Tag Archive | "Goldman Sachs"

Trumpo-Stocko-Mania! Let’s Party like it’s 1929

About this week’s show:
– Tobin’s Q,  (the canary in the coalmine for stocks) at 1929 & 2007 levels
– Goldman Sachs stock rises 50% since election of “outsider” Trump…Hmmm
– Venezuela cashless? Eliminates 80% of its circulating currency

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Nothing is Permanent…Beware the Consensus!

About this week’s show:
-When opinion is unified, prepare for the opposite
-Mario Draghi ramps up the currency war
-Two types of people: Believers in Fed success or gold buyers

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Giulio Gallarotti: The Power Curse

About this week’s show:
-Complexity is creating huge moral hazard
-Currency Wars are now the primary form of leverage
-Insensitivity to danger makes us RIPE for Collapse
-Be sure to read and purchase: The Power Curse: Influence and Illusion in World Politics

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Fed: “Let’s Penalize Unspent Cash”

About this week’s show:
-Stocks still lower than in 1999 (Inflation Adjusted)
-Fed’s Bullard NOW warns of Bubble Dynamics
-Fed Working Paper on Cash: Spend it or lose it
– Click here to read: Interest Rate Policy

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The Last Great Gold Hoard

About this week’s show:
-Numismatist Drew and David McAlvany in Europe
-“Your money? Sort of” Banks re-classify deposits
-Gold’s next move up will be explosive

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Dr. Joseph Tainter: The Collapse of Complex Societies

About this week’s show:
-Complexity is insidious in its increasing costs
-Maintaining the status quo is too expensive
-Crises are solvable with sufficient reserves
-Order Joseph Tainter’s book: The Collapse of Complex Societies (New Studies in Archaeology)

About the guest: Tainter’s best-known work is The Collapse of Complex Societies. Tainter argues that sustainability or collapse of societies follow from the success or failure of problem-solving institutions and that societies collapse when their investments in social complexity and their “energy subsidies” reach a point of diminishing marginal returns. He recognizes collapse when a society involuntarily sheds a significant portion of its complexity.

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Middle East Chaos: On the Sunni Side of the Street

About this week’s show:
-Confidence and ignorance driving current market
-Filling the Iraqi vacuum: Sunni or Shiite?
-What is the cost of holding the U.S. Dollar?


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Record Gold Sell-off, How and Why

-Friday’s sale of 400+ tons in futures contracts.
-How does a Gold(man) sell off work?
-Margin requirement increase adds feedback loop.
– Breaking News Video – Why is Gold and Silver Pulling Back? What’s Next? 

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December 21, 2011; When Will the Requisite Purge Occur in the World Economy? An Interview with Bill King

The McAlvany Weekly Commentary
With David McAlvany and Kevin Orrick

Kevin: David, it is times like these when we like to have Bill King on, because on one day we have good news and all the markets are up, and on another day we have what somebody considers bad news, and the markets are way down. There doesn’t seem to be any real continuity right now, and where there isn’t continuity in the short-run, we like to bring somebody in who not only has a long-term perspective, but looks at the short-run, as well.

David: I think what I conclude in this market is that if you are treading water, you’re doing just fine, because it’s tough to tell which direction this is going to go, and as our conversation has unfolded over the last year, the last 12 months, and even more than that, 2-3 years, we have regularly gone back and forth between the ideas of inflation and deflation.

Kevin: Sure.

David: And this is an important issue, because we have an outcome, economically, determined by decision-makers in Washington and on Wall Street, and we don’t know what the outcome will be, because we don’t know what the decision they will take will look like.

Kevin: We have a clash of the Titans. We have the Titans on one side who say, “We need more controlled socialism, we need more debt, we need to have more unity in paper currencies. And then we have the other side, which isn’t coordinated. It’s the market, itself. It is this hidden, unseen Titan, in a way, and these Titans are fighting each other all the time.

David: I think what we will end up seeing happen over the next 3-4 years is that battle become real, and ultimately, somebody wins the argument. And just because you win the argument, it doesn’t mean that you were right, it just means that you were more effective in your presentation. It will depend, I think, on what happens over the next couple of years, who comes into office here, in Europe, all around the world, and what kind of decisions are made, and the implications, both intended and unintended, on that basis.

Kevin: Wouldn’t you say, David, that other than it being maybe a scary time for people, because there is so much uncertainty, it is one of the most interesting times to be alive, because you have an entire social order that is going to have to change.

David: Yes, there is so much that is in the midst of changing, and so many interests that want to keep change from occurring. There are entrenched interests that would prefer not to see things change. Meanwhile, the market is speaking, and the market is saying, “We’ve been overcooked, we’ve been overdone now for 12, 15, 20 years. We’ve had too much leverage in the system, too much debt in the system, and we’ve got to let off some steam. We’ve got to see an unwind of this excess.”

Who will be implicated in that, Kevin? We’ve talked long and hard with people both here in the United States and overseas, as to the banking institutions, as to the individual countries, as to how individuals within those individual frameworks can be making decisions to not only survive, but thrive, in this environment.

Thriving in this environment is probably not looking at 100%, 200%, 300% annual returns. That is very unrealistic. Even 10%, 15%, or 20% returns may be unrealistic. Treading water, preserving your capital, keeping what you have, on balance, sitting the fence between a deflationary theme and an inflationary theme, knowing that politicians will choose one course or another, and not knowing, which means that investors have to sit and wait – a very challenging thing for investors to do.

Kevin: David, you talk about treading water, but actually, sometimes treading water is losing a little while you are treading water. There are times when you are treading water when you are not popping up and staying well above the water, you are just not drowning. I think of what Richard Russell has said for years: “It’s times like these that everyone loses. He who loses the least is the winner.”

David: I think when you keep your assets intact in that way, losing the least, and maintaining value, it puts you in a position, as we have discussed many years now with Russell Napier, the concept that in 1932, and 1949, just on the verge of the launch into the bull market of 1949 to 1966, 1982, and perhaps within the next 4-6 years, again, the unwind which leads us to the entry into a very productive period of time and a magical period of investment where you would have established cost basis at an epic low, and that is, for someone who has preserved value during these challenging times, very, very compelling.

Kevin: Bill King tends to give a great bird’s-eye view, and get you thinking on the right track for that timing. I’m wondering what the timing will be, David?

