In PodCasts
  • Deutsche Was $119 a share in 2007, now only $11
  • Money for nothing – Italy monetizes (creates) 500 million out of nowhere
  • Will democrats at the FED become election year political?


The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

“You have the nearness of recession which is closer by the day. You have a potential emerging market meltdown. What does it feel like? It feels like the music has been playing for quite some time and if this game is the game of musical chairs, you may be eyeing a chair very, very eagerly. In fact, I would go ahead and grab one. If you can choose a shiny one, I would grab one of those, in particular.”

– David McAlvany

Kevin:Well, David, while we were burning up here in Durango, you were burning up in the Carolinas. You did another 70.3 – this time it was a relay, but it was a half iron man. You were doing it with a guy just a little bit younger than you. Can you tell us about it?

David:Nineteen years old, I wanted to introduce my nephew to triathlons. He did fantastic. We had a great time. Between the Italian food pre-race there in Chapel Hill, and Mr. Dumplings, which was amazing Chinese food in apex afterward, we had a fantastic weekend.

Kevin:And it may have been amazing mainly because you were just amazingly hungry (laughs).

David:(laughs) Yes. I’ll tell you what, I was also amazing hot. Humidity does things to the body that just normal temperature does not do. I was thinking about this on the plane back. If you have ever been in a dry sauna versus a wet sauna, a wet sauna tops out at about 125 and you’re baking yourself to death at 125 in a wet sauna.

Kevin:You feel like a boiled egg.

David:In a dry sauna you can take it to 165 before you feel the same way. So there is about a 40-point differential between dry and wet. And it didn’t matter that it was only 85 degrees outside, it was the 87% humidity which was absolutely crushing. But we had a great time. We had a really fun time.

Kevin:Dave, you’ve been on trips before when you have gotten a call from your wife saying, “The dry season has caught up with us. We have a fire.” And you were 1200-1500 miles away. Friday afternoon while you were gone we saw that wisp of smoke, and our hearts sank because, talking about humidity, we were at 30% of what we normally would be from snowpack and from rain. We knew we were going to have forest fires. We’re in the national news right now. You guys haven’t been evacuated yet, I haven’t been evacuated, but we have friends who have been evacuated. Like you said, when you got home it smelled like a campfire.

David:I left on Thursday and had a business meeting Friday morning in Milwaukie, Wisconsin – a great group – and convened in a Lutheran college.

Kevin:You did a commencement speech, as well.

David:Exactly. I gave a commencement speech Friday night. It was absolutely fantastic. I learned a lot from the folks that I was with and enjoyed the atmosphere. But coming home after this weekend, it does smell like a campfire. It smells like we’ve been camping. The forest fire north of us has gobbled up about 2500 acres and smoke is everywhere. We do have a few friends that have evacuated. We’re a long way from it, but it’s a serious fire. There was no snow this winter. Right now the fire is about 10% contained, so it’s a bit of an issue.

Kevin:It’s a real praise that we haven’t lost any structures or lives at this point, because obviously, it is a very hot area and it’s fuel rich. That’s what they call it.

While you were gone, also, first quarter GDP numbers were released. GDP can sound like such an incredibly dry subject. We brought in Diane Coyle, who wrote GDP: A Brief but Affectionate History.It is a book completely on GDP, if you recall. GDP is a very politicized number. In other words, not just the Obama administration, not just the Bush administration, but now under the Trump administration we are seeing a little bit of finagling that probably is giving a misread.

David:Yes, and I would encourage you to go back to the archives. If you didn’t listen to the interview with Diane, it was great. It gives you some background as to the importance of GDP, how it has migrated and developed over time, what it is today versus what it was 20, 30, 40, 50 years ago. So we had the revised numbers last week, 2.2 versus the previous 2.3, and that is really no big deal. But the revision for intellectual property was significant.

Kevin:I remember talking about that in 2013 when they added that.

David:That’s right, it went from 3.6 and they bumped it up to 10.9. That was a Commentary, you’re right, in 2013, which is when they changed the GDP statistic and included intellectual property as a brand new component. It was added under the Obama administration because GDP was sluggish and it needed a shot in the arm. They literally found money to plug in.

So there in the first quarter you had the personal consumption expenditure, and intellectual property, those two components making up the largest positive factors in the figure. Intellectual property was to the positive by 0.43%. And then, again, the personal consumption expenditure was up 0.71. It is worth remembering how we got here, and I think it is also valuable not to forget that a number is never just a number. There is always a message, and there is oftentimes an agenda. And GDP, as you said a few minutes ago, has long been a super-politicized number.

