This week Steven Hochberg & Pete Kendall of the Elliott Wave join the program to discuss an era ending stock and bond downturn. The lowest volatility in 50 years signals coming high volatility. This crash will end central bank’s illusions of control. Thanks for listening to this week’s McAlvany Commentary.
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
ELLIOTT WAVE TECHNICIANS WARN OF “GRAND SUPER CYCLE TOP”
September 26, 2018
“If this is unparalleled risk, I want to be in an asset that is permanent in nature, that in fact has already gone through a thousand such crises and there is no question as to its survivability, its durability, and its value on the other side. So to me, Kevin, this is probably one of the most valuable conversations we have had all year.”
– David McAlvany
Kevin:Our guests today, Dave, represent a team. We talked about Bob Prechter last week. Back in 1987 Bob Prechter called a financial crash in the stock market. The Wall Street Journalpointed out that he was dead on. At this point he is actually calling for a crash that is even larger, maybe the largest that we have seen in 300 years.
David:That is why he suggested this is the end of an era. If you’re talking about a grand super cycle, this is something that encompasses multiple super cycles and becomes the granddaddy of them all.
For an interesting frame of reference, when our team, with Doug Noland, we look at the biggest bubble in credit history being at the heart of money and credit, that is, the government bond bubble, this is something that he started documenting in 2009 and 2010 after we saw the crack-up of the mortgage-backed securities market. He saw migration, and the migration was from the miniature bubble that was tech-related to the outsized bubble that was mortgage-backed securities related, to the biggest granddaddy bubble of them all.
Kevin:And the granddaddy bubble is our money itself, because our money is no longer gold, it’s credit.
David:To be honest, this is where you and I wrestle ideologically with ideas and the conversation that we have today with Steven and Peter is bound to be intriguing, because we don’t necessarily agree with everything, but by the way, the Commentary doesn’t require that. We can have some controversy and differences of opinions. I think one of the things that has always stood out to me is that this time around thebiggest deflation, perhaps in U.S. financial market history, is tied to, and denominated, in a very different currency structure. Past deflations have been in a currency that was gold.
Kevin:It was just a receipt for gold.
David:Right. So if you moved to dollars you were actually moving to this “worthless commodity” – gold. Today it’s different, and I wonder if, after 1987, post Bretton Woods, when we have an entirely global fiat system, no single currency has gold backing, when you get into the midst of crisis do you go to paper on the same basis that you would have before when it still requires you to have faith and confidence in the system that is in that moment being repudiated?
Kevin:And that system is being repudiated because there is, at least at this point, 21 trillion dollars that we know cannot be paid? One of the things that has been difficult, Dave, to re-educate people in thinking is how to denominate something in something real versus the U.S. dollar? I’ll give you an example. When we talk about platinum to palladium, we can see it go up and down in dollars. That is almost meaningless.
But what we have actually seen is a palladium to platinum swap where many people have tripled their ounces of platinum over the last ten years because they were looking at that ratio, they weren’t looking at prices. Gold and silver are the same way but gold and the Dow – the Dow-gold ratio is one of the key ways to denominate gold or the Dow, not really relying on what happens to gold or the Dow in dollars.
David:When we bring these guys on, I want to ask them a question about the Dow-gold ratio because these ratios mean everything to me. The price of an asset is not that particularly relevant to me. Here is why.
Kevin:In a fiat currency?
David:Exactly. Think about it this way, in bolivars. What is the value of an ounce of silver or gold in Venezuelan bolivars? Is it even relevant? It doesn’t even matter, because we’re talking about something that is intrinsically worthless.
Kevin:So how do you measure deflation or inflation if the currency is either collapsing, or going away, or changing?
David:Let me tell you a conversation I had with Dashel, one of my younger sons, this last week. He has saved 136 ounces of silver. Now, looking at the gold-silver ratio there are times when you own silver and there are times when you own gold. We worked through this process of how about once a decade he will be able to swap one for the other. You know what never came into the conversation? “What’s the price of gold? What’s the price of silver?”
Kevin:Right. He’s thinking in ounces.
David:Right. So you accumulate a certain number of ounces. You move up the scale in terms of how many you own by doing these ratio changes, looking at relative values and being able to be in one asset class or the other, on the basis of value. And lo and behold, by the time he is an old man passing his silver or gold ounces onto his kids, we have gone from 136 original ounces to almost 40,000 ounces.
Kevin:And he will never remember what currency he exchanged for the ounces. It may be a completely different currency at that time.
David:I’m not sure that that is the most relevant factor.
Kevin:What Steven Hochberg and Peter Kendall have been writing about, along with their partner, Robert Prechter, is a five-wave cycle. These guys are Elliot Wave theorists. What they are doing is picking something to measure in – in this case it is dollars – and they are looking at the waves. We have been reading about for decades, Dave, a coming culmination of all these cycles – the short, the intermediate, and the long, and having a super cycle turn down. That’s what they are calling for, and fairly soon.
David:Frankly, this is one of the reasons why I wanted to talk with Bob Prechter’s team because you don’t see this happen every day. In fact, you don’t see it happen every decade. You don’t see it happen every 100 years.
Kevin:What is it – 300 years that we’re talking?
David:This is an interesting coalescence and I think it is important that people understand the ramifications of a significant market top. This is not a short-term cyclical issue. This is a long-term secular trend change and it has ramifications for every asset class. Obviously, it is your contention and mine, and we have a philosophical bias here, I’ll be happy to note that, state it, make it very clear, that we don’t see confidence in the midst of crisis gravitating toward U.S. dollars or treasuries.
If you’re in the deflation camp, and the Elliott Wave folks tend to be, that is, in fact, what you prioritize as a cash holding. We have taken a balanced position and said, “Yes, have cash, but make sure that you have an insurance policy, and that you don’t have all your eggs in the basket being managed by your central bankers. Because frankly, the evidence is in so far this century that they have not done a very good job – nor last century.
Kevin:It is very possible that people will look back on this program after listening to the Elliott Wave cycle theorists and say, “I remember when they told me before it happened.”
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David:Steven Hochberg and Peter Kendall, thanks for joining the Weekly Commentary. Elliott Wave is something that has been on your minds, that you have been thinking about, not just for a short period of time, but for both of you, formerly being involved in it now for decades. Steven, maybe you can give us some background. You started at Merrill in the 1980s, and then you ultimately moved over and started working with Bob Prechter. Maybe fill in some of that for us.
Steven:Sure. I went to work for Merrill Lynch right out of college. Back in 1984, I believe, I was sitting at my desk and I read an article about someone who had just won the options trading championship with a 444% return in a very short period of time, and his name was Bob Prechter. I looked at that – I was reading the article – and I said, “Wait a minute. What is this guy doing right? Maybe I should be looking into that.” That really led me into my journey, and I have been following Bob since the 1980s. Back in the early 1990s I went back to graduate school and got my Masters and the minute I graduated I came down to Georgia to work with Bob. That was 1993 and I have been with him ever since. Pete and I started the Elliott Wave Financial Forecastin 1999, which is an adjunct to Bob’s monthly newsletter, the Elliott Wave Theorist, and we have been writing it continuously since then. And quite frankly, we have been having a blast just following the markets and trying to forecast what is coming around the next corner.
David:I can tell that both of you enjoy what you do. Pete, you were also there in the early 1990s and I know your interest is also in the area of socionomics. Can you define and use in a sentence (laughs) this idea of socionomics? Why is it so fascinating to you? Because it goes far beyond looking at charts. But give us a little bit of your background, too.
Peter:My story is that I was a reporter for a stock market publication based in Denver, Colorado, mostly covering individual shares, but when I asked the question, “Who do you talk to when you want to know about the market more generally?” Which turned out to be something I was drawn to as time went on. The answer came back, Robert Prechter, amongst others. Stan Weinstein was another one that was mentioned. But why it stood out amongst the different approaches is that it was more broadly applicable as I found out.
