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The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick


“Well intentioned as they may be, ultimately it is disastrous in its resu
lts. But even recent history – even recent history, as recent as 2008 and 2009 – is easy to forget because people continue to forget the past. And I think this is one of the prudent reasons, this is one of the primary reasons, this is one of the essential reasons, to own gold – people forget the past.”

– David McAlvany

Kevin:Well Dave, while you, this weekend, were finally doing the last of your Ironman races, I was up in the mountains at a gold mine with a friend of mine who is a partner in it. Tell me first about the race. Were you pleased with the time?

David:I was. There are different elements in every day and you prepare the best you can, and you never know what the day is going to bring. It could be hot, it could be cold, it could be windy. Those conditions you are not in control of, so you just bring your best to the game.

Kevin:I have a question for you because we talked about this. A couple of years ago you really, really trained for that first one, because of course, it’s always the unknown. You are now getting close – I’m not going to mention times – but you are now getting close to where if you trained like you did two years ago could probably shave off 15 or 20 minutes and get into times that mainly the pros see.

David:I don’t know that I want to commit that much.

Kevin:(laughs) Yeah.

David:The reality of business life and family life and factoring in training, I have figured out how to cheat as much as I can on the training aspect and get as much as I can with as little input as possible.

Kevin:And still have a family with four kids and a wife.

David:And not have a heart attack when I go do a race.

Kevin:Yes (laughs)

David:You do still have to train. There is no way around it. But truly, the first year was a little obsessive and I think I would have to go back to that to break into a super-competitive time.

Kevin:While you were doing that, I was up at about 12,000 feet with a friend of mine. He has purchased a gold mine that right now is inactive here in the Durango area. But if gold hits $2,000, or gets above $2,000, he understands that that is an asset that he will be able to sell for a whole lot more than what he bought it for.

It was interesting being up there, Dave, as I realized just how rugged it is. I had to get out of the jeep a couple of times. In fact, he told me, “This is where we don’t wear our seatbelts.” I looked at him and I asked, “Why?” He said, “Well, you may have to get out of the Jeep really quick.” And as I looked down the cliff, I understood what he was saying, but I had no idea – I kept thinking, “Okay, do I go over the front, do I go over the back? How exactly do I get out of a Jeep that is falling off of a cliff?”

But it made me think, as we went through the tailings and we were trying to find gold, or that was left over from the mine, it really hit me. All over the world people have done this for thousands of years. The difficulty of extraction, the difficulty getting up to that terrain – there really is something about the longevity of gold. I know we sometimes get discouraged about the manipulations in prices, but honestly, Dave, if you look at it, gold has that lasting value. It still buys what it did thousands of year ago, per ounce.

David:And you see it in the news today with sanctions being reintroduced here in recent days with Iran, the imports for gold are huge. And wherever you see chaos, you see the need and demand for gold increase.

Kevin:Did I read right that in the Wall Street Journalthey were saying the central bank in Iran has minted 60 tons of gold into coins and is encouraging their people to go into that instead of other currencies.

David:You see the same thing in Turkey where you have had currency chaos, interest rates continuing to rise, the value of the lira continuing to fall and to stabilize things there is this natural demand, this natural inclination toward gold ownership. So Turkish demand for gold, Iranian demand for gold, Venezuelan demand for anything, frankly. You have the Brazilian government closing the borders and not allowing Venezuelans to come across the Brazilian border because they have had such a flight of people. Desperate times require a rethink on everything. But one thing that seems to be repeated throughout history is the importance of gold in those periods of pressure.

Kevin:You mentioned Venezuela. It goes without saying that gold is up 3.1 million percent this year in Venezuelan currency, so I guess gold is not going down everywhere. There was a story July 18ththat a South Korean salvage team discovered a 113-year-old wreck. It was a Russian warship and they think there may be 200 tons of gold in there. Jim Grant wrote on that. “At first,” he said, “my shoulders just drooped. Oh gosh, another darn thing, there is 200 tons more of another unwanted asset destined to hit the markets.” And then he said, “On second thought, I view the story as proof of concept. What other monetary metal could hold its value for more than a century while under water? Cycles of investment fashion are forever changing, he says. Gold – real money – lasts.”

I think we should talk – there are two economies right now, Dave. There is the value economy, which nobody remembers anymore, when you actually went and bought a stock because it had value, or you bought a gold mine because it had value. Maybe it is future value. That’s one economy. The other economy is this very, very short term algorithmically traded economy that really doesn’t look for value. They just look for momentum and algorithmic trends.

