In Transcripts

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, it seems like every time gold gets right near $1600 they try to knock it down, but it’s not happening overseas, it just seems like it happens in the morning when we come in.

David: It’s a New York bias, and how long can that go on? Well, New York opens with liquidations. As you say, it’s not a global liquidation, quite the opposite. We see strength, we see demand, we see that continuing overseas, in the Asian and in the European markets, but when New York opens, there is a decidedly negative bias.

Is that sustainable? I think it is sustainable as long as the Fed and the powers that be, or the Bureau of Labor Statistics, can convince the public that there is no such thing as inflation. The problem is, if you take your current rate of inflation and use the 1990s model, you have a number that is 2½ times bigger.

Kevin: So in other words, instead of 2%, maybe we are talking 4% or 5%.

David: Correct. And if you are using the 1980s model, again, Volcker was not an idiot, but when Volcker looked at inflation using his 1980s model relative to today’s number, you are looking at a 4½ times difference.

Kevin: Almost 10%.

David: Correct. So what are we talking about? Real world inflation of somewhere between 5% and 10%. Meanwhile, the powers that be would say, “No, no, no. There is no inflation. We have that well under control. We, actually, are the first central bank in the world to be able to create trillions of dollars and not create inflation. I know it seems impossible, but we have the pixie dust that no one else has. It is a special thing, a special relationship we have with money, that no other central bank or money manager in the world has ever had.”

Kevin: Some of the guys that have been in gold operations, from the floor up, for years, like Jim Sinclair, are saying, “This thing is being beaten down by the gold banks right now. They are trying to keep the perception of this banking crisis that started with Cypress under cover and under wraps.

David: I think if you look at the most recent statistics coming from what the Fed was putting into the system, everybody knows about the 85 billion. The last numbers were closer to 110 billion.

Kevin: 85 billion is bad enough. That’s a trillion bucks a year.

David: We are talking about the Dow being close to 15,000, 14,600 and change, and at this point they are still increasing their balance sheet even more than they told the world they were going to. Why are they doing that? Is it because they need swap lines open to Europe? Are they really concerned about a banking crisis extending from Cypress, to peripheral Europe, to the United States?

Kevin: Explain swap lines. That is something that when Europe went through their crisis a couple of years ago, all of a sudden the Fed started creating money and we weren’t seeing it. It was going to Europe.

David: If you can imagine gears, they need a little bit of greasing every once in a while, and if you run out of grease the gears don’t run as well, so when you are looking at high-volume periods, it is important that you increase the grease in the gears. That is essentially the swap lines creating an easier transference of money in between banks and in between central banks. That liquidity has to be available prior to the need and I think that is where they have been addressing the issue, creating more liquidity, and frankly, I think they are very concerned.

You don’t see that in the stock market. Certainly investors today are not concerned. But the bottom line is that Fed policy has to be watched, not only what they say, but what they are doing. Over the last 18 months they have done virtually nothing. If you look at the adjusted monetary base, you can go to the St. Louis Fed’s website, and look at the adjusted monetary base. For the last 12 to 18 months they have done virtually nothing.

Kevin: So they didn’t increase money, but with Operation Twist they didn’t reduce their balance sheet, either.

David: Correct. Now they are back in the business of expanding their balance sheet and are on track to be at 4 trillion dollars by the end of the year. That is highly inflationary. That’s not being factored in to the official inflation statistics. The rest of the world is already aware of and concerned with inflation, but not here in the United States. Why? Because of faith in the Bureau of Labor statistics, because of faith in our politicians, who would say we have it all well under control.

Kevin: Funny you would say 18 months, David. I’m looking at the Fed chart and you are exactly right. It’s 18 months of just sort of sideways motion and now it’s shooting straight back up like a hockey stick. That, actually, is almost parallel to what gold has done, and mining shares. Gold seems like it has been dead in the water for the last 18 months.

David: And it certainly doesn’t explain the behavior of the mining shares, and of gold, of late. With that expansion in the balance sheet, we should see the metals price and the miners moving higher. Mining shares will recover.

Kevin: Really? Are you kidding? Mining shares are going to recover?

