The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: David, the system is broken. I want to talk about gold today, I want to talk about the stock market, I want to talk about the economy, maybe what is going on with the Federal Reserve. But all of those things really show the pricing in the gold market, the pricing in the stock market, show that the system is broken and it is being manipulated.
But let’s go to politics just for a moment, the fiscal side of things, because I know what great pain you go through on April 15th. As a small business, you pay between 35-50% of what we make, in taxes. I don’t think the big boys do that.
David: Those taxes are going into the federal coffers, and we are a part of the fiscal solution, not a part of the fiscal problem. The problem we see, and this is supported by the government accountability office this week in a report on corporate taxes, and it shouldn’t come as a shocker, but it is a very good reminder of why we are going broke. Entrepreneurship, epitomized by the small business owner or manager, which is paying 35-50% in taxes, while major U.S. corporations pay an effective tax rate, according to the GAO study of 12.6%.
Kevin: We are talking the GEs – well, actually, GE doesn’t pay anything. (laughter)
David: 7%, and that’s a bad year.
David: And that’s the reality. We have this support for corporatism via the tax code and all the loopholes that exist there. If you wanted to clean up the system, if you wanted to destroy K Street, if you wanted to see lobbyists starve – imagine, this is a bright, bright world, where are no lobbyists, where maybe we would even have tort reform.
Maybe I’m getting ahead of myself here, but this notion that Steve Forbes has promoted, that Bill King has suggested, that you move to a flat tax where everyone pays the same thing. I’m not saying that anyone should have any greater, or less, advantage, but what we have today is a system where if you can afford to have a team of 20, 30, 50 – GE has 1000 – accountants and lawyers working on your tax strategy guess what? That puts them at an effective rate of less than 7%, and here the average for corporate America, the big, fascist corporatist models, are running at a 12.6% rate. You aren’t going to find conservatives really pounding the table on this because they like the notion of low taxes. I like the notion of low taxes, too, but I do, also, in the business community, like a sense of fair play, and that does not exist today.
Kevin: Dave, you know, the lobbyists would starve. They would have to go find another job, because their whole job is to keep the large corporate taxes down. In fact, you had mentioned corporatism. Mussolini said corporatism is fascism is corporatism, vice-versa. But on everybody’s mind who is listening, gold, last week, went to $1178.
Kevin: Ow, ow.
David: Yes. Do we like gold? Now, more than ever. First of all, I think it is really worth reminding listeners of the fragility within the financial system, and the need for insurance in this context. We are going to juxtapose a number of things, here – the derivatives market, the bond market, the equity market, and then come full circle and we will look at gold as well. But just as an illustration, you have the derivatives complex, and again, sensitivity within the derivatives complex to changes with interest rates, specifically – the year-end, the bank of international settlements out of Basel, Switzerland, puts together their report.
Of course, it is mid-year and year-end, so the first half and second half, all we have is December’s numbers until we get June’s here in the next couple of weeks, for this year, 2013. December, 2012, we have 489 trillion dollars value. And the BIS assumes a gross market value in that same category of a smaller number, about 18.8 trillion. What we are talking about here is just the section in the derivatives market which is sensitive to changes in the interest rate market.
Kevin: Which is something we have been talking about, because we saw some changes in the interest market over the last week or two.
David: Interest rate volatility leaves one side or the other in those derivatives transactions exposed to losses, and that is what those transactions, that is what those contracts, are about, insuring against risk. Well, that means that risk is removed from one party and it is taken on by another, and you have entities which are paid to re-insure, if you will, or take on that risk.
That is the reality, with any change in the interest rate structure, particularly, a volatile or quick change in the interest rate structure, you are going to have winners and losers – big winners, and big losers – and the problem here is the scale of it – 489 trillion in notional value.
Kevin: That is almost half a quadrillion.
David: This is the point. The financial system today is so incredibly complex and the scale of the bets that have been made continues to boggle the mind. To assume that you can be, as an asset allocator, or as an individual looking at gold, somehow neglectful of the risks implicit in the system, this is where, price – set it aside, set it aside. How many ounces do you have of real money, stacked against something that is completely unreal, but has real ramifications in the financial system – 489 trillion in notional value? So we have the financial and banking system, which have effectively mis-priced risk.
Kevin: Well, let’s face it. David Stockman, we talked to six weeks ago, and recently, James Rickards of Currency Wars. Both of those guys pointed out that we have complete lack of price discovery. This thing is so manipulated by the Fed that you don’t have a real price for anything right now.