David:We’ve talked about fear of being left out, the fear of missing out – FOMO. I was in Denver this last weekend staying with a friend, and there was the sense that the real estate market in Denver is so hot you just have to buy something. And I know this neighborhood because it’s the neighborhood I grew up in, and these are very, very modest houses. And the idea that these very, very modest houses, both in terms of the size, the style, the material quality, the size of the lot, the location within the metropolitan complex, that these should be north of $500,000 is patently absurd. And yet they sell for a half million bucks, almost like a half million bucks doesn’t mean anything anymore. So you mentioned the rate of increase in bolivars for gold being up 3 million percent. Well, what are we talking about, really, when we’re talking about price? We have a reference that goes back to real things, and I think you begin to lose perspective when you don’t have real things in the equation. Because even a house, which is a real thing, because it is denominated in fiat currency – this is not merely an issue of supply and demand. Something is whacky. Something is very unsustainable. The replacement value of those houses is probably one-quarter of the asking price. And yet, that is the current price structure. What does the current price structure mean? It is what it is, until it isn’t.

Kevin:Isn’t it always created? Isn’t all of the inflation of assets created by debt – just large amounts of debt? I look at the Chinese right now. Ten years ago we had the Lehman crisis – that’s what we called it. That was created with too much debt. Now we have the Chinese sort of in the same boat. We’re talking trillions and trillions of dollars under the asset management of a single bank in China.

David:One more thing on debt because it’s not just overseas. I talked to a guy here in the office. He asked me this question last week. He said, “Can the average person afford $60,000 to $90,000 for a truck?” And yet, the average person walks in off the street and buys a truck any day of the week for between $60,000 and $90,000 because that is what a truck goes for these days. And you think, “Well, that’s just a lot of money. Who, on a normal salary can just plunk down that money?”

Kevin:That’s a lot of debt.

David:That’s the point. We can do a lot of things with a lot of money that is not ours, and ultimately it just comes back to how much of our current income we are willing to spend and give away, becoming some sort of a debt slave.

Kevin:What happens when cracks start forming in that debt, like we saw ten years ago? It seems that we are set up for that again, but it may not happen here. It may start in Asia.

David:Ten years ago, 20 years ago, you can look at this on any cyclical timeframe. Huarong Asset Management is a Chinese bank set up in 1999 to bury the bad loans of a previous expansionary phase in China. Just to illustrate what you are saying, it is still around, that institution, and it has an expanded financial market role. It’s not just a bad bank or a special purpose vehicle to carry bad loans, it has become a very significant bank. But originally, it was created to offload the bad loans of ICBC, China’s largest commercial bank, and frankly, the largest bank in the world if you’re counting assets – 4 trillion dollars in assets.

Kevin:4 trillion dollars – wow.

David:And today, that little bank, Huarong Asset Management, is publicly traded, they have strategic investors such as Goldman-Sachs and Warburg Pincus and there is news that you may have seen, if you follow the financial media at all, where the chairman was placed under investigation. He was arrested in April.

Kevin:But what about the co-chairman? I heard that he just sort of disappeared, strangely, while he was on vacation – where?

David:France. He went to France and mysteriously died while on a sight-seeing trip. Again, the bank has a reputation. Going back to what it was intended to do in 1999.

Kevin:It was clear up bad paper, right?

David:The cleanup job. And the first thing that comes to mind when I think of the cleanup job – do you remember seeing the movie Three Days of the Condor? You have this analyst, and he is paid to read books and write out plots which might actually be used. Those plots could develop into an espionage, a counter-attack, or whatever – a country is going to try to undermine, or change, or influence an election (laughs).

Kevin:A thought experiment, basically – different scenarios.

David:So he hands in his paper about what these novels that he has been reading inform him on, and he gets too close to the truth because there is one of these things actually in motion, and it’s being orchestrated by someone above him, and it’s going to be revealed. So there is this cleanup job that is needed. And they send in a crew. The crew is there to not only take him out, but then eliminate any evidence that anything bad every happened.

Kevin:Do you think that happened to the co-chairman for Huarong Asset Management, or can you point fingers?

David:I think the whole existence of the bank is like that, only it’s not about espionage, it’s just about, “Let’s make a bad story go away, and let’s get the cleanup guys in there.” We did this with Maiden Lane #1 and #2, when we had bad bank loans here in the United States, what we did is, during the 2008/2009 financial crisis, we created these special purpose vehicles, we took bad loans, put them in there, and it allowed for banks to have prettier balance sheets. The reputation at Huarong Asset Management is for handling the worst quality paper, and for being the most aggressive in terms of their business practices. There is a Chinese newspaper which described them as doing bad business as a bad bank.

You might recall, again, we have a history of creating our own special purpose vehicles, but these are, literally, balance sheets which are created to become the receptacle for all toxic paper, the unlovely assets, the things that you don’t really want to talk about, the things that don’t have a two-way market, no one wants to buy them at any price. But if you marked them to market you could destroy the solvency of the financial institutions, so you just move them off balance sheet.