Over maybe three to four years Bob came out with a piece in Barron’son pop culture in the stock market which subsequently developed into what we call socionomics. Another book came out in 1999 and Bob’s latest book, The SocionomicTheory of Finance, really ties together and constructs what will become, and is becoming, an academic discipline.
All that has happened, but I am still back where I was at the beginning, just kind of fascinated with how it plays out in the culture, how what happens in the stock market extends into politics, extends into music, and extends into even sports or just about anything that we operate in on a mass scale.
Steven:Let me just intervene here. Socionomics really is just the study of social mood, and its results which occur in social action. What we do here is we study how waves of mood, which are internally regulated, in turn, regulate changes in the economy, and political preferences, and financial markets and pop culture. So we look at this mood as it is moving from pessimism to optimism, and optimism back to pessimism. And it is not randomly generated, it moves in a patterned way, regulated by the Elliott Wave principle. What Pete and I do here is, we try to ascertain where we are within the development of mood because it implies certain things about what is going to happen later on in the economy and pop culture, and so forth. That is what makes our job so interesting, quite frankly.
David:So when we think about the Elliott Wave we’re talking about the forms, the patterns, and the attendant psychology. Super cycle tops are not something that happen with great frequency, but it is something that is argued in the Elliott Wave Theoristthat, in fact, we could be seeing one now. There are short-term ways of looking at the market, there are medium-term ways of looking at the market, there are longer-term interpretations of charts, and you provide a variety of interpretations along those lines. As I mentioned, Bob Prechter’s Elliott Wave Theoristthis September has that suggestion that we are at the end of an era. That’s a very big picture of you, of the financial markets. Can you explain a bit of that thesis?
Peter:It really relates directly to the wave pattern, the wave principle. As you said, it is patterned, and we call it a hierarchical fractal, meaning that there are self-similar patterns at all degrees of scale. For example, if you were looking at a really long-term scale from the late 1780s, which we call a grand super cycle, it is tracing out the same type of development and pattern as it is, say, from the 1932 low, which would be a super cycle low, or from the 1974 low.
What is really fascinating and interesting now, and exciting, is that all these cycles are culminating right now in this period, and in our estimation we are forming a top at all these degrees of trend. And the market is slowly rolling over from this super long bull market into what we think is going to be a pretty long and deep bear market. It doesn’t happen overnight. It doesn’t even happen over a month, as we are experiencing right now, but over a long period of time. And then what we have been doing in the newsletter is chronicling all the things that are happening that confirm what we are seeing in terms of the wave structure.
Peter:Now, you said the super cycles don’t happen that often. In fact, that’s true. You have to go back to 1835 to get the first one. That is from the beginning of the republic up through 1835 – that’s super cycle I. Then you get the Depression and a deflation. And then from somewhere in the 1950s right before the Civil War up to 1929, that is the second super cycle, and it ends with, of course, the great crash. Now we are in the third super cycle, which started in 1932 and is culminating now, and it is just a fascinating process to watch. It’s great (laughs). I don’t know how to explain it. As we go on, we’ll characterize it more.
David:And you began this year, January, with a variety of indicators. You were saying that we are at either multi-year, or multi-decade, extremes. Again, you are bringing together the intermediate cycle, the primary cycle, the super cycle, the grand super cycle. Again, these are all different measures of time, and they are all topping basically at the same point. How often does that kind of confluence occur, and should that matter to investors?
Peter:You put these three super cycles that I just mentioned together and you get a grand super cycle beginning in the post-revolutionary period and extending to now. That’s 220-230 years. So there is your grand super cycle. It is hard to say where the others are in the past because we didn’t have a financial framework to define them, but when we look at history we find, going back into pre-history, that these cycles exist. The Roman Empire and its famous rise and fall – there is a cycle there – and Bob and I have looked at it from different directions and come to about the same conclusion about where it peaks. So they are constantly happening.
Now, so let’s talk about the one that we have here, and why we think we are culminating. There is a long list of sentiment indicators that are reaching all-time highs in just the last recent weeks. But also, you have to go back a little bit because sometimes sentiment peaks in a third wave. So over the course of the last year, I’ll list some of them, and we can comment as we go.
Small business optimism – you may have seen the Independent Business Association puts together a weekly or monthly survey, and it is at record high. It goes all the way back to the 1960s. I don’t know, it could have gotten higher in the 1920s, but I kind of doubt it, so that is probably the highest. Small businesses are probably more optimistic than they have ever been. Margin debt, of course – 668.9 billion in May. Pension fund allocation to cash – 2.5% last year, so that’s probably a little higher now.
Mutual fund cash to assets – the lowest we can recall is 2.9, but it might be 3% cash in mutual funds, everything else invested. Buy-backs – we talked about in the latest issues – are at the 1 trillion dollar-a-year level. That has never happened before. It is by far the biggest year for companies to buy their own shares back. Corporate officers have more optimism about their own shares than they ever have. Money manager equity exposure at an all-time high.
Any of these University of Michigan sentiment surveys where they ask, “What do you think the economy is going to be in a year?” Or, “How is your pension doing relative to how it has in the past?” These also hit new highs this year, even after the January peak. Dow at record low, 12% see the economy as the top problem, so that’s 12%. I don’t know how far that survey goes back, but the record prior to this month was 13% in 1999. So all these different things are flashing as much optimism as they ever have.
Steven:Let me just add to that list, the S&P price-to-sales ratio. A lot of people look at price-to-earnings, but earnings, as we know from the last bear market, have many definitions. There is pro forma earnings, there is earnings after the bad stuff, and so forth. But you can’t fake sales. You either have sales or you don’t. So if you just look at the S&P relative to its sales, we’re back at the dot com year high.
Now, the reason this is important is because you hear all these things and say, “Oh, my God, this is so bullish.” And that is exactly the point. In other words, you get to an extreme and just the fact that you’re at an extreme, an all-time extreme, or extremes that lasted for decades, in and of itself means that the probability is high for reversal, unless you just simply linearly extrapolate the current trend indefinitely into the future.
And we know that doesn’t happen. Things move in cyclic fashion, maybe not with a fixed periodicity, but things move from extreme optimism or pessimism. So right now we are looking for signs we are in one direction or the other, and we are seeing these record signs of extreme optimism. And from our perspective that is an extremely bearish portent for the market.
David:So we are talking about social mood. We are talking about people being very encouraged, small business optimism, margin debt, pension fund allocation to cash, mutual fund allocation to cash, all of these suggesting that people are all-in and are very encouraged by what they see on the horizon. I guess philosophers would describe the spirit of the age in terms of a zeitgeist, and maybe that has to do with ideas. You are talking about social mood, feeling, and psychology. That is something that can actually change fairly quickly, and when it changes can then remain in effect for a good bit of time, can’t it?
Steven:Right. In other words, it is just a mental state of mind, and as we know, that is ephemeral. It changes. It never is constant. I guess you could say the one constant is change. So the fact that we are at an extreme – and sentiment, a lot of people ask us, “Why sentiment?” Sentiment is thesingle most important indicator of an impending change of direction for a market. When you get to an extreme and that extreme is recognized throughout the investing world, that is the strongest signal that the trend is nearing an end and ready to reverse. That is why we talk about it, that is why it is so important. And it is regulated by the waves of the Elliott wave model.
Peter:It is important to recognize that it is endogenous. It is inside the psychology that earnings are a result of the mood and not causing the stock market to do what it does. Sometimes we can predict that people are going say, “Well, it was caused by a trade war, when in fact, the trade war was anticipated well ahead because we recognized that that is the kind of psychology that will accompany this transition from a grand super cycle increase to a grand super cycle decline. And sometimes things get a little bit out of whack. Then we will get signals ahead of time and that seems to be the case with the trade war, which we forecasted would take place before, when everyone still said that a trade war can’t happen because everybody knows that it would have a negative effect on the economy. But here we are – we are having one.
