The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: David, this is the first time we are getting to talk without a guest in the beginning of the year, and there is an awful lot of stuff going on. Drew has been to Europe now twice, and of course we talked to him and listeners can hear that recording here, but why don’t you talk a little bit about some of the things that are going on in Europe as far as gold and gold supplies go.
David: Yes, I think as we look to 2014 and look back at 2013, there are a couple of things we want to reflect on. One is the tremendous power of Abe-nomics and the redefining of the Asian market dynamics there. The yen is down 17%, the NIKKEI was up, that is their stock market, up 57%. Here in the U.S. one of the defining elements in 2013 was QE, quantitative easing. We had levitation of stock prices in the U.S. and the massaging of that recovery narrative.
Moving back toward Asia, China has really tried to deflate what has become a credit bubble, and we’ll talk a little bit about that this morning, too, really, with no success. You had the more recent audit revealing a 70% increase in shadow banking activity, that’s loans being made around the banking system and side-stepping loan limits, local municipal debts have ballooned over 3 trillion dollars.
Coming back to the United States, you have Obamacare and the tax onslaught which begins this year, actually, I guess you could say it began last year. And also the gold element which you mentioned, we’ve been very active in flying back and forth to Europe. Drew Crowell, who has been with us for 31 years, has been on a plane so many times in the last 3-4 weeks it would make your head spin, in fact, I think his head still is spinning from jet leg, but we were presented with an opportunity by a bank in Europe, liquidating, literally, tons of gold, and it just so happened that there is product in the mix, that, to the non-discerning eye is just ounces, to the discerning eye is just flat-out the best opportunity we’ve seen in ten years. Drew missed the company Christmas party this year because he was on a plane to Germany.
But it is very interesting, the context is creating opportunities, it is also creating pitfalls. And I think that is where, coming into 2014, investors need to be cognizant of both, and make sure that they are stepping lightly, but deliberately, very deliberately, wherever they do step.
Kevin: And we’ll cover all those issues, from Abe-nomics, to QE, China, Obamacare, and then we’ll finish up with what you were talking about on the gold. But why don’t we go ahead and start, then, with Japan, because it is an amazing experiment in massive money-printing, massive money devaluation, with the expectation that Keynesianism would kick in and that corporations would actually raise wages in light of the yen devaluing, so talk about that a little.
David: Japanese monetary authorities and politicians that counted on the corporate sector increasing wages for workers, and that was basically the quid pro quo for devaluing the yen, and handing a massive trade advantage to the big manufacturers and exporters.
Kevin: Sure, if the yen is going to buy a certain amount less, then the expectation in Japan is that they are just going to raise the wages.
David: That’s right. On a silver platter, you have extra profits being handed to corporations and there really was an expectation that if we are giving you the opportunity to make more money as a corporation, you will compensate your employees with an increase in salaries and income and then again, as the quid pro quo, you will then see an increase in consumption, and an offset to the devaluation in the yen.
Kevin: And David, that’s not been happening. The wages don’t seem to be going up. The money is coming right out of their pockets, basically, this devaluation.
David: Right, because the prices of goods and services are rising five times faster than wages, that, according to Bloomberg. The Japanese Times reported that only 17% of companies are planning to raise wages after April 1st. Again, you have a lot that was expected and is not being delivered. There is a consumption tax which increases in April, and is a way of fiscally balancing the monetary largesse, but will be even more ineffective if corporations don’t play ball with that increase in compensation.
Kevin: That seems to be the falling out of Keynesianism in general, David. The powers that be, the academics who are printing the money, saying, “Hey, this is going to be good for everyone,” that doesn’t necessarily follow good business policy. If people are just losing the ability to buy because of the loss of purchasing power of the yen, then it actually turns into a negative for the economy, not a positive.
David: Again, politicians seem to have factored out, if you are monetizing assets, and printing money, and driving up the prices of consumer goods, your wage increase is merely going to make up for loss of purchasing power, as you mention. But come to think of it, this is really how most Keynesians think. If you were to simply hand the money out, sort of the Bernanke helicopter drop, if you were to hand it out, it might go to paying down debt, or it might go into the mattress, so to say, as savings. But by driving up the price of consumer goods, assuming that there is a pay increase, which has yet to materialize, you see any increase in compensation going right back into consumption, so every new dollar printed is hopefully creating this necessary recycling of yen, and hopefully, that’s what starts the engine. Unfortunately, it’s not expanded consumption, but it should, in their strange book, show better GDP. I think this is silly, and frankly, quite sick, but this is the conclusion they are driving toward.
