The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“Right now there is all confidence in the world that the central banks have this figured out, and yet, the gold price has not utterly collapsed. Has it moved down? Yes. After a 700% move higher, it has given up 40% of those gains. If it is moving considerably higher, then it is an admission of central bank policy failure. And I thought it was remarkable. I thought it was profound. And if people aren’t listening, I don’t know what signal is clearer than that.”
– David McAlvany
Kevin: We’ve talked about a centenarian as an investor, Dave, who sometimes comes out and gives his wisdom. Well, unfortunately, the obituary this week talked about the death of a man who actually had – how many years of experience in the market?
David: Eighty-five active years in the marketplace. Sometimes the best place to start a newspaper is not at the beginning, but at the end, and the obituary section in the Financial Times included Irving Kahn, stockbroker and fund manager, 1905-2015.
Kevin: You’ve talked about him in the past. It is interesting, when somebody lives that long and trades in the markets, they really start learning the patterns, don’t they?
David: It’s one thing to consider yourself a value investor with a timeframe of one year, two years, or three years. It’s another thing to bring in decades and multiple generations, even in your own lifetime, to see things change, and to see that which is popular become unpopular, fads come and go, and yet, developing a nose for value is something that this guy was very keen on. He didn’t come from a moneyed family where managing family assets were the key. Actually, an immigrant family, the son of Russian immigrants, and he ended up taking classes and working with Benjamin Graham, one of the fathers of value investing.
Kevin: That goes all the way back to the 1930s.
David: That’s right, and his first trade was actually June, 1929, selling short a company that was in the copper business. And of course, we know, Dr. Copper tells us a lot about the direction of an economy, and he knew that Magna copper was about as high as it could go on unjustifiable terms and it was likely to head down, so he bet quite a sum in June of 1929 and within a few months he had more than doubled his money.
There is a lot to be said for intergenerational perspectives, and there is a lot to be said about looking at money, not from the standpoint of what I am going to spend it on this week, this month, next year, or when I enter retirement three years from now, but instead, having a timeframe that brings in long periods of time that allow you to see what Charles Dow used to argue – of course the founder of the Dow Jones Industrial and Transportation averages, and the original editor of the Wall Street Journal. He would say that you need to see the tides as they come and go, and the incidental movements in the markets, the things that happen on a much shorter-term basis. Yes, it is interesting, but not quite as compelling from a long-term investment standpoint, as knowing what is happening to the tides. And I think this is an example of a man who, because of his time in the marketplace, really had that perspective.
One more thing about him, because I think something that he said is very valuable, not only for us, but for many of our listeners. To quote Irving Kahn, his secret is, “to wake up in the morning and have something to look forward to. The important thing is to keep that brain going.” And he certainly did that up until his 109th year, as it were.
Kevin: He almost made 110. Now, for the person who is not going to be trading in the market 85 years, Dave, I look at your family, and what you have encouraged all of us to do, and that is to talk to your kids and form a legacy. Sometimes I’m talking to you and you’ll tell me something that your grandfather had done and it was passed down in the family and it was talked about. And then, of course, we’ve talked many times about you and your dad’s relationship, how Don was trading in the stock market back in the ’60s and he still actively writes the newsletter, stays active with the firm. You’ve picked up so much from your dad, and you’re passing that on. You told us the story this morning, Dave, of the latest stock acquisition of your first son.
David: He’s nine years old and he’s buying his first shares, and he’s very excited about it.
Kevin: He’s been accumulating precious metals.
David: He has been. And now he has made his first foray into the paper world. Our perspective is that family wealth is an intergenerational project, and our perspective is also that wealth is not just a financial issue, but it is something that encompasses the hearts, minds and souls of family members, and of course, a balance sheet may be included in that list, but it’s one in a longer list of things that need to be managed, and managed well. As you know, that is the topic of a book I’m nearly done with. Sixty days from now, ninety days from now, I’ll be going to press with Intentional Families: Building a Legacy from End to Beginning.
Again, it’s not just resources for current consumption when we think about family wealth. We’re talking about taking a longer view. What does it look like to be a generational steward? What does it look like to capture the major trends? Yes, it’s very intriguing and sometimes there are short-term trading opportunities when you are looking at cyclical volatility. But truly, from a financial perspective, secular trends are what end up being wealth multipliers, and to be able to capture those secular trends, really, in the long run, puts you head and shoulders above the crowd, so to say.
