Tag Archive | "China"

Key U.S. Ally Suddenly Switches Allegiance To China


About this week’s show: 

  • George Soros gladly provides 16 states with “unrigged” voting machines
  • Duterte – “I announce my separation from The United States”
  • China’s Subprime Nightmare

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China Buys All the Gold Produced in 2015 (and more)



About this week’s show: 
-We are entering into another debt default cycle
-Forcing people to spend by going to a cashless society
-China pumped 61 Billion dollars in a day into their financial system

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Chinese Markets Lose 590 Billion in 7 Minutes!


About this week’s show:
-Risk assessment: Keeping the first thing the first thing
-Stocks end 2015 down-first time since 2009
-Something hit the fan in the Middle East: Sunni or Shiite?

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Can China Beat the Great Bear Market?



About this week’s show:
-Dow has biggest 2 day loss since 2008
-China’s central bank ineffective at halting it’s stock market drop
-Trump and Sanders’ popularity sign of dissatisfaction with elites

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The Power of the Word



About this week’s show:  
– China – Revolution is feared
– NYSE closes instantly & unexpectedly
– How do you value an asset?

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Wise Investing Eliminates the Time Question



About this week’s show:
-Dollar velocity at six decade lows
-T-bonds vulnerable to announcement from China
-Who? What? Where? Why? Forget the when

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China Calls for “De-Americanized” World



About this week’s show:
-Pattern of gold manipulation becoming obvious
-Erosion of trust moves to a breaking point
-Wall Street fines & litigation through the roof

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Chinese Prepare for Public Flood into Gold



About this week’s show: 
-Volker & Greenspan join ranks of the concerned
-Speculative gold shorts signal a bottom?
-Mountain biking and investment principles

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November 2, 2011; Ian McAvity: Interview in New Orleans


The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, you are just getting back from the New Orleans Investment Conference. This is the conference, of all those you attend each year, where you probably feel most at home. It goes back decades with your family.

David: It is interesting, Kevin, we do travel a lot, and there is a variety of different conferences that we will speak at, and present at, and this one is a little bit like old home week. The conference has been around since 1974. Jim Blanchard began putting it together and then it really caught stride in the mid-1980s. Gold had been popularized by the major move higher in the precious metals, through the late 1970s and early 1980s, and it was really a gathering place.

Kevin: The old patriarchs, what we would call the true dyed-in-the-wool gold bugs, from back in the 1970s. Jim Blanchard was one of them. Your dad, Don McAlvany. Ian McAvity is another one. These are guys who were there for the ideal, not necessarily for the bull market.

David: Kevin, my dad called Jim Blanchard on the phone one day. This was, again, the early 1970s, and he said, “Jim, we have to do something about this.” Keep in mind, the context is that it was illegal to own gold in the United States.

Kevin: Sure, gold had been confiscated.

David: It had been illegal since 1933. 1973/1974 rolled around, and they were trying to break the gridlock, and so they arranged to have Howard Segermark write up legislation and begin the lobbying proposal and put it in front of Jesse Helms.

Kevin: Yes, it was later given to Jesse Helms who pushed it through, didn’t he?

David: He pushed it through, and January 1, 1975, gold was made legal again here in the United States.

Kevin: Bullion gold and bullion coin gold. Collectibles had been legal, but you couldn’t own actual bars of gold, or bullion coins.

David: Exactly. So really, what you are looking at with a conference like this, Kevin, is that it is still the watering hole of the folks who were there when it was philosophically bent, and they were looking at the issues of government, of power, of politics, of fiscal responsibility, at a very deep philosophical level, and trying to come up with a solution to that.

Kevin: David, just a couple of days ago, you were actually in a room there at the conference and got some time with Ian McAvity, and it is always a great conversation, because this is one of those men who really don’t care whether gold goes up or down – he knows what it does as far as preservation and equalizing a monetary system, and that is why he does what he does every day.

David: Kevin, just two words, because before we start the interview, everyone should know, one of the best newsletters that they could subscribe to, that includes both technical analysis, and fundamental analysis, is Ian McAvity’s Deliberations on World Markets.

Kevin: Decades and decades of experience.

David: Yes, it is a fantastic crystallization. You get to see real-time, and benefit from, the long experience – decades and decades – in the marketplace. Ian McAvity is one of the founders of the Central Fund of Canada, what started as a few million, and then became a few hundred million.

Kevin: What is it now, $7 billion?

David: Exactly. Their CEF and GTU, which are both gold and silver funds up in Canada. He keeps his finger on the pulse of these issues, with a larger responsibility in mind, still advising in that capacity with CEF, with the Central Fund. He is very thoughtful, very forward-looking, and we would like to know what he sees and thinks when he looks at world events today.

Kevin: Let’s go to that recording right now.

David: There are a lot of things to talk about.

Ian McAvity: Yes.

David: And trying to wrap our minds around where we are going from here. In the U.S. there has been the political divide between what was the Hamiltonian model versus the Jeffersonian model, centralization on the one hand, or something that prized the individual, and it appears to us that it is certainly moving more toward the Hamiltonian model. In Europe you see the same thing. You would think that as Europe begins to unwind to some degree, the people would say, “Well, maybe we have to look at this differently.” And in fact, if you are looking at Germany, as a test case, the SCP and the Green Party are gaining traction. The slow-down in the economy in Germany, they are blaming on Merkel, but they are not seeing that anything is wrong with the system, as it is progressing toward a new and larger leviathan. Where do you see this going? As you reflect, are you happy? Are you sad? A few more scotches and maybe you can go back and forth between one or the other.

Ian: The thing that strikes me is that every once in a while, whenever the question of raising taxes comes up in the United states, they are very quick to boast that 50% of the population is no longer on the tax rolls. My reaction is, if more than half of the people are living out of other peoples’ pockets, have they now created a dependency on the state that can never be undone? That is my largest fear. Basically, people are now servants of the state, which is the exact opposite of the concept that I was brought up to believe in, and I’ve just watched them chip away at it over time.

I am not a big economic theorist in that sense, but the Austrian economics idea is that somehow the little guy at the bottom, walking on the sidewalk is the most important part of the chain. In a sense, it is very much like the Swiss political model, where the mayor is more important than the president of the country. That is my preference, but with the mature economies, I think the political process has become so corrupted, I fear the accident that could lead to change, and if the change does occur, which way does it go? It is either going to go way off to the left, or way off to the right, however you define them.

David: Is it too simplistic to say that is one of the drivers in the metals markets today, where people are saying, “We don’t know what’s happening. We don’t know what’s happening with taxes, we don’t know what’s happening in politics?” We have half of the G20 being replaced in 2012, and so what does the complexion of world politics look like next year? Is it more combative? Is everyone trying in a more concerted way to get along?

Ian: I refer to the G20 as the G13 versus the G7. Being a Canadian, in essence, the Canadians are there, largely, just as a balancing mechanism. We have no real business being in the G7 other than the fact that if Europe was going to expand its membership to please the Spanish and the Italians, then the Americans had to have a neighbor in as well. But the new wealth is essentially in the so-called BRICs – Brazil, Russia, India and China. I don’t really include Russia too much, because Russia has never had any history of mercantilism, so I just don’t trust any part of the Russian system.

But China, Brazil, and India have undergone an industrial revolution in a generation. In 10 or 15 years they have now accumulated something like $6 trillion worth of foreign reserves, and they are looking at the old boys’ club depreciating the value of that paper about as quickly as they can. I am waiting for the showdown, where the new boys explain to the old boys that their time has come.

From an investor point of view, while the elephants are dancing, the smart mouse gets off the dance floor and hides. People ask me, “How high is gold going to go?” My premise, and what I say to them is, that it has nothing to do with how high it’s going to go, but it’s the only safe place to hide, because it has no counter-party risk. It can’t be printed. I am not looking at gold because I’m trying to make money, I’m just trying to avoid getting trampled, when the elephants stumble, and have their rumble.

I look at gold in a totally defensive perspective at this point. As I watch the bailout mechanisms come and go, I am getting ever more distrustful. I have ever less faith in the people that are trying to engineer all of these bailouts of the bailouts. In the last few weeks we have had the Europeans coming up with a plan to have a plan to have a plan, and it is really troublesome. There is no simple solution, but the markets would like to believe that there is one.

As a result, you get the day-trading mentality that the Europeans say they have a plan, the market goes up 300-500 points, and then somebody looks at the plan and realizes it has more holes than Swiss cheese, and then you go down 300-500 points. How do you translate any of that into what I would call a thinking man’s investment decision? By the time a thinking man actually contemplates it, we have had two bull markets and three bear markets, and then they close for the day. (laughter)

David: It is interesting, when we look at the substructure for the U.S. economy, and really, one of the underpinnings for global trade, the dollar in the post Bretton Woods era, post 1945, has been critical. It has been a pillar. You mention the BRIC countries, this trend of the rise of the rest. Developed countries are becoming, not totally passé, they still play a huge role in the global economy, but the countries hitting their stride are the developing countries. That argues for a change in the monetary system. It doesn’t necessarily mean that the dollar goes away.

If you put on your imagination cap, and did a thought experiment, and imagined the year 2016 has rolled around, what significantly might have changed in the world monetary regime?

Ian: I think there is a crying need to get back to something like the Bretton Woods system. The key to the Bretton Woods system wasn’t that it was a gold standard, per se, but in essence, the U.S. had all of the liquidity coming out of World War II, and the anchor was to define the U.S. dollar in terms of $35, so that there was a common denominator against which to measure all currencies.

That worked really quite well up into the 1960s until the American political process began to creep more and more into deficit mode, and also Europe had, by that time, completed a lot of their post war recovery, so Europe was in much better shape. And it started to build imbalances, and of course, ultimately, to me, the two single points that changed the equation were the Johnson speech on April 1, 1968, that we can have guns and butter, which formally announced to the world, “We’re going to depreciate the dollar,” and then in 1971, when Nixon finally slammed the gold window because they could no longer sustain the illusion of any discipline on the dollar at all.

Since 1971, of course, the spin is that we are now going to go to a so-called floating exchange rate, and then we basically have gotten into a period that now translates to 40 years of everybody trying to devalue against each other. And we are coming to a point that may be not unlike that of the Bretton Woods era, where there is sufficient liquidity in the hands of people that don’t have a say, of the G13, of the G20, where they $6 trillion of it.

They are watching Europe flounder around trying to bail out Greece, Spain, Italy, and whoever, and American commentators are taking great delight in the agonies of Europe, which means they don’t have to look at the U.S. data, which actually makes Greece look fiscally disciplined. If you ever look at all of the debt problems of this country, Greece looks perfect – no problem at all with Greece. But the external holders of those FOREX reserves, they need something that will be a common denominator.

We will never go back to a formal gold standard on the global scale, because it is physically too cumbersome for the velocity of modern trade. I can envision some sort of a defined basket. It would include gold as a monetary component, oil, copper, a lot of basic foodstuffs, and essentially have an indexing system, but the only way that can work is if all of the major participants can be required to adhere to a discipline. And of course, everybody will adhere to it in good times, and then they will all sneak out the back door and cheat.

David: Does the commodity component, whether it is oil, wheat, copper, or gold – does that imply some sort of price fixing? That’s what added stability to the 1944 agreement.

Ian: Amazingly, you need a common denominator, in which a piece of paper can be related to an assortment of tangible goods that are in high demand – I would say a combination of high demand and internationally diverse supply. I was talking about this idea with one guy and he was saying, “We can get platinum in there, too,” and I said, “No, you won’t get platinum in there, because there are too few producers. It’s much too small a market.” It has to be something like copper, like gold, like silver, to a lesser degree, because it is produced all over the place and it is consumed all over the place. You don’t want a commodity that is produced in South Africa and Russia.

David: Well, then, the currency components within that basket – you are really talking about something that is more or less trade-weighted.

Ian: Yeah.

David: The dollar is still, probably, the dominant currency in the basket.

Ian: The dollar would still be important, and to me, it is this elevation that they should, and wish they had, built some structure like that into the euro when they first proposed it. I gave a speech in Ireland in 1992, in Dublin Castle, when they had just announced the contest to name the new currency for Europe, and I said, “Well, hearing of this contest, there is only one name that really works – the Frankenstein – because it’s going to be run by the French and the Germans no matter what committee structure you put in place.”

And I said, “Unfortunately, the way it is being proposed is as a currency that is designed to blow up in the first crisis, because, in a sense, you are creating a currency that doesn’t have central bank discipline. It has the European Central Bank, but each member has its own central bank, and you have 17 or 27 political bodies that you have to deal with. And in some respects, that is encouraging, in the sense that I don’t really like central banks that much, but unfortunately, the ECB doesn’t have enough power, geopolitically, so that at the end of the day, in a real crisis, can you picture a Brit, a Frenchman, a German, an Italian, and a Spaniard, agreeing on the time of day of the meeting that will be held to resolve the crisis? That will be the first three days of negotiations. (laughter) I think that the euro will end up surviving, in part, because everybody needs it, not just Europe, but everybody needs, essentially, a quasi-legitimate counter-party to the U.S. dollar.

David: That’s really the balance.

Ian: That’s what it is, and it is supported by a large enough economy, large enough GDP, international trade, and the rest of it. It has the structure in place to be a valid currency. Unfortunately, it is a valid currency that doesn’t quite have the disciplines we would like to see. But on the other side of the coin, if you look at what Misters Bernanke and Geithner are doing to the U.S. dollar, where allegedly, it does have all the disciplines, I think I respect the Greeks more. (laughter).

In a sense, the world needs competing currencies of that kind of stature. When Japan went through its great growth phase, they took great steps to not have the yen become an international currency, and the yen did become international, but it was all what we used to call euro-yen, i.e., yen transactions denominated outside of Japan. So a Swiss bank and a British bank could create a yen obligation. One is long, one is short, and now you have a piece of yen paper. That is what used to be called a euro transaction before they co-opted the name for the currency. And China will do the same. There is no way that China wants their currency floating outside of their control. It may be great for the American ego for the dollar to be called the reserve currency of the world, but the minute you are in that status, you are subjected to an awful lot of external pressures over which you have no control.

David: Isn’t it sort of implicit in the Bretton Woods system that we will run deficits?

Ian: It wasn’t at the time. The whole point of the $35 peg is that if American numbers get too far out of control, we will take all of our dollars and we will arrive at the New York Fed and say, “Here is all your paper, we will take all of the equivalent gold at $35 an ounce,” and what led to 1971 was a combination of the French and the Swiss arriving with a wheelbarrow with too much paper. (laughter)

David: Right. Well, $35 was chosen to cover our external liabilities back in 1933, and our stock of gold today, if we covered our external liabilities, would have to be north of $17,000 an ounce. I don’t think that is a reasonable equation. I don’t think they will be pursuing that. I don’t think they are interested in that.

Ian: They would never go a straight equivalency, because nowadays all of the (shall we call them?) political elites are sufficiently arrogant, and undoubtedly, they can hire three Chinese Ph.D.’s in math to write a formula that nobody can understand, but it will be the perfect formula, until it blows up like every other one of them. But, my larger fear is that if gold does end up playing a larger role, as one of the founders of Central Fund of Canada, my point always has been, the bullion is held in Canadian banks, in a Canadian entity, outside of the United States, just in case Franklin Roosevelt gets re-elected.

I often tell audiences, the Peoples’ Republic of Canada has made a lot of stupid political decisions over the years, but we didn’t call in the gold in the 1930s. These days I get all kinds of people asking if the government is going to call in the gold. They now have a tax mechanism that makes that redundant. They don’t need to call in the gold, because they put in so many controls over financial transactions that your social security number is tattooed on everything, and they could declare a 100% excess profits tax over a deemed amount of gold and that’s the equivalent of calling your gold.

David: This has exactly been my concern.

Ian: Yes, that’s been my fear for several years.

David: Change the tax regime, and that’s it, whether it is jumping it from 28%, which it is now, to 50%. We may see gold at $3000, $4000, $5000, or something else, but it doesn’t mean you get to keep the profits.

