a small to medium enterprise.

Kevin: And that’s not true.

David: Right. Nothing could be farther from the truth. Look at how they are treating pass-through entities. The little guy is getting screwed while big business gets the tax reduction benefits. And there is a vast difference between big businesses and small businesses. On this point, let me start and finish with this. Velocity of money is surprisingly low, and I’m just going to speculate here, but it is surprisingly low, in part, due to the sucking of local dollars out of local economies back into the tax-and-spend jurisdictions where big business is centered. When you look at mom and pop businesses, they may not be the largest employers, or represent massive jobs growth, but they tend to save and spend locally, which sets off a very different economic virtue.

What am I talking about? Higher circulation of dollars, and thus, improved velocity, on a small scale. So, is it possible that we have business conversion toward monopoly-type status – again, big business status? Can we thank them for the ever-diminishing velocity of money numbers that we have seen? And is it possible that, in turn, our credit and monetary policies – I’m talking about easy money, of course – have exacerbated the merger and acquisition consolidation, and thus, on a broad scale, much lower velocity?

And so we look at low economic growth in this period, and we say that velocity is not a constant, as it was assumed to be. It has been significantly lower. Dollars spent are not being recycled through the economy. Why is that? Where are they going? Why aren’t they being re-spent? I want to tell you, I think, one of the reasons. If you look at Amazon and its impact, there is a lot more of dollars spent in a particular locale than in all the locations where products used to be bought and sold on a more localized basis.

Kevin: Oh, that’s very obvious as we travel. The talk right now – there are several things going on. I remember a gentleman asking a question when we were in Austin, Dave. He is a family man. He is raising children. And he is realizing that most of the jobs that people are working in right now will somehow either be automated or “Amazoned” out of business. And so he asked you the question, “What in the world do I teach my kids? What do I do now so that I can prepare them for the future?

The other side of the coin – some of the cities that we visited are possibly on the list for an Amazon distribution center. The talk there is like, “Oh my gosh, we need to buy real estate here because that is the wave of the future,” to quote your dad. So we have this concern of automation, and “Amazonization” on the one side, and then on the other side, the only real economic benefit is for the person who is packing the box for Amazon in one of the cities that is chosen as a major distribution center.

David: At the same time, I look at, from a big picture perspective, things that signal to me coming ever closer to a recession. You have the yield curve flattening here in the United States. We have talked about interest rates coming up here in the tail end of the fourth quarter. In other parts of the world you actually have an inversion of the yield curve where your short rates are higher than your long rates. And that’s always been a precursor to a recession.

Kevin: Isn’t that something that Ben Bernanke has talked extensively about?

David: And other economists too. They have generally held that yield curve inversions are a precursor to recession. And frankly, flattening of the yield curve gets you there, with inversion not being absolutely necessary. We are talking about, again, short-term duration rates rising, even as long rates stay at a lower level. You have the year-end hikes. Should they go through with them, they do flatten the U.S. yield curve. China has already inverted, as I mentioned. In 2006 this was the case here in the United States, as it has been the case in the preceding seven recessions, where inversions were a signal which told you what was coming.

Of course, there are other things that would signal and compliment it, too – collapse in housing starts, a variety of things which we have not seen yet, which we will keep our eyes out for. But now the treasury curve is at ten-year lows. You go back, you look at the recessions of the 1990s, you look at the recessions of the 2000s, and those recessions came anywhere from two to 24 months following yield curve inversion. February 2006 was the inversion, and the recession wasn’t made official for another 22 months from that time. But I look at China as one of those places which, perhaps, if they catch a cold, we feel it here in the United States most acutely. It has become that way in an interconnected world. We have China – even more disturbing than their yield curve inversion is the growth in popularity of securitized assets, up 61% from last year, likely to hit 170 billion U.S. dollar equivalent, according to the Financial Times.

