August 26, 2015; Central Bank Credibility: The Next Domino to Fall

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

“What’s next? I think there are tremendous opportunities. If you have a significant position in cash and a significant position in metals, I think you are perfectly poised to put those assets to work for you in productive assets in the years ahead. And I think you are going to be able to do it not only here in the U.S. markets, but in the overseas markets, maybe even in the Chinese markets, for pennies on the dollar.”

– David McAlvany

Kevin: You’re headed to China, Dave, and so we wanted to get this program in before you left. Just a little bit a recap, some of our listeners were here this last week and you had private meetings with them. You gave a presentation of where the economy is, and then you met with each of them privately about their own portfolios. I know we can’t be privy to all of those conversations, but what I wanted to do, for those who could not come, today I would like to spend some time before you leave for China, asking the questions that your clients privately asked you when they were meeting with you.

David: By far the biggest concern was with the U.S. dollar, and what are the implications of the Chinese beginning to devalue. I think you can see some parallels between the Chinese liberalization of the control of their currency to what we had with the exchange rate mechanism and its break in 1992, even going further back in time to 1971 where we moved off the gold standard as we had committed to make payment of debts in gold to other central banks and they took us up on it. We went from 25,000 tons down to about 8600 tons. You could count it in months. Maybe it stretched over a two-year period, but a very short period of time and our gold holdings were being gutted, because people understood that the value of the dollar following the guns and butter policies of the Johnson administration were already headed down, and this promise to support the dollar with gold was going to be short-lived. And I think the Chinese have basically concluded the same thing, as we have seen with the ERM, the Exchange Rate Mechanism, going back to 1992. These are major changes in the currency world which have very significant ramifications for the rest of the world and I think our clients were right to ask, “What does this mean for us?”

Kevin: Well, when you look behind the curtain and you see where virtually all the gold has been going for the last few years, you can see that the Chinese are preparing to lay a base for their monetary system in something other than just paper. You were talking about 1971. I know by August 14, 1971, the day before Nixon closed the gold window, there was as much as 15 tons of gold an hour coming out of Fort Knox, and a lot of it was going into French hands, British hands, people who were cashing in their dollars for gold, seeing the handwriting on the wall.

David: A few weeks ago, we talked about how this was just an exacerbation of a major currency war. And it really is. If you think about the first shots fired, it really was the U.S., through their various programs, quantitative easing programs and what not, that got a major devaluation, globally, kicked off. And that has been continued. You see it, and you have seen it in China, you have seen it in Europe, you have seen it in Japan. It is a global issue, and the ramifications are pretty significant. One of the things we spent some time talking about was, since the beginning of the millennium, 2000 to the present, we have seen very tepid, very mild growth in the global equities markets, whether we are talking about the Japanese NIKKEI or the German DAX or the French CAC or the British FTSE 100, these are indexes which have struggled. They have struggled since the beginning of the millennium. And what they have struggled with is an economy which is laden with debt, and we are talking about each of these individually.

Now, when we got to 2008 and 2009, where we were challenged by systemic issues and risk within the system, starting with the mortgage-backed securities market in the United States, but ultimately creating major liquidity issues in the financial institution, it was, at its root, a debt problem. We issued a lot of debt and we did it irresponsibly, and of course, Moody’s and Fitch and S&P were there to rubber stamp the AAA grade on things that were really junk in nature. But nevertheless, it was a debt issue. And what we have today is clearly an even bigger debt issue. And it is one of the reasons why economies around the world are struggling to regain the 1990s growth strength and trajectory that you saw on that timeframe.

Kevin: When you go into debt, Dave, you have to have someone to loan you money, and historically, over the last 40 years or so, the lenders to at least the United States, have been the Chinese. And you were mentioning to me that close to 40% of the world’s growth has come from China, and now China is slowing down. Hence, part of the reason for your trip to China.

David: One of the things that I think people forget is that debt is really nothing more than pulling consumption forward in time, or pulling growth forward in time. And so, you end up getting greater growth and greater consumption in the now, but it basically takes its toll in the future. And that is what we are living with.

Kevin: The future is now.

David: The future is now, and so it should come as no surprise that we have lower growth rates given the fact that, listen, we are now in the future, and the higher growth rates of yesteryear, those benefits, quite frankly, were artificial in nature, because they were so debt-dependent and debt-driven. The topic of conversation, I think, amongst many of our clients – they were concerned about how dependent we were on central bank activism. And what do we mean by that exactly? Well, you look at how involved the world central banks are in driving growth and in propping up the system, and it really has been the lynchpin for our current perceptions of stability.

