In PodCasts

About this week’s show:

  • China’s invitation into TPP strangely absent
  • Former Fed Pres. Fisher: “Yellen has backed herself into a corner”
  • Bernanke nominates himself as the next Marvel Superhero

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

“I think this is where we see the special place that gold and silver play in a portfolio. It is under-appreciated today, that element of non counterparty exposure – it was a core emphasis in 2008 and 2009. I think that is going to be a core emphasis at some point in the future. In the months and years ahead people will demand physical delivery, at any price.”

– David McAlvany

Kevin: David, there is a lot of confusion right now. We have this Trans-Pacific agreement that is being talked about. Nobody really understands what it says, but we have an avowed, self-proclaimed socialist, Bernie Sanders, saying that it is a disaster. We have Trump coming out from the other side saying it is a disaster. You have Hillary, who, 45 times, voted for it or worked toward it when she was Secretary of State, and now she is distancing herself from it. Yet you have Obama who is supporting it. What does it mean, Dave?

David: Yes, what is it exactly? It is 12 participating countries which represent 40% of the world’s trade, in theory, and they are creating a trade block, which again, in theory, should reduce trade barriers and increase the flow of goods. That is what it is on the surface, and that is really all we have is what it is on the surface, and I may be naïve on this, but I was under the assumption that global trade wasn’t really that restrictive at this point in history anyway.

Kevin: So do you think they created a problem to solve because they have things that they want to do differently? Or controlling-wise?

David: New Zealand is a big winner. They are an ag producer and yes, there are tariffs that are going to be reduced as they export their goods, so there are some winners and some losers in the mix, but I think the interesting point is that a trade deal with a focus on the Pacific, or shall I say Asia, that doesn’t include China, keep that in mind.

Kevin: That smells strange, doesn’t it? China, the largest economic force in Asia, and actually, the world.

David: To me, that makes this whole agreement sort of three parts geopolitical for every one part economic. So, it may fly under the radar of a trade agreement, but I think there is actually some geopolitical posturing going on in the region.

Kevin: Wasn’t it strange that the premier was in the United States just ten days before they came up with this agreement?

David: I think it is also worthy of note that the agreement was made within ten days of the Chinese premier’s visit to the U.S. And this has been a five-year process, an agreement being hammered out, and it was supposed to be completed three years ago. And so, it has been lingering, and they can’t quite get it agreed to. And then all of sudden the first visit from the premier and it’s done. And China is on the outside looking in.

Kevin: Well, you know what it reminds me of, Dave? Remember the old days when everyone was arguing about NAFTA? What was NAFTA to do for the worker here in the United States, or what was it to do for the corporation? It seems like you have those same arguments with this, as well.

David: Well, that’s right. The primary opponents to this look at it as sort of NAFTA on steroids, which it may be. What we do know about it is that it is relating to trade in some obscure way. But it is a little bit like Obamacare. To understand it we have to pass it first, and then we get to read the documents after the fact. And that is, perhaps, the concerning point to me. Not concerning, I suppose, if you have implicit trust in your political leadership, but concerning if you don’t. The TPP, the Trans-Pacific Partnership, is simply not transparent. So we now have the biggest trade deal since 1994, the Uruguay round and the creation of the World Trade Organization. And in the coming months there will be more released on it as each side gets to ratify the deal that was just signed in Atlanta, Georgia.

Kevin: One of the things that people have brought up as a concern is privacy, the control of data, because you are going to have free exchange, apparently, not just of trade and goods, but also information about people.

David: Exactly. You have a whole host of things that, again, on a blind basis we are being asked to say yes to, that is, strict rules for the environment, new labor laws, standards for investment, control of data, both its flow and storage. These are issues that, again, are being agreed to on sort of a transnational basis and outside of your normal legislative processes. Fortunately, everything gets to be ratified by Congress and various legislative bodies around the world, but I think this is where it may actually come to nothing. The TPP, like the Trans-Atlantic Partnership, has taken a long time to go virtually nowhere, and the Trans-Atlantic Partnership is the same kind of agreement, in principle, with the United States and Europe.

