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About this week’s show:

  • Dow has 12 straight days “winning” tying the record CRASH year of 1987
  • S&P up 5.4% in 2017 & is getting All of the Attention
  • 2017: Gold is up 9% – Silver is up 15% & “Who would even know?”

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

“On today’s show, as long as the pied piper of credit is flowing, prices will grow and the world powers avoid war. But when the piper gets paid, watch out.”

– Kevin Orrick

“The weakness here is in not appreciating the fundamentals of supply and demand, in this case, seeing through sort of the paper gloss, which covers over the tangible metals, themselves. And it’s worth looking at the internal dynamics of the market to know if, actually, price is reflective of reality and future course, or if there is reason to be concerned. In this case, we’re seeing very healthy dynamics within the gold space today.”

– David McAlvany

Kevin: You know, perception is reality. It’s amazing that the perception is the stock market is the only place to be right now, Dave, yet other markets are out-performing the stock market significantly.

David: It’s the only game in town, except that there are, actually, a few emerging market countries and their stock markets which are doing far better. You look at gold and silver year-to-date – gold has moved higher by 9%, silver by 15.3%, and that compares to the S&P which is up 5.7%, the NASDAQ which is a little bit better at 8.6%, and the Dow, that is, the industrials, up 5.4%.

Kevin: Isn’t it amazing, though, that gold is still under the radar and, you know, I don’t mind that one little bit – physical gold. I’d like to talk about this later Dave, but physical gold represents just such a small percentage of what is actually traded as gold. So much of it is traded in paper. It’s nice to have a little physical gold available right now.

David: Well, reflect on that. There is this market perception that the Dow is doing incredibly well, and yet silver is doing three times better. It’s interesting because they both exist, that is, gold and silver exist in the shadow of the stock market because nominal prices in stocks are grabbing the headlines, and we’re at record highs, nevertheless.

Kevin: Something that is amazing, since we’re talking about the stock market, is that we are only seeing consecutive gains on a daily basis. I think we’ve recently tied a record.

David: The Dow has, as of this week, completed 12 consecutive sessions moving higher, and believe it or not, that has only been done once in the last 30 years.

Kevin: I think I can remember when, Dave. My first year here was 30 years ago and the Dow was incredible in that it really didn’t earn the points that it was gaining, but everyone was saying, “Oh, no, no – this time it’s different. It’s to the moon.”

David: January of 1987. For those who don’t recall the confident tone of 1987 – nothing could go wrong. There was this perception that when portfolio insurance had been introduced you basically eliminated downside and there was only upside. The market was a one-way bet because you had this new thing called portfolio insurance. But do you know what we call portfolio insurance today?

Kevin: Derivatives.

David: That’s right. So, we had the original roll-out there in the 1980s. They became very popular in 1987. And again, the tone and tenor in early 1987 was. “The stock market can only go up. There is this beautiful growth dynamic.” Unless, of course, it changed. And in fact, it did, later that year. We had the 22% one-day decline which got every investor’s attention.

Kevin: Dave, there are two authors, one of them that you have had on the program several times that wrote about how they were part of the insurance of that stock market, and actually, they felt some responsibility. The author of The Black Swan, Richard Bookstaber.

David: A Demon of Our Own Design. I think, still, to this day, the way he opens A Demon of Our Own Design, when he is talking about being a risk trader, and a risk manager at Solomon Brothers…

Kevin: He says, “I may be responsible for what happened.”

David: It’s the best opening lines of a book. I wish I could quote it. A book that is definitely worth reading. So, you have these closing streaks where the stock market goes up and up and up, and there’s no real balance. The closing streaks are rare because there is usually a tug-of-war between bears and bulls. You have sellers and buyers. That keeps the price moving at a measured pace, in staggered motion, both up and down. But when you have streaks of one variety or the other, often you are at a terminal phase. You’re at an inflection point. And market extremes are noteworthy for the universally one-sided opinions that accompany them.