Kevin: And aren’t we driving to the same conclusion? Let’s talk about quantitative easing here on this continent, and David, let me just put this to bed right now, because people are listening to Bernanke, and now Yellen, and we’ll talk about that in a minute, lowering or tapering quantitative easing from 85 billion dollars a month to 75 billion a month. But the reality is, they can tell you anything they want, but it’s averaging 91 billion a month, and right after Bernanke tapered, he printed 54 billion dollars that week, so they can do whatever they want. Now, quantitative easing completely blows out any kind of real price discovery. The price of anything really gets messed up, doesn’t it?
David: It does, and that is where we are seeing one of the major themes of 2013, and we get to deal with the ramifications of it this year. You have price distortions, which really reign supreme. Stocks are bubbling, real estate, in many jurisdictions, back to pre-bust levels, and we think that stocks, particularly, are likely to peak in the first quarter of this year, or by mid-year. Jeremy Grantham sees fair value in the stock market, 70% lower than current levels.
Kevin: So real prices should be 70% lower, according to Grantham. Real value, in terms of what he would consider a compelling purchase, 70% lower. You have Andrew Smithers, as we discussed with him on the Commentary a month ago, 50-75% overvalued now is what he considers the stock market to be here in the U.S. We’re looking at strong corporate balance sheets, and that’s a part of the argument for why QE has been successful, it has helped rebuild balance sheets, etc. But corporate balance sheets, frankly, Kevin, if you are looking at the Dow 30, the big companies, if you take their cash and subtract their debt, you find that there is 500 billion dollars that is in the red. They are in debt to the tune of half a trillion dollars, eliminating their cash positions, netting out cash against debt, still have an overhang of 500 billion dollars in debt. That’s a lot of leverage on the balance sheet.
Kevin: It sounds to me like they don’t have a positive balance sheet. What you are saying is, if you take the debt out, they don’t have positive balance sheets. That would put us in a decline. Wouldn’t that be a recessionary type of symptom?
David: I think what we see is that corporations have been inspired, or enabled, to mal-invest, just like we have criticized mal-investment in the past, where government-funded projects don’t always get the same criticism as the private sector might give to them, and that’s what we’ve seen in China. Well, when you drop capital costs to zero, all of a sudden capital starts getting thrown around on a very free basis, without a lot of intelligent thought going into it. So we do see, actually, quite a bit of unhealthy behavior. I am reminded of Warren Buffet’s reflections back in the 1970s, that interest rates are the key determiner of stock prices. When rates are coming down you have fuel for a major bull market, and you have tremendous growth prospects, and when rates are on the rise you have no such fuel, and the bear market is what you can expect. A declining trend is what you can expect, in the context of rising rates.
Kevin: So when we’re talking about 2013, rates are almost at zero right now, Dave, and have been, but they have been rising. That seems to be the trend.
David: Yes, you consider the events of 2013, what I would describe as a bought rate, not a market rate, but something that was manipulated, the ten-year treasury reached a low of 1.5%, and has since doubled to 3%. This is, of course, a big increase, a doubling of the rate. That is with the expectation of tapering to a small degree, and what should occur, if the Fed gets out of the business of interest rate manipulation, buying more than a trillion dollars’ worth of paper assets a year, is it fair to say, rates moving higher? And that goes back to Buffet’s notion that you have headwinds to growth when you are in a rising interest rate environment. So it’s a Catch-22. Government would like to move away from a very ineffective stimulus policy, that is, quantitative easing, and yet, the consequence of moving away from it is the rise in rates, which represents not only headwinds for growth, but definitely, a black mark for the U.S. stock market.
Kevin: One of the things that has kept interest rates from rising, as you have spoken, is the quantitative easing. If we don’t have to go out and offer competitive interest rates to the world to borrow money, then we buy it ourselves with this quantitative easing. I read something the other day, Dave, that was fascinating, that up until 2008 the Federal Reserve’s balance sheet was about 800 billion dollars, so for almost 100 years, the balance sheet, the amount of debt that the Federal Reserve purchased and held, was about 800 billion. At this point, they have been adding a trillion dollars a year to that, so they are adding 100 years of debt every year to their balance sheet. They are starting to realize they can’t do that forever.
David: And as we’ve mentioned, I think, in last year’s DVD, this notion that 5 trillion is really a critical point, where the rest of the world begins to take notice and say, “Hey, wait a minute. This can’t go on forever. Extraordinary measures on a short-term basis we understand, but addressing structural problems with this sort of bailing wire and chewing gum approach, no, no, no, this is far to excessive.”