David: They will, they will, within our lifetime.

Kevin: Okay.

David: I would say, within months, but the XAU to gold, that ratio, is back to 12-to-1. You are going to have to hold your nose, and hold on. I would suggest even adding to positions might be prudent at these numbers.

Kevin: So you have to be brave.

David: Well you do. Nothing’s changed fundamentally, the market is not doing you any favors, but looking at technicals, we have a couple of things here. Stocks, meaning the general equities market, are extending a cyclical bull, but we would argue are very near exhaustion.

On the flip side, you have an extension of a cyclical bear in the metals markets, and that, too, is nearing exhaustion, an 18-month period of consolidation, and we are, I think, retesting the lows. We could see $26.50, $26.80 on silver. Again, we saw the lows tested, $26.18, $26.80. These were the lows that we have put in over the last 3 or 4 years, and are likely to retest. Once that’s done, Katie bar the door.

Kevin: Let’s do a definition, here. You are talking about cyclical versus secular bulls and bears. It’s something that happens in the short-run, but it doesn’t change the trend.

David: The longer-term trend is what we would call that long-term or secular trend. The secular trend is what we are most concerned about, and would point out that we are still in a secular bear market in equities, and a secular bull market in gold and silver. We have seen 12 years of annual increases in the gold space, and we think this will be another year where we see increases yet again.

Kevin: On these cyclical moves, though, these shorter-term moves, you see things change, like in the mining companies. They seem to stop exploring, they seem to stop doing things new, because they are acting as if it is not coming back.

David: But that is the kind of behavior you see at a cyclical low, when the mining companies are saying, “We’re not going to do any more green field projects, no more exploration. It’s only going to be established mines, those which are most profitable.” They’ve been stepping out on a limb to try to produce as much as possible, as the price of gold and silver have been moving up, and now they are having to retrench. You have had turnover in the CEO suite, with at least 15 or 20 major/minors, where boards and shareholders have said, “Enough is enough. We don’t like what we are seeing. You’re putting way too much into CAPEX and we’re demanding that you reduce that.” This is all stereotypical of a cyclical low. In other words, we are putting in a floor, as we speak.

Kevin: I want to go back to Fed policy, because I think that has been driving everything for the last five years, Dave. You said to watch what they do, not what they say. They were 18 months off, now they’re back on. We see the stock market picking up on that, but not all the stocks are going up. One of the stocks that we know all the insiders own is Goldman-Sachs.

David: And the divergence from the S&P 500, we find this very curious. While the stock market has been putting in new highs, Goldman-Sachs has quietly been drifting lower. And this kind of divergence is, in our view, negative. We’ll see if it materializes into anything greater, but this is a bellwether for insider everything. Goldman-Sachs has been diverging from the trend. Can you imply that the titans of crony capitalism are putting a few dollars to the sidelines?

And we want to see if that trend continues. We are going to watch financials. We are going to watch the housing stocks closely to see if there is more leadership, but not on the upside, rather on the downside, with the indexes following these sectors lower. It used to be said that financials led the general stock market by six months, so again, Goldman-Sachs, as being that sort of titan of crony capitalism, if you want to know what the insiders on Wall Street are doing with their own money, well, perhaps you should look at what they are buying, what they are selling, and frankly, what they are doing with their own shares. Some analysts we read see a major recovery in play right now.

Kevin: David, the stock market isn’t everything. We know there is a lot of money being created and going into the stock market, but the average guy never actually feels the money in his hand and he doesn’t actually own the stock. Like you said, it’s crony capitalism. But for the guy who has owned a house and he has tried to put the house on the market and couldn’t sell it for the last few years, there has been so much pain.

I have a good friend who finally sold his house, and what is suspicious about that to him, this guy has been in real estate for years, but he is not used to cash transactions, and a guy just walked in, handed him cash, and right now he is scratching his head saying, “Has it really changed that much so that people are just walking up with this much cash?”

