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The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Coronavirus Market Turmoil – What Else Can The FED Do?
March 4, 2020

“What is your game plan? What is your strategy? My attitude toward the markets is a little bit like my attitude toward coronavirus. I’m not inclined to shut myself in. I’m inclined to figure out what the best strategy is. If there are some practical things that can be done, then by all means we’ll get that done, but not to live in fear or panic, just to make sure you are implementing an excellent and well-thought-out plan.”

– David McAlvany

Kevin: You have quoted this before, David. Someone once said there are decades when nothing happens, and there are weeks when decades happen. I am going to just add to that, because even today, there are seconds when days happen. What we saw with the Federal Reserve yesterday we could have predicted was coming because the markets right now are starting to realize they were overvalued. They were realizing that long before. Now the coronavirus has become an excuse for the Federal Reserve to do what they probably were going to have to do anyway.

David: We know that they can do more. They can monetize assets, and that is one of the last bullets that they have, taking rates near zero, and with a 50 basis point cut this week it does leave them with very limited options. But they can expand the balance sheet. They are currently buying 60 billion in assets a month. So let your imagination run. Is there a number that represents shock and awe in the 21st century?

Kevin: I wonder if people are going to cry out for the very thing that they would have cried about earlier. Now people are seeing the stock market falling and saying, “Give us negative rates, give us negative rates.” This 50 basis point cut yesterday reminded me of what Tomas Sedlacek told us a few years ago. He said that the new religion and the new priests of that religion have to do with perpetual growth, and that is what we have had with the central bankers continually adding to this market. And this high priesthood of this new religion of perpetual growth is the central bankers. Anything they say or do seems to be a little bit like the priests of old. In a way, they offered a sacrifice to that god yesterday and the stock market suddenly reversed and went up. It didn’t last, but it reversed and went up.

David: One of the more interesting aspects of dinner table conversation this week has been, again, just sort of taking away some of the tragic elements of people dying hither and yon, relating to the coronavirus, and just looking at things from a political or social perspective, and seeing that insecurity is something that allows for significant controls to be put in place. If you look in China, the use of technology, the Economist had a couple of excellent articles on the use of technology, the expansion of technology and drone technology and QR codes for each person, where you are either a green, a yellow, or red.

Kevin: And the drones will chase you if you are a red.

David: (laughs)

Kevin: We saw that video, that poor Chinese lady, who obviously was not supposed to be out of her house.

David: I’d be running too if I had a drone yelling at me in Chinese. There is nothing like being berated by a machine. So, I think the social aspects are interesting because there is a certain – if you tell us that something is very, very wrong and there is nothing we can do about it, then we kind of roll over and just say, well, help us solve the problem. That could be central banks doing that. That could be politicians doing that. That could be the CDC and the World Health Organization doing that.

Kevin: Have you noticed the articles coming out about global governance saying we have to somehow do this all at once for everyone?

David: This week it is no surprise that we need to coordinate efforts. The G7 puts their heads together and this is what precedes, at least in a sequence of events, the announcement by Jerome Powell of a 50 basis point cut. So you have coronavirus concerns. We went from meltdown last week to melt-up this week, and then of course, not a lot of follow-through if you watch the markets immediately following the 50 basis point cut. It really wasn’t that impressive if you’re looking at stocks.

So speculators are caught. They have been caught in the last week or so with too much exposure, and if you are reflecting on last week and the week before, there was this belief that more was visible on the horizon than actually was. So we see the future and the future is bright. And then all of a sudden stock prices start going down, treasury prices start going up, and we have last week’s constant stream of liquidations, which only let up, very bizarrely, in the last ten minutes of trading on Friday.

Kevin: Yes, but then of course Japan had to open before the Dow on Monday, and I heard Japan added 101 billion dollars to their market. They just came up with that money out of thin air to keep it from collapsing.

David: It was the largest quantitative easing program directly put to Japanese equities on record. So you look, and you say they are external in their announcements. Yes, this is the government buying. But who was buying late Friday? Was that all organic buying at the end of a long week? Here we are at the end of the month, the end of the week. No particular reason to paint the tape. And yet, we are down over 1,000 points and in about a 5-10 minute period we marched back 650 points of that loss. And it is a very modest loss by the end of the week, at least for that day, relative to (laughs) other days in the week.

Kevin: Lest we talk just about stocks, the debt markets are actually the real story right now.

David: Our colleague, Doug Noland, notes that stocks are actually the sideshow. We have corporate debt markets last week which were seizing, and credit default swaps which began to march higher, and the real concern is the plumbing that supports global liquidity was under acute pressure. And so, yes, you end up seeing the signs and symptoms of that in the stock market. And that gets most of the headlines. But what we are looking at is not unlike the 4th quarter of 2018. Equity weakness was symptomatic of liquidity seizure.

Kevin: And it is good for us to remember, we have been talking since September about the repo markets, just this massive liquidity that is going into the repo market, 80% of U.S. treasuries have been purchased by the Fed since September. And then of course we have quantitative easing. That started in October. This is long before the coronavirus scare.