And I understand, some people calculate their returns on a quarter over quarter basis, or compare from last year to this, but when you begin to look at things on a decade over decade basis you begin to see just how important cost basis is, and how powerful moves in the market can end up being if you are a longer-term value investor. So, with that in mind, we can certainly shift back toward what I consider to be a cyclical trend, and one that is quite dangerous in the equity markets.
Kevin: It is interesting, when we go back and look at charts, I think interest rates are probably one of the great indicators of risk in a market. Most of the time interest rates are telling the truth. Now, if you look at a 200-year chart on interest rates, there is only one time in 200 years that interest rates have stayed literally flat for three years, so you can see the hand of manipulation on interest rates. Now, those flat rates are being paid for by a government and a Federal Reserve that is willing to just buy all that debt so we don’t have to pay competitive interest rates.
But Dave, that can’t last. We know that you can’t keep the hand on it forever. So when does it break? When does it change? The bond market normally needs buyers of bonds and usually they have to set interest rates at what would pay for owning those bonds. Right now we don’t need buyers. We have a government and a Fed that just comes in and buys them all.
David: You’re right. To picture that interest rate trend over a 200-year period, this particular part on the far right-hand side of the chart is something that looks like an anomaly.
Kevin: It’s a straight-edge, Dave.
David: It is. It’s a flat line, and it’s like a radio signal – all of a sudden there is silence. And I’m sure you have been in conversation with someone where you ask a question and what do you get in return? Silence. And sometimes that can be a very powerful answer. We know exactly what is happening in the marketplace by the silence we see – the radio silence in the marketplace. The signal that is being sent from the interest rate world is that we are in an environment of command and control. We are in the environment of prices being propped up by fiat, and we are now on the cusp of seeing the Federal Reserve have its moment of truth. Is the economy truly – from the underbelly of the economy, do we see real and sustainable growth, or are we still dealing with surface appearances? Are we still dealing with the best hopes and hype of our central bankers?
Kevin: Dave, I think they’re scared to death to raise interest rates. Federal Reserve President Richard Fisher retired last week. He was one of your favorite voices at the Federal Reserve because he was a voice of reason. He was an inflation hawk. He did not want to print money to the degree that they did.
David: He was the only non-economist at the Fed, in his position. Everyone else is sort of a Ph.D. in this or a Ph.D. in that, with a specialty in Econometrics, and things like that. What I think is really interesting is that his routine before any FOMC meeting included going through his rolodex. Actually, he probably had a real rolodex, not a smartphone. I could be wrong about that. But, he has 50 different people that he calls, they are all business people, a variety of distributors, sales, you name it, in his region and around the country, to get a picture of what is happening in the real economy.
On his way out, he said of his experience working with the FOMC, “My local dry cleaner – I would say that if you took him and put him against the whole Fed staff in terms of forecasting, he would be more accurate.” And I think he says that because economists are a special breed. Econometricians – we’re talking about very brilliant math minds, people who appreciate models and solutions and equations.
Kevin: They love math.
David: They do.
Kevin: They love math.
David: And this is where I think if you go back to the great, and I would describe him as the last great Fed chairman, William McChesney Martin…
Kevin: The one who said, “It’s the Fed’s job to take away the punchbowl before the party’s over.”
David: That’s right. He was the longest-standing Fed president, from 1950 to 1971, and on his way out he was asked, “Who should replace you?” And he said, emphatically, “Not an economist, and certainly not an econometrician, someone who is very skilled at running numbers and doing calculations, but who is not very aware of what drives the real economy.” He said, “Granted, we have 50 econometricians in the basement, but we keep them there for a reason. When it comes to making a decision we will go out and we will solicit information and opinions from the business community and, based on our experience and that gleaning of information, we will then ask questions of the econometricians and the economists, and we will listen to them, but we will still make our decisions independently.”
So I think, yes, there is a turning of the tide, if you will, at the Fed. I think this is a very interesting departure. A man of vast experience, a man who was a trader in the marketplace, worked with Brown Brothers Harriman and knows the inside and outside of Wall Street, as well as banking, and what is his conclusion? What is his last salvo as he leaves the Dallas Fed? He says, “The markets are hyper-overpriced, and dependent on the Fed.” And he goes on to say that he’s looking for a correction of substantial magnitude.