David: I think there are a number of analysts out there who see this “recovery” being led by housing. That is sort of the engine of growth in the U.S. economy that is supporting a broad base of recovery, and we are skeptical for at least three reasons. As you mention, number one, cash transactions. Investors are doing something very healthy for the market and that is, eliminating over-supply, foreclosed homes and overstock. That overhang has been done away with. That’s healthy. But it is not a sign of recovery, as it speaks to a removal of over-supply, not a return to a natural and sustainable demand.

What I am looking for, ultimately, is that if you want to see a bull market in housing, you need to see a major increase in the national income, and in fact, we have actually seen a decrease. From 2000 to present, we are off about 8% in real terms. So we are not seeing an income increase, in which people are saying, “Hey, listen, I think I can afford to buy a first-time home.” We’re not seeing that.

The other thing you have to see, if not an increase in income, is a massive demographic boom. We actually have a sort of demographic bust in the offing, as you have baby boomers looking to downsize, move to the condo, move to the apartment, and out of the house that supported a family, as they don’t need that many square feet any more. So, actually, demographically, we don’t have a baby boom in our midst.

Kevin: And we don’t have increased income.

David: Right. Kevin, if I recall correctly, I think we are below the replacement of births to deaths. I think around 2.1 is what you need to have as a replacement for folks coming into culture and, unfortunately, leaving culture, as well. We don’t have that yet. So baby boom? No. We don’t have this burgeoning, 10 years from now, 15 years from now, major boom in real estate because of a demographic shift, major increase in people in demand of houses. No, we don’t have that. No, we don’t have an increase in income.

Kevin: David, you are talking about income. One of the things that concerned my friend was, this person walked up with enough cash to buy a fairly hefty home, but the job that he has does not provide the income. If he were to take a loan out for the same home he couldn’t handle it. So, there was a little bit of a concern there. Where did this cash come from, and what is this really for?

And I think what you have said in the past, too, is that a lot of this cash transaction is coming from investors, not homeowners, and it is also coming from foreign countries.

David: 28-31% of all homes that are being purchased are being purchased with cash. If you go to the sand states, Florida, California, Nevada, upward of 60-70% of all homes being bought are transactions that are cash-related. Again, this is investor money. This is investors who are sick and tired of a low interest rate environment, and they are not going to clip a quarter-percent coupon.

Kevin: This is money that would go into bonds if they were paying anything.

David: This would go into bonds if they were paying anything, it would be happy to sit in bank CDs, but as it is, they have finally reached a threshold and said, “We have to have some return on our investment.” So you have pools of capital, professional money, managed by private equity groups, that are moving in and buying houses. And you have individuals, as well, who are stepping in and buying houses.

But again, these cash transactions, while they help establish a floor in the real estate market, do not, and should not, suggest an overall recovery, as in, going back to the “good ol’ days” of 5-8% annual gains in your home. That does not happen except in an environment where interest rates are in decline. Then you can expect to see home prices increasing. But it requires that interest rates be in decline.

Arguably, and this is point number two, cash transactions leave us suspicious. We have a completely manipulated rate structure. The Fed is the mortgage market. For those who are not buying with cash, but are financing their purchases, the Fed is the mortgage market. This is, in fact, the most positive short-term element in housing, in terms of affordability. It is negative in terms of it being an actually sustainable long-run strategy, but for someone who is wanting to purchase a home, understand that the rates that you are paying to finance a 30-year mortgage are the cheapest you are ever going to see.

And given the fact that we have seen a 20-30% haircut in housing, on top of the lowest rates you are ever going to see, cash flow is what is in question here. And this is really a cash flow comment, this is not pertaining to the price paid. We do believe we could see another 15-30% decline in real estate over the next 5-7 years, but that is because interest rates would need to be on the rise, not because of an over-supply issue or anything else. As, and when, interest rates rise, you will see home prices suffer, but as interest rates rise, it also takes that home and makes it less affordable to the person coming in.

So today, yes, housing is affordable. On a cash flow basis, you are not going to see it any better than this.

Kevin: I think of places like Phoenix. Over the last year, Dave, Phoenix has risen 20%, but if you take into account what it has actually fallen from, it’s still down 44% from its peak. So you have people right now who are trying to just break even.

