September 17, 2014; Volatility, Volume & Seasonal Vulnerability

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David there are three Vs that I think we need to pay attention to when we are looking at history. With the stock market, we need to look at; what is the expected volatility? That would be the first V. The second V would be; what is the volume in the stock market? Both of those have been very telling in past years, as to what is going to happen in the fall. But the third one is the fall – the seasonal vulnerability. And David, just look at these three Vs. Could we analyze that a little bit in more detail on this show?

David: Sure. I think people looking at a historical perspective will say, “Well, V is for Victory.” It can be, but there are some common characteristics which I think Wall Street ignores at its peril. And it is kind of because they are caught up in a frenzy, what other economists have described as “animal spirits.” When the money is flowing, when the liquidity is there, there is a lot to be excited about. Buying begets more buying. So, we do look at low volumes; we look at the VIX, the volatility index; and we look at seasonal vulnerability, the weakest two months of the year being September and October. We see that these are some things that, frankly, again, Wall Street is ignoring at its peril.

Kevin: Let’s look at low volatility, then, because we’ve talked about how the markets almost have priced into themselves a certainty of outcome. There is very little volatility, very few people betting against each other.

David: There is an index called the VIX. It is a measure of concern in the marketplace. When the VIX is low people are confident, and they are not hedging positions in the stock market. They are basically letting the horses run. And the opposite is also true, as well. When you have a high number, that is, the high VIX, it indicates that the market is expecting a radical increase in price change, and typically, that is down. So, the VIX is basically measuring the ratio between puts and calls, it is giving you an estimate of volatility over the next 30 days, in either direction.

Kevin: So, that’s considered a volatility index. We were talking about volatility also being how many bulls there are in the market, betting on the high, and how many bears there are in the market, betting on it going lower. It is interesting, last week you brought out that there are only about 13% of the investors out there right now that are bearish. So, that, too, is showing that people are all thinking in the same direction. That would decrease the volatility index, as well, would it not?

David: It would, and this VIX, or volatility index, is sometimes called the fear index in common parlance on Wall Street, because as it goes higher it is an indication of fear in the marketplace. Again, a very low reading on the VIX is an environment where there is no fear, there is confidence. When the number gets low, traders generally agree that people see little change in price, either up or down, on the immediate horizon. And, interestingly, this year we had a number on the VIX, which the low was at 10.

Kevin: That’s unusually low, isn’t it? How often do you hit 10?

David: If you go back to 2000 when there was obviously some volatility, given the popping of the NASDAQ bubble, 2007 at both the end of the real estate bubble and the beginning of the demise of Wall Street’s credibility. Dow was about 12,000 and then we journeyed close to 50% lower.

Kevin: There was virtually no fear right before the crash, is what you are saying?

David: But low, in those environments, was the high teens.

Kevin: Oh, even higher fear index than now.

David: Correct. The high teens used to be considered a low number, and now we are on the verge of redefining complacency, with the VIX knocking on single digits. We’re just a skosh above 9. And why do we say complacency? Complacency is a basic acceptance of the status quo, without regard to the possibility of change or abrupt change. That’s where we are today. We have a tremendous amount of complacency in the marketplace, as indicated by this objective standard, the VIX index, or the fear index.

Kevin: We have a very powerful tool that has been introduced into our society over the last 60-70 years with the advent of the computer. It is called the algorithm. The algorithm, itself – is that something that is actually creating less and less fear and less and less volatility, in itself?

David: Right. The algorithm traders and investors like momentum. And what they are doing is extrapolating trends on the basis of a computer model. Investors do this subconsciously by doubling down on whatever success they have. Buying begets more buying, selling begets more selling, and in this context you have this new trader, this new breed of investor, called the high-frequency trader.

Kevin: Which is just a computer.

David: Right. So, if the investor is doing it subconsciously, the high-frequency traders are not doing it subconsciously, but once their machines are turned on, you could argue that they are doing it unconsciously. Again, you just put the computer model in place, the algorithm reads news headlines, and it’s off and running. And it really is, I guess you could consider it, a calculus-driven world, in which extrapolation of the trends is the norm, and then you have the math to support and justify the vector, where you’re going. This is where you are, this is where you’re going, we’re extrapolating this trend, and see it continuing from here. So you play that momentum until it runs out of steam.