Kevin:If you’re a politician, whether you are Obama or Trump, obviously, you are going to want to have GDP looking a little bit better. Now, 43 basis points on 2.2%, that actually is a pretty fair piece of an increase for GDP. We would have been under 2 without it. That shows the danger. Now, corporations can do the same type of thing. They can play around and show greater profits. I’ll give you an example. I got a tax refund this year, a pretty good tax refund. If I counted that as my income and said, “Hey, this is how my month is going,” if I really counted my refund, that is really not how my month is going as far as income goes. It is something that was a tax benefit, it wasn’t really profit.

David:It was a one-off surprise. Last week in the Wall Street Journalthere was an article that I thought was worth reading. Maybe you can find it. “Why corporate profits may be weaker than they seem.” I’ll quote from the article. “Government data shows profits were weak in the first quarter, and would have been down without the tax cut.” This is from the article again: “Profits for companies in the S&P 500 grew by 26.3% in the first quarter compared to a year earlier, according to Thomson Reuters. But a Commerce Department measure of corporate profits rose by just 1/10thof 1% in the first quarter from a year ago. Take away the tax benefit and the numbers are worse. The article concludes, “Before accounting for the benefits of the tax cut, profits were down by 6%.”

Kevin:So in other words, profits are down, they’re not up. It’s just the tax benefit that picked them up.

David:Yes. Many times we have noted that corporations will show better than expected results in a given quarter when they’re tinkering with their tax rates. Multi-nationals are able to game the system that way using what is called tax arbitrage. GE is a classic offender. IBM is a classic offender. But when you have almost as many tax accountants on your payroll as you do designers and technological engineers, what are you exactly crafting? And it takes effort to lower your total tax rate, but you do that via tax arbitrage.

Kevin:Doesn’t that put them in a tough situation, because what do they do next time? For example, my April tax refund won’t show up this next quarter so my profits are going to look worse.

David:Which raises the question, you have the S&P 500, which again, from one perspective, had profits growing by 26.3% due to the tax cut. So the entire index was given a one-time gift. And I think it is a reasonable question – what do you do for an encore?

Kevin:Looking at the stock market right now, small caps sometimes tell a story that some of the bigger blue chips don’t. Small caps can sometimes be very, very exciting, both on the upside and on the downside. Now, they’re getting an awful lot of press right now because the small caps are popping.

David:Yes. When you’re looking at the margins of things changing and what is really going to define the next chapter in the markets, you can look at the financials, you can look at the small caps, you can look at junk bonds. And these give you some indication of what is either developing or devolving – evolving positively, or devolving negatively. June, seasonally, is typically a tough month for stocks. But probably the most intriguing price action here in the last few weeks has been the small caps. And that, right now, is worth looking at. There has been a lot of hype in the press about small caps, and part of that is because they continue to set new all-time highs.

But you need to remember that small caps are best at the beginning of a cycle, in terms of growth potential, and frankly they’re the most dangerous at the end of a cycle because you’re dealing with stocks that are thinly traded, and have far more economic vulnerability. When you start thinking about their balance sheet strength, a lot of your small caps don’t have a lot to work with in terms of excess reserves.

Kevin:So where you have the greatest growth, sometimes you can have the greatest loss when that turns.

David:Yes, you’re largest losses are accrued in a market downturn there in the small caps. It is not a surprise, though, right now, to see small caps roaring, but frankly, it is not a good sign. When do you buy them? You buy them at a cyclical low. You don’t buy them at a cyclical high. You don’t buy them after nine years of growth. What is interesting is that investors and professionals – I would include the professional investor class in that – your money managers can’t seem to help themselves when it comes to that siren song of momentum investing.

Kevin:Momentum investing. You know, that’s what I think about when I hear people talking about cryptocurrencies. Last year toward the end of the year, people who had never had an interest in cryptocurrencies were saying, “How do I buy something?” That’s a form of momentum, when you know that other people are buying something and making money. You feel like you have to be involved. Now, when you’re a professional – you’re talking about the professionals also getting sucked into the momentum.

David:A part of that is that the professionals don’t want to be seen as different because their performance, and frankly, their careers are at risk if they get it wrong and are somehow different. They would rather be the same and wrong than different and wrong, because being the same and wrong means everyone is wrong and you can’t get fired for that.

But as a professional money manager, if you manage a mutual fund, let’s say, and your fund under-performs a comparable fund by another company, that under-performance will get you fired. So you do everything that everyone else is doing and you’re constantly looking side to side, not ahead, as to what the market holds, but side to side to see what everyone else is doing, because it is job security.