What are we talking about in terms of securitized assets? This is like our garbage repackaging back in 2006-2008 where we took mortgages, we took credit card loans, we took auto loans.

Kevin: Yes, remember all the acronyms. You just cut those things up into pieces and sell them as a security. Nobody really knows what they are.

David: That’s right. We rebundle them, we resell them. Maybe the Chinese are more careful in their construction of credit instruments, but the reality is, these are like grab bags. You have a Smorgasbord of anything that couldn’t sell individually which sells a lot easier on a collective – call it Communist soup – “You bring the stone, I’ll bring the…whatever.”

Kevin: It reminds of the book, when I was a kid, a lot of people have read it – it’s called Stone Soup. “You bring the water, we’ll bring the stone.” And then everybody is hoping at that point that all the better ingredients will be added from the outside.

Speaking of that, if indeed we are two to 22 months from the next major recession, one of the ways that we have been able to delay the recession so far has been with the expansion of credit. The IMF says over the next five years that the expansion of credit is going to be ridiculous – 45 trillion is what they are estimating in the expansion of credit. So could they delay this recession just by going further and further into debt?

David: Not only delay recession, but take asset prices literally to the moon – 45 trillion dollars over a five-year period, 18 trillion in credit expansion in the United States, 27 trillion in China, nearly doubling their current credit markets to 54 trillion total, in a five-year period. That is astounding – expansions in the asset markets which perhaps we have never seen in history. And yet, I am concerned that we are playing with fire here. Recession may bring the consumer back into the pit of despair and we may see that happen before we see this massive credit expansion that the IMF has suggested or talked about.

If the consumer goes back on strike, you are going to see massive credit growth, but it is going to come from governments, primarily, which forces the issue of how you can fund explosive budget deficits and maintain currency stability. There is a whole host of things that come in a domino effect, once government is the spender of last resort. And I don’t think it is going to be the consumer stepping up and driving economic growth, economic activity, or even credit growth, unless they are really fortified and made more comfortable with their economic realities by significant improvement in income.

Kevin: Something that I’m seeing again, Dave, and we saw this back before the crisis in 2008 – households are running their credit cards up like mad again. Household debt seems to be on the increase.

David: Yes. It’s a combination of things, when you’re talking about household debt. It did reach a new peak. It is now at 280 billion dollars above the 2008 third quarter high, which was the record up to that point in U.S. history. The New York Fed reports that they have seen gains, both in mortgages, auto debt, and in student debt, which brings us to the current number of 12.96 trillion dollars, with the largest percentage increases coming on credit cards. And who knows, maybe that is a pre Black Friday surge, maybe it is just that cash-strapped Americans are tapping credit by necessity.

But Market Watch, the news group, comments on the household credit card and auto debt portions. They are looking at a surge of roughly 116 billion dollars – that increase. And here’s the shocker. Credit card and auto delinquencies, according to them, are rising at a disturbing rate. They have commented, too, on the student loan delinquencies, but pointed out something very curious. It is difficult to wrap your head around the student loan delinquencies because you have 10% which they know are in default – harder to figure out on the rest because half of those loans – we’re talking about 1.4 trillion dollars total – so about 700 billion dollars are in deferment or in forbearance. So again, it’s just tougher to say. You can’t call those nonperforming when they are in deferment or in forbearance because they are not technically in default or nonperforming but could easily be recategorized as such.

Kevin: Everybody is going into debt. Deficit spending for the government last month – 63 billion dollars. You would think that wouldn’t be the case if we’re taking in more tax revenue.

David: And that’s the crazy thing, because when you are running 63-billion dollar deficit in the month of October, October is a little bit like April in terms of tax collecting. You get a big pop in the numbers. So the Treasury collected a record amount of taxes in October, but still ran, as you mentioned, a 63-billion dollar deficit for the month. I would think that the deficit spending theme is definitely a 2018 to 2020 issue, with some potential major implications for the U.S. dollar, as our foreign creditors, and perhaps the appetite for U.S. credit, diminishes.