Steven:You know what? This might be a little bit helpful for people to understand. In Bob’s original book, The SocionomicTheory of Finance, he had a big graph – I think it was called “Perception Versus Reality.” The way most investors think – I’ll give you some examples – is that recessions cause business people to be cautious, but the way a socionomist thinks is that cautious business people cause recessions. In other words, the causality is exactly the opposite. So where someone might say a rising stock market makes people increasingly optimistic, we would say increasingly optimistic people make the stock market rise. So it is the mood that comes first, and then the action is what results from the mood. That might be helpful to see how we think about things relative to what most of the investing community does.
David:You have folks in positions of authority who are certainly suggesting that it is blue skies from here, and I always find it reassuring when an authority says something like, “There is no recession in sight right now.” (laughs) I’m speaking of Presidential Economic Advisor Larry Kudlow. Look back in time a little bit. Can you recall other luminaries that got these calls right? “No recession on the horizon.” Did any of them ever call a recession?
Steven:Not that I am aware of. I can’t remember.
Peter:Even Irving Fisher in 1929, who I consider to be a fairly good economist, declared that there was going to be a permanently high plateau at that point. He went back on that, obviously, but you just get wrapped up in it and you can’t help yourself when you’re an economist. You become part of the dynamic.
David:We look at the New York Stock Exchange composite index and this is one of the broadest measures of equities. There have been no new highs since January. That is in contrast to a variety of other indexes. Maybe you can explore the significance of that type of non-confirmation, and what other markets are suggesting, at the same time.
Steven:Sure. Non-confirmations are usually an important part of stock market tops. The reason is that stock market tops tend to be very rounded affairs, taking time, as opposed to, say, a commodity market top, which tends to spike into a high and then reverse quickly. The reason is the emotion that propels the stock market bull market is one of hope, and hope dissipates very diffusely over time. So what happens is you get one index making a high, and then people will peel away from that index, and then another one will make a high, and then another one and another one, and they all round out into a top over a period of time.
What we have right now is a market that is starting to diverge noticeably. Like you said, the New York Stock Exchange Composite Index, which is one of the broadest measures, taking into account all stocks. Equities traded on the New York Stock Exchange topped on January 26th. And even on a short-term timeframe, we are now a month past a top in the S&P small cap index which was late August. In fact, over a three-day period you had the S&P small caps top on August 27th, you had the Russell 2000 on August 31st, and in between them was the NASDAQ 100 on August 30th.
So this is part and parcel of how market tops are formed, where you will have one index make a high and then peel away. Right now the New York Stock Exchange Composite has peeled away. And we’re looking at even shorter-term indicators of an impending turn in the market. For example, one I just looked at the other day which is fascinating to me is that the S&P 500 index over the past 40 consecutive days has not had a daily percentage move of greater than 0.8%, either up or down. That is an extraordinary low volatility within this index. In fact, the August/September period was the most low volatility in terms of this measure over the past 50 years.
One thing that we know from studying history is that low volatility precedes high volatility, just as high volatility precedes low volatility. So we are in this kind of extraordinary environment where a lot of people are very complacent. The market hasn’t had really big moves up or down. And that usually leads to a higher volatility environment. High volatility most often occurs with stock market declines. So a lot of indicators, a lot of divergences are occurring, that suggest to us that we are at the end of this move.
Peter: Yes, it’s really worthy of the importance, in terms of this peak, we’re talking about how important it is, and you see for seven months you have this high road for the S&P, and you see a low road with China, then various other indexes, housing stocks, for instance. Which one is going to win? We think it’s the low road.
David:So this last week we had the Dow Jones Industrial Average finally trade higher than its January peak, even if only by a few points. You guys have mentioned at least nine other indexes making their all-time highs in August. Is it fair to describe these chart points as establishing secondary, or in the case of the Dow-Jones Industrial Average, maybe even a double top? And for the non-technician, what does that mean? What is the importance?
Steven:It is a little too soon to say that the rally is completely over, but as we said, there are a lot of signs that if it is not, it is in the very, very late stages. Again, the non-confirmations, themselves, suggest a fractured market. Fractured markets are often unhealthy markets. You have heard the phrase that a rising tide lifts all boats. Usually bull markets are very broad-based with everything moving up more or less in unison. And when indexes start to peel off, then you know that you are entering a period of what we call distribution, where stock goes from strong hands to weak hands. And that is the period we are in right now.
If you look back through history, we are also into a very weak seasonal period. I think 12 out of 20 biggest single-day percentage declines in the Dow occurred in the September/October/November period. So things are lining up, in our estimation, for the end of this move, and we are just looking for signs on a shorter-term basis that we have actually turned the corner to the downside within, let’s say, the Dow Industrial Averages.
Peter:The wave theory organizes time for you well and when you talk about secondary peaks, for instance, it takes you back to 1966. That was a cycle degree peak, so one lower than a super cycle. And you see a peak in 1966, and then again in 1968. Now we are on a grand super cycle degree turn, we believe, and it takes us back to 2000, 2007, and now. It’s kind of a family of peaks just as it was in 1966 and 1968.
And what you see is this distribution taking place there, too. In 1999 it was transports peaking in July, and then the Dow in January of the next year in 2007, financials in January, then the Dow, and then finally the NASDAQ. So here you have it again. It’s like they’re juggling the indexes. The crowd loves higher prices so they are going to pick which index is hot and flood into it, and abandon one that is just not giving them the buzz that they need.
David:Now, you’re talking about a distribution pattern where, as you said, Steven, there is a move from strong hands to weak hands. Unfortunately, when you get to a market peak this is really Wall Street insiders big money and institutions, lightening up on their positions, and it’s the little guy, it’s the main street investor who comes in. And would you say that it is in that secondary top that you see a lot of activity from main street? The big guys are getting out and somebody gets caught holding the bag, almost every time.
Steven:That’s a great phrase – holding the bag. That’s from Joe Granville back in the day. He used to have a traveling road show where he would talk about the bag-holders. What is pretty notable about this particular – not every top is exactly the same. Each one has their own characteristics. And what is so notable about this one is just exactly how narrow the rally has been. It has really been mainly confined to the FAANG stocks – Facebook, Apple, Amazon, [Neflix, Google] and those stocks, which have accounted, depending on how you measure, for at least a third of the entire move up over the last several months.
So what we have is the generals charging to the top of the mountain and the troops behind them are lagging. Usually when that happens the generals get three-quarters of the way up and they turn around and there is no one behind them. I’m not sure that’s a perfect analogy, but usually what happens is when you get very narrow advances, those tend to occur toward the end, or right at the end of a stiff wave in terms of the wave principle model.
As people who read our analysis know, the fifth wave is the last wave of advance, when you have these non-confirmations, you have these sentiment extremes and you have this narrowness. And all that is occurring right now, so it is a pretty good signal to us of what is coming over the next several months into next year.
David:You showed an interesting chart of major indexes compared to the gold chart back in 2011, again, looking at a secondary top. Obviously, if you have been in the gold market since 2011 there is no joy in Mudville. It has been a tough road from that point until now. But you are suggesting a pretty significant decline in equities, and imminently, if that comparison holds to the 2011 period.
Steven:Yes, it’s the way the top is forming. I think what you are referring to is specifically the way the top formed in gold after the September 2011 high. It pushed up to $1921 an ounce and then it fell pretty hard in a very short period of time. And then it took an entire year to rally back and make a secondary high. So it peaked in September 2011 but that secondary high didn’t occur until October 2012, and then from there, anyone who has invested in gold knows you had a big bear market which, quite frankly, we don’t think is over yet. But from that point forward it went down pretty hard until late 2015.
And so what we have seen here is a similar process where the New York Stock Exchange Composite made its high in January and had this big rally bag since then with the Dow and the S&P making new highs but the New York Stock Exchange Composite not confirming. And it is this long topping process, what I described as this hope that is dissipating very diffusely over time.
So we have been under way now for the better part of 2018 and when the secondary high makes its final sub wave, so to speak, that is when everything, I think, rolls over together, or at least starts declining in sync together as we go forward.
