Andrew Smithers: Road to NO Recovery

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About this week’s show:

• Corporate investment low, exec bonuses preferred
• 1929,1999 & 2013, the three most overvalued years
• Raise cash now!

About the guest: Mr. Andrew Smithers is the Founder of Smithers & Co. Ltd. Prior to starting his own firm, Andrew was at S.G.Warburg & Co. Ltd. from 1962 to 1989 where he ran the investment management business for some years and which, by the end of his tenure, was the acknowledged market leader. Purchase his book here: Click here

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, last week we talked to Russell Napier, and we really didn’t get a chance to talk to him about this dramatic move over in Europe, Draghi lowering rates from 0.5% down to 0.24%. It was quite a shock to the market.

David: It’s the reality that we continue to face, that global recovery has yet to occur, in spite of the mainstream media saying that it’s already here, it’s been here since 2009. We also had Lakshman Achuthan from the Economic Research Cycles Institute reiterating, yet again, that when an economy is in recovery and out of recession, you don’t have rates set at zero here in the United States, or near zero.

And as you mentioned, Kevin, we also have the decline in rates, Mario Draghi taking them from 50 basis points, half of 1%, down to a quarter of 1%. These are signs of the times, and recovery times, the National Bureau of Economic Research said we were in recovery and out of recession here in the United States back in 2009. Contrary to that is the fact that quantitative easing continues, we have record low rates, and we’re not the only ones doing that. It’s the major central banks, the Keynesian Trio, as our guest today, Andrew Smithers, likes to call them. That is, the U.S., the U.K., and Japan.

Kevin: Russell Napier has been good at pointing out ways of determining if we are in recovery. He wrote the book, also, about when to determine when there is a bottom in a bear market. Andrew Smithers is an interesting guy, and I know Russell Napier refers to Andrew Smithers’ works, and they teach a class together. Tobin’s Q is something that Napier has fixed on and Smithers has taught on for years.

David: Andrew Smithers, our guest today, is Chairman of Smithers and Company, a leading expert on finance, economics, and global asset allocation. He has been writing, his family goes back, not only decades, but I believe centuries, into the financial industry in the U.K. I’ve been reading him for 12-15 years. His book, Valuing Wall Street, was very critical to the things that I was reading and thinking about back in 2000, 2001, 2002. His most recently published book, The Road to Recovery, is a book that looks at how far off the mark current monetary and fiscal policy is, if you, in fact, want to create recovery. He looks at many of the missteps, again, policy missteps, that are leading to the disappointment in economic recovery, both here and abroad.

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Well, I’m sure you have many a sanguine view, but both in your book from the year 2000, Valuing Wall Street, and your more recently published The Road to Recovery, you express some concerns that an intelligent investor would be wise to listen to. And we want to talk about the U.S. as well as the global economy, and today, dig into several of your bigger concerns. We’ve had numbers this week that are, on the face of it, rather encouraging. U.S. GDP for the third quarter increased 2.8%, while 2% was expected.

Of course, you dig into it, and I think this is what you do so well, Andrew, in both of the books just mentioned, you do dig into things. We had escalating inventories, we had declining imports, really a sign of economic ebbing, as the biggest positive changes to the GDP numbers. Maybe we can look at what has not been going right. Your views include an allowance for deficit spending. We’ve had that as a means to recovery, we’ve had strong monetary policy, but you would hold that the current policy-makers have taken more of a cyclical or short-term view, and are not even looking at the right issues to begin with. Maybe you can put that in context for us.

Andrew Smithers: Certainly. The thing which I agree with current policy-makers on, is what you might call the first step of the famous analysis of John Maynard Keynes. He argued that if consumers and companies wanted to save more than they wanted to invest, there were only two things that could happen. This excess of savings over investment, as intended, would either have to be thwarted by a collapse of income…, but because the two often have to be the same, governments would have to step in and run equivalent negative savings, that’s dis-savings, to offset the intended surplus.

And what happened in the Great Recession, as it’s being called, was that you obviously had this cut-back in intended consumption and investment, particularly in investment, while companies and households wanted to keep their incomes up, and in the short-run, the quite sensible, in my view, correct response, to avoid depression, or generate a very, very severe recession, because we had a pretty severe one, was to run a large fiscal deficit.

