The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“You have earnings that are in decline, you have a corporate profit cycle which has rolled over. You have stock investors who are marching into a very bleak environment. And you know what they’re doing? They’re just following the Pied Piper of Wall Street, as if all was well. This is a great time to be thinking about investing, but if you’re hoping that the market is going to hand out favors, you are sorely mistaken. Anyone on autopilot is in real trouble here.”
– David McAlvany
Kevin: We’re getting a lot of calls right now, David. We’re seeing gold above $1250. A lot of the people who are calling remembered gold at around $1050 just a few months ago. Gold is really putting on a pretty strong performance, and I know there are a lot of dynamics, but I’m getting calls from guys who have been in the gold market 40-50 years and they are saying this sounds strangely familiar.
David: I think what is happening is, it has gotten people’s attention. The first quarter was the best quarter in 30 years. To have that much growth in a very short period of time, the skeptics would say, “Well, you can’t do that over and over again.”
David: And so there are some people moving to the exits and selling gold at $1250 saying, “Look, okay, I’m just happy it’s not $1000, and I’m glad it’s not at $700, as some prognosticators have suggested it will be.” Quite the opposite, the dynamics that we have are a reflection of the pressures that were building, not unlike in the 1970s and 1980s where you had some policy mistakes, both fiscal policy mistakes or the absence of fiscal policy in our case today, which could be a mistake, and then your monetary policy, ineptitude, just nothing is really gaining traction or driving the economy forward.
Kevin: Something that I’m noticing, Dave, and I think everyone here at the office is noticing, is that it is not the average buyer who is watching the news and calling in and buying gold. It is bigger money coming in, more sophisticated money, a little like what Bill King said – this is informed money. I’m thinking of John Paulson.
David: I had a conversation with a retired hedge fund manager about six weeks ago who was planning on buying a large amount of gold from us, and this was his comment: “I’d like to wait and see what the dynamics are above $1250, because all I want to do is buy the established trend. I’m not trying to pick the bottom, but once we are in that established trend, his view, and I think I would support this, too, is that we are in the next stage to move higher. And that next stage, if we’re repeating anything like the 1970s and 1980s, could be a four, five, seven, eight-fold gain from these levels.
Kevin: I talked to Jim Deeds yesterday. You had mentioned that you would like to have Jim on next week’s show. Jim Deeds, like your father, goes back to the late 1960s in his buying of gold. He was very forward thinking. Jim told me yesterday, “Kevin, I’ve been here before. This feels like what it did back in the late 1960s, early 1970s”. We’re talking $35 gold back in the early 1970s, and then we saw a transition up to close to $200 – it was around $190 – and then it dropped back down, lost close to half of its value down to $105. And then, of course, everyone knows, the late 1970s took gold to $875 – all the way from $35 to $875 during that decade.
David: So write this down. This is important, because I think, to look at the expansion of the monetary base, to look at the period between 1980 and the current timeframe, let’s call it 2016, this timeframe we’ve seen a lot of monetary activity, we’ve seen a lot of intervention, we’ve seen a lot of central bank creativity in terms of tools that they have either created or pulled out that they had before. And what are the consequences of using all those monetary tools? Well, you just mentioned $35, you mentioned $190, you mentioned $105, which was the number that it hit as it dropped through 1974, 1975, ultimately hit those lows in 1976, and then the ultimate rise to $875.
Now, just do this. Add a zero to each of those numbers. We essentially started this bull market, if you took the average base that we were at, the ten-year average out of that bear market, 1980s, 1990s, call it $350. Add a zero to $35. Add another zero to your $190, which we just discussed, and what do you have?
Kevin: $1900, which is what we saw in 2011.
David: And then a correction to $105, add your zero you have $1050. So these dynamics, in terms of, we are just talking about a change in the nature of money in the interim, but nothing has changed, except one thing. This go-round, as we go from $1050 up to some number – $2000, $5000, $10,000 – whatever that number is…
Kevin: Let me just add a zero to $875, Dave.
David: $8,750. But what makes that number, although it sounds preposterous, what makes it reasonable is this. You are talking about demand which is not U.S. centric. The 1970s and 1980s was the story of U.S. dollar devaluation and concerns about politics as it related to the U.S. and Middle East interests and oil. So, where are the Russians? What are they doing? Are they going through Afghanistan? Are they going to control the Middle East? Are they going to control the oil fields, as well as 96% of the world’s mineral reserves? What are the grand strategy dynamics in play? That insecurity was really a U.S. foreign policy insecurity issue. We’re talking about a radically different dynamic in this timeframe.
