The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“There is going to be a period of time when value emerges, and value is obvious. And in that particular timeframe, however you have denominated your money, whether it is in ounces of gold or silver, or actual greenbacks, or some other foreign currency, you are going to want to put that money to work for you. And that is thinking, with patience in mind, about how to maximize assets across many generations.”
– David McAlvany
Kevin: David, I had to chuckle, you were telling us what you were doing Sunday night while I was watching the Bronco game, and most people who live in Colorado were watching the great Bronco game…
David: I didn’t realize the Broncos were playing. I guess I should assume that does happen on occasion.
Kevin: But you guys were playing Monopoly as a family. Explain to me how the McAlvany’s play monopoly. I was thinking, “What a learning experience. I wish somebody would have played Monopoly like that with me when I was a kid.”
David: My oldest needed a bridge loan, couldn’t figure out why I wouldn’t just let it pass for a full round while he didn’t have the money to pay up.
Kevin: He was out of money and he wondered why he had to sell properties?
David: Yes. I said, “Well, you can mortgage” and he said, “I don’t want to mortgage these, because then I can’t earn any income on them.” I said, “Well, you can sell them,” and he said, “I don’t want to sell them because then I can’t earn any money on them.”
David: And I said, “Well, you have a series of choices. There are not an infinite number of choices here and you have to make the best of what you have in front of you.”
Kevin: And isn’t it interesting? That is how the markets are for you and I. We have a limited amount of money. I know most people listening to this show probably work for a living, 8-10 hours a day, 5-6 days a week, and they bring a limited amount of income in. But not everybody plays by those rules. There is a monopoly game of the central bank where they can continually print more money, they can borrow money and lend money at zero percent, and control the game from that side.
Now, David, every year you typically go to the Grant conference. It is one of your favorite conferences in New York, and the reason you go is because you have professional players in this world like Druckenmiller who worked with Soros, and Jim Grant, himself. These are men who are brilliant as far as market analysis, and right now they are throwing up their hands. They are playing a game of monopoly where someone is creating money out of thin air. They don’t have to take bridge loans; they don’t have to sell properties when they are out of money. How do you play a game like that?
David: It is interesting. There was a point in the game when I was very tempted to bail out one of my sons. He had a couple of properties mortgaged. We had a great time playing, but we saw the full emotional range of, “You can’t do that to me,” upset to the point of tears. And laughter—hilarious laughter. We had a great time. But there was this part of me, as dad, that wanted to just pay off those two mortgages, help them out, and solve the problem.
Kevin: Keep the game going.
David: Well, and what happened was, I sat on my $220 which would have paid off his two mortgages and watched him, over the next three rounds, figure out how to solve it himself. And I could have bailed him out, I could have very well bailed him out. And I think what he would have learned in that was that when you get between a rock and a hard place you just have to ask with the right intonation, you have to bring enough emotion, you have to create enough fear, you have to be willing to walk away from the game and quit—whatever it may be that raises the temperature so that someone else does what you have come to expect them to do.
And it is that issue of the government, whether it is on the fiscal side or through the Federal Reserve on the monetary policy side, creating a world where you get between a rock and a hard place and there is always going to be a bailout.
David: Number one, it doesn’t teach us certain lessons that have to be learned. And number two, it destroys our ability to creatively solve problems on our own. And I think that is what does happen in the marketplace. It doesn’t matter if you are a six-year-old, it doesn’t matter if you are a nine-year-old, it doesn’t matter if you are a 55-year-old working on Wall Street. I believe that there is an amazing creativity within humans to be able to solve problems when they are forced to, but I also believe that deep within our humanity is an inherent laziness that would say, “If there is an easier way, I will take it.”
Kevin: David, I read a transcript the other day, going back to 2012, when Ben Bernanke, who was head of the Fed at the time, and of course, head of the largest bailout in human history, speaking of bailing out properties on a monopoly game, what you are talking about here on solving a problem, the unseen hand in market vernacular is market pricing actually solving the problem. It is creativity at a price, basically, solving the problem. And this teacher asked the question, “How did the unseen hand cause the crisis, and how would Ben Bernanke explain how the unseen hand is still valuable in setting prices?”
What Ben Bernanke did, and he took no fault for the central banks actually creating the crisis with these bailouts, but what he said was, “The unseen hand is a good thing, but it has to be monitored, it has to be controlled, because it sometimes can get out of hand and you have to have people in there who can basically bail the system out.”