Kevin: It reminds me of Richard Bookstaber, who wrote, A Demon of Our Own Design, and Nassim Taleb. Bookstaber was a guest of ours, as you recall, a couple of years ago. He was talking about how when the system starts to become complex like that, it starts feeding on itself, and it really doesn’t know how to recognize what they call black swan events. I’ll give you an example, Dave. You brought up calculus. With algorithms and calculus, people who have taken calculus realize that it sounds like a complicated subject, but it’s really not. It’s really just the study of change at a given moment. When computers are analyzing this change, they don’t understand world history, they don’t understand failures of the dollar in the past, or failures of various markets. They understand the last millisecond, and they are learning from the last millisecond.

David: And projecting forward on the basis of the last millisecond.

Kevin: That’s exactly right. I was watching, of course, on calculus for the non-mathematician, the guy was really just explaining the concept of measuring change in motion, and really, the simplicity of calculus if you take a lot of the formulas out. What he said was, continuity is important in calculus. What that would be is, if you were just drawing a line on a piece of paper, sometimes up, sometimes down, as long as you can keep the pencil on the paper, that’s continuity. Here is what these high-frequency trading (HFT) programs can’t do though, Dave. What we see in these crashes is, we’re removing the pencil from the paper. You can no longer just chart that graph without some sort of huge aberration that was unexpected. So, what you are telling us is, right now, the index that would watch for that change, for that removal of the pencil from the paper – that index is almost asleep.

David: Again, the volatility index, where people are assuming the status quo, where there is complacency… You have the market today which is driven, in large part, by high-frequency trading. That is a majority of volume on the New York Stock Exchange today. This is a system that responds to new data, and on the basis of new data tries to determine a vector, and if there is no new data, then it just keeps the course, just as in calculus, as you described. So, we say that when the VIX is at a low ebb, then very few people are assuming change, negative change.

Kevin: Including the algorithms.

David: Right. And we can see from looking at a historical chart of the VIX index, that the biggest rises in that index are, in fact, in periods of crisis where traders, again, extrapolate. Prices are changing for the worse, the VIX number spikes, and people rush to hedge their positions, minimize their losses. But there are really two key takeaways, here. These are very important. Number one, when you are looking at a low VIX number, which again, represents very high complacency, it has always preceded a crisis. You don’t have a crisis moment that isn’t preceded by a very low volatility index.

Kevin: Isn’t that an amazing indicator?

David: It’s fascinating, because it’s counterintuitive, and you would think there should be a rising sense of concern if something is getting ready to crack apart. No, quite to the contrary, just before something cracks apart, it is the calm that precedes the storm. So, low VIX has always preceded crisis. The second point I wanted to mention is that a massive spike in the VIX has typically followed low readings.

Kevin: So it’s too late, basically, you’ve got a massive spike in the VIX, fear index goes way up, people are beginning to hedge, but it’s already too late.

David: Right. And there is a fascinating parallel here. Granted, I probably spend too much time looking at interest rate trends in Latin American countries, but it is fascinating. You have rates that go lower, and lower, and lower. As we’ve talked about before, interest rates are a signal. Interest rates are an indicator to an investor how much risk is in that particular market at a given time. And so, you would assume that as interest rates come down, there is less and less risk, when in fact, the opposite is the case.

When interest rates are coming down, it is for a variety of reasons, and it may be entirely market-driven, but you may also have the strong hand of government forcing them down to create an environment where there is confidence, where there would otherwise not be confidence. And so what you have is an interest rate trend which may have a natural decline, which all of a sudden becomes artificial, in terms of the decline in rates. And all of a sudden, boom! You go from a very low rate to a very high rate. What is it that causes that? And this is, I think, where, going back to VIX, we expect the volatility index to move considerably higher as investors shift from one side of the boat, today, all bullish, we talked about that last week, the highest bullish rating since the summer and early fall of 1987, as they shift to the other side of the boat, a bearish bet. So, watch the VIX, we’re up off of 10, we’re currently 14, still a very, very low reading, and it signals complacency. Well, people come alive when they feel that they are being threatened. Today, they feel no threat, but when they do, you watch the VIX. It will be considerably higher.

Kevin: So, what we’re talking about is, the fear index is extremely low. I guess if we looked at that in a mirror and turned it opposite, we would say that the confidence index is at an all-time high.

David: Well, yes, and if you are thinking about that, you are exactly right. We’re suggesting that markets are confident, they are today, when, in fact, they should be concerned. And the opposite is also true. When the markets are concerned, that is when, in fact, they should be confident. In other words, investors are a little bit like the dog wagged by the tail of emotion, an over-extrapolation. Market efficiency – and this is what is so fascinating to me – market efficiency, and the wisdom of collective pricing of assets, this is what is being called into question. Because again, if you are looking at interest rates and they decline, decline, decline, decline, decline, the market message is lower risk, lower risk, lower risk, lower risk, just before a catastrophe.