Kevin: Now you have China, you have Japan, you have Europe.
David: All of these countries, all of these regions of the world, have followed a similar monetary and fiscal policy playbook through the last 15-20 years, and we’re in the same bind, all of us together. Now, households, individuals, middle class investors, would look at this and say, “Gosh, I just don’t like what I see. Maybe I should be pulling in my horns a little bit. Maybe I should be sitting in cash. Maybe I want to own a little gold.” And I’m telling you, the sophisticated money, the smart money, has already moved to gold at these low numbers. We talked about Stanley Druckenmiller. He has close to a third of his assets, almost 300 million dollars worth of gold as of last year, and this is a guy who has an unbeatable track record as a trader.
Kevin: He was Soros’s main guy.
David: That’s right, at Duquesne Capital. So, you go from $350 to $1900, to $1050, and we would argue that, yes, we have our eyes set on $3,000 as an interim number, $5,000 as a very possible number. And what is the difference in math between now and then? $35, $190, $105, $875 – $350, $1900, $1050, $8750. In retrospect, and I’m living in a world that doesn’t exist yet, but as we march into 2021, 2022, and 2023, will we in the rear-view mirror look back and say, “Gosh, do you remember when we had those foolish numbers picked, $3,000, $5,000? What we didn’t take into account was the massive amount of demand, and the fall in supply from mining entities in that 2009-2016 timeframe. You stop finding new mine ore bodies, big ore bodies – five million ounce ore bodies and bigger – about the same time the demand was increasing.
Kevin: And Dave, even the mines that know where the ore is, a lot of them are having to close, or have had to close. I brought up Paulson. He came in and purchased 40% of a small mine that he knows actually has quite a bit of ore. Now, Paulson runs a billion-dollar hedge fund. This is a guy who is not going to buy something that he thinks is going to go out of business.
David: That is why people look at the mining industry as a terrible investment.” It is, admittedly. It’s a terrible investment. What it gives you the ability to do is own gold below market price. Now, it’s not accessible to you; that’s the problem. You have to gain access to it, and that takes a lot of work. But theoretically, you’re not paying $1250 gold, you’re paying $300 dollar gold, $500 dollar gold, $600 dollar gold, which means you are a basically buying gold at a fraction of its market price, theoretically, if you can get it get it out of the ground.
And so large investors say, “Well, gosh, I think $1250 may be the low price over the next three, four, five years, but I don’t want to pay $1250, I’d like to buy gold at an even cheaper price, below market price if I can. That’s why they are looking at mining entities as basically an option on the price of gold, which is an intriguing way to look at it. Our preference is clearly for the physical metal in a period of time of incredible distrust, geopolitical upheaval, and financial market decay, for many reasons. One, we like the idea of having a financial asset that is outside of your traditional counterparty exposures and counterparty relationships, and gold allows you to have that, silver as well, where you have a financial asset that is outside of the financial infrastructure which we believe to be very weak, given the dynamics of derivatives and debt.
Kevin: Let’s face it, Dave, the average investor, the person on the street buying gold, that day will come. But at this point, the person on the street has treated currency as their own gold. I’m thinking about dollars, I’m thinking about yen. Look how people have been playing this yen trade. They go and borrow yen for less than 1%, then they go and leverage their money elsewhere. You have currencies, right now, being held as if they’re gold. But when those carry trades start to fall apart, or when those currencies start to come into question, they no longer play the role of gold. You have to move the next step to something physical.
David: Kevin, what is happening right now with the yen is probably one of the most important market tells that you can get. There is this thing called the yen carry trade, and it is where leveraged bets, that is, investments, have been made with the use of borrowed money.
Kevin: Because you can borrow it so cheaply – less than 1% interest.
David: That’s right. That comes under pressure when the yen begins to move up in value because keep in mind, when you are borrowing money, in yen terms, and then ultimately have to pay it back, if the currency has appreciated, you have to pay it back, you have to get the money back into the system at a higher number. It hurts you when the yen appreciates.
Kevin: Right. And if you’re borrowing it, and you’re taking that money, which is what people do with the carry trade, and putting it into another currency or another system, you have to come back out and pay more for that yen to pay the loan back.