David: I think you have the Fed committee out and active, and lowering, an emergency cut 50 basis points this week. It suggests that there are players in the financial universe that are under real existential pressure. The U.S. economy is still fine. They are willing to say, “Look, there are no issues there. We don’t see any issues there, but we are concerned about what may be.”

Kevin: How about the repo market?

David: And that is, I think, where you begin to see signs of cracks, of real concerns between counter parties. The repo market was more oversubscribed on Tuesday than any other day yet, and that is saying a lot. So you are basically looking at overnight lending between banks, which was not going to function on a normal basis without the Fed backstop. And then repo, oversubscribed, the largest yet. What does that mean? I tell you, it means something significant.

Kevin: I wonder, Dave, if what we are seeing is the second chapter of 2011, because if you remember the summer of 2011 we had the potential that the European Union was going to just completely break apart. We had gold topping $1900 an ounce, and then this guy named Mario Draghi, and Italian – a Goldman-Sachs Italian, let’s just put it that way – came out and said, “We will do whatever it takes.” That is the high priestly gown of the central bankers. They did whatever it took. Did they delay – are we just seeing a continuation of 2011 without him saying that?

David: It is like 2011, but in some respects it is more like 2008 and 2009. I think what the Fed is trying to do is draw from Draghi’s playbook and say, “Look, if we can restore calm, great.” But what they haven’t allowed to occur is enough water to go under the bridge. If you go back to 2008 and 2009 and then play the tape back between then and 2011, you’re talking about stress and strain in Greece and in Cyprus, a virtual collapse.

Kevin: It was tense.

David: Yes. All of those things were happening prior to the “whatever it takes.” Here we have a couple of percentage points off of all-time highs in the stock market, and yes, I think if you’re looking at the liquidity plumbing that is where there is more concern. But it is almost like they are fast-forwarding to, “Let’s get to the solution. We don’t need to see the problems materialize to recognize that we need to get very involved.” So the reality of such monetary intervention is that it is meant to demonstrate a disposition like Mario Draghi’s. “We’ll do whatever it takes.” And that level of commitment is supposed to bring psychological calm, which was lacking in recent days, certainly last week. Consider it like psy-ops for the stock market.

The challenge, as we highlighted last week, is that you have a combination of things which aren’t really well-suited for monetary policy, supply shock on the one hand. And then the demand hesitancy is that people in many geographies are rethinking what their essential movement is and what their public interactions are. I think one of the most interesting articles I read in the recent week was from the Economist where it is talking about a change in the way education is done, where a lot of public school education in China is having to be done on the Internet.

I thought that this could be a significant breakthrough and shift in our thinking about how we educate, how we approach social interactions. A part of this is positive in the sense that it will represent an evolution in the use of technology in new ways.

Kevin: You mentioned last week, let’s say that parts of a particular phone are manufactured in China and we can’t get those parts. There will be a redistribution of suppliers at some point. So like you said, call it positive, call it negative, it will be change.

But I have a question for you. We talked last week about throwing liquidity. The central bankers are Johnny-one-notes, let’s just put it that way. They can only do a couple of things. They can either lower rates, even negative, or they can print money. So what does that have to do with pandemic?

David: Let’s say they are Johnny-two-notes because they can influence rates, and they can do QE, which is buying assets, expanding the balance sheet. I just want to make sure we are clear on the fact that between supply shocks and demand hesitancy, monetary policy really doesn’t solve the unknowns of pandemic. So when people change their behavior and they are not interested in going out in public, or they pause even for a week or two, it begins to have a ripple effect. So the Fed, I think, is active now, and I think in retrospect will be excused from blame.

Kevin: Let’s talk about those two notes then. What else can they do using those two notes?

David: Yes, because they are definitely not going to be accused of inaction or passivity in the face of a growing health crisis, even though, as we have said repeatedly last week and this week as well (laughs), money printing is not the same thing as a cure for a virus. So if things get worse, the Fed can increase their balance sheet measures. This is the second note. Lowering interest rates they have done this week. Expanding the balance sheet would be note number two. Quantitative easing they can take from 60 billion a month to anything that represents shock and awe for the 21stcentury.

Then to be frank, if you imagine 21st century shock and awe as it relates to quantitative easing, it has echoes of Zimbabwe and Venezuela to it. So there you have played your two notes. And if it doesn’t work, then I guess you can ultimately lay blame at the Trump administration’s feet for not doing more on the fiscal side of the equation.

Kevin: We have often talked about early 1920s Germany, the Weimar Republic. At that time their mark was king, to start with. That is what we saw last week. People are starting to go to cash. But very rapidly, because of these methods – like you are talking about quantitative easing – they had their own form of quantitative easing in 1920, and the printing of money ultimately turned into what you said – Zimbabwe, Venezuela – the ultimate meltdown of cash.

And so, just a warning to our listeners. If you think moving to cash when things are in crisis is a good idea, that would have been a great idea back when we had a gold standard, when you were actually moving to gold when you moved to cash. At this point, you are actually moving to something that ultimately collapses after these measures are taken.