David: First of all, you have interest rate corruption, and I call it interest rate corruption because that is exactly what it is, by the Fed, and by various central banks globally. And of course what we are talking about is that they have set benchmark rates well below what we would call equilibrium for the natural, market-determined level. We don’t have interest rates today that are market-determined. They are market-manipulated by the various world central banks, that is number one. Number two is that on the basis of asset purchases, we have been given the impression that there is really normal supply and demand in the marketplace, with prices reflecting actual buyers and sellers. I guess you could say there are actually buyers and sellers – the sellers of assets are real enough. But on the other side you have the Fed, as a buyer, and I guess they are real enough, too, but we are talking about virtual money. We are talking about credit that is created out of nothing for the purpose of buying these assets.
Now, is there some bit of unreality where it is not an actual buyer, but sort of a synthetic buyer? The Fed balance sheet represents synthetic buying in the financial markets. Again, we don’t have prices reflecting normal supply and demand, and yet investors go about their work-a-day world, saying, “Here’s what the Dow is, here’s what the S&P is, here’s what a 30-year Treasury, 10-year Treasury, a 10-year Treasury is priced at,” and they assume that they are getting real information, real time, and that it has meaningful content in those numbers when, in fact, it is a distortion.
Kevin: Talk about a distortion. The Federal Reserve, what do they own, 70-80% right now of U.S. government debt that is going to market? What is the percentage that they are buying?
David: 85.7 is the last number, according to John Williams of Shadowstats. That’s what they are buying in terms of new issues from the Treasury.
Kevin: So they can pick the interest rate they want, because they are basically saying, “Look. We’re going to ruin the value of the dollar over time, by just printing money, and then keeping interest rates unnaturally low.”
David: I mentioned this a few weeks ago when we did our 3½-hour Q and A. If anyone hasn’t listened to it, it’s available on YouTube. You can go question by question and self-select. If you’re not interested in the full barrage of questions, you can choose the ones that you are most interested in. But one of the comments that we had there was that on that particular week we had a major spike in the 10-year Treasury, and that same week we had the Fed step in and buy 54, almost 55, billion dollars’ worth of mortgage-backed securities and Treasuries.
A major spike in interest rates, even while the Fed is doing everything that it can to keep a lid on it. It’s a little bit like the steam cooker that just blows. You think that it’s under control, you think that the valve is operating and the valve is letting off what is necessary, but everything is still in a controlled environment, and yet in spite of the best efforts of the Fed to control this, you still have the top blowing off. That is a scary circumstance to be in.
Kevin: Let me ask you a question then, Dave. Can the Federal Reserve taper, can they really change their policy substantially? We have so much debt. How could we possibly pay the interest on the debt if it goes to natural levels?
David: Not only is it not really an option here in the U.S., but you have central banks around the world that continue to accommodate with exceptionally low rates. And their monetization process, similar to ours, is necessary to influence the yield curve, to influence the cost of capital. According to the Bank of International Settlements, government nonfinancial, corporate and household debt globally, set at about 340% of global GDP.
Kevin: So this is global GDP, times that by 3½, and basically you have what the debt is.
David: That’s the debt that has to be paid out of global GDP, the productivity of the world economy. Rates cannot rise significantly around the world, let alone here at home, without causing major headwinds to growth. And this is the problem. Debt levels are too great for a return to interest rate normalcy. Does that make sense?
Kevin: Yes it does. It does.
David: We’ve gone too far in terms of the accumulation of debt, to assume that a normal march higher in terms of interest rates is going to do anything but derail whatever growth potential there is, or whatever recovery potential there is, on the horizon, as far off as it may be.
Kevin: I think it is safe to say, then, that we are going to get the natural consequence that you always get when you print money, and that is, ultimately, inflation. And I would like to go over that sometime later in the conversation, Dave, because it is a real issue.
David: But what we can conclude now is that we should continue to expect low-to-negative real rates of return for some time. This notion of financial repression – it is a viable long-term solution to the circumstances where you have too much debt. And it is going to be continued, in terms of its strategy, whether it is called QE or called something else, whether it is the United States or a combination of the United States, the Bank of Japan, the Bank of England, the ECB, this will continue to be the state of affairs, because what they need to do is rebuild balance sheets and de-lever the system on the backs of households, redirecting income that would have gone to savers, and redirect that income to the banking and financial system. That is income that would have gone into the consumer’s pocket, and there is a strange twist of irony here. They want the consumer to come back into the market, and yet they have stripped him of the income necessary to actually come back in full force with savings as a support for consumption.
Kevin: And that’s without high inflation. Wait till that hits. But it sounds to me like the Fed is caught between a rock and a hard place. Their policy really has not changed. It doesn’t necessarily have to change right now at this moment, but they know they are facing something down the road.
David: No. On the notion of taper, the recently suggested moves, they are based on an improved economic set of statistics, which is, as Mr. Bullard, one of the Fed chiefs has said, is still on the horizon. That was fascinating.
Kevin: Like housing. Is housing really recovering right now, or is it something that is sending a false signal?
