The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: David, yesterday you came in after a great holiday away – you had gone out of town and had a great Thanksgiving. But you had this pale, green look on your face. The stock market was up 300 points! Was it the food?
David: We had a great time visiting with family, fantastic food, and what evolved last week, while we were thinking about turkey and stuffing, and family time together, was the complete implosion in Europe. Wednesday, we had a failed bond auction in Germany, and how much press did it get Thursday, Friday, Saturday, or Sunday? As we came into the new market open on Monday, there was grave concern about the dissolution of the eurozone, in its totality, not just losing Greece. And we had Merkel and Sarkozy trying to patch some sort of a last ditch effort – conference, this, that, and the other – and guess what? Retail sales were great on Friday.
Kevin: We had a great black Friday, Dave? I mean, why wouldn’t spending more money, when we don’t have it, be good news?
David: Kevin, I guess what scares me is that people really aren’t engaged. Do people think that spending 52 billion dollars of money that you don’t have, on credit cards, to just feel like you are doing all right again, is somehow a revival of new growth in the economy? I’m all for improved retail sales. I’m all for retailers doing well. This is not a bah-humbug moment. I am not Scrooge. But this is the issue: We have people who are spending money that they don’t have, and it is really reminiscent of what the government is doing – they are spending money that they don’t have. And the whole crisis that we have in Europe, and in the U.S. – it’s the same theme over and over again. It doesn’t matter whether it is Main Street, Wall Street, or the folks in Washington, D.C., or any power center around the world. It seems that the problem and the solution are utterly confused, because the problem was spending money that we didn’t have, and now what are they doing more of? Spending money that we don’t have.
Kevin: David, it reminds me, and this is not necessarily a partisan issue – it reminds me of 2001 when Bush was saying it’s patriotic to go spend money because of 9/11. We need to get the Americans activated – go spend money. It just shows how tightly Keynesian economics has gripped a public who has never heard of John Maynard Keynes. It’s all about spending more money and good news, even though disposable income, I think, was down over 2%, from year to year. The disposable income was not there to make a Black Friday, or even Cyber Monday, a better day.
David: Kevin, my thoughts were bordering on the paranoid coming in on Monday, because my sort of crisis checklist was being put in place Sunday night. Moving into crisis mode, I was thinking about bank deposits, limiting them, checking the latest safety rating of my bank. I was thinking about insurance companies, limiting exposure to insurance companies and making sure that I’m with the most credible, if with any, insurance company at all. Pension funds – do I have the option of a lump sum? Take it and run, if that is the case. Literally, I was coming in Monday morning thinking this was a time to be battening down the hatches. And instead, the market went nuts, berserk, absolutely ecstatic – because guess what? There was an indication of a pulse with the consumer. And I was just thinking to myself, “Really guys? This is as deep as it gets.”
Kevin: And some of the quotes that were coming out of Europe and England were basically saying, “We may be days, or weeks, away from the end of the eurozone.” So people really are not connecting the dots.
I want to jump back, though, David, because even though we talk about the economy a lot, we do say the financial moves to the economic, moves to the political, and then it goes to the geopolitical. Iran – things are happening right now in Iran. It may not be to Americans, but it is to our ally, Britain, right now.
David: Kevin, I am reminded of a song lyric, “It only takes a spark to get a fire going.” On Sunday the Iranian parliament voted to expel the British ambassador, and reduce diplomatic relations with the U.K. On Tuesday morning, the British embassy released this statement, “There has been an incursion by a significant number of demonstrators into our embassy premises, including vandalism to our property. This is a fluid situation and details are still emerging. We are outraged by this. It is utterly unacceptable, and we condemn it. Under international law, including the Vienna Convention, the Iranian government has a clear duty to protect diplomats and embassies in their country, and we expect them to act urgently to bring the situation under control, and ensure the safety of our staff and security of our property.” It was an Iranian news agency that ran the story, and then immediately retracted it, that six embassy staff had been taken hostage.
David: So that leaves it uncomfirmed. On the one hand, we have the Iranian news agency saying it, and then obviously, we have a situation which would escalate to the next level, in terms of an international flash point, if, in fact, we have something reminiscent of the 1979 hostage crisis, where instead of the British citizens being taken hostage today, it was U.S. citizens, and what was an absolute disaster for the Carter administration.
Kevin: And David, there is such an irony here, because Ahmadinejad was one of those students back in the late 1970s, and now he is president of Iran, so to think that he is going to be just deeply concerned about an embassy being stormed. Gosh, this guy is vile.
David: Student political activism seems to be a great lead-in to a political career.
Kevin: David, if we are talking about the 1970s, we are talking about a period of time of high inflation, gold rising, and invasion from Russia. We are also talking about the Iranian hostage crisis. There seems to be some parallels. To bring us back to the economic in the 1970s, a similar type of period of time, interest rates were sky-rocketing because of inflation. That is not something we are seeing right now. We saw a failed German bond auction last week – you mentioned this earlier.