Kevin: Isn’t it interesting that he is exiting stage left just about that time? Greenspan did the same thing. When Greenspan stepped away, Dave, we were talking to people and we said, “Look out.” He built this thing up and then he wanted to step aside in time.
David: But look at the contrast between a Greenspan and a Bernanke, who in retirement will do everything that they can to justify their existence…
Kevin: Whereas Fisher probably just got tired of preaching to deaf ears.
David: And I think the reality is he has better things to do with his time if he is not going to be able to move the needle. Certainly, I would not want to be on watch as the world is falling to pieces, and I think, quite frankly, that’s what we have around the immediate corner, but I think he has said and done for years enough to separate himself and his views from what is to come.
Again, that is because his disposition has been a heartland disposition. He has basically said, “I know what runs the economy, and the kinds of policies that we have in place – they’re not going to drive the economy.” Last summer he gave a speech at the University of Southern California, July 16th, in which he said, “Listen, we’ve got to raise rates now. We are going to be dealing with major inflationary issues if we don’t raise them now.” He said, “But I’ll tell you what. I have confidence that the folks at the Fed will have already begun to significantly raise rates by the end of the year.”
Kevin: Dave, there is an understanding at the Fed, too. There is a general rule of thumb that you want to be raising rates 18 months before inflation starts to show at all.
David: And his classic example is that raising rates is a little bit like bird-hunting. You shoot in front of the target, and allow the bird to catch up. And that is the same thing – you have to shoot early, if you’re going to be a Fed president. If you’re going to be moving rates, you need to be early, not waiting for the market to signal. Otherwise you are behind the curve and you know what you end up with as a consequence? You end up with inflation.
So, it’s fascinating to me. I listened to an interview with two specialists on Bloomberg. They are regular commentators and they brought on an HSBC guest, and the conversation was relating to gold. It was interesting, and I don’t mean to be mean here, just how ignorant the two Bloomberg interviewers were, one in particular, basically saying, “But all we have is deflation, and so why would anyone own gold, because there is no inflation?” And this is the point. He is looking at the same thing the central banks of our day are looking at, and they are not trying to anticipate tomorrow, they’re looking in a rear view mirror. And when you are making monetary policy up by looking in a rear-view mirror, you are going to end up with inflationary consequences.
Note that Volcker was also a man who, here recently, has said, “We’re probably getting behind the curve.” And also, I mentioned this four to five months ago, but I think it is worth repeating. It was Greenspan – my son and I sat within a shoe’s throw of Alan Greenspan – not that I would have thrown a shoe, but, within a shoe’s throw of Alan Greenspan – and the question was asked, “Where are interest rates going?” And he said, “Higher.” Significantly higher, were his words. And the next question asked of Sir Alan was, “The price of gold. You used to be a fan, you’re not so much a fan now. What do you think about the price of gold?” And he said, “The price of gold is going significantly higher.” Considerably higher. It was either significantly or considerably – I apologize, my memory fails.
Kevin: But he said to both, interest rates are going considerably higher, gold is going considerably higher.
David: That has to be unpacked, because again, you’re talking about a central banker who understands and appreciates that the gold price is the inverse to confidence in central banks and central bank policies. Right now, there is all confidence in the world that the central banks have this figured out, and yet the gold price has not utterly collapsed. Has it moved down? Yes. After a 700% move higher, it has given up 40% of those gains. It is still doing quite well, we’ll talk about that later, but my point is that if gold, to quote Alan Greenspan, is moving considerably higher, then it is an admission of central bank policy failure.
And I thought it was remarkable, I thought it was profound, I thought it was one of the most important signals in the last decade that the former Fed Chairman who delivered to us what is known as the Greenspan put, the tradition of central bankers popping up assets prices and smoothing out the business cycle, that he would admit publicly that we’re on the cusp of seeing interest rates and the price of gold reflect loss of control by the central bank community, and failure of central bank policy as it is reflected in a higher gold price. That is profound. And if people aren’t listening, I don’t know what signal is clearer than that.