However, the next stage of Keynes’s analysis, or his assumption, I should say, rather than analysis, was that if you did that everything would be all right because the animal spirits of entrepreneurs would revive and companies would then start to reinvest again and this excess savings surplus would disappear, and as it disappeared, so would the fiscal deficit come down again.

Now, the big difference, in my view, and those who take what I might call a naïve Keynesian approach to the current problem, is that the animal spirits of entrepreneurs have not been returning, and investment and savings have remained out of kilter, particularly in the corporate sector. In fact, it’s almost entirely in the corporate sector that the problem exists.

My explanation of that is that it isn’t animal spirits which is driving investment and savings anymore, it is modern remuneration practices. There is a wealth of evidence in other people’s surveys which show that there has been a very dramatic change in the way senior management in America and in the U.K. is paid. The basic salary has become far less important than it used to be and the main element in the remuneration packages for senior people now is the bonuses that they receive.

If you change people’s remuneration, you change their incentives, and if you change their incentives, you will change their behavior. In fact, that is the reason for changing incentives. So we shouldn’t be too surprised, which most economists appear to be, however, if that, as a result of this dramatic change in incentives, we’ve had a dramatic change in behavior. Company management are now intent on saving as much as they can by pushing up as hard as they can, profit margins, and investing as little as they think they can get away with.

This means that incentives, a recovery in the animal spirits of entrepreneurs, as the economy has been recovering a bit, has been in a sort of deadlock, in which the recovery has been slow and faltering by historic standards, and corporate savings surpluses have remained very high, and this pattern is, I fear, likely to continue.

In addition to the work that I have done showing that this is what has happened in terms of the data and the statistics which I’ve sought to illustrate with a huge number of charts and graphs, because I think that’s obviously some of the best ways of communicating data, it’s much less dull if you show it in chart form than it is if you recount it, and you can see from this that you’ve got a very poor recovery in investment, and you’ve got exceptionally high profit margins for what otherwise appears to be far from being a full-blown recovery of the economy.

These are exactly what you would expect if you change the way you pay people. If you’re managing a company, you have to balance off short-term and long-term risks and the long-term risks consist of losing market share and finding that your expenses, your cost of production, are rising relative to that of the competition. If you wish to avoid those long-term risks, you will tend to be rather competitive in your pricing, and you will invest a lot so that you can get your cost of production down. However, the short-term risks of both of those operate the other way. If you invest a lot of money in the short-run, you tend to make less profits, and certainly, you make less profits per share if you can invest in buying back shares rather than invest in plant and machinery.

Equally, if you push up profit margins as high as you can get in the short-run, you can maximize your short-run profitability at the risk that you will, over time, lose market share compared with more competitive people. And what we are seeing on both sides of the Atlantic is that for the state of the economy as it is today, investment is poor and profit margins are incredibly high. At a gross level, that’s before depreciation, U.S. profit margins, that is, the profit as a proportion of the output of corporations, is the highest it has ever been, and net, it’s very nearly the highest, that’s after deducting depreciation.

So what we see is a world in which the expected response of what I call naïve Keynesianism, is not happening, and we are therefore in a problem that we have a structural, or secular, if you like, problem on our hands, not just a cyclical problem, which goes with the swings and ups and downs of enthusiasm and optimism. We are looking at something else. And the failure of economists in government and central banks on both sides of the Atlantic, to recognize this problem is meaning that the policy at the moment is inadequate to deal with the problem.

David: There are a number of things. Certainly, the buy-back that you described, and the bonus culture, this is different than past periods, and you point out that since 2008 the proportion of cash flows invested in equipment is the lowest on record in proportion to that spent on share buy-backs. To look at why that is, what is accomplished in the share buy-backs, you have changed earnings per share by limiting the number of shares outstanding, in efforts to boost the share price, and again, this goes back to the short-term management focus which you have just described. It’s a short-term focus and it’s not really investing for the long-run. And I think that would come as a surprise to most of our listeners, in addition to profitability being something that is generally regarded as a positive outcome.