David: Well, the point is, there are bargains, but we would not expect them to be money-makers, they are just bargains. Cyclical bulls can take place in the context of secular bears and that same thing should be noted about the equity markets, but when you are talking about real estate, we have a cyclical short-term bull market in play.

I bought a house in 2009. I am happy to know that it is up in value since 2009. But I bought it knowing that ultimately I would lose money on the house. Why did I buy it then? I bought it because my wife wanted a house, that’s why I bought it. (laughter)

Kevin: That’s why we all buy houses.

David: I mean, we were done. We had done what we thought was prudent in renting a place for seven years, and it was time to buy. The house was priced right, but I have come to terms with the fact that we could see a 20-30% discount to the price paid based on interest rates, and this is, I think, very compelling from the Campbell Real Estate Report. He says when rates go from 3½ to 5½% at some point in the future, if incomes stay flat, housing prices would need to fall by 21% in order for borrowers to quality for a mortgage to buy that same house.

And he goes on to say that if mortgage rates went to 6½ percent, and Kevin I’ve financed at those rates before, within the last ten years, prices would need to fall 29%. On the outside chance that we see mortgage rates go to 7½ percent, prices would need to fall 36%.

Again, you have to understand some of these financial relationships. If the cost of money goes higher, the cost of the home has to go lower, to allow that same person, without an increase in income, to step in and buy the same home.

Kevin: David, we have seen interest rates dropping now for 30 years. Bonds right now are at all-time highs, while interest rates are at all-time lows. The mortgage market, as you have said before, is the Federal Reserve. Let’s face it, that is the mortgage market. It is completely manipulated.

David: But you can say the same thing about the Treasury market today. You can’t argue that a trillion-dollar footprint in the marketplace is insignificant, and yet, that is the footprint that the Fed has buying its 85 billion (last month close to 110) dollars worth of mortgage-backed securities and Treasuries. These are fictional markets. These are markets that, frankly, have no real relevance anymore in terms of what is value, what is at risk.

The question is, and the only question in my mind is, how long can they sustain this? If they can sustain it indefinitely, then we will have, frankly, an endless boom in real estate, an endless boom in the stock market, an endless boom in everything except one item, the dollar. And frankly, there is ultimately a cost, and if you are going to create an infinite amount of credit and capital, guess what happens?

Kevin: You will have an infinite collapse of the dollar, ultimately.

David: You will – a total collapse in the dollar. So they are playing with fire, here. They need a recovery. They need consumers to come back into the economy. They are willing to create a cash flow savings for the average homeowner via lower interest payments on their homes. They are willing to do all these things to engineer a recovery, and I will be grateful if they are successful. If they fail, they will fail miserably and you will feel pain in housing, you will feel pain in the stock market, and you will feel pain, most basically, in our basic unit of currency, the dollar.

Kevin: And David, the sad thing is, we are losing jobs, we are still losing income, and our GDP actually is shrinking. We are shrinking about 5% a year if you take out this new money that is being put in, so we are in big trouble, because it is not a recovery, but that is what they are playing for, and they are playing for the perception.

But there is something else that they do, Dave. They manage seasonal adjustments, as well. You come into the first quarter and you have one thing. You come into the last part of the year and they are continually revising it. That’s a perception manipulation, is it not?

David: It is. And last year, I believe in one of our commentaries in the middle of the summer, we suggested the numbers are going to be getting worse and worse, but they are not as bad as they seem, because the seasonal adjustments in the second half of the year make things look worse than they are.

The flip side of that is true in the first half, and frankly, more skewed toward the first quarter of every year, and this has been true of the last 3-4 years, certainly following the 2008 numbers, which are still factored into the sort of rolling average. What you have is a positive bias in the first quarter than has been overstated, and again, by the third quarter, with the second sort of being a transitional one, you see a negative bias, which is negative, and perhaps overstated negatively, as well.

The models employed in creating the statistics adjust seasonally, and the basis for this incorporates past market behavior, 2007, 2008. Those numbers, because they were so off, really do skew what we have as seasonal adjustment, and this is what we have to recognize, that we have just finished, we have, actually 30 days left, of what is considered the good six months in the stock market. The “good six months” begins November 1st and ends April 30th, and according the Stock Trader’s Almanac, this is where if you are going to be in the stock market, you make any money. And the other six months is when you lose money.