Ian: Exactly, and that has always been one of the arguments for international diversification, and not just for Americans, but for citizens of any country. When a country gets in a crisis and passes laws, they tend to harness their own, not necessarily the transient visitor. I give a speech every year in Zurich, and I always thank the Swiss for maintaining the most wonderful country for a Canadian to visit. Unfortunately, they don’t look with quite the same friendly eye on U.S. passports anymore, and they beat up their own citizens pretty severely, but for non-American foreigners in Switzerland, it is the ultimate financial haven to deal with, and to visit, and to live in. I have one old friend, and I don’t want to give the title of the book away, but the only way I can describe it is the dog bone philosophy. If you have sufficient capital, be like a dog, and bury a bone in every back yard, because you are never entirely sure which back yard you are going to find yourself in. (laughter)

David: Well, Eisenhower changed the rules in 1961, and made it illegal for U.S. citizens to own gold overseas.

Ian: That was Kennedy.

David: Was it Kennedy?

Ian: It was part of the interest equalization tax, but it wasn’t just gold, it was all foreign investment that he brought in. It was 1962, I think.

David: Okay, I’m off then.

Ian: Americans couldn’t own gold anywhere after 1935, and they tightened the rules up a little bit in that period. It was 1963 when the interest equalization tax came in, because I was a broker in Montreal at that point. That was when the airline stocks were all hot, and KLM was one of the first international airlines to go to jets so it became the great growth stock. KLM and Pan Am were the two big favorites.

What we discovered in Canada is that under the interest equalization tax, KLM traded in New York under two prices. If it was KLM, it meant that it was the international stock, international seller, so that if an American wanted to buy it, he had to pay the price of the stock, plus an interest equalization tax, which I think at one point it was 20-25%. But then the New York Stock Exchange also traded KLM.Z, which meant that it was already owned by an American, and there was a 20-25% price differential to reflect the tax had already been paid.

So, with typical creativity, a number of Canadians discovered that a great many Americans had married European ladies at the end of the World War II and moved back home, and many of those European ladies still had family and friends on the other side, who could buy KLM in Amsterdam and transfer it down to family who could then sell it as American-owned stock, and I think something on the order of 30% of KLM’s market cap came across the ocean that way. (laughter)

David: Well, it is interesting, because there is a ring of familiarity with the current FATCA legislation supposed to be in motion in 2013, where foreign institutions withhold, on any U.S. product, and that can even be Treasuries, which is almost insane when you think about the fact that the Treasury Department is limiting their own audience for U.S. product, and I realize they have different intentions, but sometimes there are unintended consequences.

Ian: It’s just another form of protectionism. Everybody wants control over everything. My biggest complaint, speaking as an outspoken Canadian, as I always do, knocking Washington, this concept of America having a presumed right to the extraterritorial application of American law. Since when and where does Washington get the idea that they can dictate to Switzerland what is going on in a transaction that occurs between Switzerland and Belgium, if it happens to include either an American citizen or and American ex-pat who doesn’t even live here? Yet somehow they keep passing all of these codes as if the entire world abandoned its powers to certain power-crazed idiots in Washington. This extraterritorial application of American law drives me nuts!

And more recently, now you have them building drone bases, so we now have murder squads so that you don’t have to risk your troops. Picture the Chinese, and imagine China has some guy that they decide is a terrorist, he blows up a train in a railway station, he flees, disappears, and the Chinese have a worldwide search out for him. They finally find that he is hiding in Seattle. Can you picture the outrage if out of the blue, all of a sudden, some little bug in the sky becomes a drone that comes down and blows up a Chinese guy walking out of a Starbucks shop in Seattle?

And China explains, “Oh, don’t worry, that was just a drone attack getting rid of one of our number one terrorists.” If that happened on this soil, CNN would burn out every TV set in the country! (laughter) And yet, somehow, the State Department has the right, in the name of fighting terrorism, or whatever, to go to any country in the world and shoot anybody they want to? It just drives me crazy. It bugs me that anybody claims to have that power.

David: Well, on a similarly philosophical note, looking at your experience, you have worked in the markets for a long, long time, you have done analysis for a long, long time, thought along fundamental lines and looked at a lot of charts in your day. Is there anything you are particularly enthusiastic about, at this point? Or when you look around do you say, “You know, I wish this just wasn’t the case?” I’d like the sage opinion of where we are, where we are going, and is there something that we should be doing? Sometimes I get the question from our clients, and it’s one thing to be in the armchair as a critic, but “What can we do, creatively, to make a difference?” As I guess Edmund Burke would say, “All that is necessary for evil to triumph is that good men do nothing.” From one view, it is sort of a reflective question, on the other it is more about praxis. Is there something we should do?

Ian: Let me put it in stock market cycle terms. We, amazingly, had a great second-year bull market from 1982 to 2000. It maybe topped out with the long-term capital management bailouts in 1999. That’s really when we got into this modern bailout mechanism. But it has essentially created a period that you can call a secular other, or a secular bear, but it is not unlike the period after the crash of 1929 through 1949, or not unlike 1965 to 1982, or the first 20 years of the last century.

To me, we are in that secular other phase, and in that secular other phase, the individual cycles will tend to be smaller on the upside, because those are then contra-trend moves, so the bull markets last shorter and go less far, with greater urgency, and then the bear markets run longer and deeper. And given the excess liquidity in the system, the safest bet of all is you can bet on greater volatility, because you have more and more liquidity chasing around, and the New York Stock Exchange, with their high-velocity feed, basically, they are now legalizing front-running for computers. When two computers operating in nanoseconds get to see your trade before it gets to the market, that hasn’t got anything to do with price discovery in the marketplace.

So with this market, we are in an ugly period. I think we have, in the last few months, rolled over. I think we are now starting the second half of the bear market in 2007-2009, and if the S&P 500 is below 1258 on December 31st of this year, that will be the first negative pre-election year since 1939, and I think 2012 is going to be a down year for the election year. What does Obama have to run on in the race other than the fact that the Republican leadership race looks as though it is being organized by the Democratic National Committee, trying to determine who would Obama most like to run against? The political process is almost as corrupted as Washington is.

But I think the stock market generally is going down and I’m not known as a stock picker, per se, but one of the best I’ve probably made this year is at the New York Gold Show in a closing panel. One of the very last questions, which was sort of a curve ball that was thrown at us, was, “Tell me, what’s the best single buy that they can make for the next 12 months?” Fortunately, I had just learned that they had starting trading some ETFs that were measuring volatility. I said, “Well, the only sure-fire double I can see is volatility is going to go up.”

Learn to hedge. That doesn’t mean you gamble on them, but if you have core assets that you want to hold on to, how can you protect those core assets? Gold, in that sense, is the purest protection, but for many people, it is still going to be volatile in price. It goes from $1600 to $1900, then comes back to $1600. Some people think, “Oh, I can’t stand a $300 loss.” My reaction is, “Look back three months before and you didn’t have the $300 gain to lose.” (laughter) The biggest mistake some new gold investors make is even watching the price from day to day. They will buy it from the philosophic point of view and then start thinking like a day trader. To me, that is the biggest mistake they can make in relation to gold.

But in terms of core assets, I was joking at one stage, on one panel, that we are rapidly coming to a point where I would almost prefer to own corporate debt, issued by multinational companies that have really truly global franchises and not too much debt structure, something like a Coca-Cola. You can buy Coca-Cola anywhere in the world at this point, and half their assets and most of their business is outside the country. I would rather buy a Coca-Cola bond than a U.S. government bond, because whatever happens within this country, Coca-Cola is going to keep on going. Proctor & Gamble, Nestlé from Switzerland, the multinational companies are almost outside the state now. So, as a bond investor, what can I own in the way of bonds? I would prefer to own a true multinational that has some discipline over its balance sheet, because there isn’t a sovereign issuer that has any discipline in their balance sheet.

David: We do live in interesting times, and we appreciate you sharing your thoughts with us. It is a challenge looking ahead and trying to determine the best course. You have hit on a couple of critical elements. A conservative approach – very important. Not viewing gold as a speculative vehicle, but as an insurance policy, per se, is a better way to go.

Ian: Let me add one thing to that, because your comment brings to mind the late Harry Brown, who was one of the great libertarian thinkers in this country. I remember some of the early talks where Harry was building toward it. When you look at a portfolio, don’t look at it in the context of how much can you make on each component. Look at each component, and if you lose here, does something else gain?

David: Right.

Ian: Balance it out, and construct it from the point of view of defense, rather than offense, but invariably, I talk to people and they want to know how much they can make, and my reaction is, “Well, okay, what have you got covering the backside of that trade? And in the secular phase that we are in, I think that you should be thinking more defensively, but it doesn’t mean you stop investing.

David: But it does mean that when you look at your portfolio statement, you may have losses that you are happy about, because they were the offset to other trades that you are equally happy about.

Ian: Exactly. Probably my third largest holding this year has been this VIX ETF that I discovered in Canada, and the construction of it, and I know I’m getting eaten alive by the rollovers, but on the other side of the coin, there have been several tops and bottoms, where I have looked at it and said, “Oh, it’s probably going to go down now,” and my reaction is similar to my decision to live in downtown Toronto. I’ve been in the same place for years. I’ve been through real estate cycles, and at the top of a couple of cycles, I’ve said, “Naw, it’s a home, not an investment, so I won’t sell it.” And in a sense, I own the volatility coverage, not because I’m trying to make money. I know I’m about to lose some in the short term, but I don’t mind. If I am losing, it’s because other things are going up. Start thinking of a balanced approach. I don’t think enough people think that way, in terms of buying a portfolio. They want every single holding to perform.

David: I think what you have just expressed is a maturity born through experience, and many years of testing and understanding that markets don’t always accommodate.

Ian: The way I describe it is that they don’t always listen to what I tell them to do. (laughter)

David: (laughter) Well, again, thanks for joining us.

Kevin: David, what a great interview. I can see why you guys have been, not just professional friends, but family friends, for 40 years, as far as the McAlvany and the McAvity families go.

David: Kevin, he just brings a certain clarity and matter-of-factness to certain issues, looking at, for instance, Harry Brown’s defensive construction of a portfolio.

Kevin: I’m so glad he brought that up. That’s been around for years, but people forget the balanced part of the portfolio.

David: And the balance is absolutely critical. Kevin, obviously, that is a very mature perspective, with the defensive construction of a portfolio being paramount. It’s not just about profitability and gains. That is a temptation. It’s a temptation for investors who see a little bit of green on the screen, and say, “Well, I’d like a little bit more. And if there’s red, then get rid of that, and give me a little bit more green,” not realizing that there can be these offsetting positions that complement each other very well, lower total volatility, and ultimately give a higher rate of return, but in the immediate, show this balancing act between red and green.

Kevin: David, it reminds me of flying planes. I’ve worked with Civil Air Patrol, and I don’t want to be morbid here, but we call Bonanzas and Mooneys, which are pretty high-powered small planes, doctor killers, because these doctors see success in everything that they do, and then they get into flying, and they think, “I can do the same thing with an airplane.” They are low-time flyers, oftentimes. This is not what they do all the time.

David: You get up there, you fly fast, you fly hard, and you also fly right into the side of a mountain.

Kevin: And you want to get there. The thing that kills more pilots than anything is needing to get there when you really shouldn’t, when you need to be defensive, when you need to be sitting back on the runway, and actually not going anywhere until the clouds clear. And the triangle, in a way, does that. The triangle does not force you to get there, because you don’t just have one side covered. You have three different things working. Maybe you’ll have a loss on one side, but you probably have a gain on one of the other two sides.

David: Kevin, a couple of other things that stood out to me from our conversation with Ian was this period of a secular other. It is difficult to see the period in time that we are in as a bear market, largely because just like 1966 to 1982, it went sideways, and the real lunch-eating occurred on the basis of inflation. So the bear was eating your lunch, because that 2, 3, 4, 5, 6, 7%, whatever the current rate of inflation was then, and is now, was catching up with you, with a 0% rate of return.

Kevin: Don’t you think it’s more deceptive that way, David? He says the bulls are smaller, and shorter, so you get more bulls, actually, little bull market bursts, but the bears, the downside, run longer and deeper. If you talk to an investor who has invested the old-fashioned way, with one of the major brokerages over the last ten years, who think like they did in the 1990s, and in the 1980s, these people have just a confused look on their faces, because every time they think they are just about to make money, they lose a little bit more, but it takes so long, that they have let ten years pass, and they think, “Oh my gosh, it really is, not only the lost decade, but I’ve lost – all this decade.”

David: The last thing that stood out to me today, Kevin, was the dog bone philosophy, where you just pragmatically say that you don’t know what yard you are going to end up in, and better to have a bone in each yard.

Kevin: Bury a bone in Switzerland, bury a bone in Canada…

David: That makes sense to me, Kevin. That makes sense from the standpoint, not as an American, but as anyone. Wherever you live, looking at your jurisdiction differently, with a greater historical perspective, and insight into the nature of desperate governments. Harnessing the power of your own – that’s an interesting concept when you realize that is the easiest go-to before you start spending ammunition to harness the power of another.

Kevin: David, this is a great time for you to get together with people who have been in the industry for a long time. Next week, maybe we can even listen to the interview with the Aden sisters.

David: That’s right. We got a chance to visit with both of them while we were in New Orleans, and that was also a very fruitful conversation.

Posted in TranscriptsComments Off on November 2, 2011; Ian McAvity: Interview in New Orleans

September 28, 2011; A European Tragedy of Errors: David McAlvany in Brussels


The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, you are joining us from Brussels, Belgium. You have been in Europe through this really tumultuous time over the last few days. Do you have any comments on the fundamentals? Have the fundamentals in the market changed, based on what you are seeing there?

David: No, I think, in fact, Kevin, what you see is a reinforcement of all the things that have been in place, really, for some time now. I remember doing a radio program with CNBC, going back about 6-8 weeks ago, and they said, “Well, tell us, what is this about recession, and why would anyone be concerned about recession?” As the weeks have gone by, Kevin, here we are with the world reconnected with the idea that risk does abound, that the financial solutions that have been offered by the ECB, and the politicians here in Europe, for the European crisis, have gained no traction. In fact, there is nothing really practical in play at all.

Kevin: David, I’m thinking of contrasting that interview that you did a few weeks ago, when they didn’t think recession was an issue, with the nervous interview of you by Bloomberg on Friday when you were in London. Can you give the listener who didn’t see that on Bloomberg an idea of what you were saying? The nervousness was high at that time.

David: I think the issue is really this, Kevin, and in my opinion, a misappraisal, at this point in time, the market is looking at current events and saying, “Clearly, we need to be taking liquidity into account and preparing for something like 2008. Let’s get our ducks in a row. Let’s get into the most liquid positions possible.” What they should be looking at, Kevin, is not just liquidity, but solvency, as well, and the underlying stability of the instruments they are choosing is, I think, fatally flawed.

Kevin: One of the things that we have seen in the past, David – you and I have talked about this – when the world gets scared, they try to go liquid, and when they try to go liquid, the first thing that they try to do is get dollars. What we saw last week was an unusual sign of people fearful of a system, or a solvency crisis, yet they were moving into one of the very items that they thought was ultimately going to be an issue, and gold sold off. Why don’t you comment on the liquidation of gold last week, David, and explain to the listener who hasn’t seen this type of rush to liquidity before, what was actually occurring?

David: I think one of the things that you should keep in mind, and this is borrowing from John Exter, who was head of the Federal Reserve Bank of New York back in the 1950s, and was very adamant about the role of gold in the money system, that it should be there. John Exter had what he called the inverted liquidity pyramid, very different than today’s appraisal, and I must say that today’s appraisal, by the average investor, is a very trained behavior, to think in terms of both the dollar and Treasuries as the ultimate source of liquidity, but he actually had cash and dollars as a less liquid item than gold.