Kevin:Last week you talked about something that was really heating up in Italy. We were having a crisis in Europe and it is almost as if the crisis has gone completely away this week. I think about the fire analogy. A fire broke out here in Durango. You’ve got smoke, you’ve got flame, you’ve got growth, you’ve got people looking at the news. And then it just all of a sudden became a non-event. That’s sort of what Italy felt like this week. I think that can only come with buckets and buckets and buckets of new liquidity.

David:Right. I think last week was one for the history books. And my guess is, the vast majority of global market participants, those people who are invested in the stock market but don’t necessarily look at things on a tick by tick, or moment by moment basis – they were yawning by the end of the week. Early in the week you had the Italian markets melting down, but by the end of the week, you have Italy’s treasury which has stepped in and monetized 500 million euros’ worth of two-year notes.

Kevin:Monetized means printing.

David:Essentially. Whether it is printing hard currency, which they can’t do anymore, the ECB does that for them, or just creating digital 1s and 0s, a credit balance, to then go take that money and buy bonds, that’s what they did. It’s the same thing. They monetized 500 million dollars’ worth of euros to two-year notes, particularly. And of course, the stock and bond market in Italy rallied back. So what was happening last week? You had the Italian bond auctions which were mid-week, they were over-subscribed, and the yields were held in check.

Kevin:Sure. You can do anything with a lot of money.

David:I haven’t seen the numbers yet, who participated directly or indirectly, but my guess is that the ECB and the Italian treasury were not shy – were absolutely not shy – with their checkbooks. So you have peace and calm, which in my opinion are not always what they seem. The perception management there in Italy last week, frankly, is an extension of the theme from the last decade – at least a decade – where again, there is almost no other period of financial history like this where perception management via the central banks and direct intervention in the marketplace, brings peace and calm, at least on the surface.

Kevin:Dave, I was flying back from a conference that you and I had years ago, and I was alone on the plane. I typically will put the headset on and listen to the pilot. Some people listen to music, but I like to plug in if they’re turning the mikes on and listen to the pilots because being a pilot I like to hear how the whole thing works. I remember being on, let’s call it flight 262. I won’t name the airline because this would embarrass them, but I was listening on the headset and I could hear Kansas City Center calling our flight, and our pilots were not answering. I heard them about a minute later calling, and our pilots were not answering.

This went on for about four or five minutes, and finally – I was sitting in the back of the plane – I just quietly called one of the flight attendants over and I said, “Hey, would you please call the pilots and let them know that Kansas City Center is trying to reach them?” You know, sometimes a pilot might be on a different frequency, or whatever. Well, her reaction was really strange. All of a sudden, she was trying to manage me. She said, “Sir, you’re going to have to be quiet, you’re going to scare the passengers.”

She immediately went into perception management because that is really what her job was. I was just simply saying that you might want to tell the pilots to start listening to the radio, but her idea was to control. And I can understand that. They don’t want to panic the passengers. This wasn’t an emergency situation. But I realized at that point that it was more important to her to manage the perception of the cabin than actually solve a problem that may be happening with the pilots.

David:One of the differences between the financial markets and the plane is that if you do freak out in the cabin there is really nowhere to go.

Kevin:(laughs) You’re a captive audience.

David:Yes. It’s not like you’re going to run to the door, yank the door and jump out because there is no exit. So you may freak out internally, and you may cry and scream and yell and throw a temper tantrum, but what are you going to do? In the financial markets you can cry and scream and yell, but you do have a second choice. And that is, get out. Sell whatever asset class you’re not interested in. You have the modern era of finance, which depends on the sentiment of the public remaining, on balance, positive.

Kevin:Stay calm.

David:Right. So the work of the central bankers, the central planners, has included impacting prices at strategic moments in time, when that sentiment is shifting too far to the negative side of things. And last week was masterful. It was masterful. Just for perspective, think about the difference between Greece and Italy. Greece entered the crisis 2010-2012, with debt-to-GDP of 109%.

Kevin:So their debt was 109% of their annual GDP.

David:And Italy was at 102. That was ten years ago, roughly. Italy’s official numbers are now closer to 130%. So obviously, they have taken on more debt, or their economy has slowed. And I think, actually, their economy is about 8% below where it was before the global crisis started.

Kevin:And that’s counting everything that they owe?

David:No, it doesn’t include what the country owes to the Germans because most of your TARGET2 balances are a liability to the Germans, and that figure adds another 26% to the debt-to-GDP figure. So the Italians are actually closing in on about 160% debt-to-GDP. But no one discussed the TARGET2 balances over the weekend, as 426 million dollars…

Kevin:That’s almost half a billion bucks.