David: Off of the lows, the charts look pretty good. If you focus in on the last 2 to 3 years, it looks like there is a recovery in housing, but if you step back from the trees to view the forest, what you realize is that the levels that we have gotten to in this supposed housing recovery represent the lows of every previous recession going back 30 years. It is as if we were 500 feet underneath the water, and now we are only 100 feet underneath the water, still having difficulty breathing, but now at that level that we were at the bottom basement submerged levels of previous recessions.
Kevin: But it is not just housing that they are citing right now, David. They are citing employment, as well. They are saying the employment numbers are getting better. I think it is a lot like the housing statistic that you talked about, though. It is still recession-sized unemployment numbers.
David: You are looking at birth-death modeling. That is a statistic which allows for folks coming into and out of a life cycle. It is a statistic.
In the last numbers we had 205,000 jobs created via the birth-death model. Were those jobs created? Were those actual people going to work, punching the clock 8 to 5, earning an income, going and spending it? Or are we still talking about, yes that’s right, a statistical variable that has no connection to reality. We are dealing with birth-death modeling, we are dealing with a reduction in the total labor force, where you are taking your total labor pool and dividing that by the number of people currently employed.
The problem is, the number improves considerably if you just have people dropping out of the labor pool. Whether they are working or not, if you drop people out of the labor force, they quit looking for work, they retire, they are done, then your numbers naturally increase. So as we have gone from close to 10% on the U3 down to 7.6%, that doesn’t necessarily show that we have added any jobs at all. Birth-death modeling, reduction in total labor force. Those things improve the numbers. At the same time, according to the last GDP report, we have incomes which are in decline by about a 9.2% annualized rate.
Kevin: Okay, now, let’s point this out. A 9.2% annualized rate of income drop, and I know I keep bringing up inflation, but Dave, if we have inflation that is actually 7, 8, 9%, we are talking about people losing close to 20% of what they were used to being able to spend in a month.
David: Yes, the Fed is essentially stuck. As we said earlier, the Fed policy in place has not changed, is not likely to change. We can’t expect them to continue to buy assets and keep rates at exceptionally low levels.
Kevin: So it would be nothing to expect the Fed balance sheet to rise to 4½ to 5 trillion dollars, it is just going to continue to prop up the economy the way they’ve been doing it, but they keep talking about, “Well, we might have to take the punch bowl away.” We’ve seen in history, when the Fed actually does take the punch bowl away, Volcker is a great example of that, but back then, the United States didn’t have the situation of debt that is prevalent now.
David: Prevalent, and growing. June is the month where we clipped over 17 trillion dollars in the national debt, 17.15 trillion.
Kevin: That’s more than our GDP.
David: Yes, we’ve eclipsed 100% debt-to-DGP here in the United States.
Kevin: Has a country ever survived in the long-run when they have more debt than GDP?
David: It sure makes it tough. But you take away the 85 billion of asset purchases, and you have a rise in rates that, frankly, the market cannot bear.
Kevin: Look at last week. We already saw just the threat of rising rates.
David: And it has the potential to abort any momentum in housing, because rates continuing to move up causes rates across the board to move up, people can’t buy as much house for the same kind of payment that they were counting on, etc. Assume they do. Assume they stop with the 85 billion in purchases, or even cut it back just a little bit. You are still looking at radically accommodative monetary policy. You have low rates, and of course there are other forms of financial repression, but you have these low rates which are serving to redistribute capital, rebuilding select balance sheets, reducing the burden of debt by shifting the burden to households. So it’s you and me, it’s the middle class, actually, that ends up rebuilding.
We’ve talked about this before, a year or so ago when we were talking about China. In the banking crisis of the early 1990s in China, they used financial repression, keeping rates exceptionally low in order to rebuild bank balance sheets, but it was done via the Chinese people. Of course, it is a subtle thing, this notion of financial repression, but it is a redirection of capital. It is a redirection of income. And today, it acts as a subsidy for the national debt. Repression? Yes. This will remain until a sufficient amount of system-wide de-leveraging has occurred. The debts that we have – they have to be diminished in some way, shape, or form.
Kevin: So the repression will stay. They are going to try to keep those rates as low as possible, artificially, but let’s go back to that, because last week there was just the hint of possibly tapering. It wasn’t actually happening, and sure enough, looked what happened to interest rates on the 10-year bond.
David: And so you are starting to see the fragility in the market structure, itself. You see that in the bond market today. A few weeks ago we discussed hot money. We have had ample demonstration of buyers ignoring risk for the sake of yield, and now, in response to a potential shift in Fed policy, a potential shift in Fed purchases, away from the 40 and 45 billion dollars, respectively, there is a rise in rates, and guess what? Lo and behold, the rats are jumping ship. For June, if you look at the Trim Tab’s numbers, they calculated 80 billion dollars in bond liquidations for the month. That’s double the next closest month on record.