I say perceptions of stability because it is not as if central bank activity is driving economic growth. It is driving certain litmus tests which would give people greater confidence. For instance, the Dow is up. Okay, then all must be well. That is a contrived, determined conclusion, and I say determined because that is what you are supposed to conclude. So, it is one of those tools that is used in a vast PR campaign to bring people back to the market, bring them back as consumers. But again, we are still dealing with paying back the last round of over-consumption. Adding to it is tougher than it might seem.

Kevin: The central banks have manipulated markets and manipulated the signals that would warn us of risk. Interest rates are probably one of the most important measurements of risk. Dave, I think back when our house was first built there were smoke alarms in every room. We have a vaulted ceiling and I can tell you that some of the smoke alarms were put in very inconvenient places. One night, we did not have a fire, I still don’t know what happened, but every one of those alarms went off at three o’clock in the morning, and I could not get them to shut off. It took me forever to get to the one with the vaulted ceiling, so, I finally pulled it down.

David: Was it a BB gun or a .22? I mean, eventually, you just start blasting, don’t you?

Kevin: I broke a number of them to get them to shut up. I didn’t understand, even after I pulled them off.

David: (laughs) I think we’ve all done that.

Kevin: Yeah, so that’s what the central banks are doing now. I knew we didn’t have a fire. I checked everything first and I disabled the smoke alarms. Now, I did not re-enable the ones that I couldn’t get to.

David: This is why interest rates are so important, because interest rates send a very clear signal in terms of both credit risk and duration risk, duration risk being, you pay more for money that you are borrowing on a longer duration. Ten years is going to be paid more than five years, and 30 year paper is going to pay even more in terms of a rate of interest. There is added risk given that duration that’s involved. Credit risk, too. When we see governments doubling down, so to say, and adding to their debt – global government debt is now 40-50% more than what we had prior to the global financial crisis. Global government debt is now well over 100 trillion dollars.

And a part of the reason why they have doubled down on their debt is they have bought down the interest rate, and what you are getting at in suggesting a fire alarm – a fire alarm is there to send a warning signal, and what they have effectively done in buying down the rate is eliminate the sound signal. Interest rates tell you if there is a problem with you having committed too long or too much in terms of credit risk. Will you get paid back, is the question? And interest rates are an indication of the market voting, yes or no, you will get paid back or you are actually going to take a haircut. And so that’s why I think, of this interest rate problem, it is more than just households being unable to generate income off of their savings. It’s more than that. Because again, risk has been silenced and that is a very significant problem moving forward.

Kevin: One of the things that I know you were sharing, Dave, is that the debt that was held, let’s say, by banks and Wall Street back in 2007 and 2008, actually, a lot of the banks and Wall Street firms have gotten out of debt. Their debt has dropped, but it has been transferred to government entities, both the government and the Federal Reserve. So, it’s not as if the debt was erased, it is that the taxpayer now has assumed that debt.

David: Exactly. In a post crisis environment we have seen debt grow significantly. Shadow banking area, that is, lending that is not inside your traditional banking arenas – it could be everything from a hard money lender to a private equity group that is financing a particular project – financing that is not through your traditional banks or Wall Street firms is considered shadow banking, and you are now at 24 trillion dollars. That is just the U.S. portion. If you looked at it globally it would be closer to 75 trillion. The Federal Reserve balance sheet has continued to expand, and quite frankly, that has allowed for a reduction of debt within your financials, that is, your banks and Wall Street firms. They have been regulated.

The banks and Wall Street firms have been required to improve their capital numbers and decrease their risk, and in the process of doing that they have been able to offload some risky paper onto the U.S. government and Federal Reserve, and they have less debt today than they did before the global financial crisis. Households have reduced their debt only marginally, just a very small amount. Corporations have increased – of course the U.S. government has blown the top off in terms of adding new debt to old. We told you what it was in aggregate for the world, now over 100 trillion dollars of global government debt. But the U.S. government, of course, has gone from 9 trillion to over 18 trillion.

And the issue is quite simple. You can continue to expand debt if your plan is to not pay it back. But responsibly, if you are going to pay it back, there are limits that you want to set in place that moderate the commitments that you are making, and I think this is the reality. They know the plan is not to pay it back, and that is either going to be because some of these things simply fall out in the context of a deflationary erasure, or with other liabilities, we have said this before, it is easy to pay back with cheaper and cheaper currency units.