David: Yes, I think a part of the scramble, the panic we have seen into treasuries, is because it is a form of cash that remains liquid. You can get in, you can get out. And so that liquidity function is really critical. You are right in pointing out the difference between cash and gold and the nature of money as it has changed through time, where if someone is moving to cash today it is a very different proposition because you are talking about a concerted devaluation. You look at the price of gold in a variety of currencies and you can see gold rising to all-time highs, in British pounds, and yen, and euros, at least ten different currencies this last year. And that theme continues today.

I think the dollar will probably start to reflect that, as well, with gold being at all-time highs in dollar terms, without very much time having passed. Again, it is not necessarily a story of gold going up as much as it is a story of the dollar going down. When you are in a desperate situation, you’re printing money, QE is on the table, and interest rates are in steep decline, lo and behold, the dollar is moving lower. So you have cracks in the financial system which are widening, you have the emergency G7 meeting this week to discuss coordinated efforts, market-related, economic-related, coronavirus virus-related. You have the 50 basis-point drop. It’s the largest decrease in rates since the fall of 2008.

Kevin: So we’re going to see devaluation of the dollar at some point. Who is positioned?

David: It already hit the dollar, so you are talking about investors who are flat-footed. It’s not just a question of who is positioned for a weaker dollar, as in a gold buyer. But you have the vast majority of people who have assumed that if things are deteriorating in the rest of the world, at least the U.S. is sort of a bastion of strength from an economic standpoint and our currency is going to be more stable. So if anything, you have long positioning of the dollar, no one expecting a weak dollar, and yet here you have emergency rate cuts and the dollar taking it on the chin. Stocks go up, everyone is happy that an intervention occurred, but there is a price for that.

There is a trade-off for everything, and a weaker dollar – again, this is unanticipated – triggers a different series of asset liquidations, it triggers a different series of asset allocation rebalancing. And if the global economy is more at risk and yields are higher in the U.S., then people who are in dollars were asking the question, “Why wouldn’t we see more capital flow into U.S. dollars? This would be a place where we actually see capital appreciation, higher yields, greater income.

Kevin: Yes, but could it flow out? Could it just as easily flow out as flow in? We’re just used to it flowing in because the dollar has been strong.

David: Yes, the dollar weakens significantly, capital can just as easily flow out, unwinding of global trades, the markets are going to force. At some point you are going to see the markets throwing another tantrum and central banks are going to be put to the wall. They are going to be pressured to do more QE and so yes, balance sheet expansion of the Fed. We already see this week the Bank of Japan doing that with stocks. The ECB has talked about doing that with corporate bonds on a more expanded basis. The PBOC will buy everything and the kitchen sink.

And maybe, just maybe, if it’s all concerted, then the currency volatility can be muted. Remember, we have currencies which only show their weakness vis-à-vis one another, so in a world of fiat currencies where everything is floating, you don’t really have a gauge for which is devaluing more than another. But if they all move lower simultaneously, it might actually appear like nothing bad is occurring.

Kevin: But gold is a good monitor for that, right? Wouldn’t gold be a good way of casting light on that? If it is rising in all currencies that means that all currencies are falling together.

David: Sure. And so if there is ever a point where we get to a technical fork in the road where gold could go up or down, where there is resistance, so to say, on a chart point, I think this is one of the things to be aware of, that gold has some political vulnerability. I think the end game here is that the markets drive the price and short-term manipulation will be overcome by market pricing dynamics. But you can get to these cusp events where, is there enough momentum to get us beyond this point, or is it going to sell off?

Going back to Volcker’s comments in his memoire. He always was bothered by the signal that gold sent and wished he had done more to hammer the price in the 1970s so as to not show the inflationary hand. I’m not trying to pooh-pooh the idea of owning gold, I’m just saying you should be prepared for irrational and short-term volatility, and I wouldn’t be unseated from a position in gold because ultimately we’re talking about currency extinction events, and you don’t want to play the volatility on the metals side.

Kevin: One of the things that we have seen over the last ten years, but especially maybe eight or nine years since 2011, is that everything has become a top-down approach, and so if you want the banks to lend money, what you do is, as the ECB or the Federal Reserve, you make money available to the banks. It seems like that is happening right now with the ECB.

David: Yes, and that has been the discussion between Lagarde and her team, targeted lending to banks so that banks can continue to lend to small firms which are affected by the virus’s economic impact. This goes back to, how is it different this time, and does monetary policy gain positive traction with this kind of a market decline? On the one hand, a supply shock – that kind of lending is not going to help anything. And if decrease in demand, or aggregate demand, is reflecting a change in social behavior because of real concerns, you can lower rates and lower rates and lower rates, and I’m not going to take my family to vacation in China or Northern Italy just because prices get cheaper or rates get lower, or whatever.

There comes a point where you have to say, “Yes, but I’m a human being and I don’t necessarily want to put myself at risk, so I’m not going out today.” That may be overblown in the environment today. We’re not at a real critical point in the U.S. in terms of this being a grand scale crisis, but what you are looking at is the economic impact of changed behavior. And what I’m saying is that monetary policy doesn’t affect either of those two factors.