David: Yeah. October 2008. That was when we saw numbers that were half this size, and this was in the midst of the credit crisis.
Kevin: Oh, they were jumping out of bonds and stocks at that point. Let’s restate that. There were double the liquidations that we have seen, even in the highest month, which was 2008, and that occurred last week.
David: It’s only been in the last couple of months that we have been able to talk, both about junk bonds dipping below 5%, which is incredible, and crazy, when you consider the credit risk, all of the implicit risks in a junk bond portfolio, and yet there has been so much buying energy in, and yield-chasing of, those particular income streams.
Kevin: But that is changing now. Junk bonds, their yields have jumped up, and their values have just cratered.
David: Right. We have seen 5% yields, below 5%. Now they are yielding back above 7%. Again, we noted that 5% was insane. But do the math. That’s a 40% shift in a short period of time, erasing any gains for the year for anyone who had bought in 2012, and putting the late-comers – we might call them the lemming class of investors – severely upside down, and asking a very silly question. “Wait a minute, I thought bonds were safer than stocks?”
David: By way of contrast, you have the 40% change in interest rates in junk bonds, but you have a 35% change in mortgage securities and Treasuries. This is radically volatile.
Kevin: So, David, with what we saw last weekend in the jump in interest rates, short-term, do you expect to see those yields continuing to go up?
David: No, I think that you could expect the yields, in fact, to come back down for at least a short while, and stabilize. Prices have been hit very hard. They are oversold. There should be something of a recovery, even if it is short-term, and I think on any improvement in price in the bond market, yields dropping back 20-30 basis points, fixed income exposure should be reduced as much as possible.
Kevin: So try to sell on the jump there.
David: Yes, and I think 2014-2015 may be an unfriendly environment, to put it that way, for interest rate-sensitive assets, and that is not just bonds. That includes utilities, and that includes high-dividend paying stocks, which take on bond-like characteristics in the context of rising rates. So watch interest rate-sensitive stocks. Again, this is why. Let’s say you have a 2½% yield on a dividend-paying stock. It looks good right now, but if short-term bonds, or money-market equivalents, are paying 3-4%…
Kevin: Sure, a person is going to go for the bond and dump the stock.
David: Exactly. Dividend stocks sell off, and they lose their current premium valuations.
Kevin: David, at some point, interest rates may rise, but let me ask you a question, because there is an interesting experiment that we have seen for the last 15 years or so. Why would we not see a Japan-style era of low rates for decades, maybe?
David: That is a possibility. You have the shear scale of the debt obligations needing to be reduced, which may pressure the state to control rates, and that is exactly what they have been doing through this Quantitative Easing-3 program, the purchase of bonds in order to control rates. And yet, they are look for a desired side effect – growth in the economy. It’s not happening.
So, if it’s not, perhaps there are new rules, there are new regulations, which will somehow funnel capital into the Treasury market. Of course, you have an orchestrated swoon in the emerging market debt markets which might drive interest back to a safe haven, a Treasury position. There are various things that they might do to trip up and collect and redirect capital toward the Treasury market, but obviously QE-3 is not really working, and yet, they still need it, otherwise rates will rise, so they are really in a tough spot.
Kevin: And there is a difference between the Japanese people and the American people. We are looking for the next profit, the next thing. We are very independent thinkers, whereas they have a very Confucian society. There is almost a civil duty to continue to support their own debt.
David: That’s right. You combine American pragmatism with a lack of social duty. The Japanese have self-funded their debt through domestic savings, because, guess what? It’s an obligation, it’s what you do, whereas, for Americans, it’s either in our interest or it’s not. We’re going to do it, or we’re not. And there is a little bit more of a cavalier disposition. We are not going to be the square peg in a round hole, and that’s really what you do see as a sense of conformity, regardless of the cost. We have two critical things that are funding our deficits. One, is the kindness of strangers. And two, today it’s Fed purchases.
Kevin: About 85%, you said.
David: 85.7 at issuance. So we need to keep an eye, right now, on foreign holdings of Treasuries. The Federal Reserve reported, as of 06/26/2013, last week, that that category, which stands at about 2.934 trillion dollars, that is foreign holdings of U.S. Treasuries, declined by 32.4 billion dollars in a single week.
Kevin: Wow, wow.
David: And again, what’s not to like about rising rates, and a dollar that is worth about half its stated value. You have to understand that that is in the mindset of a foreign holder. They are saying, that’s exactly right. That’s what not to like. You see a rise in rates, and that’s why we don’t want to have that bond exposure. You see a dollar that is not worth its stated value, and we would rather be out than in. So you are seeing something of a migration out of that Treasury-holding category by foreigners.
Kevin: And there is a point where you don’t need foreign holders anymore if the Federal Reserve is going to buy 100% of the debt, but let’s shift over to the stock market, because the Federal Reserve right now is the reason the stock market is rising. We saw the stock market absolutely panic at the very thought that Bernanke might actually taper.