And the world is doing that. It’s not just us, it’s the whole wide world, with central banks, from the People’s Bank of China, the Bank of Japan, the ECB, the Fed, you name it, they know that debt, the burden of it, is reduced when you inflate it away, so the consternation of some of your member countries in the euro has to do with having to go the route of austerity rather than money-printing. So, it’s very interesting to watch the Greeks, to watch the Irish, to watch the Portuguese, to watch the Spanish hearken back to yesteryear when they could, if they got behind, just run the printing presses. They handed over their monetary sovereignty, and thus the easy fix to a debt problem of paying it back with cheaper and cheaper currency notes. But the rest of the world is going to do it.

Kevin: And there are only three ways to get rid of debt. You either pay it back, which you said is impossible, and the other two are default on the debt – Bill King talked about that couple of weeks ago – or like you said, you just inflate it away with cheaper and cheaper currency.

Now, we were talking about the Chinese originally, here, as we started the program. You are headed over there. The Chinese are starting to get sick of the inflating away with cheaper and cheaper dollars. They have gone to the IMF, as we have talked about before, and asked to be part of the SDR system. They were snubbed, to a degree, and put off until 2016, but the Chinese are trying to assert their currency as a major world reserve currency. That changes the whole game when it does happen.

David: When it happens simultaneously with a reduction in U.S. treasuries, you can begin to see a double impact to the U.S. dollar. Not only do we have to share space on the dais, so to say, where we are standing in front of the crowd, and now instead of being the only ones on the podium, at the podium, there are three, or four, or five. We are reduced in our importance, by being averaged down in terms of that basket of world currencies. If we used to be 60-70%, ultimately, if we are 30-40%, it doesn’t mean that the dollar goes away, but it does mean, in real terms, that the U.S. household loses 20%, 30%, 40%, of their wherewithal. Is that catastrophic? Well, actually, for the middle class it is. If you live from paycheck to paycheck, it absolutely does matter that your lifestyle takes a 25-40% hit.

I think the people it doesn’t really affect are the poor. Why? Because you can increase your entitlement spending and they won’t necessarily know the difference. Government cheese is government cheese. Maybe they change the packaging, but you still will get it. Maybe the food value, the actual value of it, goes down. And the wealthy, I don’t think, will be bothered by a 30% reduction in living standard. There is enough cushion there. But you are talking about changes that are afoot that basically add to the pressure and ultimately the elimination of the middle class in America.

Kevin: Well, China and Japan have been net buyers of treasuries for many years, and now we are starting to see dumps. China dumped how many billions?

David: Year to date, 180 billion they have let go. It has not affected the dollar, it has not affected the treasury market, in part because of what we mentioned a moment ago. The financials here in the United States, that is, banks and Wall Street firms are “improving” their balance sheet by getting rid of riskier loans. Those things can go to the Federal Reserve or third parties, shadow banking entities, who will try to take on a little bit more risk for the return involved, and those banks and Wall Street firms are picking up the slack, so to say. You dump 180 billion dollars of treasuries onto the market and banks who are being told they need more treasuries on their balance sheet to meet certain capital requirements, are only too happy to buy them. What is interesting though, is that your big banks and Wall Street firms that will be the large sponges to soak up that supply of treasuries – by the way in June Japan was in the same boat, 9.6 billion dollars, it was 9.6 or 9.8.

Kevin: Where they were dumping treasuries?

David: Exactly. And right now you have a sponge which is dry and able to soak it up. I think one of the things that is concerning to me is that if your small and medium sized banks, call it your local or regional banks, have to do the same, it is going to cost them tremendously in terms of their net interest margin.

Kevin: Yes, the interest rates are virtually zero for these treasuries, and so if you are small, you need that kind of income.

David: That’s right, the long-term implications for the small to medium-sized bank as they see their net interest margin shrink is that ultimately they go the way of the dodo bird and are absorbed by the too-big-to-fail banks. So, seeing greater consolidation in the banking industry over the next five to ten years, I think, is inevitable, maybe even the next one to two years. We already know 30-60% is the expansion in footprint of your too-big-to-fail entities. They were too big prior to the global financial crisis. Now they are even bigger by 30-60%. And with new bank regulations requiring cleaned up capital requirements, capital levels, etc., the small to medium-sized bank is going to have a very hard time existing.