David:That’s what the Italians own, and that’s nothing to sneeze at. So if you look at the volatility last week, and you look at the hemorrhaging in the bond market, and then of course it’s fixed because of debt monetization and whatever. My question is, what structured products got blown up last week? Because you have bond market volatility, which was immense. The German ten-year bund dropped from a yield of 59 basis points to 18 basis points. People were clamoring to get into German bonds. The two-year German bund reached a negative 82 basis points last week.

Kevin:That’s a flight to liquidity. We talked about that with the dollar, but that’s also with the euro, these short European bonds.

David:Absolutely. What you saw was sentiment which was sort of getting close to seeing the whites in people’s eyes, feeling the panic, and it was there. When you start seeing those credit spreads widen to the extreme that they did last week, when you begin to see people panicking from one area within fixed income and clamoring for another, liquidity was on order last week in a major way. And again, credit spreads told you that we were on a crisis footing. But don’t be fooled by the Italian treasury monetizing debt and thereby purchasing – purchasing– a moment of peace and calm.

Kevin:Sometimes it’s good for us to look back and say, “Let’s remember back a little ways. Let’s go back a decade. Let’s go back 15 years.” I remember billboards all over the place for Deutsche Bank during the Krispy Kreme craze. Do you remember when Krispy Kreme was just as hot as cryptocurrencies are now? Deutsche Bank was saying, “This is our investment.” So they put their name right beside Krispy Kreme.

I remember, going back to May of 2007, Deutsche Bank’s stocks were soaring. They got up to almost $120 a share, I think it was $119-something a share. They were the hot, hot commodity. And then of course when the financial crisis hit one year later they became a danger. And now, did I hear correctly that the FDIC now has them on the watch list for problem banks?

David:That’s right. Both the Fed and the FDIC are scrutinizing the German Giant. And it’s probably because of derivative bets and counter-party exposure.

Kevin:Well, let me just say, their share isn’t $120 anymore either.

David:No, it’s floating around $10 or $11, so it’s a little bit different today than it was then. But you mentioned cryptos. Maybe they’re the new Krispy Kreme donuts. I remember sitting out at Joshua Tree – this was a college weekend. We went climbing out at Joshua Tree almost every weekend. I wasn’t very good at doing homework. Well, I did all my homework on Sunday night after I got back from a weekend of climbing.

And I remember sitting around the campfire and we were making commercials for Krispy Kreme donuts. You know, the cop walks up to the car and he’s getting ready to write somebody a ticket, and he looks insides and he sees a box of Krispy Kremes. He was getting ready to say, “You realize you were going 20 miles … is that a Krispy Kreme donut?”

Kevin:(laughs) It had to be a cop.

David:And the next scene is the driver driving away with a smile, and the box is partly gone, of course. But there was a little bit of a negotiation, and the ticket went away.

Kevin:It could be an analogy: Crypto-Kremes. Maybe we’ll start calling them Crypto-Kremes. Oh, we’re going to get a lot of comments.

David:I know, I know. Well, the issue with Deutsche Bank is a big one, and you wonder if an entity like Deutsche Bank – of course they have very close political ties in Germany – would they ever be allowed to have their own version of a Lehman moment, where all of a sudden it’s liquidity-driven and they move toward a solvency crisis and it has to be solved very quickly by outside intervention.

Kevin:Well, could Deutsche Bank just be another Italy? Can the European Union just step in and save everything?

David:There is a question hanging over the markets last Monday. Of course, Tuesday is when things started to go haywire, but on Monday you had Draghi and Merkel who had an unscheduled meeting, and you wonder if the derivatives daisy chain isn’t beginning to unwind. Again, you have indications of stress and strain, and indications of market panic. Deutsche Bank is under pressure, Italy is foundering, and of course there is a political dynamic there. But again, that derivatives daisy chain – when it begins to be unwound, the question is always who is next?

And who is intertwined or interconnected to those who are being bruised and battered? It is really the job of central bankers to care for the banking system. They can talk about the economy, they can talk about employment, but when push comes to shove, central bankers take care of bankers. So caring about banking system liquidity and solvency – that, I think, has to be at the top of their minds this week.

Look, if a major institution is lost, you know others will go with it. Look at the stock price of Deutsche Bank. It is at levels that we haven’t seen since 1992 –since 1992. These are liquidity issues. They morph into solvency issues very fast. You can ask Dick Fuld about that. When he was running Lehman as a CEO, on Monday he said, “Everything’s fine, we’ve got plenty of liquidity.” On a Friday, their doors were closed. Was he lying on Monday? No, that’s how fast liquidity becomes a solvency issue, and you literally face your extinction event.