David:We are talking about speculative excess in a number of markets, and I want to play a little devil’s advocate. You have speculation in penny stocks, your OTC bulletin board shares, and it has been considerably higher in past periods of market excess, not so excessive here in 2018. Might that argue against there being a complete speculative excess in the equities markets today?
Peter:I think it is absolutely a case of what we were just talking about, the thinning of the process. It is a sign of exhaustion, I think, because it is not hard to find speculation. It’s out there, it’s just very funneled, and it’s creating a situation like bitcoin where everybody is buying the same thing even though in terms of fundamentals bitcoin probably has less going for it than most penny stocks. It is obviously unsuited as a currency, it is too volatile, and as a store of value it was fine until December, but something called a 60% retracement has gotten in the way of that. So it doesn’t have a function. And yet, bitcoin speculation and the intensity – because I’ve been reading about it a fair amount lately – is all there. Many people are as excited about bitcoin now as they were this time last year. So I think the speculative element is there.
David:A couple of negative comments embedded there in cryptocurrencies, bitcoin in particular. I want to mention two very good calls by your research group between the two of you and Bob. In 2010 you were not ashamed to say at sixth sense that bitcoin looked very intriguing and had a bright future. I’m using my own words, but roughly what you said. December of 2017, before it starts peeling off the 19,000 level to current levels, it was kind of no dice, not really interested and more likely to fall than to rise from there.
So I think, just to put in context, really, what we are talking about with bitcoin is, and you said a greater than 60% retracement, it broke an exponential curve. From a technical perspective, what does that tell you? And again, maybe, bring us back to that connection between bitcoin’s peak in late 2017 and the stock market peak of early 2018.
Steven:First of all, we have to go back to about 1997 and a consideration of financial manias by Robert Prechter. Oh, by the way, also involved in that call was Bob’s son, Elliott. He was the one who red-flagged it and said, “This is an interesting speculation” back in 2010, just for the record. So Bob explained how bitcoin fits in, as well as the dot.com mania in 2000, 1999 – in there, when he explained that in a fifth wave you get these flights of financial fancy called manias, or bubbles. It is a well-researched essay.
Basically he said what happens is people buy a given asset because it is going up for no other reason than the greater fool theory takes its most magnanimous hold over the public and you get tulip bulbs, you get the south sea bubble, you get radio stocks in 1929, which was a fifth wave, of course. And now, in this fifth wave, three separate fifth waves within this peaking process we had dot.com stocks in 1999, we had housing in 2005 through 2007.
And now, who knows what we will have? We could still have more. It looks like it is morphing into pot stocks right now. We will have to wait and see. I think bitcoin is the biggest and the last major one, and then as we turn down we will get some flares because this impulse won’t just go away. But bitcoin will be remembered as the largest and last bubble.
David:What is high can get higher.
Peter:Ha-ha-ha! You’d better copyright that. Get that down, because you need to title something that, at least.
David:(laughs) Yes, well, 32 million percent for bitcoin is, as far as I know, the largest move in any asset class in all of world history. I can appreciate many of my friends who own it and still believe that it has a great future functionally. Perhaps it will develop into something.
Peter:Just for the record, I’m not saying anything is wrong with block chain, or it’s not the future, but what happens is, as with the telegraph in 1835, the thing is born, like electricity, and they literally ran electricity through their bodies in 1835. They were so excited, there was techno-euphoria. But they priced it all in, and one incident with RCA in 1929 is another example. It was as high in 1929 as it would get in the 1960s when everybody was buying TVs. They just priced it all in. And a slight difference here with bitcoin is that I’m not sure as a currency it has a future, so it’s a little bit dicier. Even in that sense, I think it may be thebiggest mania, as well. Just as a concept, it has the least to offer, I think, as a currency, I should say.
David:I want to reverse course a little bit because we mentioned share buy-backs a little bit earlier. We have C-suite executives who are “returning shareholder value” as if that is a primary mandate. It isa primary mandate, but it seems to me that there has been some games played with your earnings-per-share figures and constant improvement in earnings-per-share figures, even as you are shrinking the deck of outstanding shares by 15%, 20%, 25%. What can you say, historically, about share buy-backs, and again, the enthusiasm that seems to permeate, not only the man-in-the-street buying the shares, but even the C-suite executive who can’t seem to help himself or herself, either?
Peter:The smoke and mirrors thing that you’re talking about, I’m just shaking my head because I haven’t really written about it a lot, but I do remember writing about it in 1998, and it was about earnings, and about buy-backs and how they dilute things. What amazes me as I look back at it now is how the financial memory just dissolves, and it has no ability to recall that what happened in 2001, 2002, 2003 was all scandalous, “Let’s go to Capital Hill and figure out what happened, why do we have these accounting standards, how did they slip?” Yes, okay, but here it is again and that is because it is a matter of mood, and the mood is still riding high, and it never washed out after 2007. They did do Dodd-Frank, but now that is gone. So you see how the mood is causing the “reform” and then the un-reform now at the top.
Steven:Right. I think Pete makes an important point there. It’s the mood that is driving it. It’s the ebullience of the market right now that is allowing these corporate executives to buy back their shares with impunity. The most interesting thing from our aspect, too, is that if you simply plot a chart of the market and the share buy-backs below it, you can see that they peak out with stocks. It is just an incredible association. So you get record buy-backs at market highs, and when people should be buying the shares, when they are really low in terms of their relative price, there are very few buy-backs.
Peter:Yes, they won’t even touch their own shares at the lows, it’s amazing.
Steven:Right, which is just a confirmation that we’re near a market peak here. In other words, usually when the price goes down and the prices go on sale people want more of it, but in a financial market, when prices go down people want less of it. So we simply plot both of them and we can see that we are at what we think is a pretty high level extreme right now.
David:Pete, you said something about the markets never washed out in 2007 and that brings in a historical perspective maybe, looking at the charts, looking at sentiment indicators, things got dark but they didn’t get as dark as they have gotten in the past. And I wonder – again, this is just me playing devil’s advocate here – in an age of central bank interventionism, really, on a scale we have never seen before, central bank balance sheets in the multi-trillions, 4.5 trillion for us at a peak and well over 5 trillion if you’re talking U.S. dollar terms for the ECB, is it different? Do we get to see a washout? Are we going to see shallower lows from this point forward, given the determination and grit of the central planners? Or am I reversing causality? Would that be your critique?
Peter:God love the central planners. They are our best example of social mood and why it works. On a long-term basis, we didn’t have the Federal Reserve until well into the fifth wave. So now what we have is a very interwoven nexus of central banking involvement in the economy. And our main point would be that what they do, and have done historically, you notice the first bailouts come forward in the 1970s, I think it’s Penn Central, Chrysler is in there, and Continental Bank – that was a little bit into the bull market.
But what really happens is, they come in at the bottom and they look like they saved the day, but all they did was react to social mood and say, “We have to do something!” So here we come into the 2000s, and we even said, “What is going to happen at this point is we are going to start to see some of these fail,” because the market had to go lower than it would otherwise have been allowed to do so.
And then if you could look at the record you did see that the Latin American bailouts – I forget which countries, but they were not way before the bottom of the stock market, the social move bottom in 2002. And then in 2007 the bailout started in August of 2007, so you didn’t even get into the decline and they were starting to bail out the mortgage industry. And you had this and that, and this and that, and then it just continued on. Yes, they were still bailing at the bottom but they didn’t bail it out, they just responded to an extreme low. And the key to that whole bubble that we had in 2007 was that people didn’t even know that we were in a bear market until September when Lehman Brothers happened.
So 2008, September, and then by October if you look at some charts you will see something started a rally even then, November more, and so you had things come off their lows, and by March it was over. So it was very severe, but it was very brief, and that won’t be the case the next time.