Kevin: Talk about insatiable appetites, we talked about individual debt going up right now, hitting records, government deficits continue to rise, and the corporations seem to also have an insatiable desire to borrow money right now.

David: Blumberg had a fascinating article on that last week, Kevin, sounding the alarms on rising corporate leverage. What is corporate leverage other than debts on the balance sheet growing disproportionately to the assets of the corporation? So, even as investors are actually turning away from the corporate debt markets all over the world, and we have even seen outflows from junk bonds, 4.4 billion dollars this last week, which was higher than usual, than in recent weeks, maybe investors are done with chasing yield. We’ll have to see. Maybe they are just locking in gains from their credit exposures as they head into year-end.

But here’s the deal. You have Yellen, you have Draghi – you have central bankers who are suggesting a rising interest rate environment with quantitative tightening now, the opposite side of the equation. Everyone knows QE, or quantitative easing. Quantitative tightening is the new description, which may be what we are beginning to see on the front edge of inflated bond prices coming back to earth, yields beginning to rise again. Again, we are seeing that particularly in the longer maturity paper and in the junk bonds, which we think of as the hold your nose credit segments.

Kevin: Dave, if that corporate borrowing was to actually make corporations more productive, we might actually have hope. But as you’ve brought out in the past, a lot of that corporate borrowing is just simply to come in and buy up the shares of that corporation to decrease the shares on the market and increase the earnings per share. Is that a game that they are still playing?

David: Yes. That’s the perception game, and that’s where a lot of corporate leverage has gone. It’s a big component in that perception game played with earnings per share. So you get the money for free, or nearly free, in the credit markets, buy back your shares – and this is the embarrassing part – at record prices. And by shrinking the shares outstanding, you can more easily meet or beat your earnings per share guidance from earlier in the quarter.

So the corporate balance sheet is worse for it, but those same executives selling their own shares – what they hold of the company, insider selling is on the rise. It allows them to satisfy investor greed on the one hand, driving prices higher through your earnings per share manipulation, and attracting new investors in on the basis of “added performance” on an earnings per share basis, while at the same time they are extracting value for themselves through insider selling of shares.

It is strange to me how no one connects the dots between insider selling of shares and the use of a corporation’s treasury to go out and buy shares back. If I were the new sheriff in town, cleaning things up on Wall Street or in corporate America, I would want to see a rule in place that precludes insider liquidations within a 90-180 day window of corporate buy-backs. That, I think, just makes sense.

Kevin: Dave, I know that you are not a proponent of a lot of government regulation, but every once in a while regulation is necessary, when it comes to breaking up monopoly, like we talked about with Amazon. Also, regulation as far as just outright abuse of the shareholder. It makes perfect sense that the government needs to step in at that point and have some say in the matter.

When we were at these conferences we met with several public servants from California. One gentleman in particular who has moved to Austin is a retired firefighter. His pension is coming from CalPERS, the California Pension Fund. Lest we sound like we are always negative on the government, something positive happened recently with CalPERS. They may be seeing the handwriting on the wall. They are moving away from their over-extended stock exposure in that pension fund.

David: It still is surprising to me, Kevin, in the private sector everything has moved to 401ks where you are basically responsible for your own retirement. You save what you are going to save with a company match, and then have to be judicious about what you spend in retirement. Of course you have to be judicious if you are drawing a pension, but it is such a different world. I have talked to a family member here in Texas who works for the school district, and there are ways that you can stay within the system long enough to ultimately capture better than 100% of your last year’s earnings. You just have to figure out how the system works and, to some degree, game it.

This is what I don’t understand. You spend 20-25 years, which is a long time, in the job, but then you live 30-40 years beyond that and collect 100% of what you had earned in that 25-30 year period. I don’t fault someone for wanting those benefits, but I look at the system and I just say, “Now, how does that work?” Because in a company setting that becomes totally nonsustainable.