Kevin: The thing is, you have insiders that are coming out and actually saying, “Look, this thing is rigged and it’s not going to last.” I read an interview a couple of weeks ago, and then ultimately the book, Dr. Pippa Malmgren’s book, Signals. That’s a book that I know you’ve read, and we’re going to be talking to her in the next week or so. This is a woman who was on the President’s Plunge Protection team and she is saying, “Look, we don’t have discovery in the market. But see that as a signal. We don’t have correct pricing in the market because it’s controlled. See that as a signal. Take cover. You need to take action now while you can because it won’t last.”
David: It’s interesting that there is a mindset in the marketplace which is all confidence. I’m a part of an advisory committee for a university for their funds, and it is interesting, as the stock market moves higher everyone believes that we should move to a higher allocation in stocks, because – well, look, on a relative basis we only made 4% here in the last quarter and we made 7% there,” and everybody wants to pile more into the assets that they made 7% on, doubling the risks, so to say, at a higher level. This is what is really interesting to me, because there is a mindset today which is really captured by Alan Newman’s analysis this last month. You contrast the equity gains with the debt that is increased, and it is as if people only look at the positive side and don’t look at the costs of what it took to get here. And in so doing, look at how unsustainable it is. You can’t do this again. You can’t do it again because we’ve reached a terminal level of debt.
Kevin: Dave, this anemic growth comes at a price, and the debt that it has cost to buy even anemic growth, like you said, is irreplaceable.
David: Yes, 5.8 trillion dollars is the increase in stock wealth that has been created since 2007. In exchange for that increase you have our national debt which is increased by 9 trillion, you have the Fed’s balance sheet, which is expanded by 3.56 trillion, you have a doubling of corporate debt, which is close to another 3.5 trillion dollars, a conservative estimate. It seems like, actually, very poor performance relative to the amount of leverage and debt which has been added to the system. It is better than a $2.50 increase in debt for every $1.00 in growth that we have had in equities.
Kevin: You can’t run a business like that, Dave. What if you were borrowing $3.00 for every $1.00 that you brought in, in a business?
David: What it reminds me of is that old adage that asset values fluctuate, but debt is permanent. And it just reminds me, there are a lot of things that we have forgotten. It appears that we are more blindly dependent on policy experts and their prognostications of what the future holds. I think the numbers speak for themselves. Newman does a great job of outlining then and now, October 2007, peaks in the stock market, and what we have today.
And what you find is a very, very interesting, and I think somewhat disappointing record. You have the Dow which is up 27%, and you say, that’s not really a disappointment, we’ve gone from 14,000 to 18,000, what’s wrong with that? We’ll get to that in a minute. GDP growth: Then it was 2.5%, now it’s 2.2%. In percentage terms we’ve declined – GDP growth has declined by 12% from then to now. Unemployment: Those who are unemployed for longer than 27 weeks, that number has increased by 108%. Those who are on food stamps: Again, Americans on food stamps from 2007 to now, that number has increased by 72%.
Kevin: That’s profound. That is profound.
David: I thought we were moving toward recovery. No, an actual increase in those who are dependent on food sustenance programs, an increase of 72%, Fed balance sheet, as we mentioned, is up 400%, U.S. debt as a percentage of GDP. You know where we were in 2007? As a percentage of GDP, it was 38% of GDP, now it’s 103% of GDP. You have the total U.S. debt outstanding, and again, we’re talking about real numbers here…
Kevin: You’re talking official numbers.
David: Nine trillion, which is now 18.15 trillion. We mentioned it earlier, but for all the hoo-rah about a 27% gain in the Dow, and of course there have been far more gains, close to a 500% gain.
Kevin: We’ve doubled our national debt.
David: Yes, we’ve doubled our national debt. Again, asset values fluctuate, debt is permanent. Well, it’s not absolutely permanent, it can be paid off, it can be defaulted on, and things of that nature.
Kevin: And we have fewer people working now than we did in 2007.
David: Right. Labor participation is down 4.5%, consumer confidence is down 3.1%. So wait a minute, if the Dow is up 27% and people are experiencing that orchestrated wealth effect promised by the Fed, where is consumer confidence? Where is consumer spending for that matter? We saw three months of declining retail sales, and maybe it’s the weather, maybe it’s the weather, maybe it’s the weather – maybe it’s a scratch in the record that just keeps on coming back to that phrase, maybe it’s the weather. Or maybe it’s a different economic reality altogether, and we’ll get to that in a minute.