It is an interesting perspective from a Federal Reserve Bank President. Anybody who wants to look at that can google John Exter, inverted liquidity triangle, or pyramid, and get an idea of what he considered the pecking order, if you will. The most stable, but also liquid, asset on the planet for this Federal Reserve Bank President was gold, not dollars.

Kevin: I remember seeing the pyramid presented 25 years ago, David, and I remember municipal bonds and government bonds and stocks, all at the top, quite illiquid when you have a crisis, and as it worked its way down through, I think of it as a liquidity funnel, where money can actually flow through and continue. But he then shows Treasuries, and then cash, and then you are right, the most liquid item, the first one to be sold when there is a real need for liquidity, strangely enough, is gold. That is, of course, repurchased, when things start to settle down a little bit.

David, we know that large hedge funds have pretty strong positions in gold and have had pretty strong positions in gold, as well as having a lot of stocks and other things. They were pretty much fully invested. But there is a rumor that those large hedge funds were going to gold, and selling that off first. Is that rumor true?

David: Let’s look at that, because I think there are some interesting observations there. Before we do, just to reiterate, the fundamentals have not changed. In fact, if you wanted to view them as being changed, you would just have to say that they have gotten stronger. We have government spending, we have bailout liquidity provided on both sides of the pond. We have monetization of financial instruments, both here in Europe, where I am today, as well as in the United States.

There are really no solutions crafted by bureaucratic socialists in the United States or here in Europe. And at the same time, we have artificially suppressed interest rates driving real yields for investors into negative territory. So yes, we have a selloff in the last few days, in this last week, and the selloff is rumored to be large fund holdings implicated in the CME’s change in margin requirements, which is effective as of the close of Monday.

Kevin: Why don’t you elaborate on that change, David?

David: This is something that applies for a speculative player. It applies to someone who is playing with paper gold, probably the most loose form, if you will, of paper gold, wherein you are buying a futures contract – a contract to take future delivery, of X number of ounces of gold or silver, and you can do that on a highly leveraged basis. This is a world where 3, 4, 5 times leverage is common, if not more, and so what you have is the CME trying to moderate and control the amount of speculative juices that are in a particular market. They are responsible not only for the precious metals, but for orange juice contracts, and copper contracts – all of these things are under their purview and scrutiny. What they chose to do last Friday was increase the amount of money that you had to have on the table, by 21% for the gold contract, and by 16% for the silver contract. So if you owned those contracts, or had some money down, they basically said, “Now you have to put that much more money down if you want to keep those assets still in play.”

Kevin: And David, it should be pointed out that this is not the actual sale of physical gold. You are in Europe right now, one of the places that the company buys its gold is in Europe, and you have found that to be quite tight. What we are talking about is paper gold contracts. This is not the common person who is hedging for the future. These are traders.

David: I have made calls and contacts, and made efforts to buy a good degree of gold while here, and that is from Zurich, that is from London, that is from continental Europe, as well, right here in the EU, and we are looking at premiums on very common products. In London, trying to buy kilo bars, and finding the cost to be 6% and 7% over the spot price. That may not sound like a tremendous amount, but for a kilo bar, which is very commonly found, and very accessible the world over, I found it to be a little bit out of line. The same is true in Zurich, and on and off here in Paris and Brussels, wherein the man in the street is taking an appraisal and he is looking at things very differently than your average investor stateside. He is not moving to Treasuries. He is moving to gold. He is moving to gold, primarily. So very little is available without paying pretty significant premiums. The smaller the item, the higher the premium, because that is what is accessible to “everyman.”

Kevin: David, with that in mind, too, when we were talking about gold falling last week, you can’t find it while you are in Europe, or you are having to pay premiums for it, I think that takes us back to these large hedge funds. They were almost fully invested funds, very little cash. Is the approach of the end of the third quarter affecting the price of gold right now? Is that part of the rush to liquidity?

David: Yes, I think there are a couple of things going on with that. The market, by the end of last week, was faced with a very ugly choice. If you are a hedge fund manager, or an asset manager of any sort, you are coming into the end of the third quarter, and your numbers are either going to look pretty bad or pretty good, depending on the kind of profits that you can book before the end of the quarter. If you are already taking losses on your equities, you may have liquidated those at losses, but anything that you have that has gains, you want to go ahead and book those gains.

I think that is what we had, in addition to the CME changes. And it is very interesting, Kevin. The selloff began in earnest well before the CME announcement on Friday, which certainly implies that there are plenty of people at the Chicago Mercantile Exchange who have loose lips and they are not sinking their own ships. In fact, I think under normal market conditions you would look at that and say, “That’s got to be illegal activity.” That is operating on the basis of inside information and pre-released data.”

The selloff in the metals began before the CME announcement, as if someone knew, and that carried through Monday. That was just in time for firms to alter their books and eliminate leverage, if needed, to get in line with those increases – again, 21% for gold, 16% for silver. That is the main reason for selloff, and notice, in subsequent days the market rebounded smartly. In fact, look at silver, for instance, at a low of $26, rebounding to over $32. Very interesting volatility – par for the course for a mega bull market – to be expected, I wouldn’t be afraid of it, but certainly gut-wrenching at the same time, to within a 24-hour period see that kind of a swing, both on the downside, and then again, on the upside, in terms of recovery.

I think what it argues for is, essentially, the fundamentals have not changed. We are looking at more than a technical glitch, but a change in the rules as they apply to the paper trade – not the physical markets, but the paper trade, and a knee-jerk reaction to that. The markets have now found their saner selves again.

Kevin: The long-term prospects for the dollar had been downgraded by Standard and Poor’s just a few weeks ago, and yet, it looked like it was playing a safe haven role – that, and the Treasuries playing a safe haven role. Is the dollar a safe haven right now, and are the Treasuries a safe haven? Is that a correct way to perceive this, especially in light of what is going on in Europe?

David: Kevin, the dollar is weak, all things considered. I think Treasuries are being, really, the safe haven of choice, and they have been the safe haven for just about everyone. The dollar, and Treasuries, as you say, have been seen as a safe haven, but I would prefer to categorize them slightly differently today – not as a safe haven, but as a liquidity haven, and the preference is for Treasuries, even over dollar-denominated cash.

Kevin: What would you say the difference is between a safe haven investment and a liquidity haven investment? A safe haven would probably be a longer time frame to hold. A liquidity haven – that’s pretty rapid, isn’t it?

David: Yes, I think that is exactly right. When you are looking at a liquidity haven, it’s the choice of, “Where can I go today, and leave tomorrow?” Whereas a safe haven really is, “Where is my port in the storm?” It’s probably a slightly longer-term commitment and it is concerned with more than just being readily available. Something like gold would be a safe haven, dollars and Treasuries more of a liquidity haven, and they are serving that purpose well at this point, but there is a difference between the two. In my opinion, the market is misjudging the severity of what is happening here in Europe, and it is misjudging the stability of even the U.S. balance sheet, and essentially, what they are considering to be safe for liquidity purposes, is anything but safe, and I think, ultimately, may be tested, in terms of liquidity, at some point in the cycle. Whether that is 12 or 24 months out, we will have to see.

Kevin: David, we have talked a little bit about gold, we have talked a little bit about the dollar, but here lately, we have seen interest in other currencies, and is there a distinction between one currency versus another, and when people are moving toward safety or liquidity, where do they go other than the dollar?

David: Well, let’s paint with a broad brush stroke, and then get more specific. The broad analysis is that they are all fiat, and worth less and less every day that you own them, because you have people who are managing the value of those currencies, sometimes managing up, sometimes managing down, but over a long period of time, we have seen all fiats being managed to lower values. Having said that, painting with very specific and small brush strokes, there are several resource currencies which have reasonable fundamentals. But they are, at this point, trading in line with the global recession expectations and the impact that that is likely to have on commodity demands.

A Canadian dollar, an Australian dollar, a New Zealand dollar, a Swedish krona, a Russian ruble, a Brazilian real – all of these have had some play to the upside, as a “dollar alternative,” “inflation hedge,” and I use that very loosely, but just in the context of a dollar alternative, having an economy that is based on resources which seem to be doing very well over the last 2, 3, 5 years.

That has been the analysis of those alternative resource currencies. They are suffering, at present, and they are suffering because they are being lumped in together, again, as I described it, a global recession expectation. Things are slowing, and it appears that they are slowing not only with developed countries. The hope was that developing countries would be doing much better, and that perhaps China would be a major contributor to growth in terms of global GDP. As it turns out, they have their own issues. As we expected many months ago, China has many, many issues to deal with, and they are now facing the same sort of recessionary pressures.

Kevin: David, before we talk about China, which just a couple of weeks ago was being perceived as the bailout masters for Europe, you are in Europe right now. China doesn’t seem to be there ready to write a check. You have likened this whole Greece situation, and actually, Portugal, Italy, Spain – the PIIGS countries – you have likened this eurozone and this crisis to the reactions of a manic-depressive, where one moment they are just absolutely exuberant, and then the next moment they are completely depressed and suicidal. We have seen this just in the last couple of days. We saw people rushing to safety and liquidity, as we talked about with the dollar, and now all of a sudden there is a rumor, that there is a rumor, that there is a rumor, that maybe something positive is going to happen for Europe. Do you see the eurozone solving the problem any time soon?

David: Kevin, there is no one here that has a clue. This is, I think, one of the failures of the news media, in portraying anyone in the EMU as having real leadership ability. We are not talking about people with vast business experience. We are talking about petty socialist bureaucrats, who have no idea what it takes to make decisions, and take risk in the context of making decisions, or even risk being wrong – the reputational risk, the professional risk, and all that comes with the simple decision-making process.

The eurozone estimates are now about 2 trillion euros which would be needed for their shock and awe backstop to European banks that are holding sovereign paper. So we have Greek 2-year notes trading at a 70% yield, and they are scrambling, at present, to make their October payments. After their October payments, there is the next big hurdle, which is the December maturity, and they have to come up with about 5.23 billion euros to pay off that debt.

If they are able to dodge the October bullet, this is something like Russian roulette. There will be great relief, and there will be great celebration, if they can come up with the October payment. The problem is, that is one chamber of six, and we are continuing to play this game of roulette here in Europe. In the December maturity, again, they have 5.23 billion euros coming due. They will have to come up with those euros, also.

Kevin: You talked about it being one chamber of six, but there is a whole carton of ammunition afterward that has to be refilled. It is just completely unpayable. There was an agreement on July 21st for private parties to share some of the risk in Europe, and it sounds like they are even second-guessing that at this point. Does that have to do with the credit default swaps? What was agreed on July 21st in Europe that right now is coming into question?

David: Over the weekend, the G20 leaders were getting together and discussing the fact that this probably wasn’t going to be a tolerable solution and they would have to put their minds together and come up with something better that was more palatable, etc., etc. Should there be participation in losses, in the event of a default, and to what degree should there be a participation? This is where we are not out of the woods yet, because, again, it is not just a question of Eurozone “leaders” or bureaucrats, we are talking about an entire world which is full of people who have no idea what it looks like to make critical decisions at critical points in time. They would rather get together as a committee, and, I don’t know, just mutually admire each other, feel important?

This is really getting to the point of utter embarrassment, wherein the people around the world who these G20 leaders represent should be up in arms saying, “Just make a simple decision, will you? Dammit, the world is getting ready to go to hell in a hand basket, and y’all are just sitting there patting each other on the back for, really, platitudes, and nothing of substance. If you are going to do something, do something, even if it is the wrong thing. But don’t tell us over, and over, and over, and over again, that you have agreed to create a concerted effort and put your real shoulder into it this time.” I think one of the things we are watching happen is the discrediting of this type of leadership by committee. It just simply doesn’t work. It doesn’t work in Europe. It doesn’t work anywhere in the world.

Kevin: I think it is quite obvious that the IMF and the World Bank don’t have enough money, and probably never will have enough money, to solve this problem. What do they have right now to throw at the problem? And then, what are they asking for?

David: Christine Lagarde has already said this week that they have 384 billion in cash to handle the bailouts, and that that probably won’t be sufficient, so they will be looking for greater contributions from their members. And this is, I think, what is shocking. We are talking about the U.S., we are talking about Britain, we are talking about some of the countries, who, themselves, are having a hard time making ends meet – sort of an interesting irony – the bailout of others when you can’t pull yourselves up by your own bootstraps.

That is essentially why we look at this and say, “This is not feasible.” All we are doing is adding more layers of debt to pre-existing layers of debt, and calling that good. This is why we were discussing with Hunter Lewis, a few weeks ago, the frailties of Keynesianism, because the leadership is assuming, both here and in the U.S., that if they buy time, saner minds will return to the marketplace, that the consumer will begin consuming again, and we will all go back to this peaceful, blissful Utopia, where no one saves, and everyone spends, and government is happier for it. Everyone focuses on getting their government cheese and living a day by day, paycheck by paycheck existence.

At the IMF, at the World Bank, certainly, they have reason to be concerned, because they know that they are going to buzz through that 384 billion over the next 12 months without skipping a beat.

Kevin: David, you know the saying, “Fool me once, shame on you. Fool me twice, shame on me.” In reality, these guys are just fooling, and fooling, and fooling, and fooling, and the markets continue to react as if there is maybe going to be a solution, but this deleveraging has to occur, and these guys aren’t willing to live with that.

David: I think you are right Kevin, that we will see a deflationary spat in here. The deleveraging she described is going to be selective to certain asset classes, and I don’t see a general deleveraging across the board. Certainly, the consumer, and we pointed this out a few weeks ago, the consumer is working on deleveraging. They have gone from 130% of debt to disposable income, to now 115%, with the mean number being closer to 75%. So certainly, we will see the consumer continue to deleverage. I think you have already seen a good degree of deleveraging in corporate America. If you look at balance sheets today, they are healthier than they have been for some time. That doesn’t mean that I would go out and buy equities, in general. Valuations are still very high, and are unattractive, from a fundamental standpoint, very unsupported by the market fundamentals. But that will happen.

The point is this, Kevin. We have the IMF and the World Bank saying, “We need more money.” We have the eurozone saying, “Well, we’ll borrow from Peter to pay Paul. We’ll steal from Peter to pay Paul.” They have to come up with money out of nothing. This is the ex nihilo creation of fiat currency. This is where we would continue to argue that there is, from a monetary standpoint, an inflationary impact. There is a downgrade to every currency, with every country who is not willing to tighten their belts, who is not willing to implement fiscal austerity measures, who can’t get that done, who can’t do that, in the context of a voting public, a democracy which won’t allow for it, and is thus forced to inflate, and inflate, and inflate, and inflate. We are not talking about the kind of inflation that would necessarily be positive to all commodities, but one that is very negative to the value of the currency, and we think is one of the good reasons for continuing to own gold, at this point, and into the future.

Kevin: You talked about not buying equities, but gold shares are extremely cheap right now, at least they seem to be. They have come down, they have made some correction. What is your thought on buying gold shares, at this point?

David: Kevin, I think with a 2-3 year view, they are very cheap, and I think that we are likely to see them as the new dividend players. If you move out over the next 3-5 years, I think they are likely to be significant income generators. The volatility is painful, they are attached to the metals market in a very volatile way, and I would just note that a company like Newmont has been very stable through the last week’s correction, relative to its peers, in light of its dividend policy, increasing its dividends, and obligating an increase of dividends with the incremental growth and the price of gold. With $2500 gold we are talking about a company that would be paying over 7% on its dividend, and that is nothing to sneeze at.

Kevin: If you think about putting money in the bank right now, maybe you get 1%, maybe you get 2%, but you are talking about actually having a 7% payout. This reminds me of what gold shares used to be known for back in the 1970s. They were huge dividend generators. A person could actually live on income just by owning their gold shares. That seemed to go away for years, but it looks like we have the return of the dividend payoff in the gold share market.

David: And what is a modest 2% today, will grow, as they continue to pay out more and more, and on a reasonable cost basis, I think that will be a huge benefit to investors. So, yes, I think they are cheap, I think they are just about as cheap as they were in 2000, just about as cheap as they were in 2008. You could say that this is probably the third cheapest they have been in a decade, and I would have to take a strong look at those.