And Kevin, there is a theme in the stock market that I think is worthy of note, going back to some of the considerations of interest rates. As we mentioned before, corporations have engaged in record share buy-backs this last year, with increased earnings, non-organically, but by reducing the supply of stock shares outstanding.
Kevin: Explain that just a little bit. When you own a corporation, or when you own a stock, what you are owning is a percentage of a share of shares, but if the corporation is coming back in and buying those shares up, it is reducing the overall pool, correct?
David: Each quarter we hear this report from companies that says that we have made X number of dollars per share. So let’s say a company makes $100 and they have 100 shares, you made a dollar per share. But now all of a sudden, if you shrink the pool, if you shrink the number of shares outstanding to 50…
Kevin: Then it’s two bucks a share.
David: You made two bucks a share, and you’ve increased your earnings per share from $1 per share to $2 per share, and it looks like your earnings per share growth is off the charts. All you’ve done is manipulate the one variable there that you are dividing by, so it’s an easy way to financially engineer a result that is easy to advertise. The media loves it. The media says, “Look at the growth. We’re seeing earnings-per-share beat expectations. It’s up, it’s up, it’s up, it’s up!”
Well, QE sets the environment for this kind of misallocation of capital. You have cash instruments which yield nothing, and should cash positions grow, you have investors who start complaining about company assets doing nothing. “It’s just sitting there doing nothing. Why aren’t you spending it to grow the business? If you’re not going to grow the business, then give it back to us.”
Then come in your activist investors. These are the folks like Carl Icahn and others who take a major chunk of stock and start insisting on one-time dividends or share buy-backs or things like this. And when you look at, this year, the impact of these buy-backs, nearly 60% of the increase in the S&P 500 earnings is attributable to buy-backs.
Kevin: That’s astounding, Dave. What you are saying is 60% of the increase in earnings is actually just this reduction of the size of the share pool by buy-backs.
David: Yes, so this is where we have reason to be concerned about current valuations in the equity markets. When buy-backs are such a significant piece, it’s not an increase in revenue, then you have companies like Merck. You have the drug manufacturer facing competition from generic manufacturers. They are not willing to increase CAPEX spending, and so instead of filling the pipeline for tomorrow’s products, they increase their share buy-backs.
Or Fedex. This week, they borrowed 2 billion dollars to buy back stock at an all-time high, and again, this is partially driven by activist investors. I think it is also driven by executives who want to capture a better benefit. They show earnings-per-share is through the roof!
Kevin: Well, I would feel like I was brilliant. If I was running a corporation and I doubled the earnings-per-share, what an amazing thing!
David: Particularly if compensation is tied to it, which is what Andrew Smithers was getting at, he is saying, basically, we have misaligned corporate and executive pay packages in such a way that they are going to play with the numbers and if you don’t appreciate that the numbers you are looking at have been fudged by corporations all around the world, then you don’t understand the game that is being played, and it starts with corporate remuneration, or boards that have put remuneration packages together that reward this kind of behavior.
Kevin: You mentioned Carl Icahn. There are large holders of shares that know when to actually sell out, and wouldn’t this be an occasion where you have the large pension funds and the inside kinds of guys saying, “Hey, I’m going to use this as a way out.”
David: Certainly. When you shrink the number of shares, yes, you may rig financial results and attract Main Street investors because it gives the media something to really trumpet and say, “Look how well things are going here.” And so it does bring sort of the lemming trade into the market. But this is a part of an exit strategy, in our opinion, for large holders of big blocks of stocks, to be able to exit the market. And you are able to do that, both on the back of Main Street money, which is lured by positive quarterly results, and corporate capital, which has no other better place to go, and so it is being put to, in our opinion, a bad use as share buybacks. Give them the liquidity they need to exit major positions.
Kevin: Okay, Dave, but companies can only do this so long. What happens if buy-backs slow down at this point?
David: What you have is hundreds of billions of dollars this last year, which has goosed the market higher. One of the largest contributing factors to the stock market moving higher has been, literally, hundreds of billions of dollars’ worth of share buybacks in the year 2013, and if you take away the hundreds of billions of dollar’s worth of buying, where does the market go? Do you have the requisite energy to get stocks higher still? You really hope for that many more lemmings to replace the corporate capital that was spent in share buyback schemes.
Kevin: And I hate to say it, Dave, but that’s usually when the guy you talked to who says, “You know, every time I buy a stock it goes down.” Well, usually they end up buying stocks after the rise, the last 10-15% of the rise.