David: Bill, it’s nice to have you back on the program, and lots of questions to cover today, from quantitative easing, monetization, corporate earnings in the first quarter, the election calendar and what happens between now and the end of 2012, and a number of statistics which we should look at in detail. But if there is a big issue, what would you consider the primary concern to be, if you had to just focus on one thing?

Bill King: I think the big issue is, when are the global leaders finally going to do the requisite purging and reforms and restructuring that is necessary in the western world, and Japan. We have been going through this for over a year. Actually, the European situation has been two years. Nothing changes. You could trot out the same headlines and the same headlines are being trotted out, on almost a daily basis. Stocks are up, always because there is encouragement that Europe is going to resolve its crisis. Stocks go down the next day. People are disappointed – they are not going to solve their crisis.

These headlines have been repeated for two years and it is the same stupidity, and it is always some goofy bailout scheme that somebody is going to lend money that they don’t have, and when people call them and say, “Wait a minute, you guys are bankrupt.” “Well, we’ll create a fund, and that fund will be triple A rated.” Well, excuse me – nobody’s triple A rated that is supporting the fund. How can this be triple A rated?” “Oh, okay, we’ll come up with a second fund.” And then stocks rally, and you know, the garbage back and forth.

But you can see from the way the markets react, there is no leadership. Nobody will take the necessary hit or do the necessary restructuring on their watch because the political consequences are severe. So just keep pushing it out in the future.

David: That makes 2012 an enormous year: We have half of the G20 leaders changing next year, including in our country, but you also see the same thing in many countries in Europe, and we have already seen a couple of elections already/ So yes, that’s right, nobody wants to take the hit. What do you mean when you say the requisite purging? Are we talking about in the banks?

Bill: It’s everything. Sure, it’s everything. I’ve been screaming for years that the real problem in the banks wasn’t real estate. Yes, real estate was a problem, but the real problem is derivatives, that are hundreds of trillions, and the CDS, on and on and on, and they’re trading, and nothing is being done about it. In fact, the derivatives keep growing, and the reason they are doing it is to craft earnings. When you put rates down near zero, all the spread lending goes to hell. You are getting the deposits because of the markets being weak.

I just talked to a banker this weekend about it at a Christmas party, and they don’t want deposits because it costs them, because the interest rates are so low, they have no place to lend, and they are getting killed on the FDIC fees, because you have to pay fees on your deposits. It is a mess, because we have central planned markets, with the Fed and the government, and the market is not working. It cannot clear itself, whether it is real estate prices, which are still too high when you look at national income – we either have to get national income up or real estate down, and we have these big zombie banks walking around that government just keeps pouring money into, here, Europe, wherever, and every day it just keeps going on, nothing changes, nobody will take the axe to these guys and break them up, or make them erase capital, or pare down their derivative books.

You hit the key point. Because of the election of 2012 for so many nations, nobody wants to go out and say, “We have to take the hit.” Look, you have to take the hit. Reagan and Volcker took the hit in 1981 and 1982, and that created almost 20 years of prosperity, because they cleansed the system, restructured the economy, and that’s what has to be done. But no one wants to take that hit now, and the longer they delay, the worse it gets. They just tell you lies, and they keep piling up, and it just gets worse and worse, and that’s the problem.

David: So let’s say that 2012 is not the year, because nobody is going to do it on a voluntary basis, and if they can push it to 2013…

Bill: That’s what going to happen.

David: At what point do the issues – talking about fiscal issues, talking about economic issues, leverage in the system, derivatives, as you say – when do these things unwind on their own? They unwound in 2008. You could argue some of it began because of FASB rules and the shock to the banking system that they might actually have to mark things to market, strange as that may sound to the man on the street – counting things at their current market value, versus playing games with the numbers and calling them what you want to, on whatever basis. Is there a change in the rules under new leadership that causes this hit?

Bill: They got away from the marking to market. They are marking to fantasy again. Everything’s been thrown out. Look at what is going on with the banks. Banks have been crafting earnings for the last year-and-a-half or two, by depleting their loss reserves. That is why, this last quarter, even though the banks reported these wonderful earnings, enough people look at it and say, “You know what? This is not only wrong, this is dangerous. They are running down their loss reserves.”

And J.P. Morgan is not reserving against mortgage litigation because they claim that the FDIC is going to eat that. The FDIC is saying, “No, we’re not going to eat your mortgage litigation costs.” Anybody who says, “Buy a bank stock because it’s undervalued,” doesn’t know what they are talking about. You cannot buy a bank stock unless you know all the paper it has on its balance sheet, and the value. And even if you know all the derivatives, all the bad paper, nobody knows the value, because it’s marked by some model. Go out to the market and try to sell it, and see how far you get. You’re not going to get far.

That’s the problem. I’ve argued that 2008 and 2009 was a crisis. It wasn’t the crisis. Because when the crisis appeared in 2008 and 2009, central banks and governments came in and bailed out everything – not the economies – the main thing is they bailed out the banks. But in the process, they have bankrupted themselves. That’s what we are seeing now. Sovereign nations’ debt problems, inability to borrow – that is the game-changer. Because most people, whether they are professionals on Wall Street, or in the financial world, have been operating under the delusion that somebody will always bail them out, whether it was the Greenspan put, the Bernanke put. “The Fed is always going to save us, the government will always bail us out.”

What happens when, as we are seeing in Europe, when sovereign nations, people don’t have confidence in them and they start hammering their debt? Who bails them out? Who bails out Greece? “Well, okay, it will be the rest of Europe.” Well, wait a minute. What if, with the exception of Germany, everybody else is in trouble? “Well, we’ll create some new entity. We’ll create an EFSF fund.” Well, who guarantees that? “Well, all these bankrupt nations.” Oh, okay. “Well we’ll get the money from the IMF.” Wait a minute. The IMF is mostly the U.S., and the U.S. Congress has already said, “No, we’re not going to give you guys any money.”

And you can see, it goes on every day, and then you’re going to create these funds by bankrupt people. That’s exactly what they did with subprime mortgages. They took crappy paper, and threw in one or two good securities. Look at Europe – a lot of near-bankrupt countries. Throw in Germany and say, “Okay, we’ll make it all triple A rated.” That’s exactly what they did with the mortgage securities with subprime. How did that work out? And that was another delusion about, “Oh yeah, they’re triple A rated.” How could they be triple A rated, when it was mostly crappy paper?