Kevin:It is reminiscent of Enron, but that was a private organization. That wasn’t a national bank.

David:Here is the difference. When you have backing from the government you can do that stuff. Enron didn’t have the backing of the government and they got into hot water. They created these special purpose vehicles named after a whole host of Star Wars characters. They took all of their bad bets, moved them off the balance sheet, and then showed Wall Street how pretty and beautiful they were, and it was just half the story. What we have in China is only half the story because these banks still exist and they are being used very aggressively.

So while the bank has attempted to convert itself to a proper source of private and commercial finance, a normal bank, it has also continued to be an aggressive buyer of assets which are at or near default. And the role is critical to the Chinese when economic growth is so heavily dependent on credit expansion. Because keep in mind, when you’re expanding credit, what are you doing? You’re issuing new loans.

And if your goal is to just push as much money out into the system as possible, then there is no way for all of those loans to have proper due diligence, for them to have been vetted in an excellent or professional – where is the procedure and protocol to make sure that these are good loans going out the door…?

Kevin:Just like subprime back in the mid 2000s.

David:That’s right. So the challenges that they are facing, highlighted by one of our regular guests, Michael Pettis, who lives there in Beijing – you have equity, you have real estate financing, and they do that on longer terms, and this is a funding mismatch because most of the borrowing from the bank that gets turned into loans for external use is on much shorter terms.

Kevin:So short term loans for things that are going to be hanging out there for a long time.

David:It’s a classic banking mismatch. We do the same thing here in the United States – borrow short, lend long – but you’re talking about a portfolio of incredibly questionable quality. As recently as 2014, this bank was used to clean up a product which was blown sky-high by ICBC, it was a high-yield product, and they bailed out the investors and bailed out the bank by shuffling off all the product mix into Huarong Asset Management.

Kevin:This is the type of asset that would be called junk here in America, right? Like a junk bond, it’s a junk equity.

David:Right. And that’s what they are doing still. They are aggressively buying junk paper, they’re aggressively providing bridge loan financing for distressed companies. So what’s at stake? You have the chairman – this is a guy that has been close to a lot of deals over the last nearly 20 years, and a lot of those deals are purposefully opaque. There is a reason he will not see the light of day.

Kevin:A little like the co-chairman who didn’t see the light of day.

David:Exactly. Already slipped on a banana peel in France. But within China you have these strong economic numbers. Let me qualify that because these are strong by comparison to the United States, but they have been in a decidedly negative trend for a number of quarters. We have declining growth rates which are now the norm in China. But you have these economic numbers and they are dependent, to a degree, on the ability of financial vehicles like the one mentioned here to clean up and pretty up the pig, so to say.

Kevin:You remember the chess master who was master for many years? He was actually King of the Universe of chess – Garry Kasparov. He comes from a controlled society, and he had a quote, probably looking backwards at his Russian background, but also looking forward to the management that is required when you have already tried to manage something. Here is his quote: “When a managed economy begins to fail, the only direction is to manage it more and more. It’s how democratic socialism leads to repression.

David:Maybe we need to keep that in mind in terms of there being a natural consequence in the movement toward repression here in the United States. We have a younger generation who is somewhat falling in love with this idea of democratic socialism.

Kevin:They have never seen the imbalance.

David:Right. But I guess the point here is that it does relate to China in that you have higher and higher degrees of management which are necessary, and Huarong has played a key role in covering over the blemishes and mistakes, the mars left by credit expansion.

Kevin:Let me ask you a question. If you’re having to kill co-chairmen, and you’re having to mute the chairmen of these organizations, are we getting close to something? I mentioned cracks in the system. You don’t really have to do that when everything is running hunky-dory, do you?

David:Clearly, the excuse in China is that they are cleaning up a mess, and the mess is not within the banking organization, itself, but they would point to corruption and graft and things of that nature. And while I don’t discount that at all, I think that’s a very common occurrence within China, we talked about the 59½ rule, where forced retirement, you begin to see quite a bit of corruption and graft where all of a sudden staplers and pencils and everything else go missing as you’re walking out the door in retirement. Minxin Pei and others have talked about that on the Commentary with us before. But where are we at now? We are at the outer reaches of global credit excess. And you begin to see the operators – they are under pressure. Managers disappear.

Kevin:That’s what I mean.

David:I think it speaks to a loss of control by the central planners. I marvel at how time wipes away the memory of so many people. Maybe that is a little bit of a rabbit trail philosophically, but it’s not like we haven’t seen this before. Forced mergers are likely, I think, as we look at China – forced mergers within the banking system, within the medium-sized banks, within the small banks, within the local and regional banks, those who have been closest to the credit spigots, and have been involved in the misallocation of borrowed capital. I think what Pettis is really capturing in some of his analysis is the complete socializing of credit.