Steven:I think when we do look for the excesses because we are trying to peer around the next corner and then say, “Okay, where is the most pain going to occur during the bear market?” I think up there, certainly in the top few, central banking as a notion, with balance sheets that are at historical extremes. The idea that in the next bear market central banks are big enough to bail everything out, to bail every piece of bad debt out is a fantasy, and I think that is going to be laid bare and the curtain is going to be removed during the next bear market.
Remember Goldman even had to be bailed out in October of 2008 so what is going to happen when Goldman gets bailed out and there is not an immediate reversal? People are going to begin to doubt the wisdom of the central bank.
David:I know you all have commented about how central bankers are reacting to social mood. Is that what we have here recently with the reversal of many of the elements of Dodd Frank? They put on constraints to banks at one point and then just a few years later, “Look – the economy is booming, we have better capital ratios with the banks and lo and behold the financial markets are now free to free-wheel again.
Peter:It’s the same cycle. It’s the Glass-Steagall cycle in a slightly smaller cycle. Glass-Steagall is a super cycle reform instituted in 1932 to halt the stock market crash that happened in 1929. But I think it will go forward. I can’t remember who is in the picture, but if you look you can do the research. Rubin is there, the guy who went to Harvard, he was Treasury Secretary – Larry Summers?
David:Yes, Summers and Rubin.
Peter:It was December or November of 1999. They had a cake to celebrate the repeal of Glass-Steagall. And we’re having the same celebration now with respect to Dodd-Frank.
Steven:The important point is that a lot of these reforms are instituted after the market makes its move, and like Pete said, the Glass-Steagall was in 1932 to stop the stock market crash that had already occurred, and Dodd-Frank came to fruition after the market had already declined in order to stop the next one. So it’s natural that most of its repeal occurs after the market has been rallying for a number of years and people don’t believe that we need those reforms going forward. Again, it’s just one more signal that we’re very late in the advance of the market.
Peter:What is so remarkable to me is the precision of it in these cases. It’s time for governments to do away with its own reforms.
David:Just an interesting note, we talked to Richard Bookstaber maybe a year-and-a-half ago and he had just finished four or five years working in D.C. helping with Dodd-Frank, helping to get it launched and everything else. He said, “Unfortunately, I think I’ve done it again. I think I’ve helped cause the next crisis because we’ve just destroyed the role of the market-maker, and I don’t know what liquidity looks like in the next bear market because the way we structured Dodd-Frank we disincentivized the market-maker function in the market. So on the one hand we have ETFs and massive people funneling into a blind pool of capital, and we assume that there is liquidity there, but we restructured market-making.”
Peter:Yes. We didn’t mean to suggest that government can’t screw things up, just that it tends to do it in a certain order (laughs).
Steven:I think the one forecast we can make with as much certainty as possible is that somewhere toward the end of the next bear market government will step in with some sort of reform, and it will come after everyone loses their money in the market (laughs).
David:That is a guaranteed winning bet. I’ll put my money on that number for sure. So we have two companies that have passed the trillion-dollar mark in terms of market valuation. Probably more important than the market cap of those two companies is the implications in the bond market of rising rates, while we’re talking about a trillion here and a trillion there and we have mentioned central bank balance sheets expanding. I get the impression that rates are near a historic low. The summer of 2016 may be the low, low, lows. But in a highly leveraged world, how do you see the rates trajectory impacting sovereigns and corporates?
Steven:The thing to understand about the bond market is that it moves according to mood just like every other financial market. So we’ve been in this long-term bull market that started in 1981 where rates peaked out well over 15% and they have been declining in a disinflationary, and then a deflationary, environment into the low until July of 2016. I think that is a seminal turning point where we are now in an environment of rising interest rates. And what is interesting to us is just the complacency that we are seeing in a lot of our indicators relative to this environment.
For example, if you look at the high-yield market and the spreads between, say, the yield on junk bonds and comparable U.S. treasuries, they’re still in a very low environment, in fact, near their lowest level in decades. And so what we are seeing is an environment of rising rates and people just really don’t care. It’s not registering on their radar screen right now it’s because we’re in a record level of complacency and ebullience and so forth.
Another thing that is really striking to us is that that quality of the loans being made in the corporate bond market is probably scraping the bottom of the lowest level in history. A lot of the loans, I think about 80% right now, are covenant-lite loans which means that you don’t need the kind of performance standards on the loans that you normally would in a different environment, so it’s not that people don’t care, they just don’t see a lot of risk in the future.
Again, it’s just one more signal of the complacency and the ebullience within the bond market. And usually, when people reach for yields like this it just does not end well. And so I think that the bear market is going to come, it’s not going to be confined to just the stock market but I think the bond market with yields going up, bond prices are going to suffer, too.
David:I guess there are some assumptions about what is driving interest rates, and so you don’t see a problem with rising interest rates, that being consistent with a very deflationary financial backdrop.
Peter:We have to stick with our tool, which is an Elliott Wave Principle, and an important thing to note here is that Steve and Bob together looked at the lines on the bond chart that said yields are bottoming. When was that, Steve? July of 2016?
Steven:July 2016, yes. The year they made the record low yields.
Peter:So they’re bottoming, and we can’t deny that, but our tool is, we have history to work with here. How are we going to reconcile this? We have to look back at history. And we can go to those bear markets that are of similar degree and we can see deflation. We can also see rates rising. How does that happen? The complacency reaches a point where rates are really low and the risks are not of the yield rising but of dissolution of the credit, of not being paid. So rates rise even though there is deflation. And that happened in corporates in the 1930s and we’ve shown the charts, and so we think they actually go hand in hand at this point. And the complacency causing rates to go, actually, negative in some places, with some corporates even. That just gives it more room for the deflation to take a harder toll.
Steven:I just want to add that we did plot interest rates. We looked at the bond market in the 1930s, the last really intense deflationary period in the United States. What was interesting is that all bond rates went up, it wasn’t just the lower quality, although those rates went up faster and higher than the higher quality governments. But even government yields spiked higher within that deflationary environment. And then they eventually turned around and went lower after that. So even in a deflation you can get rising interest rates, and as Pete said, the reason is because people are afraid of a return of their money, not on their money. And when people get afraid of a return of their money, even though it’s a high quality instrument, you get rates going up and prices going down.
David:Let me jump across the pond to China, because here we have a country that is experimenting with credit in ways that actually look familiar to the U.S. and the mortgage credit expansion of the 2004, 2005, and 2006 period, only even more so, with banking sector credit, I think coming up on 40 trillion dollars. And I wonder if the wave theory that you use, the Elliott Wave Theory, isn’t dependent on free markets.
The question here being, is China different because of the command and control dynamics, and if the U.S. wanted to adopt a more command and control dynamic where basically, markets don’t matter, prices don’t matter, how does the wave theory embrace that environment, maybe even looking at the U.S. during World War II as an example? How does wave theory come into a period of time like World War II where we have price controls, for a certain period of time the U.S. stock market is actually shut down, and we’re forcing the issue by socially trying to manipulate people into buying government bonds by claiming that if you don’t you’re unpatriotic?
So whether it is social pressure or outright corralling – close the market, close the financial system, and force winners and losers? Do you get what I’m after here? Does wave theory remain relevant in free markets only, or what’s the opt-out? If the most clear bet is government intervention in the future, some piece of legislation, who is to say that the government intervention this time isn’t just saying, “We’ve just nationalized the stock market, the bond market, the real estate market. We’re like the central planners in China.”
Steven:They can try it, but they tried it in the bear market of 2007-2009 and it didn’t work. They bailed out Goldman and Merrill and they let Lehman go under and they tried to buy all the crappy mortgages that were out there, and we still had a bear market where the stock market went down 55%. So they can try it, but it’s not going to work.
Peter:You can try to stop the winter by taking the thermometers away but it’s still going to be there. It’s still going to be cold. They are still going to have a social mood and it’s still going to register. You’re really just taking the data away and that doesn’t change the reality. I wouldn’t be surprised if we didn’t have some blackout in terms of market information. Actually, you saw it in the U.S. in the mortgage industry in 2007 when they just didn’t price stuff, but everybody knew that there was a reality, which was that those funds were worthless and eventually the market did ferret that out. And it would be the same.