Well, the reality is, there was risk embedded that was being ignored, overlooked, written over, papered over, etc., before the collective conscious regains an awareness of risk, and all of a sudden interest rates spike, or in this case, the VIX spikes. So I guess you have to reiterate that concern over market efficiency and the way that Wall Street operates is on the basis of market efficiency. They assume that the market is telling you everything that you need to know. So obviously, obviously, the Dow near 17,000 means that we are going higher because the collective wisdom of investors says that it should be there and should be going higher. Price is everything. Well, yes and no. Again, we talked about interest rates as an interesting parallel to the VIX, and when markets are at extremes, we suggest that there is wisdom in anticipating a return to the average. So, when you move to an extreme, expect it to swing back. It’s like the market pendulum going from the extremes of greed to fear.

Kevin: That reminds me of a mathematician named Zeeman who did what he called catastrophe math. I’ll give you an example of that. There was a bridge that collapsed in Minnesota a few years ago. It actually was on the point of collapse probably for a few years before it finally did collapse. I think it was bird droppings, and the chemicals from the bird droppings, and just the rot in the bridge. But it was a catastrophic return to the mean. That bridge, actually, really was not strong enough to hold, and one day it gave. That’s like we talked about, catastrophe math. That’s also having to remove your pencil from the curve and moving it to a completely different area. The problem is, that wipes out, a lot of times, a lifetime of savings when it occurs in the market.

David: That’s true. So, we could say that everyone today is greedy (laugh), and they’re overlooking a tremendous number of risk variables, and keep this in mind, when no one is fearful, you should be concerned. And when everyone is fearful, you are probably nearer to value opportunities than ever before.

Kevin: Oftentimes we hear about Warren Buffet and his unusual ability to patiently find value. I just read something in the Wall Street Journal just recently that said, as confident as everyone is, and as much as people are out there buying, Buffet seems to be sitting on the sidelines right now.

David: And this is interesting because Charlie Munger, as you know, is his business partner with Berkshire Hathaway, a legal background and sort of his cohort in value investing, and Munger was speaking about Buffet, as you said, in an interview in the Wall Street Journal this week, and he said this, “Buffet sees nothing worth investing in right now, and hasn’t bought an investment in his personal accounts in at least two years because he is waiting for an irresistible bargain.” And then he goes on to say, “Successful investing is this crazy combination of gumption and patience, and then being ready to pounce when the opportunity presents itself, because in this world opportunities just don’t last very long. It’s waiting that helps an investor, and a lot of people just can’t stand to wait.”

Kevin: You know, you’ve had that conversation!

David: I know, I know! So, it’s interesting, Munger and Buffet echo this issue of value having been absent from the market for better than two years. Well, you know what that means? We can roll the clock back 3,000 points on the Dow, even 4,000 points on the Dow, and say, yes, that’s right, we quit operating on the basis of fundamental analysis. Value investing went completely out the door and there has been nothing of great value, at least as far as Warren Buffet is concerned, and when he is spending his own money, not just Berkshire Hathaway’s, but when he is spending his own money for a personal account, he’s on hold. Why? Waiting for irresistible value. I relate to that.

Kevin: You know, I misspoke when we started the program. I said there were three V’s I’d like to look at in this program: The VIX – volatility, volume, and then our seasonal vulnerability, but actually, the lack of value is probably the fourth V that I was missing. Buffet is saying there is no value at this point; he’s waiting for value.

David: Right. What does that imply? He can’t say this from the rooftops because what it actually implies is that he expects to see lower prices and he is going to wait until he sees them. Well, that doesn’t help his other holdings to be talking down the stock market. But the reality is, he’ll spend his money when he’s good and ready to, and he’ll be good and ready to when prices are cheaper than they currently are.

Kevin: We talked about how he had about 60 billion bucks just in cash, just waiting, a couple of weeks ago. That’s the largest amount of cash he has ever held in percentage of what he owns.

David: We talked about the VIX, then volume. I want to mention just a little bit about volume which is just a measure of traffic into the market. You have the number of shares bought and sold in a day, in a week, in a month, and what you are really talking about is demand. Who wants the stuff? Who wants to own this or that company? With high volumes, what that equates to is high demand. With low volumes, that equates to low demand. I know this sounds somewhat pedantic, but when prices are rising on low volume, you are talking about a very thin interest in the market.

Kevin: And is that what we have, very, very low volume at this point?