David: Just to make sure we are not confusing causal behavior, because it is not that inflation was driving interest rates, but interest rates were rising to take care of inflation.
Kevin: To get a positive rate of return.
David: Essentially, we are talking about risk premium. If you assume that you are going to lose value through a devalued currency, how do you make some of that back? You have to have some compensation for losses that you are taking, if you are willing to commit capital, and that is when you begin to see an increase in interest rates, in which people are viewing risk in this category, or that category. Maybe it is interest rate fluctuation. Maybe it is currency devaluation. Maybe it is political instability. Maybe it is your ability to collect taxes as revenues. That has been the crisis in Greece. They now have a dual crisis. Not only do they have too much debt, but they have no means of collecting revenue to pay and service their debt. We have all of these things which can drive interest rates higher, and the only place in Europe where we have seen stability in the bond market…
Kevin: The safe haven….
David: The safe haven, just like the U.S. treasury market, but for Europe…
Kevin: … was the German bund.
David: That’s exactly right. And what does it tell you when last Wednesday, we had a failed bond auction, 6 billion euros at offer, and close to 3 billion of it didn’t go?
Kevin: So they sold just a little over half. Now, here’s the thing, too, and we had a talk about this, for the understanding of the bond market…
David: 39% was not taken, and had to be monetized.
Kevin: Well, if you don’t sell bonds at the interest rate that you are willing to pay – let’s say you are the German Bundesbank – you have two choices: You can either raise the interest rates that you are willing to pay, which it seems the Germans were not willing to do last Wednesday, or just buy it back from yourself. That is something we in the United States have experienced for far too long with the Federal Reserve. Is Germany monetizing?
David: They are monetizing. Looking at the Bundesbank, go back to December 1907, and keep in mind, we have an assumption about the stability of the German banking system, and what was the old Deutschmark, and hopefully their influence in the euro, as the largest component part in the ECB, a 27% contributor to the ECB. They are the largest vote, if you will, with the European Central Bank.
Kevin: And they are considered the strong backbone.
David: But the issue is that we perceive them as such only because we, you and I, have the historical recollection of the hyperinflation, and assume that they do, too. We are now moving into multiple generations distant from those events, and a failure of collective memory. Kevin, going back to that December 1907 date, we find the Bundesbank with a leverage ratio of 75-to-1, not exactly the pristine, conservative, non-money printing, non-accommodating bank that they have postured and advertised themselves to be.
Kevin: So they were already highly leveraged back in 2007, before the crisis. Where are they now?
David: Of course, they keep on taking over these responsibilities, a cleanup operation, if you will. If German bonds aren’t bought, where do they go? Who is buying them? How do they get monetized? That does impact your balance sheet. Now they are not 75-to-1, they are 153-to-1, and we still have this impression that they are conservative, tried, true, staid – surely they have not forgotten the social ramifications and consequences of hyperinflation.
Kevin: Let’s put this in context for the person who owns a home. Let’s say you want to buy a home for $153,000, and you ask, “Well, how much do I need to put down to buy this home?” And they say, “Well, just bring in $1000. 153-to-1, we’re comfortable with that.”
David: And if it moves down in value $1000, your equity is wiped out.
Kevin: You’re done.
David: Yes. So virtually, no change in the value of the assets on your balance sheet, and you’re insolvent. This is the irony, Kevin, because the Bundesbank, being the strong anchor within the ECB, is on thin, thin, thin ice. We have December 9th coming up and the European Summit, which features a treaty restructuring for the ease of fiscal integration. Sarkozy and Merkel are trying to say, “How do we push this forward?” We are now at that crunch time where we are not sure there is any other solution except fiscal integration.
Kevin: Explain the ramifications of fiscal union. What makes that different, for the listener who is not familiar, with the monetary union that they have now?
David: Essentially, it is a handover, to Berlin, of control of all of Europe. This may sound extreme, but we basically are witnessing the potential winning of World War II by the Germans, in terms of the transfer of power and influence over all of Europe. How many people fought and died to keep that from happening? Obviously, the circumstances were different then, from now. We are talking about different leadership. We are talking about a different mandate, a different ideal being foisted on the world then, versus now. But this is the idea, Kevin, that we have very limited options and it is either to shrink the euro considerably, or to see deeper integration, and shrinking would be, to some degree, admitting defeat. So there is a pride issue. There are many, many complicating factors, but they are not going to shrink it. It appears that they are moving toward fiscal integration.
Kevin: And isn’t it interesting, David? It’s so important to have a rear-view mirror look at history when you are looking at what is in front of you, because we just now talked about how strange it is that Ahmadinejad, who runs Iran, was part of those student protests and the capture of hostages back in the late 1970s. We also have to look back in the mirror and say, “Germany wanted what is happening, back in the 1940s and the 1930s, and we are seeing it, however, brought about by monetary crisis.”
David: We are not saying there is anything wrong with Berlin calling the shots. We are just saying that Berlin is calling the shots, and that’s what it means. So if you have a problem with that, then you do. If you don’t, then you don’t. But that is what it means. Fiscal integration means, at this point, France and Germany – again what Ian McAvity called the Frank-and-Stein monster – coming together. It actually is more the “Stein” than the “Frank” because they are the ones who are the largest contributors to the ECB, and you have to follow the money on that.