Kevin:We talked about going back 15-16 years and reminiscing. Let’s go back 25-26 years. What were you doing when Deutsche Bank stocks were at this level?

David:(laughs) I was packing my bags for college. You could say, own stocks for the long run, but if you bought Deutsche Bank then, it’s been one heck of a roller coaster ride. I don’t mean to take that theory and completely trash it – owning stocks for the long run. There is a great case for owning stocks for the long run, but I think it hinges on owning the right stocks, number one, and number two, capturing a more ideal cost basis, because if you bought at $11-$12 and rode it to $120, that’s one thing. But if you bought it at $80, $90, or $120 and have been riding it down to $11, isn’t that a little different?

Kevin:And doesn’t that disqualify the current trend of passive investing? The price paid on entry is still very, very important. And the price you get on exit is also important.

David:Yes. You can’t ignore the price paid on entry in the market. An ill-timed entry into the asset class means you’re going to have to wait longer. And the patience variable is something that is regularly tested. Most investors can’t wait, or choose not to wait. There is a part of this that, of course, if you are a dollar cost averager, there is an argument for that. And it is a consistent, routine savings and investment program. You’re not trying to time the market or time a perfect price.

There is value in the consistency, just like there is value in consistently training for something or practicing an instrument. There is a cumulative effect, which may even override the perfectly timed market. But I would still argue that it matters where you are in a cycle. If you can figure out where you are in a cycle, that is very helpful.

Kevin:You mentioned dollar-cost averaging and knowing where you are in the cycle. You never once mentioned what your neighbor is doing. We had talked before about momentum investing. Most people want to do what their neighbor is doing, especially if it looks like it is successful. But if you are dollar-cost averaging, and you understand, to a degree – you’re not going to perfectly know the cycles, but if you can understand, to a degree, what is cheap and what is over-valued, sometimes you’re going to be early, sometimes you’re going to be late. Actually, most of the time you’re going to be early, though, with a habitual investing practice.

David:I would rather be early.


David:Frankly, it is why being early is better than being late for a particular investment theme. In either case, you’re going to have to wait. On the one hand, you’re looking for a catalyst for a thesis. On the other, you’re waiting for recovery of losses after a thesis is already in motion, but may be tested with downside losses, and all of a sudden you’re dealing with the tolerances that you, as an individual investor have, really being what can you endure? Patience either way, but I think patience for those who are early is better than the patience game that you have to play when you are hoping to break even again.

Look, we’ve been in business for 46 years, and the majority of our precious metals clients own gold well under $1000 an ounce, silver well under $8-10. Let’s say, though, you came to the market in 2011 and 2012. Your patience is tested in different ways than the person with a lower cost basis. Even though the thesis for investing in precious metals may have been identical, the psychology of the investor who arrived late is far harder for that investor to manage. And frankly, it becomes less rational over time due to the degree of pain, and if you’re experiencing doubt about, “Was I right? Did I do the right thing? All I know is that it’s not working.” And over time that doubt compounds on itself.

Kevin:Yesterday when I was at lunch having my espresso, which we talked about.

David:Was it Italian Roast?

Kevin:Oh, I’ve got to tell you a story about that. I’m totally chasing a rabbit here but last week after we named the show, you had brought out that it was the Italian Roast and I think we said in the subtitle that it was bitter for the world. I told the guy who serves me espresso – his name is Benjamin and he really takes his craft seriously. I love a barista that takes espresso seriously. I’ve had one in the afternoons for decades.

There are times when he will time me a 19-second espresso and a 21-second espresso, and he’ll say, “Taste the difference.” Or he is really interested in a new roast that comes in. I told him what we named the show and he said, “Oh, you used the word bitter with an Italian Roast?” He said, “Oh, you’re going to get comments.”


Kevin:(laughs) And sure enough, we looked at the comments, and let me just read you this comment. Joel, you know who you are. He says, “It’s not burnt. I repeat, not burnt. When it comes to coffee, Italians like it darker, but it’s not burnt.”


Kevin:Now, I’m not going to read Joel’s last name over the air, but I will tell you it’s an Italian name. Back to the story – I was having my espresso yesterday and was reading a study on willpower that was really fascinating, Dave. I think we, a lot of times, beat ourselves up for not having enough willpower. But if you don’t frame your life with successful habits where you’re not having to make a new decision about everything, you’re going to fail.

There is a study by a guy named Baumeister, and other people have done the study, but he says that there is a limited reserve, a finite amount of willpower, throughout the day. If you make decisions by willpower early on you become more and more fatigued. A good example of that is, I hate to shop. Some people love to go for hours and just look at things. For me, I’m making a decision continually, and I’m exhausted at the end. That’s an expression of making these decisions. I tie in with this because the psychology of the investor who arrived late is far harder to manage.


