The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“This is a period of time where you want to be cautious, because of the character of the central planners, because of the trends in play which define you as an average investor – an average investor who is nothing more than fodder for the system. Understand what you represent and who you are to the system, and you will have a much better idea of how to play this over the next few years.”
– David McAlvany
Kevin: David, I love talking about some of your excursions outside of the office, and last night late I got a chance to look at some of the film clips from your weekend. Honest to goodness, it looked like one of those extreme movies where you have the sunshine and you’ve got the helicopters going past, you’re on top of mountain peaks that look like you’re somewhere in Alaska. But actually, this weekend you were just up north of here, up in Silverton, where a lot of the old gold and silver mining was done.
David: It’s only a stone’s throw away and it is a remarkable spot. This weekend I was skiing in, I think, what is one of the most spectacular places in North America. It is just outside a very small town here in Colorado. You have a single lift, you have a tent at the bottom of the hill instead of a lodge, and you find a gathering of no-frills ski enthusiasts that love challenge, are inspired by beauty, and they don’t mind sacrificing comfort for steep slopes and fantastic snow.
Kevin: This is known as one of the most extreme public ski areas in the world, as far as steepness, avalanches. I think you guys wear probes and you actually wear backpacks that inflate if you get into an avalanche, don’t you?
David: There is a cute little sign as you are getting onto the lift that explains that there is nothing but double diamonds on the mountain.
Kevin: This isn’t where you come to learn.
David: No, and they explain all of the risks that are included, including saying on the sign, “And you may die.” This is interesting, I actually get more of this than I do out of the pharmaceutical industry, which has all the same caveats, they just have to speak very quickly. “You have the benefit of this, this, this, this, this, but you may also bleed out of every orifice and find yourself in a heap, the equivalent of an Ebola virus patient, but… (and then the music plays) it will be wonderful.
Kevin: And sadly, it has happened up there. Those signs are for real. I know people fly in from all over for this, and you guys had a small group, about eight people, but it was a mixture of a lot of different nationalities and states.
David: Over the two days we had two different countries, five different states, and at one point during our conversation while we were up there we turned to real estate values in the town of Silverton. I’m always doing sleuthing and research and there was a spike in foreclosures which came after the closing of the last mining operation in the 1990s. Our guide, who has been up there for seven years, was intrigued to discover that the shuttered mines, when that happened in the 1990s, basically missed the bottom of the market by a matter of months. It was really interesting. She recounted that late 1998 was the end of the mining era in Silverton. I’ve heard other people say, no, it was 1991, I don’t know, but I explained how there is a similar dynamic that exists today.
Kevin: Isn’t that normally a sign, when you start seeing the shuttering of an industry, it could be the bottoming of an industry before the next rise.
David: That’s exactly right. The mines were shuttered and you missed the bottom of the market, and if you moved on or shuttered those mines you were moving on at exactly the wrong time. Back in the late 1990s when the mining industry was hemorrhaging, gold and silver, of course, were in the crosshairs at lows they hadn’t seen in 20-25 years. There were bankruptcies, there were mine closures, and projects that were suspended. Our guide was very quick to respond. She said, “Well, that sounds like right now.” I had told her a little about what we did in the precious metals and asset management business. She said, “It sounds like it’s time to buy again. It’s almost like 1998-1999.”
Kevin: I’ll bet you said, “Uh-huh.”
David: I said, “Yes, that’s correct, but most investors rarely move into an asset at the low price.” Here’s a gal who bought a foreclosure in Silverton, so she gets it, she understands value, and when things are cheap they are that much more compelling. And on paper, it does make sense that you buy things when they are cheap, but people don’t live on paper. They tend to live in a world of ideas, they live in a world of emotions, and scars, and stripes, and expectations that if not met in a particular timeframe disallows them from separating subjective versus objective reality. They live in this, “I can’t take the pain anymore,” not aware of what’s going on in a broader context.
Kevin: Dave, we can feel what they were feeling in Silverton at the time because we were there. Your family has been in the gold business for over four decades, almost five decades. I’ve been with the family for almost three decades and I remember the 1990s. Gold got down to $252, wasn’t it? That’s when they were closing those mines. Now gold is kissing about $1200; it’s been higher.
David: And they’re actually in the same process, they have been over the last six to 12 months – mine closures, mothballing different projects. I think the reality is, as investors we live our lives in the first person, and sometimes that puts us too close to the trees to see the forest. Whether that is not gaining enough perspective to be reflective, individually, or from a financial perspective, just lacking adequate view to be able to take in where you are and where you are going – being lost in the moment.