But to your point with the California pensioner that we got to meet with in Austin – very good news for the California pensioner. CalPERS is slashing its equity exposure from 50% to 34%.

Kevin: Will that be good news or bad news for the markets in general though, because CalPERS is a large investor. If we were to see that across the board with pension funds, there are no buyers in that stock market. We could see a substantial downturn.

David: Fair enough. It’s not good news for the markets, but it is very good news for the California pensioner, if you’re looking at getting out of the market at or near a high. Of course, CalPERS is a large equity shareholder. And on a more significant basis, they are a beacon to many investors. Bloomberg discusses the exit as very significant, and this a trend which should occur given record valuation levels.

This is how long-term tops are established. You end up with significant holders of the asset class, any asset class. They begin jettisoning that asset, in this case shares of companies, and they do that ahead of the general public. Then the public, who is always looking backward at performance and predicating the future on the past, wakes up one day, prices are considerably lower, and they don’t realize that some of your major holders, those who have been a repository, a long-term holder, have already exited. And then you are left with weaker hands. Those weaker hands are what represent the panic selling later on.

I look at what the general public is doing today. We have talked about Vanguard, we have talked about the ETFs. Vanguard is absolutely loving this blind optimism. And this year is no exception. Last year was a record year, now this year is a record year, another record year of investor dollars plunging into unmanaged funds – 350 billion dollars in flows this year for Vanguard. And you have institutional investors, again, who are looking ahead. They see the implications of over-valuation. They are beginning to lighten their exposures. Good for them. It’s a fiduciary responsibility. But the public is marching to the beat of a very different drummer.

Kevin: The public is being handed a bag by the institutional investors at a 31 PE ratio. The Shiller cyclically adjusted PE ratio now – 31. That’s the second highest in history, Dave, and it always hits these types of numbers before a crash.

David: Investment committees at pension funds and insurance companies don’t always get it right. Sometimes they get it very wrong. But they do understand the high math involved in the rolling average of the ten-year PE. Shiller popularized it, otherwise known as CAPE, Cyclically Adjusted Price Earnings multiple. You’re right – at 31, what it implies is a number that high, a ten-year average annual return – the next ten years average annual return? Zero percent in equities. Basically, the market is too high to offer rewards. It is too high to offer rewards for future growth, because that future growth is already in today’s price, and it would require extraordinary circumstances to drive prices higher, and valuation metrics even further into the stratosphere.

Kevin: It’s not just the price of the share to earnings, the PE ratio, that is hitting all-time highs. Warren Buffet has an indicator that he uses, and right now it is at all-time highs, as well.

David: You have the Buffet indicator, which is GDP-to-stock market capitalization – that ratio never been higher. You have price-to-sales, which is at all-time highs. All of this – what does it say? It just says we either move sideways in price for a number of years, or we are on the edge of a major correction in equities – dare we call it a crash? On the flip side, earlier in our conversation, Kevin, we were talking about the IMF estimates of credit market growth of 45 trillion dollars over five years. We are on the cusp of a market crash, and yet, for unhealthy reasons, we could see the Dow double from here. What’s it going to be? This is the craziness of a manic market, but it is also a very dangerous market because brains are not engaged. We talked about ETFs a minute ago, and the amount of money that is flowing into Vanguard. That is unmanaged, un-risk mitigated assets flowing into the stock market on the belief that you don’t need to be intellectually engaged in the process of investing, in fact, the market gives you reward if you just get in line. Granted, it would be first time in world history that that is the case, but that is the belief supporting this rampant move toward ETF investing, as if differentiation and careful studies of individual companies was not necessary for success.

Kevin: People are scratching their heads right now, Dave, very intelligent people, and they are saying, “Well, if this is the case, do we really even want managed money if you no longer have to be discerning? So there has to be a bright side to this though, Dave, because if the money manager right now is out of vogue, and everybody just herding into the same investments is in vogue, then when that reverses it seems that we have two bright sides. One is for the gold holder who is sitting this out, waiting for better valuations. The other is that better valuation in the equity market.