Kevin: And Dave, there are fewer people actually working in the economy right now.
David: Right. Labor participation. Those numbers have fallen. Now we’re in the numbers last seen in the 1970s. So consumer confidence – you would expect with a rise in stock prices an appreciation in home values, that we would see an increase in consumer confidence – it is actually 3.1% below where it was in 2007. The S&P rating, of course, was cut a number of years ago from Triple A to Double A+. And these are things that you think, well, what was the cost? A massive amount of debt – at least 16 trillion that we know of, and then, of course, there is shadow banking, lending and financial activity which can’t be accounted for in the official numbers, and I look at the 27% increase in the Dow as paltry, even compared to gold.
Look – in that same time frame gold has gone from $748 to $1150, a 54% increase. And again, what gets the press? The Dow gets the press, being at new all-time highs. Gold is not at all-time highs, but in that same period has handily outperformed the Dow, and I think that is very interesting. That includes a 40% correction off of what had been 700% gains. Even with that massive correction in gold, it has outperformed the stock market since the last stock market peak in 2007.
Kevin: We’ve said this before. Gold outperformed every stock market in the world except for the U.S. and Canada last year. It has outperformed every currency in the world except for the U.S. dollar. So, gold has been doing fine. But, going back to the stock market, Dave, it’s uncomfortable for me to see the amount of debt that the people who are participating in the stock market are taking out. We’re hitting all-time highs right now as far as the margin debt that is in the market.
David: What is particularly interesting about margin debt is, oftentimes we will just look at the New York stock exchange debt which has come down about 20 billion. In about the last year it has come off about 20 billion. If you include both NASDAQ and NYSE debt you are talking 486 billion. Its previous peak in 2007 was 377. So you’ve had an increase in margin debt by about a third, 29%.
Kevin: But as a percentage of GDP, Dave…
David: It’s at all-time highs, even more speculative confidence than we had at the stock market peak in 1929, or 1999 to 2000. But fascinating – two points. Number one: The growth rate in that margin debt has stalled for about a year now, so basically, you see an increase in the rate of change, a stall, and then the third phase is usually when it declines. Now, you could expect to see 200-300 billion dollars in liquidations, which is certainly enough in liquidations, forced liquidations in the marketplace from margin debt, to bring the market down 15-20%. No problem at all. I think one of the most telling things from 2007 to present is the New York Stock Exchange average daily volume. Daily volume then was 1.31 billion shares, now 764 million shares. That’s a drop of 42%.
Kevin: So contrary to popular belief, when the market is hitting 18,000 and it looks like it is hitting all-time highs, that doesn’t necessarily mean the participation in the market is any higher. In fact, it is about half what it was before.
David: I would like to ask Irving Kahn, “What do you think? Prices are rising on lower volume. Is that a good sign?” And I think he would say, “It’s time to take a vacation. Make sure you’re in cash before you leave.” I think that’s what he would say. Of course, there are people who are still buying, we’ve reported on this many times, this is your buy-back update. Corporate treasurers – yes, they’re continuing to buy back shares with shareholder cash. But what is interesting is, when they are given the opportunity to buy shares, that is, executive buying versus selling is very, very telling. Of the largest NASDAQ stocks, you have 365 liquidations in the last quarter. The only two purchases were in Microsoft shares, you’re talking about Intel, QualComm…
Kevin: The executives are taking their own money and selling the shares, but they’re taking the company’s money and buying the shares.
David: That’s right, because what happens is that if they buy with company money it boosts the earnings per share performance, triggering a larger bonus and allowing them to – again, they don’t have to wait for a golden parachute, they are getting liquid right now.
Kevin: This is exactly what Smithers warned about.
David: That’s right, this obtuse or unfair, even unjust, executive compensation arrangement. Do you know what the backlash will be? The backlash will be over the next 10-15 years that people prefer private businesses and private enterprise to publicly traded companies because they realize that management is managing business for their own remuneration, not for the benefit of shareholders. The great scam of this decade, what will bring about Glass-Steagall-like draconian legislation, will be the reality, the realization by the general public, that the way corporate America is structured is to fleece the shareholder, not to represent the shareholder, and actually, executives and management have been in a position to do that, very aggressively.