David: Debt correlations used to be about 20%, if you are looking at Fed balance sheet expansion, 20% correlation to growth in the S&P right now, so about 86%. So, the Fed has even acknowledged that if they weren’t involved the way they are, you could see as much as a 50% decline in equity values. “What built this city?” Not rock and roll. What built this city was the Fed. The Fed put in motion the growth that we have seen over the last 3 or 4 years in the equity market, and that is the only thing that is holding it together.
So there is this market dependency, which I think is being underestimated by market practitioners and, lo and behold, you see volatility increasing, increasing significantly, as those same investors begin to ask what is a very reasonable question: “Where should assets be priced without the Fed prop?” So if there is a change in Fed policy, “Well, I guess we didn’t think about that.” If there is no Bernanke put, if there is no Greenspan put, what should the price of these assets be? That’s a really good question.
At the same time, investors are beginning to ask the question of what is propping up the stock market, other than QE and funny money. We have an economic analyst group fact set which has noted that 87 of the S&P companies getting ready to announce they’ve lowered their forward guidance while only 21 have raised guidance for the current quarter.
Kevin: Explain guidance.
David: In other words, here is what we think we are going to make this next quarter. It is going to be less than what we made last quarter. Is that an improvement, 87 companies that are sort of out there in the street? Only 21 others are saying, “Hey things are getting better. Expect to see better numbers in the next quarter.” 87 companies so far have come out and said, “By the way, on our next numbers, they are not going to be quite as impressive.”
Kevin: David, let’s play a mind experiment for a second. There are four bowls sitting in front of you and you have a bag of marbles, and you have to figure out which bowl is going to be the best place for these marbles over the next year. You have bowl number one: Stocks. We have already talked about the danger and the vulnerability with the Fed. You have bowl number two: Bonds. We have already seen the exit from bonds.
David: Just the beginning of it.
Kevin: The potential of interest rates rising and crushing the bond market, right. You have a third bowl, which is currency. We already know they are printing currency, that is what Quantitative Easing is, and it will turn to, and has turned to, inflation. And then let’s call the fourth bowl, and in fact, let’s pretend the fourth bowl is made of gold. You can put your marbles into gold. Bowl number one: Stocks. Two: Bonds. Three: Currency. Four: Gold. Tell me about gold, Dave, because there is a lot of buying, still, of physical gold, as the price drops.
David: The other day I came across a quote by John Stewart Mill. He says that panics do not destroy capital. They merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works. When I think of stocks, when I think of bonds, when I think of the inflated values that you see there, and the potential for panic circa 2013-2014 in those markets, all you are seeing is the tide going out. The destruction has already been done. The misallocation of capital has already occurred. Now you just get to see, again, the betrayal of hopelessly unproductive works. I am very concerned about stocks, and very concerned about bonds, and frankly, I don’t like the currency markets today, the options that we have there, in large part, because all your world players are wanting to steal market share from their neighbors, keep their export game going, continue to grow, or at least maintain, their previously determined slice of the GDP pie.
Kevin: The currency war that we talked about last week.
David: Exactly, which makes the currency values absolutely expendable toward a greater purpose, which is full employment. That is dangerous. You want to be in currencies, varying degrees of danger, bonds, and of course, there is a way to structure and ladder a portfolio that takes away some of the risk. But inherently, you are talking about being at the end of a credit cycle and there being a real crunch there. Stocks: Same thing. This is where I think we continue to see demand for physical gold worldwide.
Kevin: And I think you have to define the difference between physical gold, we think we all know that, and this paper market. Talk about panics in a market, the paper market just plummeted. David, I just read a report from Commerce Bank this morning that said that China looks like they are going to actually buy more than a thousand tons of gold this year, and they are already at 800, so it could be 1400-1500 tons. That is twice what they bought last year, so somebody is buying while the price is down. It may not be us.
David: This is critical. The real weakness in the metals market has been in the futures pits, where buyers are on strike, where shorts are pressing the market lower because they can.
Kevin: That’s the paper market.
David: And meanwhile, you have the physical markets the world over, which remain robust, 11½ million ounces in the speculative short category makes for a bounce like we saw in 2005, like we saw in 2008, 60-80% off of whatever the lows end up being. If we already put in the low of $1200, I think it is very likely. Do we see $1150? Honestly, I don’t care. The move ahead – do you know what it takes to cover 11½ million ounces? That is 115,000 contracts, or more, in that speculative short category. When someone shorts the gold market, they have to step back in and buy those ounces in order to cover their transaction, close out the trade, and lock in their gains. There are 11½ million ounces waiting in the wings to be bought.