Kevin: For perspective, Dave, if we are in a recovery we can in some ways grow our way out of some of this debt. But if we’re not in a recovery, there have been some false starts as far as recessions and recoveries over the last five years, but where are we right now, because it feels like, and you talked about this last week, that we are slipping back into another recession.

David: We have sat out much of the rise in equities the last several years. Our posture has been very defensive, and part of that is looking at the cycles. The normal business cycle, we were veering into recession in 2011, 2012, 2013, and according to the Economic Cycles Research Institute we are on the verge of entering another recession right now here in 2015. Well, what did not materialize in 2011, 2012, 2013, and what may not materialize now?

Again, this goes back to the issue of central bank activism. When you have governments buying government bonds, buying asset-backed securities, buying corporate bonds, buying stocks – imagine this. Imagine a world in which the Swiss government through its central bank is buying stocks and corporate bonds and government bonds, where the ECB is buying corporate bonds and government bonds, where the Japanese central bank, the BOJ, is buying government bonds, asset-backed securities, corporate bonds, and stocks, in order to prop up prices. Does this strike you as odd? Does this strike you as funny? Does this strike you as normal? Does this strike you as sustainable?

Kevin: It’s the socialization of the world, Dave. The market is going away.

David: It’s the socialization of the capital markets which is very damaging to the capital markets, and raises this issue of, are we now in a brave new world where the business cycle no longer exists, where there are only tulips coming up tomorrow and roses coming up tomorrow, there is no winter, it is only summer always?

Kevin: Doesn’t that overprice the market, Dave, when the government has to come in and buy to keep markets stabilized just like China did a couple of weeks ago?

David: This is where I turn back to, again, the ECRI reports. The Economic Cycles Research Institute has been raked over the coals by the news media, saying, “You guys just don’t know anything. You’ve been around for 50 years, you have called one, two, three, four, five, six, maybe eight recessions going back to the 1970s, and you nailed it? And yet here in the new era, you don’t know what you’re talking about. 2011 you missed it, you thought there was going to be a recession. Was there? Of course not. 2012 you were calling for a recession again. I think you guys at the ECI are a bunch of Negative Nancies.”

You know what they’re looking at? They are looking at a normal business cycle, and the normal business cycle does not include extraordinary, never been done before central bank activism, the kind that we have had in the last five to seven years, not only where, as we mentioned earlier, you have had a massive expansion of government debt, but that debt being erased, has gone to some pretty interesting things.

What are these central banks doing buying stocks? Twenty-four different instances of intervention in China just to hold up the stock market, where they actually have a division of government which has spent close to 600 billion dollars U.S. in order to prop up the Shanghai stock market. Does that look normal to you? Does that sound normal to you? Does this look like the free markets? And I think that’s where the ECRI would say, “Well, it’s kind of tough.” It’s kind of tough when you are looking at historical things relating to normal ebbs and flows of a business cycle to then take into account things that, frankly, aren’t normal, aren’t predictable, don’t belong in the business cycle at all, and yet that is all we have today is intervention after intervention after intervention.

Kevin: Well, the central banks have been the sugar daddy to the markets at this point, but if that effort to reflate fails, let’s say the market still comes down, let’s say we do go into a recession, seriously, do the central banks once and for all lose their credibility?

David: I think this is one of the reasons why Stanley Druckenmiller just stepped into the gold market and bought 2.9 million shares of the exchange-traded fund, GLD. Why does he want several hundred million dollars in gold within his portfolio, amounting to over 20% of the assets?

Kevin: Stanley Druckenmiller is the investor behind Soros, right?

David: Duquesne Capital was one of the operators, so to say, for the Soros funds. Going back decades, a good part of Soros’s success was dependent on the keen execution at Duquesne at the direction of Stanley Druckenmiller. He got out of the markets in 2010, closed down Duquesne, turned to a family office, and has been managing his own money since then. Well, putting several hundred million dollars into the gold market, I think this has a lot to do with looking at what happens when confidence in central banks comes into question. You are talking about a credibility issue.

And if their efforts of the last six years to reflate the system, to reflate and avoid deflation, if they fail to keep us from deflation, you’re not just dealing with a deflation problem, you’re dealing with a central bank credibility problem, because these guys have been treated as the masters of the universe. If, in fact, they move into – “You know, sometimes we don’t get it right” – what does the general market begin to think and believe? Now you’re talking about a crisis of faith. Why do I say a crisis of faith? Because the market has put faith in a few Ph.D.s, again, whether it is the Bank of Japan, the ECB, the Fed, a few Ph.D.s which are being treated as if they have godlike capacity.