David: That’s what we have. And in that environment, you’re looking for either an increase in volume of buying, to take the price trend, which is up, and make it a real healthy trend, with an increase in buying, with stronger, more robust volume, or eventually what you end up having is that thin level of buying turning to no buying at all, and then sellers come out of the woodwork. Why do sellers come out of the woodwork? Well, you know what? If there isn’t going to be growth, then those who own the asset already look to lock in profits before there is a marginal erosion of their gains. And so, again, like we mentioned earlier, selling begets selling, buying begets buying. And this is why you have the trending up, and then trending down.

Here is the strange reality, the very strange reality, in relation to volumes that we have encountered over the last 12-15 years. Volumes used to be a combination of individual investors and institutions, where, specifically, the institutions were buying and selling, both for large investors and for pension funds, and for managed funds, etc. But the market today, we’re looking at those types of purchases, again, the individual investor, the institutional investor representing the pension fund, the managed fund, the large, individual investor.

Kevin: They’re replaced by computers, Dave.

David: That traditional buying has shrunk by between 40 and 60%. The last decade, volumes of real, long-term buyers have been hollowed out. Where are the real long-term buyers? They’ve been on strike for a decade, and the question is, is that for a good reason? But you’re right, the high-frequency traders who trade momentum in either direction, and again, as we mentioned earlier, are extrapolating trends, we’re talking about something that is devoid of human appraisal. We’re talking about programs designed to read a headline and trade that news headline, either buying or selling, on the basis of the headline or reported number, and so this is what becomes very intriguing: If you have a positive spin from the news media, if you have a positive spin in the news, it brings in a self-reinforcing cycle of buys from these computer-generated buying programs, who literally will read a headline and within a nanosecond be long or short a particular asset based on the bias in the article.

Kevin: And talk about a loop, when you have a feedback loop, as we have talked about many times before, when you have news that is feeding the markets, that are feeding the news… I know Bloomberg actually sells the service to the stock brokers, those programs actually read Bloomberg News, and if they see positive words they buy, if they see negative words, they sell. But it’s all done, how many trades per seconds? Hundreds and hundreds of trades.

David: In a nanosecond.

Kevin: In a nanosecond.

David: Here’s the dark side. The dark side of the new kind of volume is that we’re not talking about institutional holders who are buying low and selling high, we are talking about momentum trades, and just as you have a positive bias you can also have a negative bias. Negative news begets, and just as you described today, a feedback loop can either be positive or negative, and this is the danger of a turn in the marketplace. You can have liquidations just as easily as you can purchases. The bias in the market has been high-frequency trading on the buy side. You can have high-frequency trading and a momentum trend on the downside just as easily. And what I don’t like is, it is devoid of human appraisal. Again, you are talking about programs reading headlines, headlines being influenced by the feelings of a few people.

The major indexes, the NASDAQ index, the S&P 500, the Russell 2000, the Dow 30 Industrial Average, they are driven in price, today, by the weightings of a few large companies within the index, so a move in the price of just a few of those companies, if they are the largest companies, and guess what you end up with? An over-representation in the index which causes a greater up-move in the index, or down-move in the index, as it were.

Kevin: So, you’re not really getting a clear representation of the whole market, you’re just basically saying, okay, well, Netflix did real well, or somebody did real well, and it pulls the whole index up.

David: Exactly. You could say Apple and Google are on a tear, NASDAQ is up. Well, that doesn’t mean the entire index is up. In fact, this is what is troubling right now. Right now, in the NASDAQ, we have 47% of NASDAQ stocks which are down over 20%. Technically, anyone on Wall Street will tell you, if you have had a 20% decline from peak…

Kevin: That’s a bear market.

David: You are technically in a bear market. So, we have 47% of NASDAQ stocks which are over a 20% decline from peak levels, and therefore, technically in a bear market, yet NASDAQ is trading at lofty levels, given the positive impact from companies like Google, Apple, Amazon, Tesla, Netflix. You have volumes in just a select few companies which have been high because hedge funds favor them for liquidity, they favor them for increased volatility, and volumes, as we have pointed out, have over the last ten years become less and less the investor, the long-term buy and hold person or institution, and more and more the transitory trader, equally interested in the downside swing of that stock as the upside, should momentum move in the opposite direction. Yet, this is the state of affairs we have today. The average investor just looks at the indices and says, “I want in. Look, the price is going up, I want in,” not knowing that Wall Street is already a veritable ghost town on the one hand, and on the other hand you have bear market dynamics that are growing by the day.

Kevin: Okay, bear market dynamics. This may be unexplainable, but strangely, for whatever reason, Dave, the people who are looking at these indexes usually get nervous in the fall. Now, why is it that we have this other V, this seasonal vulnerability?

David: Right. It’s not every September/October period that is punk, so to say, but you have all of your major crashes which have occurred in that timeframe, and you have to appreciate that there were prerequisites for the September/October period, prerequisites for collapse. You needed low volumes.