We also talk about the commercial positions. These are your producers. These are the miners. These are the folks that make money year-in, year-out, by digging in the dirt and selling ounces, and hopefully having some sort of margin, the difference between what they produce an ounce for, and what they sell an ounce for. And any time that you see commercials stepping into the market and shorting it, it’s because they have some margin to protect.
Let’s say, for instance, they sell it at $1500 an ounce, and their cost of production is $1000. There is $500 dollars worth of margin in between there that, yes, they want to capture, they want to protect, they don’t want to be dealing with the vicissitudes and volatility of the market, and they will be in the market, shorting, in order to capture that spread. They are not there now. They are not shorting.
Kevin: They are not shorting.
Kevin: It’s the speculator, the guy who is going for the quick profit.
David: They have the lowest short position, the commercial interests do, since the year 2001, and here’s the deal. Moving to the long side of the equation, just as they did 2001, 2002, you have to remember, these guys are rarely on the wrong side of the trade. The bull market in precious metals is anything but over.
Kevin: David, you had mentioned 2005, 2008, of course, in this gold bull market, as gold has gone up, those were lows, interim lows, and then it went on up to make a new high. And of course, probably the speculators were very, very short at the wrong time, like normal.
My son called last night. He had seen your CNBC interview and he was fired up. He said, “What are these guys talking about with gold going down?” And he said, “Dad, I went back and I looked at a 10-year chart. What is occurring right now in the gold market occurred in 2008. It occurred in 2005. This does not seem that different.” The only people who think that this time it’s different are the guys who have missed this gold move all the way from the beginning.
I listen to these stock guys on CNBC trying to tear you up about gold’s drop, and why you didn’t see it coming, and why you’re not out of gold, and I’m thinking, “You guys don’t own any.” They don’t own any gold, they never did, they missed the whole move, and they’ve got a stock portfolio that’s probably up about 13% in ten years, whereas gold is still up 200 and some odd percent over the same amount of years.
David: What most of your pundits are looking at is an environment of disinflation. They are assuming that QE is going to be tapered. They are looking at no inflation at all, and they are assuming that with that being the case, and a slight rise in rates, now you are talking about a positive real rate environment, which would be negative for gold. They are looking at a declining money supply with the ECB, certainly not other central banks by any stretch, the Bank of Japan and the Fed, of course.
But then you also have this issue over the last several months, even a year, year-and-a-half, gold has gone nowhere and equities have gone somewhere, and lo and behold, the liquidations that you have seen have been primarily in the spider gold ETF, and that is a U.S. asset, if you will, and that is U.S. investment managers liquidating. So it is isolated, but they are looking at these variables, and they are saying there are reasons for it to go down.
Clearly, there is no inflation. Today, there is no reason to believe that inflation will be here tomorrow. And I think this is where you have to consider the current low levels of inflation, and you need to recall what is called the Cantillon effect. If you imagine this: Pour honey in the middle of a plate. What do you have? You have this substance that starts in the middle and then it spreads gradually to the edges, and this is very much like monetary policy. Monetary policy first hits asset inflation.
David: First immediate impact. Stocks, real estate, what have you. Secondly, on a lagging basis, then you have consumer price inflation, so asset inflation precedes price inflation. Who is Richard Cantillon? He wrote an economic treatise in the 1700s which became very influential with the likes of Joseph Schumpeter and Friedrich von Hayek and he was a partner with John Law in the Mississippi bubble.
Kevin: Which was that incredible inflation of 400 years ago.
David: This isn’t just a work of theory. He had practical experience with increase in the money supply, where it impacts first. First it’s assets, then later it’s consumer prices. I think even though there are reasons to disbelieve the gold thesis, there are also reasons to counter that, and I think, really, what we see here is the end of a bear raid. We mentioned earlier the difference between speculative shorts and longs. From a historical perspective, these sorts of orchestrated moves lower, they are actually common.
Kevin: Dave, let me just give you a personal example of that. Back in 1989, when Saddam Hussein was in Iraq and Kuwait was Kuwait. They were preparing for a war, and little did we know that, but Saudi Arabia did. I was working for your dad at the time, and we would come in and gold was down 10% on a Monday morning on low volume. We would call and ask, “What just happened?” And they would say, “Well, the Saudis are bear-raiding the market,” which means they were trying to accumulate gold, getting ready for this war. That happened three or four times in 1989, and we should have seen something coming. We did. I remember calling clients and saying, “Hey, something’s going on in the Middle East. They are bear-raiding the market, they are accumulating gold at a lower price. They are fixing the price down lower and then coming in and buying it.” And I’m just wondering, is this, indeed, a bear raid that we are seeing now?
David: A bear raid it was. That’s what we witnessed, no more, no less. Prices have gone down because they can, when and if a collection of interests get it in their minds to make that happen. What are the needed circumstances to do that? We have had those circumstances in the futures pits where buyers have been absent and naked shorts have been active.
Kevin: David, what is a naked short?