Kevin: Let me ask you, Dave, does this have anything to do with what you talked about three weeks ago after you got back from Asia? You said that China is going to put trillions of dollars toward opening up the markets between China, Europe, the Middle East – a free flow of goods. Do you think this is our response, by excluding China, to try to build up some sort of defense against that?

David: It is what Peter Chow described as globalization 4.0. The next round of globalization driven by the re-establishment of the Silk Road in China, creating not only an energy, but a transportation pipeline, to all of Europe from Asia. And I think it could very well be, and maybe that is the smartest part of this is us creating some sort of a block against Chinese growth. And I suspect that that counterweight is, perhaps, what gives it some merit. But I think notable is the tighter relations that it creates between the U.S. and Japan.

And you could even consider it something of a strategic alliance. It has been suggested that the U.S. and Japan will see much greater integration in terms of a supply chain, and when you think about that, you know who is going to oppose it, you had probably better appreciate why Bernie Sanders and others who are more associated with labor would be concerned, because if we integrate our supply chains more with the Japanese, what does that mean for car parts manufacturers and car manufacturers here in the United States? Labor here would have to look at the TPP and be very upset.

Kevin: Do you remember when we interviewed Friedman about a month ago, and Dr. Friedman said that Japan is where we should be looking, not China, as far as a rise in trade?

David: I thought about that when I was looking through the details of the TPP, and I thought about Friedman’s comments and I think you are right. It is a way that we get to, as a collective, instead of just us doing a bilateral trade agreement with the Japanese, it allows us and ten other people to be in partnership with the Japanese and reinforce their importance. So, you have two of the top three economies in the world – if you take China out of that top three, who are, in principle, agreeing to closer economic ties and relationships, that is very, very significant.

And I think what Friedman was suggesting was, essentially, the next decade or two is not the decade of the Chinese, it is the decade of the Japanese. That is going to be hard to swallow for many market operators who look at the current situation in Japanese markets and consider it very frail. And I’m not exactly sure how to address those concerns, but I do think our partnership with the Japanese underscores some support for them geopolitically, at least.

Kevin: Well, you know, there is something else that affects the rest of the world outside of the United States, and that, of course, is currency manipulation. We have seen the emerging markets literally falling apart because the U.S. dollar is so strong relative to their currencies and you have brought out in the past that any of those countries that have borrowed in dollars have to pay it back in dollars. Now, is there is a limitation on currency manipulation in this agreement?

David: No, there really isn’t. It is not addressed explicitly, and maybe that is because two of the biggest participants in the group are two of the biggest offenders, so to say, in terms of currency manipulation. Our quantitative easing, that program was death to the dollar on a short-term basis, and if you look at the Abe-nomics, the approach that Abe’s cabinet has taken to managing their economy over the last several years, it has put a lot of pressure on the yen. And so, we are two of the great offenders in terms of currency manipulation.

Kevin: Watching the news over the last couple of days, it was amazing to see how violent the French can be. When they are not running away from the enemy, they are running after their bosses. Talk about labor relations – labor is always, who is upset about the NAFTAs and the trade agreements. They are always looking at, “Will this displace my job?” Rightfully so. And what we saw in France, of course, these guys literally undressing their bosses as they beat them up, the executives of the corporation. Where does labor factor in on this?

David: I think one of the funny things is, there is an undercurrent of Marxism in the TPP agreement and it is this strong support for labor. That is not to say that there is not a good reason for fair wages and things of this nature, but I think we are in a context where we are going to see a shift away from emphasis on reward to capital, and more of an emphasis on reward to labor, over the next three, to five, to ten years.

Kevin: Which is clearly out of Marx. If there is going to be profit it needs to go to labor and not to capital.

David: That’s how Marx saw profit. He didn’t see it as a return on invested capital, he saw it as excess, and that excess was exploitative to labor, and in fact, could only be explained in terms of what should have by rights gone to labor and was instead squeezed from them and given to capital instead. And so, it seems to me that the days of labor arbitrage are ending, and to the degree that we see an increase in the cost of labor, which is one of the things that the TPP is calling for – imagine a base wage in Vietnam, a base wage in Malaysia, a minimum wage, if you will. As soon as you start marking up the cost of goods, consider what that does throughout the world. Number one, it makes them less competitive in terms of the goods that they manufacture, unless of course they are willing to pass through those higher costs to the United States and Europe, in which case we see the equivalent of price inflation – the Walmart effect.