Kevin:What you and I have both found is that some people will check the prices all day long, and re-question whether they have the right investment all day long, as they watch the market go up and as they talk to Joe down the street. It is an exhausting process. You were talking about dollar-cost averaging. You were also talking about knowing the cycle.

You have also, in past Commentaries, talked about compartmentalizing your life. If you’re going to be a prepper, for ten minutes, go ahead and do your preparations, or an hour, or whatever. Then put it aside. The same thing with investing. If you’re checking the price all day long, actually, in a way you’re taking away from that willpower reserve. Am I making any sense?

David:Yes. Again, going back to the gold market, it doesn’t matter for the person who came late – 2011, 2012, 2013 – it doesn’t matter that gold and silver are well off their 2015 lows. It doesn’t matter that, if you’re looking at a chart, it is building a massive base for growth in the next few years.

Kevin:It is still a reasonable decision.

David:And they may feel like, “Well, I’m still in the red today.” So they’re dealing with the psychology of being a one-time “believer” in a particular thesis, and now they’ve turned skeptical. But keep in mind, facts are a part of the fabric of reality. Feelings add color to the picture. And in many instances, it is unhelpful color.

Kevin:It is an emotional drain.

David:Right, it is. In the chart trend lines for gold and silver, they have held up very well. Sentiment is in a range where you would expect a strong rally. But again, the psychology is different for someone who has owned gold for 20 years versus someone who has owned gold for only the last five to seven. And it’s worth taking account of who you are, because you don’t want to make a mistake in the interim, “All right, I’m just done. I’m done, I waited long enough.”

What is long enough? What makes you think that your timeline is the appropriate timeline? I look at what is happening in Europe and I think to myself, they are desperate to hold things together, and I admire their resolve to keep the whole euro structure in motion. I understand why the ECB and the powers that be in Europe want this to survive, and they’re fighting an uphill battle.

Kevin:Sure. Oh, you’d probably do the same thing if you were in their position.

David:Absolutely, but the challenge is going to be, ultimately, if it’s workable or not. So, do you have the patience to sit around and see? Some people will, some people won’t. But I think this is where, over the next year or two, many of the imbalances in the financial markets, both overseas in the emerging markets, here in the United States, will be revealed, and they will be revealed in ways that are beyond the capability of the central bankers to manage. And in that moment, again, it is – were you early or were you late? And if you’re late, you’re chasing prices again. If you’re early, you have to be willing to be patient. I am, and I encourage investors to be.

Kevin:Let me restate what I think you’re saying. If you’re an investor in gold and silver, cyclically, you’re in a good position. Let’s say you own small caps right now.

David:Right, so back to the small caps today. The investor that may attempt to go the distance – they’re long-term investors, they want to own small caps, they’re buying today – obviously the decision is colored. Again, there is an emotional aspect to this. It is colored by enthusiasm. There is a present-tense ebullience in the market. But the odds are, they’ve just bought at the high, and they’re going to be forced to stubbornly hold. I know the rest of the story here and I think most investors do, too. They will hold until the pain is so great that they throw in the towel, and it will be somewhere near the lows.

Keep in mind, small caps – the NASDAQ is along for this ride, too, setting new highs. And as we see capitulation in the market, again, you have investors who are current tense, they are buying a momentum trade, and they will hold, and they will hold, and they will hold, and they will hold. I will tell you that most people bought on the basis of emotion and not on the basis of fact.

So the contrast here between the small cap investor today and even the gold and silver investor of 2011-2012 – it may have been an ill-timed purchase, but ultimately, there is veracity in the thesis. And the reality that there is fact basing it will serve you well. I’m not so sure that buying small caps at the top of a cycle is a good idea – ever.

Kevin:I got a call from a client that I hadn’t talked to in 17 years. We had lost track of each other. He had moved and he didn’t call with updated information. It was wonderful to talk to him. He had purchased from us in 1999 and he sold in 2001 – had to sell, they were buying property – and he took somewhat of a loss. But we were lamenting because the crowd in 2001 was very similar to the crowd today with gold. Most people today would say, “Oh, why would you be in gold?”

2001 was the same way. He was talking to me on phone and he said, “Kevin, I made a huge mistake. I would be up four-fold right now if I would have just held the gold that I purchased in 1999. But the crowd was not saying that. Now, like I said, he had to sell, he was buying property, but he actually was following the crowd at the time, too. I remember the conversations and he said, “You know, it’s over for gold. Y2K didn’t happen (that was his reasoning), it’s over for gold, and I need to sell.”