Kevin: Dave, this last several weeks has been very interesting for me just personally. From a mental and emotional standpoint I wouldn’t think that I was that emotional about the markets, but I have been sickened over the last three years about the comatose nature of all the markets. It is as if the trust in the central banks had taken away these beautiful forces called market forces. Now, I’m going to be honest, I don’t care whether gold goes down or up, if they’d just leave it the heck alone. But it has been comatose for the last three years. I felt over the last couple of weeks like I’m watching an old friend blink his eyes after being in a coma for three years. I’m starting to see life, I’m seeing my old friend, gold, and it’s starting to tell the truth about the markets instead of what somebody is trying to tell me about the markets.
David: Right. It is interesting, that idea of a traumatic event where a medical practitioner, an emergency medical service person will induce a coma in order to control the state, and markets are now coming out of a controlled state and they are beginning to react to real things. So the Fed-induced coma that was powerfully felt through 2012, 2013, 2014, 2015, things are changing, and it is our contention that since 2013 real things in the marketplace have still been there as real issues to pay attention to and real risks to be apprised of, but they’ve been ignored and they have become temporarily irrelevant due to central bank intervention.
Kevin: It’s because the prices were not accurately reflecting what was going on.
David: Right. Now we have a reappraisal of central bank effectiveness, which is under way, and with it, a reappraisal of gold. And just as a reminder, it was Larry Summers who wrote, in the Summers-Barsky thesis, about how gold plays a role in a low to negative real rate environment. So he was clarifying the real appeal of gold in that low to negative real rate environment, and he was talking about real rates, that is, your interest once you factor out the cost of inflation. But he was not, in that paper, addressing nominal rates, where you can actually set them negative, and I think it applies even more in the context of negative nominal rates. An investor today is looking and saying, “Where does the migration need to be?” And I think the migration is just getting ready to begin.
Even this last week, Kuroda speaks, and ordinarily, when a central banker has spoken for the last three to four years, there is market impact, and that market impact has some legs to it. In other words, let’s say Kuroda over at the Bank Of Japan says something significant. Guess what? It may cause a rally in the NIKKEI for two to four weeks. Now Kuroda speaks and the NIKKEI falls 3%. And I think sentiment has shifted. Draghi, same thing last week. There is an initial, literally, five-minute positive response to his comments, and then all of a sudden the euro stock markets either sit still or drop. Again, I think it is sentiment shifting as we go back to that, markets are coming out of the coma.
Kevin: The central bankers have almost been Marvel superheroes. They will come out and it’s like they’re there to save the world. You have Bernanke, when he was there, any time he would say something positive about the markets, it would go up. Or if he would say something negative it would go up even more because it meant that he was going to give them some candy. We have Yellen, we have Kuroda, we have Draghi. These guys could come out and literally make the stock market go up hundreds of points, or down hundreds of points, and then give it some candy. But like you said, they’re losing control. Now the markets are starting to say, “Wait a second. I’m waking up. I’ve been in a coma for three years, but wait a second, I’m going to tell the truth.”
David: There is an argument, and certainly, Richard Fisher at the Dallas Fed, who retired last year, has said, “Look, we’ve got the big guns at the Fed and they’re out of ammunition. I agree with that, and I disagree with it. I agree that they are in a corner. I agree that there is not much that they can do. But the ammunition yet to be spent is in that negative rate territory.
Kevin: Negative rates and cashless society.
David: That’s right.
Kevin: We talked about the cashless society last week and how much information is coming out of central banks, but did you see the Paypal commercial during the Superbowl?
David: It was fantastic.
Kevin: It basically was saying everything we were saying last week. The old money is cash. They showed pictures of these old men on bills – Ben Franklin and U. S. Grant – and then it said, “But the new money is for the people.” They showed pictures of very attractive people. They ended the commercial with an attractive gal just smiling into the camera. She represents the new cashless society.
David: I don’t know exactly what that gal had to do with cashless society and Paypal except that smile and that’s your last impression. You’re like, “Oh, okay.”
Kevin: Right, but negative rates. So how do you keep money in the bank if you’re paying someone negative rates, which means you’re taking from someone some of their cash. You give them cashless society and you make them captive.
David: What I think most people have forgotten is the changing nature of our entire financial system. When you go back to 2008 and 2009, not only have we gotten intervention from the central banks to save your commercial banks, but the battle cry of the moment was, “Too big to fail. We can’t let them fail, they’re too big to fail.” And lo and behold, the too-big-to-fail institutions are now 30, 40, 50, even 60% larger than they were before. And you think to yourself, maybe that was by design. Maybe the proper response to any crisis is to consolidate power and influence and control, and maybe what you have in real time is a soft nationalization of the entire financial system via the banks, and in fact, we are going to do away, not only with cash, but with the branch banking system that you have known where you are a depositor at this bank, and we’re just all a part of one financial system. Forget the relationship.