This is one of the reasons why, as a company, we prize the availability of cash. We have stubbornly kept cash in our managed accounts, between 30% and 50%, and so the volatility which we have seen of late – not only does it not hurt us, but with this break in prices to lower levels, for us it is a very happy affair. We look at pricing and say, “This is fantastic.” The profits that were generated between 2008 and 2011, were, in large part, because of the liquidity variable, and the ability to put money to work for you at an opportune time, so what appears to be a noninvestment is absolutely one of the most critical investments that you can make, and it is simply having liquidity when it counts most and that is what this last week has been about. We really enjoyed it.

Kevin: I think about all those hedge funds last week, that we talked about, that were almost fully invested, that had to just do whatever they could – sell gold, or whatever, just to generate a little bit of cash. Then I think about McAlvany Wealth Management, and the fund was very flexible because of this 30-50% cash position. It allowed you not to have to liquidate when everybody else was, and to go in and buy after everyone had liquidated. Isn’t that the primary goal of being ready to invest on the dip?

David: Yes, Kevin, and I think this is where the whole philosophy at most hedge funds is just so aggressive, when they are playing with other people’s money – and that is exactly what they are doing – they are playing a game, and they are playing as fast and as loose as they can so that they can retire when they are 28, or 32, or some stupid number like that, and they are invested, not 100%, where they would have zero cash – they are invested to the tune of 110%, 120%, 130%. So they have leveraged portfolios with no liquidity at all. If there is a hiccup in any way, shape, or form, you have forced liquidations, and it is a very speculative way to live and invest, and in this market, a very speculative way to die. A lot of hedge funds have been crucified over the last year-and-a-half to two years.

Our management style is very different. We have been able to make money through 2008, 2009, and 2010, and we are doing quite well this year. Even with the volatility of the last week or so, we are not in a position where our hands are tied. In fact, we are able to allocate assets very, very effectively here. So the hedge funds that are liquidating gold today, to book profits, and to have something to show to their investors to justify their existence – we are just not in the same position, where forced liquidations are the measure of the day, because someone outside of the firm, like the Chicago Mercantile Exchange, changes the rules, requiring us to get in compliance – we just have a safer margin for that kind of volatility, and are very comfortable with the kind of cash positions we have been acquiring.

When I was at the Bloomberg studio there in London this last week, they were asking me some pre-questions, saying, “Hey, listen, we have talked to a lot of fund managers, and it seems like they have wanted to increase their cash to 5% and 6%, up from 2% and 3%.” I just kind of shook my head, and I said, “Yes, but we’re at 30% to 50% already.” I guess they don’t really understand what’s happening, 3% to 5% is not enough to get anything done, unless you are going back to that 110% or 120% invested on a fully-leveraged portfolio.

Kevin: David, that brings us to a point. You have the luxury sometimes to stay in 30% to 50% because you have had commodities rising. When we think of the triangle, part of the triangle rises when the other parts sometimes just sit liquid. We have talked about a third in gold, a third in growth types of assets, and a third in cash. But for the person who is retired – I am just thinking about my mom, and my grandma who is 92 years old. When she was building up her asset base to live off of, she was assuming that she was going to get a little bit of interest.

You have talked about financial repression. What was announced last week by the Federal Reserve was just one more example, I think, of financial repression. They are basically saying, “Look, if you thought interest rates were going to rise, we are going to see to it, even artificially, even with your money, that interest rates don’t rise.” Is this something new, this financial repression, or have we seen stints of this in the past? And is there an end?

David: We have seen it in the past, Kevin, but never to this degree. To define what we are talking about, in the current environment, 2007-2009, we have had zero interest rates for the last 33 months, and the commitment from the Fed is to continue that forward for at least another 24 months. The reason we call it repression is because it is taking the interest rate and pushing it below a natural level. It is a suppression of this form, which has never been done on this grand of a scale, but it has been done before.

If you go back to the early 2000s, the Fed dropped interest rates to 1% for about 12 months, and it was very stimulative to the economy. That is what they are trying to do, is stimulate consumer activity, and business borrowing – borrowing and spending. Of course, rates were manipulated lower in an earlier period of time. If you go back to the 1989-1991 period, it was just a different interest rate environment then, so rates were lowered significantly to what were very low levels then, at 3%, and they kept them there for about 17 months.

Kevin, I guess if you want to look at financial repression this way, imagine a Keynesian with an imaginary gun in his hand, going to your grandmother and saying, “You will spend every last dime, or we will punish you for it, and punishment comes in the form of nonpayment of interest.” Essentially, it is the Keynesian gun in hand, saying, “We’re not going to pay you one lead cent, therefore you get out there and spend. You do your job.”

According to the Keynesian model, that’s what every person is supposed to do, and that is contrary to what you just described, Kevin, where you mother or your grandmother may have put away for a rainy day, and needs the interest income just to live on, just to pay bills, never wanting to dip into principle, because it gives them the insecurity of feeling like, “What if I end up on Ramen noodles or Vienna sausages in my latter years, and that’s all I’ve got? I don’t want to starve, I don’t want to be out in the rain. I want to be able to take care of myself. That’s why I forewent those present pleasures for some future reward, and now that reward is being taken from me.”

I think it is the right description, Kevin – financial repression – and I think that is something that, for the average investor, whether they know it or not, is being done to them, not for them, and a low interest rate environment certainly helps certain financial players in terms of being able to borrow at very cheap rates and speculate. That is actually a part of the reason why we have seen the dollar do what it has been doing here recently, with this “operation twist” from the Fed, you have something of an unwind of the carry trade, and as short-dated paper is moving the opposite direction, and as the dollar is appreciating, we are having these leveraged players having to pay back the dollars that they have borrowed, as they are watching their profit margins get squeezed.

Kevin: David, the carry trade is sort of a complex thought process. It is something that we saw with Japan a decade ago, and now we are seeing the carry trade here. Without going into great complexity, maybe that is something that we could spend a show covering down the road. Would you be willing to explain that in a little bit more detail later?

David: Oh sure, because it certainly is a dynamic that has fueled speculation and creates instability in the marketplace and that is something that should be well understood.

Kevin: In the meantime, I think one of the questions that needs to be addressed that I am seeing our listeners come up with is that the Dow has just been stuck in this range for, it seems, forever, really. I look back 10-11 years ago, when the stock market was at 12,000 points, and here we are in the 10,000-11,000 range, and it just wanders around. How long are we going to be range-bound in the Dow?

David: Kevin, there are some dynamics that are changing in the marketplace that are frankly very unhealthy, because while the Dow is range-bound, there are investors who are pulling funds because they are just reaching that state of demoralization. They don’t want to do this again, so we have seen upwards of 375 billion dollars in withdrawals from equity mutual funds. In their place, and the reason we have described, in the past, the stock market as something of a ghost town, high-frequency trading has taken the place of the general equity investor.

High-frequency trading today accounts for over 75%, almost 80%, of all volumes on the New York Stock Exchange. If we are looking at the dollar values involved in this churning process by high-frequency traders, we are talking about 66 trillion dollars which is being turned over annually in the stock market, to generate somewhere between 5 and 10 billion dollars in profits. On a percentage basis, that is just nothing, it is absolutely nothing.

What is interesting is that we have basically eliminated the average investor from the marketplace. They are now playing for pennies, and trends and long-term issues really don’t matter to the high-frequency trader. So the pricing mechanism within the stock market, I think, is fairly inaccurate. Just as we have seen suppression in the interest rate market, and bonds, the U.S. Treasury market does not, today, reflect the solvency risk associated with the U.S. balance sheet, we, too, look at the stock market and say, “Things are not reflective of value, and what you see in terms of price is really a misrepresentation.”

A lot of that has been confused, starting about six years ago. Since 2003-2004, we have seen a tripling of volume on the New York Stock Exchange, and we have been range-bound. Obviously, there are different elements that go into a historical appraisal of this, but the Dow has been range-bound before. It was between 1966 and 1982, and that period, like this period today, was also a period of negative real rates. When companies are cheap, when yields are considerably positive, when inflation is falling, then you have an environment where markets can recover, where companies can prosper, where business cycles can resume and uptrend, and frankly, in that environment, the need to own gold becomes less important, and that is not the environment we are in. We are still in that range-bound, 1966-1982 market, not a bear market where it is catastrophic, à la the 1930s, but you just get ground down and you can’t handle it anymore because it’s just so cotton-pickin’ boring.

Kevin: David, that is the glass half empty portion, and yes, a Dow that is range-bound does seem like the glass is not only half empty, but even more empty. But the glass half full portion of that 1966-1982 period of time was that gold went from a ratio of 30 ounces of gold equaling one share of the Dow, to 1-to-1, during that period of time. You were saying that that is when the need to own gold occurs; there are great gains in other areas when the Dow is range-bound, and I am thinking of this time period that we are in now. We have been range-bound for ten years, but gold has gone from about 42-ounces-to-1, on the Dow, to where we are now, which is in the 6-7 ounce range, probably on the way to 1-to-1, wouldn’t you say?

David: Yes, and the real gain that you are describing, Kevin, is in purchasing power of real assets. I think that is what becomes very compelling. As more and more people exit the market – I mentioned 375 billion dollars being taken out in equity mutual funds – this is a sign of the times. This is what is involved in the slow, bleeding process, where, ultimately, we will see a period of capitulation, and price shock, to the downside on the Dow, and we will see the market so bombed out, the general public so uninterested in equities.

But we will still be looking at companies like Johnson and Johnson, and Bristol-Myers Squibb, and Caterpillar, and Illinois Toolworks, and the Heinz company – these are companies that still are going to be selling soup and ketchup and Band-Aids, and yellow iron. They are still in business, and they are still moving products all over the world, and they are still making money, and they should be owned intelligently, and they are owned particularly intelligently when you can buy them just for pennies on the dollar. It is what is developing, Kevin. I think if there is anything encouraging to me in the context of a, frankly, fairly dark period of time, it is that these are the necessary steps, the necessary events, that get us to the point of compelling value, and we are getting closer and closer to that.

I would be remiss in not mentioning China in today’s program, Kevin, because this is an area where I do not see compelling value, have not seen compelling value, and don’t see stimulus as effective for long-term growth at this point. Move out 20 years from now, and I think you and I would both be China bulls. But over the next 20 months, probably more China bears, the only exception to that being if the government is going to spend, literally, trillions of dollars in a very short period of time, and then, just like a small child on a candy bar, we are talking about spastic behavior. I guess if you want to view that as positive, you can, but it is certainly not lifeless. That is not really a growth story, in my opinion. I want to see something organic and fundamental before I am shelling out hard-earned dollars to risk in capital markets that, today, are too opaque to be investing in with serious money.

Kevin: David, I know we joke about your dad saying that China is the next thing, and I think he would admit, too, that a little time needs to pass. You feel more time needs to pass, I think, than he does, but just think about Mercedes saying that growth in luxury vehicle sales has really slowed through the summer months up to present time in China. The Chinese economy seems to be slowing. The excess funds that seemed to be so readily available, seem to be tightening up a little bit, in the face of, maybe, 14-15% inflation in China right now. So if we have a contraction, maybe this is more of an inflationary contraction.

David: It is, and their official inflation is closer to 6% to 6½%, but they have tortured their statistics like they have tortured a lot of other things, and they can make them sing, so 15-16% is a real-world number, with 6% being the reported. Kevin, it was in the spring of this year that Fitch said they expected 30% of the bank loans in China to be nonperforming. Now that we’re seeing a slowdown in China with the purchasing managers index under 50, I think what we are likely to see is a lot of real estate developers go to the wall, and that is a 12-18 month period of time as they scramble for borrowing abilities in lines of credit. But barring another trillion-dollar stimulus, we are going to see major hiccups in the banking arena in China over the next 18 months.

Kevin: Would you say that is the case for the emerging markets, as well, David?

David: It is interesting, Kevin, this idea of decoupling was, and is, a fool’s errand, in my opinion. The emerging markets are far more dramatically impacted than the developed world markets. You could say that future growth is going to be predicated on the developing world, not the developed world, and if you look at Western Europe, if you look at America, that we have seen our growth cycle, and we are likely to see better growth elsewhere.

But that doesn’t mean that it is going to be tomorrow, and it doesn’t mean that they are on a platform to do that at present. Remember, it was England that was an emerging market when Italy was the banking center, and it was America that was the emerging market when England was the banking center, and yes, China, and many of these emerging markets, are likely to be very successful, including Brazil, as we pass the baton.

But these are things that don’t happen very quickly, and not usually on a voluntary basis. The U.S. doesn’t want to give up its preeminence on the world financial scene. That is something that is usually ripped from a country, just as the British didn’t voluntarily give it away, it was taken from them through multiple world wars and true bankruptcy.

But Kevin, the risks are there. We have the currencies in these developing countries which are under pressure, and as you know, trade is the predicate for growth in the emerging world, and when world trade slows, so does the cash flow to these little outposts, and we are not talking about only little outposts. Brazil is a giant – but the Brazilian real, their currency, is off 16% in less than a month, Kevin, and as commodity prices are under pressure, that trend will stay down.

Kevin: What about Asian currencies? You talked about the South American currencies, but the Asian currencies – are they as volatile?

David: They saw their worst week, last week, since 1998, in what was then called the Asian flu. Different dynamics, today, than there were then, but we are seeing weakness in the currency markets the world over. I would like to be able to say that there is a better story to tell, even in our own economy, but new home sales are down, we have prices dropping from last year by about 7.7%, from 2010 numbers to today. It only costs you 125 ounces to buy the average single family home, whereas it cost between 500-600 ounces at the peak.

Kevin: David, what you are talking about is 125 ounces of gold would buy a home right now, which is really about one-fifth of what it was cost just a few years ago.

David: That’s right, and we may ultimately see that target at 100 ounces, at 50, maybe even 25, in select areas. Again, when we were talking about equities a moment ago, and certainly real estate is in the same camp, we are talking about an increase in purchasing power. When I look at gold, I don’t look at it as a growth asset. I look at it as the ability to preserve value, to insure that you protect and preserve wealth through a period of extreme financial contraction, and then are able to redeploy assets when those other productive assets are selling at a discount, so it serves a function, like a life-boat, like a life-raft, like a life-vest. We are not talking about winning fashion shows, we are not talking about pleasure cruises, we are just talking about something that is highly functional in a dysfunctional world.

That is why I look at where we started our conversation today, Kevin, and say, “Is the world any more functional today than it was two weeks ago, two months ago, or two years ago?” I think we would both agree that it is far more dysfunctional. That is why I think that the role of insurance is ever more important, and it is going to dawn on more and more people around the world that that is what they need – not gold as a speculative investment, not silver as a growth play, but money – money which has been a form of wealth for 5,000 years, and has stood the test of time, whereas every other asset class has been through the ringer, to one degree or another, and has, at different times, because of liquidity concerns, or solvency concerns, or the combination of the two, been priced at zero, and that has just never been the case with gold.

That’s where we are, Kevin. The rising price of gold represents failing trust in fiat currencies. And I can tell you, having spent some time in Brussels, and I am here again today – I have never been more scared in my life. Brussels is the belly of the beast, and the EU. I hope next week I can have a better comment for you on Europe. We will be talking to some folks that spend their lives here. There are 15 different analysts from around Europe who compare notes, and as part of a think tank we will be participating in two days of meetings with them this next week. Perhaps they can change my view on this, but it appears to me that the grand social experiment here in Europe, something that could have been a test case for the world, is in the process of failing.

Kevin: David, going back to the beginning of the program when we asked, “Have the fundamentals changed?” For the listener who has been listening for 2, 3, 4 years, and they do have a position in physical gold and silver, and they do have a position put aside for growth and some cash, would you say, with the volatility that we saw over the last few days, the drop in the gold price and the silver price, is there something that they should be doing differently? Or is this the time to hold tight and maybe even add more?