It’s the same things that are going on now. They’re trying to create all these bailout funds. And then I saw today, the latest news, the sort of spark over the weekend was that the EU leaders wanted to put 200 billion more euros into the IMF for lending, demanded 25 billion euros from the U.K., and the U.K. said today, “No.” But it’s kind of funny, this is what they are doing. “We’re going to borrow money, put it into the IMF, so that we can then borrow from the IMF.” It’s absurd! That’s a daisy-chain bailout. It’s unbelievable! Who is the ECB? It’s the European nations, again, who are bankrupt, or near-bankrupt, with the exception of Germany.

And this nonsense goes on every day, and the game is to just keep this game going until some magic genie appears that will make everything better. And you can see that nothing is changing. We go day by day, the market gyrates and wiggles, and the rumors come out, and the stories. In the afternoon now, we get a daily rumor, about an hour before the New York Stock Exchange closes, about some new bailout scheme, where someone is going to put up some money into some fund, and then we get a rally until the close. Well, that is totally contrived, because they want to keep the stock market firm going into the close.

For example, last night, the markets were under pressure for all the negative reasons over the weekend, and Asia was getting hit. As soon as Asia closed – I mean it literally closed, and boom! Someone takes the S&Ps vertical by about 16 handles before Europe opened. Well, there’s no question somebody was trying to influence the opening in Europe so that it didn’t go to hell in a handbasket. And it stayed there for about 2-1/2 hours before the New York Stock Exchange opened and it started rolling over. We had a modestly higher opening and we’ve gone straight down.

So, it’s the same nonsense every day. People are fooling around in the markets, people who have vested interests to keep stocks higher. Just like now, the game today is watching Bank of America. As we speak, it is trading 501, 500 being a big threshold, because under 500 a lot of mutual funds and pensions cannot own it, and they are afraid of some kind of collapse. If you remember, we had this exercise a week or two ago where it traded down to 490-something, I can’t remember, and then right before the close, it was marked up above 500. That’s the game today – where are they going to close Bank of America today?

David: Whether it is Bank of America, Goldman, or J.P. Morgan – we are talking about U.S. Banks and financials and European banks, which are really in the same precarious place. Does 2012 represent the point in time where we see 10% of these major banks disappear, or 10% of these major banks get nationalized? We have seen Commerce Bank – that has been a discussion in Germany, the issue of what the state involvement is with running that bank now. Is nationalization the new trend in banking?

Bill: It will have to be, and I argue this is what should have been done in 2008 and 2009. That is the best way to protect the taxpayer. The taxpayer has put all this money into Citi, and other banks, AIG, whatever. Where’s the benefit? They will say, “Well, we sold the stock for this profit.” That’s garbage. Look at the money that these guys took out. It’s the same thing with GM. If you go in there and nationalize, wipe out all the equities, the bonds, wipe out the contracts, what you have done is you have bailed out the insiders, and in the GM case, you have bailed out the unions. If you were to nationalize these banks and then spin them out, you would save your taxpayers a lot of money.

David: What is the implication for pension funds, and insurance companies, with that wipe-out of equity?

Bill: They are going to lose their value, and if you hold those shares, that is exactly what will happen. And that’s the way it should be. These guys are the smartest guys in the world, they get all these fees to make decisions, so why do they own this junk? And then what happens when they make money? These guys extract the money. Goldman, after the crisis ebbed, made 30 billion in one quarter, and they took 20 billion out and paid it to themselves. Why was that allowed?

That’s why this isn’t capitalism. It drives me nuts when people say, “Oh, well, this capitalism isn’t working.” We don’t have capitalism here. We have crony socialism, where you give contracts to your buddies, you bail out your buddies or your friends, or the elites, on the back of taxpayers. Certain people always use the term, crony capitalism, but no, it’s crony socialism. That’s what it really is. Socialism is government control, central planning, picking winners and losers. So they can let your community banks go down and collapse, but they’re going to bail out, not only the big U.S. banks, they’re going to bail out the European banks.

And then you’ve got Dudley, the New York Fed Chief, trying to tell you this is good for U.S. taxpayers, to bail out European banks. Well, by a stretch of logic, what he won’t say is, because if we don’t, then we’ll have problems in our U.S. banks. But again, the problems just keep getting worse. If you nationalize them, wipe out all these stock options, especially for the executives, then you will get people being prudent again. Look what happened with MF Global. This guy was head of Goldman, a U.S. senator, Governor of New Jersey, and what did he do? And what happened to the firm? And what happened to the customers?

David: Let’s talk about rehypothecation. Is that anything other than theft?

Bill: No, I wouldn’t say it’s theft, it’s just that it’s stretching the limit. What a lot of people aren’t talking about, especially, is that what happened to MF Global is what happened to Long Term Capital Management. If you read the book, When Genius Failed, and other press articles, when the Street was talking about bailing out long-term capital, Corzine was in those meetings. He was the head of Goldman. He didn’t learn anything, because that is what they did.

What happens on Wall Street is that when you buy something, or you have money in your firm from all your different trading, you have a money desk there, and they are watching the money come in and go out, and the securities come in and go out. So what you want to do is that when you buy a U.S. bond, you immediately turn around and try to lend it out to somebody, you repo it out, and you get funds back in. Then you buy something else, you repo that out. And so you’re leveraging this up constantly.

What is interesting is that there are limits here in the U.S. to what you can do with your capital. In Europe there isn’t. That’s why this stuff all ends up in London. That’s why when they are saying, “Where’s the missing funds?” – a few articles allege that the funds are in J.P. Morgan, in London, because it is almost limitless what you can do there with this rehypothecation.

All hypothecation/rehypothecation is, is that you buy something, you get a security, you repo it out, and now you have money again. So then you buy something else, and then you lend that out. On and on and on. And this game works as long as your financing stays low. So that’s why the idiot Fed, that says they’re going to keep rates low for two years, or the rest of your lifetime, encourages this kind of speculation, because you don’t have to worry about your financing costs going up.

At the same time, what happens is that when you don’t have collateral, and this is what happened in 2008, why they lost control of the game, even with all of the bailing out they were trying to do and all the facility that was creating, is that people starting grabbing for collateral because they got scared. When you have that many people buying and repledging things, the chain breaks down, and once the chain breaks down, everything starts collapsing.