You look at executive compensation today and it is averaging better than 300 times the average salary, so the average worker in a company is making truly a fraction – but that’s okay for the average worker to make less than the executive, we understand that. We understand the responsibility, the scope, the liability, everything else that goes to the executive office. But 300 times – we are now back to an era that is almost the robber baron days of discontent between the rich and the poor, and we’re perpetuating it, remuneration committees who are responsible for this, this is where I think you are going to see a significant change on Wall Street.
Kevin: As long as debt can make people feel like there is some degree of normalcy – it’s like they turn the other direction and just choose not to look. But Bill King has been warning that the signs are there right now for a major top, very similar to 2000, or 2007. We’re seeing those same signs right now.
David: He is a guest that we have on once or twice a year and we get emails fairly regularly from clients – “What is he thinking?” Because they like his perspectives. He is warning that a top is being formed like those in 2000 and 2007, that you have your monthly technical indicators which are going negative, and they suggest that Q2 or Q3, the second quarter this year, or the third quarter this year, could leave us with some interesting economic surprises, interesting market surprises.
Because one of the things he is looking at is, you have a worsening economic condition but with the stock market continuing to trade higher. And you began to see those same divergences in 2007 with the stock market motoring higher and ignoring the signals. One of the reasons why we want to have Pippa Malmgren on next week is, her notion that you can’t ignore signals. If you want to be able to anticipate and defend family wealth, you have to pay attention to the signals. And if you don’t, then there will be hell to pay.
She recalls looking at HSBC’s billion-dollar payout. They were setting aside a billion dollars in the year 2007 for a mortgage company that they had bought and were already recognizing that they had paid way too much for. She looked at that and said, “Hmm, they’re taking a billion-dollar loss on a mortgage company, and nothing has yet been announced in the U.S. real estate space? I’m heading for the hills.” And literally, she put her house on the market, sold it, and it was very perspicacious, very wise of her, that is, wisdom put in action, because she read the signs and followed through with a specific action.
And I think, again, Bill King is suggesting that the technical indicators, the monthly MACD on the S&P 500 is rolling over. It is in the process of rolling over, moving lower, just as it did in the year 2007, and just as it did in year 2000 before that. Granted, the declines in the market in those two previous instances were between 40% and 50%. I think we’ll be lucky to see a 15-20% decline in equities. We could certainly see something to the tune of 30%, 40%, or 50%. And then again comes the question, how successful was Fed monetary policy? Because that is the litmus test today for Fed success: How’s the stock market doing?
Now, everyone should be looking at the core fundamentals in the economy, and they’re not, so the stock market is sort of the free pass. If you lose the free pass, yes, all of a sudden you see this discounting of the quality and success of central bank policies. And then what happens to the inverse of central bank policies? Gold is at a discount today, I think it sells at a premium tomorrow.
Kevin: And there really are such imbalances in the world. If you look at the map of the world, Dave, half of the world, the eastern side of the world, basically Asia, has high interest rates. But if you look at the West, you look at Europe, negative interest rates in some places. The United States, what do we have as a Fed funds rates right now? Is it 0.125 basis points?
David: Exactly. You look at the ten-year treasury and we are closer to 2%, with treasury yields being anywhere from 1.85 to 2%. You have the German bond which is a negative 0.256%. You have other European banks which are getting the benefit of rates that are just ridiculous. Has Italy fixed itself? Have we dealt with structural issues? No, we haven’t. Yet, their ten-year treasury is at 0.35%. That’s half a point less than U.S. treasuries. I mean, come on, anyone with half a brain knows that if you are looking at interest rates as an indicator of risk, something is terribly wrong.
Something is absolutely caddy-wampas when Italian and Spanish debt sells for half a percent less than U.S. debt. That’s insane. We are supposed to be the benchmark interest rate. Clearly, these things don’t matter in a context where central banks are active and buying rates down. So yes, imbalance is correct, and I think that is what we will see, a major correction in imbalances, and people will have to check their assumptions in terms of the assets that they think are warranted in a portfolio. Today, it’s why not own equities? Today, it’s why not own the most attractive stock market on the planet? Last year, you realize, Venezuela was the top performing stock market in the world.
Kevin: But would you have wanted to own Venezuelan stock?