David: Right, so who are the patsies that buy the last 10% of the move? If you look at the top 100 companies out of the S&P 500, which have been buying shares back, the outperformance of those shares since 2009, the lows in 2009, is by 50% compared to the index. So tell me executive bonuses don’t factor in. This is, again, the theme that we discussed with Andrew Smithers. If you haven’t spent time listening to that discussion, by all means, visit the archives. It’s too important. And without those insights, you may conclude, in error, that the improvement in the stock price that we have had over the last 6, 12, 18 months, is an indication of economic recovery. Not so.
Kevin: Well, speaking of recovery or non-recovery, we have Ben Bernanke now out, Janet Yellen has now been confirmed. What are we looking for? Everybody was saying she is just going to be a dove and print and print and print.
David: We’re looking for the dawning of the Age of Aquarius. That’s what we’re all looking for. (laughter) We’re looking for world peace. We’re looking for our grandma to bake apple pie or cookies when we get home from school, with a nice glass of milk.
Yellen has been confirmed, and actually, in all seriousness, she may surprise us with far more aggressive reduction of QE. You have the media which will herald the triumph of central banking, and central planners the world over will be reinvigorated, looking at this sort of apparent success story. The further reduction in QE, in our view, is coming from a bubble in the making, in the stock market, not as a success story for an economic recovery. We haven’t seen that in the jobs market. We certainly haven’t seen that on Main Street. We’ve seen it on Wall Street and the recovery for the 1% has been very robust, but for the 99%, not so much.
So again, we have bubbling activity in the stock market, we’ve got inflationary expectations which are now shifting, and we have corporate lending which is reaching extreme risk levels, where junk is the new black.
Kevin: You’re talking about junk bonds as the new black.
Kevin: You look great in junk bonds, by the way.
David: Well, thank you. My portfolio looks very nice with that 7% yield in junk bonds, everyone has to have it. And this is, I think, what the Fed is actually looking at, as opposed to what they are talking about. They talk recovery, but what they are actually looking at is the stock market moving up and up and up, inflationary expectations beginning to shift, corporate lending at risky levels, where even a junk bond issuance is getting massive over-subscription. There is too much of a fever pitch, frankly, a little too much going on in the credit markets for us to be comfortable with. The quality, your covenant-lite loans. The percentage of covenant-lite loans, this is like a rehash of 2007, where you don’t have to have any money down, you don’t have to have any assurances, no skin in the game, there’s money available.
Kevin: This is exactly what created the real estate bubble in the first place.
David: It’s the consequence of easy money, and this is really basic, but QE and the theme which started out in 2013, and is being sold to the general public as our great salvation, and the means by which the economy is recovering, is, in fact, the very same thing that brought us the collapse in 2001 and the collapse in 2008.
Now, just to sort of offset this, you do have the Fed’s reverse repo facility, which is gearing up for a drain of liquidity. I think they know they’ve put too much liquidity in the system. The question is, how do you eliminate it? Can you eliminate it? And you’ve already got fixed-income buyers and money-market funds aiding the Fed, again, through their reverse repo facilities.
Kevin: If interest rates actually do go up, and that’s what we’re talking about here, when we talk about tapering quantitative easing, and we talk about a drain in liquidity, we are talking about interest rates having to rise. How does that affect corporations?
David: You have 427 billion in corporate financing which will have to be rolled over, it’s coming due in 2014, and that means that rates at a very low level would be ideal.
Kevin: So you’d want to lock it in now if you think rates are going up.
David: Absolutely. But the Fed’s indicated course is signaling the opposite, that, in fact, rates are going higher, and won’t be low, and may not accommodate a 2014 rollover of 427 billion dollars in corporate bonds. Corporations have been very savvy in terms of refinancing their debt, and this is where, again, you look at corporate growth and how their numbers have improved, and you see, going back to Warren Buffett’s comment that interest rates are everything in the stock market, everything in the stock market, how much of corporate growth in recent months has been driven by sales or improved revenues? When you look back to 2000 you have corporate net profit margins which are up about 8.3%, you have total employee expenses which are down about 8.1%.
Kevin: Which makes sense because unemployment has not been solved.
David: Sure, and so the “increase in productivity” goes in lockstep with an increase in unemployment. Each employee that you retain is that much more productive because they have to do the work of three people. This is the point. The net interest expense from the year 2000 to present is down 41.7%. The cost of capital or interest rate trends are the key to equity prices over the next decade. Keep them low and this game might continue. Lose control, and it’s game over for the equity investor.