As the book, When Genius Failed, said, what these guys are doing is picking up nickels in front a bulldozer. In other words, when you keep buying and lending, buying and lending securities, more and more, it’s a very, very, very small spread, especially with low interest rates. But you do it so many times. In other words, if I can make a trade and make 20 cents on it, that’s great. But if the spread has collapsed down to only two cents, I’ve got to do ten times the leverage. If it goes down to one cent, that’s 20 times. What if it is half a cent? As long as I can keep levering that, I can maintain my profit – not the profit margin, but the net profit. So as the profit margin decreases, you keep looking for more and more leverage. That’s what is going on. That’s what appears to have gotten MF Global. And again, that’s what got Long Term Capital, to some degree.

David: On collateral, we have Dudley talking about taking European paper as collateral. Going back to 2008 and 2009, we saw the Fed accept all kinds of stuff, including the kitchen sink, into Maiden Lane I and II. Speak to collateral a little bit, because isn’t that really what we saw, a collateral call, with MF Global?

Bill: Yes, the system is so levered, because of all of this trading and speculation, and all these derivatives, and all this nonsense, that when people get concerned, they grab for collateral, and then the whole thing breaks down. Because they are playing this high speed game of buying and relending, and relending, and all of a sudden a few people pull the securities, and then there are shortages of collateral, and then this whole chain breaks down and it reverses. And when it reverses, you start losing money, and when you lose money, you take capital hits. And that makes you sell other things.

That’s why commodities are getting crushed now, too. The global economy and austerity means there is going to be weaker government spending, which means weaker economies, but also, the grab for collateral. That is one of the reasons, when the dollar goes up, if you remember, the dollar surged in October and November of 2008, and gold just got crushed, and everything got crushed, because that’s what was going on – when people start grabbing for collateral, they run to the dollar, because that’s what they are short. They are short dollars when they borrow. The whole chain breaks down – boom, boom, boom. And we’ve seen that happening in gold and the other commodities over the last month or so.

David: It’s a challenging picture, because as an individual, you ultimately have to make an allocation decision, and it seems really boring to look at the areas where there is not a lot of counter-party risk. Physical gold – no counter-party risk there. Dollars – I suppose you could stuff your mattress with them, but it appears that even if you put them at the bank, they may be rehypothecated. Nevertheless, between cash, or its equivalents, and gold, where else do you go in a period of unwind?

So we go back to that big issue that you mentioned. There is a necessary hit that has to be taken. It was voluntarily done under Reagan and Volcker. They took the hit. It is not now being done on a voluntary basis, which means things are going to get worse, not better, in terms of the ultimate ramifications. When this happens, even on an involuntary basis, where do you want to be? Because there is no good place, there are just better places.

Bill: Yes, exactly. That’s exactly right. That’s why the dollar is surging now, because it is a better place to be than in the euro or commodities, because we have deflation. We have had this ebb and flow of inflation/deflation. The system is trying to deflate. It’s clear. It has been trying to deflate for over twelve years. That’s what the big stock bubble collapse in 2000 was. And then we have central banks and governments trying to stave off the debt deflation, because they think it’s too horrible, and in the meantime, they have bankrupted themselves. And they have bankrupted individuals, they have bankrupted banks, on and on and on, instead of letting the system wash out. Greenspan wouldn’t allow it, because he was afraid that it would take the bank, because there is just too much leverage. So they make it worse and worse and worse.

They could have done this in 1991 when Citibank was down for the first time, the Bank of Boston, Bank of New England, all those banking problems in 1991 and he bailed them all out, leading to the carry trade. And then the Bank of Japan went to zero interest rates in 1995. So this thing has been going on for two decades, trying to stave off the day of reckoning for the financial markets.

David: So, what makes us think that 2012-2016 is the period where there is a forced comeuppance? Because surprise, surprise. At the end of the twelve years, we continue to be able to kick the can down the road.

Bill: You can keep doing it as long as you can borrow, and that’s what is happening now. The real crisis is the sovereign debt crisis, because that is the ultimate guarantor.

David: That is the game changer.

Bill: Right. That is because, “Well, you can always get bailed out.” And that’s what we did. That’s what Greenspan did. Go back to 1987. We are looking at 25 years of bailing out people. So if somebody comes into business at the age of 22 or 23, we are talking about, basically, everybody under the age of 50 has been in a market where they always believed someone’s going to bail out the markets. There’s a lot of experience of that.

At the same token, we haven’t had a bear market in bonds for 30 years, so again, we are talking about almost anybody under the age of 55 hasn’t traded in a real bond bear market. So you might go up for a quarter or two, or a year, but you always get saved, and the reason is because the government has kept buying bonds, whether it was for their own good or for currency intervention.

We have had an unbelievable period of central bank and government intervention in the markets and the economies, to save the socialistic model that developed early last century. Whether it was the European socialism or communism, or the U.S. socialism that Roosevelt created in the 1930s. This is an unwind of 75 years, or more, of this economy and financial system, and it’s going to be very painful. Again, they are just trying to extend and pretend, and hope for some magic genie to show up so they don’t have to take the hit.

But you are right, the market is forcing the hit, and just like it did with communism, when it started breaking up in 1989, 1990, 1991, the weakest nations just kept falling and falling and falling. And now that has spread into Europe, where the weakest nations are going down first there – Greece, Portugal, Ireland, Iceland, on and on, it’s just going to roll through the regions like that. And that’s what we are looking at, here.

And the big problem now is that it’s not just one or two, it’s everybody, because everybody has played this game for decades. And it’s the end game, because when you can’t borrow money anymore, or the rates start going up, then we are going to see the debt defaults. That’s what I see. I see debt default. Just look at history. This happens. You try to inflate, you try to borrow, you try austerity. There’s nothing new here. This has all been done many, many times.

Your only recourse then is either to go Weimar and just print it up and pay it, or you default. And the recent history is, you default. Whether it was Russia in 1998, or in 2001 and 2002 when we had Argentina, and we had other countries in there, too. You default, because that’s what best for your country, and that’s what leaders will figure out, eventually. “Okay, we just can’t pay it.”

And it’s not so drastic. Russia, in 3-4 years, was running incredible surpluses and acquired 200-300 billion in reserves, a lot of which was because the energy business took off, but you can default, and it works for your country, if, when you default, you do the necessary reforms. Then you can get back in the capital markets and borrow again. And they have. Again, the game here is for the elites to try to bail each other out, without taking the hit.

David: Is it any different for a country that has reserve currency status?