David: Not particularly. And of course you have to net out the currency losses, they’re moving toward hyperinflation, and in those terms, perhaps it’s not so attractive. But I think people will have a major readjustment in the years to come. You know, Eddie Ardini is an excellent analyst and I read him as often as I can. He looks at this in a very interesting way. I came across some comments last week which echoed what Felix Zulauf shared with us in a recent commentary, and it was, really, that easy money, counter-intuitive as this may seem, has a deflationary impact. And this is quite interesting, because if you think about the policy that Japan has had for years, they have propped up zombie companies and zombie banks now for decades. And it has created a tremendous amount of unproductivity.
And what Ardini says is, “I know it’s hard to believe since we’ve all been taught that easy money is inflationary; however, easy money has been provided by the world’s major central banks for so long that it seems to have lost its ability to juice up demand.” And this is where it gets really interesting. I like this. “That’s because so many borrowers have borrowed, that they are maxed out, and easy money can only stimulate supply.” Think about that, it can only stimulate supply. What he is suggesting is that we are living in an era of global over-capacity.
And he goes on to say, “Easy money allows zombie companies to stay in business, thus boosting supply even though they’re losing money. The result is near-zero inflation, with a whiff of deflation.” And he says, “Needless to say, the central bankers don’t get it. They don’t understand why their ultra-easy monetary policies aren’t boosting inflation. Their conclusion is that they must continue to provide more easy money, which perversely, is deflationary, since it’s inflating supply more than demand.”
And it’s interesting, think about what’s happened in the oil markets. In the oil markets in the last few years, we have financed a tremendous amount of drilling. Financed. We’re talking about junk bond lending to finance a drill baby, drill trend in the United States. That easy money, and cheap money, if you will, has allowed for what we have today, which is supply moving ahead of demand. How much of a glut will we have, and how much of that will remain? Time will tell. But what we do know is that today, on today’s count, we have an over-abundance of supply, and demand is having a hard time keeping up. So, it’s interesting that oil is parallel to consumer goods, which again, companies that aren’t selling as much product as they need to, it doesn’t really matter, because risk and the probability of demise in the corporate sector has been taken away by easy money policies.
Kevin: Well, you know, there isn’t a reason, necessarily, to be productive if you are always going to be bailed out. In a way, easy money, Dave, serves the same purpose that welfare serves in a system. A person receiving welfare checks, that doesn’t necessarily make them more productive in society, it just basically pays for the person on welfare. And in a way, easy money is welfare for…
David: The corporate class.
David: That’s exactly right. One of the things that we want to talk about with Pippa Malmgren this next week, her experience on the President’s Working Group on Financial Markets – she’s a former member of the committee, worked in the oval office, on the PPT, otherwise known as the Plunge Protection Team, she was on the job for 9/11. And she makes the case that intervening in the markets has its place, and she describes it almost like – the way I would put it – the purpose of an emergency room doctor. You need to keep the heart going, you need to intervene where necessary so that the system doesn’t fail, and then ultimately you can consider a healthy trajectory down the line.
The problem is, the economy today is behaving like the vagrant that comes in and treats the emergency room as that warm place to stay on a weekly basis. They may be in there once or twice a week, confusing a hangover headache with a critical care issue. And the Plunge Protection Team, the President’s Working Group, has really gotten in the habit of treating every symptom of our vagrant economy, if you will, and not allowing things to go a particular course. Do you we need them? It’s arguable. Now, she would certainly argue that it was necessary in the context of 9/11. We had to figure out how to get power to the New York Stock Exchange. Who was going to deliver generators and how were they going to get across the bridge? Were they coming out of the tunnel?
So, there’s a practical nature to it, which the nuts and bolts of make all the sense in the world to me. When you combine a lack of Fed independence, that is, Federal Reserve central bank independence, from the political process, when you look at the smoothing out of the business cycle, and the objective of perpetually seeing asset prices move higher, it makes me think that the PPT, or the President’s Working Group on Financial Markets, that their mandate has morphed, and now they are helping defend the White House. Now they are helping defend those in the political elite from facing the music.
Kevin: And that’s why she wrote the book, Dave. Felix Zulauf, last week, if he sounded frustrated to any one of our listeners, and I know he did sound frustrated, this is a man who spent all of his life studying markets, trying to find value, and at this point he is basically saying, that’s almost impossible because the value is being paid for, the price is being bought and paid for with printed money. Now, here is something interesting, though, Dave. This only works as long as the dollar is the world’s reserve currency. Look at what the Chinese have requested as far as the SDR at this point. There seems to be a change coming. The balance is shifting.