Kevin: And look at the Federal Reserve just since 2008, the Federal Reserve had less than a trillion dollars on their books in 2008. Now that has moved up more than four-fold. I think it is like 4.4 trillion dollars. So, their ability – they have shot a lot of bullets and they have pulled a lot of this debt onto their books. How much more can they do?

David: They can do an infinite amount. The question is, what are the consequences for doing so?

Kevin: For the dollar?

David: Yes, and that is where, again, during the periods of QE-1, QE-2, QE-3 and QE-4. QE-1 overlapping late 2008 to early 2010, and then mostly 2011 for the second round of monetization of assets, this is when, again, our central bank is out there buying agency debt, mortgage-backed securities and treasuries. And then overlapping 2012 to almost the end of 2014 for QE-3 and QE-4, not only do you see a rise in the markets with every intervention, with every asset purchase, but yes, there is a real consequence to the value of the dollar, and the consequence of QE-1 through 4. They stop and the dollar begins to recover because there is less pressure on the dollar, and now it is the turn of every other central bank to do the same thing in terms of quantitative easing, and so we see on a relative basis, the dollar moving up while those other currencies are moving down.

What we have is, I think, a context where the next round, QE-5, QE-6, QE-7, QE-8, puts more pressure on the dollar. Why will they do that? Well, one, because they can; two, because they have to. We are getting to a point where, again, you look at treasury rates today. Treasury rates are indicative of a perfect world, and yet we live in anything but a perfect world. We have had a collapse in currencies in the emerging markets, anywhere from 20% to as much as 60%, in a fairly short period of time.

And we know, from knowing how interconnected the world is, part of the success story of globalization is that we are interconnected, economically and financially, and it does mean that problems transmit, problems are not nation-bound or nation-centric. A problem in China is a problem in the United States. A problem in Brazil is a problem in Argentina. These borders and boundaries do not somehow isolate us and keep us safe because capital flows, and to the degree that capital flows freely, these problems flow from one country to the next.

Kevin: Yes, but you’ve brought up over the last month or two that if we were in any other country, Dave – let’s take gold as a barometer for crisis. We were looking at interest rates, but gold is a barometer for crisis. In every other currency worldwide gold has been rising. But we, here, in our little bubble here in America, even though it does translate long-term, we look at gold in dollar terms. You have quoted Paul Volcker who has been seen as a hero in the past by raising interest rates when he needed to back in the early 1980s. Volcker said in his memoire that he should have broken the price of gold because that is the barometer people look at. When does the barometer start telling the truth with the gold price, relative to the dollar, not these other currencies?

David: This is where I think the average market practitioner, who is just looking at, say, the Dow or the S&P and saying all must be well because prices are high – what they don’t understand is that most of the market signals which tell you that risk is plentiful and increasing – those signals have been silenced. Those signals have been silenced. We have talked about interest rates for a few minutes here. Do mortgage rates tell you that we have had a crisis in real estate here in the last three to five years?

Kevin: Right. They don’t.

David: They don’t. You have 30-year paper that is available for less than 4%. That’s not a real rate. That’s not a real rate, that doesn’t indicate that we have just gone through a mortgage and real estate crisis here in the United States. That is not an appraisal of risk. That is a bought rate. That is a manipulated and contrived rate. Treasury rates – we already know that they are contrived.

Kevin: Even junk bonds, corporate bonds, they’re not telling the truth because you have these altered rates from the government.

David: Well, that’s exactly right. If you look at all rates as almost like a ladder where the higher you go up the ladder the greater the risk if you fall, it’s almost as if we’ve taken the first five rungs of the ladder and just sunk them into the dirt, right? For all intents and purposes, being on the high rung of the ladder doesn’t mean that you’re taking any risk anymore. That is the impression in the market. There is another one that is, I think, very interesting. Not only interest rates and gold being signals which would tell you something bad is about to happen, but now you have the New York Fed suggesting through Citadel – Citadel is one of the largest hedge funds in the world now, it employs none other than Ben Bernanke.

Kevin: Ben Bernanke? No conflict of interest there, by the way.

David: Zero, zero. In fact, he said he is going to work with Citadel because he wouldn’t want to work with a regulated entity – that might be a conflict.