Essentially, if you want to consider the last 20-30 years of consumption spending in the United States having been subsidized by Walmart’s trade agreements and manufacturing benefits, where they have been buying the cheapest products from the cheapest suppliers anywhere in the world, that Walmart subsidy is about to go away. And again, it is a change in the equation where labor the world over does see some benefit, but capital is going to have to ask the question, how do we invest in the context where we are being disadvantaged or returns are being diminished?

Kevin: So whenever we hear the words free trade or globalism, the way I think, I think of prices coming down worldwide, but in this case, it’s like Obama healthcare. Sometimes you have to say, “Well, is it really health care or is it something the opposite of that?” And free trade – they’re calling this free trade, but actually, maybe it’s not, maybe it’s restricted trade, and the money is going to be apportioned elsewhere. I think that is what you are saying.

David: We have said this before in a different context, but the powers that be like to choose winners and losers, and we have seen the central banks do that in terms of who gets what at the free money trough, and this is really, again, a question of who gets what. I think, in that sense, there is a strong political overtone, undertone, I don’t know how you would want to describe it – where essentially, you are determining who is going to get what over the next three, to five, to ten years.

And if Wall Street and corporations get a little bit less and labor gets a little bit more – I will be honest – maybe that is “fair,” but it is going to force a decision amongst the allocators of capital, and it is going to change the marketplace pretty radically. So I think there may be some unintended consequences from this that, again, it is intended to increase global trade, but it may actually create some real consternation because you’re disadvantaging capital.

Kevin: And we have seen, with the control of the marketplace over the last five or six years with the central bankers, the feeling that there are people who are in control, and capital and labor will just flow wherever they choose, but it is turning out that volatility is scaring away people who would normally lean on that control. I’m thinking of hedge fund managers. Just this week you were talking to a hedge fund manager who said, “You know what? We’re going to play wait and see for a little while. We’re going to go to cash and gold. We’re not going to play right now.” Because volatility is making them think that maybe they don’t want to be there to catch the falling knife.

David: There is a growing audience, whether it is Ray Dalio, Bridgewater, or Stanley Druckenmiller – there are many who are saying to themselves, “Something doesn’t look or feel quite right.” Mohammed El-Erian wrote in this week’s Financial Times, arguing that, “The increase in volatility may keep institutions much more tentative,” and that they normally play a role, that of market stabilizer, as they come in and allocate assets and create sort of a counter-cyclical cushion when stock prices begin to drop. And he is suggesting that that role is likely to be abdicated.

And what is the basis for that? It is that there is this structural shift in volatility and it is causing institutions to reconsider what they want to allocate toward a risk exposure. And he discusses the “prolonged period of volatility suppression created by the Fed and the ECB and how they would rather not give that up. So, we have had volatility suppression for years. And again, think about that. He knows it, we know it, we have talked about it before. The activity of the world’s central banks has been to create a sense of calm. It has been a vast PR gambit to bring about amongst the minds of the average investor, “All is well, it is okay. Put your money to work, go spend like a good soldier.”

And the reality is, they can’t undo what they have been doing without a grave consequence. So what are they going to do? You have this prolonged period of volatility suppression, now you have volatility peaking up, and what is the cause of that? Really, it is an anticipation of an increase in rates. And I ask the question: What would change their attitude toward risk, and the normal asset allocation shifts into stocks, what have you, at lower prices? The clearest answer is, in terms of a structural change, an awareness of higher rates, and how that recalibrates equity values.

Kevin: I think what you are saying, Dave, is that asset prices are over-valued because interest rates are artificially under-valued. And so, if you are looking at prices and you are saying, “I’m not going to pay that price until they raise rates,” what you are really doing is looking down the road and saying, “Those prices are going to come down.”

David: They have to. We have discussed this before. Rates are a basic ingredient in your discounted cash flow models, they are a basic ingredient in investment hurdle rates, and as rates rise you can expect a reduction in returns on capital, and therefore a reduction in the value of those assets. So, an asset manager who is assuming a zero rate environment is happy to price assets to the moon. But if all of a sudden you have to recalibrate on the basis of a rising interest rate environment, what is the other part of the equation?