David:So I guess we’re jumping a little bit from what a chart will tell you according to a wave pattern, and if you no longer have price discovery because it is essentially blacked out, what you are saying is you still have social moods. We toggle over to socionomics, sometimes you see social trends that reveal more than meets the eye. I am interested in where we are, but also where we are going – edible gold, ridiculously fast cars, the resurgence in space exploration here in 2018 on par with 1969. What are those social trends telling us? What can we glean? If they give us no price discovery, where can we go for information that indicates exactly where we are in terms of social mood?
Peter:Right. We have those extra market indicators, and in the case of the ones that you cited, the space exploration rekindled at this point in time – this is definitely like 1968-1969 – fast cars, muscle cars – that was basically late 1960s or early 1970s peak, like the stock market peaked in 1968 and 1973. And edible gold – we can trace this back to peaks as well. In fact, the first time we ever recalled hearing about it was in Japan in 1989, which is exactly when the NIKKEI peaked.
And it happened to certain extent in 2007 and we mentioned it in the newsletter, and it is happening again now, but even on a much grander scale. It’s very common in many restaurants in New York, or it had been up to a certain point in time, I don’t know immediately to the day, but edible gold was as popular as it had every been globally, in terms of cuisine. So that’s telling us exactly what all those indicators I mentioned at the beginning, we had an optimism that we have never experienced before.
David:So fast forward to a period of deep pessimism, where we actually are at a bottom in the marketplace, but again, just assume a worst case scenario – this may not happen, but where we don’t have price discovery, people are playing with the markets, maybe the government is trying to sit on yields, maybe the stock market is not trading, maybe we are not allowed to short in certain sectors, a variety of things that represents manipulations by the central planning community. In terms of social mood, what does that look like at a market bottom? What are the pop culture indicators of being at a low?
Steven:First of all, they don’t get away with it. That is the thing you have to understand is that in a bear market all the things that people let slide in a bull market because they are just ebullient toward rising prices, you get strife and polarity and distrust of government. So, all the little shenanigans that central government tries to play – it is not allowed in a bear market, so to speak. The negative mood doesn’t allow them to pull these sorts of things. Even now when they try to suspend trading because of limit moves in the stock market over, say, a short period of time, usually what happens is that mood just expresses itself once the trading starts again. So you can argue that maybe they would try to suspend trading for a period of time, but the mood is going to express itself when they start trading again. So our view is that there is no doubt they are going to try something, it is just that it is not going to be successful.
Peter:Yes, historically, a good example is with 1973 and maybe early 1974, Nixon tried to institute price controls and it failed miserably. Another good point to make would be 1914 World War I was about to start and there was actually a point in time when the market was shut down. And yet, if you go to a stock market chart you can find the data somehow, or you can find bars on a chart for those months in the second half of 1914. So I think the way that happens is they go back and say, “Well, people were still trading, there was still a market, and they just reconstructed because it couldn’t be suppressed completely.
As far as what we are going to see at the bottom, the bear market will have certain trades and some of them are starting to emerge already. I would say, authoritarianism and polarity, political polarity, are common bear market trades and that they will express themselves dramatically as we go lower. So in politics, the strongman becomes viable. In Brazil, for instance, that is emerging now and we know all the other countries where it is already in place. In Poland and many parts of the world you are seeing these leaders who do many of the things that you are describing. They are trying to say, “No, rates aren’t as high as they say they are in Turkey,” for instance. But they are. If you want to get money, you pay the rate.
Steven:Right. And the point also is that the weakest markets usually show these symptoms first, and then it moves into the center. So you are seeing it in the outer reaches of these emerging markets and eventually it is going to make its way into the main markets. And so, that gives us a little window into the future of what we are going to face sometime down the road as we move lower.
Peter:Transparency and openness are bull market features and so, less of that – less clarity, less transparency. You can’t always see, or always know what is going on as well.
David:I love the stuff that I read from you guys on the car models and fashion trends and things like that. I’m going to be in London in the next few days and I’m taking my daughter to the London fashion show. She is only seven years old but she loves sewing and very creative and I just thought it would be interesting. But I’m going there for a different reason. I want to know, and I’m going to take some notes, and I’d like to compare those notes with you guys to say, “Here are the trends that I saw in London. This is the fourth largest out of Milan, Paris and New York. What does this mean?” You know, the hemline test. But you see the same thing in terms of car design and other elements. To me, that’s really fascinating in terms of what it reflects in terms of how people feel about themselves, the world they live in, the prospects for the future, and things like that.
Peter:Yes, it is always interesting, when you go to a new city you will see things that you hadn’t known because you have new eyes for it. In London, you will see that the heights of the buildings are higher. On the runway, are skirts still short? I don’t know where they are right now, but when the market turns, they should turn down, as well. Historically, that’s what happens.
David:A question for you on two commodities – oil and gold, and then the sentiment for bulls and bears, and that is, I think, where we will wrap our conversation. The gold market, the Elliott Wave Theoristpublished a chart of the Dow-gold ratio this September. And what it showed was the Dow in terms of real money had reached its ideal target in what was described as a seven-year counter-trend advance favoring equities. Where is the Dow-gold ratio likely to go from here?
Steven:I think it is peaking out in its counter-trend rally and the next major move is going to be to the downside. And one of the keys in that is where gold is right now within its bear market pattern. So as we said earlier, gold made its high in September 2011, $1921, had a 45-48% decline into December of 2015 where it made a low around $1046 an ounce. And now we’ve been in this long, meandering, winding bear market rally since then. This bear market rally, in our estimation, is probably two-thirds of the way through, maybe a little bit longer, but it’s probably going to go a little bit higher before we peak out and start a decline.
So in terms of gold, we’re in a bear market rally since 2015, we have a little bit more to go, and when that peaks out, that is probably going to fall well under $1000 an ounce until its final bear market low and then we’re going to have a huge bull market after that. But we’re years away from that right now. So in terms of the Dow-gold ratio, it is suggesting to us that the rally, particularly with the Dow ending in its fifth wave right now, that ratio is going to roll over and go back to the downside, and gold is going to continue lower. So our forecast on gold has been pretty spot on and we’ve been able to catch a lot of the twists and turns as we move through this bear market.
What is interesting is that the oil market is expressing commodities right now and that is trending with gold. We have had this bear market rally in oil since February of 2016, several months after the low that gold made in December of 2015 and they have been rallying in this bear market together. Oil has been a little bit stronger because we have taken out certain retracement levels on the way to the upside, but nonetheless, it has been in our estimation a bear market advance, a counter-trend rally. We may have ended that counter-trend rally in July/August of this year. We don’t have quite the pattern just yet to suggest we have turned the corner back to the downside, but the odds are pretty good. And I think as deflation intensifies, as this dollar-denominated debt shrinks, commodities in general are going to go down along with gold and along with stocks.
In bear markets the trends tend to converge in what we call the all-the-same-market theory, as we saw in the last bear market, and when things start going to the downside in stocks, commodities are joining in, and gold and silver are going to join in, too, as deflation intensifies throughout the economy. So in our estimation, both of those markets are key markets. They have both been in bear market rallies. Gold probably has a little bit more to go. Oil may have a little bit more to go, but I think we are pretty much well along the way of that counter-trend move and both of them are destined, I think, to roll to the downside.
David:Two points of clarification. One is that in nominal terms you are comfortable saying short-term bullish on gold, medium-term bearish. Very long-term, again in nominal terms, you would be bullish on gold. And that is in the very long term.
Steven:That’s very long-term, right. I don’t think we are at the end of the bear market there just yet.
David:The second point of clarification is back to, not the nominal valuation, but in relative terms, when we are talking about gold as real money, you are talking about the Dow-gold ratio dropping from roughly 22 back down, implying an increase in purchasing power for the metal and implying, actually, the role that it does play as real money, which is buying more real stuff even in the context of a deflation.