Kevin: It is amazing how many people are ready to buy at the top of a market. We all joke, “I buy high and I sell low.” That’s an experience that most people have suffered through. But it’s a human nature dynamic.

David: It happens at both ends of the spectrum. At a market low, buyers are scarce, and the market seems destined to go even further down. That is the psychological tone in that kind of a market environment. At a market high, sellers are scarce. Nobody is selling, everyone is buying, and the market seems to know zero limits.

Kevin: So, this is a stupid question, but where are we now?

David: We’re in a period where we believe that the market will go inexorably higher, and with 12 consecutive up days, it tells you something. But there is more than just price action, and there is more than just this sort of consecutive streak. The daily sentiment index reached 91% bullish, that is, three out of the last six days it has been 91%.

Kevin: So nine out of ten buyers out there don’t believe it is going down.

David: It is another measure of the feelings amongst investors about the market at present and where it most likely to go next, which is up, up, and away. And yes, the stock market can go higher, but the trade is, as they say, getting crowded.

Kevin: Yes, last week I read a CNBC question, which was, “What should we buy now.” And the answer was, buy everything.

David: Buy everything.

Kevin: But price, Dave, is not everything. Price action, sometimes, can betray something underneath the surface that you may not be able to factor in.

David: Kevin, about a month ago you and I were talking about discrimination, and we weren’t talking about racial discrimination. We were talking about what goes into deciding what to own and what not to own. And you have to choose to avoid certain things and to engage certain things. We were talking about the use of ETFs and the use of this sort of auto-pilot approach to investing, and there is no discrimination in the investment process, where you say yes to something because of its own merits.

Kevin: Right, you just buy everything.

David: You just buy everything, and so I think that lack of thoughtfulness, that lack of discrimination, is very telling. But I think you’re right, the price of an asset – yes, it is important. Yes, it tells you what you want, what you need to know in that moment. But there is more, and I think this last week Steve Hochberg pointed out very interestingly that the Yew York Stock Exchange’s advance-decline ratio had more stocks closing down than up, and that five out of six days ending last Friday had a greater percentage of volume on the New York Stock Exchange which was negative than positive, even as prices continued to move higher.

In other words, you have the price improvements which are taking us to record highs, and that is encouraging to stock owners. But what Hochberg was pointing out is that the internals in the market are deteriorating. Of course, we mentioned the rarity of a 12-day positive closing streak, and then on top of that you have the divergence in the advance-decline ratio in the volumes.

Kevin: That’s what is amazing. We’re seeing this 12-day streak of up, but not everybody is making money. The advance-decline ratio is telling you that a larger percentage is declining.

David: That is, the number of stocks that are going down relative to the number of stocks that are going up, and if the ratio is in decline, it is telling you that, again, something is wrong with the internals of the market.

Kevin: So it must mean that there are just a few stocks that are really going up.

David: Right. You have a few names that are dragging the indexes higher, those names that have heavier weighting in the indexes, but it is not broad-based, and that is concerning because it’s not typically sustainable. When you don’t have a broad-based move higher, you have to pay attention to that. It’s typically not sustainable. When a move has powerful volumes, and more stocks are advancing in price than declining, that kind of move can go the distance. That is very positive. So, when the internals of the market are not supportive, I would suggest you are playing with fire.

Kevin: Well, you know, Dave, one of the things that I have appreciated about you, not just with this program, but even when you are not being recorded, you surround yourself with people that you would consider smarter than you in particular areas. I’m thinking of Doug Noland. I’m thinking of the four-page letter that Jim Deeds just wrote you. You’re basically looking for guidance from other people and they’re happy to give it to you. No one right now is warning there is a high probability of a reversal in stocks.

David: I know his process and his philosophy. It was in his most recent Credit Bubble Bulletin – by the way, if you don’t read it over the weekend I would encourage you to kind of incorporate that into your routine. Go to and look under the CBB, which stands for Credit Bubble Bulletin.

