Save The Bankers! Sacrifice The Currency

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• Man on the street intuition: “I want some silver coins,”.
• Fed Intervention is about keeping bankers solvent.
• Warren Buffett Speaks: Beware of what he says but watch what he does…

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Save The Bankers! Sacrifice The Currency
May 6, 2020

Start reading the Credit Bubble bulletin every week. Doug made money, our tactical short, made money in the first quarter. If you need a hedge for an existing or legacy equity portfolio, you should be talking to him right now. Not in the context of chaos, but this is a bear market rally. If you’re not taking advantage of that—lightning equity positions, raising cash, adding to gold and silver. If you don’t understand gold in a portfolio, you don’t understand history. You don’t understand economics.
  – David McAlvany

Kevin: Every week, the night before we record, Dave, you and I sit down and have a Talisker. I think you had a soda water last night, but I had a Talisker and you had a cigar and you asked me, you said: “So what are the people you’re talking to saying?” And I had been on calls all day long, and you know, I had to think just for a second, I thought, you know, I’m talking to a lot of people I’ve never talked to this last couple of weeks because a lot of people are coming into the vaulted program and they’re finding us out on the Internet. They’ve never heard The Commentary necessarily. So I’m getting a chance to talk to fresh voices that I have not talked to before. And here’s what I’m finding. I’m finding there’s a consistency. People who have never purchased gold before who maybe find something on the Internet and they say, well, okay, I want a little bit of gold, but I definitely want to buy, even if I have very little money. I was talking to a number of people with less than $1,000 but they wanted silver. Somehow they intuitively understood that something’s changing in the money. I just thought it was interesting because I normally talk to commentary listeners. I talk to clients that I’ve had, maybe for decades. In this case, I’m talking to, in a lot of cases, the uninitiated that are now starting to look at metals.

David: When you think of trillions, it doesn’t really compute, and that’s whether you’re an economist or the average guy or gal on the street. It’s just a really big number. At a certain point, it’s just a really big number. And so I think that intuitive understanding that something’s not going to end well for the global currency system. It comes from this idea that, wait a minute, now everybody’s just playing around with trillions and this can’t work out. Right? So we’re not talking about high math. We’re not talking about an uber-sophisticated approach. It just…and frankly, you don’t need it. 

As we’ve gone through the March period and April period we anticipate significant gyrations in the financial markets ahead of us. You know, one of the things that I’ve done is reviewed a book I read years ago. It’s a very, very valuable book, probably the most valuable book in terms of looking at the Great Depression. I generally don’t recommend it because it’s like 500-600 pages long, and it’s too detailed to matter to most people. But The Crash and Its Aftermath by Barrie Wigmore is fascinating, finished at Goldman and decided this was how he was going to spend his retirement was documenting what happened. And so it’s a very in-depth look at it, and anyone who was operating on the basis of instinct prior to the crash, was served well by that instinct, and there was lessons to be learned after the crash as well. Barrie didn’t live through it, so this is sort of a postmortem decades later, but a guy who did live through it in another book I do strongly recommend, if you can find an out of print copy is The Battle for Investment Survival. It was written in 1935. This is one of my favorite books. This is a book that I read 30 years ago.

Kevin: That was Loeb, right?

David: Right, Gerald Loeb and The Battle for Investment Survival. I think, you know, what you said reminds me of what he says about gold and and silver. He says, “In the history of the world, we find the record of savings really saved through buying gold, hoarding precious stones and other forms of hard wealth privately secreted. In the future history of America, most of us will, in my opinion, learn this lesson too late. Currently, this is a personal matter for each individual to decide and execute for himself without consultation.” That’s the end of the quote, but it’s fascinating because here he is two years into a depression.

Kevin: 1930…4, 5? Is that when he wrote that?

David: So here he is writing a book, and he’s in the midst of the Great Depression, actually, a few years since gold was made illegal, right? So I think that’s why he brings in the precious stones. There’s an aspect of “If you can’t own gold, what can you own?” And it was illegal, starting in 1933, after what they called the Trading with the Enemy Act. An interesting way of framing that, isn’t it? We’re going to control the domestic money supply, inflate the crud out of it, and we’re going to get away with it by calling it the Trading with the Enemy Act. If you don’t like it, your objection will be duly noted.

Kevin: And what he’s basically saying is what we’ve been saying. You know, you’d better own something physical and real when you’re going through a financial crisis and this is back in the 1930s.

David: Brilliant book, it’s worth looking at from a variety of perspectives if you want to understand the value of diversification, if you want to understand what someone who walked through the Great Depression experienced in terms of a market crunch. It’s a personal look. It’s also a professional look because he was actively trading the market all through the Depression and the Roaring Twenties leading into it. So I think it’s worth looking at that and saying, you know, the man on the street today, if they’re interested in silver, if they’re interested in gold, if they just want to buy what they can buy, whether it’s $10 through vaulted or you know in the form of gold or you know, $150 worth of silver here and there, they’re responding in a way that for someone who’s really sophisticated, they might say, well, why are you doing that? Why are you bothering?

Kevin: Instinct, okay. A lot of times, the more professional an investor becomes, the less they have instinct. You know, the more informed they are, they can actually start looking at charts more than listening to their gut.

David: Well and the more they assume the future will be exactly like the past, they start making certain assumptions about continuity of themes and maybe even the constancy of progress.

Kevin: Okay, so let’s say that we’re looking forward. You know, we had a GDP of what, $21 trillion? And so we’re seeing debt skyrocket, and our debt is skyrocketing relative to what our GDP used to be. But there’s going to be a dramatic slowdown I would imagine in GDP. So the debt to GDP ratio, which we’re looking at right now, is only probably going to get worse as we start measuring the slowdown, right?