David: Right. So we’re seeing that the yen has moved very dramatically in the last couple of weeks, and we see that as a source of intermarket shifts, this is very significant because of that funding function. The funding function of the yen is played, and it is allowed so many leverage bets in other asset classes. So the yen is moving up in value, investors are being forced to get rid of their yen bets, and get rid of the other bets on the other side. So that would be, let’s say, U.S. equities.
Kevin: On equities, Dave, if I borrowed cheap money from the Japanese, and I turned around and bought U.S. equities, and then I saw the yen appreciating, I am going to be inclined to sell those equities because I think, “Oh my gosh, this ship is leaving the harbor, I’d better pay that loan off before it goes up too much.”
David: That’s exactly right. So you have the European Central Bank, you have the bank of Japan. They are both incredibly frustrated right now by the fact that in spite of all their verbal interventions to weaken those currencies – the euro and the yen – they are, in fact, going the other direction. We have dollar weakness; that is on display. We have had yen strength, and it is making it impossible for these European and Japanese bankers to verbally jar the markets in the direction that they want to go.
Kevin: Isn’t it interesting? I have a client who spent her childhood in Asia before she moved here. She said, “Kevin, what you guys said on the Commentary a few weeks ago was absolutely right. If interest rates go down, and Keynesians would say, ‘Lower interest rates or talk the yen down,’ a lot of Keynesians and central bankers would say, ‘Gosh, that’s going to stimulate the market.’” But instead what it does is cause, especially the Asian personality, to save more money. Now, they’re pulling the money off the system that causes the yen to increase in value. There are a lot of dynamics here.
David: And let me attach something very basic to the Asian personality. It’s good math. They’re looking and saying, “Well, if our currency is worth less, or if we’re not having as much income coming in from our investments, it implies that we must have more investments, we must increase our savings, to compensate for a lower amount of income generated from the current savings that we have. So if you’re going to lower rates, it’s going to force us to save, not to spend.” And Japan, curiously, or perhaps not curiously, provided this real-time test case of how consumer behavior changes in the context of negative interest rates. So you have them set at a negative level by the Bank of Japan, particularly, Haruhiko Kuroda, and now you have 10,000 yen notes that have all but dried up. And you also have small safes – this is home safes, office safes – they are disappearing off the market because people are opting out of what we have described as a very repressive wealth tax embedded in a negative interest rate policy.
And the Japanese have adopted this, and consumers are basically saying, “If we’re going from a zero interest rate environment in which we had to save some money, to now a negative interest rate environment where we have to save some, and hide a lot, just to avoid having money taken from us, you are getting to see in real-time that this is how consumers protect themselves. We will continue to operate with a degree of self-interest that central planners can’t appreciate because we’re not a part of an elegant mathematical formula, we’re just people, and we do care about what happens, at the end of the day, to us, to our families, to our culture.”
Kevin: What you mean is, they’re not academics. They don’t work a theory instead of actual practicality. The big question right now, Dave, is how bullheaded are the central bankers going to be with their academic theories, thinking that the lower that they lower interest rates, the more they are going to stimulate consumption, which is exactly opposite to what is going on?
David: That is exactly right. You have the test case in Japan in real time, and it is a failure, and will they deem the negative interest rate an impossible and inappropriate policy to implement elsewhere, or will the central bank community push forward with the idea that is as insidious as it is elegant, and will they propose some sort of similar measure for other countries? As you just said, have they fallen in love with a theory? Have they made commitments to a theoretical course regardless of what the practical consequences are?
And in Japan, the consequences include an already stressed demographic of aging people unable to meet their income needs and thus out of this insecurity we have just described, relating to their future ability to pay bills and stay financially afloat, they are saving more and spending less, and they are opting out of the financial system in order to save, so as to avoid the wealth tax implicit to negative rates.
Kevin: So when do we get to the end game scenario with Japan? This seems to be different than what we have experienced the last three decades, where they have had just sort of an ongoing grinding deflation, lack of business growth. It seems that we are starting to see things come to a head with this carry trade unwinding.
David: And you look at the Bank of Japan’s operations in buying up debt, and in buying up other assets, and it has been a cleanup operation. Imagine a sponge. The Bank of Japan squeezes it dry so they can go into the market and clean up any mess that is out there so as to avoid the obvious conclusion that, oh, there is a mess out there. So there is no mess because the Bank of Japan keeps on abusing its balance sheet, like that dry sponge, to just soak up anything at all.
Kevin: Well, don’t they go buy market ETFs and stocks? Aren’t they doing that right now? They’re coming in, and I think they own a good portion of that market, don’t they?