David: If you don’t own the underlying asset, and yet you sell it via a futures contract, it’s considered to be an uncovered, or naked, transaction, due to the lack of actual product in play.
Kevin: That doesn’t even sound like it should happen.
David: And in fact, there are some limitations to that, when you are talking about stocks, but not with a commodity. When you are dealing with stocks, you have to go out and borrow someone’s shares in order to sell them short, and then you have to return them at a lower level, and of course, you are hoping to profit the difference.
Kevin: But with gold you don’t need to do that.
David: Well, whose gold are you borrowing? In this case, there doesn’t have to be gold backing the transaction. You can, frankly, on a naked short basis, continue to short and short and short on an infinite basis. The number of ounces short today, as I mentioned earlier, about 11½ million ounces, that already exceeds what you have in terms of COMEX inventories by 4 million ounces, not that it is particularly relevant, because those transactions can settle in cash. They don’t have to settle in kind, where that gold would be required. But the vast majority of short positions in the market are unbacked, and most likely, as I said, to settle in cash.
It seems like metals should be required for those transactions. That’s what makes sense on a common sense basis to you and to me, but that’s not the case. Add to that the misperception that these markets are weak due to price volatility and we find a very different characterization of that in the physical metals markets. As we mentioned earlier, that’s where there has been a real strength. This is the circumstance in which the price begins to fall, a classic bear raid. Here is why we think it is coming to an end quickly.
Kevin: This drop in the gold price.
David: If it hasn’t already resolved here in the last several days. Number one: You have institutional sellers that are moving to the buy side, and for very good reason. You have Oppenheimer, this week, and J.P. Morgan, this week, and select pundits, Dennis Gartman being one of them – they are canceling their sell and short recommendations, and recommending purchases, just here in the last 24 hours. Granted, J.P. Morgan’s recommendation is commodities in general, not gold-specific, whereas Oppenheimer’s is gold-specific, recommended a sell in January, recommending a strong buy right here, right now, gold shares, you name it. If it’s gold, Oppenheimer likes it. And Gartman is the same way.
You have that growing list, and this really represents a tipping point in terms of institutional sellers and selling pressure, now translated, converted to buying pressure on the other side. That list will grow as we head into the fall, and this is kind of embarrassing, but leaving the media outlets confused as to why they were getting so loud, frankly, so obnoxious, with their anti-gold kick, right as you were hitting the bottom.
Kevin: Like the CNBC interview yesterday.
David: Maybe even the bottom. They asked me, “So you’re recommending gold, right now?” And I said, “Between $1100 and $1200? You’d better believe it!” And they looked at me like I had five eyeballs, I mean it was this bizarre: “Who are you?” And I’m looking back at them, “Who are you?” Oh yeah, you’re the guys who have never bought an ounce of gold. Maybe you have something that your grandfather gave you, and that’s the gold exposure you have in your “portfolio.” But you’ve never actually paid real, hard cash for the metals, wouldn’t appreciate why they are needed.
Kevin: And you have mentioned the commercial interests. We are talking about the mines. These guys, for their very livelihoods, can’t see gold go down much further.
David: Right. Number one, the institutional sellers are moving to the buy side. Number two, you have commercial interests, and they are setting up to drive the price back to levels that allow them to survive. That’s the critical point here. They have to recover to a level where they have the cost of production, which is between $1200 and $1400 – $1400 if you are in South Africa, $1200 to $1300 if you are in North America, South America, Indonesia, what have you. These are your all-in costs. They have to have a number that is above that to even survive.
Kevin: So, basically, Dave, you have two types of people. You have the speculators who are in it for the profit, they don’t necessarily have to have this for survival, they are in and out, in and out. They could be just as easily buying long, as selling short. And then you have the commercials, who have to make a living. They have to mine gold, and they pay a certain price to mine it. They’ll hedge it when they need to, and they’re not hedging on the downside at this point.
David: I think I know who wins the fight. As they want the price higher in order to survive, versus the speculators who are just benefitting willy-nilly. Yeah. You don’t want to, as I mentioned in the CNBC interview, you don’t want to fight the commercials. That’s a bad idea. That’s a little guy getting into a big guy’s fight.
So what do we have? We have the paper markets, the futures, specifically, we are talking about futures. The paper markets have exaggerated the correction, and have fundamentally mispriced gold. In an effort to naked-short their way to profits, traders have essentially ignored the underlying fundamentals of the market. If you want to tie that, specifically, to an economic variable for the cost of production, it’s not as if the last ten years have brought out a dramatically higher number of ounces to the marketplace, from mine development.
And that’s one of the key differences between your industrial commodities and your precious metals commodities. Miners have been increasing their capex in order to replace production. They just want it to stay around, replace production, and extend the life of the mines, unless they are businesses, and that is not the case with your industrial producers. You have had a massive ramp-up in production, and now they are not only suffering from slowing global demand for the commodities in question, but you are also dealing with an overhang of supply from the last decade’s expansion. You don’t have an oversupply in terms of the gold market.