David: Yeah. It’s fascinating me. Because when you think about sort of this idea of perpetual progress, we’re assuming that we will just go back to normal. And normal is $21 trillion in economic activity. Well, that also was the peak of all time in US history. Right? So we define normal by our high water mark, and that’s what we’re trying to get back to. So we have all of our debt to GDP figures. They’re based on that GDP of $21 trillion.

Kevin: And what is that in relation to the debt? Okay, so our GDP, $21 trillion. What’s the percentage of the debt relative to that?

David: Yeah, we’re moving from 107% debt to GDP, and obviously that number as a percentage is going to grow, and it’s growing right now because we have massive deficit spending, the debt expansion, that’s occurring at present. So we’re on track for at least $3.6 trillion for this year in terms of deficit spending.

Kevin: Do you remember when we were appalled about eight weeks ago on the show? We said It’s going to be $1.2 trillion, boys and girls. The deficit is going to be $1.2 trillion. I guess that has changed.

David: Well, it keeps on increasing because the need keeps on increasing. So it’s not a surprise to see the debt to GDP figures on the increase. And, you know, just for reference. When we talked with Carmen Reinhart, you know one of the reasons I wanted to visit with her years ago on the commentary was because she co-authored a book with Ken Rogoff called This Time Is Different. It was a study of debt and the dynamics relating to financial crisis when you got to a point where debt levels were unsustainable. And so they did all the statistical research and basically said you begin to encounter financial crisis when your debt to GDP figures exceed 90%. We’re at 107%. It’s going higher very quickly on the basis of debt increasing.

Kevin: So let’s play a mental experiment though, Dave. Let’s pretend, let’s say the government comes in with huge spending projects or what have you. And we actually don’t have a slow down. Let’s say we can hit that 21 trillion. Is that a possibility?

David: Sure, but I guess what we’re assuming is that we can get back to a $21 trillion economy. And the question of whether we can or can’t, I mean that remains to be seen. We’re in limbo in that regard. So the answer would be maybe, but not right away. So if you look at debt to GDP as an equation, it’s a little bit like price earnings in that multiple. Again, this is one number divided by another number. And the price earnings multiple, just like debt to GDP, can blow out. In the case of the price earnings multiple, if your earnings drop more than your price, again the numbers can blow out very quickly, and this is what we are going to see here in the U.S. economy. Our debt to GDP figures should be soaring, and as soon as we get official numbers all documented, I think this is where people are going to be surprised. Because the economy is slower than our assumption. Our assumption is we went from 107% and it’s moving higher on the basis of an increase in debt. But you’re also changing the denominator, and this is a really critical point. You’re changing the denominator, and it’ll cause a spike in your debt to GDP figures.

Kevin: So what we’re looking at, though, is let’s say we have potential. So what can be produced versus what is being produced or what will be produced. How do they measure that?

David: That’s what economists call an output gap. So if the difference between 21 trillion, the old number, and the new number, let’s say it’s 18 or something else. That difference is a gap, right? And the standard Keynesian Theory is you fill that gap with fiscal spending.

Kevin: You build bridges.

David: In this case, it could be spending on the order of $3 trillion to make up the difference, and the object to do that is to keep people employed and avoid sort of a negative feedback loop, transitioning from a recession to something more severe, like a depression.

Kevin: There’s where we got Hoover Dam. That’s where we got Mount Rushmore, right? In the 1930s, that’s how they responded.

David: Big spending programs. So we have seen the filling of a gap. But to be frank, we still don’t know how long the current state of affairs will last. And so we’re talking about a gap of unknown proportion. Does that make sense?

Kevin: Yeah, it sounds like The Princess Bride, rodents of unusual size was a gap of unknown proportion.

David: (laughs) Right, right, that’s interesting. I’ll have to come up with an acronym for that. That’s a G.O.U.P. A gap of unknown proportion. And so unemployment hit 15.3 million before rolling the clock back to 2008, 2009, the global financial crisis. Unemployment hit about 15, round down to 15 million. We have 30 million already filed at this point for unemployment.

Kevin: So, let me repeat that. Okay, so unemployment, which was a real problem back in 2008 and 2009, we have double the unemployment at this point. It was 15 million, and now it’s 30 and we know it’s more than that, probably.

David: And how long this goes on will be the difference between a recession and depression. So depression, if we allow this to go on, will have sort of a further consequence. That is sort of a reshaping the social fabric of the country. And so really, we mentioned this how long ago? Maybe January, when we first talked about COVID-19. Duration is the key. Duration is the key. If this is over and done very quickly, it’s no big deal. But if you leave 30 million people unemployed for very long, you’re talking about the loss of businesses, diminishment of tax revenue. It recycles negatively into a number of spheres because now you’re talking about municipalities which are compromised. I was reading an interesting point on Detroit, who five years ago were, you know, in the midst of the biggest municipal bankruptcy in U. S. History. And today 17% of their revenue comes from gaming. Well, how many people are going to the casinos in Detroit to fill the Detroit coffers? Which is to say, the longer this lasts, the closer you get to recycling a bankruptcy event for Detroit all over again. And how many other cities and state municipalities face the same music?

Kevin: Well, you just came up with the solution. All we needed lottery tickets and casinos. You know, we live on reservation area down here. There’s a lot of casinos. Maybe we should do what Detroit did and just increase the games.