David: There was a balance that was shifting in 1999, with the introduction of the euro and central banks around the world said, “You know, we’ve been on a dollarized system for a long, long time. It certainly wouldn’t hurt to diversify a bit.” And they started the process of buying euros. And that difference of buying a few euros, and selling a few dollars, took the dollar from a 120 high, down to a 72 low, relative to the euro index, about a 40-45% decline in the value of the dollar since 2011, and the lows of the dollar we’ve seen about a 40% rise in the value of the dollar.
So here we are at 98, 99 on the euro/dollar index, and the question stands. In front of the IMF this year, 2015, do we change the constituent currencies in the special drawing rights? This is basically a fiat currency for fiat currency-makers. In other words, you have the BIS, which is the central bank of central bankers. Well, how do central banks settle accounts between each other? One of the ways that they do that is by using a synthetic currency called the SDR, and the special drawing rights, or SDR, is a basket of currencies.
Kevin: But it has always been slanted toward the United States and Europe.
David: That’s right. And the request has already been made to consider the renminbi, the Chinese currency, to be included as a reserve currency in the SDR. This is the year it will be under review. Christine Lagarde has already sort of given a nod that it makes sense, if you look on a trade-weighted basis, it should be included, to some degree. My question is, do we go through another cycle of the dollar being threatened, or just a simple asset re-allocation, a shift, of a certain number of dollars that are currently being held by central banks, that need to be replaced by a certain number of renminbi?
I think that is very probable this year, and I think that may be a part of the trend of gold repricing to much higher levels as we move toward the end of the year. But again, it doesn’t have to be a change in the world of currency. I think you are talking about imbalances normalizing in the world of interest rates, in the world of stock valuations. There are so many different places we could pick on in terms of imbalances. Any one of them normalizes and you begin to see a change in sentiment toward what has been an overlooked asset over the last three to four years, and I think will be an asset of growing importance in a structured portfolio over the next three to five to seven years.
So, what do we have in front of us? Does Greece default? What do we have after that? Is it Italy and Spain to follow? Perhaps the French? The world is on the cusp of significant change, significant fluctuation and significant volatility. You are already seeing it in the daily volatility and fluctuation in a variety of asset prices where you can see 1-3% swings in a day, where a fraction of that is normal. And you’re at a point where markets aren’t getting a clear signal. We think the signals are very clear.
Kevin: So Dave, there is a radical imbalance, there will be a normalization, things are going to come back into line. Gold is going to go up, the dollar is probably going to go down at some point, the stock market is peaking. What should people do?
David: I think this is part of the conversation with Pippa next week. You look at the signals, and you are looking at the signals for a particular reason. Aristotle said human flourishing is found in action. He didn’t say, like his predecessor, human flourishing is found in contemplation. Plato considered figuring out the most abstract idea as the ideal of human flourishing, and Aristotle came along and said, ‘Yes, but you’re failing to live.”
Kevin: Go get your hands dirty.
David: Get your hands dirty, do something, and then we can talk about whether you’re flourishing or not. And I think that is a conclusion. When you look at the signals that are around us, what do you drive toward, in terms of action? Many years ago on the program I mentioned that the price of nickels, the value of the nickel in them, and its composites, was worth nine cents, and yet, you could still go to the bank and get them for five cents. So, just as a matter of discipline, I went down to the bank and exchanged $100 bills for bricks of nickels. Now, granted, those bricks of nickels are only worth 6½ cents today versus the 5 cents that I paid for them, not the 9 cents at the time. I don’t care. My point is, you habituate success.
Kevin: Just like you taught your son, “Go buy that stock. This is a time to do it.”
David: It is a good value. And we looked at a variety of ways of considering that value. And this week I am adding to both a gold and silver position. Silver is under $17. It hit a low of $14 and change and is beginning to outperform gold. That’s a significant signal to us in the marketplace. When silver is weaker than gold you can expect the direction of both metals to continue lower. When silver begins to firm up and is outperforming gold, you can expect both metals to head higher. And I think that we are going to see that as we move toward the end of the year. A cost basis under $17 makes sense. Gold under $1200 makes sense. As a matter of discipline, I’m adding to the positions because it makes sense. You look at the signals, and you take action.