David: And I do believe that there is an element of what he says that is true, but the monitoring of the market is almost a self-regulatory function where you just allow for logical consequences. If you have created a bad business then that business will go the way of the dodo bird. Why? Because it is embedded in that business’s DNA. And so you have a natural repercussion for the choices that are made, the plans that are made, which are either sustainable or not sustainable, and it is within the unseen hand of the market that there is something of a self-regulating function. However, when you begin to choose winners and losers it changes things dramatically. Go back to the Grant conference. Druckenmiller was saying there is nothing in his experience, going back to 1977, again, Stanley Druckenmiller began in the banking business, started working for Soros very early on as one of the chief traders of the quantum fund.
Kevin: Probably one of the most successful money managers alive today.
David: Yes. Anyone who can compound assets at better than 20% per year for about 30+ years, yes, that would say they are good. So Duquesne Capital, which was his hedge fund which he shut down in 2010, and he manages his own money exclusively today, and he says, “I’ve never seen an environment like this before. In all of my history, this is unlike anything I’ve seen.” And it is because the professors are in charge. There has never been a period in time where the markets were determined, or ruled, by professors – never. That’s a significant issue. It is a significant issue because you don’t have people with street smarts making decisions, and you don’t have the man-on-the-street, collectively, being that unseen hand, directing things, as well.
Kevin: Rather, it is Ph.D. theories. In fact, they call that the Ph.D. standard, don’t they? Instead of gold now we’re now on the Ph.D. standard.
David: (laughs) That’s right. So he is looking at interest rates and saying, “Look, we’ve got an election cycle coming in, that’s 2016, and you might raise rates 26 basis points.” But the reality is, rates are not going to move considerably until after the election.” I thought that was an interesting observation. And in this low rate environment, looking for where to keep your capital, where to keep it safe, what currencies you would prefer, his conclusion is, there is really nothing to like, which is one of the reasons why he has chosen to have a modest allocation to gold. Modest for Stanley Druckenmiller is 300 million dollars, nevertheless, he is very comfortable being there rather than in dollars exclusively, or in some other foreign currency exclusively. And as he ended his discussion it was something that I recall from Oppenheimer’s book, The Battle for Investment Survival.
Kevin: This goes back to the 1930s.
David: That’s right, 1932, chapter two, he says, “Look, you’re not an expert in every field. Put your eggs in one basket and watch that basket closely.”
Kevin: Rather than diversifying into everything.
David: Druckenmiller scratches his head and says, “You’re a fool if you think diversification is how anyone makes money in Wall Street. Look at all of the biggest names on Wall Street, including Warren Buffet, and Stanley would say, “Look, they have concentrated stock positions. They have concentrated asset positions which they prefer for particular reasons in a particular period. And they apply pretty strong discipline to how they manage those, as well.”
I think the other things that stood out to me from Stanley’s presentation was the notion that corporate profits have probably peaked, and if you want to be able to predict a recession or appreciate where you are in a recessionary cycle, you are looking for two things. One, either corporate profits in their cycle—have they peaked, where do we go now? And secondly, where are you in terms of interest rate cycles? Is the Fed going to tighten? Do you have an inverted yield curve? And if you find yourself in a tightening scenario with an inverted yield curve, you will be in a recession—categorically. And as I mentioned earlier, the second version of, how do we know we’re in a recession? See where the profits are. If they’ve peaked and they’re moving lower, yes, you will find yourself in a recession. And that is the case that he makes.
Kevin: There were other guests there that are worth listening to. John Hathaway of the Toqueville Gold Fund, I remember you saying that he had brought out the fact—remember three weeks ago we talked about how at one point the contracts for gold, for delivery, basically the commitments for gold, outnumbered the actual gold that was there to deliver by over 230-to-1. We talked about that.
David: Yes. The open interest versus gold inventory—that’s the ratio that we are talking about—is the physical ounces compared to the paper trades that are against them. And by late October they had skyrocketed—we’ve seen 100, we’ve seen 150. I don’t know that we have ever seen a point in recorded history where the open interest compared to the available gold for delivery has been this extreme. It is 202,000 ounces of gold, which sounds like a lot, but you have 46.7 million ounces of claims against them. You see, that’s where you get your 231-to-1 ratio.
Kevin: This is completely paper versus the real thing at this point.
David: Yes, so with 202,000 ounces available and 46.7 million ounces of claims against them, we ask the question, “What could possibly go wrong?” Clearly, we’ve seen the physical market has already migrated. The physical market has migrated to the East in the direction of Shanghai and Mumbai, while the Western idea of gaining gold exposure in a portfolio is strictly limited to the futures market, and it is exclusively in paper contracts, it is exclusively settled in cash. In other words, those who are buying futures market contracts are not expecting to take delivery of those bars at the end of the term, they are settling that in cash.
So, it’s just a speculative game to play the price either up or down on a very short-term basis, which is, again, a very different mindset and model compared to why people are owning it in the East, and I think, why your intelligent investor is moving toward goal in this period, as well. It is not a trade, and it is not making a few bucks on the upside or a few bucks on the downside, it is having a financial asset which is outside of a system of financial intermediaries and financial conflicts of interest, because quite frankly, you look at the financial world today and it is rife with conflicts of interest.