The other part of the equation is, interest rates up, asset prices down. So this is, again, where your institutions who would ordinarily step in and support a falling market – if they take the Fed at their word that rates are going to rise, they are not willing to step in, not yet. Maybe they will at some point, but there is absolutely no reason for them to do that until you have gotten rates to a normalized level. And that’s a long way from here.

Kevin: One of the dangers of that, and we have seen this in a number of fields, is that if they are the buyers of last resort, they are the providers of liquidity to people who want to sell those assets today.

David: That’s exactly right. El-Erian is raising the interesting point that volatility may be changing the behavior of the largest institutions as it relates to that role of buyer as last resort. So, what happens if you change the buyer of last resort and remove them from the equation? That not only exaggerates volatility, but as you way, it also diminishes who you are selling product into. Where did liquidity go?

Kevin: Yes, one of the amazing wakeup calls to any investor in anything is when they buy something thinking that they can just go ahead and sell it anytime. And when they actually come to do that, including bonds, municipal bonds, it can be stocks – when they go to do that, they find out that there is no one to buy.

David: That’s right. Doug Nolan points that out when he describes financial assets as having “money-ness.” What does that mean, exactly? A financial asset that has been treated as a money-like instrument is regarded first as something that is safe. And to the degree that central banks have encouraged the inflation of prices, and if we want to borrow from the old Greenspan put days, guaranteed that there is really no downside, then you can view financial assets as “safe.” And then the second component is to have that money-ness quality, those financial assets are “liquid.”

Kevin: You’ve got to be able to sell it.

David: That’s right. So liquidity is the attribute that, I think, is less understood. A few months ago we talked about the issue of illiquidity sort of latent in the market. And it was in talking about the popularization of index funds and ETFs. My son and I just met John Bogle in New York who started the Vanguard funds and sort of popularized what has now become indexing and ETFs and things of that nature. There are now trillions of dollars in these asset baskets – ETFs, or basically, proxies from market segments – which hold more or less liquid assets. And the investors who own them assume that with the click of a mouse they can buy it, with the click of a mouse they can sell it.

Kevin: You know what it reminds me of, Dave. I don’t know how many times you do the “Buy it with one click now” on Amazon. I do. In fact, it’s dangerous. They advertised – I bought some shaving soap on Amazon the other day and a couple of days later they advertised a nice, new bristle brush to go with that. Well, of course, “Buy it with one click.” Then they advertised something else that sort of ties in, and it’s like, “Well, of course, buy it with one click.” The problem is, you can’t sell an ETF with one click if there are no buyers.

David: Well, the point I want to make is that not all the constituent parts are created equal, though they will be sold in equal measure in the event of a mass liquidation. 2016, in my opinion, is likely to be the timeframe where these kinds of products face their first real structural difficulties. What if no market maker is interested in taking the assets in? What if there is no real bid that seems reasonable? Liquidity is the issue, and I think you are dealing with an environment where we may see radical price drops because the vehicles which have assumed liquidity that no longer provide it, but again, by contract, by legal force, have to liquidate the assets when requested, force this catastrophic decline in prices.

And so, what happens? We haven’t been there yet, except in the “flash crashes” of 2012, 2013, 2014 and 2015. The instances where we have seen flash crashes – they basically unwind the trades and reset the clock. And I’m not sure how we navigate the next couple of years if those shifts in value are radical enough and the exchanges have to step in and call a do-over, it is, to some degree, like Ben Bernanke’s comment in this week’s Wall Street Journal, “The Fed can mitigate recessions.” He said, just point blank, “We can mitigate recessions, and we can determine inflation. We can determine employment rates.” He takes credit for that. So why can’t exchanges mitigate declines and determine the trajectories for stocks? Why can’t they just always make them go higher? And when they go lower, in the extreme, just say, “Ah, we’re not going to count that.”

Kevin: Well, they can, to a degree, if they are continually given free money by the Fed, but let’s face it, reality still has to set in at some point.

David: In both cases, what you are talking about is artificially fixing reality.

Kevin: Right.