David: I wouldn’t change a thing, Kevin. I wouldn’t change a thing. I would pick some particular prices to come into the market, and add, if that is your prerogative, but the fundamentals, if they have changed, have just gotten stronger. That would be my only point, that if they have changed at all, they have simply gotten stronger. The argument for owning gold, in particular, Kevin, has never been more compelling.

Posted in TranscriptsComments Off on September 28, 2011; A European Tragedy of Errors: David McAlvany in Brussels

July 6, 2011; Felix Zulauf: Marching Full Speed into Calamity


The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, we often take an international perspective. Sometimes we have to go overseas to get that perspective, be it a founder of a European central bank, or, in this case, a Swiss banker. We do have a guest today who can bring some insight into what is going on, don’t we?

David: Kevin, we do. Felix Zulauf is with Zulauf Asset Management in Zug, Switzerland, and a regular contributor to the Barron’s Round Table, where he, along with Bill Gross and Fred Hickey, and a number of other experts in their field, diagnose and prognosticate about the direction of the market. In the case of Felix, what you will find is someone who understands the complexities of the world economy, and from a global macro-perspective, brings some keen insights, both into Europe, but also into particular asset classes.

Kevin: One of the things we have enjoyed about reading Zulauf is his interest in the short-term, the middle-term, and the long-term. Very rarely do you find somebody who has the whole picture, and he really has insights, and he actually talks about dates and times.

David: Whether it is looking at a monetary framework, considering valuation metrics, looking at momentum trends, or as contraindicators, considering sentiment in the marketplace, he does a very good job, as you said, of looking both at the big picture, but also drilling down into the details, as well.

If it weren’t for government deficit spending, the U.S. financial landscape would be radically altered for the worse. No one is searching for structural solutions to structural problems of debt and deficits, more paper seems to be the sufficient substitute for harder decisions, which are likely to come anyway, just somewhere down the line. The consumer is on strike in America, as wages stagnate, the cost of basic goods is rising, and asset values have plummeted, dragging down the average American net worth. Thus the government has had to step in and spend, and print to do so, if necessary.

Today we are joined by Felix Zulauf from Switzerland, to bring both an international perspective to the global markets, the U.S. markets, and also to look at the variety of different markets, whether it is equities, fixed income, commodities, gold, or currencies. There are so many things in play today that it seems never in history have we had so many things converging at once, when you think on a global perspective.

Felix, let’s go back a few years. You have considered the equity markets to be selectively opportunistic. There are a few areas that you have thought it made sense to allocate capital. You have projected, really, a 2-3 year time frame in which greater bargains could be had, going back to interviews with Barron’s in 2009. That would make 2012 an interesting time. Would you extend that time frame any further at this point?

Felix Zulauf: Oh, I think we are really entering very difficult territory here. We have had two years of a tremendous rally, probably the most powerful rally on record within a short period of time, and the market is optimistic, and the money managers running other people’s money are all more or less fully invested, because they have no choice. When a market rallies like it did, even the skeptics have to join the bandwagon or they face a severe career risk. That is the name of the game.

Today we have the majority pretty fully invested in equities and the economy beginning to stutter, and there is a clear reason why the economy is beginning to stutter. Most of the observers, economists, and strategists I read and speak to believe that central bank monetary policy has been the main driver of the asset markets and the economy recovering. I agree, only when it comes to the asset markets. There, the central bank policy, easy and highly aggressive stimulative policy was the main driver, but when it comes to the economy, I think the main driver was fiscal policy.

When you look at the situation today, and it is actually not only true for the U.S., it is true throughout the industrialized, developed world, the fiscal policy has been extremely stimulative, and turned stimulative at the point when the inventory swing was turning around for the better, for the positive. I think all those positive factors have been spent, and now we have entered a situation where fiscal policy is turning negative. It is becoming less expansive, or more restrictive.

It is certainly the case in Europe, where we have austerity programs going on at the periphery, but it is also true in the U.S., where fiscal policy, net-net, turns to become a net-negative from early this year on. The disappointing economic trends that we see in the U.S. economy have to do with that, primarily, and not with monetary policy. I do not expect that fiscal policy can become more stimulative from here onward, and that is why I do believe disappointments in the U.S. economy going into 2012, as well as in Japan, and Europe, in particular, are going to come, and will surprise the investment community. I think that is the main factor that is driving the equity markets.

David: Speaking of disappointments, as we come into the third and fourth quarters of this year, we also have an adjustment of expectations off of unreasonable levels. We had a tremendous amount of seasonal adjustments in the first quarter, and so when we look at economic data now, it looks like it is getting worse and worse, when in fact, it was already bad, we just had seasonal adjustments which were covering over that in the first quarter of this year. With a suspension of quantitative easing II, might we expect some unpleasant volatility in the equity markets coming into the third and fourth quarter?

Felix: Yes, that’s true, and actually, when you look at the typical recovery numbers since World War II, we are extremely far below those numbers, and this tells you that there is something wrong with the whole economic setup. As you mentioned in the introduction, those are the structural factors. The consumer is basically spent out. 80% of the consumers are under water. They work hard, when they have a job, if they have a job, and at the end of the month they have nothing left, and once you have built up a debt that we have seen in the U.S., and then you cannot continue to accumulate that, it weakens final demand by the household factor on the structural basis.

That is what the situation is like, and there is nothing the authorities can do. You cannot force it even with further money printing. You cannot do it with further fiscal programs, except you can do that, but then you create all kinds of other problems, and hell could break loose. So we are really trapped here, and we have to expect, at best, a very stagnation-like, low-growth sort of environment in coming years.

At some point, the authorities will respond to that, particularly, in an election year like next year, they will probably try to stimulate again, because the employment situation is unsatisfactory due to the low growth or stagnation-like growth, and that may stimulate the portfolio managers or some investors to buy some more stocks, but there is nothing one can do. We have to sit it out, if it is several years that we have to go through, and that is why I think we have another maybe five years or so until this secular sideways or bear market environment in stocks will be over.

David: You have argued that we have seen the cyclical lows in the equity markets back in March of 2009, but you mentioned the word secular. That could be something that is 4-5 years on the horizon. In terms of valuations, we saw in the 1930s, the market trading at half of book value. Do you think we will see things get that extreme, à la the 1930s, or 1949, or 1982 period? What would you expect as we grind, or stagnate sideways? Is this catastrophic, or do we just grind sideways like the bear market in equities in the U.S. between 1966 and 1982?

Felix: The main difference to the 1930s is that in the 1930s we had a fixed exchange rate system in currencies that was based on the gold standard. You could not print as much money, unlimited, as you would like to. Today, we are in a fiat currency system, not linked to a gold standard, or any other standard, and there is no disciplining anchor. That is the main difference, and therefore I would expect that we do not reach those extremes that we have seen in the 1930s in terms of valuation.

But even during the 1970s and early 1980s, the last major secular lows in the stock market, we were trading slightly below book value at maybe 90% of book value or something like that. I did expect the stock market to decline into a secular low to around a book value of slightly below that. Book value is roughly 500 or a little bit over 500, depending on how you define it.

David: On the S&P 500.

Felix: That is still a possibility, but I do not expect that to happen over the next two years. I think we are too close to the major crisis calamity. It is too early. I would expect it to happen closer toward the middle of this decade. The next 2 or 3 years, I think authorities will do everything necessary to extend the recovery attempt in the economy, and from time to time, come up with stimulus, and that will limit the downside, and I said maybe the downside is around 1000 in the S&P, or between 1000 and 1100.

Once we get to that territory, I think the authorities would get very concerned and come up with interventions and all sorts of tricks, another rabbit out of the hat, to provide support. They can do that with monetary ammunition. They cannot do that by kicking the consumer in a major way. But they can support it for a while. Therefore, I think we are in for some very frustrating years where we trade in a range, maybe between 1000 and 1500 or so on the S&P, and lots of traps and mine fields, and at the end of this period, I would say 1400-1600, we have a major disaster coming, and then they cannot support it, and the dam breaks, and then we get another washout.

That is what my working hypothesis is. For an investor, in such an environment, you should have a defensive basic position, and trade, medium-term, on the bullish and the bearish side, in the stock market. That is what you can do. I do not believe we are in an environment in which you can really frame a long-term investment policy where you are primarily long equities. I think that is too risky.

We are living in an environment where the risk-free returns are below the inflation rate, where the risk-free returns for one year can get wiped out in an hour move in the stock market. We have never seen such an extreme situation. Most people tend to add more risk to the portfolio, not recognizing the sort of risk they are taking, because they want to achieve a return that they are used to, that they need for retirement, or future retirement, or for living. That is the situation we are in, and it is very complicated, very challenging, very difficult, and the layman investor is hardly going to come out as a winner.

David: It seems, just to summarize, that we have used up much of our fiscal ammunition. Coming into the 2009-2010 period, we had that boost from inventory restocking, and the fact that there was fiscal stimulation and inventory restocking at the same time leaves little in terms of options on that side. We have experimented with the monetary side. Certainly the developing world is experiencing more acute inflation than the developed world, although there are growing concerns there. And yet, in that apparently inflationary environment, you still have a tremendous amount of debt and deleveraging which is still to occur. It appears that the process which began in 2008 has much further to go.

The question we would have for you is this: What asset classes get sucked into that same deflationary, or deleveraging, vortex? Has the market matured at all? Certainly, gold felt the impact of the last period of deleveraging, along with almost every other asset class. Correlations went to 1 across the board. Have the markets matured or changed in the interim? Might we expect shorter corrections in the metals, or is deleveraging something that is a vortex that you simply cannot escape?

Felix: First of all, I do not know the future for sure. I do expect some further forced deleveraging, but I do not expect that the de-leveraging process will continue at the same speed as in the past few years, because most of the decline in the housing market is behind us. We may go a little bit lower, and there may be some further deleveraging, but not to the degree we have seen.

Therefore, I do not see an immediate calamity in the economy so that it spirals down 1930s-style or so, due to an Austrian policy imposed. I do not see that. I think it is just a very choppy, sloppy, economy, with underemployment. You could actually call it an inflationary depression, because we know that the true consumer price inflation for the average household is probably 5-6%, and if you take that number, it means that you have a shrinking economy, in real terms. That is how the average person really feels, because their financial situation reflects that reality.

What we can expect is that from time to time the authorities will come in and stimulate. I do not believe that the last fiscal stimulus was spent just this year. There will be more in the future, but they will only be able to do it when there is a crisis sort of environment. The same goes for monetary policy. Either the stock market has to come down, asset prices have to come down, housing prices have to come down, or anything that will trigger another crisis prevention, or crisis intervention sort of program, and then we have intervention by the authorities, and what does that mean for the different assets?

I think in the long run, that is not very good news for bonds, because the public sector will continue to go up relative to the economy, and in absolute terms, and that means eventually supply will take over, and it will push interest rates up, although I do think that maybe for another two years or so, they will probably swing bond yields within the extremes of 2008. We had the extremes on the upside and the extreme on the downside, and I think those two extremes will probably set the range for a number of years during which we build a yield bottom, out of which we will eventually break topside.

So bonds are not an attractive investment. Equities will beat bonds, but I do believe that equities will hang around for maybe another 2-3 years in that range I described, 1000-1500 on the S&P, and swinging widely, and toward the middle of the decade I expect that we get close to the lows of March 2009 once more, because I do expect that the way the world is setting up and marching in those different directions, we will march full speed into the next big calamity, and at that time, I do believe that markets will sell off one more time – big time. I cannot say whether we will go below those lows, or just come close to those lows, but I do believe that equities, for the next 4-5 years, will not be a good investment, in absolute terms.

Then we come to commodities. I think commodities are a China’s play. China is slowing down. I do not trust those numbers. From anecdotal evidence, I would say that China is slowing more than is generally expected, but the Chinese will eventually turn around. The pork price cycle tops in early 2012, and we probably have the grain prices topping out here, and getting a little bit softer, because the harvest outlook is improving, as I understand, and so by early next year they should have some room and leeway to become a little bit more aggressive again, and provide support for the economy.

So I think it is a pretty difficult environment. Gold is the one currency that reflects all these problems. I consider gold to be a currency and not a commodity, and I think the authorities, central bankers, as well as fiscal authorities, will continue to do dumb things, and the size of indebtedness by the public sector will continue to rise in the developed world, quite dramatically so, in my view, and this will eventually force central banks to accommodate and help to finance the budgets and the governments.

I think this is just a spiraling debasing of our fiat currencies, and that is reflected in the rising gold price, so I think the major theme of commodities and emerging market equities, doing better than developed markets, is still in place. The emerging market equities have had a pause and a rest, or some under-performance, and I do expect that sometime early next year, maybe even from late this year on, the emerging markets will begin to outperform again, as the inflation rate will moderate a little bit for cyclical reasons.

David: This is a two-part question, one relating to deeply negative real interest rates, and the somewhat oblivious nature of bond holders. I don’t know if they are content with these yields, or just oblivious to how negative they are, but perhaps you can relate that to the gold market, and development in that market, where once you described there being a disbelief of the moves in the metals. Have we changed, where people are now beginning to see the failure of both fiscal and monetary policies, and looking for a way to protect their portfolios?

Felix: Fiscal and monetary policies have not failed. They have helped to prevent a 1930s type of systemic breakdown, but at a price, of course. QE-II was counterproductive. It was not necessary, and it only helped push financial market prices further up, but it really was counterproductive for the real economy. It created more inflation, it created higher prices for food and energy, and it ate deep into the average consumer’s pocket, and this is actually going to slow down the economy. It is one of the factors that is in play.

I think QE-II was really only successful for the financial markets, but at the price of slowing down the economy further. I do believe that, because of this, and because of the criticism, we will not see QE-III very quickly, but eventually we will see it, because authorities will get desperate. They have no solution, and it is clear why. They are looking for a painless solution. There is no painless solution. In a democracy, we cannot go the Austrian way and clean things out. This is impossible. It would be worse than a 1930s style of depression. Therefore, they are trying to muddle through.

The Europeans, under the pressure of the Germans, are trying to put austerity through their public spending programs and their budgets, etc. This will fail because it will lead to recession. It will be very interesting to see how the U.K. will react once they really start cutting expenditures, as they said, namely 25% of the budget. That will create a deep recession, and therefore, I do not believe that they will execute this program in full. You cannot do that in a democracy, I believe, and therefore I think that what you will see is probably higher taxes, particularly for the wealthy.

The U.S., historically-speaking, is at the lower end of the tax rate. When you look at total taxes relative to the economy, the U.S. is at the very low level and can increase taxation, to some degree. The corporate sector is paying very low taxes in many countries around the developed world, and I do believe that you will see those changes.

Whatever you do, whether you tax more, or whether you cut some entitlements, and it will probably be a combination of both, you will eventually end up with lower prosperity for the average citizen of the Western world, and that means less spending power for the private households, and less consumption. And as you have less consumption and less final demand growth, you will probably also have less investment. That is the name of the game, and we are trapped in that situation, and only if we are back to healthy levels, can we dream of a new upswing and prosperity, like we could in the early 1980s under Ronald Reagan. We have a long period of time ahead of us with hard work and falling prosperity for the average citizen of the Western world.

David: Coming into the 1980s, we, as a country, had an average savings rate of between 12 and 14%, so we began to not only leverage our balance sheet, but spend through savings, two very stimulative sources for growth in the equities markets and real estate. To summarize, it sounds like the next 3-5 years will be stagnation, low growth, perhaps even defined as an inflationary depression.

Felix: Yes. That is what I think it is. It is not like the 1930s because we lack the gold standard, we have the fiat currencies. It will be a very difficult time, and the final outcome is very difficult to say. Usually, when you go into such a period, you end up with adjustments that primarily go through the currencies. In the history books you can read about all those adjustments and currency debasements and currency reforms, etc.

The problem we are faced with now is that virtually all the developed world, with a few exceptions, may be in a similar trap. You have all those currencies going down, and therefore, you don’t have a slump right away. If the U.S. would be alone in all the problems it has and let’s say we didn’t have a euro and we had Germany with a strong D-mark, the U.S. dollar would have slumped dramatically already. If the Chinese would not have adopted a Bretton Woods II fixed-exchange rate system, or sort of between the renminbi and the U.S. dollar, the U.S. dollar would have slumped dramatically. Your inflation rates and your interest rates would be much higher, and your financial asset prices would be much lower.