David: It’s back to a world where you are rewarded for work, and the investment process is a thoughtful process, and it is hard work. Since 2012 it has been completely unrewarding. The harder you work, it’s not the luckier you get, but the dumber you appear to be. And that is the way it has been for every macro manager, for every mutual fund manager out there, because the only thing that has worked effectively is riding an index higher on a sea of easy money. So you are right, on the bright side, gold owners in that mean-reverting period will be ringside once again for market action the likes of which we haven’t seen in 3-5 years.

And for those with patience, in the end there is reward. And for those that lack patience, I promise you, it’s a double regret. After stabilizing and moving higher in the 2016-2017 timeframe, you have the price of gold which may now benefit from having investment inflows from investors who are experiencing more normal market volatility. Do we have normal market volatility yet today? No. Are we anticipating it? Absolutely. Absolutely. And a part of it is because there are components within the market which are beyond the control of the Fed. They are tied, specifically, to vulnerable positions in equities and a vulnerable psychology which supports it.

You look at the margin debt numbers which were pegging at new all-time nominal highs 6-12 months ago – 551 billion dollars. And now we are at even higher numbers – 606 billion dollars, according to Alan Newman. This is the ticking time bomb in the stock market. You get a downside correction in motion and wonder where the massive liquidations come from? You have over half a trillion dollars in forced liquidations. Realistically, it’s only 50-60% of that number which would be forced to liquidate, but it is still very large numbers. Markets are made at the margin, therefore 200, 300, 400 billion dollars in liquidations and equities – you know what? It has a huge impact. It’s not a dollar-for-dollar impact, it’s a disproportionate impact.

Kevin: You know, every major market downturn in stocks, Dave, has always been preceded by this margin debt hitting a new high.

David: Right. And then one slides, and they both slide together, sort of a self-reinforcing price vortex.

Kevin: We were talking about the pension funds possibly starting to move out and hand the bag over to the investor, but the professional traders are not moving to the exits at this point.

David: Part of that is because they are still banking on central bank largesse. They believe that central banks have got their backs, and they are ignoring the warnings signs. They are buying every dip. At least the last 10-20 days, every time we have had a dip in price you’ve had folks step in and buy the dip. And maybe that’s the freedom they feel playing with other people’s money. Maybe it’s the consequence of cheap finance, combining those two into some sort of a speculative cocktail. Their heads are spinning. Wall Street managers – the fascinating thing is that they are 100% invested. They are leveraging up to buy more on the dips. And a part of that is they fear that their performance heading into year-end is going to fall behind in a peer group. It is a very fascinating investment environment because you have active managers – not the passive ETF guys, but the active managers – who are being discouraged from moving to cash on pain of being fired because of concerns over relative performance lapses. So instead, you have the average institutional manager now who is carrying a portfolio which is 102% long. It’s fascinating.

Kevin: Wow. That can only be done with debt. When you’re 102% long, you are beyond 100% exposed. You’re just hanging it all out.

David: And of course, that’s an average. But we had last week, which was options expiration, and if we don’t set significant new market highs in these indexes, within days, we could be putting in a market top. You have waning enthusiasm, again, amongst a few institutions, CalPERS being a really big one, and that is typically followed by a more spirited exit from positions by those who don’t necessarily know why they are selling, except that the price is going down and they had better sell. And that margin number is certainly forcing the issue at some point.

Kevin: This is the big question in my mind, Dave. We have algorithms that have been set to buy at different levels, and the algorithms seem to be running the market. High-frequency trading – 70-80% of the market at times. So is there a time when these spirit exits from positions really have no buyers, where there is no bid because, say, the algorithm is overwhelmed?