David: And hoping that it sticks. And in both cases, the casual observer might say that you’ve basically eliminated the market. If you can, by decree, make something so, “This is what the price of the interest rate is going to be, therefore, this is what the price of the bond will be. This is what the price of the stock will be and we will erase that nasty little downturn,” capital doesn’t know what to do with that. So, we started by saying there is this growing conflict between labor and capital, and the TPP, the Trans-Pacific Partnership, underscores moving into an era where labor is probably going to be favored over capital.

And then we also have the artificial nature of the markets where people who are allocating capital, when they see how artificial the inputs are into the market, do you know what they say? “I don’t like it, I don’t trust it, I don’t understand it. It doesn’t make sense, it’s not rational. I think I’ll just take my marbles and go home.” And this complements Napier’s thoughts which we mentioned last week that capital may very well disappear for a while. And what was the last period of time when that happened? 1944 to 1949, where the footprint of the government was so large that private capital basically said, “We don’t know how to make money with our money. We’re either going to get taxed out of existence, or the reward for the risk taken is going to be snatched from us. Why would we play this game? It is not within our arms to control, so why don’t we just disappear for while?”

Kevin: This week was the first week, ever, that U.S. treasuries, three-month treasuries, sold for zero percent. That shows there is demand for three-month treasuries. That shows there is demand for cash. We talked about this last week and the week before, the gold is running out. The supplies of gold are running out. Anyone who is trying to buy physical gold is paying a premium right now because there is not much out there. We are seeing the same thing with treasuries.

Now, you still have a lot of people sitting in stocks and bonds, thinking that they can sell them at any time. Dave, you told a story just a few minutes ago before we started recording, of a friend of yours and your dad’s, who was in the bond market in the brokerage business back in the 1970s, and he walked into his boss’s office and he saw stacks of paper behind him, and he said, “What’s that?” And I’d like you to tell the rest of the story.

David: Well, it was all the bonds that that firm could not sell, and these were client assets that had been returned. Again, this was a day in which paper reigned. There was no sort of digital accounting for who owned what. You had stock certificates, you had bond certificates. And in this case, he had stacks of bonds which there was no market for. No one wanted to buy them. No one wanted them.

Kevin: So like consignment, like taking something down and selling something on consignment, like somebody selling a guitar at a pawn shop…

David: “If somebody comes in the door and wants it who is willing to pay the offered price, or wants to make an offer on it, maybe we’ll consider that offer, but right now, there is no market for it.” Well, liquidity issues are going to look different now than they did when the bonds were stacking up behind this Wall Street guy in his office. What I think is much more likely is you click the mouse to sell the asset and the bid drops to the floor. You thought you were going to get X price for the ETF that you own and lo and behold it’s 20-30% less when the trade settles. That’s an indication of illiquidity. Why? Well, everything is liquid – at a certain price.

Kevin: Last week you recommended that a person hedge their portfolio, which means if you own stock you take the opposite bet in the form of a put option or selling short that same stock. Now, isn’t a hedged portfolio also, to some degree, at risk if there is no liquidity in the market?

David: Let’s look at this in the big picture. We’ve talked about hedging an equity portfolio, and we’ve encouraged clients to get to a neutral position, in addition to raising cash, having a precious metals allocation. There is a flaw in thinking that a hedged portfolio is one that has eliminated risk. It may have eliminated a degree of risk for you, but no risk is ever eliminated by hedging. It is simply shifted to someone else. Does that make sense?

Kevin: Yes.

David: Whenever you create a hedge you are making a bet that neutralizes another bet, a directional bet. You think this is going to go up and you buy the other side of the equation, you think it’s going to go down and it just creates sort of a neutral balance, if you will. Imagine the scale with an equal amount of weight on each side, right? Now it’s in balance, now it’s equal and level. To do that, someone in the options or futures market, in the derivative market, is willing to “take the other side of the trade.”

Kevin: They’re betting against you, basically.

David: Exactly. So one of you is going to make money, and one of you is going to lose money. But somebody must lose, so risk may have been offloaded, but it was not eliminated. And in fact, if you recall the 1987 crash, it is what exaggerated the decline. You had more and more people getting themselves insurance on existing stock positions, and the more insurance they bought to cover their existing portfolio, “portfolio insurance,” the lower the shares they were insuring.

Kevin: They were betting against themselves in a way.