Kevin:Where the government just owns it all.

David:That’s right. And so, for those who have come to the conclusion that China is maybe the new bastion of economic activity, perhaps the greatest 21stcentury example of the free enterprise system, I think this needs to be a reminder – a reminder of the importance of ideas, of ideological commitment, and of the reality that socialism, as an offshoot of communism, and as an expression of command and control dynamics, is anything but an expression of free enterprise, and of pure capitalist economic activity. China is ratcheting up control. Huarong, once a cesspool for dumping bad debt, is now having its own financial issues, and what do the financial markets of China look like over the next 10-20 years? Are they more open or are they less open? Do you have more free market dynamics in play or less? Do we see them having a greater international footprint or less? These are questions that come to mind because if China’s place in the global economy, and if China’s place geo-strategically is going to improve, and is going to challenge U.S. hegemony, then I think you can look at little test cases like this with Huarong and watch it carefully and see how they manage it. Because you are talking about a nightmare in the making. Do they make it go away? That which was created to solve other problems, now that it is having its own problems, where does it go? How do they resolve it? How do they assign the losses? Who takes the hit?

Kevin:Let’s go ahead and unpack this a little bit because there really are two economies. I had mentioned Jim Grant earlier, but Grant has a newsletter called the Interest Rate Observer. He likes watching the free markets and he realizes that gold and interest rates, actually, are the message that the free markets send. So you have a free market, which requires judgment and value judgment to buy and sell. Then you have this market that has been created by the Huarongs out there, and this massive amount of debt, like you said, $60,000 to $80,000 dollar pickup trucks everybody can drive. Why? Because they can all borrow.

So you have economy #1, the value economy, that ultimately has to be funded with real money. Then you have the credit economy, or what I would call this artificial economy that we have had, especially the last eight years. And really, value means nothing. Momentum means everything – algorithms, the quants, I’d like to look at that. Let’s look at the points on what has shifted in recent years.

David:Two things, I think, stand out to me, things that have worked in recent years, and I think it is likely to change moving forward. In recent years, you have had indexing.

Kevin:That’s that quant economy – indexing. It’s passive.

David:It is a passive way of investing in a particular fund. And indexing has been key to success as an investor. And the closer you have been to an index, the better your performance has been. So this whole period over the last eight to ten years where you have had massive financial interventions by central banks, active money management was not taking you anywhere.

Kevin:No, you’re encouraged to turn your brain off and just invest.

David:Right. In that same timeframe, if you look at some of the best and brightest hedge fund managers, these are the guys that worked for your big Wall Street firms for five years, ten years, 20 years, and then launched out on their own and created their own hedge funds, and their own money management platforms.

Kevin:These are value guys.

David:The guys who focused on macro factors that drive prices, whether that is shifts in policy – monetary policy, fiscal policy, event-driven type things, changing relationships politically or geopolitically. Anyone who is managing from a macro perspective, all these funds have, in the last eight to ten years, under-performed the index. This is fascinating because what worked alongside the indexes were other kinds of hedge funds called quant funds.

Kevin:You know what? This reminds me of what my wife tells me. She says, “Kevin, you’re thinking too deeply on this. Stop thinking so deeply, just do it.” In a way, that is what all of society has been told. “If Facebook just gaps down, just go buy Facebook. You know it’s going to go up.” Or if you are going to invest money and you don’t really want to look for value, you just go into an index. Now, quant funds are a little bit different because at that point you’re really just investing in pure mathematics, are you not?

David:Sure. An algorithm that trades off a set of rules and profits only on the micro-oscillations, picking up a penny here, picking up a point there. It was quite something to watch performance improve in many of these quantitative strategies over the last few years, and then all of a sudden that reverses. But they did so well up until January of this year. Volatility diminishing, central banks ruling the show, and quantitative funds which are just, again, operating within a set of narrow parameters, with a very narrow set of rules, with a very limited look at financial history – they’re making money hand over fist.

Kevin:They’re counting on the central banks creating a platform of stability so that they can trade the tiny little moves. I read something, Dave, that these quant funds, by their own admission, these quants only use about 30 years of data. Now, last week when we were talking on the show, I was saying it hit me that you have an entire generation all the way up into their 50s of people who do not remember having to manage money in a rising interest rate market. These quant funds – the central banks are creating an element of stability at almost zero interest rates. These algorithms are trading on that. What happens when you have an anomaly and you actually have something that hasn’t happened in the last 30 years, which is a rising interest rate environment?