Kevin: Do you remember when monetary policy did? Just like two to three weeks ago we were in the days of complacency, the days of wine and roses. Monetary policy solved everything. Yes, we heard a little bit about coronavirus, but it really wasn’t a concern. Look how much difference a couple of weeks make. Last week you brought up how you have Greek debt lower than U.S. treasury debt. That shifted just since the last Commentary.

David: Do you remember the movie, The Days of Wine and Roses? My mom mentioned to me one time that was one of her favorite movies, and I thought, “Oh, I’ve got to watch that some time.” And I watched it and it is basically about how two people destroy their lives becoming alcoholics, and I thought, “What in the world?”

Kevin: I haven’t seen the movie even though I used it here on the Commentary, and I’ve only played the song on my trumpet.

David: I wondered if maybe I got the title wrong, or if my mom has sort of a nuanced appreciation for themes of what goes into healthy or unhealthy relationships and she was kind of looking at it from a psychological viewpoint. I never have understood, I need to have lunch with my mom and have her unpack that.

Kevin: I was just thinking of the song, Dave. The days of wine and roses… (laughs)

David: Well, back to the issue of commercial and corporate enterprises. They will get some benefit from the ECB coming in and buying bonds because that is the other big change the ECB is talking about. Government bond purchases are a given, but they might expand the list maybe to include anyone and everything in the corporate sector.

Kevin: Buy it all.

David: And that is really good relief for corporations who might need to refinance or might need a little liquidity, but it is still not going to drive aggregate demand. So there are some issues there in terms of seeing monetary policy flow through to a real positive economic impact. The fixed income markets – you remember we talked about Greek debt.

Kevin: Last week that was still lower than U.S. treasuries. That shifted.

David: This is insane, it doesn’t reflect reality, and the beautiful thing is that the market does fix these things eventually. Those prices flipped, the yields flipped, we were at 91 basis points on Greek debt and U.S. treasury, ten-year, same duration, same maturity, about 130. Now all of a sudden you have about 130 on Greek debt, and 109-112 is where the U.S. ten-year treasury is fluctuating. We’re off the lows by a few basis points. But it seems like the market is moving interest rates toward zero.

Kevin: What do they call it? There is a fancy name. They don’t call it zero. We talked about that the other day.

David: The effective lower bound.

Kevin: Yes. The effective lower bound. Not zero, the effective lower bound.

David: The beauty of all of these fancy words is that, say you are at a cocktail party eating canapés, and sipping on champagne, and you’re not talking about zero rates, that would be far too … sort of hoi-polloi. But the effective lower bound – we doing the managed rates near the effective lower bound.

Kevin: Let me tell you a little bit about canapés, and I don’t even know how you say it. But we were doing a wine-tasting and our son was with us. They weren’t canapés to him, they were dinner. And so he finished them all while we were supposed to be matching this food with that wine. The effective lower bound – maybe I’m a PBR drinker, maybe just low-brow, but to me it’s zero and that means nothing.

David: Lowenbrau, that would be just as good. You go for PBR, I’ll go for the Lowenbrau. But I think if you note that the Fed funds rate moved this week, but it was not the prime mover, and I think this is one of the important things that in the history of market movements and market prices, what moved first? The interest rates markets driven by market participants, or was it driven by the Federal Reserve? And in fact, the Federal Reserve is playing catch-up. The markets repriced interest rates all across the curve, and now you have the Fed funds rate that is playing catch-up. Markets re-price, the Fed’s moving the rate so that it reflects the current fixed income pricing.

To me, this is encouraging because it says, “Yes, market dynamics are alive. Market participants ultimately drive prices. And so, regardless of short-term manipulations or the belief that the central banks can move everything – that is actually not the case. As investors, we actually still get to engage rationally. There may be periods of irrationality, but in the end the math still has to work.

Kevin: And the math on the credit default swaps, which is just the cost of insuring on these markets – they are popping way up. At this point, insurance is pretty expensive.

David: It was moving higher. It is nowhere near the levels it was in 2008 or 2009, but if you look at investment grade corporate credit default swaps, you have the largest weekly gains last week since 2011.

Kevin: There is that number again – 2011.

David: Yes. High yields saw default insurance costs increase and the financials also finally saw a jump in CDS pricing. So it seems like the moves in the financials were a lot, but it’s only because they were off such an incredibly low base. And many of the figures that we were seeing, just in the week before, last week, were just bleeding. But the week before you had credit default swaps basically priced where they were in 2007 at the lows.

Kevin: That’s why I say people were complacent two weeks ago.

David: Absolutely. Imagine that. The efficient markets not pricing something in.

Kevin: Hmm – how does that happen?

David: Exactly.

Kevin: How has that happened now for nine years?