Kevin: So David, until we see that fiscal union, or until we see some clarity, what is it that you recommend people do?
David: I think you have to learn to wait, Kevin. I think the stage we are in right now is battening down the hatches for a European storm, and it is important that people be positioned ahead of the storm, and then just have the ability to be patient.
Kevin: That’s so hard.
David: Kevin, you went out to New York just before Hurricane Irene hit New York. You were there preparing and helping your daughter get ready – cans of tuna, water, batteries for the flashlights. And then when everything was done, and you had gotten ready, then there was nothing.
Kevin: There was nothing more to do, and it was strange, because they say 12 million people, roughly, live in New York. Well, these people are doing things all the time. It’s why you live in New York. You don’t not do something. But they shut New York down on Saturday afternoon. I think I mentioned this in a prior program, the only thing you could do was just sort of walk around and wait, because we knew Irene was going to come 8 o’clock that next morning. The weather service told us exactly when it would be there. It was supposed to be one of the worst storms in history to hit New York, thank the Lord it wasn’t, but nonetheless, that waiting – you don’t know what to do with yourself. If a person has money, or assets, in an account, and they are just champing at the bit to move them around…
David: This is the time frame in which the fundamentals will ultimately speak, but the question is, when you will begin to see the market react to those fundamentals – you have no idea. That is what you cannot judge, and this is to borrow from a Keynesian idea, which I think has some relevance. He said, “The market operates this way: It’s like a beauty contest, and you don’t choose, when you are an investor, the most beautiful woman in the beauty contest. You choose who you think other people will view as the most beautiful woman in the beauty contest.”
Kevin: So you are investing for perception, not necessarily reality.
David: That’s right. So the reality already exists in terms of the very frail, frail market structure, both in Europe and in the United States, but the perception is that all is well, and we come into this week with the sense that all is well, that retail sales were up, this bodes very well. And if you will recall, Kevin, corporations were very wise, I think, several months ago, to not be overstocking shelves. Remember we talked about what was happening in the Long Beach port, what was happening all up and down the West Coast, as longshoreman basically had nothing to do. This is very uncommon coming into the holiday season, but you had purchasing managers saying, “We don’t see it. We don’t see it. We don’t think it’s going to happen. We think this is going to be a very slow season.” Statistically, Kevin, when you come out of the gates strongest in a selling season, like this last weekend, typically, you have already seen the best already, and you have a very negative taper from that point forward.
Kevin: What a contrast, though. I keep hopping back across the Atlantic, but during the time that people were doing their Black Friday shopping, the weekend news from Europe was the worst since 2008. It’s like a subprime crisis occurring all over again.
David: Yes, we have the British embassies in the eurozone which have been instructed to do scenario planning for helping ex-pats through a collapse of the single currency.
Kevin: So an ex-pat who is maybe living in Greece, or living in Portugal.
David: Or Italy or Spain. They are now doing scenario planning to figure out what they need to do if there is a collapse in the currency, if they see countries begin to leave, and this is an imminent thing. Their concern is that this could happen within weeks or months, and they may have a stranded ex-pat community without access to bank accounts and liquidity because they no longer have, via their credit cards or debit cards, the ability to move, the ability to purchase things, the ability to exist as they had previously.
Kevin: So it’s the British taking care of their own. This reminds me of a financial Dunkirk – preparing for Dunkirk. That’s when Hitler blitzkrieged across Europe, and Britain got their people out of Dunkirk in just the nick of time.
David: I think it is very interesting, Kevin, that we have the British embassies doing that scenario planning now. We have ICAP PLC, which is a large firm, facilitating settlement of currency trades between banks. They are testing systems for trading the old European currencies. These are stress tests in the event of a member state exiting and going back to their old currency, where they would be responsible, this company who is responsible, in large part, for the settlement of currency transactions in Europe, they would have to, then, get more creative, go back to the old ways of doing business, and converting between 1, 2, 3, 4, 5, or 10 currencies, but at least having one new variable in the mix.
Kevin: So, if someone is planning for the scenarios that could occur with Europe, I think it has been distilled by Jim Bianco down to three things. The first one would be to just disband the currency, completely. Right? Is that something that you see happening, David?
David: The disbanding – we have these two strong interests. We have the folks who have had a vision of a unified Europe since 1950, who are like bulldogs in terms of their tenacity. They will not let go of this idea, and I think they would be willing to sacrifice anything to keep that union, including inflation. It’s a small price to pay, and it’s a temporary price to pay, for something that took decades to plan and execute, in terms of political change.
I think this is where we go back to Franck Biancheri’s interview, when we talked to him about the fact that a crisis compresses time, and this, for them, speeds up the opportunity for a deeper integration. No, I don’t think we will see countries leave. That’s one element. We are talking about the powered elite in Europe holding on to a vision of Europe and not letting go of it until they have absolutely succeeded.