Kevin: Hmm.

David: And yet here you have the New York Fed coming to Citadel and saying, we basically need you to manipulate the VIX futures. What is the VIX? The VIX is the Volatility Index. It is a ratio of puts and calls, and it is an indicator of concern in the marketplace. If someone thinks the stock market is going to sell off, they’ll buy put options. Why will they do that? Because you can make money if the market is going down.

Kevin: Or if you think it’s going to go up, you’re going to buy calls.

David: That’s right, and so this Volatility Index will go to a higher number when there is concern in the marketplace. For the New York Fed to be suggesting, “Well, Citadel, why don’t you just sit on this number?” Again, it is the deadening of a signal, it goes back to you trying to just get that fire alarm to shut up. Why? Well, you knew there wasn’t a fire. But what if you did know that there was a fire and you wanted to control an outcome, control the traffic, control the response to that crisis? I think they are also dealing with a credibility issue in the sense that if they can silence these signals, the Volatility Index, the bond market, and gold – if they can silence those signals, do you know what you end up with? Nonculpability. Nobody saw it coming.

When the next catastrophe occurs, when we have round two of the global financial crisis, who is responsible? Well, these guys were supposed to see it coming. We know they didn’t see it coming last time, but they don’t want to be thrown out on their keister for getting it wrong again. So, you kill all the signals and guess what happens? “Oh! Nobody could have seen it coming. But I’ll tell you what. We’ve got all the answers to this problem right here, right now, we’ll be happy to solve it. We just need more keys to the kingdom.”

Kevin: One of the things you and I have talked about a number of times is how sad it is that income-starved investors – let’s take the average person who is retired, and they had enough money to retire if they were retiring 15 years ago when interest rates were actually paying, they could actually live on their interest. But at this point they are living on their principle. Income-starved investors, Dave, are being forced into these markets, and these markets are not looking like they are dangerous because that Volatility Index has been smoothed out to almost nothing.

David: Well, and the interest rates are also communicating to you that there is no risk in the marketplace. So, between the central banks distorting the risk-free rate and altering all asset prices, that’s a part of the issue. But you are exactly right, you also have investors who are saying, “Listen, I used to get 5% in the bank, now I can’t get half of one percent at the bank. Looks like I’m going to have to go elsewhere, whether that is buying equities, or again, lower quality fixed income to get that old 5%. And what are they doing? Well, two things. They are exaggerating the price trends in those risky asset markets and they are also ignoring the greater portfolio risk now embedded in their savings and retirement assets. And you know what is going to happen? They are going to wake up one day and those asset prices are going to prove to them what it means to be in something of lower quality.

Kevin: Right. Not just lower quality, but lower liquidity.

David: Well, and lower price.

Kevin: Yes.

David: Because ultimately what happens when you shift into something with greater volatility, lower quality, and higher risk – someday those chickens come home to roost, and what you thought was safe because you pegged it to some sort of a 5% number which used to be the equivalent of a bank deposit, and that bank deposit you imply is safe, and now you’ve shifted asset classes to something that has the equivalent return but five times the risk, you know what happens? You don’t have the resources that you need when you enter retirement, because like 2008-2009, something surprising occurs, and it shouldn’t be a surprise, but it will be a surprise to most investors.

Kevin: Something that actually exacerbates the fall when it happens is the margin that is built into the market. Wall Street, the momentum players, especially, they use margin to their advantage when it is going up, or when the momentum is going their direction, and the margin we are talking about right now is at the highest level, really, any time in history.

David: Yes, it’s a combination of leveraged products – you can buy double, triple, insanely leveraged ETFs. Some of them are structured very well, and some of them are not structured well at all. And so you have ETFs and mutual funds which give traders the ability to take a position in an asset class, and you think as a trader you have a lot of liquidity. Maybe you don’t. But you are right, the combination of lower liquidity, higher leverage, and leverage both in terms of the vehicles chosen, as well as actual money borrowed to be invested, that is, your old margin debt numbers – 505 billion dollars is quite a bit.

It’s the greatest number we’ve ever seen relative to the size of the stock market. It’s greater than what we had at the market peak in 2007, it’s greater than what we had in the market peak in 2000, and it’s even greater as a percentage of both stock market capitalization and GDP at the time, going back to 1929. What I am saying is, there are more speculative dollars in the stock market today than there were at the end of the roaring ’20s, leading up to 1928 and 1929, when it seemed like the sure bet, the only sure bet, the place where you could make your gazillions, was the stock market, and you didn’t even have to use your own money. That’s where we are today.