Kevin: Remember that little saying, “Sell in May, and go away.”

David: It is in anticipation of summer and autumn flat-to-down trends. Interestingly, it is the fall and winter season which are usually the strong periods for gold and silver, and I think we will see that same kind of pickup, traction gained, and major momentum carried forward as we get to August, September, and October of this year.

It is interesting, Sy Harding is an analyst that I read with some frequency, and he says that the economic recovery has stumbled in the spring and summer of each of the last three years. It is not the market’s biggest problem, but it looks like it might happen again this year. Reports this week showed new home sales unexpectedly fell 4.6% in February, the biggest monthly decline in two years. Pending home sales declined 0.4%. Basic durable goods orders, ex the volatile aircraft orders, declined 2.7% in February.

Conference Board’s consumer confidence index fell sharply in March, dropping from 68 in February to 59.7 in March, and I should note, Kevin, that I read a Bloomberg article that was playing up this consumer confidence number, but they weren’t using the Confidence Board’s number, they were using the University of Michigan’s survey and saying, “Listen, consumer confidence is on the rise, this is fantastic.” And literally, they just walked past and ignored the Consumer Confidence Index, which was one of the greatest drops we have seen in recorded history.

So you have the Chicago PMI, back to Sy Harding, which is often a bellwether for the National ISM Manufacturing Index, unexpectedly falling from 56.8 in February to 52 in March. New weekly unemployment claims jumped by 16,000. He goes on to say, perhaps more ominous, “FedEx, the global shipping giant, reported a 31% decline in quarterly earnings, and warned that global trade has slowed to levels not seen since the last two significant economic downturns. And Caterpillar, the giant global manufacturer of construction and mining equipment, also considered to be a bellwether for global economic conditions, reported an unexpected 13% drop in orders in the three-month period from December through February. The company said its Asia Pacific sales plunged 26%, and North American sales fell 12%.”

Kevin: Dave one of the things that I like him pointing out is that we continue to hear on the news, “Oh, the stock market is at new highs, new highs, new highs.” We’ve been in this secular bear market for years, yet we are just now for the first time in 12 years getting new highs, but he points out that that doesn’t necessarily mean anything.

David: No. 2000 was when we reached an all-time high. That was matched and bettered in 2007, but not by much, and here we are back against a sort of 2000-2007 ceiling and we just got above it. But I think this is really what is compelling. You look back at history, and it has not been decisively breached. We’ll have to review this. If we move 3000 points higher on the Dow, if we move 500 points higher on the S&P, let’s re-look at this.

But that period of 1906 to 1923, the Dow was capped at about 100, and you are talking about close to a 17-year period where it went sideways. And periodically, “Oh look, there we are, above 100. We’re 5 percentage points above.” Then the same thing happened. In that consolidation “bear market” 1966 to 1982, of course, the Dow was at different levels, but the Dow was trading right under 1000. It was capped at 1000. We had seen sideways movement 1966 to 1982. In the early 1970s, we broke out above 1000, by about 50 or 60 points. It looked like a decisive breakout, and then it failed.

Kevin: For another ten years.

David: But the important thing is, immediately following that false breakout was a 45% decline in the Dow. It took us to about 600 on the Dow from just over 1000 points. And the challenge, in historical comparisons, is that by any measure, we have no historical precedent for the amount of money and credit that the financial markets have been fed over the last five years.

Kevin: Pun intended – Fed – over the past five years.

David: (Laughter) That’s right. Well, there are instances of hyperinflation, in which a specific country created that kind of liquidity, but this is the first ever non-country specific event where global liquidity, the pool of liquidity, is a global issue.

Kevin: This time it’s global.

David: Now, what is fairly predictable is that when liquidity is created, bubbles are created, and this, again, is fairly clear even in the past 15 years, following the 1998 Long-Term Capital Management collapse, you immediately have the doubling of the NASDAQ stocks. 2001, the World Trade Center attack, change in the rate structure, which ultimately drove housing in the 2005-2006 time frame to all-time highs. And the period we are now in, except we don’t know what asset classes will, in the final analysis, be the “bubble” assets.