At the other end of the political spectrum are not the powerful elite, but we are talking about the grassroots. We are talking about the unemployed. We are talking about folks who may vote. Kevin, this is the point. We have the democratic element. We have the people who want to be enfranchised – one man, one vote, one election. They will have their voice heard, and they would say to themselves, “We are not being fairly represented. It appears that we are paying the price, and someone else is benefiting.” Whether that is the banking class, whether that is the political elite, and this is theme of Occupy Wall Street, but writ large globally, it is just the disenfranchised people, who do still have a vote, and get to say, “I’d rather have the peseta, I’d rather have the lira, I’d rather have the drachma, than stick with the euro and be the whipping boy for the Germans.” That, again, is not our opinion, but that would be the opinion of the disenfranchised, nonworking, unemployed, whether they are Italian, whether they are Greek, or Spanish, who are saying, “We’d give anything to leave.” We have that struggle of the powerful elite, and the disenfranchised, who do carry a vote, and live in a democracy, coming into conflict.
Kevin: And that conflict probably comes from the second solution. The second solution is austerity. Who feels the pain during austerity? Is it the rich or the poor?
David: It really is the people who feel austerity. That is where you begin to see the electorate hit the streets. It is one thing to be unemployed and feel like you can’t make ends meet because of inflation. You still don’t have a person to point the finger at. But when you begin to implement austerity measures, now you have a party to blame, you have a persona to blame, and that is when you can take to the street. That is when you can get either uptight, or actually violent. And that is where we see the second option, that of massive austerity, as off the table, because politicians are not willing to be that tarred and feathered character marched out in the political parade.
Kevin: It’s almost impossible to have austerity when you are, for instance, a Greek leader, like you said, or a Spanish leader, but if you have a single fiscally united union, and I don’t know how that happens, but that is the third option. If they fiscally unite, and that is what you talked about, everything being run through Berlin, do you see that possibly bringing about a long-term solution? Would it be a smaller Europe, like we have talked about before? A smaller European Union, maybe getting rid of the excess weight?
David: Jim Bianco, of Bianco Research, has done a great job talking about these three elements, and the issue with that third one, Kevin, a fiscal union, is that it is, essentially, a way of saying that Germany wins World War II, and that is something that, ultimately, I think, there would be a gut check to.
Kevin, essentially, what you are talking about is a rewriting of the script, because they only allowed for the giving up of monetary sovereignty. To give up fiscal sovereignty – what is fiscal? What does that mean? We use that word a lot. Just to refresh, that is when someone can tax you, and then take that revenue and spend it. They are the decision-makers, and not only how deep they can get into your pockets, but what they can do with that money on the other side. What we are talking about is the Italians saying, “Somebody in some other country is going to pick my pocket and spend it on their pet projects. Don’t like it.” Or we have somebody in Greece saying the same thing: “I don’t want the Italians picking my pocket and spending it on their road projects.” Or we have the Portuguese – it goes on, and on, and on, Kevin, so that you don’t have the sense of accountability for the leadership that you elected to represent you in the political structure. How is the money being taxed and spent? Now it is out of your hands, under a consolidated fiscal union, which implies: Fiscal union – one step toward political union.
Kevin: I think about Rome, David, because the last time we saw this region unite was under Rome, but there was no fiscal unification based on peaceful treaties and meetings in December, for instance.
David: It was a double-edged sword, that’s what got it done.
Kevin: It was the Roman military and a whole lot of bloodshed, and it took a lot of blood to continue to keep that thing together as long as they did. So what you’re saying is, if we do have a fiscal union, a Greek by birth, but a European by “not your choice.” Or a Spaniard by birth, but a European, not by choice, because you are talking about no vote on this. This is something that would be brought down from the top.
David: Yes, Kevin, when people feel disenfranchised, they do everything that they can to get re-enfranchised. We had this with the Basque separatist movement. If you go back and look at European history, and the different factions that represented “terrorists,” whether that was the IRA in Ireland, or Black September, there are all of these groups which had a particular view, and felt like they needed to be enfranchised, and the existing government did not adequately represent their interests.
What you are talking about is immediately creating the possibility for total chaos, wherein you have these individual factions who are saying, “Not on our watch. Not on my dime. This doesn’t represent me. We’re a democracy and you are not respecting my vote. If you won’t respect my vote, then I won’t respect your right to x, y, and z.” That is where you end up with total political chaos, verging on anarchy. But I think the anarchy of tomorrow is designed, and is orchestrated, and I want to know who is behind the scenes. Who will take advantage of that groundswell of energy?
Kevin: Let me throw this out to you, because you have brought up, many times, these guys that we call bond vigilantes, and I have asked you: What is a bond vigilante? But really, the bond market is so huge in comparison to stock markets, commodity markets – you name it – the bond market is the world’s money system.
David: And it is smarter than the equity markets.
Kevin: And last week, the bond vigilantes – talk about anarchy – said, “No, we’re not going to take the strongest bond in Europe, the German bond.” Tell me this: Italy has two bond auctions this week. If the bond vigilantes didn’t want the European Union’s strongest country’s bond, how about Italy?