David:Right. So you have future financial determinism, which is predicated only on the most recent past. That is really what you are talking about with the quant funds. And so, a lot changed in January and I don’t that many people have made that observation, or if investors have taken note. But equity prices peaked in January, volatility was hitting record lows. Both the index ETF craze and the quant out-performance seemed to have hit an inflection point in January, and I think the likelihood of a reversal in both of those venues, in both of those popular trends, is very high – a reversal back the other direction. What does that imply? It implies that active money management is preferable in times where value matters.

Kevin:In other words, turn your brain back on.

David:I think it’s going to be very important over the next ten years, and the process of determining value, of owning value, has been out of favor longer, certainly, perhaps than any other time I can recall in financial market history. But I don’t think that lasts forever. This circles us back around to the many hours that we have spent discussing interest rates and the central role that rates play in the pricing of risk. And because of that, influencing the judgment of investors on every asset class under the sun. Interest rates have an impact on every asset class under the sun. So if you are tinkering with the rate of interest, you are tinkering with the value of every asset class. And when you stop tinkering, there is a natural consequence into the value of every asset class. The period of time where indexing, where quant investing has flourished was, in fact, the period where market signaling and prices, as a reflection of value, were completely irrelevant – were not relevant. So you could work off of a chart, you could work off of a basic trend, a few rules, a few micro factors, as Jim Grant describes them. That was all that was necessary to make money. The holy grail of investing in the last ten years has been based on a strange twist on the idea of trust. Trust and technological advancement. Again, running an algorithm that operates according to a set of rules, that is determined by a set of assumptions, that is informed by a brief glimpse in history.

Kevin:Yet, strange, the almost index, this turning your brain off and just investing, stupid. Just invest, stupid. Just invest, stupid. In fact, it’s sort of crude the way they say it, so I won’t say it the way it is said the most often, but it’s called “buy the dip,” and literally, if the market dips at all you’re guaranteed by the central banking community right now to just buy the dip. It really doesn’t matter what you buy as long as it’s in favor of the Wall Street markets.

David:Something you said last week, Kevin, you referenced your daughter and the retirement plans that have been proposed to her by her employer. “When are you retiring? All right, well, then choose the 2050 plan, or choose the 2040 plan, where the year that you are retiring all of your investments are going to be at a perfect alignment on the day that you retire.”

Kevin:Nobody evens knows what is in those investments. They just say, “Oh, well, it’s going to be the right mix for 2040 retirement.”

David:Think of all the assumptions that are packed into that. You’re talking about just riding the market. No research, no risk management, no question as to the viability of such an approach, particularly if you have the return of macro factors, because we have had a ten-year hiatus of macro factors and it has been the micro that has mattered, where literally you pick up a penny here, you pick up a penny there, and that’s what you get to keep at the end of the year.

But in real terms, interest rates are one of these macro factors that matter. Not today because if you look at treasury yields between 2% and 3% and factor in the rate of inflation, in real terms they are still at zero. So in real terms, they aren’t a factor yet, but you are talking in nominal terms, they are already a factor. And so, 2%, 3%, we are at this threshold. This is why last week we were talking about the importance of interest rates, the importance of the ten-year at 3%, you begin to put pressure on an over-leveraged system.

Kevin:I’ll tell you what, though. Do you realize just how lonely you are in the room that you are standing in, Dave? Because what you are talking about is still using your mind for investing, actively managing. What you are talking about is looking for real value, not artificial value. You are also asking the question, what happens when history repeats itself and interest rates actually rise? All of those things you are still asking yourself, and last night I asked you, are we just hopeless romantics sitting here thinking this? Because a lot of the guys who stood in this room with us who would have said, “Yes, this is how we have made our living all of our lives,” have basically thrown the towel in. They have entered the next room where all the people are, and they are like, “You know, if you can’t beat ’em, join ’em. What we are going to do is we’re going to actually start buying and selling. It doesn’t matter what the value is, it can be just garbage.”

David:Just write it.

Kevin:Just write it.

David:Trade it. Trade at share point. There are those, I think, that propose the financial system is so rigged at this point that a serious decline is out of the question.

Kevin:That’s the room I’m talking about. That’s the one that is populated right now.

David:(laughs) A few of these people I know quite well, and they have suggested to me on the same basis that “gold is therefore unnecessary – unnecessary– in an asset allocation because while we don’t know the future, what we do have is the predictive capacity of algorithms. And that predictive capacity is now so robust that the system can be effectively managed away from crisis, away from price declines. We have a permanent floor in the market which has been established by the powers that be.” This is the argument that they would make. I quite take exception to it.

Kevin:“This time is different.”

David:“This time is different,” and therefore there is also a permanent ceiling for gold, as well. I disagree. What I sense is a forced answer to a question that is not ours to answer in the first place. What does the future hold? Fill in the gap.