Bill: Yes, it would be, and that would be in reference to the U.S. again, that is, if you do the necessary reforms. I would tell you right now, if you said, “We’re going to run a balanced budget, we’re going to have a flat tax, we’re going to get rid of all this nonsense, and oh, by the way, we’re in default. Your T-bill is here, you’re only get this, whatever the number is, two-thirds, whatever it is – and we’ll take that half, and whack!” And at first people would be cautious to see if you follow that plan, but if you followed that plan, you would be fine. Look at how fast Russia rebounded.

David: Right.

Bill: It was very quickly. And what was their history of jurisprudence or business dealing? Please.

David: (laughter) Well, in terms of a default, we have roughly a 50/50 split, if you are looking at our Treasury market, held by foreigners versus held domestically.

Bill: Yes. But who holds it domestically? This was my view of why you should nationalize, that you shouldn’t bail out Wall Street, you should bail out all the bank deposits. When you start looking at the United States, with the average household and what their assets are, there is very little. You are only talking about a handful of people with assets. So when you are talking about Treasuries and you are talking about default, you are talking about the 1%, by and large, and institutions, obviously pension funds and insurance companies, and whatever, in here.

But this isn’t going to impact the average person on the street. Not to his balance sheet. It will have effect on the economy in the short-term, and that is why you will get default eventually, because with the majority of people, their balance sheet and checkbook isn’t impacted, because what assets they do have are in bank accounts. They are in passbooks, maybe CDs. But there aren’t a lot of people holding T-bills, maybe some money funds and that kind of thing. But it is not the same as the big institutionalized money that would get hit, or the big private wealth. That’s why the big private wealth has been a big buyer in gold. That’s their hedge. They buy gold and they are buying bonds, and they are just waiting it out.

David: Hypothetically, if we look at 2012, 2013, 2014, 2015, what do we see? Money market funds? Breaking the buck? Banking institutions?

Bill: I don’t know. See, the thing is, rightly so on the street is the argument, deflation or inflation, and we have been getting periods of both over the last decade. The deflation shows up because the system wants to deflate, and again, the central banks and governments are trying to prevent it by inflating.

David: Inflate it back.

Bill: Right. Right now, we are in deflation again, which you can see in the commodities – they are telling you that. Bernanke moved away from QE-II in May, and nobody listened to him. The FOMC said that the trade-offs of quantitative easing are no longer beneficial. And I’m thinking, “What else do people need to hear?” But yet, the same clowns are running around saying, “Oh, QE-III is imminent. It’s imminent, it’s imminent, it’s imminent.”

And you could see the rallies. When they did the QE-II you could see the bonds went down, the stocks and commodities went up, and then that kind of rolled over, and then we had the twist, we had another little rally, and then in October that all fell apart. And now everybody is running around saying, “Oh, QE-III in January, QE-II in January.”

Well, I don’t think so, but the point here is, we are getting both inflation and deflation on a periodic basis. Now, what’s the next big wave? I don’t know. But the one thing that I’m highly confident of is that we will get both, at some point in the future here, but it’s probably not going to be 2012, probably afterward, maybe a year from now, 2013 perhaps, when the new administration and new congress come in and start doing reforms, we will get the deflation, and it depends how far they will allow it to go before they inflate.

On the other hand, if we have an administration that comes in and tries to inflate right away, we’ll get the inflation, but then that will blow up when we get deflation. So my view is that we are going to get a big wave of inflation and deflation. That’s what history tells us. We just don’t know the sequence. So you have to have a portfolio constructed so that you are hedged against both, and when the wave develops you can jump on and play it, and you won’t get swamped and crushed by it.

David: We have Dennis Gartman saying we are in a new bear market in gold. Is he talking about a talking about a cyclical bear, or a secular bear? Is it over?

Bill: It’s too early to tell. Because what the governments will do – it’s way too early to tell.

David: We have gold up 630% during the duration over the last ten years, silver up 700%. These numbers aren’t the highs, these are current numbers. So, yes, they’ve had a good run, haven’t seen any sort of speculative blow-off phase, which you might expect at a tail-end of a super bull market. Maybe that’s around the corner, maybe it’s not. But yes, inflation/deflation, we know that there are fiscal measures that can be employed, and monetary measures which can be employed.

Fiscal measures are not all that popular with the voter base, unless you are sort of lynching the rich (laughter). Unfortunately, there is not enough money to take, and steal, and reallocate, to actually make a difference there. But fiscal measures really don’t work. I guess we’ve looked at the monetary measures as the only ones that they would employ, because they are not politically volatile – not if they can “control the inflation,” and maybe that is their misperception, that they can actually control it. It tends to move.

Bill: It’s the arrogance of these guys, mostly these Ivy League types, who spent a career saying, “Oh, we’ve just got to make the right policy mix.” No, they’re not that smart. And they’ve proven over the last how many decades that they’re not that smart, so why don’t they just get out of the way and let the market operate? And of course, they are saying now, as well, “We can’t, because it would be so horrible.”

Yeah, that’s the horror they created with their Keynesianism mantras and everything else, that they’re always going to be there to fine-tune and micromanage the economy and the financial system. And it’s not working. That’s another reason why they are digging in. This isn’t just the banks, this isn’t just the country – this is these guys’ lifetime work. It’s their self-esteem, it’s their egos, and they’re going to try to prove that they’re right, at all costs, no matter what the costs are.

And that’s another reason why we have to let the market work and get rid of all these clowns that want to put their fingers in the pie and keep manipulating it. And we are getting revolts all over the world about this type of action, and it’s going to continue. We are starting to get the social unrest. We are starting to see it here in the U.S. We don’t notice it in Europe, because they don’t talk about it as much, but it is going on, and it is probably going to worsen, because nobody is doing the requisite reforms. So they just keep making it worse and worse.

People will take a hit and pain, if they believe they are going to have a better future, which is what 1981 and 1982 was about, under Reagan. Thatcher did the same thing. Nobody here wants to do that, or in Europe. Nobody wants to go in and do what is necessary to reform. And until they do, we are going to play this silly game until the market revolts, like in 2008 when the market revolted. And the market is revolting now, and you can see they just keep trying to stop it.

That’s the only reason they are doing QE. It hasn’t gotten into the economy. It’s not helping. It’s not helping housing. And when people said to Bernanke, “QE is not working,” or “Why did you think QE was working?” The first words out of his mouth were, “Stock prices are up.” The first words out of his mouth! That’s the only thing they could hang their hat on is that they were inflating assets, and the reason they think that helps is that they are trying to get the banks recapitalized.