You do point out many times in the book that profits do revert to the mean. Right now we have the highest level of corporate profits, arguably, on record. Maybe you could just speak to what that implies. If profits revert to the mean, where are we, where are we going, in terms of the corporate profit cycle, and to put a bow on that, what does that mean for share prices? What does that mean for the market? Is it over-valued and heading to lower valuations in light of profits being at record highs?

Andrew: Certainly, profits are best, I think… when you say that something is high, you are obviously implying that it has a sort of normal level, and when you said mean reverting, that is exactly and correctly what you have said. And what, historically, and in theory, mean reverts, is the proportion of output of corporations, which goes to capital, and the proportion which goes to labor. All output has to go to one or the other, and the proportion that goes to capital at the moment is extremely high and that is the profit share of output. As I said, measured one way it is at an all-time record high, measured another way it is very nearly at that high. So labor is getting a very low proportion of total output at the moment.

Now, profit margins have been mean reverting in the past. It doesn’t necessarily say they will be in the future, though I think it is likely, and if they are, what it means is the profit margins are going to fall, and as profit margins are more important in determining profits over the next five years, the growth of the economy or anything else because the swings are so much bigger, what we are looking at is a high probability that profits are going to fall, and fall perhaps quite sharply, over the next five years. What does that mean for the stock market? Well, stock markets go up and down for a number of different reasons, and probably two of the more important things are what you can get elsewhere, i.e., what are the competing animals around, how much you can get on cash or bonds, and how high profits are.

It is quite likely, I think, that looking ahead we are going to find that we are in a world where the competing instruments, cash and bonds, yield more than they do today. Certainly in the case of cash, it could not yield any less, whereas profits are going to be actually going down. I think that the probability, therefore, is that we are in for a very tough time. I wouldn’t know when it’s going to start, nobody does, but it looks to me as if the stock market outlook over the next five years is very poor, and this can be shown in another way.

I publish on my website every quarter when the data come out, and will have some new data early in December, the valuation of the market depending on two particular criteria. One is Q, which is the relationship between the market value of nonfinancial companies, and the value of their assets, and the other is the cyclically adjusted PE, which a way of saying, if profits were at their normal level, how would the PE be, and both of these things show that the stock market is around 60-70% overpriced today.

That’s not as bad as it was at the peaks of 1929 and 2000, but it’s at the heights of other peaks. The other great major peaks were 1906, 1937, and 1968, and we’re currently at, or indeed, perhaps occasionally a little above, those levels. So we are at dangerously high stock market levels.

This doesn’t mean that you can say the stock market is going to go down next year. If high markets were followed by falls, even financial analysts would notice. Even, perhaps, central banks would notice. And it wouldn’t, therefore, ever happen. If it was easy to forecast when markets came down, you wouldn’t find them getting over-valued, or under-valued, for that matter. It is the uncertainty about when things happen that enables all these things to continue. But if you are looking at a reasonable distance, you are not looking at the short-term, we must, I am afraid, say that the prospects for the stock market are very poor.

David: When you put that in the context of the amount of debt that we have, set side government debt for a moment and just focus on private sector debt, it has been reduced somewhat since 2008. We were cumulatively close to about 600% of debt-to-GDP if you combined the financial sector, the corporate sector, the household sector, and now we are about 525%. You do point out that we also have off-balance-sheet debt in the United States. Corporations in the U.S. since 1952 have increased their debts, but really haven’t disclosed it, so to say. It was, in 1952, 3% of GDP, now it’s close to 90% of GDP.

Number one, is it fair to include that in the total liability structure, which would bring us well above the 600% we had, to about 615%, and is this a degree of leverage there on corporate balance sheets and in the system, which does, in fact, set you up for, not just a minor decline in the economy, but a severe recession, as, and when, or if, we have a decline in asset prices?

Andrew: The answer to your first question is, I don’t think it is fair to include off-balance-sheet finance. The reason for that is I think that most off-balance sheet finance are nonfinancial companies and include households who, in America, I believe, quite often people rent rather than buy cars, for example, these debts should appear in the financial data. The financial sector’s debt should represent the whole, and presumably, represent a large part, at least, of the debt in the nonfinancial sector. So I think the first thing to say is that I don’t think it is sensible to double count. It is why you need to include financial debt, however, when you are looking at the total debt of the United States in the private sector.