Kevin: It’s amazing. I was reading some quotes from Paul Krugman, who is, of course, the award-winning Keynesian economist. He is probably the most quoted economist over the last decade. Paul Krugman, in 2001, said, “You know, we could really use a bubble. Even if we have to pay for it later, we could use a bubble.” Well, they got it. They got it in real estate, and then in 2008-2009 he started calling for another bubble, not because he likes bubbles, but because he realizes we are doomed without one.

David: That is, in essence, what the Fed is creating. They are not creating economic activity. What they are creating is asset appreciation, which, unfortunately, creates greater social divides because you have some people who have those assets, and some people who don’t. If you have a large equity portfolio that has doubled since the lows in 2009, you love the Fed. If you have no assets to speak of in the stock market, you haven’t participated in the doubling, 125% or better, since those lows, and you are saying to yourself, “I don’t see an increase in economic activity. What I do see is the cost of goods since 2008 is higher, and it is intolerably higher.”

This is the problem, and ultimately, the Fed is driving a wedge, culturally, between the rich and the poor. They think that they are solving the problem in terms of economic growth. They are not. They are creating an asset bubble, and I think they are blind to the fact that they have done this over and over again. Whether it was Bernanke earlier, whether it was Greenspan before that, in a different era, this is the entrenched Fed belief.

Kevin: David, the one thing we do know about bubbles is that they always pop. John Bogle, the founder of Vanguard, says that when this thing pops we are going to see some major, major drops.

David: And the question is, from what level will it fall? Yes, John Bogle, the founder of Vanguard, has assumed that we are going to see multiple 50% declines in the next decade. That is to say, we are going to be at levels that are expensive, that are over-priced, and that are unsustainable in the stock market. What does that look like? What is unsustainable? Look at something like the price/earnings ratio. The S&P today trades at just under 18. That is, the stock today, if you took the S&P in aggregate, trades at just under 18.

Kevin: For the listener who doesn’t pay attention to price/earnings ratios, let’s just go ahead and give a simple analysis of what that is, because it is actually not that complex, but a person needs to get their head around it.

David: Sure. The price of the stock is one side of the equation, and the earnings of the company, or in this case, the aggregate 500 companies, is in question. So, the price of the stock versus earnings, the price that you are paying today is the equivalent of 18 years’ worth of earnings.

Kevin: So if I were buying a company, I would say, well, I’m going to break even on this company in 18 years, if it was my business.

David: Right. So private party transactions usually trade hands, low side 3, 4, high side 6, 7, 8 times earnings. With a publicly traded company you have a little bit more leverage, a little bit more exposure, and you can see them trade anywhere from 10, 20, 30, and if you are Amazon, you are north of 2500. You’re really special.

Kevin: 2500 years before we break even on Amazon?

David: That’s right. At their earnings level, you are paying, and their stock price today is the equivalent of, actually over 2500 years’ worth of earnings. That is an extreme.

Kevin: What’s the rule of thumb? That’s an extreme, we saw that back in the late 1990s with a lot of tech stocks, but what would you like to see the stock market at before you start buying, Dave?

David: As a rule of thumb, expensive is 20 and higher. Below 10 is, on a historical basis, cheap. These numbers imply that you could have another 8-12%, potentially, on the upside, in the S&P and Dow, but a return to bargain-type pricing, assuming the move higher first. Let’s say we see 20 as a PE.

Kevin: On the S&P.

David: That’s right. That would be to below 900 on the S&P. That would be your 45-50% Bogle call, and that would bring you back to a PE of about 10. 900 on the S&P puts you at cheap. 15 is what most consider fair value, and that is 16-18% lower than we currently are. To see a 16-18% correction in the Dow or S&P from here just brings you back to fair value, that doesn’t necessarily give you a bargain, but at least it is not overpriced.

Kevin: My question is, if we don’t have increase in income, and we really don’t have consumers out there able to buy more, what is the equity investor buying today? What are they playing for?