Kevin: Yes, and it’s not $5,000 a year, or $20,000 a year; they can read it for free on

David: He is looking at a number of indicators which signal a higher probability of a reversal in stocks. You have financials, which are now lagging. You have small caps, and generally, high beta stocks which are under-performing lower beta ones.

Kevin: Explain that, if you don’t mind.

David: Right. Something that performs right in line with the stock market is considered to have a beta of one. If you have a higher number than that on the beta scale you’re going to out-perform, or on the downside…

Kevin: Under-perform.

David: In a more exaggerated fashion, under-perform the market. So, a low beta stock is considered something that is more conservative, less volatile. And actually, when you see low beta stocks garnering the attention and high-beta ones being kicked to the curb, it tells you about what people are doing as they are assessing risk. And we’ve seen the best performance which has come in those lower risk stocks.

In fact, last week the best performing stocks in the U.S. markets were utilities, which tells you that at the periphery of the market, risk appetite is shifting. It is the same shift which we are seeing occur in Europe, both in stocks, where risk is being cut back, and more notably in bonds, where you are now beginning to see the spread between the peripheral European countries and the core countries begin to increase.

Kevin: Dave, when you’re in a fight you have to be careful of the person who is going to fake one punch and throw the other. Looking at prices, I’m thinking of the Dow theory concept where a person will say, “I’ve studied this for many years and the price tells everything. All risk has been related to the price.” But the thing is, the price could actually be the faint. The real punch could actually be the flow of liquidity, or credit.

David: Right. That’s why, when I’m going back to Europe and thinking of the core countries, the cost of credit is a very important signal, and credit flows, of course, are very important, which I want to elaborate on in a minute. But you look at the increase in the cost in, say, Spain, Portugal, Italy, and France, relative to Germany, and if your finance costs are increasing dramatically in those spaces, that spread – the difference between the lowest cost, which would be the German benchmark ten-year, or even two-year, and the French, the Italians, the Spanish bonds – it tells you something. Again, you can look at European stocks and say, “Oh, they were down 1% or 2% last week.” Well, that’s interesting, but it is not nearly as interesting – and it could have been up 1% or 2% cent – but far more intriguing is what is happening with credit spreads.

So, between the under-performance in financials, the under-performance in small cap, the increase in credit spreads, there is a lot going on. You mentioned Dow theory – back to prices and the idea that prices tell you what you need to know – that is a Dow theory concept, which simply says that in the price you have the current collective opinion of an asset, for better or for worse. And I think a problem that I have with Dow theory is that to a degree, it implies or assumes the efficient market hypothesis. It is, at least, not in contradiction with the efficient market hypothesis.

Kevin: Which assumes all information has been taken into consideration, but not all information, necessarily, is apparent.

David: Right. So some would argue, therefore, that you should not battle against price and trend. Look at price and trend, and don’t get in the way. And I agree with that. I would not argue with price and trend, but I am going to continue to explore other contributory factors which, if they shift, can dramatically impact price. And I think, for the person who is studying the markets and looking at macro concerns, you can anticipate the things that will ultimately move the markets and be ahead of those price action trend changes.

Kevin: And Doug Noland is one of those guys.

David: I consider him sort of a credit market mentor. It was curious, about ten days ago, I literally woke up with an epiphany. Credit, and therefore liquidity flows, determine asset prices. I have books on the subject. Gordon Pepper, who is probably my favorite author on this, has a compelling book called The Liquidity Theory of Asset Prices. I think that for investment and finance geeks, you have to get that. You should read it. But this little epiphany – it wasn’t an intellectual epiphany. It wasn’t like a new insight. It was something of a settling in of reality. Prices go higher until the flow of credit becomes restricted.

Kevin: Right. You know what it reminds me of? It’s like turning a faucet on. When the faucet is flowing, the water level rises in the sink. Now, everyone knows that, but you don’t think about it until you actually see it. Now flow – what I’m talking about as far as a faucet – credit provides liquidity. Liquidity provides price increases.