David: But I think the efficient markets are really just kind of a side name for the stupid markets, because they are where the treasury markets and the gold market, which has been pricing in dislocation for weeks, and we had treasuries on the move, and then of course they just moved to lower lows in terms of the yield, higher highs in terms of the price. There is a difference between safe haven buying, which has been happening in the weeks leading up to it, and panic buying, which is what we saw this last Friday. Panic buying in the treasury market was on display.

Kevin: Let me ask you, though. Some of these bonds in some of these countries – remember you mentioned Argentina a few weeks ago having 100-year bonds and we just laughed because you really don’t even want to buy a bond for a week in Argentina, much less 100-year maturity.

David: This is the funny thing. You have pension funds and insurance companies and their “long-term investors” so they say to themselves, “Look, we’re trying to manage cash outflows and we’re going to maximize our current income off of this debt, and we’re going to be around because we’re not an individual person, we are an entity with a longer life. We will, because of our perpetuity mandate, be able to invest in things that span beyond the normal lifetime.” So insurance companies and pension funds loaded the boat with 100-year Argentinian bonds. And last week the Argentine CDS, credit default swaps, were up 700 basis points, priced at $4,895 basis points. That is what it is now costing to insure against default on Argentinian debt. And those 100-year bonds that we talked about trade, if I am not mistaken, right around 43 cents on the dollar.

Kevin: Yes, because when interest rates rise, the principle value of the bond – what does it do?

David: Oh, it goes down. So last week, volatility all over the place. Costa Rica jumped. This is credit default swaps, again, 49 basis points to 300. And then you have yields, if you are looking at your emerging markets and developing countries, significantly higher – Turkey, Russia, Indonesia, South Africa, Mexico, Columbia – rise in yields. And again, when you see a rise in yields you’re talking about a tightening of financial conditions in those places.

Kevin: Let’s look at this a little closer to home. You have a lot of internal meetings with managers here at McAlvany – Lila, Doug, Robert – and you guys have got to be talking about the volatility, the impacts of some of these unwinds like the carry trade unwinds. What have you guys been talking about?

David: Well, the energy in the air is certainly like 2008 and 2009 in the sense that there are so many things happening so fast and the inter-relations between the markets are very intriguing, so having a matrix to work off of and look at the interactions is very helpful. In this week’s internal meetings we discussed extreme volatility in the markets in both directions. Last week we could see the implications of carry trade dynamics, leveraged speculation, and then ultimately the unwind of hedge funds, and their bets which were hitting all asset classes, including gold.

So a part of the gold sell-off last week was that you have risk parity strategies under pressure, and gold selling off in an environment where liquidity is paramount, and margin calls proliferating, and you have an unwind of carry trades. Remember I talked about the increase in rates for Turkey, Russia, Indonesia, South Africa, Mexico and Columbia? On the other hand, you have sort of an unwind, a selling off of those assets, selling off of debt and an increase in yields, and a repurchasing of the currencies in which you originally borrowed.

So again, carry trade dynamics and unwinding of carry trades – that’s just very simply were you borrow on a currency with low yields and invest in higher-yielding currencies elsewhere around the globe, and that is the drama that we were watching.

Kevin: Carry trades are interesting because it is hard enough to be right on one aspect of the market, whether it is going up or down, but a carry trade forces people to be right on two aspects at once. One is the currency. Two is the investment direction. And so carry trades are fine, they give you an awful lot of leverage when they are working.

David: And three – timing. So you have three things that you have to get right – the currency differentials, the interest rate trends, and the timing of the trade.

Kevin: Do you remember when Barings Bank, the oldest bank in England, or one of them, went under because a carry trade went wrong in Asia?

David: It was considered the 6th great power. They considered Barings to be the equivalent in terms of power and influence as a significant nation.

Kevin: But it was one guy, Ian Barings, and he just made the wrong bet at the wrong time.

David: And Doug said this about the carry trades. He said, “In recent years carry trades, along with similar derivative strategies, have proliferated globally. Japanese yen and euro with low negative interest rates are popular “funding currencies. Speculators short these currencies and they use the proceeds to lever in higher yielding bonds around the world. Especially Thursday and Friday there was evidence of a serious de-risking, de-leveraging illiquidity episode. The yen jumped 3.5% last week, and the euro gained 1.7% versus the dollar as losses on popular carry trades rapidly escalated. Currency declines versus the yen included 7.4% for the Russian ruble, South African rand, and Columbian peso. The Indonesia rupee lost 7.1% and the Mexican peso fell 7%.”

So again, you’re talking about an unwind of leveraged trades. So gold gets caught in the middle here where it is in an environment of liquidity and people need to raise cash, and so it gets implicated in the short run.

Kevin: One of the positive aspects of why gold is going down is that it is so doggone liquid. If you think about it, people don’t sell their house when they need to raise liquidity. They don’t sell stocks, or a lot of times these margined accounts, they have to keep them going or they lose their shirts. So they will sell gold or cash.

David: We had one Wall Street firm contact us last week to say, “Hey, we need to liquidate a gold position, and it is the only position that we still have a profit in.” The rationale was, we can take a gain here, we have instant liquidity, and now we can go either buy other assets that are cheaper today or just reserve those cash positions or what not.