David:The real tragedy here is that by the time gold and silver hit their peaks over the next few years, he will have missed not just a four-fold move, but from his cost basis what would have been a 15 or 20-fold move. There is a normal pattern for investors. They buy when there is crowd support for what they are doing. You have the support of the media, you have the support of a broadening investor base, and you have positive feedback everywhere you go, and you’re getting positive feedback from Wall Street.

That adds to the context for what we have sometimes called the Greater Fool purchase, which is buying high and hoping someone else comes in to pay an even higher price than you did. That’s the Greater Fool theory of investing. Very few people – this is the opposite of the normal pattern for investors – are willing to buy low because they risk being alone. Most people think and act en masse. It is the minority who are willing to step outside of their current cultural milieu and risk isolation. That is truly a minority.

Kevin:Isn’t that why we love the maverick scientist who breaks out of the mold? Or the maverick artist? A lot of art that we appreciate today was not appreciated by the culture at the time it was created because the art didn’t fit into the norm.

David:The fact that we have breakthroughs in any field of endeavor means that there is a certain pattern that develops within every field, and that pattern is something like a rut. And then all of a sudden there is the opportunity, whether it is the artist, or the scientist – they are willing to look at things differently. And often they are willing to borrow an idea or an influence from a different field and introduce a fresh insight or a fresh perspective into what they are doing.

Part of the reason I believe we have gone so far down the rabbit hole of debt-driven growth is that all of the experts share a common base of knowledge. There are very few independent thinkers. As I think about the current trend toward moving kids into science and math, everyone wants computers and science, and that’s great. But do you realize the advantage that you have on a broad basis, a societal base, when you have a “liberal arts education” where people have studied literature and history and philosophy. Even if you are a scientist, a scientist needs to know literature. And the writer needs to know something about science. And when you cross-fertilize, that’s when you have a dynamic which brings in new and fresh ideas. But Wall Street today, by and large, is a place driven by consensus.

Kevin:Right. They have a system and they all want to look the same.

David:But that describes the whole world we live in. Beyond Wall Street – beyond those streets, Wall and Broad in downtown Manhattan, consensus is what you study when you focus on any one field to become an expert. There is nothing wrong with being an expert, but understand that you’ve learned a consensus view. You learn consensus views, and very rarely do you find an academic.

Academics live in a peer-reviewed world. Everything that you do is under the microscope from people who have studied the same things, and they want to see how well you studied what they studied. And they check the box and they say, “Okay, you’re okay with us.”

Kevin:You have to be published. You introduced me to Thomas Kuhn’s book on scientific revolution. It has nothing to do with staying in the norm. In fact, sometimes we ask ourselves as humans, “Is this normal?” That question right there is a very non-creative question.

David:If it is damaging, it’s damaging to the status quo. If it’s dangerous, it’s dangerous to the status quo. And that may or may not be truly damaging or dangerous. But Kuhn describes these kinds of consensus outlooks as textbook enclaves – that is more or less the language that he uses – where no one breaks free of myopic thinking until the textbook answers are failing in area after area after area. And as you start counting up all the failures you just think to yourself, “Well, then, what is in the textbooks is wrong.”

Kevin:Einstein did that. When Einstein had his major breakthrough back in 1905, as far as relativity – first special relatively, and then, later, general relativity – he was not studying physics, he was actually imagining himself on the front of a light beam. He also was studying strange math that a guy named Riemann came up with that had to do with what they call tensor math, but it really is typology, it is shapes. It changed his idea of gravity and light and he started thinking about space as possibly curved. This typology that these guys in the 1860s when Riemann came up with this math didn’t think it really existed in the real world, they just thought it was an interesting math logic concept. It turned out that it revolutionized the way we look at the universe.

David:There is the revolution in thinking – borrowing from another idea or field, and bearing the benefit of that in your own.

Kevin:Consensus actually transitions not just from science, not just from the arts, but in investing. But the Federal Reserve – how many academic economists are at the Fed? You’ve mentioned that in the past. It’s hundreds, isn’t it?

David:700 Ph.D.s – 700 Ph.D.s – work for the Federal Reserve. I was interested to read that Ms. Brainard, who is one of the Fed members, has gone here recently from being a dove to being a hawk this year. That is, all throughout the Obama years there was a firm argument from her for accommodation and for easy money, and now she sees the need to raise rates.

Kevin:Let me just point something out, though, Dave. Do you remember three or four years ago when Obama was in office, we went back and looked at the statistic as to how many Federal Reserve members are Democrats – liberals – and it turned out it was over 90%. I can’t remember the exact number, but it was over 90%.