Kevin: It’s like Robert Higgs. Build the leviathan. Create the crisis, build the leviathan. Create another crisis, make it even bigger.
Going back to gold, you brought something up a month, month-and-a-half ago, actually at the end of 2015, that the relationship between the gold mines – you were talking about these shuttered mines – and the price of gold had reached almost a historic separation, or gap, which might have been a signal at the time that the gold market was bottoming out.
David: Just as real estate was an indicator to you of a bottoming out, and of a bust phase, if you will, in the gold mining space in Silverton – you said, okay, we’ve got foreclosures, you’ve lost 150 guys that were mining and making $60-80 an hour, and you can’t make that kind of money in Silverton outside of this particular industry. So they lose their house, all this stuff happens – they’re indicators. The real estate market in that place was telling you what was happening in the mining industry, and the mining industry was telling you what was happening in the gold market, that it was as bad as it gets. And in December of 2015 you had the relationship between physical gold, and the companies that mine it, that reached a five-decade extreme – a five-decade extreme!
And for those of us that know the wide gyrations in price and the relative values between gold miners and the physical asset, itself, this is a signal, not only that we are at the end of a consolidation cycle, but that both the metals and the companies that mine them are now on sale. So if you will recall, to throw in the towel on the miners in 1998, 1999, 2000, and to throw in the towel on gold in that same timeframe, it was naïve. Investors were wrong then, and they’re wrong now, to believe that pendulums swing only one direction.
Kevin: Dave, unlike owning the physical metal, when you are buying mines you have to take other things into account. Sometimes they can work against you, sometimes they can work for you. Right now there is an amazing advantage because a lot of the mines are peso-denominated labor that is paying for the gold that is coming out, and as we know, the peso has lost quite a bit of value, but that gold is still being sold in the market for U.S. dollars.
David: Sure. And whether it is the South African rand, or the Canadian dollar, or the Australian dollar, the reason for mentioning the Mexican peso is actually two-fold. One, vacation there is truly cheaper with the depreciated peso. So whether it is time to vacation in Puerto Vallarta or Cancun or Acapulco, the peso is at a record low 18.75 to the U.S. dollar, which is far worse in terms of an exchange rate than the market extremes of 2008 and 2009.
Kevin: It was 2001 if I remember right, even when I went to my brother’s wedding – he lives down in Puerto Vallarta.
David: And then is stretched, ultimately to 15, and recovered to 12, and now we’re at 18. But also, I think, the second point worth mentioning on the Mexican peso is that it serves to illustrate this critical issue. You have miners that have major operations in Mexico – and this applies to Canada and Australia, as well – and they pay their bills in the local currencies. So the peso dollar exchange rate has fallen by 50% – we were at 12-to-1, now it is 18-to-1. The Canadian dollar has fallen by 30% relative to the dollar. The Aussie dollar is about the same as the loonie, as well. And if expenses are paid in those currencies, but the price of the product you sell is realized in U.S. dollars, you have gained, even if the dollar price of gold is stagnant.
Now, that’s not the case. We find, year-to-date, the increase in the U.S dollar gold price is up over 10%, and silver is up over 9% just since January 1. And if you roll the clock back slightly, since the Fed rate rise, which of course many analysts were predicting would devastate the gold price, we argued that actually it is nowhere near a threshold that would hurt gold, but gold has increased since that point, since the Fed meeting, by 13%, even as U.S. equities have dropped anywhere from 10-25% depending on the index and the sector that is in view. So you have, in certain jurisdictions, whether it is Mexico, or Canada, or Australia, or South Africa, the double benefit of a currency decline which alleviates your wage and expense pressures and you have a bump higher in the cost of the commodity you produce. These are the jurisdictions I would certainly snoop around in.
Kevin: Let me ask you. Your family has gone back to South Africa many, many times. Your father took groups over there, I think, 30-some odd times before he finished doing that. What about South Africa, because we have the same dynamic going on there, but it’s less stable. It’s hard to say that it’s less stable than Mexico, itself, but it is less stable, is it not?
David: It is less stable. I’m going to be down there in July of this year speaking at a conference, and I would say that while South Africa has the same benefits, it has less legal assurances, and as an investor you are not sure you are going to get to keep what you mine. South Africa is, to a large degree, a political disaster zone, and it’s a much higher risk than the other jurisdictions mentioned. There are certainly values there, for sure, but as you mentioned, we have been traveling there as a family and have had investment interests there since probably the 1960s, and all I can say is that the risk there can only be moderated by the depth of discount applied to the assets. At the right price, most things can become intriguing. But I’ve stayed away from South African investment since 2004.