Kevin: Which we have.

David: You needed high complacency.

Kevin: Yes. Got it.

David: Which is certainly indicated, represented by the low VIX numbers today. You needed a high degree of leverage in the market.

Kevin: Right, now isn’t that at a high?

David: Over 460 billion dollars in margined stock purchases, that is, money borrowed from the house to go buy stock that you couldn’t afford otherwise. And now, the interest clock is ticking. You had better be right, and if you are not, guess what happens? You have 460 billion dollars in assets ready to be liquidated. So, you think a surprise of some sort may be possible? I look at what happened in different periods of market decline in the past, and actually, it was a variety of different kinds of market surprises that took the complacency out of the market and really started to put people under pressure. Monetary policy, fiscal policy, geopolitical surprise, national security surprise? Actually, any of those would suffice so long as it pushed investor psychology out of the comfort zone and forced them to reappraise market risks.

Kevin: Going back to that bridge analogy, the bridge that was going to collapse. The real cause was already built in. The bridge was going to collapse. So, trying to look for any particular trigger, to say, “Well, do you think it’s going to be the red car that does it? The yellow car? Do you think it’s going to be the van or the truck? It didn’t matter. The bridge was going to collapse. So, I guess these triggers … rather than looking for which trigger it’s going to be, you just get off the bridge!

David: Right, right. Let’s look real quick just at the recent history of, we could call them autumn surprises. Very curiously, they come in nearly perfect seven-year increments. You have the 1987 surprise, when you had a weakness in price in the autumn, but it was preceded by a late summer rally, so the stock market was moving up, on very low volume, and again, the volatility index, the indication of fear, virtually nonexistent, everyone considered it to be fine. Fast forward a few years to 1994. Here you are, the Fed had not prepared the market for the rise in interest rates which occurred in 1994, and the market ended up being surprised by both the extent of the increase and the speed of the increase, and those things caused significant ramifications, not only in debt markets here in the United States. As you recall, that was Orange County’s collapse, that particular timeframe, as a result of that. And then, of course, you had a whole domino effect into Latin America, and into Asia, in terms of debt crises, for several years thereafter, but originally sourced, I believe, in 1994.

Okay, fast forward to 2000-2001. You have, again, an autumn period, late summer rally, low volumes, increase in price in the equity markets. The volatility index was about 18, and commentators at the time were saying, “yeah, it’s pretty low.” Yeah, it was low then, and it’s even lower now. But before we get to the current timeframe, we had the collapse in 2000-2001. The NASDAQ bubble popped, and then we had sort of the reinflationary trends, the Fed trying to stimulate growth, extraordinary measures, lowering of interest rates, etc., and that caused a major rush and boom in the real estate market. Of course, that, and the stock market came unglued in 2007, but interestingly, if you go back to the autumn of 2007, what do we have? We had just finished a summer, low volume rally in price.

Kevin: No fear, in any event.

David: No fear. The VIX was very low. Again, you are talking low teens. And again, what did we have in the autumn? September/October. Welcome to the neighborhood, guys. Welcome. We’re here. We’re home. Now, fast forward to 2014. What do we have? Well, we certainly have the circumstances. We certainly have everything surrounding a market decline. What did we have recently? Late summer rally, on low volume. The volatility index hits nearly an all-time low at ten. What are we talking about? Incredible leverage in the stock market. More leverage in the stock market today, both in nominal values, and as a percentage of GDP, more today than 1929. And yet, the pundits would say, as we mentioned last week, no, 3000 on the S&P, Jeremy Siegel, 18,000 on the Dow, finish this year, no questions asked. And as I said last week, we may very well have it, but all I’m suggesting is, 1987, 1994, 2000, 2007, I don’t know if there is anything to 7s, but we’re awfully close to almost a rhythm. If you are wanting to keep rhythm, if this is 2:4 time, every seven years there is a major hiccup, or nearly every seven years.

Now, listen, I don’t want to overplay that, but I think there is going to be a turn in sentiment and a real reappraisal of risk in the marketplace. That brings me to a very critical, critical issue. That’s gold. Gold continues to get beat to snot, and it’s no fun. What’s the big picture? Why does an investor want to own gold? We talked about the volatility index as a measure of fear. There is no fear in the marketplace. No one is concerned today. The investing community, professional and private, are saying, “It’s all up from here.” Actually, a Bloomberg article I read last night: “Why are we interested in the gold trade? It’s boring. We don’t need it. The equity markets are doing so well, who needs gold?”