David: (laughs) Again, we go back to the gap of unknown proportion. We should not be surprised by further funds being needed. The question will be how much of our previous economic capacity will return. Are we going to get back to 21 trillion? Is that what’s going to be in place six months from now, a year from now, three years from now? If the new normal for the U.S. economy is reduced, let’s say by 10 to 15%, for instance, then GDP is going to be in that 18 to $19 trillion range. And again, we’re talking about a growing debt level on top of a shrinking GDP figure, which makes, again measured off a smaller base, makes the percentage debt to GDP a little bit scary. 

So when you change the denominator, there’s a significant impact on the math which, if you are Fitch, if you are Moody’s if you are S&P, the rating agencies which look at corporate debt and sovereign debt, they didn’t do a very good job of looking at mortgage backed securities debt back in the day, but hopefully they’ve learned their lesson. You know, this is where it begins to matter. You look at the math and you say, oh, this is going to be a bit of an issue. Fitch this last week assigned Italy a negative triple B rating. This is sort of like hanging on by your fingernails.

Kevin: It’s like, oh, you think? I mean, they should have done this years ago. Now they’re finally saying…

David: Well, and it wasn’t a complete downgrade to junk, but I mean, it’s like a half downgrade and just barely keeps them hanging on. So, you know, and S&P was like, well, as we mentioned last week, S&P said no problem here as long as the ECB has got the Italians’ backside, or back, rather.

Kevin: (laughs)

David: We won’t worry about it. But what impact is COVID having on the country and the globe in terms of consumption and spending habits?

Kevin: Okay, so I wanted to bring that up because I was thinking about this the other day. In the 1930s, we were a producing nation. We produced things. We made things. Right now, I mean, what percentage of our economy is me just going down to Starbucks or going to a movie? Consumption, isn’t that the major driver of our economy at this point?

David: Yeah, so as we have transitioned to more of a service oriented economy and we’re not the world’s greatest producer, you see the economy driven by consumers. You and me, you go back to 9/11 and what did George Bush say, I think in his first interview after 9/11…”We need to get out there and do our patriotic duty.” We need to spend something because he’s basically saying, look, the reality is if we all freeze up and are afraid of terrorism, we’re not going to spend and we’re going to collapse the economy. Do your patriotic duty and get out there and spend. Well, that is because the U.S. Economy is based 70% on consumption. 

So again, if there’s a reduction in consumer spending, even if it’s at the margins, 10-15% reduction in consumer spending, you’re talking about 70% of the total economy being reduced by, all of a sudden, it really is a big number. And it’s not unreasonable to think that the new normal is more like 18 trillion instead of 21 trillion. Reduce economic activity today, if you do that and you reduce economic activity, you’re talking about something that has major implications for the corporate sector. Why? Because if you’re not spending, they’re not making money. 

And so as long as we remain in this limbo state, you know, we have a reduction in economic activity that flows through to corporate earnings, they’re going to remain under pressure. And this goes back to that equation, the numerator/denominator. The E (earnings) is also a denominator. Reduce E (earnings) and your PE looks even more overvalued. So you can see your PE ratio…again, we’ve got stock market in recovery. That’s got to bounce here since the March lows and so prices are increasing, earnings are actually decreasing. We should see a blowout not only in terms of the PE ratio, but also in terms of the debt to GDP ratio, because the denominator is shifting.

Kevin: As we talk about that, I mean, when the stock market was close to 30,000 points, I think the Shiller 10-year adjusted PE got up to about 34 if I’m right on that. And now the PE can change, not even if the stock market rises. What you’re saying is if earnings fall, which it seems to me like earnings have to fall. Okay, if earnings are falling, you could have a higher PE with a lower stock market number.

David: That’s right. That’s right. So everyone sees, you know, the all time high and the Dow of 29 have changed and says, well, gosh, we’re buying 24 we’re buying at value. Not on that metric you not. So take a look at last Friday and the action that we saw in the stock market. Friday was the most recent 90% down day for the S&P 500.

Kevin: What is that? That’s 90% of the stocks were down versus 10% up.

David: That’s right. Actually, I think was more like 94. It was high, in the nineties, so a very small percentage of companies actually traded higher. Over 90% of the stocks listed on the index traded lower for the day and it was close to drawing other indices into the same dynamics. If you’re talking about the small caps and mid caps, 80% down for the small and mid caps, not quite to the 90% level. But I would watch for that as a confirmation of the bear market rally being complete. And that’s the position that we would take is this is not a new bull market and in the first uptrend or of a V shaped recovery in an uptrend, that that was what we’ve seen in recent weeks was a bear market rally.

Kevin: So that would be one of the confirmations. But you’ve been talking about declining volumes, okay, and a lot of times in a bear market, you can have rising stock prices for a period of time. But the volume is decreasing, and that’s something that most people don’t see because they’re just looking at the points on the stock market.

David: Yeah, the whole rise since March has been on declining volume. So less and less people buying, and that’s really not a defining characteristic of a bull market, that is more characteristic of a bear market rally than the beginning of a new bull market. So you combine that with the 90% down days, again where you’re counting the stocks that advance in price versus those that decline, and you begin to see, maybe this is not the time to be putting a lot of hope or money into the market.

Kevin: Okay, so for the generation that’s just used to the stock market just really rising since 2008, let’s call them the V shaped recovery group. People were saying, well, you know, I’m going to bet on America. Okay, I’m going to bet on this coming back. What do you think about a V shaped recovery?

David: Well, I think one of the things you would need as a confirmation is commodities moving along with the price of stocks. Because again, if you think about what is happening, not just in a service economy, but more broadly, in an everything economy where people are buying stuff, it makes sense for you to see the price of the raw materials that go into that stuff moving higher along with the stock price and demand for this product is going up.

Kevin: So copper, lumber, oil, the things that it takes to build things.