David: That’s right. They own a huge portion of Japanese government bonds. They own a huge percentage of the stock market exchange-traded funds, the ETFs. And that has been to boost prices in the hopes of boosting confidence amongst investors, and therefore consumer spending. It is the same sick idea that our folks here in the United States have fallen prey to. “Yes, we can create a wealth effect if we just pump money into the system, and we’re going to see this wealth effect come out in terms of economic activity and consumption and everything else.” Well, it hasn’t played out there; it hasn’t played out here.
But let’s just say for the sake of argument that the policies that they have adopted did work, and all that asset purchase mumbo-jumbo was actually working. The issue is, their other policies are neutralizing any positive effect that they might otherwise have from those asset purchases, because again, negative interest rates destroy the incentive for people to have money in the system, and it destroys the incentive for people to have money invested in bonds or things like that, because again, what is the reward? All you can calculate is the risk. There is no reward to calculate, and that is a bad bet for an investor.
Kevin: I want to just look at the flip side of that, Dave, because we can talk about the yen appreciating initially as they talk about negative interest rates, but if that forces a larger market out there that is holding this yen carry trade to sell their positions and pay back the yen, ultimately there is an insecurity that develops in the currency that was originally a strong currency, like the yen, and it turns into a falling value of a currency. Right now, the yen is a fairly safe place for a person to pull out of the bank, put into a safe, if you’re in Japan. But at some point, there is an insecurity that is built into that whole system, and it reverses. It turns into inflation.
David: It turns into inflation when central banks get desperate. And you might have that developing now in Japan. Look at this, since the beginning of the year, Black Rock and other institutional investors have pulled out 48 billion dollars from the Japanese stock market. So, who is going to own the 48 billion dollars’ worth of Japanese stocks if it is not U.S. and other foreign investors? It creates a void. Either Japanese investors step in because they view Japanese equities as a value, or again, it is this strange thing – does it strike you as odd that a branch of the Japanese government, the central bank, owns over half of all equity market ETFs?
And when you see liquidations from abroad, it forces them to buy even more. That kind of monetization is precisely what set an inflation fire in the United States. Talk about changing expectations, we started to monetize debt in the United States in the 1970s, and that changed inflation expectations, and as inflation expectations changed, so did consumer behavior, and all of a sudden you have a self-reinforcing inflation dynamic that is outside the control of a central bank.
Kevin: Which take us from that $35 an ounce gold to $875 an ounce gold. In the 1970s, it was that exact dynamic.
David: Right. So it’s a change in market perception, and you have had people very content to play the game with yen, and to invest in yen, particularly in the domestic markets, and that may change. So last but not least, on the issue of yen dynamics, remember that leveraged players, that is, investors using borrowed money to enhance their returns, have the most at risk in a volatile market, because it is not their money they are investing. They have to pay all that borrowed money back. So they are typically the first to sell, and they sell first, they ask questions later.
If you were a leveraged speculator, borrowing in yen to buy U.S. equities, and you are now on the verge of first quarter earnings reports which are expected to be bad, and you didn’t want to take the risk of a repeat January downdraft in the U.S. stock market, would you be selling stocks?
David: Would you be paying back the yen loans, the reason why the yen is appreciating? What I’m saying is that smart money is exiting the equity market and booking the gains of the last seven-week stock market rally. And what are the footprints? How do we know that smart money is leaving the U.S. equity market? The yen appreciation. The yen market is telling you everything you need to know about what the smart money has already done.
Kevin: Again, Dave, that is the yen appreciation. That is what we are seeing temporarily right now. But when does that reverse course and turn into an inflationary problem and a yen depreciation problem?
David: That’s a big question. We’re not done with the yen appreciation dynamics because the yen appreciates, those who haven’t moved out yet have to buy back yen at even higher prices. So now they are dealing with basically a foreign currency short squeeze, as their equity positions are sold off and they move the money back into yen. The irony of a strengthening yen foreign currency market is that it may be, to your point a moment ago, the last move higher in yen before the Japanese people figure out that they, in fact, are the investing patsies, and begin to sell yen in earnest.
So if the Japanese people are selling yen in earnest, and selling JGBs, Japanese government bonds, that may, in fact, create an inflationary death spiral. If you live in Japan and you want to consider gold as an alternative to yen notes, I think now is the time to be doing that. They already have their 10,000-yen denomination notes, and I think within the next 36-48 months they may be issuing 100,000-yen notes, 1 million-yen notes, or even 1 billion-yen notes.