Kevin: David, you had mentioned Shanghai and how things are migrating East. You were invited to a forum put on by the Shanghai Gold Exchange not too long ago. Do you think that COMEX, the New York and Chicago markets, is going to replaced, ultimately, by the Chinese market?
David: Yes, well, I mean we’ve already talked about the difference between the physical market which deals with bullion ounces versus the paper contract market just dealing with futures contracts. And the futures market does continue to set the cash price for gold. And the bullion markets are drifting farther and farther from that, both in terms of quantities available, as well as the prices which are relevant to the actual metal, where we are seeing premiums on the actual physical metals.
And so your question is a great one. I think the baton is ultimately going to be passed in the next decade from West to East, not only the domination of the physical market, which has already occurred—Shanghai is in the driver’s seat there—but I think setting the prices Western style via the futures market is also going to migrate from your Western traders who are, as we speak, losing their grip on the asset class completely as Shanghai volumes, in terms of futures trading, continue to increase.
Kevin: You know, the Grant conference actually attracts billionaires to speak, and really, they don’t necessarily need to be there for the money, but they always look forward, actually, to hearing Jim Grant, himself, speak. What did Jim have to say?
David: My disappointment with the conference is just this—we don’t hear enough from Jim. He has a few opening comments and a few closing comments, and then he facilitates a brilliant discussion amongst some of the brightest minds on Wall –Street, whether it is Jim Chanos, John Hathaway, Stanley Druckenmiller—there was a whole host there on this particular conference. But he is one of my market mentors, and he has written a book, I have it on the shelf, and I’ve likely read it once, maybe even twice.
Kevin: He has been a great guest on the show, as well.
David: Yes. He was listening to a conference call in mid October with the CFO of Fastenal. You could consider Fastenal something of a critical component within the heartland of American industrial production. And their CFO had this sort of economic appraisal. His name is Daniel Florness. He said, “The industrial environment is in a recession. I don’t care what anyone says, because no one knows that market as we do. We touch 250,000 active customers a month.”
Kevin: This is a guy who would know whether we are in a recession or not.
David: With that as something of a bridge, I want to look at last week’s economic numbers. He would suggest we are already in recession. Stanley Druckenmiller says we are probably—probably—six months already into a recession. Again, that is not exactly the kind of commentary you are hearing from the Fed, from any of the Fed chiefs, as they consider a December rate hike. But again, Fastenal would say the industrial segment in the United States is awful, 250,000 active customers a month would indicate to them that they are already, at least in terms of the industrial part of our economy, deep in recession. Now grant you, making things and selling things is very different than, say, the new economy based on Twitter and Facebook and these sorts of new-fangled new economy opportunities.
Kevin: Well, you know, recession doesn’t really sell. If you want somebody to be spellbound with financial TV you need to be giving them hope, not hopelessness, and I know that you are on the Cavuto show on a regular basis. What was the hot topic last week when they called you up?
David: Before we get there, I don’t know if anyone watched the GOP debates this last week, but it was interesting, in the aftermath of the debate the CNBC director for this particular debate is an ex-Clinton White House staff member, and I just think, “Well, it all makes sense. It all makes sense. The questions, the tone, the direction, what they were trying to accomplish.” And I kept on wondering when one of the GOP candidates was going to say to the CNBC folks who were asking the questions, “It’s these kinds of questions that have your ratings at 22-year lows. You understand that no one cares because you continue to make yourself less and less relevant. The news does not matter to you, the story does not matter to you. It is about spin.” And I tell you, CNBC or Bloomberg, these guys are becoming a part of the spin machine as it relates to the Wall Street agenda of “things have never been better,” the Fed agenda of “things have never been better,” the Washington D.C. agenda of “things have never been better.”
The hot topic last week on Cavuto’s show—I was there with one other guest—was the decline in new home sales, that was a disappointment, and the third quarter GDP figures, which were also disappointing to say the least. And it appears that whatever strength we had in our economic figures, that is, GDP figures from the second quarter, was due to a massive inventory buildup. So here we are in the third quarter and we have numbers coming in that are lower than expected and the lower numbers actually appear to be a deception, as well (laughs). And I’ll get to that in just a minute. At the same time you have October consumer confidence which fell very hard, and this is fascinating, for those of you who don’t compare these charts with any regularity, consumer confidence is in freefall at the same time the stock market is going up. This doesn’t typically happen.