David: They were betting against themselves to cover their existing position, and the more they bet against themselves, the more the price declined. The biggest permutation today is that there are insurance products that don’t openly trade. These are the derivatives contracts which take reams of paper and specialized lawyers to read. And one of those contracts, if it is in violation, may trigger a legal obligation to pay. But when do you pay, and how to you enforce it? Because it is a legal contract, it is going to take a date in court to make sure that a judge says, “Well, you must pay now.”

Kevin: It reminds me of Argentine bonds. Talk about fighting something, Argentina could have either just declared bankruptcy or … it’s been in court for years.

David: Well, that’s exactly right. You have a number of hedge funds that want repayment on debt and there has been a default which has occurred, but who is going to enforce it, and on a contract basis it is going to take someone to intermediate. The old school hedging had sort of an automatic recalibration to it, and the new school hedging, using derivative contracts – it may or may not even be enforceable, certainly not on an automatic basis.

So the conclusion in all of this is that rather than merely hedging a portfolio from volatility, speculators have taken the hedging idea to a new level. They have believed that risk has been “eliminated” and therefore more risk can be layered into a portfolio allocation mix to enhance their returns. What is the net result? Well, there is more risk in the marketplace, there is more systemic pressure, and there are lots of people believing that they are adequately hedged because the counter-parties have them covered.

Kevin: They are sleeping safe at night, when really, the Titanic may be sinking underneath them.

David: Yes. And one thing the world is very limited on, and this is in spite of ample central bank liquidity that has been created, there are no vast sums of idle cash laying around amongst the financial community to serve as payment if a counter-party is required to make good on those derivative contracts. And this where, again, you begin to see cracks in the system, someone like we mentioned last week, a commodities trading firm who begins to go under – who is on the other side of all their bets? Are they going to be okay? Is this going to represent financial solvency, insolvency? Are we going to end up with something like an MF Global all over again, as we watch this large commodity trading firm in Switzerland implode?

Kevin: It’s like pyramid scheme, Dave. You know, when you look at a pyramid scheme, or let’s just even say a multi-level marketing program that doesn’t really have a product. As long as you have five new friends that you can bring in, and they have five new friends, and five more new friends, the whole thing continues to work, but when you start running out of the five new friends, the whole thing falls apart.

David: It’s the actual cash available which is the missing element. So, what makes the derivative pyramid scheme so dangerous is the lack of actual cash available relative to the commitments outstanding. And you go back to the 2006-2008 memory bank, if you will, and you had a liquidity crisis – you are talking about firms that are very significant. AIG was not an insignificant firm, one of the largest insurance companies in the world. You would say, well, they’ve got to have billions in cash.

Kevin: Well, they were solvent.

David: If they had billions in cash, they needed tens of billions. If they had tens of billions in cash they needed hundreds of billions. The point was, there was a mismatch in terms of the liabilities and their ability to make good on them in short order.

Kevin: But on paper they were solvent.

David: That’s right. So you ended with a liquidity crisis triggering a solvency crisis on the street. So that kind of liquidity is still lacking, and as volatility increases, more and more participants have, and will continue to, seek “protections” in the derivatives market. Well, listen, at this point, God forbid something bad actually occurs in the derivative space, because the same liquidity solvency dynamics exist today as they did in 2008 and 2009. They still exist, and to some degree, they have been exaggerated.

I think this is where you see the special place that gold and sliver play in a portfolio, one of the few spaces that you can put money that allows you to have a financial asset without counterparty risk. It is under-appreciated today, that element of non counterparty exposure, but it was a core emphasis in 2008 and 2009 amongst large and sophisticated investors coming into the gold space, in particular, and I think that is going to be a core emphasis at some point in the future, and a prime reason why in the months and years ahead that people will demand physical delivery at any price.

Kevin: Yes, there is a lot of false pride and hubris built into the system. You look at Bernanke coming out with his new book and he is just so incredibly proud of the job that he has done.

David: Yes, I think the history channel could likely do a special on him like they do on World War I, World War II veterans, and really just sort of – you can hear the music playing, you feel the triumphalism, you feel the patriotic zeal. And then you have a recap, and this is what Bernanke actually basically did in this week’s Wall Street Journal – “I am writing this reflection on the success of a successful man while at the helm of a most successful central bank which succeeded in saving the world and, oh, the economy, too.” (laughs).