David: Yeah, raw materials are needed for the production of goods being created and sold. So commodities, you know, and we know to this last week, they’re not matching the pace of the equities markets. Recently, you had a couple of your commodities indexes, obviously oil is a significant component and the index as a whole, even with oil rebounding off of those lows, is still sort of in the seventies malaise, early seventies type pricing in the commodities market. And I think that divergence between commodities and your major stock indexes is very meaningful. If you’re trying to discern whether or not this is a new uptrend in stocks or just a bear market rally, I think that divergence tells you what you need to know.

Kevin: One of the beauties of having this show go for, you know, a dozen years is we were able to talk through the 2008-2009 crisis. You know, 2011. What we found out, I mean, there was real worry about the banks in 2008 and 2009. I guess we also found out there was no reason to worry about the banks at all because the government would do absolutely anything to save the banking system. In fact, what we saw was the bonuses of the bankers who supposedly caused the problems. Those bonuses went up.

David: Yeah, no, and I did an interesting study about this. This goes back to one of Lex Rieffel’s books on restructuring sovereign debt. And he had a couple of charts that I’ve kind of fallen in love with, which showed how when you had a banking crisis prior to 1913, that is the creation of the Federal Reserve system, prior to that, there really was no connection between a banking crisis and a currency crisis, but from 1913 forward is a period of time where, you know you can create as much money as you want. Now, all of a sudden, there is more of a trend towards banking crisis preceding currency crisis, and a part of this is because, and you can now abuse the currency to save the banks.

Kevin: So save the bank, destroy the currency.

David: (laughs) Right, but that never was the case prior to the creation of the Federal Reserve, which in large part as you suggested, is really about protecting the banking sector. So I thought it was interesting, Richard Duncan, who’s been a guest many times in the program, was discussing the practical purposes served, you know, by the consumer and business loans. You know, this is where government, our government in the last few weeks and months has basically extended a lot of money…

Kevin: Where they’re telling us that they’re helping us out.

David: Yeah, we’re helping small businesses and we’re helping consumers. And I guess the implicit argument is no, actually, you’re just helping the banks. And so he focuses on J.P. Morgan. He could have picked any bank, but he chooses J.P. Morgan because they’re a big one, the biggest of the big ones.

Kevin: Which, by the way, before you go on, we filmed for almost three days at Wall Street and right across from Wall Street, where the stocks are traded, was the bank that J.P. Morgan sat in, the original J.P. Morgan, the man, okay, and saw to it that Wall Street took care of him.

David: I was talking to my kids last night about somebody who had influenced my life, a guy named Dallas Willard, and I said, you know, he also influenced a guy named J.P. Morgan. And I said wait, wait, wait, no, J.P. Moreland.

Kevin: (laughs) So you tripped.

David: It was it was a philosophy professor that I had in college. Anyway, yeah so J.P. Morgan there at Wall and Broad. But the new bank that is J.P. Morgan in its current iteration, they have about $47 trillion in derivatives on their books. That’s the notional value of derivatives. They are the largest bank in North America, among the largest in the world, and they generally trade at the lowest risk premiums. If you’re looking at credit default swaps, and so, you know, you could say that this is kind of a conservative estimate. If you’re looking at J.P. Morgan, this is not to pick on them by any stretch, it’s just to illustrate a point. And his point is that you can look at complete bank system insolvency very, very quickly if the Fed does not intervene in the fixed income asset markets…

Kevin: Because of the leverage.

David: That’s exactly right. So Duncan’s argument, the Fed intervention in the fixed income asset markets, as well a sort of directing benefits to the consumer and the small business community in order to keep loans to us out there in the general space. The general public. This is really about keeping banks solvent.

Kevin: So because anytime someone’s leveraged in an investment, if it goes down or up, if it goes up, they actually make money on that leverage. If it goes down, it actually has a compounding effect.

David: Yeah so what Duncan did is he went through the quarterly results of J.P. Morgan, and he concluded that a 10% decline in the value of its consumer and wholesale lending portfolios—again, this is really key because you’ve got the Fed trying to keep the consumer in small businesses alive, correct? So if you see a 10% decline in the value of the consumer or wholesale lending portfolios, that is sufficient to wipe out 100% of bank capital.

Kevin: That’s quite a margin call.

David: Yeah, so when the capital is depleted, you’re talking about bankruptcy. So J.P. Morgan, the strongest bank, arguably, in the country, at least measured by their credit default swaps, you would say, not likely to happen. They can’t possibly go down. Well, what you see in terms of the Fed behavior is actually a defense of that balance sheet. If there is a downgrade to the balance sheet and you’ve got a number of assets, right? You’ve got loans to the consumer. You got loans, they have actually very diversified loan portfolio. But if you saw a 10% hit to the loan portfolio, it’s a very big deal.

Kevin: The Fed can’t allow that, in their own minds.

David: Yeah, if you’re looking at other parts of their assets where it’s the security side. This is where you’ve got stocks and corporate bonds and government sponsored entities. You know, Ginnie Mae, Freddie…this is the paper where it would take probably a 20% loss in that portfolio, but that, too, could wipe out 100% of bank capital at J.P. Morgan.

Kevin: And again, they can’t let it happen.

David: That’s right. So you have support in the fixed income markets, support indirectly into the equity markets, support for small loans, consumer loans and what have you. And really, we’re talking about bank solvency because if there’s much of a correction at all, these guys are very leveraged.

Kevin: So what you’re saying is, this goes back to when you have a banking crisis, which you’d have to look at this as a banking crisis, the currency is going to be sacrificed. The problem is that just means that you and I and the prices at the store is what pays for the bailing out of the bank.