The second part is quite correct. Although debt has come down a bit since its high, it is still monumentally high by the standards of even, shall we say, 1929, when we last had a debt crisis, and it is in my judgment, far too high for financial safety. And you quite rightly say this means that we are in grave danger that if there is a sharp fall in asset prices, stock markets included in that, bond markets included in that, then we are in grave danger that we will simply have a repeat of the financial crisis we had in 2008, and it will be worse in its impact, because having spent so much money in terms of fiscal deficits and quantitative easing and all these other things, the firepower to deal with another financial crisis is considerably less, I think, than it was in 2008.

It seems to me, therefore, that the aim of central bankers, particularly the Fed, should be to get asset prices down slowly. The trouble with asset prices is not that they fall occasionally, as that wouldn’t worry anybody too much, it’s that when they fall sharply they have a much more pronounced impact, that it is a nonlinear event, i.e., a 10% fall probably has a fairly minor impact, if any, on GDP, but a 20% fall has well more than double the impact on people, and a 30% fall is, again, well more than treble the impact.

So central banks, particularly the Fed, should now, and should for some time, have been aiming to get a slow decline in the stock market and the bond market, and unfortunately, they have been doing exactly the opposite. If you go out on quantitative easing and buy up assets, you don’t get a slow decline in them, you tend to get a rise in them. So I am extremely critical and think that the policies that are being pursued by the Fed are very dangerous and almost exactly the opposite of the ones they should be pursuing.

David: It was William McChesney Martin, the Fed chief that suggested the role of the Fed was to take away the punchbowl before the party gets started, and it seems that the Fed is actually spiking the punchbowl instead.

Andrew: It’s done more than that, it’s put out this (laughter) enormous punchbowl at which everybody has fed in large quantities, and no doubt, it’s an alcoholic punchbowl, too, to judge by the reaction. And when, a few months ago in June, they started to even talk about taking away the punchbowl, the reaction in the stock market, which was actually probably useful from their point of view, the stock market said, “Oh dear, we must go down,” and it went down. It didn’t go down so much as to cause the economy to be badly hit, I don’t think, but it caused the Fed to lose faith in their own business.

The trouble, I think, at the moment, is not just that the Fed is failing to remove the punchbowl, but having started quantitative easing and put out this enormous amount, it just doesn’t know how to get out of its own problems. It has created a policy, it’s done one of the things you shouldn’t do in life. You shouldn’t start something you can’t end.

David: You know, that is an interesting issue, creating dependency in the market. Combine that with New York Stock Exchange volumes, which today are half of what they were in 2007, a decline of 50-60% from those peak volumes. In addition, you have the proliferation of high-frequency trading and computer algorithms dominating the volumes that remain. It seems that participation in the equity markets is actually quite thin, even though prices continue to be pressed higher.

When you combine these issues, and yes, we just talked about Tobin’s Q, what goes through your mind? Overvaluation, going to even greater levels of overvaluation? You’ve already mentioned there are only two dates where we have seen even greater overvaluation, according to Q, and that’s 1929 and 1999 or 2000. Can this end well? Obviously, you’ve said that they need to lower asset prices, but that doesn’t seem to be their mode of operation.

Andrew: No. Obviously, I am entirely in the direction of your thought. It seems to me that the policy being pursued is dangerous, and that we are therefore going to rely on luck, because if you have a dangerous policy being pursued by the Fed and no sign that it doesn’t want to continue to be dangerous, it’s obviously a matter of alarm. However, I don’t know the future any more than anybody else. I don’t wish to be overly gloomy. We often have had a lot of luck, and we’re going to need it, that’s the only thing I’m afraid of.

David: Again, we started out by saying you do have many sanguine thoughts, but you are an analyst in the dismal science, and your analysis has been very prescient. In the year 2000 you were pointing out, 1999 I assume when you were writing the book before the 2000 publish date, you were writing about the fact that markets had never been over-valued to that extreme level, and that it did argue for a decline in equity values, and it was a matter of months, not years, before you were proven right in that analysis, and the fact that we are now at levels similar to 1906, 1937, and 1968, these were also years of incredible overvaluation. If you were sitting with a grandson or granddaughter and trying to share some wisdom, how would you advise them? How do you navigate these waters? Yes, maybe on the horizon there is a better day, but in the interim, knowing what you know, with some precaution, how do you take the next several steps?