Steven:Exactly. I think you’ve got that right, yes.
Peter:It will go down but the stock market will go down faster so the ratio will continue to go down once gold rolls over.
David:I think this is a tough one for investors to wrap their minds around. Roy Jastram tried to address this in the Golden Constant. I think he did a very good job, saying that gold doesn’t do a very good job of marking itself to market to help you in an inflationary scenario, but in terms of purchasing power, it is far more reliable in a deflation and minimum increase of 50%, maximum of 250% increase in purchasing power.
Again, we’re talking about a ratio, in this case, between the Dow and gold improving your position in purchasing power terms. The nominal value, you could actually lose money. Here is the amazing thing for the gold buyer. Can you imagine liquidating gold, taking a tax loss, and increasing your financial footprint by 20 times relative to what it is today?
Steven:Yes, it’s funny. Yes, that’s one way of looking at it. The other point that we would make in terms of the Dow-gold ratio is, keep in mind that gold has been in a bear market since 2011. So it’s much farther along the path of its bear market than stocks are right now where the New York Stock Exchange Composite just turned down in January and the Dow is at a new high right now. So in relative terms, gold is going to do better, but in nominal terms they are all going to go down.
David:Again, this is maybe something I just haven’t figure out yet, but I know between Bob and you guys, you tend to be fairly deflation oriented. Correct me if I’m wrong, but this is the first deflation in world history where we have all currencies unhinged from gold. So when we talk about gold as a commodity, and it and silver going down in value, it is now in a different role. What is to keep it from being treated as real money as opposed to being treated as a commodity, and maybe abused as a commodity?
Steven:Well, it’s both, and it tends to be psychological. Now, we have to delineate between a currency and deflation because they are not one and the same thing. The deflation we are looking at right now is an overall contraction in the volume of money and credit. It is the money and credit part, the credit part, that is important because we are at record highs in the amount of credit that is out there. So what we are saying is that in a deflation, as psychology turns, credit contracts faster than the Fed can print dollars, or money. And that is a deflationary environment.
Now, gold eventually will return to its status as true money. In fact, maybe it has never given up that status, but that doesn’t mean that it is apart from waves of social mood, and if you look at the structure, the wave structure, the Elliott wave model, it’s telling us that the nominal price is going to go down whether it is still a store of value or not. Eventually, gold is going to have a huge bull market, we’re just not anywhere close to starting that just yet.
David:I tie the question here into oil because you guys are looking for oil in the single digits. From a wave standard or if you’re looking from a technical chart perspective, maybe you can make sense of that, I don’t know how to relate that to supply and demand fundamentals. Certainly, if you’re right and we see single-digit oil, you’re talking about an international relations nightmare. You’re talking about a geopolitical dislocation that could lead to things far worse than World War I or World War II. Desperate nations do desperate things – just like desperate people.
But again, I’m seeing healthy supply and demand dynamics in the metals markets where central bank buying continues to increase, investor buying certainly in Asia and in Europe are continuing to increase, and there may be a chart pattern that suggests a lower nominal price, but the supply and demand dynamics are certainly arguing to the contrary at this point. For oil, again, help me with the supply and demand dynamics.
Steven:I would say, we’re not supply and demand experts, but what was the lull in 2008 in crude oil? Crude oil, just as recently as February 2016, was $26 a barrel. So to get from $26 down into single digits is not that far of a decline.
Peter:Let me just finish this thought. It was even lower in 2008 and the supply/demand function worked out then. It hasn’t been that long, and it can do that again. And also, I would say, use that as your model, just look at 2008 and examine whatever dynamic you want and then multiply it times two or three, and then you have a good picture. I think that’s the best you could do.
David:That’s fair for gold, too, because the front edge of the deflation that we saw in that period of time, gold sold off. By the end of the year it didn’t matter. It had recovered and was actually up the year by 5-6%, but it still had a 30% selloff in the interim. What I saw in 2008, 2009, 2010 and 2011 was massive purchases by hedge funds and folks who were very concerned about counter-party risk. So again, some volatility and gyrations in price, some of which were not even helpful to the gold market, but huge, huge demand by folks that were concerned about the viability of the financial system.
Steven:Right. And what happened in 2011? Gold topped. So we have been plotting central bank purchases because central banks are a great sentiment indicator. They are usually the last entity to act on a trend because you have to go through a consensus before a central bank can take action. And if you saw what central banks were doing in 1998, 1999, 2000, 2001, they were selling their gold in massive amounts, and we actually discussed this in our newsletter. The reason they were selling it is because gold had been in a long-term bear market since 1980. So they thought, “Why hold onto this relic when we can get a better return some other asset?”
Well, what happened in 1999? Gold bottomed and started this huge bull market, and central banks reversed their course. Around 2006, 2007 and 2008 they said, “Wait a minute, gold is going up. We should be buying it now, not selling it.” So they upped their purchases in 2010 and 2011 and what happened? Gold topped in September of 2011 and declined over 40%. So to us, the way we look at things is a little bit different. Central banks are the ultimate sentiment indicator and when they start jumping into a market, usually you are at the end, or very near the end of a trend.
David:Again, I’m not trying to be contentious, here, but I look at the emerging market central banks as the ones who are primarily adding to positions and we’re looking at a deal that is coming out of Europe right now, specifically, out of the French central bank. And it is ironic that you have the French selling gold while the emerging markets are buying. So there are some mixed signals in terms of the way the West feels about gold and the way the emerging markets are feeling about gold and I wonder if we’re not at a point where everyone is reconsidering the monetary system that has been post Bretton Woods.
What does the monetary system look like as we devolve, as you suggest, the financial markets devolve, over the next six, 12, 18 months, where do people go for safety? Because if it’s not the U.S. treasury market, if it’s not the U.S. dollar – maybe it is – but if it’s not, where do your emerging markets go? Russia, Turkey, Brazil – these guys are all buying gold. They don’t want to buy treasuries. Why? Because there is something of a repudiation going on in terms of the norms and standards post Bretton Woods.
Steven:Right. In other words, what you are really saying is, there is a ton of crosscurrents right now and that is perfect for where we are within the wave structure of gold. It’s in a bear market rally. And it has been that way since late 2015. And so what we have are these crosscurrents where the emerging markets are moving in, some of the central banks are moving out. It’s a perfect validation, in our opinion, of where we are.
In terms of what is going to shake out and where you should put your money right now, our over-riding recommendation, so to speak, and our general recommendation is, you want to be as safe as possible. You want to be in the safest short-term, maybe treasury instruments, something that you can reasonably be assured over a short period of time that you are going to get a return of your money, not so much a return on your money. So right now we’re just preaching safety until we see the bear market play out and we’re able to step in and say, yes, this is a pretty low-risk environment to purchase either equities or treasuries or gold.
And that time is going to come. It’s not the end of the world, but in our estimation we’re just not there yet and we have to go through this process to get to the point. And we will know we are getting close when people don’t want to buy it. When people say, “Why do I want to buy gold? It’s $700 an ounce.” Well, that’s probably the time that we should be looking at moving into an instrument like that. We are just not there at that point in time just yet.
David:When we look at the landscape and how you should invest, we concur – safety, reducing exposure to the equities markets, tightening up maturities on bonds, focusing on the highest quality credit. If you wanted to think of a paint-by-numbers approach, our paint-by-numbers approach would be almost a barbell strategy – balancing a cash and a gold exposure where you offset your central bank risk, and the repudiation of our current monetary system with having some ounces, but at the same time keeping a lot of cash liquidity.
Now, I wonder, and as you may be aware, we hired Doug Noland from the Prudent Bear Mutual Funds and developed our Tactical Short Program over the past 18 months. Are we close to an environment where having a healthy cash position, or to go one step further, even being short makes sense to you?
Steven:I remember reading Doug’s work back when he was working with David Tyson and both those guys just did a tremendous job chronicling the excesses that had built up throughout our financial system, and particularly in the debt market. So, boy, I think you’re in good hands there, and I think that, yes, we are at the verge, or on the verge of approaching an environment where you can be looking at bear market positions, shorts position, and so forth for your speculative money, but certainly having a high cash level in order to take advantage of lower prices to come.