And this is the point I’m making, is that gold is an insurance. What is it an insurance against? It is an insurance against experimental monetary policies. It is an insurance against central bank balance sheet expansion. It is an insurance against the high probability of fiscal deficits being monetized by various central banks. It is an insurance against currency volatility, a breakdown in the value of a given currency, whether it is the euro, the yen, or the dollar. When we see a breaking of equity investor complacency, and a selloff in equities, it is also a safe haven, just like treasuries in that environment. It is an insurance used for systemic hedging. If there is something wrong with the system as a whole, go back to Lehman Brothers. Replay 2006, 2007 and 2008. Why were people interested in gold in that environment? I’m talking about billionaire interests interested in gold because gold is an asset that doesn’t bear counter-party risk. That is not an issue today, no one cares today, and I’m telling you, they should.

But again, what is gold? It is an insurance. It is an insurance against systemic risk, counter-party risk, geopolitical volatility, changing inflation expectations. I got off the phone with my dad this morning, he is over in the Philippines, (laughs) and he just laughed, and he said, “You know, there is a good part and a bad part to gold being lower priced. I like to buy my insurance premiums when they’re cheap.” Gold is insurance against the unintended consequence of fiscal and monetary policies that we have yet to experience, the unintended consequences. We know what the intended consequences are, but what are the unintended consequences? Do we need insurance? I would suggest, yes, we do. Can the price of gold go lower? The big picture is that it is insurance. What is the little picture? Well, it’s weak. It’s breaking down through support. We’ve closed below $1240 two days in a row. That’s not constructive, if you’re looking at a daily chart. From a technical perspective, the daily chart is weak, but here is one positive element to that. You are very near what they would describe as an oversold condition. In other words, we’re exhausting ourselves on the downside.

Remember I said, buying begets buying, and selling begets selling? Both of those trends run their course, and capitulation in the market is when selling begets selling, and then you run out of sellers, you see? And the market upside is exhausted the same way. Buying begets buying until you run out of buyers, and then the trend changes. So what I’m suggesting is, the daily chart? Yes, it’s near that oversold condition where you are running out of sellers, and yes, we expect a number of days, perhaps a few weeks, of declining price before a swing to seasonal strength. Why seasonal strength? Just as you have seasonal weakness in that September to October period in the equities market, you also have seasonal strength because we’re beginning the Indian wedding season. And it’s not quite axiomatic, but it’s awfully close, that when an agrarian society who has a love affair with gold is marrying off its daughters and want to give them some sort of a dowry, if they’ve had a good crop, guess what they do? They harvest, they get their money, and they marry off their daughters in the fall and winter months. That’s why, seasonally, we’ve typically had an up-tick in the price of gold. The follow-through is December/January when you head toward the Chinese New Year, which is, of course, huge, in terms of physical demand for gold, very, very clarifying, in terms of demand dynamics.

Then you’ve got the weekly chart. We’ve been talking about the daily chart. The weekly chart is pretty ambiguous, and I think you’ve got clarity on that as we move two to three weeks out. The monthly chart is the one that puts a big smile on my face. If you look at a monthly chart of gold, we’re probably two weeks out from having a buy signal. Pull it up, whether it is a stock chart, or some other chart service, the monthly chart is very close to a buy signal, which would indicate the end of a cyclical bear market, that is, a decline in price which started in 2011, ended in 2014. I’ll just say it boldly, I think it ends in 2014, and ,a move back to the long-term secular trend. I think, as and when we get this buy signal, and I think we’re days, maybe two weeks out, in terms of a buy signal on the monthly chart, you’re looking at 18-24 months of solid growth, and an upside target of $2100 to $2300.

So am I discouraged? Am I sitting on the edge of a cliff, or sitting out on the window ledge ready to jump because I don’t like the fact that the price of gold is down? No, actually I’m not. My dad and I were putting together a buy trade, both of us, this morning. Why? We like the price. Can it go lower? Sure. Are we going to add more to our insurance at lower levels? Yes. Not with reckless abandon, but we like this thing called dollar cost averaging. And we like this thing called cheap prices. And we don’t like that thing called chasing prices on the upside. And we don’t like that thing called being surrounded by an investor class that is all doing the same thing at the same time, mindlessly, which is essentially what we have in the marketplace, and that’s why Buffet is saying, “Not me, not now. I’ll sit on my cash and I’ll wait for [his words, not mine] an irresistible value.”

And I think we’ll have an irresistible value, and I’m looking forward to that.