Kevin: What you are talking about is aluminum and copper and iron. Those are the industrials.
David: Yes, if the sell-off in gold were fundamental in nature, and John Williams points this out this last week. He shows a number of charts showing the correlations between Swiss francs and oil and gold and saying, “This isn’t fundamental related to gold. You have a concerted sell-off in the price of the metal, naked shorts driving the price lower. They have to cover at some point and the price goes 60-80% higher, as and when it does, but there is nothing fundamentally wrong with the gold market.” Characteristic of a major decline in the price of gold would be, complement to it, a major decline in the oil price, and a major decline in the Swiss franc. You don’t have that.
Kevin: David, looking at the price action, there seemed to be a major battle at the $1200 level. What is your thought in this range, right where we are at now?
David: Maybe we’ll have days of respite, maybe weeks, maybe months, but there is hard work ahead. We could go lower, probably retest, if we do, $1200, but there are buyers in the futures pit for the first time, and they are stepping in for the first time in months. Looking back, this will be one of the great jokes played on Westerners, because here is the underlying current. While there has been panic selling which has occurred in the West, you have grounded decision-making in the East, and they have been buying ounces at levels well below the natural price set by supply and demand of the real asset.
In essence, you have put the most precious commodity on sale, and as we have pointed out elsewhere, if you go back to our Friday comments at the Wealth Management website, this has basically allowed for a paper physical arbitrage. Even if you look at the premiums that they are paying in Asia – $20, $40 per ounce, to have the physical metals delivered instantly, they are looking at this and laughing their way to the bank. They are saying, “Listen, price doesn’t belong here. It’s gotten here on an arbitrary basis, and it’s not going to stay here. It’s on sale, even with the premiums we have to pay, even with an increase in taxes,” as in India.
Kevin: So these guys are saying, “Go ahead and play all the paper games you want, we’ll just take that gold, and I’ll pay you a premium for it, if you don’t mind.”
David: That’s right. Even after a 38% correction in the gold price, it has still outperformed the stock market, by a country mile. Marc Faber noted this in his most recent missive. Going back to 1999, you have pundits and asset managers who should rightfully be embarrassed for not participating in the best bull market of the decade, which goes a long way toward explaining the degree of scorn and animosity that enters the conversation when gold is the topic. It should be beat down reputationally, less the pundit or asset manager have their own reputation beat down instead.
And that’s really what you see, that you have to discredit it as fast as possible to help justify why you didn’t own it in the first place. Now we are in a position, and this goes back to Barry Bannister at Stifel Nicolaus. He points out that we are on the cusp, corporate profits have an inverse correlation to the Fed funds rate. Lower rates equal higher corporate profits, higher rates equal lower corporate profits, if that makes sense.
As we head into the end of the year, you are going to see this change in relationship between stocks and gold. We have had a counter-trend rally in equities, we have had a counter-trend decline in gold, and the Dow-gold ratio has gone from 6 to 12, on a ratio. It will probably be year 2014, maybe 2015 at the latest, but I would suggest 2014, that we go from 12 to 6 on the Dow-gold ratio, yet again.
Kevin: You know what? I’m going to put you on the spot, to finish up the program, Dave, and I know people love to go back and say, “Well, you said this price, or that price, but I’m going to put you on the spot and just ask you what we are looking at year-end, and as we look forward, on gold? If you had to be a betting man right now on price, what would you say?
David: I counter the technical damage below $1530, and then another break below $1340, and I think your outside number for this year is $1500-$1600 an ounce, with year-end 2014. So fast forward, say, 18 months, and I think you are opening up the possibility taking out the old highs of $1920. Remember, 2005, 2008, when you had a major short position in the market, and those shorts had to cover, you drove the price higher by 60-80%. If we assume a $1200 floor, plus 60%, puts you spot-on, $1920.
Kevin: Isn’t that amazing?
David: That would be the number to shoot for – 80%. Now granted, there is more of a short position today than 2008, and 2005, almost in combination. So there is a high probability that 60-80% is a conservative estimate, and we see $2300 to $2500 by the time we get into the end of 2014 as we ease toward 2015.
This is pie-in-the-sky. This is so far on the horizon, so many events can happen to either speed this process up and take us to higher numbers faster, or slow it down, I think we are ultimately moving, as we have said consistently through the years, to $3500 to $5000 an ounce. How long does it take us to get there? Well, gracious, we really don’t know that, do we? Is it 2014? Is it 2015? Unlikely.
But as we move toward 2016, 2017, and 2018, there is a time frame where $3500 to $5000 gold begins to make a lot of sense, with some interim steps, gradually, this year finishing $1500-$1600, gets us moving in that direction.