Kevin:We have talked about this so often. In fact, this is the reason for us to do the Commentary, this is the reason for us to read what we read and look at what we do. We can look back at history. We have that available to us. What we don’t have available to us is the knowledge of the future. And nothing has to happen in the future based on history. But history is a good predictor of markets, far better than saying this time is different.

David:Why is that the case? What does the future hold? No, we can’t know it and you shouldn’t pretend to know it. And I think there is a certain degree to which when you put your faith and confidence in an algorithm, you are saying that the future will take care of itself on the basis of these rules, which implies greater knowledge of the future and greater knowledge of the processes into the future than you actually have. But why is history important to us? Because it gives you a caricature of humans and their behaviors and their choices. And those patterns can become probabilistic. And so, no, there is nothing determined about the future, but we can certainly improve our odds by being students of humanity, being students of psychology, being students of sociology, and then of course, all of the other things that are most relevant to money which would be economics and finance.

Kevin:And we also need to be humble. And I think sometimes people think that a person who buys gold is predicting the future, which is just the opposite. You buy gold out of humility for admitting that you can’t predict the future. There is a difference. There is an arrogance when you are relying on an algorithm, or you are relying on an index, there is an arrogance saying you must know the future. When you buy gold – I know for me, the reason I buy gold and continue to buy gold is because I don’t know the future, and I know one thing still – just like that shipwreck from 110 years ago, if that was my gold under that water, it still has value today.

David:I’m planning on spending some time with Jim Grant this fall, and his perspective, I think, is refreshing. He’s an interest rate guy. He is a bond guy, but he is also a gold bug, which is kind of an interesting coincidence. He says, “The future is too interesting to be predictable.” It’s much too interesting.

Kevin:I love that quote. “The future is too interesting to be predictable.”

David:He goes on to say, “The bullish story on gold is reducible to the single word events. The legacy monetary asset is the armor against adverse monetary and credit events. In our time,” he says, “it’s most particularly the armor against the consequences of adulterated interest rates.”

Kevin:An interest rate is really just the cost of capital, is it not?

David:Yes, so in essence, the money mandarins have tried to play games with one of the core components of capitalism – capital – specifically, the cost of capital. Grant comments, “Interest rates are the most consequential price in capitalism. They are the traffic signals of investment, they are the calibrators of risk, they are the measures of time preference.” (laughs) He’s a great writer. “They discount the present value of future cash flows. They have defied investment hurdle rates. Try to imagine a world without them.”

And here’s the fascinating thing. You don’t have to, Kevin, because we have just had ten years of a world without interest rates, one of the key components to capitalism, and one of the key components to the pricing of all assets. And if you think for a moment that we have lost cyclicality in the market, and that it is only a return to Eden from here, because the central planners, whether it is the Chinese or the folks at the Fed, have figured things out this time, who are we kidding?

Kevin:What you are talking about, when you put interest rates to the side and you no longer actually have that way of monitoring the cost of money, here’s what he says. This is a continuation of the quote. He says, “Lastly, ultra-low rates of interest push and pull. They pull consumption forward. Car loans and mortgage rates invite consumers to spend. They push business failure…” You’ve talked about this often. These zombie companies that should fail, they push these way out into the future, so that failure is still coming but it is pushed into the future. He says, “Zombie companies can find credit with which to extend their unnatural lives. Now, when you have this kind of dislocation and distortion in the market, you had better be a value investor when things change.

David:(laughs) The “success” if you’re talking about the ECB, the BOJ, the Fed, the People’s Bank of China, the world central bankers…

Kevin:The providers of Eden.

David:Right. The guys who are cleaning up the various past credit excesses, with even greater credit availability. This goes back to Kasparov’s idea. What you said about Kasparov – more control being required to maintain control, not only in the supply of credit, because that’s what they do is create lots of it, infinite amounts of it. But they also want to influence the distribution and allocation of credit. So there are greater degrees of control by the ECB, BOJ and Fed.

Kevin:It’s like they can promise forever day, no night – forever day, no night.

David:And we are left with this idea – many now think that because of this there has been an erasure of cyclicality.

Kevin:Right. No more seasons, no more day or night.

David:The erasure of the moves from boom to bust. That’s your virtual Eden.

Kevin:Let’s look at China because, really, they are, as far as what is fueling economic growth worldwide right now, China is a major component. If we were sitting here ten years ago we would be talking about subprime loans. China, really, is the harbor of subprime loans at this point.

David:Last month we mentioned the percentage they contributed to global GDP growth and they are a far larger contributor than even the U.S. economy. Even though we have the largest economy in the world they contribute more to global economic growth than we do. So we come back around, we return to China because this is not only the primary contributor to global economic growth, far more than the U.S. at present, but also one of the primary points of concern, the connection points in a world of interconnected finance.