David: Yeah, and remember, the assets held at the bank can represent a far larger number than bank capital. Bank capital is going to be smaller than the assets that they actually control because of leverage. And so, you know, 10 times balance sheet leverage is not an excessive figure industry-wide, and many bankers post-global financial crisis would see a 10 times leverage balance sheet as a conservative number. You and I would say that means they’ve got a skinny dime on the table. That’s not a lot of skin in the game, because obviously a small percentage fluctuation and asset prices can wipe out that dime pretty darn quick.

Kevin: And when they’re looking at this, okay, capital adequacy is adequate as long as the normal is the normal. You know, I mean if we were still at a $21 trillion GDP and we were pre-COVID-19 it makes sense.

David: Well, that’s exactly right. So they run these quarterly capital adequacy ratios, have to maintain them. And those numbers are based on an analysis of risk and probability in terms of loan losses under a variety of circumstances. Very good case scenarios, very worst case scenarios. What would you bet that the capital adequacy ratios that were made at the end of the year coming into 2020 had adequate risk parameters? Do you think anyone had the conversation about the global economy being shut down for weeks or for months or for, who knows, some indefinite period of time?

Kevin: Let’s do that ourselves. Okay, we talk about the future and economic history all the time. That’s sort of what we do around here, and take yourself back to Christmas time. Just imagine back to Christmas 2019. Could you have imagined that the world…this is the first time in my lifetime that the world has been affected by something to this degree. I think in everybody’s lifetime, so none of us could have… You know, we were maybe talking about COVID-19 within weeks of that. No, but we weren’t talking about a global shutdown.

David: No, the gist of our conversation at that time was, look at QE4 it’s already been launched. The repo markets are telling you something is not healthy within the banking system.

Kevin: There was already a liquidity crisis.

David: Yeah, and this is September, October. This has nothing to do with COVID. This predates, right. So, COVID again, it provides cover for the central bank community to do whatever they want and for politicians to spend whatever they want. And that is our new reality. But, you know, we’ve got 6 to 8 weeks which we’ve logged now. Maybe if you’re talking about Asia a little bit longer and we’ve basically exchanged suicide for death by plague, and this is something I’m not really sure how it’s going to be recorded by the historians. We’re talking about economic suicide with consequences or the benefits from quarantine. They’re going to have to be weighed by social and economic commentators, and, you know, looked at for decades to come. It’s too soon to tell what the ultimate costs are going to be in terms of human life and in terms of economic destruction. We’re talking about revenue losses, we were talking earlier about municipalities and the pressure that they can come under, shrinkage of the tax base, reconfiguration of employment. These are things that haven’t yet been figured out, right? So we have no idea what else we’re going to see initiated to fill the gaps coming back to that output gap.

Kevin: Well, and when you talk about output gap, I mean, how do you fill the gap? You either print money, you raise taxes, which when you’ve got productivity going down raising taxes isn’t the greatest thing to do. So I guess you print money in some form, right? Or you spend, you print and you spend. You know, we’re talking about filling the gaps. You brought up Keynesian economics early on in the show. Keynes would say, well, you have to go build a bridge. Gotta go build a dam. You need to go carve president faces onto a mountain. You gotta go do something, print the money to do it.

David: Yeah. I mean, last time we moved into a period of uncertainty, the Fed balance sheet expanded fivefold, and that’s what got us to about $4.5 trillion. And so then, if you look at the pre-corona levels, we were back into the threes, 3.6, 3.7. So off the pre-corona levels, a fivefold increase this time would be, you know, again, 20-21 trillion. We’re talking about better than $16 trillion in new resources sitting there on the Federal Reserve balance sheet.

Kevin: Well you’ve been playing 21 on a lot of things here today. We talked about 21 trillion being our GDP, our entire GDP. Now what you’re talking about is if we had that increase in the Fed balance sheet, you could literally have the entire GDP amount, pre-COVID-19 GDP, on the Fed balance sheet.

David: Well, and it’s hard to fathom. In fact, $21 trillion on a Fed balance sheet sounds absurd, but stability of the financial sector is the priority of the Federal Reserve, and they’re not going to compromise on that. Before things got really nasty, we had Rosengren…again, you wonder what is seen in advance and what is not. You’ve got Rosengren from the Boston Fed on March 6th, who is talking about amending the Federal Reserve Act for the fifth time.

Kevin: Which means to expand their role.

David: Yeah, so starting in 1913, that’s when the Federal Reserve Act came into play, if you know the history it was written a few years before that. They couldn’t get it passed. Finally it was passed…

Kevin: When everyone was on Christmas vacation, correct?

David: Correct. So very few people meeting the roll call. Anyway, the Federal Reserve Act has been amended in 1932, 1945, 1965, 1968. And think about the context for each of those: ‘32, ‘45, ‘65, ‘68…they’re all dates that resulted in major changes to our currency system thereafter, right? So almost always negative for the saver. ‘32, ‘33 devaluation. ‘45, again a year after the Bretton Woods agreement, ‘65 to ‘68, this is a period of time where Jacques Rouffe was talking about the eminent demise the dollar, the breaking of the Bretton Woods system, advocating with the French that they take gold instead of greenbacks. This is, ‘65 was, remember, they changed the silver content in the coins, devaluing our actual coinage, and these were signals and signs that the man on the street could see, could pay attention to. It didn’t take a PhD to know that if you have a coin with silver that’s 90% of its content and you start reducing it, that means you’re being screwed. You’re not being taken care of, you’re being taken advantage of.

Kevin: So, if you’re thinking you’re going to trust the system, okay, let’s look at the people who trusted during that period of time. 1968, the dollar has lost, what, 95% of its value since 1968?