Kevin: Well, lest we sound like Negative Nancies, Dave, I know you talked at this meeting about opportunities that are going to start coming about, and before we get to the opportunities, because anytime there is a market move, especially if prices go back to real numbers, you start to get opportunities for the person who is looking, and for the person who stayed liquid and safe enough to have some money to go ahead and buy. But what I want to talk about before you get into the opportunities, as we wrap up, are some of the things that would accelerate this move back to the norm – normal pricing. I’m thinking of the currency war, derivative trading, the defaults. All of these things amplify the downside and make the prices better when the time comes.

David: Part of the reason we want to spend a little bit of time in China is, the changes that are occurring right now, which are an escalation of the currency war, are one of the most significant things that can occur in any business cycle, or when you are looking at the markets in general. You look at monetary policy, and you look at liquidity flows, and these things are the determining factors of asset prices in a given period of time. And monetary policy, the liquidity flows are very significant, and what we are suggesting is, the changes that are occurring in China have a major impact, not only to other emerging markets where you can see financial asset prices become very, very volatile – they already have been, to some degree, but they can be exaggerated even more so – but you also see, as a consequence of one central bank changing monetary policy, extreme foreign exchange variance and volatility.

And ultimately, you may see a return to the world pre-globalization of capital controls being the common element where, because there is so much money flowing and it’s destabilizing in its effects, governments just basically say, “Throw up the walls, we’re not going to have liberalized trade, we’re not going to have the free flow of capital, we’re going to try to stem the tide of exit which is creating things like volatility in our stock and bond markets, and massive devaluation in our currency markets.

Kevin: One thing that has made this period of time so different than any other time in our careers, Dave, is that central banks have always manipulated prices to a degree, or various entities have manipulated things. But what we have had is a coherence, we have had an agreement amongst the countries, including China. We have never seen this kind of agreement before. But you said something the other night that I thought was really profound. It looks like there is some disagreement within China’s leadership, and so we’ve got some wild cards that could be played. You are seeing emergency interventions in the market and you are starting to see this coherence break down to where you don’t see the same kind of cooperation probably that we did even a month ago.

David: On the one hand you have consolidation of power. Better than 40 generals, their heads have rolled – not literally, but certainly from their positions, on corruptions charges and what not, here in recent months. And the guys who participated in the Deng Xiaoping transformation of China and have made billions, personally, in the process, are being looked at by some in the politburo as a problem. And the solution is – get them out, and get them out of the way. So this recentralization and greater inclination toward control is one thematic.

On the other hand, you have, again, an attempt at greater liberalization in terms of currency control, not pegging their currency to the dollar in the same strict manner they have, trying to introduce more of a free trade with the yuan, which of course, is part of what is causing it to move down in value. This is an interesting juxtaposition because it looks like two different camps within the politburo angling for different outcomes, and I could be incorrect about that, but it appears to me that there is some conflict behind the scenes.

Kevin: I know in meeting with this investor group, you talked about opportunities that you are looking at, actually some opportunities that you are taking advantage of right now, and positioning for. Can you share some of those?

David: Some of this is just a perspective on asset allocation, and for a long time we thought, yes, it makes sense to be heavy on the cash side, and heavy on the gold and precious metals side. And a part of it is because we don’t buy what is being given to us as an information feed from Bloomberg, from CNBC, from, frankly, governments that are putting together numbers, many of which are very, very suspect. And what we are going to deal with in the future are the ramifications of changing monetary policy and liquidity flows. And what does that look like? For the person who has cash it looks very, very interesting. For the person who has gold, a financial asset which is, essentially, outside of the financial system, different from other assets which have a tremendous amount of counterparty risk and exposure in terms of systemic risk, we think there is going to be tremendous opportunity.

Let’s just take a case in point. The Mexican stock market, the Brazilian stock market, the Peruvian stock market, in Chile, South Korea, Taiwan, Malaysia, Australia, Indonesia – these are countries that are coming under intense pressure as a result of the Chinese devaluation and will continue to be under pressure as time goes on, not only in their currency markets, but in their bond and stock markets, as well. Well, think about the option value of cash and how you diversify your cash position is really the difference between whether or not you have greenbacks or gold and silver ounces. We are talking about a vast cash hoard just split up between a paper promise to pay, which is okay, but only to a certain degree, and then ounces which you can take to the bank, as something that have never in the history of man gone to zero.