Kevin: Going back to physical gold, like I said, it really is like seeing the awakening of an old friend. One thing I’ve always loved about gold, and I think every generation, really, for the last 4,000 years has loved about gold is, ultimately, it tells you the truth.
David: That’s right. So gold is performing like gold again, and that’s after a three-year identity crisis. You see, it performed exceptionally well through 2012 – normal, anyway. And even with the correction in 2012 in price, that was to be expected, it was healthy, it was within the realm of reasonable behavior within that market. But from 2013 to 2015 the belief that central bankers had redefined the nature of risk, and invented new tools to mitigate it indefinitely, put gold into this twilight zone of identity confusion.
Kevin: It’s like The Avengers I was talking about, they thought the Marvel superheroes could come in and save the day. That’s never worked in the past, and it looks like it’s not working now.
David: So we have misplaced confidence in the central bank community, and that was the primary contributor to the confused identity 2013 to 2015, but on a number of occasions, including last year at this time, gold was trying to gain traction. As you say, a 5,000-year history, it’s true, as a wealth preservation tool, and each time in the last couple of years it has been clobbered. And perhaps it will be again, but it appears that monetary policy legitimacy and effectiveness are being reappraised, and we’re talking about in the Asian context, we’re talking about in the American context, we’re talking about in Europe, where in each of these spheres there are disappointments which are setting the markets up for reappraisal of the metals. So gold is performing like gold again.
Kevin: Yes, but you know what’s interesting, you talked about how it gets clobbered every time it tries to form some traction, we saw some of those clobbering events just in the last few days where someone, somewhere, decided they wanted to see gold go down, so last Friday 1.2 billion dollars’ worth of contracts sold onto the market knocks gold down eight or ten bucks, and then gold reverses and ends the day strong.
David: And it comes roaring back.
Kevin: The same thing happened on Monday. My son, Sunday night while the Superbowl was going on, said, “Dad, have the Asian markets opened yet? I wonder is somebody is going to try to clobber gold?” Because it had ended strong on Friday. Usually when it does they try to clobber gold behind the scenes, low volume in Asia. Sure enough, they did, and then of course Monday – beautiful.
David: It came roaring back. We have had a dynamic shift. We have had a sentiment change. And you’re right, it’s the usual suspects, trying in Friday’s trade, again on Monday before the market opened here in New York, to obliterate its price. You have massive selling operations and they were met with sufficient buying. By the end of the day you had a rise in price. So here we are, we’ve passed the critical demarcations of $1120, of $1140, of $1160, and $1180 – those have been bested, technically – and quite frankly, getting above $1180, you’ve technically negated the downtrend line in place since 2012. And I would like to see $1200 in the rear view, and we may have that this week, but I would like to see it in the rear view before coming to a hard and fast conclusion. But as I said in December, it’s either 2016 or it’s 2017 that are spectacular years for the metals.
Now, it’s very sad for those that have been unable to stand the volatility and got out near the lows, but honestly, it’s typical. That’s very typical of any correction. If you owned it for the wrong reasons, or if you doubted the veracity of those reasons, you sold out, and you’re probably not going to return to the market. If you owned it for the right reasons, you recognize that in spite of central bank braying about a fixed financial system, little to nothing has changed from 2009 to the present. And quite frankly, the relevance of gold never went away.
Kevin: Dave, I want to point something out, and this is not to be mean, because we’re all human, but I can think of several clients of mine who owned gold through the 1990s and they’d just had it, they were done, after Y2K didn’t occur, or whatever the reasoning.
David: It’s like the shuttering of the mine in 1999, it’s like, “Okay, you know what, we just can’t make it.”
Kevin: The sold their gold, and they bought stocks, they rode them all the way up until 2008, and then the crash came. So they lost money, and then they came back in and bought gold from me.
David: (laughs) The timing’s not great.
Kevin: And a lot of those people have gotten out in this last three years. So sometimes you will talk to someone and they’ll say, “I don’t know what it is, I just always buy and it drops.” And it’s like, “Well, think for just a second. Are you possibly buying when everybody else is buying?”
David: That’s right. It’s a position which has been unrewarding in the last several years. An unrewarding position is not necessarily a wrong position.
Kevin: It’s like what you talked about with John Templeton.
David: Yes. It’s not a bad position to have, and last week we discussed Templeton’s timeframe of, say, five years, and his willingness to allow time to test a thesis.
Kevin: Even a five-year period would be worthwhile, like with gold, we’ve had a three-year hiatus, but we may see in this five-year period that it proves itself out as a valuable investment.
David: I think time has tested the gold thesis and now it’s game time. You have central bankers that are desperate to prove their relevance, and they’re going to fight for headlines, they’re going to fight for market impact. Gold may temporarily fall out of favor, but not once in 5,000 years has it lost its luster. The last three years have been a hard slog. The primary reason, most recently, to doubt a move in gold was rapidly-rising rates, the promise of interest rates rising, the dollar moving up in lockstep – those reasons are gone.