David: And my experience was like watching the sink getting ready to overflow. You begin to feel something different when it’s not just an observation. “Oh, the sink is being filled with water.” When it’s getting ready to overflow, you have to make choices. “Is it going to overflow? Do I need to get some towels? Should I let it out? How is it stopped up? What am I going to do? Should I turn off the water?” This is it. Prices go higher until the flow of credit becomes restrictive. And then when credit dynamics shift, the fuel for the flame, so to say, using a different analogy – it dissipates. And with it, you have a temperature that declines. The fire dies out without it.

Kevin: So, this would not be Dow theory, because Dow theory would be saying, “Well, do I think the stock market is going to go higher?” What you’re actually saying is, “Is the faucet on?”

David: Well, the prices of assets are important. It is a measure of success for anyone in the investment world when you’re on the right side of a trend. And I think that kind of brings into focus what is on offer in terms of reward. Have you been able to capture a reward by capturing the price movement? But there is another side to the analysis. The risk analysis must include the source of energy which underlies the trend. And I think Doug’s focus on shifts in credit dynamics, which end up preceding market declines – that allows him to improve the probability of predicting a decline in the markets and profiting from it. I think Gordon Pepper drives home that same point in his book. By the way, he was one of my lecturers in Edinburgh a number of years ago.

Kevin: When you were up there with Napier and Smithers.

David: At the Edinburgh Business School.

Kevin: So, I’m going to make it more complicated, Dave, rather than just price. Okay, we’ve already talked about price not telling everything. Now we’re shifting to looking at the flow of credit which brings liquidity. But now you have to bring politics in because, not just here in the United States with Trump, we have no idea how much liquidity the Fed is going to allow Trump to have. But look at Europe.

David: Well, so we shift the conversation to politics, and we do that because there is a very thin line that divides economics and financial and political realities. Life is not like a college course catalog where real world related information is separated by a department, separated by a course load, separated by an individual syllabus.

Kevin: It’s more like a casserole.

David: Yes, life is like a casserole. You have the elections in Europe later this year, which are already growing contentious. We mentioned the change in credit spreads, well, the difference between the OATs, that is, the French government bonds, and German paper, is widening. The French government bonds are more expensive to finance now, and a lot of this is as Le Pen improves her standing in the polls. The markets understand what that means. They immediately translate a new populist party in France as sort of the next chapter in the death of the euro project. And then the odds increase of a Le Pen victory. The markets smell it out, and they begin to adjust and look for the knock-on effects.

Kevin: And then you get into the complexity of Germany, and their approach toward money, and Mario Draghi with the European Central Bank. You have to have relations strained a little bit between Merkel and Draghi right now.

David: Of course. Angela Merkel is under pressure in Germany. You have some polls which are indicating that if an election were held today, she would lose to a man considered by some to be Germany’s version of a Bernie Sanders, that is, Martin Schultz. And how does Merkel respond? Let’s just say that relations between Mario Draghi over at the ECB are more and more pressured. You have the ECB, you have the bond-buying schemes which have lowered bond yields across Europe, and they are likely to be discontinued or curtailed due to political pressure. So this comes back to that idea of credit availability and liquidity flows. What happens to asset prices when credit is available? It goes up. And what happens when that credit is cut back? Look, it’s already scheduled to be cut back at the end of March. We’ll go from 80 billion euros a month in European Central Bank purchases of government bonds in the Eurozone. That is going to be cut back to 60 billion. By election time in October, there in Germany, will that number have shrunk yet again? The probabilities are pretty high that it will have.

Kevin: So it begs the question, does it really matter what happens at the ECB, the Bank of Japan, for U.S. investors, or Brazilian investors, or other investors? With your Eureka moment that you had, where you were thinking about the flow of liquidity, the answer has to be yes.