Kevin: Sort of reminiscent of Zimbabwe dollars where they just continued to add zeros.
David: Yes, so gold, in dollar terms, has already been a great 2016 story, a fantastic phenomenal first quarter, best quarter in 30 years, nothing to complain about there in U.S. dollar terms. Gold, in yen terms, is probably a great story for 2017, and depending on the British exit from the euro, or non-Brexit, gold, in pound and in euro terms, could be a sensational story in between those two.
Kevin: So Dave, we go right back to the beginning of the program when we were talking about getting calls from guys like Jim Deeds saying, “Hey, can you smell it? I remember smelling this before.”
David: Right. And the reality is, in case you’re wondering, we have entered the final stage of a gold bull market. One to two years is the duration, at a minimum, from this point. So mark your calendar, 2016-2018, bare minimum. It could be five to seven years at the outside. We could stretch into 2022, 2023. We are entering the era of $5,000 gold. Do the math on silver. You’re talking about a conservative 30-to-1 estimate. That’s the ratio between gold and silver. Currently it is 80-to-1. I think you need to own what you’re going to own because the last stage of the 20th century repricing in these metals is here. It’s now.
Kevin: And you wonder what Wall Street is really thinking about the Fed now. I don’t know what to make of what Jamie Dimon at J.P. Morgan said about what he thinks Yellen is going to do over the near future, but it is interesting, when he said, “Well, she will probably raise rates, but she is going negative before this thing is over.”
David: Of J.P. Morgan management fame – CEO, Jamie Dimon – he makes the case to shareholders that the U.S. central bank will raise rates first, then go to negative territory. And if rates are raised too fast, the financial market hemorrhaging will force dramatic action, and perhaps it will justify moving rates negative. When I say justify, I’m not legitimizing, it, but I’m saying justify in the minds of U.S. central bankers what is an extreme course. And yes, they would simply ignore the examples elsewhere on the planet, including Japan, which we talked about earlier, where that same policy has failed. But do recall that it was Janet Yellen in 2009, before she took over from Ben Bernanke – in the context of the global financial crisis, she was wishing for the ability to take rates into negative territory then.
Kevin: That’s amazing! When we talk about the bag of tricks that Bernanke pulled out, all you have to do is go to speeches that he made before we ever had the financial crisis.
David: Right. To know Yellen before she was in the seat of leadership, you know her über-dovish tendencies by all the things that she has thought of and dreamed of. This has been on her mind as a viable option, as an “elegant solution” to financial market chaos, for seven years! All she needs is the context to justify the move, and again this is in theory, which is provided, perhaps not by accident – keep that in mind, perhaps not by accident, if rates rise too quickly, and the market meltdown forces the hand of the Fed from zero interest rates into negative interest rates. So zero interest rates you begin marching higher, and oops, just as Jamie Dimon says, now we have to reverse course and actually take them negative.
Kevin: Let’s face it, if you were out buying a ten-year bond right now here in the United States, you are already negative in real rates.
David: In real terms, that’s right. The Wall Street Journal, over the weekend, was lamenting that when you factor in inflation for a real rate of return, the ten-year treasury and anything of shorter maturity, is already unable to keep up with inflation. So as you say, in real terms, we have a negative rate already. All I’m talking about is moving from negative real rates to negative nominal rates, which if you are watching any country in the world that has implemented that policy, and now has negative nominal rates, keep this in mind. The banks and the banking sectors in those countries have been crucified.
Kevin: So Dimon needs rates to be positive, actually, for his industry to survive. Let’s face it, banks, insurance companies, people with annuities through those insurance companies, those insurance companies have to come up with rates somewhere, even if the Fed is trying top pull things negative.
David: The entire pension system requires an actuarial accounting for money in, money out, earnings on the assets, in order to pay and cover what is going out to pensioners. So I think if – and this is an if, still – the Fed marches down the road of negative interest rates, Dimon and every other CEO of the U.S. lending institutions you are familiar with, will be under pressure. And you can look at your Swiss banks, you can look at your Japanese banks – these are banks that are off 30-50%, and it is telling you that negative interest rates is a slow bleed-out for the industry until – and this is a critical transition point – negative interest rates can be successfully engineered to trap and tax the depositor instead of the banking institution.
Kevin: Are you hinting, then, at the cashless society? Are you hinting, then, at bail-in?