Now, we have a situation where the Chinese, obviously, haven’t done that, but they are realizing that the system of a quasi-fixed exchange rate to the U.S. dollar is becoming counterproductive for them because it creates enormous inflation and too much liquidity in the domestic economy that creates havoc with the real estate market, that is very difficult to control. I feel that the Chinese want to move away from that quasi-fixed exchange rate system. If they do, it means that the dollar has more downside risk against the Asian currencies. And if that is true, you will have more import price inflation. And if that is true, it means the acceleration of the process we are in, and that should eventually lead to some higher bond yields, and that should eventually lead to lower stock prices.

But I think it is a slow process. It is not changing overnight from black to white. It is a process that will probably play out over the next 2-3 years. At the end of the process, you have a big waterfall decline and adjustments in the markets, and you can probably best escape that, or survive, by owning a lot of gold. I say that we are moving into a thunderstorm here, and it will rain and pour. There will be lightning. There will be flooding. There will be mudslides. Everybody will get wet. But the most important thing is, not to stand where the lightning strikes, not to be where the flooding is, or the mudslides. That is now I describe it. It is very difficult to come out as a winner, and actually, if one is smart enough to figure out what exactly to do, and comes out as a winner, I am pretty sure that governments will tax his profits away quite dramatically.

David: There is something very interesting that has happened in the last year with the Swiss franc. The Swiss National Bank, a year ago, tried to suppress the rise in the franc, and that was a very costly effort. As we look at fiat currencies around the world, they are all, relative to each other, in decline. The Swiss franc seems to be a winner for the last year. What are your thoughts? We are in this non-virtuous cycle of competitive currency devaluation. Is this just a question of who is the winner for the year? Or is there an argument to be made for select currency exposures on a longer-term basis?

Felix: In a fiat currency system, all currencies debase, and as you rightly say, it is a relative game. Longer term, those currencies will come out as winners that have sound structural fundamentals. By that, I mean, it has to be a competitive economy. It has to be an economy that runs structurally current account surpluses on a continuing basis, and therefore, structurally, is forced to improve the efficiency of the economy all the time.

Switzerland is a good example. As a youngster, when I entered this industry, the investment business, we had to pay 4 Swiss francs, and 32 cents, for one dollar. The dollar is now 83 cents. Now we have to pay only 83 cents for one dollar, so the dollar has declined by a factor of 5, or by 80% relative to the Swiss franc. The U.S., at that time, was enjoying a trade surplus, a current account surplus, and so was Switzerland. Switzerland still has a current account surplus, but the U.S. has not, and it shows that once you go the way of weakening your own currency, you really take the pressure away from your economy to adjust constantly to that particular pressure.

Switzerland was forced to really force out the low value-added industries and go up the ladder and move more and more into the high added-value industries and sectors of the economy. That is how you create winners. The same is true for Germany. I think Singapore and Asia are doing the same thing. They are extremely well-run. The Swiss Central Bank used to be well-run, but it has had a problem, it made a major mistake lately, unfortunately, although I must say, they handled the situation with UBS in 2009 extremely well.

But the intervention by Switzerland against the euro when there is a fundamentally flawed currency – that was dumb – and the timing was wrong, and the level was wrong, and that has created a situation where the Central Bank has relatively little room for maneuvering right here. But it doesn’t break the Swiss franc as a strong currency. Then when you look around, it is all the same currencies that stand out with those credentials. It is the Singapore dollar, it is the Norwegian krone, it is the Swiss franc, maybe the Chinese renminbi, but that is a little bit intransparent, and therefore I have some question marks about that. But that is what it is – it is a relative raise in currencies.

David: You mentioned Germany, and this is an important point to make. You have already seen the state elections upset the standing party and we are seeing a rebellion, if you will, even today, in Greece, against who is going to pay for what. The Germans have one perspective on that as they carry a certain burden, and the Greeks and peripheral European countries feel a different sort of burden. Looking at European stability, and the European Union as one unit, can you see these peripheral countries remaining a part of the union? Do you think we will ultimately see a few of the weaker hens drop out? Will Germany, at some point, say, “This is our only way forward. Just like the Swiss franc, just like the Singapore dollar, we have the economy, and certainly could have the currency to be a standout and a leader in our own right.” Am I looking at this correctly, or perhaps you can add some insight to the EU issue?

Felix: You have to go back to the point of time when the idea of the euro was born. Europe had a very well-functioning currency system called the European Snake. All the currencies traded in a range against each other, so it was crazy, like a flexible fixed exchange rate system, with a range.

David: That is the ERM – exchange rate mechanism?

Felix: Yes. It worked very well, and after a few years, those who could not keep pace with the high-productivity nations had to devalue their currency, and stayed in the Snake, but at a different level. They just reset the level and devalued the currency; that was functioning very well. The idea of the euro was not actually coming out of the Snake and out of economic circles, it was a political factor.

Concerning the price for re-unification of the two Germanys, the U.S., the U.K., and even the Soviet Union at that time – all three agreed that the two Germanys could re-unite without asking for anything as a price. It was only the French who had suffered under the strong Germans for ever and ever, who thought, “We cannot let the two Germanys re-unite, and then there is a big Germany again, and we will suffer under them, and we are always number two, and never at an even level.”

So they said, “You can do that, but we want to have a further and more deeply integrated European economy, and for that we have to create the euro, a common, mutual currency.” That was the price. The majority of really serious economists saw the flaws from the very beginning, and I said at the hour of its birth that if they stick to the rules, it will be the shortest monetary union on record, and after three years they broke the rules, and virtually all countries except Luxembourg and Finland, I believe, have broken the rules decisively, Germany and France first, without any sanctions. The whole setup is flawed, and it leads to enormous stress within the system.

You cannot have currency union without fiscal union, and fiscal union means political union, and one nation paying for the other, and I do believe that is against the German law and the German high court would probably say no to the parliament if the parliament said, “Yes, we agree to a fiscal union,” because it is against basic German law. That is why it is so delicate. They can create a monetary union, but for legal reasons, they cannot create a fiscal union, and also for political reasons, it is very difficult to sell the German voters and citizens and taxpayers the idea of the fiscal union.

Therefore, the European leaders are somehow struggling to find solutions to survive with the euro. They all think that time will solve the problem. We had the vote today with Greece, and the markets were bullish on that. This is just a postponement and procrastination of the problem. We all know that Greece will default. We all know that Ireland has to default. We all know that Portugal will default, and most likely Spain, and possibly even Italy and Belgium, and the longer they stay in that monetary union, the more likely the default will be, because they have to stick to an austerity that creates a deflationary ongoing recession. You could call it depression at the periphery, and that means you have a shrinking economy, and you have rising debt, and this is a cocktail for disaster.

Therefore, at some point, someone, be it the peripheral countries, the governments, or the voters, will say, “We have had enough.” I think you will see, sooner rather than later, that some countries will say, “We cannot live with that. We cannot do it. Our citizens are better off if we leave. If I were the Greek government, I would ask for as much money as I could get, and I would try to introduce some austerity, and particularly, change some structural issues under that pressure, but then, in a year or two, I would default. I would exit the euro, and I would introduce the drachma, then I would devalue the drachma by 50%, or even a little but more. There would be one more year of problems, and then the economy would recover, and tourism would bloom, and Italy and Spain would lose all their tourists because they would all go to Greece because it was so cheap. And then the next one would come, etc. I think this is an ongoing disaster, an epic drama.

There is only one solution for the euro. They have to make the euro a very weak currency to survive, as weak as possible, so that the weakest links in the chain can live with it, but that would mean a dramatically lower euro against the dollar. The ECB is against that. The ECB will most likely lose the fight against the politics and the ECB eventually has to turn around. The ECB is now the only central bank that has tried to reduce its balance sheet since it has inflated it during the crisis period in 2009. The first time they triggered the Greek crisis, the second time the Irish crisis, and now, the third time, they are reducing their balance sheet, and the whole monetary situation in Europe is extremely tight.

That is why the banks, particularly at the periphery, are refunding themselves via the U.S. money market that is extremely liquid, and half of the money in the U.S. money market funds is really money to fund the peripheral European banks. Once those money market funds get hit by redemptions because investors find out, then you have a funding crisis of major scale at the periphery of Europe, and that is the next step. It is a never-ending drama until it breaks in a big way.

I think the euro will break apart. You will have a few countries leaving the euro and then the center, or the northern part, will continue with the euro, and could probably also live with it. But I do not think that Germany could exit, which would probably be the easiest way, because they think they bear a responsibility for European integration due to European history, World War I and World War II, etc.

David: But as you have said, they can only devalue where they would need to devalue to accommodate the weakest link in the chain, which is at odds with Frankfurt’s stated intentions of maintaining monetary stability.

Felix: Absolutely, and although they have now elected an Italian as the head of the ECB, you will see that Mario Draghi, the new head of the ECB – that Italian will act much more like a German than even a German.

David: Interesting.

Felix: That is why I think they will not hike interest rates here in July when Trichet is still in power, but in September, when Draghi will be in power, he will hike interest rates to prove that he is more German than Italian. The monetary policy course by the ECB is completely unsustainable because it will create another crisis.

David: Essentially, whether it is two weeks ago, or 12 months ago, because the structural issues persist, nothing is different, whether it is the Greek vote here of late, nothing has changed. The problems persist.

Felix: You are absolutely right. In fact, I think, because of the setup as it is, and more austerity introduced, it is even worse than 12 months ago.

David: There is one issue that seems to be in the backdrop and keeps people resisting default, it is almost like tinkering with something nuclear. The credit default swap market, the onion layer of complexity just behind all of this sovereign paper, is what no one really wants to touch. If Greece is allowed to default, or if they choose to, what dominos begin to fall as a consequence of that, and does that trickle back to New York and London, primarily? Who holds that counter-party risk in the credit default swap market? It seems that there is a major defense right there.

Felix: You are absolutely right. The American banks own a lot of the CDS paper, and they will get involved, of course, once Greece defaults. But there is more to it. It is not just the U.S. banks, it is all the European banks. The European Central Bank, by itself, will be completely under-capitalized. By a default in Greece, they will lose more than their equity capital, and I think the same is true for the German Bundesbank, so you move the whole problem to a much higher level.

In 2009 we had a banking crisis, due to the indebtedness crisis of private households in several countries, the U.S., the U.K., France, Spain, etc., and then you had a banking crisis because of that. Then the public sector intervened. You now have a public sector government crisis, you have a central bank funding crisis, an equity capitalization crisis. You bring the whole thing to a new level, and I do not know – in the next calamity, I mentioned I expected to see in the middle of this decade who can bail all those guys out. It will be impossible.

By that time, government debt to GDP will be much higher than today, no question. Central banks will be much weaker, and their balance sheets will be full, and littered with bad paper, and I wonder who will bail the system out then. Then it comes to a major systemic calamity, and I think that is the case for gold, really.

David: To just wrap up, the trigger, it seems, and you mentioned something very interesting, that in the context of democracy, we really cannot go the Austrian way, and yet, it seems that the ECB and the EU have forced austerity measures because the monetary way is not an option. Everyone has given up their monetary sovereignty to be a part of the EMU. It seems that the trigger, in terms of an unwind, whether it is the credit default swap market, or something causing default in an individual country, may be democracy, where people say, “We can’t bear these austerity measures, and whatever government is going to impose them on us is a government that has a very short shelf life. Give us another election and you are all out, every one of you.” It seems perhaps the instability is in the people, themselves, who won’t stand for the pain.

Felix: Yes, you see it going on in Greece. I think that a wealthy Greek today, the guy who has a big villa, or mansion, up on the top of the hill, is in trouble. It is very uncomfortable to live that life there. I think that will go further, throughout the periphery. And the U.S. is basically the same. The only difference is that you have the option of printing money, and in the European setup, that option is gone, or the ECB doesn’t want to do it.

That is the main difference between the U.S., and Europe, and the U.K., of course. As long as you can walk away doing this, and this is going to be decided by the bond market, everything seems fine, everything continues to function. But once the bond market turns around and begins to riot against it, then you are, in the U.S., in the same trap that Greece is in right now. It is not exactly the same, but it is very, very similar.

You have to understand, we are all trapped, and there is no way out. You can postpone it by printing money, by debasing the currency, you can go into devaluing your currency and trying to steal trade from your neighbor, you can try to do that, but we know from history that that usually does not end very well. That is the situation we have.

In politics it is very interesting. I spend a lot of time in Germany because it is my neighbor country here from Switzerland, and when you talk to the average citizen, they have not realized yet what a fiscal union would really cost them. That is why the people, so far, are relatively relaxed. There is a certain group that is against the euro situation, and against fiscal union, but all the political parties, if they could say yes to a fiscal union, would. But if they say yes, they get voted out. There is not one single political party in the German parliament who says, “We are against the euro, we are against the fiscal union. We don’t want that. Enough is enough. We turn around.” There is not one political party, from the extreme left to the right, so those voters who really want to say no, have no means and no tools to say so.

The result of that is when you study European politics, you see that up to about eight years ago or so, we had a situation where in most countries we had two big people’s parties, one included social democrats on the left side, and one included the conservatives, and usually, a few smaller groups, and they were always able to form a government with a solid majority.

During the last eight years, more and more, the classic large people’s parties, on both sides of the political spectrum, have shrunk to a very low level, and you have a splitting up of the whole political landscape, more and more new parties, and it is impossible to form strong majority governments, so all the governments are basically weak, and that is a big problem when you are faced with the challenges that we are faced with right now. This is a little bit like the situation in the Weimar Republic, unfortunately.

David: Felix, there are so many more things that we have yet to talk about, and we are out of time. I love your analogy of the rainstorm. Avoiding the lightning is critical. The reality is, we will all get a little wet. The question is, can we avoid the mudslides? Can we avoid the lightning strikes? Perhaps we can continue our conversation over lunch. I have a favorite restaurant in Rapperswil. If you have one in Zug, next time we are in Switzerland, perhaps we can get together and compare notes.

Felix: That will be a pleasure. Thank you very much, David.

David: I look forward to it. Have a wonderful evening.

Felix: Thank you – you too.

 

Posted in TranscriptsComments Off on July 6, 2011; Felix Zulauf: Marching Full Speed into Calamity

June 15, 2011; A Gradual Sudden Catastrophe


The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, just as there are moving plates and continental drift, and they change the geology of the earth over time, or sometimes very quickly, you have events in the geopolitical realm that also shift geography.  I am speaking right now about Turkey.  Things have really changed in Turkey, and we have talked about it for the last couple of years, but this last election was really a decided outcome that is going to change the face of Middle Eastern politics.

David: It was last year, in our interview with Kamran Bokhari from STRATFOR, that we looked at Turkey, we looked at the implications of a revival of the Ottoman Empire, we looked at the regional balance of power which was upset by the U.S. involvement in Iraq, and the regional balance of power which shifted after the Cold War.  We talked about a number of different things that related to the Middle East, and one of the things we looked at was the election, upcoming, June 20, 2011.  We have just had the election in Turkey.  Erdogan and the AKP, or the Justice and Development Party, want a third term.  Again, as we discussed quite a bit in that interview with Mr. Bokhari, the direction of Turkey, both nationally and regionally, hangs on this election.

Kevin: David, what Bokhari was talking about was this void that had been created in the Middle East when we took Saddam Hussein out.  Now, Saddam Hussein was a bad guy.  You take him out, but you create a void that only can be filled from one direction or another.  It either is filled by Iran, or it is filled by Turkey.

David: And in fact, there was a third option, which would have been Egypt, until Mubarak was overthrown.  So, exactly – this power vacuum has to be filled, and who will be the regional player?  Who will be the dominant voice within the world of Islam?  And it is pretty easy to imagine the Ottoman Empire reborn.