David: Yes, because it just boils down to this. Prices are going to rise until they don’t. Now, you want to know, well, when will they stop rising? They’ll rise as long as liquidity is flowing. And so, in short, yes – it should matter to a U.S. investor, it should matter to a Brazilian investor, it should matter to a Mexican investor, or any investor anywhere in the world, what is happening with the European Central Bank and the Bank of Japan. They have been the ones who have provided the most liquidity during the 2016 timeframe, and they’re still on the hook as we get into 2017. You have excess liquidity, and that drives asset prices higher. Too much credit, too much liquidity, boosts prices. Too little, and prices recede. So, if you have a change in global liquidity dynamics, that is a, if not the, primary driver of asset pricing.

Kevin: So, most people would like to know when. That’s the tough question to answer – but when?

David: 2017 is ripe for a reversal in asset prices. Look, you have the ECB and the Bank of Japan – their liquidity provisions which have filled the gaps in recent years since the Fed began to taper. So, we had the taper and the taper tantrums of a few years ago, and now we also have a mild version of tightening, with an increase in rates. Rates are on the rise, but as Bert pointed out last week, liquidity is still flowing. So, it hasn’t showed up as an actual tightening, although in theory, raising rates would be. We’re going to look for changes in these liquidity dynamics as, again, what are we trying to do? We’re trying to anticipate triggers in the financial market for either a further increase in price, or correspondingly, decreases in price should the flows change and move negative.

Kevin: Well, honestly, the biggest question mark in, I think, everyone’s mind is, how does the Federal Reserve respond to Donald Trump? I brought that up a few minutes ago. What happens at the Federal Reserve actually affects this excess liquidity that we’re talking about.

David: I think this is where I hear the echo of Richard Duncan in the back of my mind, who would say, “Look, monetary policy is one thing, and we’re grateful for QE, to some degree, because it prevented a financial apocalypse. But the transition needs to be hard and fast to fiscal policy spending, and Duncan’s focus on liquidity dynamics is right in concert with Gordon Pepper’s and Doug Noland’s.

Kevin: Keep the liquidity flowing, keep that faucet on.

David: And he would prescribe it. Duncan would say you have to. And where Noland, I don’t think would say you have to, he would say that continuing forward with it just means that you’re adding to greater malinvestment, and ultimately, a bigger mess to clean up in the future. Duncan’s conception is that, no, now is the time for helicopter money. Now is the time for fiscal policy spending, and you can’t do a trillion dollars over ten years, you need to be delivering 1-2 trillion dollars per year, immediately, or else. And there is a real tone of desperation in that.

Kevin: This reminds me a little bit of Fiddler On the Roof. Remember when Tevye said, “Well, on the one hand, it’s this, and on the other hand, it’s this.” So my question is, are we going to have more credit expansion from the Fed, or are there going to be some rational people there that actually try to normalize rates?

David: I think it’s anyone’s guess what the Fed will look like here in Trumplandia circa 2017 and 2018. You have three more vacancies on the seven-member Board of Governors, which open up in the next 24 months. And we can guess that they might be more business and banking savvy. They might actually have some experience in the real world as opposed to just academic experience.

Kevin: Do you think they might be from Goldman Sachs, like – well, everybody?

David: Well, try that on for size. If you put a few Goldman bankers in charge of a printing press, and literally, say fix the system – Kevin, anything could happen. Anything could happen. So, I think for all the positive vibes that the stock market has toward Trump at present, there are innumerable uncertainties out there. On the Trump issue and what this means for the economy, if you’re interested in reading an article from Project Syndicate, I would.

I’ve read a couple of books by Michael Mandelbaum. Interesting writer. Very thoughtful. I think he is at Johns Hopkins. Mandelbaum writes an essay at Project Syndicate this last week. I think it’s titled, “Navigating the Trump Landscape,” or something like that. It’s food for thought. He doesn’t get into the Fed issue and who is going to be appointed, but I think what I see, with the number of uncertainties in the market, whether it is fiscal policy and the ability to deliver monetary policy, what will the Fed look like? Will it have a complete makeover – a radical makeover – Trump-directed? There are a lot of uncertainties, and to my mind, gold is reflecting a host of those uncertainties and unbounded risks.