A lot of people ask why gold got caught up in the maelstrom and on Friday dipped in price so much, and I thought Bill King’s comments, who is a veteran trader, were very apropos. He said, “Gold plunged like it usually does when equities tank, on liquidity crunch, liquidation by hedge funds, investors and foreign holders as well as the regular month-end manipulation by gold shorts. When margin calls come you must sell something. Some have to sell most everything. Some will sell the vehicle that still has gains when the crunch appears. This occurred in the 4th quarter of 2008, in October of 1987, and in the 1st quarter of 2000.

Kevin: I remember all three of those dates. Gold went down while people were trying to make liquid their positions. But it was very short-lived. It doesn’t last long. People come back in and buy gold because they realize that is one of the only safe hedges that they have.

David: And it is just periods of time. That one time slice you have leveraged bets that are in play, you want to meet margin calls, and you haven’t changed anything in your game plan. And then there does come a point where a strategic course shifts and in the face of worsening market conditions, gold, which was the go-to for liquidity, all of a sudden you go back to it because you’re not sure whether it is from counter-party concerns or what not. I thought it was very interesting that here in the beginning of this week Goldman-Sachs raised its gold forecast to $1800 for the year.

Kevin: Oh, well, good for them. Goldman-Sachs now says it is going to $1800. They normally trash-talk gold, so not bad.

David: (laughs) I’m sure they’re not talking their book. But, fascinating week this week. Where does Monday open up? You mentioned the buying of Japanese equities before the Monday market open here in the U.S., and we actually had U.S. stocks down 2% overnight Sunday night. And then we finish Monday at up between 4-5%. So call it a 7 percentage point swing. Massive, massive volatility.

Kevin: In dollars. Just like what we’re talking about with gold – in dollars. But we have been training clients for years to measure in other things. You talk about the Dow-gold ratio.

David: I think, like Doug was pointing out, there is really a bigger issue in play here. Stock market volatility is very interesting to look at from a symptomatic standpoint of what is going on within the financial system and how people feel about the financial system, but the more important aspects are within the world of derivatives and leveraged speculation, where, again, you have a tremendous amount – we’re talking tens of trillions of dollars in play and very little shifts in terms of calibration can mean insolvency for a variety of firms. I think that is really what you see when the Fed comes in and starts lowering rates, or when they do, and I think it is inevitable that they will, continue to expand their balance sheet, it is their effort to resolve liquidity and solvency issues within the financial system. Stocks end up being less important than the healthy functioning of the liquidity plumbing.

Kevin: Going back to the Dow-gold ratio, however, if you really look at the difference in where the Dow was relative to gold versus relative to the dollar, we’re seeing a far better indication of what is really going on.

David: This is definitely a mind-twister, but I think it is worth going through the exercise because, first of all, I want to say gold has done very well, not only finishing 2019 positive at new all-time highs in a variety of global currencies – that in itself is a very interesting story – but the Dow-gold ratio is also an interesting story. So in answer to the question that people asked us earlier this week, how could gold get caught up in this maelstrom, how did it go down along with the stock market?

In fact, if you’re looking at the ratio, gold did just fine vis-à-vis stocks, gold improved its position and improved your purchasing power by over 16%. We went from 18.75 on the Dow-gold ratio to 15.75 on the Dow-gold ratio. I think we are currently at about 16.65. So seeing an increase in purchasing power is compelling. What we want to see, ultimately, is an increase of purchasing power, not just in a few percentage terms, but 6, 9, even 18 times the shares which we think you will be able to purchase as gold bumps up and we get to bear market targets – the market goes lower.

Kevin: You’re always thinking in terms of compounding something of reality, not currency that they can print out of thin air, but compounding real things with more real things. Be it stocks, be it gold, or whatever, you want to end up with a lot more of something that is not printable.

David: I tend to think in terms of the expansion of shares more than the increase in the quantity of dollars. But ultimately, if I can generate more shares, and these are companies that have a history of generating dividends, and I’m also increasing cash flow or an increase in the flow of dollars. And so if I had a 4-6% dividend payment, but in the future owned 6 times, or 9 times, or 18 times the shares I would have otherwise, I stand to benefit not only on the income front, but I also stand to benefit from the long-term capital appreciation front. So I would say if I can increase my financial footprint by 6 times, by 9 times, or by 18 times in a life cycle, then, number one, it’s worth the wait, and number two, there is a huge benefit to seeing the investment gains through a different lens.

Kevin: Your dad started the firm back in 1972 and it was primarily gold – gold, silver, platinum and palladium. When you came in, you had done your stock brokering episode and spent some time out there and you said, “Dad, where is this money going to flow when we see this compounding of shares?” And so, wasn’t it about 2008 that you started the other side of the equation, let’s say, to where we start looking at how we compound, ultimately, from what gold will buy?

David: The conversation started in 2004 and 2005 and putting the groundwork in place we started managing money in 2008. What we wanted was kind of a combination of the offensive coordinator responsible for putting points on the board to complement what was already there which had been started, as you mentioned, in 1972, the defensive coordinator. We tend to see gold and silver and the precious metals complex as a sort of insurance offering. So the defensive coordinator for our football team, if you will, and the offensive coordinator, both have a place on the field at a particular point in time.