David: Yeah, so the pattern of gaining greater flexibility and gaining more tools for the Fed, that may mean they can create greater stability for the financial system and specifically for the banks, but that does not mean they’re creating currency stability going forward.

Kevin: So the guys in the black suits, we’re the Federal Reserve. We’re here to help.

David: His proposal is for expanding the list of assets that the Fed can buy. Okay, it’s kind of like the Bank of Japan that’s going back to Rosengren. He’s suggesting that they might be a buyer of last resort for all assets, no limits. So far, there has been no amendments to the Federal Reserve Act. What they’ve done instead, to skirt the legal limitations, is they’ve just set up a shell company to make purchases of junk debt. Because you remember junk debt is not, according to their mandate, allowable. They cannot buy it, and yet they are buying it. It’s called a special purpose vehicle. So they’re not buying it. Another entity that their funding is buying it…

Kevin: It sounds like the Mafia, it sounds like a drug ring or the Mafia or something like that. No, no, no. We don’t own the business that’s doing this, but in a way they do own the business.

David: It sounds like if I asked my kids a question like, did you do this? And they’re like, they have some technicality they figured out. No, I didn’t do it. What do you mean you didn’t do it? Well I didn’t touch it? No, you just poked him with a pencil. You didn’t touch him. The pencil touched him. I mean we have little kids and so this kind of logic exists. Our sub-teenage children are doing the same thing in terms of their behavior, creating special purpose vehicles to remove guilt and absolve themselves of any responsibility. It’s crazy. But Rosengren, while he’s promoting it March 6^th, by the end of the month, they’re already doing it. Actually, I take that back. By the early part of April they’re doing that with junk bonds.

Kevin: Okay, so as we talk through these things…I was talking to a man in Denver the other day and we were talking about the progression of what we’ve seen coming over the last few years. You know, you talked to Carmen Reinhart on the show a few years ago. We just replayed that show in the last year because it was so amazingly prophetic. But what she was saying was, they’re ultimately going to have to close the system. First, you go to negative rates and then everybody wants to get out of the bank, and then you basically go cashless or you close the system. The gentleman I was talking to in Denver went to a Whole Foods and they won’t accept cash. Well, why won’t they accept cash? Well, it’s a COVID danger. And he then went to take money out of an ATM through a Schwab account, and they were discouraging it because the cash is now dangerous. I don’t know if people are sneezing into $100 bills or what the heck’s going on…

David: I blow my nose on hundreds actually.

Kevin: But what an amazing excuse for what Rogoff already wrote the book about last year, which is The Curse of Cash.

David: Okay, so if you’re listening to this and you don’t read Doug Noland’s comments on a routine basis, you should. It should be a part of your weekly routine. Call it a Saturday morning ritual. Grab a cup of coffee, you probably need it. He usually is packing a lot of information into it, and you want to pay attention. But read Noland’s comments from this last weekend. He covers a bunch of quotes from former Minneapolis Fed Kocherlakota, and Kocherlakota is talking about negative rates. He’s talking about praise for moving towards a cashless society, he is talking about the need for greater flexibility with the Fed tools in order to create this perpetual growth and never have a serious correction in the financial markets. And he references Rogoff’s book, The Curse of Cash, as a brilliant addition to the conversation. And I couldn’t help but think this is really, what he’s talking about is gaining the flexibility, gaining the power to do what Carmen Reinhart described on our commentary a while back. That investors ultimately have to be corralled once cash is gone and the financial system is closed, then you can begin to extract value from an existing asset base. If you’re going to see a diminishment in GDP, economic activity, and you can’t, as you suggested, increase taxes on a diminishing resource. What you do is you go to the savings pool and you start surreptitiously extracting value to feed the system and make sure the banking system stays home.

Kevin: And you keep them from being able to escape. I remember when I was a kid…

David: Financial repression, that’s what it is.

Kevin: …Friday nights my mom and dad would go out and we had a babysitter and we were allowed to stay up, okay? And so Twilight Zone would come on. No, no, no, no, it was Outer Limits. And I’m sure we’ll get comments here because I’m going to get one of the shows wrong, but Twilight Zone, Outer Limits, those were the black and white shows where they really sort of played with your mind a little bit. And there was one where aliens had come to Earth and everyone thought that they were there to help, and people would continually get on the flying saucer to go away. And they were very excited to go to this new planet. But there was this book that they had not translated the title of until the very end of the show. You know, a typical Twilight Zone or Outer Limits finish, and then finally the guy comes running with line of people who were getting on this flying saucer to say no, the name of the book is How to Cook and Eat Humans.

David: So what you’re basically saying is our version of Outer Limits today, the central banking version of Outer Limits, is we’re not here to help, we’re here to harvest.

Kevin: We’re going to close the system, we’re going to have negative rates. And it’s going to be good for you.

David: And you are a part of the harvest.

Kevin: (laughs) Okay.

David: So go back to revisit the March lows. You know, the Dow is getting to 18,000, 18 and change. And as we get to those lows again, because I think we’re heading there over the next couple of months, start reading the Credit Bubble Bulletin every week. Doug made money, our tactical short made money in the first quarter. There’s no surprise there. It’s a short product. If you need a hedge for an existing or legacy equity portfolio, you should be talking to him right now. Not in the context of chaos, but this is a bear market rally. If you’re not taking advantage of that lightening equity positions, raising cash, adding to golden silver, if you’re not getting defensive, you don’t get it. This is like Ray Dalio. I like to quote him, we did last week. “If you don’t understand gold in a portfolio, you don’t understand history. You don’t understand economics.”