So this thing comes down to saving the big banks, and saving sovereign debt. And the reason sovereigns and the central banks are in trouble is because they were bailed out. They got too involved in the economy, they got too involved in the financial system, and now they are on the hook. Again, that’s the game changer.

David: So not 2012, 2013, 2014, 2015. We are still talking about a slow burn. It takes forever until it just happens and it’s done.

Bill: Yes, I think there are only two possible outcomes: One is that the market revolts, the second is that you get the right leaders in and get ahead of that, which is like what Volcker and Reagan did. They both saw how bad it was, they understood the problem, both of them. That’s the problem here, is that you have to give the medicine. You have to purge, but you also have to restructure. If the U.S. economy hadn’t been restructured – in other words, if we had just done austerity – it would have been horrible. So you have to do your austerity, but you also have to liberate the private market so it can do its work

It’s similar to after World War II, when everybody thought we were going into this enormous depression, back into the depression, because all the men were coming home, millions of men. There was going to be massive unemployment, on and on, and instead, we had this enormous boom. Now, it took a little bit, it took 3-4 years to purge that out, but then by 1949-1966, it was unbelievable prosperity, because you had pent-up savings, pent-up demand, after World War II. And the restructuring was done, and off to the races, the private market worked, and it worked splendidly.

We did the same thing in 1920. People call it the forgotten depression. The same thing after World War I, enormous inflation crushed the global economies. The scale of World War I had never been seen in history, and the costs were unimaginable at that time. There were problems, of course, like Weimar Germany, but here in the U.S. we had prosperity, because we were supplying grains and materials and supplies in World War I.

We had incredible inflation. We had the same thing, men coming home, and all of a sudden the factories and the farms weren’t as prosperous, the demand wasn’t there from Europe. Warren G. Harding was getting the advice that to get of the depression he should increase government spending and raise taxes. He went the other way. He cut government spending in half. He slashed taxes. It took a year-and-a-half, and then on to the roaring ’20s boom because he did the right thing.

That’s just what we need here, and just like Thatcher did when she started blowing up the British socialism. Of course, she had the benefit of north sea oil coming online too, which helped, but until you get someone who says, “Okay, we’re going to take the hit for a year-and-a-half, but we’re going to do it right, and we’re going to come out.”

That’s the problem in Europe. They want to stick austerity measures on people, but they don’t want to blow up the structure, to unleash the private sector. And unless you unleash the private sector, get the government off their backs, downsize government, you are just going to crush your country, and you are going to have some kind of revolution, because people aren’t going to take the austerity forever.

David: We have two different kinds of revolutionaries to remember this week. Vaclav Havel passed away, and so did Kim Jong Il. On the one hand, with the first, there was freedom which came on the other side of revolution, and on the other, with the second, two million people starving to death, and nuclear weapons. Those are sort of Kim Jong Il’s claims to fame, or infamy. The kind of leadership that we need – can you imagine it? Can you draw a caricature of that leadership, and do you see that emerging this election cycle, or is that something we have to wait another election cycle for here in the U.S.?

Bill: You know what, it depends on the country. The good thing in the U.S., and I was very negative in 2008 about what was happening, and maybe you should get your money out of the country, but I think the reason you see the dollar rallying now is that the people in Europe seem to want more socialism, whereas in the U.S., if you read the surveys, in everything you read, they want less. Most of the people in this country realize the problem is that government is too big – too much government spending.

The Tea Party keeps saying, “We want to cut government spending.” That is so abhorrent to the vested interests of big government and the welfare state that they go out of their minds. But it is coming. It’s going to happen. The mathematics tell you that the spending is going to get cut, it’s going to get slashed, it’s going to disappear in a huge way.

If you have the right leaders, you prepare the country for this, but you also have to prepare the means to get out, which again, is to unleash the private sector. We all know what that means. It means that you crush government – government regulations, the structure of government, government workers, government spending, etc. That’s how you get out of this. Everybody understands this, except, again, the diehard dependents of the state, and if they had any sense they would understand that that is all going to disappear, and that they are better off getting a productive economy.

That’s the thing here in the U.S. The U.S. had such an enormous economic and financial advantage after World War II that it was just incredible. Never in the history of man had we had a nation as powerful and had such an industrial and financial base. So by the mid and late 1960s the welfare state was unleashed, in an enormous way. It was the same thing in the cities – all these deals, it was just ridiculous. And you struggled in the 1970s. Then Reagan and Volcker unleashed the U.S. economy again and you went berserk in the 1980s, and into the 1990s, and you got away with this, and now that all the global economies are rolling over with this massive transfer of wealth from the western world to emerging markets, and you can’t support the socialism anymore.

It’s just like in a family. If you have a family of five, and two are very productive, and the other three live off of them, that’s great. All of a sudden, if you have only one productive, it starts to become a struggle, because you have four living off of one, and when the one that was productive all of a sudden is getting reduced, then the whole thing comes down. That’s the western world. It cannot afford its social welfare state that it has created over the last 70-80 years. We are unwinding a social, political, economic system. That’s what is going on. It’s huge. Beyond secular. This is Kondratiev type of stuff. And that’s why we are stuck in this, and we have been stuck in this for years.

David: Out of that Kondratiev-type change comes either leadership that you are pretty excited about, or leadership that you really want to hide from. We have seen both, the good and the bad. What would you suggest is a way that we could either help, or promote, or get behind positive change, as we see this requisite purging occur? What kind of mindset would you suggest we need to take on?

Bill: I just think people have to be informed. I think one of the reasons they are getting this now is that the elite media has lost control of the megaphone. We have the Internet, and we have other sources of information, and data, so people in the U.S. have begun to understand what the problems are here. Again, what you are hoping is that people vote in leaders that will do what is necessary. Right now, though, I don’t see that happening, especially over the next year, and even in 2013, I still think events are going to force people.

We have seen this in times of war, the same thing, the events force people to do things, and we just hope we have the leaders in charge, that when the real game starts playing, can make the adjustments on the fly, and understand what is happening and can lead the nation and get the people to do what has to be done. That is still a long way in front of us, I believe.

David: It sounds like we are talking about a totally different election cycle, not this one.