David: And we have already seen it, Kevin. The first one is done, and we have one more later this week. Essentially, we have the potential for triggering the credit markets into an utter debt panic, this week, or next week. In fact, you could go week-by-week between now and the end of the year. The Italian Treasury issued 7½ billion dollars worth of bonds earlier this week and they have a similar offering later this week. What is particularly interesting about the 7½ billion dollar offering is that it was only a week to ten days ago that the news in the U.S. was, “Gracious me, rates are at 7%, we’ve got to do something to get them under 7%! There’s panic in the Italian market. The bond vigilantes are at work again. There’s chaos. We’ve got to do something. Where is the easy way to intervene?” Guess what it was this week, Kevin? Just shy of 8%.
Kevin: So it’s going up, and that is what is supposed to happen when risk increases.
David: Right, but what is emerging is that the façade of stability is being torn down, and people are saying, “Wait a minute. It’s not just the Italians who have wrecked their financial house, the Germans have done the same thing!” And that’s why you had the absolute failure of the bond market last week in Germany. Last week was the critical turning point in the European crisis because of the failed German bond auction.
Kevin, it would be like us coming to market with 20 billion dollars here in the U.S., and having a no-show by the Chinese, having a no-show by the Japanese, and having a no-show by the institutions here in the U.S. On top of this, we have U.S. money-market funds, who had been funding Europe up until last week, pulling 8 billion dollars in short-term funding. So we have European banks who have been financed in the short-term by U.S. institutions, and we have U.S. institutions, money-market managers, saying, “Wow, this is going from bad to worse, and we are going to have some serious egg on face, if we don’t stop our bad buying habits, and get some of that money back on our side of the pond.”
Kevin: David, it doesn’t sound like December is going to be a very merry time for Europeans.
David: It’s going to be both a time of giving, and receiving. It’s a time of giving gifts, and great hope and expectation, that perhaps something is received, as well (laughter).
Kevin: You know, I think of the Twelve Days of Christmas (the music of which begins playing in the background, and continues throughout discussion of Thirteen Days of Christmas), but in reality, we have bond auctions, and all these critical turning points.
David: And it makes it more like the Thirteen Days of Christmas (laughter) if you are counting all the bond auctions necessary and all the generosity which Europe is expecting.
Kevin: Okay, let’s take the first of December.
David: There is a Spanish auction, and a French auction early in December. Then again, December 5th.
Kevin: That’s the second day of Christmas.
David: Then there is a French auction again for shorter-term bills. Then there are Irish budget presentations to parliament.
Kevin: That’s the three French hens (laughter). Keep going.
David: Or the Irish hens.
Kevin: Oh, the Irish hens, yes.
David: And then there is the fourth day of Christmas, which is the Greek budget. They have to vote on that on the 7th, as well as the Portuguese auction, yet again looking for money. The fifth day of Christmas, there is the ECB Governing Council.
Kevin: Now that’s the five golden rings. They may finally get that.
David: And they will probably just cut rates to 1%, that’s sort of the expectation, that they will be forced to accommodate.
Kevin: How about the sixth day of Christmas?
David: December 9th, as if we weren’t doing anything in early December, the European Council Summit. We mentioned it earlier. This is where they are going to have to decide whether or not they can change and ratify these treaties in order to allow for greater fiscal integration.
Kevin: Dave, the seven swans a swimming, the 7th day of Christmas, which, in this case, would be December 12th.
David: The Italian auction for bills, the French auction the same day for bills, and then you have December 13th.
Kevin: We’ll call that the eighth day of Christmas. That’s eight maids a milking.
David: These are Greek maids a milking, and Spanish maids a milking. They are looking for treasury bills. The 14th day of December there is the Italian auction, again for bonds – the Spanish auction for bonds. Kevin, we are talking about over 100 billion dollars in capital that has to be raised in Europe between now and the end of the year.
Kevin: Maybe it will be their Black Friday. Maybe people will just come out of the woodwork and spend money.
David: You have to believe that they are hoping that, because by the time we get to the 10th day of Christmas…
Kevin: Which is the lords a leaping…
David: The French auction for bonds. Kevin, it goes on and on, because we have the Greek auction after that.
Kevin: That’s the 11th day, right.
David: We have the Portuguese auction after that on the 21st.
Kevin: We’ll call that the Twelfth Day. And then December 24th, let’s call that the Thirteenth Day of Christmas. We didn’t stop at twelve, but thirteen is probably more appropriate.
David: But before Christmas we have the Spanish auction for bills, and that’s not even the end of the year. We still have the French and the Italian auctions for bills and bonds on the 28th and 29th (music ends). Kevin, we are talking about liquidity starvation. We have institutions here in the United States which are pulling back. If you look at this, there are rings of the subprime all throughout it, as institutions are saying, “Listen, about our longstanding relationship. We love that. But we’re on hold for the time being. The folks upstairs said that we need our money back. That’s why we’re not extending you any more money, for the time being. We’ll be right back.”