David: I think that is the new world that we are in. We can imagine a lot of profit-taking in the year-end, if folks want to secure good numbers for 2017 performance. And that profit-taking may, at a certain threshold, overwhelm the algorithms, as you described, smoothing out the declines, intervening on the downside. But when we get the collapse in the market, I think a part of the postmortem is going to tie to the inadequacy of the new regime, the new algorithm trading machine, trading settlements there in market dark pools. We assume that they can match all buys and sells. We assume that they are doing that with greater efficiency. That’s the sales pitch that has been made by these dark pools that are settling trades today. But if you have a preponderance of liquidations, sells, and only a limited number of people stepping in to buy, what we are going to get to witness, and I think this is all a part of a postmortem that is talked about in 2018, 2019, 2020, is that we have had a re-engineering of the system already.

Kevin: Right, like the Volcker rule. Bookstaber, who is a regular guest of ours, was helpful with writing the Volcker rule, and then he turned around and said, “Oh my gosh, we may have created a monster.”

David: That’s right. Post-decimalization, post Volcker rule, in which there are hardly any market-makers left to warehouse the inventory shares. This time is not different due to a changed set of market drivers. Greed-oriented or fear-oriented investors – I think those are always going to be there. But the backdrop into which the fear dynamic plays has been altered, and I don’t think there are very many market participants that appreciate the re-engineering that has taken place. This is going to be the first significant decline we have with an absence of market-makers.

So who might become the buyer of last resort in that environment? I hate to say it, but it is probably the Fed. We have seen the Bank of Japan step in and fill that role for the NIKKEI, and is the next major balance sheet explosion, or expansion, at the Fed to accommodate a radically different asset class? Again, no longer mortgage-backed securities or treasuries or corporates, as we have seen with the ECB, or ETF stock, ETFs as we have seen with the Bank of Japan, but direct investment in the U.S. stock market by the Fed. They may be forced to be the buyer of last resort.

Kevin: That is the thing that has made this so difficult. Dave, you were talking about the harder you work, the dumber you look, when you are in the investment field right now. The smartest of the smart guys, the guys who understand history, the guys who know how to do analysis of the balance sheet, they are all losing to just the general herding of putting everything into, say, a Vanguard. But what we have is a complete lack of price discovery, and the beauty of the market is that we actually can see the appropriate price between a buyer and a seller that they can agree to, unless there is a third party coming in and buying everything. That is what we have seen in Europe, that’s what we have seen with the Bank of Japan. That is what we are seeing here. So this buyer of last resort – I guess the only thing that would stop it from happening is the inability to continue to borrow and print.

David: I remember sitting at dinner with a bond fund manager. He owned his own business and had been trading bonds for 35-40 years. He thought that pricing dynamics in the bond market were getting crazy. This was 40 years ago – 40 years ago. There was an offer on the table. Somebody wanted to buy his company, and they did. Very, very healthy, eight figures. And happy to walk away and retire, happy to move directly into the gold market at that point, and happy to sit and wait. Because one of the things that he knows, being in the business for 30-40 years, is that what he was looking at, and what he was trading at on a daily basis, was no longer tied to reality. You have had a massive distortion in prices within the bond market. What could drive greater distortions in the stock market? Again, we go back to central bank intervention. You have 11 trillion dollars in sovereign and corporate bonds, which are trading today with yields less than zero. And that is a distortion created by the central bank community. We may see even greater distortions in other asset classes. It is a mania. But I am betting the surprise element of a no-bid market is enough to scare the whiskers off any Wall Street alley cat. And I think the opportunities on the short side will at some point open up considerably.

We have rough patches in the past, if you look at a November to December timeframe. And I’m not saying there is a symmetry here, but there is an interesting frequency where November to December you end up with a real rough patch in the stock market. This is 2017. Where were we at in 2007? A bit of a rough patch November to December. A bit of a rough patch if you roll the clock back to 1997. A bit of a rough patch if you move back to 1987. A bit of a rough patch if you move back to 1957, 1947, 1937, 1917, 1907, 1897, 1887. All of these saw a very difficult environment late in the fourth quarter. I don’t know if 2017 is going to be the same, but we will see.