Kevin: Okay, let me go ahead and go there, because last week’s Commentary, and I would recommend if a person is listening, to go back and listen to last week’s Commentary with Bert Dohmen. Your conversation was fascinating, and Bert very much liked gold. He said something, though, that puzzled me, Dave. I’ve been in the gold business now with your family for 30 years, and I see gold as a crisis asset. When people feel there is a crisis they go in and buy. Now, Bert didn’t agree with that. Bert said, “Well, no, it’s more about uncertainty toward currencies.” And he’s right, but it seems to be that you could bleed the two over on top of each other.

David: I disagree with Bert on this point. I think he’s looking for correspondence in a chart, where something happens, and there is evidence, immediately, in a chart where you can say, “Ah, correlation, causation. I see it. They’re connected.” Right? He’s looking for that consistency in a chart pattern. This is where I do disagree with him because while the price of gold does not have to move in lockstep with crisis, what we see in the business is that the volumes of purchases in the physical metals market are very reflective of confidence and a desire for a crisis hedge.

Kevin: Well, isn’t it interesting, we can see the physical flows of gold and silver and they are so small compared to the gigantic paper market that affects the prices that Bert is looking at.

David: This is why I say, when you look at a chart, you don’t always have what you need to have in price alone. There is the sort of misleading nature of nominal pricing in the gold market and it relates to the scale of the futures market relative to the physical metals. Market price is ultimately determined by total exposures, and the totality of the gold market, which is, in fact, more than 90% paper, and less than 10% physical.

So while we see the supplies in the physical market come under pressure when crisis is brewing, that doesn’t necessarily translate into a price movement on a chart – an improvement in price. You have leveraged futures traders which lead that action, and yet, you can have supply – true supply – of the metal dissipated in the context of crisis. We did see that in 2008 and 2009 and we saw massive volumes. In fact, before the bottom in the market, sort of March of 2009, we were having to restrict purchases.

Think about this. We were having to restrict purchases to one kilo bar per day per client. This was October/November/December. So, the stock market is in decline, the price of gold is in decline, and yet demand for the physical metal is so high, we don’t have access to one-ounce product, we don’t access to ten-ounce product. We don’t have access to coins and bars of any sort except for kilo bars, and that, again, was because of a constraint, ultimately, from the fabricators. We could only deliver one kilo bar per client per day.

Kevin: Yes, it’s counter-intuitive. I remember that. The price was dropping on paper, and as a firm, we couldn’t get physical metal to meet the demand.

David: Yes, so Bert does great chart work and we rely on technicals, as well. But the weakness here, too, is in not appreciating the fundamentals of supply and demand, in this case, seeing through the paper gloss which covers over the tangible metals, themselves. So yes, as Bert said last week, gold does respond to a collapse of confidence in a currency, but there are many other things that drive physical demand.

And ultimately, that will be reflected in price, but again, this goes back to that whole issue – we’re talking about price in the stock market, and it’s worth looking at the fundamentals, and it’s worth looking at the internal dynamics of the market to know, if actually price is reflective of reality and future course, or if there is reason to be concerned. In this case, we’re seeing very healthy dynamics within the gold space today.

Kevin: We’ve talked about Europe, we’ve talked about the United States. Again, I keep going back to this Eureka moment where you think, “Wow, it’s credit, it’s liquidity. It’s not price.” If we get ahead of the credit and liquidity question, we can then possibly answer the price question. Now, China, we all know right now, is exploding in credit. It’s huge. Now, that could reverse any time, as well.