That’s exactly what happened in 2008, when people started to limit the inter-bank lending – and guess what? The Fed stepped in during 2008 and in a short period of time, offered 7.7 trillion dollars into the marketplace to make sure that not only U.S. banks, but European banks, didn’t go under. Now we have adulterated balance sheets. Now we have more constrained activity by local fiscal authority, whether we are talking about the Spanish, or whether we are talking about the Greeks. It’s already happened. They can’t save themselves. The British can’t save themselves. They may have an issue in Iran. Kevin, we are just talking about an absolute mess! This is what I took in over the weekend, and yes, I had a little indigestion from too much turkey, so I’m not saying that all of this is European (laughter).
Kevin: Did the turkey cost you more? I think we need to talk about the United States here as we wrap up the show, because there are a lot of people who are listening to this, saying, “But that’s Europe.”
David: One final point, because we came back to the office Monday morning to the cheers of the Wall Street opening bell, and Dow futures were up 250 points, and everyone was ecstatic, because “People are spending money again, which means there are no problems anywhere else in the world, and there is no possibility for a negative feedback loop from Europe to the United States, because can’t you see? The consumer is out there spending. We’re on top of it.” Kevin, this is a joke. This is a joke. We are in very, very dangerous territory, in part, because people have deluded themselves.
Kevin: Yes, David, it was a mess. But I still had turkey. I still had stuffing, I had cranberry sauce. My wife is an amazing cook. It cost a little bit more. I don’t know about you, but I think somebody actually looked at the statistics.
David: Well, we did last year, and we are looking at it again this year, and in terms of the hedonic adjustment, the question is: How much better was your turkey this year than last year?
Kevin: It was awfully tasty, she tried new recipes – but it was more expensive.
David: It was more expensive. And did you get more for it, either in terms of poundage or pleasure?
David: Then this is the issue. There is a bite with inflation, and there isn’t something to offset that bite. 13.2% was the total increase in your turkey dinner, from last year to this year. So that is a sobering reality – but guess what? It doesn’t break the bank. The fact that we are spending an extra $5 or $10 more on a turkey dinner, when you throw in the 16-pound turkey and the gallon of milk and pumpkin pie mix and the whipping cream.
Kevin: Yes, but didn’t relish go down in price?
David: Well, it did. Actually, that was the sort of anchor. You had some miscellaneous ingredients in your 1-pound relish tray, (laughter) which was actually down 1.3%. You have to wonder, is that just the relish that has been sitting in a can for a year-and-a-half or two years and was up against any expiry date?
Kevin: Dave, at 13.2%, you’re right. On a year-to-year basis, you may be able to afford Thanksgiving this year, maybe next year, but at 13.2%, that means that turkey dinner doubles every five years. What is wrong with the system? You talked about it being a mess in Europe. It’s a mess here, and we haven’t even had the realization yet, because Europe has been the focus – we haven’t had the realization of the mess we are in now. We are worse than Greece.
Dave: Let’s finish there, Kevin, because I think when you look at the U.S. we are talking about recession recognition. We have the backdrop of high unemployment. We have growth expectations which are already built into the system, and we think that you could see, as people recognize that we are in a recession – not that we ever came out, but we have been in recession, and it has been papered over. It’s been covered up, the statistics have misled us. I think what we will find is a 7000-point lower Dow, and we are going to find an S&P which is plumbing the depth, and exploring for the 2009 lows.
Kevin: Are you making a prediction here, in 2012, that we could see the Dow, or will see the Dow, a couple of thousand points lower than it is right now?
David: Yes, Kevin, again, I didn’t respond to the Black Friday weekend bonanza the way the market did. I came in, as you described, with an ashen look on my face, and with grave concern, making a financial survival checklist, in terms of, “What about my bank deposits, what about the insurance company, what about pension funds, what about business liquidity, and any advice that we can give to clients?” If you were trying to arrange for business liquidity, lines of credit, anything like that – get that done now, or you will not have that opportunity January or February of next year.
Kevin: David, I will say this. It becomes wearisome to look at what is wrong with the world all the time. We are looking at, “This is wrong, this is wrong, this is wrong,” but what makes something wrong is that it is in contrast to what would be right. I think what we should encourage our listeners to do, as well as looking at what is wrong, is to say, “Okay, this is wrong. Do I have to participate in this, or is there something that I could make right with this situation?” In other words, what is the ideal that we are pursuing? You were talking about a checklist. Check your bank deposits. If a bank is wrong in the way they are investing your money, then you should come out of that bank. Wouldn’t you recommend that people even check their bank right now, again?
David: Between now and the end of the year, you can call us at 800-525-9556, and any of the folks in our office can give you a free bank safety rating, anywhere in the United States. It does not cover credit unions because they have a different FDIC reporting requirement. They don’t have FDIC insurance, so there is a bit of an issue there, in terms of the transparency of how they are invested. But banks, insurance companies…
Kevin: They can check those, too?