But ultimately, it’s going to be a translation, a move out of gold for our family, and into assets of irresistible value. What are we talking about? Again, until we are blue in the face, we have talked about the Dow-gold ratio. It’s edging to 14-to-1. We think we will see a decline to 5-to-1, ultimately 3-to-1, and maybe, if you throw in a little geopolitical chaos into a punk financial backdrop, guess what you have? The possibility of a 2-to-1 or a 1-to-1 ratio. Why do I like that? Well, let me tell you. Very simply, I get to increase my financial footprint a minimum 4½-fold, and if we see a 2-to-1 or a 1-to-1 ratio, I get to increase my financial footprint 12-14 times. We’re talking about purchasing power. We’re talking about owning the land, plant, and infrastructure of some of the finest companies in the world, but not paying premium prices for them today, waiting for irresistible value. I define irresistible value as moving out of my quasi-cash position, that is, gold ounces, and putting that money to work for me when everyone else is panicking. That’s right, 1987, 1994, 2000, 2007.

Is it 2014? We wait with bated breath. We do not know. There are things which have dramatically improved this year. The dollar has had the largest rise in 17 years and gold is holding above $1200. I’m comfortable with that. Now, am I uncomfortable with the declining price? Sure. But in terms of a rate of change, going back to what you described as rate of change, calculus, trying to determine the course for a given asset class, everyone is extrapolating and assuming the absolute best and absolute worst on the opposite ends of the financial spectrum, specifically, those who are investing in equities today are expecting good to become better and best, or best to become “bestest,” and “bestest still.”

That’s the extrapolation of the upside in the equity market, and Goldman and others have suggested, “No, gold is not only lower, it’s going lower still, until it moves into oblivion, until you can’t even remember its price, because nothing is nothing, is nothing, is nothing. And that’s what we had, but again, the largest move higher in the dollar in 17 years and gold is still holding comfortably above $1200. I actually think that’s pretty strong. So, no, you won’t find me out on the edge of the cliff getting ready to jump. If there is anything I’m jumping on, it is the price at these levels. I’m very comfortable with the expectation of prices moving higher over the next couple of years, and I’m very comfortable looking at prices like – I remember my interview with Steve Liesman on CNBC Squawk Box, in December, tail end of the year. He laughed at me. “Gold is $1180.” I said, “$1180? Are you kidding me? If we’re not at the low, we’re within 5% of the low. Why wouldn’t you add to a position at this point?”

If you look at gold as an insurance policy, why wouldn’t you add to your insurance position when premiums are low? Roll the clock back. It’s been better than a decade now, when I was buying life insurance, real life insurance, not a financial insurance policy (we’re talking about in the form of gold ounces), but real life insurance. I knew that my 30th year was coming up, and I knew premiums would be going up. You know what my motivation was? To lock in those prices while I could. I’m very well taken care of, my family is, with life insurance. And it was done so inexpensively, ridiculously inexpensively, and I look back and I think, “That was a really smart thing to do.” I’m glad I did that, because if I was buying the same insurance today I’d pay five times the price for the same coverage.

Kevin: Dave, I think sometimes… I was thinking about this while shaving, before I came in today. Sometimes shaving is my best time to talk to myself and to talk to God, and I was thanking God for allowing me to do this for my career. And I remember back to 1987. You started that as the seven-year cycle: 1987, 1994, 2000, 2007, 2014. I remember all those years. I came to work for your dad back in the summer of 1987. Confidence was high, all the things you’ve talked about. But I had purchased a little bit of gold. With the little bit of the money I had at the time, I purchased a little bit of gold, because I had read his newsletter, and it made sense. It was like, you know what? Gold is just insurance against paper, and I don’t trust paper. What is interesting is, in this career time, we’ve talked about good timing, bad timing, markets going up, all these complexities. But here’s the simplicity of it. It takes four times more dollars to buy the same amount of gold I bought in 1987 from your family than it did when I started. Now, it takes four dollars for every one, and all of those years we just added gold. I remember 1987, I remember 1994, I remember 2000, I remember 2007 and 2014. I remember all the years in between. What we did was to just say, hey, let’s just make sure that we keep adding to the gold because you’re going to have markets go up and down, you’re going to have the pencil smoothly moving up and down on the curve. You are going to sometimes remove that pencil and have these huge shocks. But you know what? Shock or no shock, I’ve got gold that right now is worth about four times what it was when I first starting adding. My clients have gold that is worth four times what it was when they first started adding over the last 28 years. And that is just going to continue. It is a hedge against false confidence.

David: Just to sort of change the subject and wrap up the day, two things we haven’t mentioned, but we really should have an in-depth discussion on, are single malt Scotch and Vodka.