Kevin: Then I’m going to shift to something that is near and dear to a lot of peoples’ hearts, especially our clients who live in the Dakotas, in Texas, energy has taken it on the chin, and we’re seeing a large amount of job losses, we’re seeing checks that would normally come in from well royalties not coming in anymore. So, what do you think on the energy sector? Are we seeing signs of a bottoming, or do we have more to endure?
David: Let’s talk about that. Exxon is on the verge of losing a credit rating that is has held since 1930. So, note to self, significant changes. That’s a headline worth remembering. It’s the first downgrade for that company in 86 years, and if it occurs, I think it will signal a bottoming process, not necessarily a bottom. You have Chevron, you have Royal Dutch, you have other majors which are well into the credit downgrade cycle, and they have been hit by downgrades, many of them are still on negative watch. Most of your smaller producers have also been downgraded. And this is all typical in a commodity price cycle. But I think you are probably looking at finishing that whole process about three years out.
Kevin: So that hurts for the person who says, “You’re kidding me. It could take three more years for this bottoming process?” But in the scheme of things, three years is not that long, is it?
David: That’s right. What I see is investor behavior which is eager to buy the bottom, and you have a ton of people who want to call the bottom by the bottom, and that’s never the mark of the bottom. When people are eager to buy, that suggests that there is a stronger belief in higher prices than there is in lower prices, and that doesn’t mark the bottom of a market. When you get to a cyclical low, when you are in a bear market, sentiment washes out along with price, and people are no longer interested. Does that make sense at all?
Kevin: It does, and if you’re actually running the company, there has been a hesitance to cut production. There are a number of reasons, but they don’t seem to want to cut their production, even with the price lower.
David: It has been argued that one reason for the unwillingness of producers to cut their current production is the fear that politicians, both here in the United States and globally, are in the process of forcing a transition away from fossil fuels to renewables, which over a 20-year period will dramatically reduce demand and therefore the price of the commodity.
Kevin: Look at what Obama said last week. He wants to start taxing, what was it – ten bucks a barrel?
David: That’s right. Add a tax of $10 per barrel of oil to help fund green projects and I think what you find is that producers want to pump all-out. They want to get as much out of the ground at a reasonable price and gather every last dollar. I hate to imagine what kind of regional instability we’ll see when, or if, the oil price dips below $20. It’s not as if that’s unfamiliar territory in terms of the price, but keep in mind, the last time we were there, 10-15 years ago, under $20 a barrel, governments have bumped fiscal spending during that timeframe, as the price of the commodity was rising, and they can’t turn off that spigot, that is, the fiscal spending spigot, as fast as the commodity price can drop. So you have a lot of your gulf states which are very politically vulnerable, with too many promises to pay, and not enough money to keep them.
Kevin: Another area that we are seeing just void of any kind of return is in the fixed income area. I talked to you yesterday – I have a client who has been a client for 29 years. He is a very valued client of mine, he buys gold on a regular basis. He runs in the Midwest a bank with several branches. He called me and said, “Kevin, I can’t squeeze return. I’ve got more deposits than I can make loans. The deposit-to-loan ration right now is very, very high. People are saving money (like we’ve talked about).” He said, “I could be putting those deposits to work somewhere, but I really don’t know where to go to squeeze out return.” Your response is, ultimately, it’s probably going to have to be in government bonds, but he’s feeling the heat, as a banker, of this negative rate environment.
David: And you’re seeing more and more banks having to allocate more and more resources to securities. And that security segment would be fixed income securities. Maybe it’s mortgage-backed, maybe it’s, as you said, treasuries – two, three, five, seven, ten-year treasuries. And just to follow up on last week’s discussion of negative rates, you have embedded in the annual stress tests for 2016 for the U.S. banking industry, the banking industry giants have been asked the question, how resilient will your operations be if we implement negative interest rates in this environment? And the test, according to Bloomberg, is going to assess the stability of these institutions with rates going to negative 50 basis points – that’s negative ½ percent – and being held there through the first quarter of 2019. So already, as you said, there are too many deposits in the banking system, and nowhere to loan all the money. But imagine that world where treasury yields are negative and banks have had to choose whether or not to pass on those negative rates to depositors. You begin to wonder, what relevance is a bank if it’s not a safe place to keep deposits? And I can see some time in the future, the negative rate environment creating a further consolidation in the banking industry, and ultimately, this representing a soft nationalization of the entire financial industry, specifically, your big banks, who are struggling to survive an ever-flattening yield curve. And this is, again, too many depositors, or depositors who just say, “We’re not interested.”