Bill: What FDR ran on in 1932 was cutting the deficit. That’s what he ran on – that Hoover was recklessly spending. And he came in and he did a 180. Again, I don’t care what people campaign on and what they say. What do they do? Especially, when the game is being played, when it’s real-time, and there are real situations, and real dangers, and opportunities appearing. Are they mentally and emotionally agile enough, and smart enough, to make the adjustments quickly, and lead the nation on the proper course? We’ll see.

David: What a happy note to head into Christmas with (laughter).

Bill: Yes, well, the good news is, if you are paying attention, and you have a reasonably sound portfolio – you are not levered, you are not in big debt, and you have a nice cash reserve, and you have your hedges against that cash – you can sit and wait and watch. There are a lot of people who are desperate, they are panicky, and they are fighting for their lives. Again, if you are treading water, you are winning right now.

David: Yes, for the laymen, essentially, you are talking about a cash and gold position – cash, and a hedge against it.

Bill: Yes, or something like that. Well, not farmland anymore, that got overpriced. One of the reasons I think grains are in trouble is because if you have a family farm, you don’t care what the price is, and you produce your crops. If you are some hedge fund or private equity group, and you are paying all-time highs for farmland, all of a sudden you start trying to produce every square inch of that property. And so you can see that the size of the crops now are just enormous. That’s how the commodity markets work. Produce too much and the price goes down.

So, again, it’s a game. We just don’t quite know. The information isn’t good out there. It’s being guarded, they don’t want people to know the truth. They are not telling the truth. So you just have to be very, very careful, and you have to be very defensive. If you own stocks, you’d better have verifiably sound balance sheets. I wouldn’t touch a big bank right now, because there is just no way to verify what their real holdings are. Just remember, when Washington Mutual sold for 2 billion dollars, it was carrying a book value of 75 billion, and it sold for 2 billion. How good was all that financial analysis and balance sheet analysis?

There are some great companies, some of the top tech companies, some like Johnson and Johnson, Exxon, these type of companies that have good, sound balance sheets, low in debt, a lot of cash, and a company that is going to exist, no matter what we get first – inflation, then the big deflation, or vice-versa. That’s fine. On a micro-level, you are looking for businesses that are going to be able to generate cash. That’s what you want. You want businesses that can generate cash no matter what kind of environment we have.

David: We look forward to having you back on the program some time next year.

Bill: Okay, great.

David: And looking forward to a dinner in Chicago before too long.

Bill: That would be very nice.

Kevin: David, it is Christmas-time, but that was a sobering talk. When you look back at 2008 and 2009, just so much went on. Bill says that was a crisis, but not the crisis, so we need to hold on for a little bit.

David: Because all of these problems continue to get pushed uphill if you will, and the responsibility is given to someone who has deeper pockets. In this case, we have reached the end game, so to speak, because the sovereigns’ ability to borrow, or inability to borrow, ends up being the game changer.

Kevin: And you know, they are running out of room, because when Europe wants to give the IMF money so that they can give it back to them, as you said, they are just playing games at this point. They are out of money. Now, when people start to realize that, the daisy-chain stops rolling. That’s what Bill is bringing out, isn’t he?

David: Yes, and I think one of the things that he is suggesting is that the voluntary purging is more attractive than the involuntary, when the market forces it – because guess what? You actually put yourself at a strategic advantage.

Let’s say, for instance, that in 2012 we had leadership that came in and was very strategic about what they put in place in terms of policy measures, and they were both austere, and as Bill said, also did something that helped restructure our economy. So on the one hand austerity, and on the other, restructuring the economy for growth.

If those two things were introduced in 2013 as a result of the elections in 2012, then we might, in fact, be the country to lead through the crisis. If we don’t, then the question is – who leads, if they are willing to take the hit voluntarily? Otherwise, we may find ourselves all in one nasty stew pot, all of us dealing with the same things, taking the hit, but the market forcing it on all of us, at inopportune times.

Kevin: Hindsight is 20/20, I know, but we have had Paul Craig Roberts on, and he was with the Reagan administration when they were trying to get some things through that would have continued to make the economy grow, but there was conflict at the time. We had Volcker, who was coming in and tightening things up, and actually, there were certain steps that were taken by the Reagan administration at that time, as well, to clean things up from the Carter years, to clean things up from the early 1970s, even the mistakes that Nixon made before he resigned. Looking back, that was painful. 1981, 1982,1983 – those were painful years, but look at what happened after that. That’s what Bill brought out.

David: And I think even scooting back a little further – 1974 and 1975 – there were painful years that preceded it, but there wasn’t a voice of leadership. So Bill is also correct in saying, “Listen, if this is painful, people will listen, and people will tolerate the pain, if they think they are following someone who is credible, who has the ability to say, ‘Here is where we are going, this is what we are going to do. Watch how I get it done.’”

It reminds me a little bit of Yuval Steinitz, and what he rolled out for the Israeli government, saying, “Listen, here is how we are going to increase taxes, and this is how we are going to decrease taxes, in an orderly fashion, immediately. Yes, we are going to use fiscal tools to solve this problem (this was back in 2008 and 2009), but this is our credible way of both solving the problem, and unwinding it. We are not looking at over-reaching our boundaries, we are not looking at permanently stretching our new-found capital, in terms of revenues to be allocated beyond the crisis, into pet projects. But if we have to increase the pain today, we will decrease it tomorrow – we promise you.” And you know what? Steinitz was right. He did what he said he was going to do, and they have done quite well, actually, in terms of recovery.

Kevin: Then, during this period of unknowns, since most of the people who are listening to us are not policy-makers or decision-makers in Washington, though there may be a few, what about the person who says, “David, it’s Christmastime, I’m trying to figure out what to do with my finances. I’m looking at this last year. I’m confused. What do I do now?” You and your dad, last week when you were talking on the program, came to the conclusion that you really need to keep your powder dry and ride this thing out, so that you can move the right direction when it presents itself. Is that what you would suggest?

David: It is, and it comes back to something that is very simple, along the lines of that back-of-the-napkin conversation, with the perspective triangle, where you have a balanced approach where a third of your capital is powder that is kept dry, a third of your capital is allocated to creating a hedge for the capital that is kept dry. You have precious metals, which are an offset to your currency risk, in your liquid position. And then you also have a productive bet, a play on recovery, if you will, where equities and bonds can be in the mix, selectively chosen. You do have that balance built in.

Kevin, as basic as that is, I think you come back to the basics in these challenging times, because if you don’t have those basics figured out and covered, then you don’t have anything covered.