David: Yes, it’s amazing to me that price is what’s now, it is not what’s next. That is where, if you’re appreciative of credit, and the impact of credit on pricing, you can begin to see a little bit better what is next. And again, an increase in credit flows, an increase in price. You’re going to see a decrease in credit flows and liquidity availability – guess what? You will see a decline in price. China becomes more interesting by the day. New credit is literally blowing up. That is a massive bubble. The government is attempting to control credit growth, and they have set all kinds of limits on the banking sector. So, credit growth that is through normal lending channels, and the response, within the financial sector, by market operators has been to move even deeper into the shadows.

Kevin: Well, isn’t that what happens anytime the controls start being put on? You have people who go into the shadow banking realm.

David: This was a comment from Dave Burgess a few weeks ago in his Weekly Wrap-up on the Wealth Management site, just saying that when you include our shadow banking debt, we exceed 89 trillion here in the United States. So, we generally look at a range of 60-70, in terms of our current U.S. market debt. But actually, it’s bigger than that, because of what happens outside of the normal lending channels.

Kevin: Explain shadow banking, just in a minor way.

David: Shadow banking is the lending and securitization which occurs outside normal financial channels. So if loans exist outside a controlled universe, then they’re not regulated.

Kevin: So, it’s a loan on the side, really. That’s what it is.

David: That’s right. Look, this has been done so many times, and this is how games get played to work around regulation. Do you remember Enron? Do you remember something called Chewbacca [Chewco]? That was one of many off balance sheet special purpose vehicles which allowed for them to sequester assets, and/or debts, liabilities, and it made the company look better than it was. So, we do the same thing, but it’s not illegal, or at least, it’s not treated as illegal (laughs).

Shadow banking is nothing more than creating off balance sheet liabilities which go unaccounted for, and it gives you the impression that all is well when, frankly, you’re in deeper than you can actually know. So here you have loans which exist outside of the controlled universe, off balance sheet, and that means that banks are, in fact, meeting their credit quotas, they’re meeting their capital adequacy ratios and requirements.

Kevin: So they look good on paper.

David: That’s right. So, the regulators are happy, and yet, you still effectively have a balloon that is growing. And it truly is balance sheet exposure even though it has been quietly hidden here and there. The Chinese have done this through wealth management products. Last year, 2016, wealth management products grew at a 30% annual rate, and you had traditional bank lending which grew at about a 10% rate, according to the People’s Bank of China. So, a three times growth differential in shadow banking relative to what is regulated and more controlled through your traditional bank channels.

Kevin: So if you tried estimate – a lot of times credit, or debt, is looked at as a relationship to the GDP, the actual economy – what would be the estimate for China?

David: Probably close to 300% at this point, which means that as UBS has noted, they were sitting at, say, 150%, or thereabouts, before the global financial crisis, we’ve nearly doubled that to today’s levels. I think 277 is what UBS estimates the current Chinese debt-to-GDP ratio is. Again, 277, relative to what? What is the spectrum? Well, it’s worse than the Japanese, and it’s well beyond the Reinhart-Rogoff threshold of 90%, where they assume that, statistically, you begin to run into problems. So, do we expect problems? Look, it is not unlike the Chinese era. What we have in Japan, going back to the 1980s and 1990s. The risks which were in the financial system ended up being shared from one company to the next within the Japanese corporate space where I would buy shares in your company, and I would loan you money, and you would loan me money, and you would buy shares in my company. And that cross-company exposure – you’re seeing that now happen in Chinese financial firms. They’re creating the same kind of risk dynamics, according to Bloomberg, which, “lead to potential chain reactions in the event of a default.”

Kevin: Chain reactions. See, Dave, that’s what you’re getting to – a chain reaction. Any time you have these debt events, you can paper over it for a while, but if you have enough things go wrong at once, it creates a chain reaction like we saw in 2008.