So think about what has happened in the last week in Pakistan. Financial collapse on the heels of taking on massive loan programs, much of their loans direct to the Chinese as a part of a financing scheme tied to the one belt/one road initiative. So they are willing to build up the world, create infrastructure projects, they export Chinese workers to each of those locations – I think they have deals with 60-70 different countries where they are building out infrastructure. They don’t hire people in those countries, they send Chinese workers to do this. And then they create loans to these people. It’s a really interesting thing because here you have Pakistan which is now borrower and servant to the lender, China.

China has its own banking issues. They may have to have a restructuring of these loans with Pakistan and with many of their other one belt/one road partners. All of this is a fascinating thing. They are trying to expand their reach, grow globally, and use credit to do that, and yet the mechanisms to do it are not clean, they are not pure. This is not normal banking. This is not traditional banking. This is actually beyond the outer reaches of anything we have seen in the history of finance.

Kevin:We were talking about Huarong Asset Management. That was 4 trillion dollars on their books, but really, the Chinese banking assets equal ten times that. Isn’t it like 40 trillion dollars?

David:There is kind of a pecking order. You have ICBC, which is your 4 trillion dollars in assets under management. And then Huarong, which is kind of the garbage bin, if you will, for ICBC and many of the other PBOC initiatives. The Chinese banking system as a whole, if you’re counting all of it, you have 40 trillion U.S. dollars, the equivalent of 50% of global GDP. For comparison, look at Japan. We know that they went to excess. We know that the credit growth that we saw in Japan in the 1980s which placed the Royal Palace in downtown Tokyo at a greater monetary value than the entire state of California (laughs). We’re talking about pricing which was absolutely nutty driven by credit which was absolutely nutty, and yet, it did not even come close to what we have in China today. 2016 alone, Chinese credit grew, it expanded at 16.5%.

So we come back to Huarong Asset Management. Not all those loans being pushed out the door are good loans. With the increase in credit and the decrease in prudence in lending comes the increased risk, the necessity for those SPVs, the Special Purpose Vehicles, and there is a requirement here of running a tighter and tighter ship within the country because things are getting to the outer limits of these credit excesses. So when you run a tighter ship, what does that include? In the free world it does not include the gulag (laughs).

Kevin:But in the third world, it does.

David:Absolutely, up to and including re-education camps. So you have company managers who know too much, maybe they get too greedy, maybe they don’t follow the party line close enough. We’re trying to preserve our view of a financial Eden. And we’re trying to keep, as investors, this bright and cheery picture of global growth, of U.S. domestic growth, but it is all tied to one very frail system. And it is a system of finance driven by infinite credit creation.

Kevin:We talked about those two rooms, the room that you are very lonely in right now, which is using your brain, still buying value when nobody cares, and the other room that is completely packed. I think of quotes going back all through history, Alan Greenspan, Irving Fisher, Larry Kudlow currently – these guys are all saying that the boom is sustainable. Even your friends, even people that you know really well, Dave, who have said, “You know, I’m not going to do it anymore. I just can’t wait for value to kick back in. I’ve got to go play the game by the rules that have changed.”

David:(laughs) You asked the question, is this romanticism? I don’t think so. I think this is contrarianism at its best. Because here you have the bull-to-bear ratio, if you’re looking at the Rydex ratios where you look at the number of dollars that have gone into and been invested in bear funds versus bullish mutual funds, and the ratio today is 24½-to-1.

Kevin:Everybody is bullish.

David:Twenty-four times the number of people bullish versus bearish.

Kevin:Twenty-four people in that other room, Dave. There are you alone (laughs).

David:Right. The only time it has been higher, 27-to-1 was the only other higher ratio. So the contrarian would say, “This is setting up perfectly.” You have confidence in the system at the highest possible levels, and confidence is always at the highest possible levels as the system is at its most dangerous point. So Larry Kudlow ends up echoing here in recent weeks Alan Greenspan back in 1973, Irving Fisher back in 1929. Kudlow says, “This is a boom that will be sustainable, frankly, as far as the eye can see. This is no one-shot, ever.”

Then you have Steve Mnuchin, who again has joined the choir. He says, “I don’t think this is a one or two-year phenomenon. I think we definitely are in a period of four to five years of sustained growth, at least.” And then Trump trumps with his expectation of economic growth of 8-9% annually here in the United States. Okay, while that is possible, let’s bear in mind that the prevailing sentiment, which is very positive today, can flip on a dime. If you go back to the newsreels of the first two weeks of February, everybody is changing their diapers because sentiment was super positive in the third and fourth week of January, and then everybody is confused. “What just happened? Why is the market down 10%? We don’t understand.” And there is confusion and chaos.