David: It doesn’t typically happen. So I think to myself, “Something is not quite right. Durable goods orders—they were ugly. You had major revisions lower for August—and that was the big surprise, the revisions lower for August, down 3% in August, down 1.2% in September. It was the revisions that people had to look back and say, “Oh, so this isn’t just a one-off number. This is actually something of a trend.” We have a couple of months here suggesting that things are not so hot in the economy.
Kevin: And let’s face it. When you are first hearing the numbers come out, that’s when they make the press. Revisions have to be searched out.
David: Well, that’s exactly right. At the same time you had factory orders which were also revised lower for August, and as you say, you report on the good number even when it doesn’t necessarily reflect reality (laughs) and then when no one is looking, well, after the fact, you come back and revise it lower to a more realistic level. And if we want to send a message to Putin, this is our implicit message: “Pravda should be taking note.”
Kevin: They really should. In fact, it’s funny, when I first started working here back in the 1980s, Pravda was known as just pure propaganda. At this point, I know that I have clients that read Pravda every day to actually pick up good facts that are not showing up in the U.S. media. It is an amazing transition.
David: Well, see, you have these two revisions, factory orders and durable goods. And then you have GDP estimates which are coming down. Goldman-Sachs, because of these two revisions lower, expected third quarter GDP to be lower by 2/10 of a percent, so they lower their estimate from 1.2 to just 1 percent for the third quarter.
Kevin: So what does retail look like for Christmas?
David: Well, that’s a good question, because that’s what we’re all hoping will finish the year strong for us. I think these revisions lower take out some of the air from the balloon, and yes, people are still hoping for a strong second half which is going to be dominated, hopefully, by strong retail, as sort of the cherry on top as we get to the end of the year with Christmas sales being a strong contributor. My colleague, Dave Burgess (sp?), reminds us that we need to watch for early discounting as an indication of weak sales and inventory concerns. So as we move toward and immediately follow the Black Friday sales season, if you start seeing retailers discounting their products aggressively before we get to Christmas you are going to know that not only are sales and traffic actually weaker, but they have inventory concerns heading into January which could be terrible. Instead of a cherry on top you might have something very nasty on top of a bad third quarter number for GDP.
Kevin: You were talking about statistics and you said that you would cover, actually, why some of these lower revisions. Tell us about it.
David: (laughs) Again, it’s minutiae that matters, particularly if you want to play the BS card occasionally, because here you have the Bureau of Economic Analysis making suggestions which just can’t actually be true. So, here are statistics for you, liars figuring, as it would appear. You have the July durable goods numbers—if you have a pen just write this down—your July durable goods numbers were plus 1.87, you have your August numbers which were minus 3, and you have your September numbers which were minus 1.2, which gives you, if you are adding that up…
Kevin: Negative $2.33. I was doing it in dollars, actually. It is an easy way to remember, you start with 1.87, then you lose 3.00, then you lose another 1.20.
Kevin: You’re down $2.33 at this point.
David: And yet, when you get to the GDP figure and look at the durable goods contribution to it, they are saying that for the third quarter, durable goods added 0.48.
Kevin: So, my negative $2.33 just became a positive 48 cents.
David: That’s right, if you are counting it in cents, that helps. And so, yes, you have GDP numbers and the associated durable goods figures associated with them that are totally inconsistent with actual durable goods figures which have been awful. And so, with this discrepancy, with this inconsistency, the Bureau of Economic Analysis was challenged by it, and do you know what they said? They just noted that their models for a quarterly report of GDP rely on a five-year economic census which they then apply to the monthly and annual data. They don’t use the census durable goods report, although they do still reference durable goods in the GDP report.
So what are the issues here? There is equivocation of terms, there is modeling of numbers which allows for assumptions rather than the hard data itself actually applying. And you have a basic inability to do math. I guess the other issue is that it fabricates a falsehood. It foists it on the general public and well, it’s really that part of the general public that still holds sort of a blind faith to the bureaucracy in Washington. But we’re going to end up with positive numbers, or more positive numbers, on the basis of people just tinkering with, again—are these irrelevant numbers, are these irrelevant facts? We’re either in a recession or not in a recession. We’re either in recovery or not in recovery. And people make decisions on how they allocate their assets, whether it is investment assets or consumption on particular products on the basis of how they feel about the underlying reality.
And here is the truth of it. The underlying reality is being colored with a rose tint. “It is better, not worse, than you think,” and yet you have a guy who just spent 300 million dollars on a small allocation to gold, in his opinion, because he thinks that we are six months into a recession. You tell me who is better at judging whether we are in a recession, Stanley Druckenmiller or the statisticians at the Bureau of Economic Analysis?
Kevin: It just makes me think, “What would that monopoly game have looked like on Sunday night if it was a bunch of Bureau of Economic Statistics guys playing?”