Kevin: Isn’t that interesting? What a strange pattern. So, in a ten-year stretch, that which is the 7th year has, more often than not, been a rough patch between November to December. Who can explain why that would happen, but it is an interesting observation.

David: We are seeing some revelation of weakness within individual companies. We have General Electric, who has sold off over 45% since the beginning of the year, and they were considered sort of a bellwether, almost a mutual fund in one company, if you will. I am reminded, as we wrap our comments today, of the importance of moving from one asset thematic to another at a critical juncture. Roll the clock back to the year 2000. I’m working with Morgan Stanley, I go to a special meeting at the Ritz Carlton in Pasadena, California where some of the larger blueblood holders of General Electric shares were invited – Pasadena is a fairly ritzy part of Southern California, some of the very wealthy families, largest shareholders in GE are in that neighborhood.

This was actually the first year that I bought gold as an adult, selling for around $300 an ounce. I remember GE, in that timeframe, because I began to think, “ I can choose one or I can choose the other. What do I want to have, a cross-section of corporate America or something that is, in this sense, alternative?” I looked at $30,000, which was a modest investment at the time, but it was either 100 ounces of gold or 500 shares of General Electric. I opted for the 100 ounces of gold instead of 500 shares of General Electric.

Fast forward to the present day, and this is, again, why a transference of value is so important, and why catching some of these big thematics is so critical. I’m not opposed to owning General Electric shares. I think, today, if I wanted to, I could own 15 times the number of shares.

Kevin: With that same 100 ounces of gold?

David: Yes, if I moved from my 100 ounces of gold, currently 127,000, at $17 a share that pencils out to about 7500 shares, so I’m up from 500 shares of GE to 7500 shares, and yes, I’ve had to be patient for the last 17 years, but it is not very often that in 17 years of practicing patience you get to increase your financial footprint 15 times. I’m still holding out. I’m holding out because I think, ultimately, the transference of gold at, say, $2000 or $3000 an ounce, into GE shares, frankly, there are other companies which I may prefer in the future, but I just remember GE because that’s where I was in the year 2000 and that’s what I decided to put in motion with ounces of gold.

Fast forward into the future. I don’t know what the future is, but I think gold, let’s say it is $2000 just to keep it conservative. $2000 an ounce – GE shares, I think, in that same context, are $10 or less. This is what is fascinating. At that price, this now easy math — $2000 gold divided by $10 a share – I can now own, or then, future tense, own 20,000 shares. Think about that.

Kevin: Yes, that’s a 40-fold return by holding gold until you bought the GE shares versus buying the GE shares and holding onto them instead.

David: Oh, and by the way, if we’re just counting the new adjusted GE dividends of 12 cents a quarter, you are looking at $9600 a year in dividend income off of what was an original $30,000 investment – $9600 a year in dividend income from GE on what was originally a $30,000 investment. I like these massive transfers of wealth, and if you can ride the right horse during the duration of a race, even if it requires some patience in the interim – this has been almost 20 years – the numbers are already working. 7500 shares – if I wanted it now, that’s what I can have. I’m holding out for something closer to 20,000 or 30,000 shares for the same dollars invested.

And, I think, for the patient investor, that is what we are about. That is why we have an offensive coordinator in the form of wealth management strategy, a defensive coordinator in terms of the best folks in the industry in the gold and silver space, to help move from one asset class to the next, and vary value from secured and safe asset classes like gold and silver into the land, plant, and infrastructure productive companies in America.

I’m looking forward to that transfer, I think it’s going to happen, and as we finish where we started the conversation today, I’m glad that we are working with tens of thousands of clients across the country to help them with this major transition ahead. Two years from now? Three years from now? Five years from now? I’m willing to be patient, because the numbers involved are almost unimaginably large.

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