Kevin: We talked about last week that the psychology is different than what the equation represents, that these bankers have been trying to employ with negative rates. Every time the rates go lower, whether it’s zero or negative, people save more money. I know Fisher has just recently been saying he’s sort of attracted by the whole negative interest rate concept. I don’t know why – it hasn’t worked.
David: Now, this is not Richard Fisher, who we quoted earlier. This is Stanley Fisher, who is also at the Fed. He’s the number two guy.
Kevin: Gosh, I keep getting all these “Fisher-men” – these guys mixed up.
David: He came over from the Bank of Israel and he did a good job of managing crisis events there, but in a presentation at the Council on Foreign Relations this week he said, “Look, I’m changing my mind. I kind of like the idea of negative rates, and I’m impressed by the results that I’m seeing in the countries that have implemented a negative rate policy.”
Kevin: What is he talking about? Where is he impressed with the outcome of negative interest rates?
David: I have no idea. Sometimes I scratch my head and I think, “What is he looking at that I’m not looking at?” You have the consequences of these kinds of policies which have been, and are, negative in the commercial banking arena. We have money markets which also are experiencing, let’s call it a Darwinian moment, where they’re going to fail a survival test of a financial ice age. In a zero interest rate environment, how do you keep the pulse? They are unable to earn anything, thereby unable to pay anything, and investors are asking, “Why should I stay?” You have Nomura, which is a big bank in Japan, which already is having problems with their money markets because of the Bank of Japan’s new negative interest rate policy and they have basically said, “Look, we cannot take any more deposits into these structures because there is not enough income for our fees to be paid, and for us to pay you anything.” So, again, there is a massive 2 trillion dollar pocket of liquidity in this money market arena which is going to be looking for a home, and if investors turn away from your commercial venues like banks and bank deposits, and they turn away from money market funds, what do they turn toward?
Kevin: Well, they’re going to fund the government. The government is not paying much, but they’re paying more.
David: I’m reminded of something I said last week. It is the likelihood that investors are being moved like cattle into the chutes, the ones we described, the Temple Grandin chutes, where government bond markets, you end up shuttling savings into government bond markets, not like you did in World War I and World War II, by throwing down the patriotic card and saying, “Look, if you want to fight the enemy, here’s how you help. If you don’t want to fight the enemy, then don’t buy government bonds.”
Kevin: You crush the commercial competition.
David: You crush the commercial competition, and literally, you have money market funds and bank CDs go the way of the dodo bird because they can’t pay anything, and all that money gets funneled into funding treasury liabilities.
Kevin: If we’re in a deflation or zero inflation that’s all fine and dandy, especially if you don’t have any defaults on those treasury bonds, but the reality is, Dave, that things still cost more and more every year. I mentioned last week how it’s nice to have low gas prices, but that’s really the only thing I see that I’m paying less for.
David: And as long as you can hide the dangers of inflation, investors will see government bonds as a reasonable option where it still looks like your treasury yields are better than the other options. I guess we can go back to that little diatribe earlier on how investors may not see the forest for the trees, because if you go back just 30-40 years, what you find is that U.S. treasuries were once known as certificates of confiscation, and I think maybe that’s a problem for the 2020s. We may not have to deal with that, it may not materialize in the next two years, but as people start going into treasuries, for whatever reasons, even those that seem self-interested and healthy, they are going to find the old nature of treasuries, again certificates of confiscation, a real issue.
Kevin: So instead of actually liking negative rates, Stanley Fisher may want to actually pay closer attention to what’s going on in the European banks based on the negative rates.
David: I don’t understand anything that he said about seeing an impressive response from a negative interest rate environment. You have such nastiness brewing in the European banking system, negative rates are not preventing a serious decline in European bank shares. There are stresses and strains showing up in the credit default swap market in the European banking space, and why? Number one, you have a slowing economy in Europe, in general. Plus, you have a low-to-negative interest rate environment which is not improving profitability, the financial market stability with these banks. So you have lost revenues, you have written into the laws now for bail-ins, depositors can become share-holders on a forced basis. That is codified into law. And it makes me think, again, I don’t know what he’s looking at, but I see that it’s cloudy, with a 90% chance of rain.
Kevin: George Washington wrote that you have to watch out for government, because the government will grow and grow and grow, and it will act like any animal when it is threatened with its survival. It will do anything, including kill the people in the very country that it lives in. And what we’re seeing right now in Europe is they’ve gone negative. We’re talking about this here, possibly in America, to get people to buy government bonds. China is a great example of a slowing economy, a government that is willing to eat its people. They’re spending a hundred billion dollars a month right now to keep this thing from really showing what’s going on underneath the skin.