Andrew: In terms of the investor’s portfolio, what you said is obviously correct. How should you apportion your assets at the moment? Let’s talk about only the three major groups of assets because no doubt there are clever people who can find something else which will behave well even in dark times. But for most people, the opportunities open are to buy bonds, equities, or hold cash. It seems to me that both equities and bond markets are extremely over-priced, and a wise person will therefore hold a great deal of cash.

How much cash depends on a number of things, one of which is your age, and whether you want to hold assets for your children. I’m 76 years old and I take a cautious view, though I’m hoping that my children will be able to inherit something from me, but I do hold a portfolio which is predominantly in cash. People dislike that. I find often they say, “But it doesn’t yield anything.” Well, I’m afraid my view is that the main aim at the moment shouldn’t be trying to make money, it is trying to preserve what you’ve got, and I think, therefore, a high proportion of cash.

I wouldn’t hold bonds at all, I think that you mentioned just now the low turnover of what you might call long-term investors in the stock market. I believe that in corporate bonds, particularly, it’s even worse, and I think that means that in the event that we do have trouble in these markets, the liquidity will dry up very heavily, and that is, actually, of course, all one’s experience of large declines if declines take place. When liquidity is very poor, you can’t get out.

So, basically, I think the aim of investors at the moment should be to preserve wealth rather than to make it, and the way of doing that is to hold cash, and you have to suffer, in the meantime, the pain that you are getting no return on your cash, and the value of your assets are, therefore, falling, by whatever the inflation rate is, though fortunately, at the moment that’s not too much. I’ve often found that people, when I say these things to them, get positively irritated because of the low return on cash. In fact, it’s almost as if cash has become a four-letter word.

David: There are several points that I would like to come back to here, I think this is absolutely critical. One of the things that you prescribe, given the imbalances that we have in the international or global economy, is that the current deficit countries force other surplus countries to do their work in rebalancing and that may only be possible through a devaluation of their currency.

So let’s assume that the Japanese have a head start on this, and the U.S. and the U.K. have not really gotten started in the devaluation process of their currencies, again, “to encourage” further rebalancing by surplus countries. That does put your cash position in an even more precarious position, assuming that it’s losing purchasing power, not at a low level of inflation, of course now it is a current low level of inflation, but I’m reminded of several places in your most recent book, I just can’t recommend this book highly enough, The Road To Recovery. But you do point out a number of instances, both in U.S. and U.K. history, where we went from low levels of inflation in a very short period of time, from 2% to 20%. 2% inflation is not a big deal, but if you are a cash-holder, 20% is a tad bit more than discouraging.

With that advice in mind, which I consider sage advice, yes, we would agree, hold a great deal of cash today, but how do you juxtapose that with the challenge of preserving value when one of the only solutions in terms of global rebalancing, is a concerted devaluation of those currencies?

Andrew: You have made an extremely important, and quite complex point. One of these is, of course, the extent to which devaluations will be reflected in domestic inflation. I think at the moment that is going to be quite mild. We are not operating in a world which is booming ahead. And if you are going to devalue, without having bad consequences for inflation, that is the time to do it. It’s the time to do it when the world as a whole is not going to simply push your own inflation rate up. And I think that is the case at the moment. So I’m not overly worried about the knock-on effects of devaluation on domestic inflation.

The next issue, of course, is that given the present policies it looks as if the Fed may well wish to drive the economy up until it does get inflation and we get inflationary expectations. My own hope, and to a large extent, expectation, is that we are not going to see that happening. I don’t think it’s going to be very easy to drive the American economy up to the point in which inflation starts to take over. The quantitative easing, which is the main method, seems to me to have been quite effective at the very beginning in preventing panic. But I think it has had very little benefit to the economy since then, and I don’t think, therefore, it will do much damage to it if it eases off, unless it eases off so fast that we get a crash in markets.