Kevin: The same gentleman that I was talking to who tried to spend money at the Whole Foods, we were talking about the Buffett call because Warren Buffett, of course, had a shareholder call. Nobody was in the group. But we started talking about making sure that when you listen to Buffett talk, you also make sure to watch what Buffett does. Because talk and does, they don’t always match.

David: Yeah, exactly. I think we actually have two Buffett indicators, right? The first one we’ve talked about in The Commentary pretty regularly. It’s stocks vs. GDP. That’s the ratio between total stock market capitalization and the total scale of the economy. You’re comparing the financial assets and the prices thereof versus the engine that’s generating profits, that’s the ratio, and that’s the first expression. The second expression is watching the activities, as you say, of Buffett, Munger, the Berkshire Hathaway crew, and there’s a very interesting, nonverbal communication there. The shareholder meeting took place this weekend in an empty auditorium. Usually there’s 40,000 shareholders in attendance, but obviously with COVID concerns, not the case this year. The show must go on so Buffett was there, and he handled it very well. But the numbers in their quarterly release and the tone in the call, I think, are worth commenting on.

Kevin: Okay, so what was the Buffett indicator? It’s got to be high.

David: Well, what it is today. 134.9%. The ratio is unambiguously overvalued. When the ratio is above 115% it’s considered significantly overvalued. So the first Buffett indicator says, yep, you think you’re buying value today? Good luck with that. You are overvalued 134.9. The threshold for not just overvalued but significantly overvalued is 115. We’re well beyond the pale on that. As for the call, you get Munger is 96 years old. He didn’t travel in for the call, but the highlights that stood out to me is, as we mentioned, maybe 3-4 months ago, $137 billion in cash.

Kevin: Which is a large cash position for Berkshire Hathaway.

David: Largest ever. No big acquisitions. And this is based, according to Buffett, on current valuations being high. So it’s interesting, he says. If you’re the general public, you should step out and bet on America. Don’t bet against America. Okay? And so invest in equities. Invest in your market index. And yet he’s got $137 billion in cash and views acquisitions as being too pricey to step in. Okay, that’s interesting.

Kevin: Yeah, keep buying stocks because I own some.

David: And he had, also of interest, is he had to mark to market losses of $50 billion. That’s on a $200 billion portfolio, which was a result of a change in disclosures where you now have to report your unrealized gains and losses for the quarter. And so yeah, 50 out of 250, you know, that is back of the napkin math, close to 25% loss for Berkshire. Doesn’t matter the quality of the companies, this is a tough environment to be in. Those are unrealized losses, right? So next quarter, he could put $50 billion back on the table. No problem.

Kevin: So let me get this right. Okay, Buffett’s got a large amount in cash. Okay, what is it? $137 billion in cash? But he still owns almost twice that in equities.

David: Yeah, $200 billion. And essentially, if you’re looking at Berkshire Hathaway, it’s like a mutual fund that controls most of the businesses they’re invested in. Whereas mutual funds own a small portion of a business, very rarely, if ever, a controlling interest.

Kevin: So even if he’s heavy cash, he’s going to do what the general market does.

David: Yeah and these are not companies that he buys and sells. He buys them and holds them forever. But the market still prices Berkshire A shares and B shares according to what they view the intrinsic value of those companies, the earnings power of those companies, to be, the underlying companies to be. So the companies that he controls showed operating profits for the quarter of $5.8 billion. That’s not that bad. Down, obviously, from the prior quarter. But what’s interesting, this was very interesting to me. He is writing, selling, put options.

Kevin: Which is a bet that the market would go down. He’s selling the bet that the market would go down. He has to pay that debt if the market goes down, right?

David: Well, exactly. So he’s collecting a premium on the belief that the market will not go down. You know, think of it as he’s selling flood insurance because he thinks we’re in a drought, right? So it’s great, you just collect the insurance premiums, you’re in a drought. We’ve got global warming.

Kevin: “Don’t bet against America.”

David: What are we talking about? One in a hundred year flood. Floods don’t happen. Rain’s not happening, you know, sell insurance. And that’s what he’s been doing. Selling put options. So he’s selling put options. He’s collected a total of $2.5 billion in premiums. Oops, but in the first quarter he lost close to 1.4 billion of that in derivative losses, and this is again on his puts. So, for the first quarter, it’s $2.5 billion in premiums collected minus 1.4, which they gave back to Mr. Market. That’s just interesting, because derivative exposure, I wasn’t aware that that was something that he was real keen on. Do the math, 1.4 versus 5.8 in terms of operating profits. He basically, through his derivative losses, gave up 24% of his operating profits from all of his segments.

Kevin: Right, and he wouldn’t necessarily come out and tell you he was playing in the derivatives market. This is where we’re going. Don’t necessarily listen to what Buffett says. Watch what they do.

David: And it’s a very interesting period of time to be selling flood insurance, don’t you think? Could those derivative losses, you know, this was Q1 2020, could those derivative losses wipe out an entire quarter’s profit or a year’s worth? Remember, puts are asymmetrical in nature. You know, if somebody is buying a put, they may put in a dollar and expects to make 100. That’s not perfect math, but I’m just demonstrating asymmetry. Berkshire is saying, it’s not going to happen. It’s not, not, not going to happen, so you know he’s willing to take the other side of that bet. The problem is, if he’s wrong, he may have collected premiums of a dollar, but all of a sudden he has a liability, which has grown to 100. It’s negative asymmetry if you’re the person who has to make good on those derivative obligations.

Kevin: So you have a double wrong, actually, because if you do own 2/3 of your portfolio in general equities, then they’re going to go down when the stock market goes down. If you’ve sold and you’re taking responsibility to pay off those puts, you’re also losing in that area. So this was not a great call.