Kevin: Turkey is not necessarily just a dictatorship.  In other words, Erdogan doesn’t have open season on being able to do anything he wants.  There still has to be a vote.

David: You’re right Kevin, they have a parliamentary system in which they have 550 seats, and it has to be a multi-party cooperation unless one of two circumstances occurs.  If during this election you end up with a super-majority, which would be 367 seats out of the 550, or just a majority – not the supermajority, but just a regular majority, 330 seats – then you can approach politics very differently.  With a supermajority, Erdogan could have done anything he wanted without any recourse.

Kevin: Did he get that?

David: No, he didn’t, and he didn’t even get the majority, so there were two things communicated.  One, Turkish people really like the fact that they have had close to a decade of economic growth, this last year between 9% and 13% GDP growth.

Kevin: Do you think that’s why the incumbency worked for him?  Let’s face it, when you have economic growth, remember the Clinton years, he got back in partially because the United States was on an expansionary cycle, and it really didn’t have anything to do with him.

David: If you want to talk about American politics for a second, it has been in U.S. history that any incumbent president who comes into that final stretch, if unemployment is above 7.2%, they’re out – they’re out.  So that employment number is very critical.

Kevin: Even in Turkey?

David: Even in Turkey, so he has brought about a great social success.  At the same time, there are a diverse number of people,  groups within Turkey, who aren’t so sure that they wanted him to have sort of dictatorial or autocratic power, so he did not get the super-majority, and he missed the majority, 330 votes, by 4.  He got 326 votes.

Kevin: He missed it by that much.

David: And the difference is just that he would have had to go to the people in a direct referendum.  If he had gotten the 330 votes…. he can’t do anything he wants.  Here’s the concern that investors have had.  You know what he wants to do?  He ran on the platform of, “I’m rewriting the constitution.”  “Okay, well, how are you going to rewrite it?  Is it going to be more, or less, Islamist?”  That is the critical point.

Kevin: Do you sense that this is a shift toward more radical Islam for Turkey?

David: Ultimately it is, but not having the majority or supermajority, he is going to have to focus on regional, not just domestic, politics, and when he focuses on regional politics, that is going to include his relationships with Syria, with Iran, and with Russia.

Kevin: Let’s face it, on the other side, it also includes Israel.  This is the guy who was in power when the flotilla floated last year, and you went to Israel to find out really what that meant.

David: And that defines his role in the region, because what is he trying to do?  Is he trying to upset the balance of power in Israel?  No.  Does he really think he can change anything in terms of the Israel/Palestinian relationship?  No.  But by making a strong and public stand in support of the Palestinians, he communicates to the rest of the Islamic world the role that he intends to play as a regional leader.  He is being very vocal and it is for a very clear reason.  If he had been given the supermajority, we would have seen a rewritten constitution, and Shari’a law being something that was just commonplace in practice within Turkey.

Kevin: So we came dangerously close to a dictatorship in Turkey that would have moved toward radical Islam.

David: Right.  One last point:  He, recognizing that Egypt was a potential filler of that balance of power, that power vacuum, if you will, was nonsupportive of Mubarak.  Just a few months ago, with the uprisings in Egypt, we saw Erdogan condemn Mubarak and jump on his ouster immediately.  But, he has been very quiet, without initial comment at all, on Bashar al-Assad in Syria, and also on the bombing of Khadafi, and what we have seen in Libya.

Kevin: He is seeing the removal of competition in the Middle East.  Let’s face it.  He was looking toward Europe for a European Union membership just recently until Europe just continually shut the door in his face, so now he is looking East.

David: Exactly, exactly.  Looking East brings us to China, because that is the other thing that I think is particularly significant right now.  Jeremy Grantham, at GMO in Boston, points out that China is the world’s second largest economy.  They consume 53% of the world’s cement, they consume over 47% of the world’s iron ore, almost 47% of the world’s coal, 45% of its steel, and they are huge consumers of lead, nickel, aluminum, zinc, and copper.

Kevin: Really, it’s almost half of what the world produces that you make things out of:  Copper, lumber, zinc, and even what they eat.

David: That’s right, Kevin, we are not just talking about industrial metals, we are talking about consumables, as well.  As a percentage of the world’s pork, they are consuming 46%.  Of the world’s eggs, 37% disappear into the Chinese hole, (laughter) 28% of the world’s rice, 24% of the world’s soybeans.  Of course, this has been a major boon to Brazil, to Australia, to New Zealand, both on the industrial commodity side, and in terms of the consumables.  These are interesting times, because what we have seen so far is the reward.  We think there is going to be less reward and a lot more risk realized in coming months, both for China and their trade partners.

Kevin: David, you’re singing the song of Bert Dohmen, who last week said, the real surprise is probably going to come out of China.  I think about these people who are supplying these materials to China.  What occurs to them and the investors that are investing in those countries, if something does happen to China, and that consumption goes down?

David: Australia is a great case in point.  25.3% of their total exports  go to China.  Anything happens to China, guess who is in trouble?  Yes, the Australian market takes a hit.  In fact, when the Chinese economy hit the skids in 2008, the Australian dollar dove 39%.

Kevin: Currency diversification isn’t always a positive, it can actually be a negative.

David: I guess this is a point worth belaboring, because as people look, with reasonable concern, at an inflationary environment, there is the idea that, “I need to be in commodities.  That will give me diversification.” Or, “I need to be in foreign currencies.  I want to remain liquid, but I don’t necessarily want to be in dollars.”  All I can say is that you have a number of choices directly tied into the Chinese thesis, and if anything is impaired in that thesis, so are you.

Kevin: It was interesting.  We got a couple of calls after Bert Dohmen, last week, called for a dollar rally.  Callers were saying, “What are you saying?  Are you saying the dollar, now, is going to go up, it is going to start buying more?”  That’s not what he was saying at all.  The dollar can continue to fall in buying power, but fall slower than some of these currencies that you are talking about, so it is relative.

David: It’s relative to other currencies, so it may rally relative to the Euro, because there, you are talking about who has the greater chicken pox.  “I’ve got two dots, and you’ve got twelve.”  Really, you are just talking about relative maladies, you are not talking about relative strength.

Kevin: Okay, let me ask you, because this means a steak dinner between you and your dad.  You guys have talked about this.  Your dad is convinced that China is going to be the thing in the next couple of years, and you guys disagree on that.  Your real feeling is that there are some cracks in the dike.  What are some of the things that you are looking at that would make us think that maybe things aren’t as rosy in China as is reported?

David: I think the thing that you can bet on, is the hard work, the work ethic, the desire to succeed, amongst the Chinese people.  Don’t underestimate that.  But what I do remain suspicious of, and this probably reveals some philosophical bias – I don’t have confidence in a command economy.  I don’t have confidence in the ability of bureaucrats determining the best allocation of assets, and I think we’ve got plenty of historical precedence for how exactly poorly this works.

Kevin: Name a good communist country, as far as an economy goes.  When you go to the communist country, you say, “My gosh, this is such misallocation of assets.”

David: “Why is everything gray?  Why are they making only left shoes?”  When you move into production, it is interesting what happens in a command economy.  You have 17 state-owned enterprises that, according to the Chinese National Audit Office, have misreported their financial data, so you have this command economy which is misconstrued as a new form of capitalism, and it is running out of creative fixes.

Kevin: So when they say 5% inflation, it is probably not 5%.

David: No, it’s 11-16%.  It is twice, to three times, the stated inflation.  Let’s talk about gold for just half a second.  Last year, they quadrupled their imports of gold, and brought in, for the year 2010, 245 more tons than they actually produced.  They are now the world’s largest producer of gold – 245 tons all of last year.

Kevin: So they produce the most, yet they consume even more, so there is nothing coming out of China when it comes to gold.

David: In the first four months of 2011, they are already at 200 tons, according to the World Gold Council, so they are on pace to triple or quadruple last year’s imports of the metal, and the question might be, why?  Is it because they have some speculative energy?  Is it because the stars are in alignment and they’ve looked at all their astrological charts?  The Chinese do like the year of the rabbit, and the year of the dragon.  Is it the year of gold?  No.  It is the year of, “How do we save ourselves from understated inflation?”  And this is becoming a global issue, where individuals say, “How do I create an insulation from monetary policy being foisted upon me by our central bank, whatever central bank that is.  Pick whichever one you like.

Kevin: And the crazy thing is, we actually just import that inflation right off the bat, because they tie their currency to the dollar, so we print a dollar, and they have to print something, and it creates inflation for everybody.

David, another thing that I know you watch is leverage, both with the banking system, and in the private sector.  Leverage for central banks right now has been skyrocketing.

David: It has, and China is no stranger here.  Let’s start with Europe because that is where everyone has current concerns.  The central bank of Greece, for instance, has 159-to-1 leverage, if you are talking about their balance sheet.

Kevin: Wow, you had better not lose that bet.

David: Again, just for frame of reference, we are talking about Bear-Stearns and Lehman, between 36 and 40 times leverage before just a little hiccup caused bankruptcy, because they didn’t have enough capital to cover the liabilities.

Kevin: Let’s put this in perspective.  The average person who buys a house is either at 10-to-1, if they put 10% down, or they are at 5-to-1, if they put 20% down.  What you are talking about is 159-to-1 for the Greeks.

David: Pennies on the dollar, in terms of assets to liabilities.  At the Fed, we have been reporting that it has been 71-to-1 for some time, but it is not 71-to-1 anymore.  We thought that was a reasonable number, and it was for 2010.  Now it’s up to 103-to-1.

Kevin: So we are rolling the dice just as much.

David: Exactly.  The Federal Reserve Bank of New York is at 103-to-1, Ireland is at 122-to-1.  These are the central banks’ leveraged assets compared to liabilities.

Kevin: Okay, we were looking at China.  Is China leveraging right now?

David: (laughter).  “I have no concerns about China, I think they are the world’s greater story” – 1200-to-1!

Kevin: Which means your dad better win that steak.

David: (laughter) With a huge amount of nonperforming loans in the system, opacity that you can cut with knife!  We are talking about more numbers being obscured.  The fact that it is now coming to the attention of the audit office in China, and they are saying, “Guys.  Oh guys.  These SOEs have been lying to us.  The numbers aren’t adding up, they are misreporting the numbers.”

Kevin: SOEs are state-owned enterprises.  This is out of China, this is the command economy.

David: Yes, and it’s not just 1, it’s 17!  This is like saying, out of the Dow 30, 17 of them are lying about their numbers.  Would that be a news item?  That would be a news item, wouldn’t it be?  We are talking about 17 of the most significant organizations in China that are being caught red-handed.  What are the consequences?  You tell me.

Kevin: Yes, but David, you are talking command economy.  You can’t trust that, but we are in a, supposedly, capitalist, free-market economy.  Now, I am saying that tongue-in-cheek, because we have moved so far away from that, but there is leverage in our stock market.  In fact, it is one of those things that if you watch, and understand the past numbers, it can actually, in a way, to a degree, foretell the future direction of the market.

David: Anytime we have gotten margin accounts – this is what stock investors are borrowing from the house, so to say – anytime we have gotten a cumulative margin number above 350 billion, the next one-year period and two-year period following, are disastrous in the stock market.  It is ugly.

Kevin: That’s amazing.  350 billion just seems to be the magic number for a down market the next two years.

David: And we are at just over 360.  Let’s recall the last two times we were near 360.  Let’s see:  2007 – Oh, 2008 wasn’t too pleasant, was it?  That was painful.  What about before that?  2000?  Oh, 2001, that wasn’t so pleasant.

Kevin: March of 2000 it really started hurting.

David: What margin tells you is that, basically, the little guy who thinks he is going to maximize his returns, the few little guys that are still in the market, they are the last ones in.  They are the last ones to make a purchase.  There is no one else to buy.

Kevin: Is that a time, also, where you would watch junk bond purchases to see if speculation is increasing?

David: Speaking of last ones in, this is where Wall Street is enjoying the easy credit available to them.  They are putting together products that aren’t just lending to the big companies.  You can see a billion here, a billion there – there is a lot of money flowing in the fixed income space right now, so the credit markets are flowing, if you are a major corporation.  They have also started flowing to worst-credit bets, what we would consider junk bonds – high-yield fixed income, and now they are redefining junk bonds.  If you have a company that generates 5, 6 ,7, or 8 million dollars in gross revenues, now you can go to Wall Street, and you can borrow directly from Wall Street, too, and we are not talking about a local bank loan.  We are talking about going to Wall Street and financing 5 or 10 million dollars here and there.  Five to 10 million!  The requirement used to be 50 million for a small loan, if it is going to be financed and issued in the debt markets – 50, 100 ,150, 250.

Kevin: But you are talking about small, unproven enterprises going out and just being able to borrow in the junk bond market.

David: What we see in the junk bond space does look a lot like the leveraged market in equities, where the last guy just got in.

Kevin: It seems like we continue to make the same mistakes over and over.  It is like the model itself is flawed, the historic understanding of the model.  It is hard, as a human being, because we only have a limited history to maintain objectivity, and it seems that that is the most important thing.  Most of us like to think that we are objective, but in reality, we are formed by what you have called, in the past, first-order questions.  Our second-order actions are actually based on the very things that we learned, maybe, when we were young.  You have talked about the copybook, the old attitude of the things that you know are fundamental truths, you have the kids write over, and over, and over, out of the copybook.

David: Right, the distinction between first-order and second-order questions.  The first order questions are the things that you assume to be true.  You assume that gravity holds.  That’s why you don’t go jump off buildings because it is a pretty safe assumption that you are going to hit hard.  So there is the practice of, “I’m not going to defy gravity,” and there is the understanding of the law, and a predisposition, or a presupposition about the nature of the universe.  So you have the first-order questions, the things that you assume, and the second order, which are the things that you do on the basis of those assumptions.

Kevin: Let’s just jump in there.  You brought up gravity.  Let’s look at Aristotle.  For several thousand years people were following what Aristotle said about the earth being the center of the solar system, though they didn’t call it a solar system, and there were amazing mathematical models built on a false first-order premise.  It caused a lot of confusion, as anybody who has read Dante’s Divine Comedy will know.  This guy was an astronomer extraordinaire.  He was able to explain the movements of the planets, but it was from an earth-centric point of view.  Until Copernicus, or Keppler, or Galileo, we didn’t have an accurate rendering of that.  We really would not have had a Newton without that.  So the changing of that first-order misunderstanding changed everything over the last few hundred years.

David: I sat on a plane this last week, traveling from Seattle to Denver.  There was a young man that I sat next to who had just finished a Master’s Degree in geology.  We got to talking and I pointed out the fact that what we did was very similar.  The issues that he faces are very similar in his field, the field of geology, to ours, finance and economics.  A very bright guy, an enthusiastic young man, interested in folds, and interested in the impact of time and pressure on the earth’s crust.

Kevin: What is a fold, geologically?  Are you talking about the Rocky Mountains?

David: Sure, that would be an example of a fold.  That’s maybe an example of a broken fold.  Or if you look at geologic formations that haven’t broken, you can actually see some curvature, where it looks like an ox-bow in the river, only it is actually rock layers which have been bent through passage of time, pressure, and maybe even heat.  I am not a geologist, I don’t what causes them.

Kevin: That was this guy’s area of interest.

David: He is fascinated by them,  He is enriched by looking at them.  He loves the metamorphosis that he sees in these rock layers.  As we discussed the school of thought in which he had been trained, there was an acknowledgement – and the word that he used was faith – there was an acknowledgement of faith placed in the great names of science that had laid the groundwork for his intellectual explorations.  Their work was, in his mind, legitimate, even if their assumptions were, on his side of things, assumed to be correct, and admittedly, he had left them unchallenged.

Kevin: That goes to the Aristotle example.  It was unchallenged, even by the church.  The church gets a bad rap for following Aristotle, and rightfully so, but let’s face it, that was years and years ago.  How about in geology?  These men that he is reading, you have to challenge the assumptions, do you not?