David: Really, it’s the promise of more credit in the future and more cash flowing from the central banks of the world. While that is predictable, we remain concerned about the inflationary effects this has down the road. Note that over 70%, closer to 78% of companies that reported earnings in the first quarter, lowered guidance for the second quarter and the full year 2013.

In other words, while the numbers are okay, just lower your expectations moving forward, because I don’t know that we are going to deliver what we did this quarter. This is, of course, how they can continue to “beat expectations,” which is an easier task to accomplish when you have lowered the expectation bar.

Again, even if you lower the earnings expectations, and beat it by a penny, that’s very popular among CFOs, a game they like to play, lower the expectations and then come in and beat your expectations by a penny.

Kevin: And keep your job. (laughter) Always beat expectations.

David: We would expect the price earnings numbers to rise very quickly. As prices stay relatively elevated, I think we could see the S&P hovering around 1500-1550. But here is the question. If earnings begin to fade, then again, you go back to the two variables, price versus earnings, you are going to find yourself in the 20s very, very quickly, and, without any argument, at a level that is not sustainable.

Kevin: So David, what you are saying is, prices could continue to increase, but if earnings start to fall away, your PE ratio gets out of whack.

David: And your CFOs, CEOs, COOs, have already told you to lower your expectations for the rest of the year. So what is an investor buying today? He is buying momentum. He is not listening to earnings calls, I can tell you that much. He is not listening to earnings calls, and he is not doing his homework. He is buying a momentum trade, period.

Kevin: Talking about momentum trades, everybody remembers 2007-2008. That was very, very painful in the stock market, and we really didn’t even have that high of PE ratios at that time, so you don’t have to have outlandish PEs before you have a major crash.

David: That’s right. The downturn took place and we were not in the nosebleed sections at that point. But also recalling 2007 and December of 1999, we have January’s 30 billion dollar increase in margin debt. That puts us now north of 360 billion dollars in margin debt.

Kevin: That’s borrowed money going into the stock market, but it has to come back out just as soon as it starts falling.

David: Right. So by the time February and March are counted, we may have already surpassed the records, but until we know that, we have now the third highest on record, and an indication that investors are not only all in with their own money, leaving very little cash on account, but they are borrowing from the house, a little bit punch-drunk, borrowing money from the house, to get more exposure to what has quickly become viewed as a sure bet.

Kevin: Some people, let’s face it, they just need income, Dave. They need some sort of return. Inflation is such a drag. When you can’t earn anything in fixed type of income assets, sometimes you feel like you have to either buy real estate, like you have talked about before, or equities, just to be able to keep up.

David: And on that theme, when you are looking at inflationary effects, remember that a little bit of inflation boosts equities, as investors seek a hedge in traditional allocations. It boosts oil, boosts gold, but it does boost equities. But also remember, investors are ultimately concerned with, and they are seeking, a real rate of return. And of course, we have had our taxes raised considerably this year, and more is expected going forward, but after taxes, and after inflation, which again, the official numbers are tame today, in our view, understated, but after taxes and after inflation, they would require a considerable appreciation to stay in that break even category on your investment. Thus, periods of inflation are ultimately very discouraging to equity investors.

Kevin: So inflation may push money initially, but inflation ultimately pulls it back out.

David: And requires a painful recalibration in corporate America as the cost of capital increases. Think of refinancing debt on your house at ever-increasing rates versus lower and lower rates. It is the opposite benefit. Instead of having extra cash to spend because you refinanced at a lower rate, refinance at a higher rate and you have less cash to spend.

That’s the same with a company that is needing to do research and development or product development or marketing, or whatever, to grow their business. There is less money to go around in a rising interest rate environment and it hurts their earnings further. So although equity investors are told inflation is good for you, sure, in a minor dollop, a small dose, of course.

But in a large dose, it depends on whose methodology you are using. Our methodology from the 1980s would put us close to double-digit. Our methodology in the 1990s was about 5%, and our methodology today, conveniently, says there is no inflation today. Your cash flow ends up being more constrained if you are an investor in an inflationary environment, if you are a company manager in an inflationary environment. This is the problem.