So, what is the option value of cash, however you hold your cash? The option value of cash works something like this. If I stepped into the market and bought shares of General Electric, not that this is the greatest company in the world, but if I bought shares of General Electric, say, at $30 per share, some value of cash can be put to work and you can buy X number of shares, right now, at 30 bucks. My suggestion is that the option value of cash is apparent when you can own two, three, four, five times the number of shares, coming from a cash position to a deflated asset price.

Kevin: So, in other words, staying in cash at this point, let this thing fall, and then go back in and buy.

David: This has nothing to do with, “The sky is falling, therefore get out of the system and never return.” The point is, there are extremes in terms of market volatility, given crises, that are precipitated by monetary policies, precipitated by liquidity flows and capital flows, and if you are not out of the system, to some degree, that is, your gold and silver position, and still in the system, but with liquid assets, that is, your greenback, or choose your currency, position, you will not be able to take advantage of assets selling at cheaper prices. What we expect over the next three, six, nine, twelve months, is problems to crop up in the derivatives market, problems to crop up which are already apparent in terms of defaults, both in terms of governments and corporations.

And what these things do is they cause a market to reassess risk and in spite of interest rates being sat on, in spite of manipulation of the VIX futures, in spite of gold as a barometer of risk being broken, deliberately, by central bank activism, what we will see is a reassessment of risk which will bring foreign exchange markets into a very, very chaotic and volatile environment. What will that do to asset values, both stocks and bonds? I think stocks and bonds are going to be eviscerated. Is that an 18-month timeframe, a 24-month timeframe, or within the next two weeks? I don’t know, but the context is perfectly set for it.

Kevin: And you’re not alone. Albert Edwards of Société Générale, and I quote – this is what he just recently said, “We (speaking of Société Générale) expect the acceleration of emerging market devaluations to send waves of deflation to the West to overwhelm already struggling corporate profitability and to take us back into outright recession, as investors realize yet another recession beckons without any normalization either of interest rates or fiscal imbalances in this cycle. Expect a financial market rout every bit as large at 2008.” So, you’re not alone on that.

David: Well, let me just say that he may be alone. When he says “we” maybe he is not talking about Société Générale.

Kevin: (laughs)

David: Maybe that’s the royal “we” which is another way of politely saying “I” because every Wall Street firm has their token bear, and he is their token bear. But I think he is right, I think there is a major market reappraisal coming and it is related to interest rate and fiscal imbalances, yes, it is related to emerging market devaluations and the fear which has been absent from the marketplace, I think is going to come back with a vengeance.

I do think we are beginning to see pockets of value emerge and for the person with cash and liquid assets in the form of gold – and again, Druckenmiller doesn’t move to gold because he is a gold bug. He moves to gold, I think, because he sees problems with the system. It is the same major purchase that we began to see in 2008, 2009, 2010, and 2011, as investors would take, not 100,000 dollars, not 250,000 dollars, but a million here, five million there, 50 million there, and own their gold.

You remember our conversation with Bill King. This is where they just say, “No, I want some insurance. I don’t like what I see.” And you know what? Those major interests have been sitting on their gold ever since. They don’t care. They don’t care that they paid $1500, $1600, $900, whatever the case may be.

Kevin: They’re just quietly accumulating.

David: It’s insurance, and you want it. Why do you want it? You want insurance because, as Albert Edward says, “Emerging market devaluation sends waves of deflation to the West, overwhelming an already struggling corporate profitability.” What are the ramifications for an investment community that is caught short finding that they had too much confidence in their central banks and those central banks’ ability to reflate the system? When the reflation of the world economy is considered a failure by the general public, then I think you look at gold in a very, very different way. Do you want to be buying gold in that environment? Absolutely not. You know why? Because it is already priced for the moon.

This is what happens. People try to do the right thing at the very last minute, and it ends up costing them quite a bit for just delaying the process. Better to be early than a day late. Better to be too minutes early than one minute late. Better to be three years early than one minute late.

What’s next? I think there are tremendous opportunities, whether it is being short the market, or ultimately allocating assets to the long side of the market. If you have a significant position in cash and a significant position in metals, I think you are perfectly poised to put those assets to work for you in productive assets in the years ahead, and I think you are going to be able to do it not only here in the U.S. markets, but in the overseas markets, maybe even in the Chinese markets – for pennies on the dollar.