David: Right. We’ve gone over the cash burn rate, that is, the monthly decline of China’s foreign currency reserves. And we’ve said that hundred billion a month rate is not healthy, it’s not sustainable. And this week we have January’s numbers which are true to form, they’re consistent. The Chinese foreign currency reserves are down another 99.5% billion.
Kevin: They didn’t break 100 this time – 99.5 billion.
David: Right. So this is interesting because you have the IMF which is now expressing deep concerns about China’s financial stability should that number slip from the current 3.2 – again, we’re adjusting from last month, 3.3, no 3.2 – the IMF says if it slips below 2.7 we’ve got a significant crisis. Again, 800 billion is the total decline since July of 2015. They’re spending these resources to defend their currency, and it is at a very high cost.
Kevin: This is a reminding me so much, Dave, of 1992. We’ve talked about 1992 before, but if you remember, we had the exchange rate mechanism in Europe, and currencies were not able to maintain within the band that they had all agreed to maintain in, so George Soros, if I remember right, saw the unsustainability of the exchange rate mechanism, and he bet big against the British pound.
David: Right. Kyle Bass is, I think, trying to mimic the trade to some degree, and other hedge funds are lining up, like that 1992 event where they were lining up against the pound. Now they’re lining up against the yuan on the belief that you will see a massive devaluation, 30-40%, because these interventions are not sustainable, and ultimately, they will have to devalue. So the exchange rate mechanism was a currency arrangement in Europe, which Soros believed was unsustainable – he bet against it. That’s what they’re doing in China. And I smile, because there may be a significant difference in the current trade, because you’re dealing with folks that can go nuclear on you (laughs), I mean, quite literally. But you have the Chinese politburo, and you have the PBOC, with the benefit of hindsight, the lessons learned in that 1992 period. Do they want to lose face to U.S. hedge funds? I think they may attempt to. Who knows if they can succeed, or if they will succeed, but they may just want to wreck the trade to prove that they carry a big stick. So the longer it takes for that trade to work out, the longer it takes for the yuan to be devalued the less profitable it is, and ultimately, the higher the likelihood that all those hedge funds have to basically throw out and reverse their trades.
Kevin: And it could be that this is one of the reasons why the Chinese have been accumulating so much gold. I had a client come in yesterday to pick up a statement, and we talked a little bit about the goings on in the gold market, and he said, “Kevin, have you been calculating the Dow-gold ratio?” This is an important point, the Dow-gold ratio, you just, of course, take the Dow-Jones Industrial Average, which right now is about 15,000, 16,000, and you divide that by the price of gold, which is in the high $1100s right now. The ratio we saw at one point all the way up in the 40s, you could get over 40 ounces of gold for a share of the Dow back in the year 2000. And then, of course, we saw it get all the way to 6, and then swing back up into the mid teens, but we’re starting to see some real action. The Dow is going down, gold is going up. Haven’t you been calling for a 3-to-1, 2-to-1, possibly even a 1-to-1 ratio at some point?
David: Yes, on an economic basis, I think a 3-to-1 ratio is a given. Where you get to a 2-to-1, or a 1-to-1 ratio between the Dow and gold is when an economic environment is exaggerated by political or geopolitical pressures. And so the higher the number, the more attractive gold is. Now, counter-intuitively here, because again, the highest that number as ever been was about the time that Silverton mines were closing down, and you were at 43-to-1 on the Dow-gold ratio. It may have, on a day, slipped up to 45 just on a single day trade, but that was roughly where it was, in the mid 40s. Then, as you said, it slipped to a 6-to-1 ratio by the time we got to 2012, jumped to 17-to-1, which, again, from 45 to 17 you’re still well ahead of the curve, going back to performance starting in the new millennium. Now we’re at 13-1/2, we’re targeting 9. As an initial play I believe we’ll see 9 this year. And then I think by the time we head into 2017 we see 6, and it wouldn’t surprise me at all if by the time we are in the year 2018 we’re at a 3-to-1 ratio. Keep in mind, gold has recorded three straight weeks of higher closes, so we need a little bit of digestion, that would be nice, seeing it consolidate, maybe even consolidate at lower numbers between $1110 and $1130. The next major move higher has to take out $1200, and then it’s en route to $1350. And these, I think, are numbers that will correspond with the next leg down in the stock market indexes. So you have January 20th, the lows that were set for the Dow of 15,450, and the S&P 500 at about 812, those are going to correspond with a $1350 gold price, I think, sometime in here as we head toward a 9-to-1 ratio, and then ultimately slip, in the years ahead, to a 6, and ultimately a 3-to-1 ratio.