And our approach is definitely different on the wealth generation side, on the growth side. We are still interested in real assets. We’re still interested in real wealth, focusing on tangible assets like infrastructure, global natural resources, even precious metals to a degree, at least the companies that mine it, and especially real estate. It is all real stuff with cash flow.

Kevin: 2008-2009 were interesting years to enter that market because most people were losing their shirts. I think you guys made money at that time.

David: Yes, volatile for 2008 and 2009 for most of the investment universe. We made money in both years. Between then and now the team has expanded, the offerings have been refined, and from the perch we sit on, there is today an even more dynamic mix of real assets that fit the world in its current evolutionary form and make sense going forward. So whether it is driven by demographic trends or technological shifts, or, for us, considering the rapid expansion of central bank craziness and its impact, not only on market psychology and assets prices, but also the impact on the value of underlying currencies, we feel very well positioned.

So investing in the present tense is not for the faint of heart. Certainly, it is not for the autopilot indexer which has been so popular over the last 6, 7, 8, 10 years. But on the horizon we see the greatest shift in asset values in 40 years. Well, it is actually 38 years, because here we go back to that conversation about the Dow-gold ratio. As the ratio reverts, so the buying power of real money increases exponentially. I think it is appropriate, with the passing of Jack Welch this week, long-time CEO of General Electric, for those of you who have listened to the Commentary for a decade or more I have drawn out the GE example before.

Kevin: I love the example. You have to think it through, though.

David: It was a real example, but I was there at the Ritz Carlson in Pasadena and was running the numbers and made an investment decision myself on the basis of this ratio.

Kevin: I remember the call. Didn’t you call me and say, “I’m going to be picking up 100 ounces of gold?”

David: That’s right. And I basically split it between Canadian Maple Leafs, Krugerrands, and American Eagles.

Kevin: You were still at Morgan Stanley at that time.

David: Yes, I worked at Morgan Stanley in 2001, and that was the year that Jack Welch retired from the company. He had transformed an industrial giant into a very complicated, leveraged financial behemoth. It did a little bit of everything, and I’m not sure it did anything very well at that point. In fact, they are still struggling to sort of come to the world with a clear identity. But through the 1990s it worked very well, not only an increase in leverage, but complexity was no issue and so shareholders benefited throughout the 1990s. I would say shareholders have benefitted a lot less in the decades since.

Kevin: What made you make the decision back at that time?

David: We had an opportunity to go to the Ritz Carlton. There was a missed quarter on earnings which was the motivation to gather at the Ritz Carlton in Pasadena. I think it has changed ownership. It is no longer called the Ritz Carlton there. That’s a little piece of history from Pasadena, California. A few of the larger shareholders lived in that area and they were going to be present with questions to pose to the visiting executive coterie. They were there to kind of explain why the numbers weren’t so bad.

Kevin: What were the share prices back then?

David: GE sold for about $60 a share. And so my conundrum at the time was, I had always discounted my dad’s views on gold and was working on Wall Street and rather enjoying it. I was concerned a little bit. We had seen Sun Microsystems and a few other high-flying tech companies already kind of start to hit the skids. At the time I chose to invest a modest $30,000 in gold, and that was saying no to the inflated GE shares – $60. The executives were there to say, “It’s $60 going to $100. We’ll be fine. Any set-back in price is temporary in nature.”

Kevin: So you invested in 100 ounces of gold. I remember that. That was about $30,000 at the time.

David: $300 an ounce.

Kevin: Or you could have purchased at that same time, had you been convinced that GE was the better investment, 500 shares at $60 a share.

David: Yes. I think this demonstrates the power of the ratio well, by showing what has happened in the interim. I could re-invest dividends in those GE shares, 500 shares, and grow that position over time, and I think it would probably take me seven generations, maybe even ten generations, to grow in this way. I think, basically, what the ratios do for the investor is that they compress time. Seven to ten generations’ worth of growth – if you’re willing to wait and not wonder what is happening for you in the next quarter, the next week, even the next year – in this case it has taken two decades.

Kevin: You can compound. That is the word that we use all the time.

David: Yes, and expand your financial footprint fairly significantly. Again, GE illustrates how the ratio expands your financial footprint. As someone once said, and you mentioned earlier, there are decades where nothing happens, and weeks where decades happen. And so it is with ratios, like the Dow-gold ratio. Again, GE illustrates the multiplier effect.

Kevin: This is the GE-gold ratio that you are personalizing at this point. GE shares have fallen in value in dollars right now.

David: They have fallen from $60 to approximately $10 – I’m going to keep the math simple at $10. They dipped last Friday to $10, so we will just use that as the number, it’s easy math. They fell from $60 to $10. That’s about an 80% loss, a little bit over an 80% loss over a 20-year period.

Kevin: In dollars.