And the financial markets – this is where I think we have the key – the financial markets hold the key. Rising inflation, rising rates, and a world with too many debt obligations – these are the essential ingredients for cyclicality, and these ingredients fly in the face of those that hold to this idea that you can indefinitely manage financial market environments toward some sort of a Shangri-La. (laughs) It’s the opposite. These are pro-cyclical factors we are talking about, things that make the future outcomes far more exaggerated, and not for the good.

What are we dealing with today? We’re dealing with the residue of aggressive monetary policy on a global basis. You couple that with very aggressive fiscal policy on a global basis. You meet with a very tight labor market. Are we going to have surprises for a variety of asset classes that have assumed that we are going to see low rates forever? Absolutely.

Kevin:Couldn’t we see, though, that the markets, even subconsciously, are starting to sense that there is a problem? Copper, housing – that type of thing would normally be booming with what Trump was talking about, 8-9% growth rates, we would see copper sky-rocketing. We would see housing sky-rocket – home-builders, anyway.

David:We brought this up in June and July. This is important because for all the discussion of economic growth Dr. Copper doesn’t lie. And I’m not saying that there isn’t economic growth. There is. But you have economic statistics which are backward looking. This is really important. If you’re looking at an economic statistic, it is reporting aggregated data up to that point and it is rear-view baby. When you’re looking at prices of assets, that is trying to anticipate the future and what supply and demand will be. So when you see a divergence between economic statistics, which are backward looking, and asset prices, which are forward looking, I think you ought to pay attention to what is forward looking, if you care about what the future may hold.

So yes, home-builders and copper? What do they tell you about the future growth here in the United States? I think they tell you a lot. Take any time at all to look at a chart of copper, to look at a chart of the home-builders – in what historical context did you have sustained economic growth without these asset classes blowing off the roof. What we appear to have is the markets – I think you are right – they are already anticipating troubles ahead. Yes, we have positive economic statistics, but they lack financial market reality. And I think financial market reality is in that anticipation mode as we speak.

Kevin:Every year the powers that be, the Titans of the universe, the central bankers, meet at Jackson Hole. Now, what do you think they are talking about this August, as far as continuing to keep the stable structure alive and allow the indexing and the algorithmic types of programs to continue to work for more?

David:They have announced their title for the gathering this year, what their focus is going to be, and it is Changing Market Structure and Implications for Monetary Policy.

Kevin:So it’s not the same market structure and implications for monetary policy. They are actually saying something is changing.

David:Right. Well, to my mind, it should read the inverse, if they were for a moment self-reflective, if they were for a moment self-critical. It should be Implications of Monetary Policy Fundamentally Changing Market Structure.

Kevin:Oh, it’s a cart/horse thing, yes.

David:Yes, because it’s not as if they are reacting to a changing market structure, they changed the market structure because of their policies. When we talk about indexing, when we talk about the drive toward quant funds clipping for pennies and points here and there, what we are talking about is projects that only work in the context where fundamentals don’t matter, value doesn’t matter, a thoughtful investment process doesn’t matter, because you have a permanent floor in the asset price market.

Kevin:By the way, the story that I had read, or listened to, last week and I couldn’t remember the name, is called The Pedestrianby Ray Bradbury. It was a story where society in 2050 had gotten everybody to be just completely passive in every way. This one man, who was a pedestrian, who still walked outside in the evenings, was picked up by the police. I likened that to the markets and to this passive structure. Financial Timeshad an article on August 2ndand quoted, “A fundamental shift in the market structure toward rules-based passive investing over the past decade means a lot of trading is no longer based on fundamentals.” This is exactly what you are saying, Dave. It says, “This shift in market structure could well be a trigger for the next global downturn.” That’s the Financial Times.

David:When I mention the permanent floor, I don’t mean permanent floor. It’s a permanent floor until you discover the trap door. It’s well supported until there is nothing underneath you, and it is a Wily Coyote moment. The article suggests that there has been a change in market structure because of what they have done, and I agree with that. The proximate cause of all our financial crises has been central planning and banking activism. And I will grant them positive intentions, well-intentioned behavior. When we talk to Carmen Reinhart and others in the central bank community, these are not mean people, these are not vitriolic people, these are not people of a diabolical priority. They are just trying to make a better world. And they are working off of assumptions and off of theses which they have studied in their Ph.D. programs which support the kinds of policies that they promote.

Kevin:And that’s theses with a “th” right?

David:(laughs) My kids would be joking about that.

So, well-intentioned as they may be, ultimately it is disastrous in its results. But even recent history – even recent history, as recent as 2008 and 2009 – is easy to forget because people continue to forget the past. And I think this is one of the prudent reasons, this is one of the primary reasons, this is one of the essential reasons to own gold – people forget the past.

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