David: It’s like your food companies. They’re between a rock and a hard place in a rising commodity price environment until they figure out how to shrink the box, or increase the price – pass it along to the end purchaser. So the banking industry is caught short by negative interest rate policy in the short run. I don’t think it hurts them in the long run as long as they can engineer the pass-through to the trapped depositor, because right now it is on their backs. They can’t do that forever, and you are seeing that show up, as I say, with the Swiss and Japanese banks. They are saying, “Look, we’re going to die if this continues.” And I think that is why politicians will figure out a way to pass it on to the end depositor. So that is a very significant puzzle piece that needs to be put in place. The banking and financial firms in all of these geographies where the negative interest rate policy is alive will be dead and dying until they figure out that pass-through.
Going back to Dimon’s comments, in his annual letter to shareholders he is predicting first an up-move in rates on the presumption that the economy is healthy, and then a down-move in rates which may, without him intending it, have also been prophetic as to the movement of JPMorgan shares, along with all your other financials in the U.S. So as long as the economy is improving and interest rates are rising, the financials are going to do great. And then all of a sudden, the shock and awe of negative interest rates, you could see a real roller coaster in the financials.
Kevin: Dave, I saw a poll on TV a couple of days ago. Instead of asking how many people would vote for Hillary, or Bernie Sanders, or Trump, or Cruz, it was actually how many would not vote for any of those people? And it was an astounding thing. All of a sudden you started seeing high numbers instead of low numbers, as to the polls of who would vote for these people. The higher numbers right now are how many people are dissatisfied with all of the candidates. When we were talking about 1968, I remember seeing a film when I was a kid called, The Late, Not So Great 1968, that talked about all the social unrest, and the discontent and the riots, the killing of Bobby Kennedy, the killing of Martin Luther King, Jr. The nature of society at the time was just discontent. It was a cauldron waiting to boil over. Don’t you feel like we are seeing that, or feeling that, in this current-day election, and the financial markets, and the geostrategic, ISIS?
Kevin: It seems like this is a repeat, but it feels bigger.
David: Peter Berger is a sociologist, a pretty reputable guy, who wrote a book on France, and specifically what was happening in France in 1968, from a sociologist’s perspective. And there were some significant philosophical shifts in literary criticism and philosophy and a whole host of other fields following the chaos of 1968. It created a real social and intellectual shift, and that was very important for what happened over the next 10, 15, 20 years.
Next week we will consider some of the similarities with the political discontent of 1968 and today. And we will also look at a few of the market dynamics in play starting in 1968, which lasted through 1982, and represented, really, the slow bleed of the average investor here in the United States. On the surface, not much was happening. Under the surface, the irresponsible monetary and fiscal policy moves of earlier administrations were all coming home to roost. You can recall that by 1982, although the stock market had barely budged up or down in price from 1968, it had basically flat-lined, the average investor had lost over 65% of their stock portfolio’s value due to inflation.
Kevin: Yes, just the devaluation of the buying power of the dollars that it was denominated in.
David: Clearly there are differences, as well as similarities, today. But when you look at political discontent as an indicator of the real state of the average U.S. household, what it suggests is that the welfare and well-being of the middle class is in jeopardy now, and that the political rancor will only get worse as income and financial pressures increase, which we think is unavoidable at this point. So the summer of 1968 becomes even more relevant, with riots in every major city around the world.
Of course, we have a new language for riots. Imagine what was happening in 1968 in Paris, in New York, and in London, where cars were being burned, Molotov cocktails were being thrown. What are we talking about? Then we were talking about students who had a little too much time and money on their hands, and were just expressing themselves, and this was all first amendment stuff here in the United States. But not today. Today, it is categorically terrorism, right? So it would be treated very differently, and you end up with a political response to it which might be very onerous.
Kevin: And you call it radicalism, if not terrorism, anyway.
David: Right. That is what it was then – disenchanted youth. Radicalism is increasing at both extremes of the political spectrum. And let’s maybe finish that thought on a positive note. For those who are sitting in cash and in gold, a ratio of equities-to-GDP, that is, the economy, which is in keeping with a bear market low, is around the corner. So there is a good time to be buying assets. If you are looking at that ratio, we are currently at around 200%. That is your equity values, in aggregate, relative to GDP. This is thanks to Doug Noland and his recollections in the Credit Bubble Bulletin. I love reading his stuff.