David:Well, any parting shots? I really appreciate both of you being with me today, Steve and Peter – great analysis. I appreciate the lively conversation, maybe even a little debate (laughs). I appreciate it, it’s what I live for.
Peter:I’m trying to place Doug, as far as when I was reading that. Was that before 2000? Was that 1999 or was that 2006? That was 1999, wasn’t it?
David:Yes, he started Credit Bubble Bulletin, started writing that in 1999.
Peter:Okay. Wow, that was good timing. Yes, he’s got a lot to cover now – even more.
Peter:The credit picture was tame by comparison then, you know?
David:What we consider the greatest bubble of all time in government debt.
Steven:Sure. But I just want to say from our perspective, thanks for having us on because it is this debate that makes markets so interesting. It is what makes markets, and it is what we do for a living. We just get really excited talking about it and following it, and I just want to thank you and I’m sure Pete does, too, for having us on and being able to discuss this.
Peter:Yes, thank you very much. It has been fun.
David:You’re welcome. We will have you back on. There is nothing like educated discourse and dialogue to sharpen perspective, and thanks for adding that, thanks for helping us sharpen our perspective in many ways today, and for our listeners, too. You guys have a great day.
Peter:Okay, you too. Bye-bye.
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Kevin:Dave, can you imagine how exciting it is, and scary, to be in one of the generations where a super cycle actually plays out. I really liked your point when you were talking to the guys about fiat currency, because the last time we went through this, it was gold and silver, actually, as money.
David:It was still money. That was the coin of the realm.
Kevin:Exactly. So today, to look at cash that’s based on 21 trillion dollars’ worth of debt, as being gold – I think there is a hole in that argument.
David:Right, or to have confidence in the system on the basis of that system’s ability to tax. There is some legitimacy to that, but I do think when you are talking about the greatest bubble in the history of the United States bursting, and that bubble is at the heart of money and credit, and the U.S. dollar is clearly implicated in that, you want to hedge your bets. At least I do. I want to hedge my bets and make sure that, dollar for dollar, if I have cash, I have gold as an offset. That’s me. I like the balance there.
Certainly, there is the possibility of a lower gold price, but I’ll be quite frank with you, I think that the reason I own gold in the first place is because of the increase in purchasing power it offers me. We started the conversation by talking about Dashel and I looking at gold and silver, and seeing how you can compound your ounces through time. Price is irrelevant. You take advantage of something being higher value relative to something lower value, and you don’t have to make a judgment call on all markets at one time. You can be invested, but on a relative basis shift back and forth and continue to buy the value.
Kevin:And if it is mood that you are going to go against, if you are going to be a contrarian, the Elliott Wave team has looked at gold and said, “Look at what the press is saying right now about gold. It is certainly not highly positive.”
David:I’m not all the way through The Socionomic Theory of Finance.It is only about 700-800 pages, but I am part-way through. Page 366 there is a great little excerpt from Barron’sand it gives all the reasons why in February 2001 “gold is absolutely worthless.”
Kevin:And that was the bottom of the market.
David:Just to illustrate, “There doesn’t seem to be anything on the horizon that will make gold prices go up.” That’s a quote. Another one, “We’re an industry incapable of realizing good returns for our shareholders, says Dipinar” – that is a mining executive. “It’s difficult to find any positive news in the depressed gold market at around $260 an ounce. The metal continues to trade near its cost of production and almost no one believes it will rally soon.”
Lo and behold, fast forward to today, we are trading near the cost of production. And here again, Bloomberg, this go-round, in August of this year is on a rant. “Gold may fall by a third. Gold rout fuels precious metals carnage as investor seeks dollars. Gold investors give up hope.” This is actually not an environment where everybody is stepping in to buy the gold market.
Kevin:Right. The mood has changed. People don’t know why they would own gold – the man on the street.
David:No, no, no. It’s not like our doors are being knocked down with aggressive gold buying. We have been around 47 years. We know what that looks like when people will stand in line to get what they can get at any price. But the really important factor with the Elliott Wave Financial Forecastand with Bob Prechter’s view on the markets is that you’re talking about the majority of investors today, and you’re talking about total net worth in the United States right now hitting new highs of 107 trillion dollars. We’re talking about most of that wealth being eliminated. We’re talking about it shrinking.
And yes, I completely agree with Steven and Peter. There is a point in a deflationary cycle where trends converge and it is an all-the-same market. We saw that in 2008. My dad has prepared me for that for decades. At the front edge of a deflation gold typically sells off. Don’t look for it to sell off for very long because people start looking at the quality of credits they have access to and the places they can go for safety, and all of a sudden you have psychology shift dramatically. And you go to the only place you have control. And it is in a financial asset that is outside of the financial system.
Kevin:Dave, you and I oftentimes do thought experiments, something that Einstein used to do, and a lot of times when you can’t do an experiment on it because you can’t see forward, you have to do a thought experiment. Now, here is your thought experiment. I’m going to pretend that we have a time machine, and you know that in five years we will have completed a major crash of a grand super cycle ending. Now, I’m going to hand you whatever it is that you want to take on that time machine, but you have to pick one or the other – a stack of dollars – now, you’re going to show up five years from now after a grand super cycle crash – or a handful of gold. Now, in this thought experiment, Dave, and I want you to be quite honest on this, you only get one. Which one do you pick?
David:I can tell you why it is a no-brainer for me, because we are already seeing the periphery to core migration with the problem. These guys agree that we are seeing the emerging markets cave first. The credit markets, the stock markets overseas and the currencies are all in decay, some of them losing 40-50% in value this year. If, in fact, there is a migration and that problem is moving toward us next, yes, it does include a decline in those three categories – equities, fixed income, and in the currency itself.
So to me, I look at that as a no-brainer. I want to be in gold. I don’t want to be in a stack of $100 bills. By the way, if I had a stack of $100 bills there is no telling that the bank is going to take them from me without filling out a suspicious activity report. So what we really are talking about is, if you are in a large cash position you have to have your funds in the financial system. And that is my problem. Kevin, let me tell you a story. Today I cashed a check for $10. That $10 check came from MF Global.
Kevin:MF Global? Where are they now?
David:This is the final settlement for the cash position that I held with MF Global.
Kevin:What did you start with?
David:I started with more than $10,000. Let’s call it two to three times that.
David:So here I am getting the final settlement check for $10. And do you know what I was in? I wasn’t in commodities. I was prepared to trade commodities, but I was in a cash position. Cash did not save me because the institution failed and my concern is that in the greatest bubble in recorded history, U.S. financial history, that is (laughs), I don’t know that I want all my eggs in a basket, what have you, in a financial system, that is not necessarily reliable.
This is hilarious. I got a call from the bank today. Apparently my wife went down and she was getting something notarized, and she said, “We’ve found a check for you in the waiting room.” I said, “What do you mean? What check is that?” “Well, it’s ready to be deposited, but we wanted to make sure it was yours.” I said, “What check would it be? Is it for $10?” And they said, “Why yes!” I said, “Oh, that’s the MF Global settlement. That’s brilliant!”
Kevin:That’s the $20,000 that I used to have.
David:That’s brilliant! Yeah! That’s my cash position. Oh yeah, well, I didn’t get it all back. I didn’t get it all back, but that’s where I feel like you have to be smart in your engagement with risk. If this is unparalleled risk, I want to be in an asset that is permanent in nature, that in fact has already gone through a thousand such crises, and there is no question as to its survivability, its durability, and its value on the other side.
So to me, Kevin, this is, today, probably one of the most valuable conversations we have had all year. Do we agree? On many points we do. On some points do we disagree? Yes, we do. The value, I think, for our listeners, is for them to engage and thoughtfully appraise risk (laughs). I can’t believe that today, of all days, was the day I cashed my check from MF Global.