David: Absolutely. And if you ask me where the disaster lies in 2012 and 2013, it is the insurance companies and pension funds, because they have not had to seek any reforms, they have not had to clean up their balance sheets at all. Granted, the banks really haven’t either, but they have at least gained some liquidity. They have excess reserves of 1.6 trillion dollars. You can argue that U.S. banks are in a better position today than they were in 2008, given the fact that FASBI is not forcing them to disclose toxic assets and write them down. So as long as we can pretend that those things don’t exist, our banks are in a healthy place. The place where there has been no reform, whatsoever, is in the insurance companies, and in pension funds, where they continue to take outsized risks, and they continue to swing for the fences.
This reminds me of exactly what Jon Corzine was trying to do in trying to reshape and bolster earnings. How was he going to bolster earnings? By bringing in what he had learned at Goldman-Sachs, which is proprietary trading. He wanted that company, MF Global, to be a global financial force, trading its own book into the billions and billions and billions, so that it could be a cash cow for the owners, or the influential within the company. He drove it through the floor. He destroyed the company by taking outsized bets and doing it on a leveraged basis.
Kevin: And now people are just standing in line to get their money back.
David: But his basic assumptions were that there was a mispricing of risk with European paper, and that the risk was actually overblown, that there was not as much to be concerned about in Europe as the market was pricing in. So he thought he was buying value. And then as the prices of those bonds went lower, and the yields went higher, he added to the position, added to the position, added to the position, until he had over 11½ billion dollars’ exposure – and guess what? When it came for a margin call, guess whose money he used?
Kevin: The customers of MF Global.
David: Right – with segregated cash accounts! Kevin, the interesting thing, at this particular point, will be if people like Corzine get a free pass because of how much support they have given to the current administration.
Kevin: Well, to do a little bit of a background, not only did he run Goldman-Sachs…
David: I mean, Kevin, we are talking about fraud. You cannot take money out of someone’s segregated account and meet a margin call with it!
Kevin: David, but he is, financially, the largest contributor to the Obama campaign. It is huge for the 2012 campaign. In 2004, he made Obama. They said this was the creation of Obama – it was Jon Corzine.
David: The 2008 campaign, of course, you are exactly right, and going back to 2004, he was someone who helped cultivate the persona and brought him into the political limelight. The question is this: Who did he give the money to? Because he owed the money to someone, and he made someone else whole at the expense of segregated accounts. Kevin…
Kevin: Nobody’s talking about it.
David: Nobody’s talking about one of the biggest bankruptcies in U.S. history, and the man who single-handedly claimed responsibility on October 25th for being overexposed. Will there be ramifications? Or is there political protection, depending on who you make your campaign contributions to? This is what I suggested in our weekly comments Friday, maybe two weeks ago. We have endemic corruption in our political system at a level we have never seen in U.S. political history. The question is, will that be cleaned up, or will that be the status quo from this point forward?
Kevin: Okay, so Dave, we already have established that it is going to be very tumultuous over the next month, maybe the next few days, definitely the next year or two. What is it that we would encourage our listeners to do right now? We talked about staying the course, getting things put in position, and then waiting, and we likened it to waiting for a hurricane – you batten down the hatches. What does that mean? What does the financial triangle, or the perspective triangle look like right now?
David: Okay, let’s start on the left side – growth and income, your equity and bond portfolios. If you are in bonds, you are a fool. I am sorry, but I am not going to mince words. The stakes are so high in the interest rate and bond market today, that if you are sitting there passively collecting your coupon payments, and just knowing that if you hold it to maturity you are going to be fine, you will get blistered in this environment.
Kevin: When the interest rates go up.
David: I think 2012, 2013, 2014 – this time frame represents the turning of the tide in the interest rate market, and for someone who is not nimble, navigating this as a trader, in today, out tomorrow – you have no business being in the bond market today. I realize I am speaking in a vast generalization. There are good bond positions to hold, but I think the general interest rate environment is caustic and dangerous at this point.
On the equities side, because you have earnings, this reinforces a negative move lower in equities. Look at Jeremy Grantham’s comments out last week, Kevin, that we basically have seen a peak in earnings. This has been ideal, where you have seen a benefit, given higher productivity, laying off of staff and requiring more from your existing people.
Kevin: It sounds like a positive to me, Dave, for the stock market, if earnings are high right now, or better, in relation to the stock prices.
David: Well, what I am saying is that it is as good as it has ever been, so where do you go from here? Grantham is assuming that we have mean reversion. In other words, if this is as good as it gets, then we also have a bit of average sometime in the next 6-12 months. Which, the repricing of equities? Again, acknowledging this mean reversion? It puts 2012 as a very negative year for equities.
Kevin: This is where you said we could lose 2000 points in the stock market.
David: And here is the caveat: QE-3 adds positive upside potential to equities. So, on the upside, we have the potential of 2000 points. On the downside, we have the potential for a 4000-point loss on the Dow. You tell me if you are comfortable with 2000 on the upside and 4000 on the downside.
Kevin: Well, it doesn’t sound like it makes sense.