We are currently at 200% equity-to-GDP. We started the 1980s at 44%, and we started the 1990s at 67%. So again, stock market valuation relative to the total economy – we are at an excessive and unsustainable level. What I am suggesting is that we go back to the 1980s era, and I’m not trying to confuse you here, but the 1980s represented the end of a long-term bear market in equities. It began in 1968, and it was only felt as a bear market as you got to the tail end of it, when inflation took its full bear bite and you were down 65%. In 1982, you finally cleared the decks and you were ready for a new bull market in equities.
Kevin: When you look at people who specialize in looking for the lower valued assets, there a huge firm – Kohlberg, Kravis, Roberts – who is looking at the credit cycle right now and they are saying, “You know what? We’re at the end of the profit cycle, the corporate profitability, the credit cycle. All these things seem to be coming to a head where we’re going to have some really, really, good cheap prices coming soon.”
David: I think that is somewhat reminiscent of the Bass brothers. The Bass brothers were buying assets on the cheap in the early 1980s, they had sat in cash and in tangible real assets prior to that, and then they transitioned back to paper assets, financial assets, in the early 1980s when those assets were dirt cheap. So for the liquid investor, that is, someone who has cash and gold, there are good times ahead. If you’re over-committed – as Bill King likes to say, if you are a little too far out over your skis – the next couple of years are going to be miserable for you. And the time to recover probably won’t happen in your lifetime. (laughs) How fun is that?
It’s only a fun environment if you are thinking, if you are engaged, and you are making some very critical, strategic investments at this point, and then be willing to, as we have for the last three or four years, engage in the long march. Wait, and wait patiently. It will take forever, until it’s done in a nanosecond. KKR – Kohlberg, Kravis and Roberts – as you mentioned, is a massive private equity firm, and they are very concerned about being at the end of a credit cycle. What does that mean? It means that corporate debt is going to be selling very cheap – it’s not today, but they believe it will be. And not just in energy, but much more broadly, there is an expectation of corporate debt hitting a wall.
Albert Edwards, who is at Société Générale – he is their biggest bearish analyst – sees the corporate profit cycle and declining profit margins, which we already have, as the catalyst for a massive debacle in the corporate debt market. So you have KKR, who agrees, if not with Albert Edwards’ logic, but how we get there, at least with the opportunities that will present themselves in the next few months or years, and KKR has already amassed a nearly 4 billion dollar war chest – 3.5 to 4 billion dollars – to buy distressed assets.
Kevin: Isn’t that what you are talking about to the listener of this program?
Kevin: Put a war chest together and wait.
David: That’s exactly right, and be willing to buy distressed assets. So KKR has no desire to bail out the currently suffering companies, whether it is an energy complex, or what have you. They are still stinging from a five billion dollar loss to their company in their energy exposures. But they are nonetheless seeing a future opportunity, and that future opportunity will come at the expense of existing investors.
Kevin: In other words, those who are holding those assets now.
David: That’s right. So corporate debt trades lower – imagine what that means for corporate stock values. Again, if corporate debt is their target, debt is considered a safer investment than equity. If debt is trading at extreme discounts, equity is getting obliterated – absolutely obliterated. So when debt investors are frightened, guess what? You are seeing prices in the bond market move lower, but that implies that stock investors are in panic mode.
So I think you can expect share prices to reflect panic, if not by the end of this year, certainly 2017. Early 2016, the moves that we saw in January with the Dow, the S&P, the NASDAQ, everything was off 10, 15, even 20% – preview of coming attractions. Just a minor preview of coming attractions, because keep in mind, we are now conveniently coming into the May to November period, the weak seasonal period where stocks generally don’t go up anyway. And in addition, as I mentioned earlier, we have first quarter earnings reports which are expected to come in lower than the fourth quarter by 10%.
So you have earnings that are in decline, you have a corporate profit cycle which has rolled over, you have stock investors who are marching into a very bleak environment, and you know what they are doing? They are just following the Pied Piper of Wall Street, as if all is well. Recall, Bloomberg, April 5th, they were also acknowledging that this profit recession is not just a U.S. issue, it’s a global issue, citing research from the Institute for International Finance which was connecting these dots, saying, “We have declining corporate earnings.” That is an 18-24 month long trend if you are looking back. “You have poor productivity growth, you have weak demand, you have a lack of pricing power.” Again, margins are getting squeezed. (laughs) This is a great time to be alive. It’s a great time to be thinking about investing. But if you’re hoping that the market is going to hand out favors, you are sorely mistaken. You are sorely mistaken. Anyone on autopilot is in real trouble here.