Kevin: (laughs)

David: We’ve neglected those asset classes for a long time and demand for Vodka, obviously, is on the rise. You look at the pressure that the Russians are under, and the fact that fiscally, it’s a nightmare right now. Why? Because oil continues to slip. Why is oil slipping? Well, in part, you’ve got supplies, in the short run, increasing on the U.S. side, maybe that doesn’t last forever. But in the short run, we’ve had global supplies increased. Demand, a little bit soft, suggesting that the global economy is not as robustly in recovery as everyone hopes or expects. And on top of that, you’ve got the Ukrainian/Russian conflict. Who owns what? We have kind of an interesting parallel because the Russians want something back, and they’re taking it. It once was theirs, they want it back. In Scotland, those enjoying a single malt Scotch, and anticipating maybe enjoying a lot more, after the 18th – this week is a very momentous occasion.

Kevin: And a lot of them are watching Braveheart right now, as we speak, and they are getting fired up.

David: They’re getting fired up. What is interesting is, Scotland is the opposite end of that spectrum, a people that may leave and re-establish themselves as their own country. So, you’ve got these things that are changing, and I’m very fascinated by all of it. We don’t know how the Vodka problem will be solved. We don’t know how the single malt problem is going to be solved. But, on the other hand, we do know that the risks inherent in the marketplace are underestimated and you’ve just begun to see a little bit of concern. And this is just in a two-week period. No one really thought that the single malt problem, that is, the Scottish secession, was going to be an issue until about two weeks ago, and that’s when the U.K. pound started going to heck in a hand basket.

It is fascinating to me to see people go from zero concerned to very concerned very quickly. But you wouldn’t have been negative the pound six or eight weeks ago. It only became negative here recently, and I would say the same with the euro. The euro was holding its own at 136, now it trades to 129. Why? Mario Draghi says one thing about asset-backed securities purchases and the fact that he is going to double down negative rates. Now, negative 20 basis points, it’s amazing. We have a single malt problem, we have a Vodka problem, we may even have a Budweiser problem here in the United States, but we can get into that on another day.

Kevin: Well, but let me just point out that gold has been rising against the pound, it’s been rising against the euro. It hasn’t been rising against the dollar. But in keeping with what you are talking about, insurance against the black swan or the event that you can’t predict, gold is doing exactly what it needs to do in the currencies that it is doing it in.

David: I read a spoof of an article six or seven years ago, and the argument against owning gold was, “Why would you own gold when you could buy Budweiser? If things really get that bad, at least you can drink it.” Of course, I’m not a fan of Budweiser, but anyway, this idea that we need it at a particular point in time and you don’t know when that particular point in time is, so you make a decision ahead of time to own it in advance, and if you are not thinking in advance, that’s a problem.

We’ll end with this anecdote. A good friend of ours who works with us here in the company, he has been with us for 33 years, we went to his father’s funeral a number of years ago. And we sat in the back of the church. This friend of ours, myself, my father, we all three of us looked at the price of gold that day. This man, the man who we were burying that day, had anticipated higher gold prices, and he died five days before gold broke $850 on its way to $1920, and we sat there and smiled, thinking, he did the right thing. His timing may not have been perfect, but he put his family in such an amazing position, having thought ahead. And no, he didn’t live to see it. He missed it by about five days.

Kevin: Dave, it goes back to what you have been talking about for a long time: Legacy. Who are you investing for, and what is your timing? Do you have to be right this year? Do you have to be right this month? Or if you are a high-frequency trader, do you have to be right this nanosecond?

David: This millisecond? Exactly.

Kevin: Exactly. But really, in the long scheme of things, we should have a legacy mindset. You don’t do the right thing for today, you do the right thing for forever.

David: I think this gentleman… and I could say the same thing: I apologize, timing has been off. Are we in the right thing, for the right eventuality? Oh, I believe so. I don’t think anything has changed one iota, and to consider the insurance policy you want, present and future, is absolutely imperative. Timing? Does anyone get it perfectly right? No. Is that an excuse? No. Do I fully apologize? Oh, yes. And this man might have apologized to his family, too. Yet, he didn’t know, just a few days later, he was right. Right as rain. I wish he could have seen it. I wish he could have, in that moment, seen the old highs taken out. $850. We all sat and thought, “Boy, he would have enjoyed this.” A remarkable man with remarkable vision, and a remarkable degree of patience.

I think back to Charlie Munger’s comment: Some people just don’t have the patience to be successful as an investor. This man did. Warren Buffet did. I would encourage anyone concerned about market gyrations, again, what is your timeframe? Can you be patient? Can you wait? You will be rewarded in due time.

By | 2014-09-19T13:09:10+00:00 September 19th, 2014|Transcripts|