David:It’s interesting, because that may or may not be a factor at all in her perspective. The switch from dove or market-supportive to more tightening of liquidity and market-restrictive – that switch may well be because of unemployment stats and inflation targets being hit.

Kevin:But do you think it could be the elections that are coming up, as well?

David:I don’t know. You do have the employment number, which shrunk to 3.8, actually, 3.75% to be precise. That is the best number since December of 1969. Let me repeat that – best number since December of 1969. It’s ironic that that was the first significant year of decline, 1969, in equities since 1949. So you had about a 20-year stretch of boom and the statistics were the very best just before they went into the 1968-1982 inflationary bear market.

Kevin:Let me repeat so I understand. The employment number right now is as good as it has been since 1969, and that was the peak of the market. Now again, we don’t believe the employment number, we know that they doctor that, but the official employment number right now, 3.8%, is the best we’ve seen since 1969.

David:That’s right. And again, I think statistics are usually very good – very, very good – just before a major turn. Certainly that was the case in the 1968-1969 inflationary bear market in stocks.

Kevin:Let me go back to the political. Could we see some monetary/political decisions coming up here in the next few months based on the idea of maybe getting more Democrats in Congress?

David:I hope that Brainard and the other Fed chiefs are operating according to the numbers, but there is a small possibility that it is political. As a Democrat, put yourself in her shoes. It would be frustrating to see Trump getting credit for positive economic activity, stripping away one of the easy critiques of the current administration as you head into the mid-term elections. Again, the more restrictive you get with monetary policy, the less oxygen there is in the system, and the more likely the financial markets begin to convulse.

Let’s just say, it’s helpful if you’re a Democrat with aspirations for November, to begin to see some hiccups in the stock market. And certainly, as history would be our guide, the more restrictive you get with monetary policy, the increased odds of that get higher and higher.

Kevin:But she still has an argument. She could say, “You know, I’ve done this for a long time, Dave. I think I’m credentialed enough to stick with the numbers and stay objective.”

David:Well, she is credentialed enough to stick with the numbers. The thing that makes me question this is, I think about her experience as Undersecretary for the Treasury for International Affairs. So she understood international affairs and the Treasury Department and the impact of what we were doing on overseas and to these countries’ companies, what have you. And it should have given her a greater sensitivity to the impact of a strong dollar on the rest of the world.

Kevin:Right, so she’s going hawkish – she’s really going strong dollarish.

David:Right. When rates are rising, the dollar generally is strengthening, and that creates a crushing pressure for the emerging markets. And for her to ignore that, or at least diminish the importance of a flattening yield curve here in the U.S., it makes me wonder why. It makes me wonder why.

Kevin:We talk about politics and objectivity. Nancy Pelosi, of course, one of the most objective people that we know – she said strong employment numbers really don’t mean anything – they mean very little.

David:(laughs) No, just totally downplaying the positive jobs number, exactly. “Strong employment numbers mean little.”

Kevin:Okay, so we have small caps numbers hitting highs. We have unemployment hitting lows that we haven’t seen since 1969. In one way you could say, “Gosh, this thing is going really, really well.” And then on the other side of things you could say, “Well, any time that has happened in the past, you’re right on the edge of a recession. Is there a way of measuring timing? People love to ask about timing. Is there a measure that can give us an idea of when the cycle changes?

David:Yes, I think January is a great picture of this for us, because in January you had the Volatility Index, the VIX, getting to single digits again. And we’ve been pounding the table for months, “Look, the lower it gets, the closer you are to crisis.” Now, the lower the VIX gets, the Volatility Index, what it suggest is that there is no trouble on the horizon whatsoever, no one is hedging their bets in the stock market, because there is no need to. So the Volatility Index is better and better and better and better just before it blows up. So to say, “Hey, we’re in a really good place,” frankly, it means nothing. It means that you’re in a very, very dangerous place.

Bank of America runs a list of 19 indicators that signal recession. When about 80% of the indicators are triggered, your recession is alive and well. You’re in the middle of it. You have 13 of the 19 which have triggered thus far, so we’re waiting for two more. And then we have that issue of the past echoing into the present. The context is set. You have the Fed tightening. You have the nearness of recession, which is closer by the day. You have a potential emerging market meltdown, which is ever closer, with the tightening of monetary policy in motion.

What does it feel like? It feels like the music has been playing for quite some time, and if this game is the game of musical chairs, you may be eyeing a chair very, very eagerly. In fact, I would go ahead and grab one. If you can choose a shiny one – I would grab one of those in particular.”

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