Kevin: Okay, what I want you to do, Dave, let’s just play a thought experiment for the next year. Take me to December of this year, maybe January or February of next year. What has Yellen done, what is she saying, how is she making up for either past mistakes or past successes? What do you think the news reads like? I’m not asking you to predict the election, I’m just talking about Yellen, herself. What do you think?
David: Well, I’ll probably be wrong, but this December or next January Yellen will probably be telling us that the chaos in the equity markets does not reflect what she views as a robust economic recovery and therefore all the volatility is unwarranted. She is going to say, “Look, the stock market is going crazy. The economy is still healthy.” And perhaps she will say that it reflects market uncertainty with the new political regime which is taking office in January – again we are fast forwarded to January 2017. And this will be her excuse, which always is a central banker’s excuse, that “there was no way that anyone could have foreseen the animal spirits, the irrational fear, which is on display, and has been on display since January of 2016. It didn’t make sense then, it doesn’t make sense now, we have a strong economy. But listen, here is my combination to bring calm to the marketplace. We have launched this new asset purchase program, and it is not contrary to our monetary policy tightening which we initiated earlier in 2016, and 2015 raising rates, because the economy is healthy, we just need to soothe the nerves of financial operators who are freaking out.” Those won’t be her words; she will come up with something far more elegant and academic. But you have to remember that the truth can be disposed of when things get desperate.
Kevin: Right. But I think we should print up what you just now said, go ahead and send it to the papers; that way they don’t have to actually wait for the news to happen, because I think you’re right, Dave. I think we are in for a huge volatile year, but also a year of denial by the Fed, another year of denial of their policies not working.
David: Well, why do they have to deny? It is an issue of ego, it is an issue of credibility. Keep in mind, the times in history where they have utterly lost credibility – do you know what happened to them? They went away. They lost their charter. This is the third central bank in the United States. The first two were done away with. The business was closed because all credibility was lost. So will they defend their credibility? Will they shift blame? Of course they will. And will they consider negative interest rate policy?
Well sure, in that sequencing of events, that’s probably a 2017 event, in response to the first effort, which I just mentioned might be asset purchases of some sort falling flat, and then they bring out the big guns. And it is a last ditch effort to go into negative interest rate policy environments with that being a 2017 eventuality. And Dimon, writing to his shareholders, is probably correct about the sequencing – first an interest rate move up, then a move to negative interest rates in response to, why else would rates go negative except that we are in an absolute bit of hell?
Kevin: So to conclude, Dave, we are looking at large hedge fund managers, we are looking at KKR, we are looking at these big money managers who have seen these things before, coming in, building a war chest of cash.
Kevin: Building a war chest of gold – I’m thinking of Paulson, I’m thinking of some of the others that you have mentioned.
David: Certainly Druckenmiller.
Kevin: So your recommendation at the end of this program? Here is my prediction. You predicted what Yellen was going to say, but I think your prediction is, build your war chest of cash and gold, and get ready to buy things at pennies on the dollar.
David: Right. I think owning some mining shares makes sense. Why? Because it is like a call option on the price of gold. Is it speculative? Yes. Is it a terrible investment? Absolutely. Does it work on occasion? Only on occasion. And I think that occasion may be here.
The move from $35 to $190 was really exciting. My dad was there, Jim Deeds was there. These guys anticipated it and were actually figuring out ways to take a position in gold in the late 1960s. And they felt it in their bones. They had great instincts. So they went from $35 to $190. And do you know what? They surveyed the environment and they said, “Nothing has changed, although the price has declined by 40%, almost 50%, as it dropped from $190 to $105.”
Kevin: That was painful.
David: “Nothing has changed.”
David: And all my dad did, and I believe that Jim Deeds probably did, too, was buy more on the way down. Now, something did change when we got to the early to mid 1980s, but we had gone through our cycle, and $105 was the low. And $875, an eight-fold multiple above that, had already been established. Where do we go now? Why do you want to own cash? We may not end up at $8750. We may not have $8,750 as the ending price for gold. Hedge your bets with some cash.
But with your cash position, hedge your bets with some gold, because if Janet Yellen has her desires, she will get more and more creative as things gets more and more desperate. And that means your cash position is more and more at risk. So yes, I think cash and gold make sense, and $350, $1900, $1050, $8750 – that may be our step sequence.