David: Yes, so, it just doesn’t take much of an imagination to see a domestic financial crisis in China. You talk to a Jim Chanos, who was at our recent Grants conference, and he would say, “Yes, China’s doomed. You have big issues in China.” And he is not the only China bear out there, but there is domestic financial crisis in China which leads to a political shift, and I think we’re seeing that political shift happen as we speak. I know a number of people in China that are growing concerned about freedom of speech issues, that have felt a real clamp-down in the last six, 12, 18 months, and the political pressure is on the increase. The consolidation of power in the politburo is happening, as we speak. And they’re tightening down the reins considerably.

Kevin: Was it Napier who said that China’s political system is all about control? They don’t have to be communist as long as they’re in control, but when they start to lose control, the one thing that you can count on is that they will grasp it back.

David: So this is where I think it is really important to not draw hard lines between fields of study or things that you might to want to categorize as politics, economics, geopolitics, geostrategic issues, because here you have the makings of a domestic financial crisis in China, and you already see a shift toward ratcheting down controls in China, also a shift toward nationalism. What do you have next following a shift toward nationalism, a call to arms?

We already have that, to a lesser degree, here in the U.S. with, if you want to call it the middle class muddle-through economy. The middle class muddle-through economy gave us the populist up-swelling that brought Trump into power. Chinese nationalism, central control of the media, an opportunity to unify the nation around a common enemy – history provides very similar scenarios where financial crisis leads to political chaos and that political crisis actually causes a turning external in terms of anger. That is what allows for unification in that sort of nationalist theme.

Kevin: If you just look at what is going on at that political or geostrategic level, we’re seeing China look more and more like a super-power, militaristically.

David: Last year, early in the year, we were talking about the South China Sea, the Spratly Islands, and all the other pelican roosts within their “9-line.” It was Reuters, last week on the 22nd, that suggested that the nearly two dozen structures on the artificial islands which China has built appear designed for long-range surface-to-air missiles. You look at the area – this is where it is important to look at maps on occasion — there is an author that I would love to have on the program who wrote an absolutely fascinating book called The Revenge of Geography. Sorry, I’m giving too many book recommendations today, but The Revenge of Geography is just fantastic. It’s absolutely fantastic.

Kevin: So, he looks at the world like a chessboard.

David: Absolutely, and there are certain limitations, given certain geographies, and there are certain opportunities, given certain geographies, and you see a repetition of conflict around certain geographies, because of the geography. Control of waterways has always been a massive strategic objective, and you have this waterway, the South China Sea, which carries one-third of the world’s maritime traffic. I don’t want you to think that World War III is on the horizon, but you have to note who runs the traffic stops. You have to note who charges the fees for safe passage in terms of the goods and products that are moved.

And if as an investor you can see where hot spots may exist, that means that you are bringing a proper awareness of risk into the equation. You can juxtapose that with any reward-seeking venture, which is, again, to say, it’s not all in the current price. You have to see a broader picture to appreciate the risk that you may have to a particular price. And again, if you are looking for reward-seeking ventures, then make sure that you have that awareness of risk properly juxtaposed.

Kevin: It reminds me of, “for want of a nail. “ If you’re just looking at the price, all you are really looking at is just one element because, just looking at this China situation and you’re Eureka moment, as long as credit is flowing, and can continue to flow, you have liquidity. As long as liquidity is flowing, you have growth, price, economic – whatever. If that tap is turned off, now we have “for want of a nail.” And so, you no longer have credit, you no longer have liquidity, you no longer have growth in price. You now have domestic problems, which turns, ultimately, to war.

David: Yes, you’re talking about Benjamin Franklin, “For want of a nail, the shoe was lost. For want of a shoe, the horse was lost. For want of a horse, the rider was lost. For want of a rider, the battle was lost. For want of a battle, the kingdom was lost. And all for the want of a horseshoe nail.”

Again, I go back to credit. Credit, in China, as everywhere, is at the center of the universe. If you see a significant shift in accessibility, or flow of credit, you can either create wealth and opportunity, or in a worst case scenario, you could open up the possibility of World War III.

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