Kevin: Dave, this may seem like it’s from left field, but just statistically, Piper Jaffrey’s research has shown that mid-term election years, the average decline in equities is 17% and they go back to 1930 with that study, so take all this stuff out of the equation and just say, “Hey, we’re sort of in a mid-term election year. The average decline has been 17%.” This is a good year for a peak in the stock market, isn’t it?
David: It is, whether it comes in Q1, Q2, we do think that it comes early, and that this is a tough year, this is a tough year. An encore to 2013, that’s a tough one to pull off.
Kevin: And one of the bright spots, I guess, growth-wise, this last decade, has been China. Everyone has been looking toward China because the growth rate has been spectacular. You’ve weighed both sides of the equation on China. You’re positive in some ways, and you are negative in some ways. What is your thought for 2014?
David: Right. Well, and 2013 highlights, where we were, and where we are going in 2014, as you’ve mentioned, negatives, positives, we look at all the sides we can, and try to figure out what, exactly, outcomes will be. There are transitions afoot, which, if they are successful, will redefine the global economy with China moving up the ranks. However, and this is a big however, the transitions require a political will which may or may not exist. And so if politicians cannot gather the gumption to sacrifice some of the vested interests in the state apparatus, it’s not going to happen.
Kevin: And what we’ve seen over the last few years in China, a lot of it is government investment in infrastructure, is it not? I mean, that’s where the growth came from.
David: Exactly. The economic gap created by the 2008 crisis was filled by government investment in construction and infrastructure, and this allowed China to show growth figures while the rest of the world was contracting, lacking growth in that 2008, 2009, 2010 period. It was, and is, artificially stimulated growth. Now the question remains, what becomes of all the project financing put in motion in the context of the crisis? Just as we had in the West, a credit blowout circa 2006 to 2008, with multiples of official or balance sheet debt. Again, it was the official debt everyone knew about. Then there was the non-official debt, off balance sheet debt, what is known as the shadow banking system, through financially engineered products which allows for even greater systemic leveraging. Well, so too, China has expanded its official, and its non-official debt. As we mentioned earlier, you have a 70% increase in shadow banking activity, and with loan limits being completely ignored or worked around because of the shadow banking activity, we now find, in the most recent audit, local and municipal debts ballooning to over 3 trillion dollars.
So this, again, is where you weigh positive and negative. You can see a masterful chess game being played, and the right decisions being made on paper. There is always a difference between the ideal plan on paper, and how it’s implemented, and I think this is, again, going back to that British phrase, “Many a slip between the cup and the lip.” There is many a mistake which can be made from the paper planning process by the politburo (say that ten times) and then the implementation of those policies. Couple this with the rising risk of Japanese confrontation and really, you know what you have in 2014? You have an echo of 1814. You have an echo of 1914. These time-frames where, if you looked back, you had only positive prospects, and then things went south very quickly.
Kevin: I think that’s important to point out, because when you look at 1814, I’m thinking especially 1914, Dave. There was a great article in The Economist a couple of issues ago, where he was saying, You know, if you were in early 1914, you’d think everything was absolutely perfect. You had a globalized world, we had a gold standard at the time, nations were trading with nations, John Maynard Keynes even wrote a little piece that said, I can sit in bed and use this new item called the telephone, and actually order things from all over the world. My gosh, that sounds exactly like now.
But there were tensions brewing that could be changed simply by just a couple of alliances breaking down and it seems that China is starting to beat the war drum.
David: I think that article in The Economist that you mentioned, late December, 2013, is a must-read, looking at parallels between 1914 and 2014. Since the 2008, crisis China has become much more aggressive, after decades of practicing “go along to get along” kind of attitude and Deng really set that in motion, Deng Xiaoping, where he basically said, “You know, listen. We’re not going to cause any waves. We’re not going to invade Taiwan. That would just create problems for us. We will saber-rattle, but that will be the extent of it.” That go along to get along has come to an end as of 2008. We have China reasserting its claim to Indian territory, that’s the Arunachal Pradesh region, and you’ve got the declared sole rights to the Senkaku Islands. You have the unequivocally claimed vast tracts of the South China Sea as Chinese territory. All of these things are very bold, and they are outward moves after decades of sort of an internal focus, “Let us do our own thing, we’re not going to make any waves.” And again, that meets with some degree of friction when you have the same sort of nationalist saber-rattling with Japan.
Kevin: And Dave, we had James Rickards on the program, and I’d like to have him again, because he talks about how war can be fought with currencies. We talk about laying claim to these areas of geography that they say they hold dear, but actually, the tensions are building with the currency war with Japan. They threw down last year, when they drove the yen down they forced another exporter of goods to also have to devalue its currency, and I’m talking about China.