Kevin: But for now, Dave, they have managed the perception of inflation. Most people would tell you that inflation isn’t really that high, because that is what they see on TV. So for the time being, the Fed has rates under control, though they are massively buying Treasuries, they are massively buying mortgage-backed securities, and it is putting a false spin, what some of our other guests have called a false pricing in the market. But for the time being, Dave, they seem to have this under control.

David: And I think it is vital to note that the balance sheet expansion we saw from 800 billion at the Fed, to just shy of 3 trillion, was followed by 18 months of no balance sheet expansion whatsoever, and an 18-month stagnation period in the dollar price of gold. That has come to an end. The Fed balance sheet is again increasing, even as the number of regional Fed chiefs discuss doing less rather than more, they are doing the exact opposite, they’re doing more! You must watch what the Fed does, not just what it says.

Kevin: Right. What you are saying is, you are seeing money skyrocket again. We had an 18-month breather, people were starting to think it was a recovery, and now we are back into the inflationary mode.

David: Which is ironic, because we see gold testing again below $1600 this week, and silver below $28, and what does this say about the art of redirection? The Fed is saying, “We’re not doing anything of an inflationary nature,” and yet, their balance sheet being stagnant for 18 months, now they’re moving back toward those radical interventionist measures that they were employing circa 2009, 2010, and part of 2011. They are actually stepping up their efforts. Last month was closer to 110 billion, well above the 85 billion promised, and out of line with the equity market continuing higher, to all-time record highs.

So why are they doing it? Why are they continuing to expand their balance sheet if there is no economic problem, if we are in recovery, if the stock market is the leading indicator of all being well, and there being no inflationary concerns, as indicated by the price of gold and silver selling off, the dollar stabilizing, etc., etc., etc.?

Kevin: Well, David, this is the highest-stake magic trick there is. You had mentioned the art of redirection. Anybody who has ever learned any kind of card magic or coin magic understands that it is all in the art of redirection. “See? The coin is in my hand, and now it’s not in my hand.” And the Fed is doing the same thing. They are saying, “See? We came in when we needed to. Now you have a recovery.” The problem is, behind their back is 110 billion dollars last month, and at least 85 billion dollars a month from this point forward. Why?

David: And this is the irony. Of course we have problems in Europe. The question is, do they print more? Do they put more into the system because it was necessary for swap lines to create liquidity between central banks and the banking community in Europe? Perhaps they see the difference between asset growth and economic growth. I don’t know if they do or not. This is really where I’m not sure that anyone but the most entrenched bulls actually believe that we are in an economic recovery.

Kevin: And a lot of people don’t believe that, Dave, so let’s go back to the precious metals, because we have had some people who are patiently holding onto their metals. They are adding to their positions. But let’s face it. It’s been 18 months and people are saying, “Come on, where is the bottom on this?”

David: Patience is needed. Gold bottom several weeks ago, now silver is in the process of bottoming, with both of them establishing a base. Silver above $26, $26 and change. We’ve seen $26.16, we’ve seen $26.70, $26.80. Somewhere, let’s say $27, not below $26, gold above $1560, $1580s, we’re set up for a strong move later in the year. Certainly patience is tested. Well worth the wait.

We have long held that the purchasing power of the metals has been increasing. The last 12 years has been considerable thus far, but we would also hold that you have greater purchasing power increases, over the next 2-4 years, than what we have experienced thus far over the last 12. In other words, we are moving toward that end game in the precious metals market, where prices move on a parabolic basis.

What I mean by that is, an inflation expectation changes radically, and people start deciding they don’t want stocks, they don’t want Treasuries, they don’t want anything but something that gives them inflation protection. Maybe that’s farmland, maybe that’s an oil exposure, maybe that’s gold and silver, but they realize that they have been lied to.

When is the wool is removed from people’s eyes, and they realize that inflation is not just tame and well-anchored, but in fact, some of those older methodologies that would imply that it is 2½ to as much as 4½ times higher than the official rate, come closer to the truth. With that reappraisal of an inflation threat comes a reappraisal of all asset classes, equities lower, bonds lower, gold and silver higher. Period.

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