David: No, no. And in fact, I mean, it’s not like he was buying the puts to hedge his equity position. He’s selling the puts, and it makes him even more pro cyclical in terms of his performance.

Kevin: It sounds a little greedy. It sounds like just sort of adding frosting to a cake that’s fairly dangerous, maybe a poison cake.

David: Yeah, well, I think everyone, at a certain point in a market cycle, has a hard time resisting the casino aspects of the market. And so also from the call, no buybacks, no acquisitions, liquidation of $6 billion in publicly traded shares.

Kevin: That doesn’t sound like a bull. A bull, you know, as far as bullish on the market, if there are no buybacks, no acquisitions.

David: And most of the liquidations were airlines. He thinks it’s going to be years before they recover. So all in all, you’re listening, looking a few the numbers, it was not an indication that Berkshire thinks the worst is behind us. So again, looking at what they do, looking at what they say, you know, look, $6 billion in liquidations is only 3% of the equity portfolios. It’s not a mass liquidation, but they are hoarding cash. They are cautious with their buybacks. They are cautious with any major acquisitions. Maybe I’m wrong here, but I would say that the concern was palpable. Listening to the call.

Kevin: Let’s go ahead and go back to the people that we were talking about initially, who aren’t necessarily Warren Buffett. And they don’t spend their day looking at economics and numbers. Just the guy in the street who says, you know what? Something is really, really wrong. I want to buy, my intuition says I want to buy some silver and some gold, and I want it to be small and I want to be able to barter with it, you know, I mean, on and on and on. But that’s that intuition thing we talked about.

David: It’s intuition. Something’s going to change with the currency, and this is domestically. But it also applies to the global system. It’s not rocket science. It’s not a partisan judgment to surmise that trillions in government programs here and overseas, we’re talking about fiscal and monetary initiatives, ultimately has a dilutive effect on the currency. There’s a price to pay for preventing a depression. Maybe the financial markets can make it through. You know, this is where Doug’s concerned, we voiced this last week. It’s about financial markets not always being liquid and continuous, while trillions are being brought into the market in an effort to keep them to ensure that they are liquid and continuous.

Kevin: What can be deceptive, and I had a couple of conversations this way where I’m talking to someone and they’re saying, well, Kevin, the dollar actually is getting stronger, not weaker. Well, that’s pretty deceptive because other countries are doing the same things that we’re doing and their currencies are just falling at a quicker pace. But you can only really measure a currency by what it buys, not necessarily by what other currencies it buys.

David: Yeah, I think this is where if you don’t know a little bit of monetary history, you don’t have to be a geek to appreciate the impact that policy shifts have had on you, the consumer. 1971 is a key year. But weaker global currencies when, as you say, there’s other currencies that are also weak, that ends up shining a favorable light on the dollar. We’re talking about relative, not absolute strength. Since 1971, that is the end of the Bretton Woods system, we have 100% fiat currency system. This is all paper promises, nothing real backing those paper promises. It’s just the PhD managed system…

Kevin: And the trust in the PhD managed system.

David: And the expected trust from the hoi polloi in the system. But again, we come back to relative strength versus absolute strength. This is like running from a bear. If you want to think of absolute versus relative, the absolute speed of a bear is 25 miles an hour. That’s about what they top out at, right? So if you are Usain Bolt, you can run 28 miles an hour, and you’re just fine. Your absolute speed beats their absolute speed. You’re okay. Absolute speed versus a grizzly. You stay alive if you’re the fastest runner in the world or close to it.

Kevin: And you can run for a long, long ways, I’m going to guess the bear can run 25 miles an hour longer than Bolt can run 28.

David: True. That’s 100 meters or whatever, but in relative terms, you only have to run 10 miles an hour as long as your companion in the woods is running nine.

So relative speed, like relative strength, makes you circumstantially viable. Does that make sense?

Kevin: mhmm.

David: But in the domain of currencies, it doesn’t prevent the destruction of value in terms of purchasing power.

Kevin: Right.

David: It’s a peer group measurement that allows you to set the curve. That’s the relative strength, right? You look like a winner walking away from your mauled currency alternative, what you could’ve been.

Kevin: Do you remember our guest, before he passed away, over and over and over, family friend Ian McAvity. Remember what he would say about that?

David: He love turning anything into an acronym. BLHGF was his acronym. You know what? Scratch the head… but BLHGF was best looking horse in the glue factory, and that’s the way he viewed the dollar. He’s like, okay, so you’re thinking it’s strong. Strong relative to what?

Kevin: Let’s look at the other currencies, then, relative to gold. Okay, cause the other currencies are falling relative to the dollar, but what are the other currencies doing right now relative to gold?

David: That’s how you can gage the currency death march. In absolute terms, you can look at real things and have an idea of what is happening with the yen. What is happening with the rupee? What is happening with the ruble? What is happening with the British pound? What is happening with the euro? And instead of comparing one against another, what’s your plumb line? What is something that is constant through 5,000 years, has never been through a currency meat grinder like every other paper currency has through time. By the time we have new highs in US dollar terms, you will have a complete picture here because gold is at, it’s already at all time highs in euros. It’s already at all time highs in yen. It’s already at all time highs in British pounds, and it’s a few hundred dollars away from all time highs in US dollar terms. But the global audience for gold is seeing the same thing. New highs in their currency terms. Does that make sense? When you compare, for instance, the euro weakness relative to US dollar strength.

Kevin: You’re missing something critical, and that is that they’re both falling in buying power.

David: Yeah, so if you measured one against the other, you’re talking about both running less than 25 miles an hour, and that is in a range, if you like that analogy, that is in a range that currency maulings occur.