So my expectation is that we are going to see a slow rise in inflation and inflationary expectations and this will be sufficient for the Fed and other central banks to actually find that they are forced by the pressure of events to be putting up interest rates and thereby to be containing too much inflation forever and getting going again. I don’t think we’re going to go back into the 1970s when we saw these dramatic rises in inflation. I think we’re almost operating in a very risky way, at a time when those dangers are perhaps rather less, in fact a lot less, I hope, than they were 30-40 years ago.

David: It is with the eeriness of the ring of familiarity that we see monetization then, in the 1970s, and now, and a lot of asset purchases by central banks, in past periods of inflation, and perhaps you can expand a bit on how you think it is different this time, and different, perhaps, than what we saw in Germany in the period of 1919-1923, in which we did have monetization of assets and we have seen that also in Zimbabwe and Hungary and a number of other countries, leading into strong inflation.

Andrew: Yes. Well, it’s a judgment about the behavior of the Fed. Basically, I think that if and when inflation does start to pick up, the Fed will delay too long, it will get behind the curve, but I don’t think it will do it to a damaging extent until we get inflation rising to more than 5%. Believe you me, 5% extended for several years is very unpleasant, so it’s a choice of evils. Would you rather lose 5% on your cash, or 14% on your bonds, or 60% on your equities? That’s the sort of nasty prospect ahead of us. Not that I know what the figures will be, of course, I don’t. But it seems to me that being worried about inflation is sensible. Being worried about inflation and then saying this is the reason for not holding cash, I don’t think is sensible.

David: I would agree with you, and there seems to be the issue in play for most equity analysts that if you are going to be concerned about inflation you need to own equities to preserve value, which doesn’t, in itself, make a tremendous amount of sense.

Andrew: No, that doesn’t. I think one also has to remember that some managers have a very big conflict of interest, and one mustn’t blame them for it. When Stephen Wright and I were writing Valuing Wall Street, the market was very much more expensive than it is today, and therefore the probability of it falling over the next 12 months was much higher. And we calculated, or estimated, on the basis of past falls and timing, that there was an unusually high probability that the market, at the beginning of March 2000, which was when we published the book, would fall over the next 12 months.

It was still, however, only about 70%, and we said that if you were a fund manager, and you read our book, and you understood it, and you decided to act on it, what would you do? And we said you would probably sell your own portfolio and remain invested for the club because a 30% chance of seriously damaging your business and your career is probably too large a risk to take, and there is, therefore, this great conflict between the interests of the business of fund management and the interests of the cartes, and in our book we said, as a result of that, you want to make your own decisions about the degree to which you are invested in cash, bonds, or equities.

Read our book, we said. Don’t follow other people’s judgment, because there is simply too much conflict of interest, and too many people who don’t like facing up to reality, who will argue, “Oh no, it isn’t perfectly objective, and therefore you should behave this way.” Be careful. Investors, I am afraid, cannot rely on advice, even my advice. I kept saying, “Don’t rely on my advice. Read the book and make your own mind up.” This is the only way in which you can get a really objective view of what the prospects are and how you should invest your money.

David: James Tobin developed the Q ratio, but I would say, though he may own the concept, you expanded it in such a way as to make it accessible to the investment community, so I cannot recommend your other books strongly enough, either. Valuing Wall Street, yes it’s 13 years old, but it’s a concept that is young in people’s appreciation and use and application of it.

And as you mentioned earlier, if we are 60-70% overpriced in the equity markets today, what you are referencing is Tobin’s Q, and your second favorite valuation metric is the cyclically adjusted PE. Both of those give you invaluable insight into where the market is, not necessarily where it’s going, as you have just said, it’s a question of probabilities as to whether or not we go higher or lower from here.

But to look at those valuation metrics and see where it is either overvalued, or extremely undervalued, from the standpoint of managing wealth on an intergenerational basis, it’s really, really critical, I think, to, as you said, make your own decisions, but do that from an informed perspective, and one that perhaps gives you an insight into whether or not you are paying a high price, a very dear price, or, in fact, are paying very little for quality assets.

Just to reiterate, the reflection you had, would you rather choose a -5%, a -40%, a -60%? No, that’s not with a crystal ball, no you’re not the Oracle of Delphi, saying this is what will happen in those precise numbers, but there is greater risk today in the bond market, and greater risk today in the equities market, than there was yesterday, or six months ago, or two years ago, and it continues to compound the wrong direction.