David: Oh yeah, far more important than laying claim to the Senkaku Islands is laying claim to a slice of global GDP that belongs to your neighbor. So you add to the geopolitical pressures between China and Japan, the steep devaluation of the yen in 2013. That’s a 17% drop in the value of the yen, and you have the makings of a competitive currency war between these two manufacturing and exporting giants. Japan was displaced by China. Think about the sequence! Japan was displaced by China as the second-largest economy in the world, and shortly thereafter, the Japanese government begins Abe-nomics. Devaluation, with the intent to improve exports, at the expense of trade competitors.
Kevin: Yes, and that’s what Jim Rickards talks about. He said there’s no way that you are going to improve one country’s exports without taking something away from another country.
Okay, speaking of taking away, and this is painful, I hate bringing this concept up, I don’t even like seeing it in the paper.
David: It’s like surgery without anesthesia.
Kevin: People are calling, they’re saying, “How’s is going to affect me?” You know it’s a tax increase, I just don’t understand all the tax increase.
David: When in the history of government benefits have we ended up with anything other than a veiled tax hike? Every major program as you go back to the Johnson era. [My son] Declan and I were going up to the ski area the other day and we were talking about LBJ and the Great Society programs, and how you promise a little, and all of a sudden that little bit of a promise represents this huge slice of GDP. It’s a major part of our economy, and again, it was nothing more than a veiled tax hike. We’ve had that over, and over, and over, and over again.
Kevin: And it’s never reduced. Let’s face it, they’ve never shrunk a government program.
David: No, so you have higher health care premiums, that’s a given. Then you have new taxes and fees. Heritage Foundation has reprinted this, worth going to their website, heritage.org, and looking at the increased cost of Obamacare. This comes from the joint committee on taxation and the Congressional Budget office, and they highlight 18, to be precise, there are 18 various tax increases and fee increases. You look at it and you just say, “Oh, my word, what have we done to ourselves?” Including a 10% excise tax on indoor tanning services.
Kevin: Right. Except let’s face it. Anyone under 18 is not going to actually…
David: (laughter) Right, at least in the State of Illinois, you’re right, because one of the many new pieces of legislation that is being put in place in 2014 is that in Illinois, minors can no longer go to tanning beds.
Kevin: So we don’t actually always have increased taxes, we also have tax breaks going away. I know there are few that are going away this year.
David: 55 tax breaks disappeared December 31, 2013. Then, getting away from Obamacare, but 40,000 new laws which take effect this year. That’s state lawmakers that have put 40,000 bills in motion for this year. And I know this is a long way from Obamacare, but it’s boggling my mind. You have California, which is approving high school students using any bathroom they choose, claiming that gender identity trumps birth identity. Junior high boys? You choose which bathroom you use? This is insanity! This is just frankly not even common sense. I appreciate being sensitive to everyone and trying to be PC, but this is just simply insane.
Kevin: Dave, you talk about 40,000 new laws, what it reminds me of is a book that we have on our list of required reading on the website, it’s Fredric Bastiat’s The Law, and what he talks about is civilizations and societies that move from moral and ethical understanding of the law, have to have a law for everything, and what he says is, you really can look at a society and judge just how free they really are by the thickness of their law book, and unfortunately, 40,000 new laws is showing me that society is running out of control.
David: It is running out of control, and it is also being defined by what Bastiat described as legalized plunder. That’s probably, in my mind, the most important book in the law, is how the law is used, either to protect you, or to abuse you, and the fact is, the law is not neutral. It can serve the greater good, and it can serve mankind, or it can serve as a baseball bat, and that is what legalized plunder becomes.
Kevin: Speaking of plunder, this takes us to our point on gold. Things started to change last February when Germany asked for its gold back. They said, “You know, go ahead and send a little bit of the 600-700 tons back to us.” The United States government came back and they said, “Well, okay, we’ll do that, but it’s going to take 7 years.” Now, has something been plundered on this side?
