Posted on 17 June 2011.
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.