Kevin: You would say, “Hey, you’re out of money, you need to sell some properties and they would say, “No, I’m not really out of money, you need to understand, we use the five-year plan.”
David: “Technically, I’m not out of money. We’re on a rolling average.”
Kevin: Right. Okay, Dave, we’re starting a new month. Give me some good news, okay? Give me something that’s working.
David: Well, what’s working is that we continue to push stocks up at the end of every month, as we try to game for performance numbers, whether it is quarterly performance numbers or month-end numbers, and so you see this strange tendency to have weakness earlier in the month and then strong tendencies to push the market higher– literally, deliberately, manipulatively push the market higher as you get to month-end so that when scorecards are kept, when bonuses are determined for those on Wall Street, it always looks good.
Kevin: So you are saying this is being massaged by the few, not the many.
David: That’s right. At the same time you also have gold which gets the snot kicked out of it at the end of every month, and this goes back the last two to three years. So, it’s a very predictable move—knock down the price of gold near month-end, push up stock prices. And folks, this is PR. It’s PR.
Kevin: “Happy days.”
David: “Happy days are here again. The powers that be will not let anything bad happen.” So, of course, insurance products—if the powers that be, the Ph.D. standard, is truly in control, guess what? Insurance products like gold are a waste of time. In fact, if you are watching the gold Sunday nights, which some of us actually do, there was another concerted attack mounted on it, very thin volume, very few ounces being bought and sold, and somebody tried to literally tank the price of gold on Sunday night. And it didn’t happen. It dropped precipitously, bounced back within a minute or two, but you could see it. “Run the price lower and see if you can trigger a cascade of stop loss orders.” And it nearly worked over the weekend.
Kevin: David, we’re going into an election year in which, typically, you’re going to have a lot of gaming going on, but we’re already seeing some central bankers, even Mario Draghi, making the point that quantitative easing may not do the trick. It may not be working. Now, if they can’t print money and start the economy, and they can’t keep interest rates at zero and start the economy, the only other option is to spend money from the top, basically, the government.
David: Right. So last month we talked about the shift from strictly monetary stimulus using rates, using quantitative easing, using the verbal interventions which Bernanke in his most recent book said, “Listen, when we give a speech we are absolutely trying to influence the market with our speech. He describes the speeches as one of the tools to intervene and push the markets the direction they want to.” It is fascinating. You should look at his new book. It might cause fits of rage, but I actually find it helpful as I’m working through anger issues. It is a great way to arbitrarily bring them to the surface and then deal with them.
Kevin: It would be a book that my wife would hide from me. And I know, because when I get the CFR stuff, foreign affairs, she usually hides it until we have dinner.
David: So, here’s where the debt deal fits in. You have government spending, which, another way of looking at this is, we just moved from monetary reflation using monetary policies to inflate the economy and inflate asset prices. Now you switch gears using higher levels of debt and government spending to fiscally reflate. And this is a theme which takes center stage for 2016. Democrats love it. You’re going to see economic activity—even if it’s not generated in the private sector, it will show up as GDP growth for 2016, and the argument in political circle may be something like this: “Okay, okay, Obama’s foreign policy wasn’t that strong, it may have had a few gaps. But look, judging by the 2016 growth figures, you have to be impressed with what the Democrats have resurrected from the ashes of a 2008/2009 crisis period. So, goes the story, so goes the narrative.
Kevin: Now, that’s if the markets cooperate, right? That’s as long as the market hangs in there.
David: You’re right. There is this idea that maybe we give these guys in the oval office a hand. Maybe we give the Democrats a hand. And I think they have been holding back fiscal stimulus until the election year. I think it’s clever. I think it’s very clever. See what you can do to juice the system with monetary policy, and when push comes to shove, make sure that you can spend like a drunken sailor. You have the debt ceiling negotiation with Boehner and McConnell—they rolled over completely, and they put all the tough budget decisions and discussions until after the election, which gives Washington, D.C. the ability to spend whatever they want, and in so doing they get to create the narrative for the public to vote on next November.
Now, why would the GOP do that? Why would the GOP roll over when, in fact, they could have held some feet to the fire? I think the GOP could not afford, or did not want to, take the risk of appearing obstructionist. You have the Fed on the edge of tightening rates, and I think the Republicans caved in, not wanting to be blamed for a potentially rocky 2016 economic environment.
Kevin: But here is the sad thing. As we move into this election we are going to add a lot more debt just getting there.
David: Who cares? I mean, who cares? We’ve got 18-1/2 trillion dollars in debt. It was 17. Actually, when Obama started it was 9. Who cares if you go from 9 to 18, or from 18-1/2 to 19-1/2? Or frankly, if we touch the 20 mark? Because our national debts, yes, they are going to rise another 1 to 1-1/2 trillion dollars. And the markets are going to yawn because they are going to look at it as a reason to have another party. Now, our foreign creditors may feel differently and we will get to that in a minute, because there is going to come a day when we are going to have a huge deluge of Treasury paper which is not wanting to be owned and held by our foreign creditors anymore, and that’s going to be a real issue.