David: Well, that’s what’s interesting. I think there are high-stakes games being played here, and if people aren’t paying attention to the nuances, and the themes between the lines, you are missing exactly what is happening in the geopolitical spheres. You have Venezuela and Germany requesting ounces to be delivered. You can sum up the gold market in 2013 and say, “It stunk, it stunk, the price went down.” But there are really interesting stories in the context. Venezuela and Germany request the ounces that they have stored in “safe locations” in the Western World, and very suspicious futures trading begins immediately. And then you’ve got a market beating in the metals space, which was accompanied by panic selling from investors who are only recently purchased the asset, probably for all the wrong reasons, chasing the price. Obviously, the price moved up 60% in one year. And just like Bitcoin today. Show me a positive rate of return and I’m going to chase it. That’s the way most investors behave. “What is this about Bitcoin?” The same attitude pertained to gold, fall 2011, “Tell me more about gold, tell me more about gold. I don’t know anything about it, but the price is moving up. I’ve gotta own some.” The general public started to come into gold, late in the game, and again, they got their heads handed to them. They came in for the wrong reasons, chasing a price trend, and not understanding why you own it, from a fundamentals standpoint, why you own it as an insurance policy embedded in your total financial picture.
Kevin: And this isn’t new. Games have been played. We’ve talked about the 1970s.
David: Yes, the IMF gold sales. They were announced in the 1970s. That was the, if you want to call it, impact news. It was intended to drive prices lower. That has had a diminishing negative effect, then and now. In this year’s DVD we are going to highlight several of the factors impacting gold demand, along with investor demand, consumer demand, and one of the things that we are going to detail is also central bank demand. This is very interesting because we have central bank currency reserves at a new high.
Kevin: You’re talking about currency in the form of fiat currency.
David: That’s correct. And it’s easy to increase the currency reserves that you have when you have no limitations in terms of your printing presses. We’ve gone from 1.6 trillion dollars, according to the IMF, in 1999, that was total global central bank currency reserves, 1.6 trillion in 1999. Now, we reached a new high, 11.4 trillion.
Kevin: Unbelievable. So for hundreds of years they built up to 1.6 trillion dollars, and then in 13 years we’re up 7-fold.
David: 7-fold. So the U.S. dollar now accounts for 61.4% of all currency reserves. That’s down from 65%, what it was at the peak of the crisis in 2008. You have expanded holdings of the euro. You have smaller holdings of the Aussie dollar, the Canadian dollar, the British pound, Swiss franc, etc. Just something I want people to know. UC Berkeley is holding a gathering for young central bankers, here in the next couple of months, from around the world, it’s co-sponsored by the World Gold Council, to discuss how to incorporate gold into the mix of reserve assets.
Kevin: Isn’t that interesting. We’re starting to see the soundings of a return to a gold standard, per se.
David: Well, then I would say, not a gold standard, at least if Barry Eichengreen is giving the presentations, because he hates the gold standard with a passion.
Kevin: Well, you’ve talked to him about it on this program.
David: And I guarantee you he’s one of the main presenters. He’s a professor at U.C. Berkeley. He has to be a part of this conversation.
David: Yes, so U.C. Berkeley is hosting it, the World Gold Council is a part of it. Really, what you are looking at is long-retired central bankers, coming from the Bretton Woods era, 1944-1971. They understood the centrality of gold. But since 1971, bankers have lost touch with gold as a primary reserve asset, and you can see that as it is reflected by the very, very low percentage allocations to gold amongst the developing markets, your emerging markets, as they call them. The legacy holdings that we have in the West? This is stuff we’ve owned, Europe and America, it’s not like Italy has been out buying gold in the last 10-20 years. This is the stuff that they were able to acquire before, or immediately after, World War II. The same with American gold. Our 8,000 tons, plus or minus, was product that we owned, again, World War II. We actually owned quite a bit more than that, and that’s we closed the gold window in 1971, because we saw it rapidly going in the direction of Europe.
So, we have this coaching, which is now available for these freshman central bankers, as to how to manage gold as a reserve asset. And the only downer, as I mentioned, is that the short course is going to be partially presented by Barry Eichengreen, who, no doubt, has done more to shape the Wall Street view of gold as a waste of time than anyone else I know. At best, the gold exchange standard is what Barry will present as the most reasonable approach.
Kevin: Which isn’t really a true gold standard. That’s what we went to in the 1920s, right?
David: That’s right, the Council of Genoa in 1922, we came off of the gold standard and went to the gold exchange standard, and what they basically were able to do is say, “Listen, we’ll have some gold in the mix, yeah, yeah, yeah. But for the ease of convenience, the sake of convenience, and safety, transport costs, all of the rest, when you put that whole ball of wax together, we want paper assets as reserves alongside gold. So the main fudge factor in the 1922 Council of Genoa was that they introduced paper into the gold equation. Now, they’re moving backward toward gold because they think they’re dealing with a paper equation which is, as we speak, being discredited. We have a growing sense of dread as it relates to currency devaluation. All central bankers can look and say, “Gosh, what happened to the Turkish lira this year? Down catastrophically. What happened to the yen this year? Down catastrophically. What’s happened to the dollar over the last ten years? Down catastrophically. These trends inspire a return to something solid, but no one really has the intellectual framework anymore for understanding how gold fits into the picture.