Kevin: (laughs)

David: It was pretty funny. “And we did our job, but what about everyone else? We really were the ones who stood in the gap.” Again, roll music, maybe bombs bursting in air, or the rocket’s red glare, and there was Ben Bernanke who saved the world.

Kevin: Well, and we talked about Greek tragedy. The entertainment value of Greek tragedy is that hubris gets reduced in humility.

David: (laughs) Richard Fisher commented this last week – you may recall he retired from the Dallas Fed at the end of last year – he underscored something that we mentioned in the Commentary a week ago, that monetary policy has done what it can do.

Kevin: They’ve spent their bullets.

David: They have. They are out of ammunition. You can go to QE-4, the question is, how long will it give you any benefit before people realize that it is a desperate measure stacked on top of three previous desperate measures, none of which worked, or delivered what they were advertised in terms of what they were supposed to deliver. Perhaps that is why Mr. Fisher left the Fed last year. I think it is, perhaps – again, this is conjecture on my part, but when you hear the music and anticipate it stopping, choose your seat, go ahead and maybe start moving in that direction and take the seat before the music stops.

Kevin: So, do you think Yellen is still walking around as the music is starting to stop?

David: Well, he said that not only had Yellen backed herself into a corner, but that monetary policy had played out. You recall what Napier has suggested, the next round of a reflation? The next round of reflation is likely to come from fiscal stimulus because monetary policy measures have already been acknowledged as dangerous if allowed to linger. And they have also been seen an ineffectual in creating economic activity.

So, we’ve been talking about an exit strategy from our monetary policy since 2011 – they haven’t done anything. And now we have last week the Atlanta Fed posting its updated real-time models of the U.S. GDP and instead of the previous estimates of growth at 1.8% – that is what they had estimated as of September 28th – the calendar rolls over to October 1st and they reduce that to 0.9, so they cut it in half. That is on top of last week’s September employment report. And come on, 201,000 was the expected number. We ended up with 142,000, along with revisions downward for August and July. You have the revisions, which I think are very significant when you consider that the positive expectations built into the stock market in those months, both July and August, turn out to be premature.

Kevin: Yes.

David: They turn out to be premature. In fairness, we always talk about the death/birth models and these are your fabricated numbers, whether it is people who have died and so they are taking them out, or arbitrarily putting them in, just assuming that this number of people have been born, therefore there should be this number of jobs created. Whether or not those jobs are actually created doesn’t matter. Statistically it is just a way of imputing, on average, the number of people who are coming in and out of our culture.

Kevin: It’s a little like massaging Kobe beef. It’s that same type of thing, you’re just trying to make it taste just a little bit better to the public.

David: Well, in this case it was a negative 34,000, so in fairness we always acknowledged when they have goosed the number. This instance they took out 34,000 jobs. Factor those back in and you still have a disappointing number. Your 201,000 number still comes in shy of that if you factor in your birth/death models, 34 plus your 142, you are still well below the estimate. It was interesting, the participation rate put in a new low, that is, 62.2%, a 38-year low. And even Bernanke took the time to comment on that in his Wall Street Journal article. After saying, basically, we can determine the unemployment rate, he says, “But there is this anomaly, the participation rate, which still isn’t quite in line. So maybe – maybe our labor problems aren’t completely whipped yet.”

Kevin: Well, and let’s go ahead and call it what it is. Participation rate of 62% is saying that six out of ten people in the United States actually have a job.

David: Right. So, of the people that could be employed, that is also saying that, basically, over 90 million don’t.

Kevin: Right.

David: So, this 5.1% number is a number that we should all cheer, but there is this anomaly that goes unexplained.

Kevin: Which sounds more like 38% to me.

David: How are we dealing with it with a participation rate of people that could work and aren’t working, that equals over 90 million people?

Kevin: Yes. Unbelievable.

David: That’s a big deal.

Kevin: Well, like you said, Bernanke may be a hero. You know, we’re in an age right now where the superhero movie seems to be bringing in most of the box office money, so maybe now we will start to see Marvel pick up Ben Bernanke and give him some sort of superpower.

David: I can see it. He’s on the cover of his book, he’s wearing a cape.