But in the meantime we have pork barrel spending and pet projects in the hundreds of billions which are going to move forward without debate, without scrutiny, and you know what we are going to call it, the classic robbing Peter to pay Paul? We’re going to call it economic recovery, we’re going to call it a return to growth, and the Democrats are going take full advantage of it. Kevin, this is like giving the pigs full access to the cosmetics drawer, loading on more lipstick than you can possibly imagine, in an election year. You get to spend whatever you want in an election year. I realize the risks that the GOP was trying to mitigate, but I think that you can’t underestimate the value of being able to spend between one and two trillion dollars with no questions asked, in an election year. See what I’m getting at?
Kevin: Yes, and I can’t help to say that of all the elections that I have seen there is nothing that has been more circus-like than what is going on right now. You talked about the GOP debate the other night. It was substantive only when the GOP candidates were not answering the actual questions that were being asked.
David: Right. So, if the Democrats have their way, then 2016 promises to be very carnivalesque, and if they don’t get their way it is because the stock market comes unglued and they will call in every favor from the Fed that they possibly can, while having plenty of ammunition to spend and start, again, that fiscal reflation project. And I think the combination of a desperate government putting political pressure on the Fed, plus having a couple trillion dollars to spend—I think you can change inflation expectations pretty quickly. And I think if you want to see a massive change of dynamics in the bond market, it is not when the FOMC starts to raise rates aggressively, it is when, in fact, you have the sociological shift, the change in inflation expectations.
But what do we see, really, here? Kicking the can down the road? Yes, that is a phrase used, perhaps, too often. But it applies, because you have the red shirts and the blue shirts, the political class, one team or the other, and the reality is, the more things change, the more they stay the same. At the end of that debate, and frankly, at the end of the nondebate over the debt ceiling—at the end of that, if you didn’t hate the GOP leadership before (laughs) you might now. And it’s not for what they are, because I think any self-aware human being can cut another human being some slack. You do things wrong—everybody does things wrong. It’s for what they are not. I remember C.S. Lewis saying that courage is not simply one of the virtues, but it is the form of every virtue at the testing point.
It is at those moments of opportunity, Kevin, where they get to prove that they are more than weak-kneed, blood-sucking creatures. You remember Ian McAvity used to say, poly and ticks—politics is many blood-sucking creatures. Well, our politicians remind us that they are, and ever will be, something other than statesmen. And it is that disappointment, I think, that I just say, “The leadership in the GOP—what a disaster.” Both sides of the aisle are taking fiddling lessons while the world central banks are playing with matches and gasoline. And they are hoping that somehow in the midst of this they are going to come up with a fiscal spending solution, which is a solution. And I think, as for the general public, ultimately, people are going to say, “This is so many versions of insane, why don’t we just replace them all?”
Kevin: A friend of yours, the brilliant Russell Napier in Scotland, had told us that where the central banks leave off, the government will start taking over in the form of fiscal spending.
David: Yes, and so government-driven reflation taking over where the central banks leave off. We have to remember that spending is either from what you have or from what you can borrow, and if a debt ceiling has been pushed off, then first of all we will see economic activity and investment like we haven’t seen in the last seven years. And you need to keep in mind that that improvement comes at a high cost because, number two, we need to keep in mind that deficit spending is only helpful in the short run, but in essence it is drawing growth from the future into the present. Does that makes sense?
Kevin: You gave an example the other day, Dave, when you were speaking at a conference in Coeur d’Alene, that I just loved. A bunch of us are training right now for a triathlon so we are running most every day, and you gave an example. We were in a very large conference room at the time and you said, “Imagine yourself on one side of the room and you are told to run to the other side of the room as fast as you can.”
David: You know you can do it. You know you can do it at a pretty good pace. But then if someone gives you an 80-pound sack of concrete and says, “I want you to run as fast as you possibly can,” you realize that there is going to be a difference in performance. And this is what happens to an economy that is overly laden with debt. You can’t expect the same kind of performance when you are carrying that kind of a burden. My issue, too, with the debts that we accrue, is that it will create economic activity, but just like the zero percent financing gig that you see amongst auto companies today, all they are doing is moving a future purchase into the present, which means that for the benefit of moving product and inventory today they are gutting future sales. Zero percent financing is a bad deal if you are a long-term player. It is a short-term fix, but it’s a bad long-term deal, because again, you are gutting your future business.