So, preserving wealth, yes, that should be a strong motivation. Maybe you can address this. Even though the average investor would say, “But look at what I’m missing out on.” If the market goes up 20% from here, do you really want to be left out of that? How would you counsel, again, if you brought it back to the familial level, how would you counsel someone in your own family, to say, perhaps sometimes it’s better to let someone else make those last few dollars?

Andrew: Yes. My poor family know me well, so the counseling is not terribly important with us. They know my views. But the point you’ve made is a good one, and it’s crucial, I think, to say what you just said. Value is a measure of risk, not of the likely short-term behavior. If people knew that the market was going up for a year and then was going to crash, everyone would sell in 11 months and therefore they won’t have to sell in 10, etc.

The timing of the fall-off must be unknowable, or markets would never get overvalued. What, therefore, you have to accept, is that if you are going to take, on my view, a sensibly cautious view, when markets get wildly overpriced, you have to accept that you are going to probably miss out on the last few bits of the market, and if the current bull market goes on the way the last one did, you’re going to have another couple of years of very, very bad worries as you see the market roaring up, and people will keep on telling you that this time it’s different, and you will feel very sad, and you will say, “Smithers, you’re an idiot, you should have told us, later.” But I can’t do that, I just don’t know, and nobody can know. What I can tell you is that markets at today’s level are extremely risky, and that is the information that you should go away with, and on that basis you must make your own decisions.

David: One last question, and perhaps this will be a controversial one, but going back in British history, the crown was concerned about how they were going bankrupt in the early 1700s and Sir Isaac Newton was brought in to figure it out, one of the great scientific minds of the time, and he put the British in 1717 back on the gold standard, and fixed the problem that the money guild had created. To a certain degree, we have the “money guild” today. There is devaluation. The crown is not going bankrupt, I don’t think, and certainly the U.S. is not entirely bankrupt, though our books are not as pristine as some believe them to be.

But this issue of gold being money was in 1717, it’s not today. Today we have faith and confidence in the Ph.D standard, more than the gold standard. But if you do increase your cash position, does it not make some sense to find an offset to those potential losses as a consequence of devaluation. Is gold, or a personal gold standard, is that apropos?

Andrew: I don’t think so, myself. I think that history would tell you that if you are going to get a really sharp rise in inflation, gold is probably going to be quite a good place to put your money. But it doesn’t help much if you get the sort of increases in inflation that I’m talking about, 5% per annum inflation for several years, and I can’t see any predictive element which tells me how gold should be priced. I just don’t know it. I’ve looked at gold, I’ve listened to wise men talk about it, and I’ve come to the conclusion that as far as I’m concerned, gold, even over 10-15 years, is pretty much a casino.

David: So then cash is a preference, and keeping your options and a certain degree of optionality open, would be a preferred course.

Andrew: As I say, I concentrate my analysis on things which I feel I can get some reasonable guide to – cash, bonds, and equities – and, for the long term, if I had to hold an asset of those three for the next 30 years, I would expect equities to give me a marginally better return than the other two, certainly a better return than bonds, and probably a better return than cash. But my view is that during that period over the next 5-10 years, shall we say, we are going to have a very, very much worse return from equities and bonds than you will from cash. And I therefore think that it’s wise and prudent for investors to hold substantial cash ratios.

But as I keep saying, I can give you the analysis, and I look to other people to study, and if they think that my analysis is poor, to take a different view. But I think it’s very important that you don’t listen without severe critical analysis. A lot of the stuff is put out because it is self-interested. There are very big conflicts of interest out there, and it is important for investors to be able to take a critical analysis of what they are told.

David: Andrew Smithers, I appreciate your time, I am in your debt, having learned a tremendous amount from your published works, and those who would like to read more can order your book on amazon.com, The Road to Recovery: How and Why Economic Policy Must Change. And as a two-for-one, while you are ordering it, go ahead and get Valuing Wall Street. I have read some of your other books, as well. These two I consider seminal, one for understanding where we are and where we are going, and the second, your older book, for just a basis in valuing the equity portion of one’s portfolio.