David: I’m not saying there isn’t upside potential there. I’m just saying that it is only there for the wrong reasons. It is only there with the junkie’s infusion of liquidity. I think that is where we are. It is a very tenuous situation. I would not be in equities unless it is a strictly managed portfolio, and carefully managed, in terms of the risks, with offsetting hedges and everything else. That is a dangerous place to be. The left side of the triangle is fraught with concerns coming into 2012.
Kevin: So that leaves us with the right side, with cash. Obviously, gold is the base, and we’ll end with the gold. But the cash – dollars, euros, yuan? Where can a person go right now for paper liquidity?
David: That’s a real challenge, because on the one hand, if you look at the U.S. balance sheet, you say, “Wait a minute. We’re no better off than the Germans, we’re no better off than the Greeks, and we’re no better off than the Spanish or the Italians.” It just is a question of perception, and as long as we perceive, and the world investment community perceives, that there is a greater threat with the euro, and with the European Union, and an unwind of that currency, and a lack of clarity as to what happens there – guess who is out of the limelight, and guess who gets buoyed in the process? The dollar!
Kevin: I know you guys have been betting on the dollar, even though you don’t see the long-term substance of the dollar. Short-term, you have had to stay in the dollar with your management.
David: And if you watch what has happened with foreign currencies, the ones that are commodity-based, which have better balance sheets, and a longer-term better play – guess what has happened to them recently? They have all been blistered, Kevin. It has been a very, very ugly go for anyone in New Zealand dollars, Australian dollars, Canadian dollars. This is a very difficult environment to be in.
The gem from the McAvity interview was this: You are going to lose somewhere. You have to lose somewhere, because you can’t place all of your eggs in one basket, because you don’t know, you don’t have the certainty and certitude, to make that particular bet. If you are in the deflation camp, I gave a speech for the Harry Dent folks a few weeks ago down in Florida, and the idea was, deflation is the deal, and you don’t really want exposure to anything except what is going to get positive play in a deflation – Treasuries and dollars. Period. Full stop. End of story. The problem is that we don’t now.
And we have the inflation camp on the other side who would say, with the clarity of a ringing bell, “We know what we know, what we know…”
Kevin: Sure. QE-3, QE-4, it’s going to be inflation at some point.
David: And that would argue for being in commodities, to some degree. That would argue for being in gold and silver, to some degree. That would argue for having something that will be inflation, or even super-inflation, boosted. The problem is you don’t know, with the certainty you think you have. You may think you have certainty, but that means you just haven’t studied enough philosophy.
Kevin: Well, Dave, then that takes us to the thing we have not touched up to this point in the conversation, and that is, this broad, ever increasing in size, base of the triangle, and gold. You have brought out in the past, inflation or deflation – all you need is instability, and gold really seems to be the only reliable source of preservation of wealth.
David: Kevin, it is actually a hedge against inflation, deflation, political turmoil, geopolitical turmoil, and political flight capital. There are so many things that drive the gold market – it’s not one element. And I think, of any asset class, that makes sense today. And I realize, this sounds like a Johnny-one-note phrase, but there is only one place that I would go with great confidence, and that would be gold. Even more than silver, I like gold. Why? Because I am afraid that those who love silver love it because it can make them money, and that is the wrong motivation to have, in an environment like this, in which you want to prioritize preservation of capital. I don’t care how much money you can make. Ultimately, the silver bugs will win out in the money that they make, but I think the better motivation in this environment is the money that you preserve, not the money that you make.
Kevin: So, of the two P’s in investing, preservation and profit, you would land solidly on P #1.
David: Preservation. Absolutely, with profit being a secondary motive. You will have the opportunity to profit if you preserve and walk out the other side with assets intact. Kevin, we have run two companies now for 40 years or more, and what we do on the wealth management side is really restricted to a particular kind of investor. We have a high minimum. It is something where someone says, “We like the way you think and work. We like the way you approach the markets. And we want to partner with you in that.” And we do have a minimum investment there, Kevin. And it is substantial.
On the other side, we have no minimum investment. Look at gold and silver. I remember taking a call back in 2004, a young college student. He was back working on the family farm, running the tractor during the summer months, and he had an extra $400, and he said, “Dave, I want to do something. What should I be doing?” I said, “Listen, it costs me more to book this trade, in terms of our overhead. It makes no sense for me to book this trade, but we have never had minimums. Why? Because if it’s the right thing to do, just do it. Just do it!”
And I think, Kevin, looking at 2012, it’s very difficult to say, with any certainty, what will happen. It’s very difficult to say, politically, what the landscape in Europe will look like. At the end of 2012, it’s very difficult to say what the political landscape will look like here in the United States. But there is one certainty – that you are not going to go broke owning gold, and if that was the easiest, or only, decision that you could make, muster the courage to make it.
Kevin: So, if you are like the young man on the farm, do something. If you haven’t done something, do something, because things are changing.
David: They are changing, they are changing rapidly, and I still have that ashen-gray color because I think the environment we are in is the ugliest we may ever see it in our lifetime.