Kevin: And let’s look at central bank activity just over the last 16 years, because we’ve talked about this with what’s going on with Drew going back and forth to Europe. The Bank of England, back in the late 1990s, horrible timing on their part, great timing on ours, we were able to accumulate a large amount of small gold coins that had been put in reserves, maybe 50-70 years before. The Bank of England then was almost out of gold, but the other central banks had been net accumulators of gold, so we have been in competition now with the central banks. They’re buying gold, China’s buying gold, Russia’s buying gold. So what makes this unique, Dave, is you’ve now got a commercial bank, we can’t name the country, we can’t name the bank, but they are actually divesting several hundred million dollars’ worth of gold and we are taking advantage of this stuff that hasn’t seen light in over 50 years.
David: I love this because, again, we’ve been operating in Europe for many years now, ICA Europe is one of our companies over in Brussels, and it has put us in the position to be able to look at product which comes available on short notice. This was something where, literally, our coin buyer, we were getting ready for a black tie event, our normal company Christmas party, and we get a call from Germany, and they say, “If you want it, you’ve got to look at it. We’ve already sold the first tranche to Russia.”
Kevin: And we lost our poet. The Poet Laureate of the company, which we only hear a poem each year at the Christmas party, is Drew Crowell, our numismatist, and he was gone. He had to go to Europe.
David: So we have been very active in Europe, buying from this commercial bank. I think it’s ironic. I think it’s absolutely ironic, because this is a bank that used these as reserve assets. They used them as reserve assets, but what they used them for was, for them, a compelling part of what their total business plan was. “We’re going to have it as a reserve asset but we’re going to lease it out and collect an income stream from it.” Well, compliments of the ECB, and compliments of Ben Bernanke, compliments of the world’s central bankers, rates, both lease rates for gold, and interest rates across the board, have been pushed so low that their primary justification for having gold as a reserve asset for a commercial bank…
Kevin: Which was interest…
David: Earning interest, on loaned-out product, just went away. So they decided, “We’re done with it. Get rid of it, let’s move to paper, we can get rid of the ounces.” And literally, we’ve moved from one man’s trash is another man’s treasure, and we’ve found, again, product that is 100-150 years old, and it’s in original mint condition. We’re pretty excited about it.
Kevin: And as we talked about before, you can listen to Drew’s interview, it’s about a 20-minute interview, just click on the link that we have one the main page here for this particular program today.
David: And I think it comes at a compelling time, because we’ve got prices … let’s take worst case, best case scenarios. Worst case scenario, let’s say we’ve got gold that goes to $1,000, you’ve got 20% downside. Best case scenario, you’ve got a 400% return ahead of you. And I think this is exactly where we were circa 1999, 1998, when we saw similar product, found similar product in Europe, placed similar product with our clients, and anyone who bought that product from us in 1998-1999.
Kevin: They’re still at quadruple, even with the drop this year.
David: So, I am just smiling from ear to ear, looking at this and saying, “This sounds so much like history. This sounds like a repeat of where we were 10, 12, 13 years ago. Providence that we were able to find the product, and I think the pricing structure in the market is brilliant. We assumed that we would have to pay huge premiums to buy this product, because that would be the only thing that would get it out of the hands of this commercial entity. We’ve known about this deal for a long time, we just thought they would be selling it for other reasons. We didn’t think they’d be scuttling it, asking for virtually no premium for the product. THAT was the coup, as far as we were concerned, is that they fell prey to Société Générale. They fell prey to Goldman-Sachs. They fell prey to all of the gold reports that have come out and said, “Nope, it’s a ridiculous relic of the past, you don’t need it, nobody wants it, can’t earn anything on it, might as well get rid of it before it goes to zero.” That’s the attitude that is out there, and we’ll take the other side of that bet.
Kevin: Okay, Dave, we’re not making price predictions here on gold, we’re just saying, it’s better than the dollar, and at this point, this may look like what we’ve seen in the past before a large move.
David: So I would suggest that when you look at 2014 you have to keep in mind the unintended consequences of Abe-nomics, the unintended consequences of quantitative easing here in the United States, the unintended consequences of China trying, and unable, to deflate their credit bubble, the unintended consequences of Obamacare, and I think this is an era where, yes, you want to make sure you have adequate insurance, not too much, but certainly not too little, in the insurance category, what we consider precious metals. Right here, right now, 2014 is the year of unintended consequences.