Kevin: The beauty of the Dow-gold ratio is that you’re measuring two things that have value, not a paper currency, so it’s an easier thing in the long run to actually calculate. Sometimes it’s better to have heavier in stocks, sometimes it’s better to have heavier in gold. Bill King, who is a regular guest of ours, has shown, though, if you take 15 years, if you take 50 years, it’s always good to have some gold, because no matter what the Dow-gold ratio is, gold in the long run outperforms the S&P 500, which is a broader index of stocks.
David: Right. The argument that is typically made against owning gold for a long period of time, because when people are making this argument they say it sorely underperforms stocks, is when they incorporate a timeframe that captures from 1933 to about 1967, when the official price of gold was set in stone. Of course, it was officially set free and allowed to float in the 1970s, right? But that period of about 40-odd years mutes the total returns for gold because it was fixed. In a freely trading market, say 1967 to the present, roughly a 50-year span, or a shorter timeframe, the last 15 years from the year 2000 to the present, gold has outperformed stocks, not just by a small margin. So I think, when I look at the Dow-gold ratio, it continues to be a very intriguing value reference point, where there is a time to exit the gold trade, there is a time to use your ounces as capital, as cash, to buy real assets. And historically, that needs to be at roughly 3-to-1 to be really compelling, and you may even see a 2-to-1, or a 1-to-1 ratio. You may say, “We’ve just had a correction in the stock market. Surely the stock market is already at value.” And I would say, “Look, even if Warren Buffet were standing on stage answering the question, his favorite measure of market cap of the stock market compared to GDP – this is what he considers to be the best valuation metric – is still two standard deviations above the mean. It is well above – well above, right now – the valuation levels that we had at the peak in 2007 in that housing bubble era, and it is now just a skosh below the 2015 highs.
Kevin: So we still have plenty to go on the downside. Friday my wife called me and said, “Hey, Kevin, I thought you just ought to know, Obama is going to get on TV, he’s going to talk about the economy.” That usually does affect the market, I was appreciative that my wife was paying close attention. But Obama got on TV, really, to let us know that we were the strongest, most resilient economy in the world. He said, “Hey, how about that jobs number? 4.9%, that’s it, that’s the only unemployment we really have.”
David: And curiously, for the month of January, I think this would be the first time in the nonfarm payroll history that you have added close to 60,000 jobs in January. Normally, those are positions eliminated after the holiday season, but retailers are supposed to have added 58,000 jobs in January, which I find hard to believe. I also find it hard to believe that we, in the middle of an industrial recession, added 29,000 manufacturing jobs.
Kevin: Dave, I’ve mentioned in the past that I was a toy store manager before I came here, while I was in college. We would run a crew of about 130 people up to Christmas and we would reduce that to less than 30 right after Christmas. So strangely, I’m wondering what retail and nonfarm payroll jobs are being added to that degree in January.
David: Well, what’s being added is pressure from the White House to take advantage of particular numbers that can be entirely politicized, coming into the Kabuki theater that we have that we call the political process, the election process. But you know that between that particular number, the employment number, and the GDP growth figures, these two are going to be monkeyed with all year long to prove one particular point, which is, the Democrats have delivered the sun, moon and stars, in terms of recovery, to the average man on the street.
Kevin: We’ve had this conversation in 2008 on this show, we’ve had this conversation in 2012 on this show, we’re having this conversation in 2016. I don’t know, what’s the significance? Does it have to do with the summer Olympics?
Kevin: No, I don’t think so, I think it has to do with the election cycle.
David: Well, let’s look at our game plan as we look back at 2015, I’m going to say we sound a little bit like a scratched record because the record we played in 2015 was simply this: You need to reduce your equity positions, you need to effectively hedge them. We said that before the stock market started selling off 10%. There may be another 20-30% in declines ahead of us. We still reiterate, you need to reduce your equity positions and effectively hedge them. Otherwise, you need to raise cash. And you need to put away adequate amounts of gold and silver. And as a speculative play, going back to Silverton and the ski trip, as a speculative play on the price of metals, choose a few miners in the proper jurisdiction, and see what happens next. It needs to be an amount that you can stomach, because we are talking about volatility, we are talking about an instance where some simply cannot hold on, even if we have turned the corner. They have gone too far in terms of debt obligation.
Kevin: What would you say, 10-15% of a portfolio, max?
David: Oh, not more than that. Not more than that. And that’s enough as a speculative play to be very interesting over the next couple of years. So cash, gold, a few mining shares, hedged equity positions. There are a few places in the fixed income space that you can weasel out a percent, or a percent-and-a-half and not take on too much risk, but this is a period of time where you want to be cautious because of the character of the political operators. You want to be cautious because of the character of the central planners. You want to be cautious because of the trends in play which define you as an average investor, an average investor who is nothing more than fodder for the system. Understand what you represent and who you are to the system, and you’ll have a much better idea of how to play this over the next few years.