So from a legacy perspective, you have to balance the positive effects, if they do exist, from the investment today—that is, spending of money (laughs) in the form of money that didn’t exist before but IOU’s that are being created. Spending that money on various projects, you have to balance the positive effects therein with the long-term costs. And those long-term costs are going to be felt over the next three years, the next five years, the next seven years—however long it is depending on the structure of debt applied. So, I think 2016 could be a very confusing year where economic indicators start turning up for the first time, but for many of the wrong reasons. And we start to see a change in trend from fear of deflation to a snap-back concern over reflation taking effect and changing inflationary expectations.
Kevin: Something about two weeks ago just took my breath away. We have seen this trend, but I couldn’t believe it actually happened. Let’s just review for a second. Interest is what you get paid for the risk you are putting your money to. So, when you buy a bond in Spain, or you buy a U.S. treasury, you are supposed to be paid the interest that is reflective of the risk of a default. Now, Italy—Italy is a basket case. Italian bonds, two weeks ago, Dave, went negative, which means if I buy an Italian bond—let’s say I put $10,000 into an Italian bond…
David: You were paying to own it, not paying to hold it.
Kevin: At maturity, I get less back. I get no interest. I get less than that.
David: That’s right. That’s the two-year paper. The two-year paper traded negative for the first time. The U.S. ten-year treasury, just to kind of capture a comparison between the U.S., Spain and Italy, the U.S. treasury is giving a 2% interest payment on their ten-year paper. The Italian treasury is paying 1.48.
Kevin: Isn’t that amazing?
David: The Spanish treasury is paying 1.67.
Kevin: These are countries that are likely, at some point in the future, to default.
David: The point is, for the U.S. treasury to be yielding 2%, and these basket case countries, Spain and Italy, with unemployment rates of between 12-1/2% and 25%, depending on the age segment in question, the market is implying that there is less risk in Spain, and less risk in Italy, than there is in the U.S. I don’t know exactly how that works, except to say that all government bond markets have been corrupted by governments and central banks interfering in the pricing of those assets and buying them in various forms through quantitative easing programs. We have had ours, the Draghi’s conversation last week is that we are going to do even more.
Do you realize that last week we had four central bankers from around the world, the People’s Bank of China, the European Central Bank, the Bank of England, and the Bank of Japan, all talking about doing more, not less, in terms of quantitative easing and buying assets? This is absolutely screwball—absolutely screwball. The Japanese central bank now owns 52% of the entire exchange-traded fund market. Exchange-traded funds are a proxy for various indexes in Japan. They own 52% of them because they are just out there buying with money they have printed out of nothing. It is absolutely insane. Now, there are some signals which I think are very critical. With all the shenanigans that are being played, very critical signals that I think suggest smart money already gets it. We talked about gold, we talked about Druckenmiller taking a pretty significant position in gold. More important than that is the sovereign wealth funds which are pulling their assets from various asset managers, and basically taking their marbles and going home.
Kevin: Staying liquid, basically.
David: That’s right. Most recently it was a 70 billion dollar pull of assets for the Saudi sovereign wealth fund, 661 billion-dollar fund and 70 billion dollars of that was just yanked from asset managers. There is an indication that this next year is going to be all kinds of fun.
Kevin: Something that has changed recently, also, Dave, the Chinese had asked the IMF if they could be included in the SDR system, and the IMF a couple of months ago brushed them off. They said, “No, definitely not this year.”
David: “Come back to us next year.”
Kevin: “We’ll look in 2016.” That changed. Something has changed, because the IMF came back and said, “Yeah, I think we could probably use you guys.”
David: “Yes, it’s an all clear. We’ll move in that direction. You’ll be included in the SDR system. We’ll get it finalized this next year.”
Kevin: Well, is that a big deal or a little deal?
David: It’s a big deal and a little deal. Many people have said that it’s an absolutely disastrous event for the U.S. dollar. I don’t think it is. I think what it does is raise the profile of the Chinese currency and legitimizes it to some degree. And because it is legitimized by inclusion in the SDR basket there will be more central banks that hold it as a reserve asset. And that’s the big deal. The big deal is not being included in the SDR basket. The bigger deal is its legitimacy, and thus, its larger inclusion in the central bank holdings. Because what happened, when the euro was brought in, in 1999, it went from a zero percent allocation to almost 10-12% allocation in a variety of world central banks.
Kevin: And that had to come from somewhere.
David: That’s right. The U.S. dollar went from being basically 70% of all reserves held by every central banker in the world, to being a 60% allocation for all your world central banks. And what was the net effect for the dollar? About a 30-40% decline. So to the degree that we are reduced and the Chinese are increased, as a central bank asset, I think you could see the dollar take another 25-30% hit, maybe even a 40% hit. And that is what is lined up, I think, as a result of, and in sequence, following inclusion in the SDR basket.