Kevin: (laughs)

David: He is not only the man of the hour, but he is some salvific character, too. I mean, it’s just fantastic.

Kevin: Well, Dave, before we wrap up here, I know liquidity is a big issue on this particular program. What we are talking about is, if you can’t sell something you really are stuck with it until you can, and that can change the price. But there is another issue with what you’ve done and what your family has done all of your life, and that is, in the gold business it’s not about liquidity as much as it is supply. That is the other side of things. And as you brought up last week, supply is literally drying up.

David: There is something very interesting here because we source product from all over the world. And occasionally we will find a large hoard of product, and that is fantastic. But it is once in a blue moon that that occurs. And ordinarily we are dealing with product that is in the secondary market, and floats between people who want to sell and people who want to buy and there is just kind of a general stock out there. That’s a pretty thin float of product. What we see right now is that all smaller products are already diminishing. There is still some out there, but it is diminishing rapidly.

Kevin: Now, when you say small, you are talking about the smaller than one-ounce coin, something half-ounce, quarter-ounce, that type of thing – and silver.

David: That’s correct, definitely. So, I would say, the man on the street, when he is making a purchase, he is interested in small products. He is not buying a 400-ounce gold bar, he is not buying a 1000-ounce silver bar. Those are products that are more in tune and in keeping with an institutional purchase, or a large investor purchase that is going to be stored someplace else.

Kevin: But a quarter-ounce gold coin, or a one-ounce silver coin, those are barterable.

David: That’s right. What I find intriguing is something that has changed in recent years. U.S. fabricators are gone. Englehard is gone. Johnson Matthey is gone – they got bought by the Japanese beer company Asahi, and they don’t provide product for the U.S. anymore. So, when you are dealing with this issue of small product, and when it runs out, there is an interesting thing that occurs because you can look and say, “Well, but there are tons of 400-ounce good delivery bars.” The problem is, nobody wants a 400-ounce good delivery gold bar. Most people are not buying gold in increments of half a million dollars or more.

Kevin: Right.

David: You might buy $1,000, $10,000, $100,000 – but this is the issue. There are plenty of 1,000-ounce silver bars. I can get my hands on 26 million ounces of silver tomorrow in 1000-ounce bar format. But if I wanted that in one-ounce coins or 10-ounce bars, or 100-ounce bars – not doable.

Kevin: Even with delayed delivery, it’s not possible.

David: Well, it just depends on how delayed.

Kevin: Right.

David: But the reality is, the fabrication business has completely changed, and some of the main players that were there 20 and 30 years ago – they don’t even exist today. So, in an environment of increased demand, you are dealing with a stratification in the marketplace where the common man who buys anything less than a kilo gold bar is not going to have access. And your institution will have access, but only on the large format products. And you say to yourself, “Well, why can’t you take those bars and just melt them down and turn them into something that is smaller and good for regular distribution?”

Kevin: Well, don’t they do that?

David: The fabricators are out of business.

Kevin: Right.

David: They went the way of the dodo bird in the last bear market, and your primary producer, which was JM here in the United States, Johnson Matthey, they don’t have a retail arm, they don’t have product provisions, they have made the determination that dealing with industrial uses for metals is a far more reliable demand source than investors, which can be very fickle. And they have basically shifted all of their fabricating capacity toward industrial users.

So, you are in this interesting space, and I think the next few years are going to create some fascinating dynamics where premiums on particular products exist, and no premiums exist on other products. And so, how you position in a portfolio, I think, will be very interesting. There will be some great opportunities in light of that, and an ability to arbitrage between products and capture those premiums in terms of new and greater ounce positions for a client. But again, these are some things that we are seeing, both in the U.S. market and in the overseas market.

Kevin: So, Dave, it is my turn to be a broken record. You are still saying gold and cash, cash and gold. And as we saw a few days ago, cash at this point is paying zero percent, if you are buying three-month treasuries, and gold is becoming very, very scarce.

David: I just think that the next 12-18 months you are going to see the little guy priced out of the gold market, and priced out of the silver market. Unless you are able to step up to a 1,000-ounce silver bar, or a greater than kilo bar size in the gold space, being priced out of the market is the reality on the horizon.

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