Thank you for your contribution. I really hope this is not your last book, but we appreciate the education that you continue to provide, and the insights. Your wisdom is greatly appreciated.

Andrew: Well, thank you, David, for the kindness. A little flattery is very welcome. Thank you very much.

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Kevin: Something that you’ve been talking about, David, as you’ve been on the road talking to our clients is how critical it is to be in a cash position, to be outside of the markets right now, especially with the lack of recovery in the market. Of course, David, we take a little bit different view, that cash should also be treated as a gold position. Cash for 4,000 years has been gold. Paper cash is being printed. Why don’t you comment a little bit on your difference on the cash position and how you view cash?

David: Sure. I think the obvious take-away here is that the risks implicit in the bond market and the stock market are very high and only growing, and it’s very much like climbing the steps of a ladder. The higher up you get, the greater the risk when, or if, you should fall, and that, I think, is something that we need to keep in mind. If you only include, in your asset mix, bonds, equities, and cash, then cash is your preferred go-to, we would include real estate and gold in a five-basket mix: Bonds, equities, cash, gold, real estate, your five major asset classes. And would say that today, some balance between actual greenbacks, and actual ounces, is a good way to offset and negotiate that road between the intended efforts of devaluation by the Fed, by the Bank of Japan, by the ECB, and in the consequences of that for your savings, the loss of purchasing power. That’s not something that you have to receive and thank them for. A loss of 5%, yes, is certainly better than a loss of 40% or 60%.

Kevin: But is it necessary to even lose the 5%? That’s my question to you, David.

David: I recall reading Valuing Wall Street, this was a good ten years ago, and thinking that if you look at the Dow-gold ratio, and if you look at how the Dow moves into periods of decline after reaching its peaks of over-valuation, you see a very compelling case, a quantifiable and compelling case, going back over the last 100 years. These are the periods of time that you do, in fact, want exposure to the precious metals sector, and it is an incredibly powerful ingredient in an asset mix, and there is a time to come back into equities, there is a time to come back into bonds, but to move to cash and only cash, as in fiat currency, misses a very powerful ingredient.

But again, going back to 1890, 1910, if that’s your starting point, and moving forward, every period of stock market excess, followed by stock market decline, those periods of decline were the periods of time in which gold and silver did their very best. So that’s where I think maybe a distinction, our view versus Mr. Smithers’, would be, and that is, we would prefer to denominate our cash in the real and enduring properties of precious metals, as opposed to the paper promises to pay, which are issued ad infinitum by the world’s central bankers.

Yes, we like cash, and would even concede, owning greenbacks, redbacks, whatever color your currency is around the world, that is, having a precious metals position that offsets the losses from that cash position.

Kevin: I think Russell Napier, just listening to the interview last week, would agree that gold does play a role, cash plays a role, and it’s important to make sure that you hedge yourself that way. I know, Dave, you and I do that. I’ve got kids who are in college and I don’t keep all of my cash ready to go for college. I have to sell gold when the tuition comes up each semester.

David: I think there are many things to take away from our interview with Mr. Smithers today, and I would encourage you to look at The Road To Recovery, look at Valuing Wall Street, and mine through those books, gathering the nuggets that will add to the backdrop, the wisdom from which you make decisions. I would probably lean less on the judgment about the behavior of the Fed than Mr. Smithers, and rely less on luck and more on the predictability of human behavior, which is, again, if you are looking at the historical record, tending to swing from extremes of greed to fear, well reflected in that Dow-gold ratio which we refer to so often.

This is the time, in full agreement with Andrew, to be eliminating, or reducing, exposure to equities and bonds. Yes, someone else may have the benefit in the short-run, of an extra 5, 10, 15, 20% run higher, but the 20, 40, 60, 80% potential declines in those markets, we are now in an era where there is more to lose than to gain, and the bond market has us very concerned, levels with interest rates we haven’t seen since 1946, and if you look at the cumulative losses over the ensuing 35-year period, cumulative losses were over 90%.

These are things that are not particularly encouraging for someone who is owning stocks and bonds, to have and to hold, from this day forward, till death do they part. Don’t be married to your investments. Consider, pragmatically, where it makes sense to be, and yes, cash and the enduring qualities of cash in ounce terms, would certainly would be where we would stake our claim.