David: Right.  We are not here today to discuss the differences between uniformitarian gradualism and catastrophism.  We did have a good discussion about that on the plane, but we are not laboring the point of the probability studies that support or detract from one or the other of those theories.  We have a topic that we have covered before, and considered before.  It is the significance of perspective in judging or reading the world around us.  This is what we are driving at.  How is it that two people can read a poem and walk away and surmise different content?  How is it that two observers in an art gallery can stand side by side and seemingly describe two different works of art while looking at the same thing?  Voters can listen to a political debate or a speech at a rally and some are enthralled and others are disgusted.

Kevin: Wouldn’t you say then, first-order questions determine their judgments?  The things that they grew up with and learned, and their predisposition, is how they are going to look at either art, poetry, or let’s face it, science.

David: Right.  So your first-order questions serve as the assumptions upon which your daily life gets lived.  Even if those questions never see the light of day, they are the baggage that you bring into relationships.  It is the bias that you have in conversations, whether it is philosophical, or theological, or political.  Those are the things that you are not supposed to talk about down at the pub.

Kevin: With that being said, you were talking to this gentleman about how your job, and what you do in the financial world, is relative to what he is doing.  How do you see the similarities working out?

David: We have two professional groups that practice, whatever they practice, whether it is finance and investments, or science, specifically, geology.  Whatever you may have studied at school, whatever exposure you may have had of a theoretical nature, you get to a certain point in life where you are just flat busy, and you are doing the work right in front of you.  You show up at 8:00 and you have a task to complete immediately.

Kevin: You don’t have time to go back and challenge the very foundations of what makes you think the way you think.

David: So it is the work of science, it is the work of an investment house, and there really isn’t a lot of allowance for those philosophical discussions, or a re-analysis of assumptions.

Kevin: Then let’s look at a couple of assumptions.  Let’s look at paper currency.  Is that an assumption that may be going away?  Is the assumption that paper assets versus physical assets are a better way to go, just because they are more convenient?  There are assumptions that our generation has become very comfortable with, but we are starting to see shaken.

David: We are witnessing what Alan Newman describes as a sea-change – a sea-change in the fundamental case against paper assets and the case for hard assets – the long-term secular shift that could conceivably keep gold in the superior position for quite some time to come.

Kevin, you remember freshmen psychology – well, maybe not (laughter).  Okay, psychology 101, Gestalt theory:  What is that?  Is it a bat?  Is it your mother-in-law?  Is this your worst nightmare?  Is it your best dream?  You see all these ink blotches, and what do they mean?  As a part of Gestalt theory, now you bring out these ambiguous pictures.  In the ambiguous pictures, are you looking at two ducks, or are you looking at a rabbit?  Are you looking at two vases, or are you looking at a face?  You look at it, and you look at it, and you look at it, and you only see one thing, because of your predisposition – whatever your predisposition is, not to add judgment to what your predispositions are – and then all of a sudden there is a perspective change.

Kevin: And then you can’t see anything else.  I remember those old pictures from the late 1800s of two women talking, or it’s a couple of faces.

David: A Gestalt switch is when you go from seeing one thing, one way, one second, and then the very next, seeing it completely differently.  I think that is what Newman is getting at – a sea-change in the fundamental case against paper assets and the case for hard assets.  I include real estate as a paper asset, because if it has debt against it, you have something floating out there which is out of your control.  It is not as hard as it would seem.  It is not as basic as the dirt that may be under your fingernails.

Kevin: Let’s face it, Dave, if, really, the world was able to see clearly that there was a shift to, for example, gold versus paper assets, there would be a massive void that had to be filled, because the whole world is into trillions and trillions of paper assets, and they are seeing them wither away, but they are really not truly reacting.  Let’s face it.  China is buying a lot of gold.  America?  Not really.

David: And there is no reason for our perception to have changed, because it is in these developing countries where inflation is acute.  You talked about the recent number – it went from 5.4 to 5.5%.  That is the official inflation rate in China.  Well, it’s not.  It’s closer to 11-16%.  The reality is, the average Chinese man, the average Chinese woman – guess what?  They know what real-world inflation is, because they don’t make enough income to be cushioned from the increase – this marginal increase in food prices.  It impacts them dramatically.  They look at the rest of their assets and they say, “If this is what is happening to our paper currency, what do we do with our savings?”  Any wonder that the imports in the last four months have already nearly rivaled what we saw, in total imports of gold into China, last year, for the entire year.

Kevin: In a way, what you are saying is hunger, itself, forces some of these switches.  David, this brings me back to a book by Thomas Kuhn that you had me read years ago.  You said, “Kevin, this is an absolute classic, you have to read this, everyone who has any sort of education needs to understand how the structure of scientific revolutions occurs.”  What you are talking about is a scientific theory, or a financial theory, or maybe even a relational theory, being challenged to the point where people don’t just slowly shift, but you actually have a cusp event where it snaps to the other side, but it almost takes a new generation.

David: It was interesting in this conversation with the young geologist.  It doesn’t matter whether you are a Wall Street professional, young or old, neophyte or battle-hardened, these are irrelevant.  One of the things that he said was very interesting.  He assumed that these leaders, these innovators in science, had, in fact, evolved in their thought processes over time, and I said, “No, no sir, what you don’t realize,” and I suggested that he read Kuhn’s book, “is that you create a community of belief, or a community of thought, and it becomes very intransigent.  It is the world as we know it.”  You are talking about daily practice within a community.  You show up to work at a Wall Street firm and you don’t challenge the status quo.  I remember Don originally going to work for Dow Chemical.  This was an internship, he was studying chemical engineering, and he was in his last year, and decided to take a summer internship with Dow Chemical.  His manager said, “Don, imagine your life as a calm, glassy sea.  Don’t make any ripples.”  When you show up to work, you are not supposed to be the person who is throwing down the gauntlet and saying, “Here’s how we are going to innovate and change.  This is how things are going to be different.  Here’s how we are going to make our mark, as a company.  Here’s how we can be different.  Here’s how we can innovate.”

No.  In fact, if you want to be a healthy participant within the community, you learn the rules of the community, you learn the beliefs of the community, or you can step outside the community.  Invited, or we’ll throw you out on your keester.”

Kevin: It’s the flat earth of society.  Basically, you just go with the flat earth theory until it absolutely doesn’t work anymore.

This does bring me to a memory of a guest of ours just a few weeks ago, who wrote the book, The Fourth Turning.  You have these cycles when people starting realizing there is a problem, but you really have to have an event, in a particular generation, to change the thinking radically.  He pointed out that we are in that period of time right now.  It seems to me like you are paralleling this with the Thomas Kuhn work.

David: The point I was making with that young man was that finance professionals are no different than scientists.   There are operative models that are generally accepted, that are utilized up until they are forced out due to either cumulative small failures, or utter bankruptcy of the idea, itself.  Practice ends up being the crucible of an idea, and when it’s no longer workable, assuming that it was internally coherent and verifiable externally to begin with, then all of a sudden it is no longer considered to be true, so you have a revolution of ideas.

Kevin: That brings me to a question.  We have had a paper currency paradigm most of our adult life.  Nixon closed the gold window completely in August of 1971.

David: And there was some concern about that.  With the run-up in gold up until 1980, there was an immediate reaction that said, “Hey, this is not good.  This can’t be good for us.”  But there was a paper solution that was offered, and it was, “Let’s show you more wealth than you can imagine, beyond the dreams of avarice.  You will succeed.  Just invest in the Dow and the S&P.”

Kevin: Then let me ask you the question:  Are we nearing the end of the age of paper?

David: Having enjoyed a clear benefit from 1980 to 2000, paper assets have been more and more challenged since then, since the year 2000.  Problems are arising, solutions are being attempted, further problems are being followed up on that.  So, as a paradigm, when you look for a revolution of ideas, this is just it.  Where is the explanatory power of the Keynesian system?  How do we solve this particular issue?  As Ben Bernanke begins to experiment with different monetary mechanisms, if any or all of them fail, we are getting to the point of community acceptance that it was a bad idea to begin with.  We just lived with it for a long time because we didn’t realize how many fleas were down under the fur.

Kevin: And actually, the problem is, going back to these first-order, and second-order movements, that if they are wrong, and they are unchallenged, you can run yourself right into a wall not changing your thinking.  If you have a singular vantage point, and you are going to stick to that no matter what because that’s how you’ve earned an income for all of your life, then, if it’s wrong, it’s going to be a rude awakening when you find out.

David: I think it’s going to be a rude awakening for some, and an expected reality for others.  The sea-change described by Alan Newman, may, in fact, have been underway for the last ten years, but who has perceived it?  The reality is right in front of you, why can’t you see it? It, again, comes back to those predisposed ideas or conceptions of what you are seeing and how you interpret it, how you read it.  It is, in fact, easy to ignore, if you are trained to see investment realities from, as you described, a singular vantage point.  We have Wall Street practitioners who have ignored the bull market in gold, largely because it didn’t fit their model.  It couldn’t be integrated without, in fact, destroying some part of their zeitgeist.

Kevin: They are almost blind to it.

David: If your livelihood depends on a perpetually positive outlook, a hopeful view of the world encouraged by the Keynesian smoothing, or elimination, of the business cycle, an attempt of that, anyway, then the rise in gold is an anomaly which you can easily explain away, you don’t have to address as an issue, because frankly, your system is better.  “We know it’s better, it’s been better, let me show you the past history, the last 20 years,” again, going back to 1980 to 2000, the age of paper.

Kevin: This could be a debate.  In one chair you could have the guy who is the Wall Street guy.  In another chair you could have the guy who is the banker, who says “cash only.”  In another chair you could have the gold guy.  At some point, each of those three guys is going to be right, and at some point, each of those three guys is going to be wrong.

David: In terms of ultimate realities, I’m anything but an agnostic, but when it comes to financial realities, I’m much more so.  We have, for years, taken, not a singular, but a three-part, or tripartite, view to investing.  If you look at the perspective triangle, we’ve realistically, at least by our reading, anticipated positive outcomes due to growth in the business cycle.  That’s why one-third of an allocation should be toward growth and income.  We’ve anticipated what can be positive outcomes, even in the event of deflation, by having an adequate allocation on the right side of the perspective triangle, to cash and cash equivalents, our liquidity mandate.  And we have encountered positive outcomes even with the extreme encounters of inflation, or superinflation, looking at the insurance component, which are precious metals.

Kevin: Gold – the foundation of the triangle.

David: At the end of it, it’s an agnostic allocation.  It is driven by the assumption that no one knows the future.  We can know human behavior.  We can know the workings of a political machine.  We can know something about history.  We can judge what might come next, again, going back to Neil Howe’s book, The Fourth Turning, but what we know with cold certainly is on a pretty short list.

Kevin: That’s the thing that I’ve loved about the triangle for the last 20 years.  It has allowed us to be sort of healthily schizophrenic.  In other words, we don’t have to commit to any one first-order question to be right, because we are allowing for, with those three allocations, things to happen outside of what our predictive power can bring, and still gain.

David: It is interesting, just considering, and I’m kind of fixated now on the conversation I had with this young man, the uniformitarian view, or the gradualist view…

Kevin: Billions, and billions, and billions of years.

David: Billions, and billions, and billions of years – that’s what it took, Darwinian evolution, or uniformitarianism being the substructure for Darwinian evolution.  It’s an excellent theory.  It offers a narrative explanation of our beginnings and perhaps current placement in natural history.  Ignore the fact that the probabilities are low, given even billions, and billions of years of random chance and sequential mutations are productive and additive and progressive.

Kevin: And ignore the fact that you really have no example of it actually occurring, biologically or geographically.

David: I feel like the modern equivalent is Jeremy Siegle’s book, Stocks for the Long Run, because it is a sort of progressive view of the markets, where, over a long enough period of time, everything comes into alignment, and there is nothing but profits, and it is like, “Wait a minute.  Jeremy.  My friend.  What about 1966 to 1982?  Was that particularly productive, in your averaging of 7% per year, or are you, in fact, looking at something that is more akin to catastrophism, wherein in a market cycle you have years of boom and there is a lot of money to be made, and you have years of bust, where if you aren’t careful you can hand it all back?  And then guess what?  You go right back to the boom and bust, and boom and bust.  If you average it out, or if you are able to avoid some of those down years, then you can cast it as something that is very uniform in nature, progressive, and growth-oriented, and in that case, we should all be invested in equities from heretofore, and forever.  But, there are these events which really can’t be taken into account by the sort of gradualist, or uniformitarian, view of the markets.

Kevin: They are called long-tail events because they weren’t supposed to happen, but it makes me think of Velikovsky, a friend of Albert Einstein’s, a brilliant scientist.  He took an exception to this whole gradualism theory, as far as how the earth was changed, and actually, how the solar system was changed.  He really believed that things actually went along in fits and starts, like you say that modern finance does, and now that we have sent probes out we are seeing the solar system, and we are realizing, that was a very violent, unpredictable place, and it wasn’t gradually formed.  When we are talking about forming, many people would say, and I would agree with this, that it was just created intelligently, but there are things going on out there that a human being cannot predict.

David: Kevin, coming back to the markets, there are periods of exceptional progress and advancement, and there are periods of destruction and deterioration.  That is largely what we have had for the last ten years.  It looks more and more like that 1966 to 1982 period.  But as much as we would like to conceive Wall Street as progressive, which it is at times, it’s equally regressive.  The low probability interruptions in sort of a financial saga, those black swans that you mention, or multiple standard deviation events, are like the catastrophic landscape, being altered by a singular event – a meteor, a flood, an earthquake, a volcanic eruption – low probability, and yet, they do occur.  Without allowing for the highly improbable, there is this tendency by most investors to assume that tomorrow will be as good as yesterday or today, and that hindsight bias can keep you in a defunct science, or an already disproven finance.

Kevin: Taking into the account the improbable, what you are basically saying, if I can restate it back to you, is that you have to protect yourself, from yourself.  Bert Dohmen, last week, was saying you have to be prepared for the impossible to happen.  We really cannot be fully prepared for, or predict, the impossible, but you’d better not be where you shouldn’t be when it does.

David: What Alan Newman describes that sea-change, which I think has been occurring for a decade, really is a system of Ponzi finance, and it’s running out of confident participants.  Equities, bonds, real estate, they are all going to get a reappraisal.  They are all going to see that moment where investors have the Gestalt switch, where at one moment, it’s two rabbits, and the next, it’s a dish.  What is it?  They were good investments yesterday, and now they are shunned today.  What changed?  Nothing changed.  The only thing that changed was perception.  Newman assumes that a return to a Dow-gold ratio of 6-to-1, roughly the average from 1975 to 1994, is a given.  I would argue that in an attempt to reach equilibrium, the averages, 6-to-1, or the actual number is 5.67, serve as a general and safe target to estimate, “this is where we’re going.”

Kevin: But markets almost always over-reach their boundaries, and then come back to an equilibrium number, do they not?

David: Exactly.  Going back to Aristotle, it is the idea that virtue is the mid-point between excess and deficiency.  The markets may want that mid-point, that may be an ideal, but what ends up happening, both in our moral lives, and in the marketplace, is a swing from one extreme to the other:  Piety – profligacy.  Excess – negativity.  What will ultimately take the Dow-gold ratio to a 3-to-1, or a 2-to-1, or a 1-to-1 ratio, is not fundamentals that justify those numbers, but market participants panicking out of paper assets and moving into the one thing that they consider to be trustworthy, namely, the one thing that is no one else’s liability.

Kevin: David, going back to the triangle, if a person has a third in an insurance policy of a gold type, physical gold, and a person has a third in growth and income types of investments, and then a third in cash to pay the bills, there really is that balance from excess, because each of those sides of the triangle, at some point, is going to move toward excess or reduction, but overall, they seem to compliment each other.

David: I think the best acknowledgment in some sort of a practice like that, where you have a balanced approach, is that you don’t know the future, and you should do something reasonable.

Posted in TranscriptsComments Off on June 15, 2011; A Gradual Sudden Catastrophe


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