David: Yes. Gold has increased from $300 to $1600 an ounce, over a 500% gain. Now certainly, if you had sold GE shares at $60 and just sat out the decline of 80%, sat in cash and went out and bought more shares today, you would be better off because of instead of your 500 shares, a move to cash, and then a repurchase of shares would bring you to, at current prices, 3,000 shares.

Kevin: That’s not bad.

David: No, not bad at all. But combine the math, take both sides of the ratio, and this is where you begin to see real power, because you can own 16,000 shares instead of the 500 original, or instead of the 3,000 that you would have had just moving to cash. That is a 32 times increase in shares versus just the six times you would have had selling and buying back at lower prices. So this is compelling to me because to re-invest dividends, how many generations does it take of re-investing dividends to turn your 500 shares into 16,000 shares? But if I wanted to, today, right now, sell those 100 ounces of gold, I can go buy pretty near 16,000 shares of GE.

Kevin: Wow. Instead of the original 500.

David: Now, suppose GE goes back to paying a healthy quarterly dividend. They are still under pressure from a financial standpoint, reorganization – not like Chapter whatever reorganization, but they are trying to figure out what the soul of the corporation is. Immelt leaves and they get a new CEO and try to fix things up again. So you have the dividend at a penny a quarter. But going back to 1941, the average quarterly dividend for General Electric shares was 44 cents a share. If we go back to the average, those 16,000 shares would now generate $28,000 a year in income.

Kevin: And you started with $30,000. That’s what you are saying. And so you are talking about the dividend alone in one year would be what the original investment was.

David: Right. Of course, it doesn’t do that today because the dividends have fallen off. But assuming that GE has a place in the future and isn’t joining sort of the dust bin of history, it is the last of the original Dow components. 125 years on, there is only one Dow-Jones industrial stock that was in the original list of ten, and then it became 30, and it still is the only one there. But should it survive, should it to any degree revive, which I think it can – they generate between 95 and 100-billion dollars in annual revenue now, so they do have something to work with, to reshape and remold – then I think the ratio exchange will have done its job and multiply the financial footprint.

So I look at these two weeks, this period of volatility, and its crack psychology in the marketplace, and it has people asking a different set of questions. I hope they are not asking, “Should I be backing up the truck and buying stocks right now because they are at a 10% discount off of all-time highs. And oh, I missed the opportunity because did you see the huge run on Monday? I knew I should have stayed in and just stayed the course – stocks for the long run. Jeremy Siegel, the man of the hour, the man of the century, should keep our feet to the fire and keep us invested forever.” No, in fact, if you are willing to strategically engage with your portfolio, there are periods of time when hard assets make so much sense – so much sense – and where gold as an insurance play represents your means of not only opting out of the system, which may go through a period of chaos and turmoil, but it allows you to re-engage that same system, on your own terms, and in the right time. And that is where, again, increasing your financial footprint is so powerful.

I think it goes without saying that we’re moving into a period where central banks do nothing but monetize assets. And this is where real crisis begins to dawn on the average investor, not just a few who were over-leveraged in a fund and forced to liquidate last week.

But this one of the reasons why I love gold for the long-term because it reflects the realities of where we are going in terms of central bank monetary policy, in terms of fiscal policy, and ultimately, if you are playing the value equation, and playing the ratios, you’re still on the right side of the trade. At 16-to-1, classically, we get to a 1-to-1 at an extreme. A 2-to-1 is highly probable. A 3-to-1 is where you always go on the basis of economics without any, either political or geopolitical complication. And of course, those geopolitical and political complications are how you get the Dow-gold ratio to a 2-to-1 or a 1-to-1 ratio.

But 3-to-1, 2-to-1, 1-to-1 – our friend at Crosscurrents likes to say 5-to-1 is the average, you can count on that, take that to the bank. Well again, at bare minimum you can increase your financial footprint by three times, a 300% gain in your ownership of shares if you play the Dow-gold ratio just starting now and exiting at a 5-to-1 ratio. But a 3-to-1, 2-to-1, 1­to-1 are clearly possible, and I think that is what we are playing for, a massive increase in real wealth as it is reflected in a variety of asset classes.

So I guess, to conclude, there are things that you can do, there are things that you should be doing, and most importantly, I think there are questions that you should ask and a disposition you should adopt as it relates to engaging your financial assets, and engaging your long-term financial goals.

Coronavirus – yes, it is a concern. Yes, we will see melt-ups and melt-downs. We will continue to see volatility. We will continue to see market interventions from the Fed, from the ECB, from various central bankers. But what is your game plan? What is your strategy? If that is not clear enough in your mind yet, I would encourage you to work that out. Work it out on paper. Call us and we will help you work it out on paper.

And so, there are things that you should be doing. My attitude toward the markets is a little bit like my attitude toward coronavirus. I’m not inclined to shut myself in. I’m inclined to figure out what the best strategy is. If there are some practical things that can be done, then, by all means, we’ll get that done, but not to live in fear or panic, just to make sure you are implementing an excellent and well-thought-out plan.

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Calm, Independent Thinking When All The Crowd Is Stampeding