Kevin: So, it is not something that necessarily collapses the dollar to zero, but it does take away a portion of its market share.
David: It just means that three to five years from now, the dollar is probably trading at a 30-40% discount to where it is today. Instead of close to 100, maybe it is trading in the 60s or even the high 50s. What does that mean for the U.S consumer? The bottom line is that we have a five-year course for the dollar which is going to compromise the average family’s ability to pay their bills. That is the reality. The bottom line is, if you can’t afford a 40-50% increase in the cost of groceries and your basic necessities–that’s what you have to look forward to.
Kevin: Dave, before we wrap up, I’d like to just talk about something that I’m seeing, which is frustration. People are looking at the markets right now and listening to the Commentary. They are keeping their powder dry—they are in cash, they are in gold. They are watching nothing happen and they are getting frustrated. I had a conversation yesterday with a client—great client, I’ve known him for decades, and he is now reaching retirement age, and he is looking at putting money into various annuities, things that seem to promise income. But when we really analyzed it—he called me to analyze it—and we looked at the investments in the portfolio, or in the insurance company that was promising the annuity, not only did they have high costs, they had high penalties for taking money out early, but the majority of their portfolio was what it had to be, because there are no interest rates right now that are safe, so it was triple B bonds.
And we talked about interest rates rising, and he said, “Yes, I think interest rates could possibly rise,” and we talked about triple B bonds, and I said, “Do you think possibly triple B bonds could default?” And he’s like, “Yeah, I do, but I need to retire and they are promising an income.” He is seeing what a lot of people are seeing and he is very, very frustrated. And he asked me a question, Dave. He said, “What should I care if there are triple B bonds in the portfolio as long as they continue to pay my income in retirement?” Now, what he was doing, and I think he even knew he was doing this—this is a very intelligent man—he was wanting retirement and wanting the income from retirement so badly that he was willing to bypass the danger that the investments in the underlying portfolio portrayed.
David: It makes me recall the anecdote that Stanley Druckenmiller shared at the conference and it was that year 2000 he recognized the bubble, he benefitted from the upside in some of your technology shares, and got out, moved to cash, and sat in cash, and then watched his competitors as they were making 4% a day in these high tech stocks. And he looked at it and told himself, “No, I’m not going to do that. I know what I know what I know, and these are not justifiable prices, they will revert to the mean, they will head lower.” And he stayed out until he couldn’t take the pressure anymore. And he kept on looking at his peer group, and he kept on looking at other people doing better than he was, and he changed course, moved into technology shares…
Kevin: Against his better judgment.
David: Against his better judgment. And to the day, not the hour, but to the day, he called the top. He would say, “I didn’t call the top because somebody bought after I did, but only a few minutes after I did, and then everything reversed.” And he started accumulating losses so quickly he blew out of the positions and he quit the business for four months. He quit the business, because he thought to himself, “I don’t know up from down. I thought I was right in the beginning, and I changed my mind. And then I lost money again. I lost an opportunity, and then I lost money, and I don’t even know up from down anymore.”
And I think it is interesting, the perspective that you lose when you start making comparisons. And I think that is one of the things that I often see with clients is, “Hey listen, I want to be retired now. My neighbor is retired, my colleague is retired, I want to be retired—now.” That’s fine, make your comparisons, but just be aware that the market is the market, and it may not be opportune for you to make changes in a portfolio at this particular time in the marketplace. Could stocks go higher from here? Sure. I supposed the Dow could go to 20,000. Is it overvalued? Yes. Does that mean it can’t become even more overvalued? It probably will be. I remember Doug Noland used to say this back in the 1999, 2000, 2001 timeframe. He would say, “Just about the time you think things are crazy, in terms of the price being too high, sit back and watch them double. They will.” And so I think to myself, “There are lots of ways to confuse yourself.”
Kevin: Well, Dave, as boring as the advice seems to be, I gave him the same advice that you have been giving to the listeners now for the last six months, and that is, “Just stay liquid, stay in cash, stay in gold.” I asked him, “Would you actually go buy triple B bonds right now?” And he said, “No, no, no.” But the insurance company that is offering him the income, which is what he really sees, that is the carrot right now that is hanging in front of him, they have triple B bonds and they are giving him a “guarantee.” So my advice was to stay in cash and gold. Is that still the way to play this?
David: I think it’s very simple. The key ingredient is not those two things that you own, but it is a disposition, and that disposition is one of patience. There is going to be a period of time where value emerges and value is obvious. In that particular timeframe, however you have denominated your money, whether it is in ounces of gold or silver, or actual greenbacks, or some other foreign currency, you are going to want to put that money to work for you. And that is thinking, with patience in mind, about how to maximize assets across many generations.