Posted in TranscriptsComments Off on December 21, 2011; When Will the Requisite Purge Occur in the World Economy? An Interview with Bill King

December 8, 2011; Massive Emergency Bailout Temporarily Saves European Implosion

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, last week we had a show that was posted hours before this huge swap line infusion of currency over in Europe saved the day, but the reports came out afterward saying that banks were going to fail, literally, hours after we recorded that program, had that not occurred.

David: Kevin, I have looked all over for an increase in credit default swap spreads with individual institutions and I still can’t figure out which bank it would have been, whether a German or French bank, but the single line item in the Fed balance sheet, which is usually for pocket change, the kind of thing that you would have as a petty cash account in your company, expanded from, literally, a couple of million dollars, to 88 billion dollars. That was a first clue early in the week that somebody needed some kind of cash and they didn’t want to really draw attention to the fact that they were active in the markets, in a bailout scheme.

Kevin: David, that miscellaneous account at the Federal Reserve, is really treated as petty cash. We have talked about it before, it is like having a box with a few hundred dollars in it that you buy pizza with, and 88 billion dollars all of a sudden shows up. We talked about this before, but we are seeing huge amounts of money disappear and no one really wanting to talk about it. Like you said just now: “Was it a French bank? Was it a German bank?” We don’t know who was saved, but we know a lot of money was provided.

David: Just giving you some concept of what it was, within the first 24 hours of these funds being made available by six different central banks, 357 billion euros went someplace in order to keep the gears turning, and to prevent a freeze-up in the banking system within Europe.

Kevin: David, you have pointed out that this is just a temporary solution. This is papering over a problem that we discussed, and for the listener who wants to really understand the problem, they should listen to last week’s program, because you had terror in your voice. You are normally a calm guy, but you had this look on your face as if, unless something was done almost immediately, we were going to see a major failure over on the European side.

David: (laughter) I have mixed feelings, because on the one hand something was done immediately, but I don’t think that it actually is a solution. Here is what is at issue, Kevin: At issue are the European bank debts, and we are talking about commercial institutions. These institutions have over 2 trillion dollars which they need to be rolling over. These are loans that they have outstanding, debts that they have out to other institutions. They have to roll that over between now and the end of the year, and these are denominated in dollars, so U.S. money market funds, as we may have mentioned last week, have been willing to loan money to these banks. Essentially, these banks have been funding themselves with inexpensive money provided to them by U.S. and global money market funds.

Kevin: When you are talking about these banks, you are not talking about the ECB, in particular, you are talking about banks that answer to the ECB.

David: Exactly. That could be Societe Generale, that could be BNP Paribas, that could be Deutsche Bank, that could be Banco Bilbao, whether Spanish or Italian – all of them are funding themselves, to some degree, with short-term money, and a lot of this money has come from the U.S. in the form of money market deposits. U.S. investors place money with their brokerage firms, into a “cash equivalent,” where their assumption is that that can never break the buck. What we saw a few weeks ago was U.S. investors probably making lots and lots of calls to their money market managers, saying, “I hope you don’t have exposure to European paper,” and there was enough of an outcry that – guess what? Those money market funds said, “Okay, we’re done for the time being. We’ll see ya. We’ll be back, but not for now.” That created a rollover crisis for these banks which are reliant on short-term paper, again, in the form of commercial paper or repurchase agreements.

Kevin: The Federal Reserve and five other central banks basically stepped in and filled that void. And I’m part of that, Dave. I mean, let’s look at what this is. We have talked about this before. You continue to print money, you continue to keep interest rates unnaturally low, and what you are basically doing is diluting the buying power of the American public now to bail out Europe. It’s just another form of easy money, is it not?

David: It is a form of easy money, and I think this is what is interesting, because if European banks had to raise that money privately instead of through the central bank, the collateral would be significant. Something would have to be pledged. You would have an interested party on the other side wanting to know if there was a real value that could be assessed to the collateral that you were pledging. This is really the problem. It is why the ECB has to be involved, why the ECB is the conduit for these other central banks, and the liquidity that is being provided, because the ECB is really willing to turn a blind eye to the value of the collateral offered by these banks.

Kevin: It sounds a little bit like here on this shore, when we had the real estate bailout, all of a sudden the collateral didn’t match what the bailout was.

David: That’s exactly right, Kevin. Good recall. Maiden Lane I, Maiden Lane II. That’s where toxic paper went onto the New York Fed balance sheet and Treasuries were issued in response, so kind of a swap transaction. “Okay, you need liquidity, you need something better. What we are doing to do is just an even exchange, if you will. We’ll take the toxic, you take the good. We have time on our side, as the ‘Fed,’ to allow these assets to go back to normal value. You don’t want to sell them in a distressed period of time. We’ll just let them return to full value and we’ll recapture that, and maybe even have a profit at the end of the day.” That’s the stopgap measure we had with Maiden Lane I and Maiden Lane II, and that’s what we have right now – a stopgap issue. It solves liquidity crises in the moment, but it does not solve the debt crises and the solvency issues which remain.

Kevin: I think you have mentioned in the past, it solves the problem maybe for seven days at a time. In other words, we have maybe a seven-day reprieve, and then another seven-day reprieve. We talked last week about the Thirteen Days of Christmas, the critical days in the fate of the European Union, and it has to do with this 2 trillion dollars that you are talking about.

David: Yes, absolutely. Let’s talk about that, because on the one hand, you have private institutions or publicly traded institutions, if you will, but you are talking about commercial enterprises – banks that have to roll over 2 trillion dollars’ worth of short-term loans, and that’s now running in direct competition with the funding needs of central banks throughout Europe, which have close to 100-120 billion dollars, and that’s what we were talking about last week, with the Twelve, or Thirteen (and it’s actually more than that) Days of Christmas. We are talking about a competition in the debt markets for a scarce resource. That scarce resource is money.

Kevin: There is old borrowing and there is new borrowing. What you are talking about is that old borrowing is needing to roll over, and new borrowing needs to still come into the market.

David: That’s exactly right, in order to finance current budgetary requirements by these particular governments. The Financial Times ran an article last week, and one of our guests, Otmar Issing was the author. It was a fantastic piece. He basically said that the ECB’s bond buying is unacceptable. And let’s be clear on this: What happened last week was not ECB bond-buying. That’s not his point of concern. We are now talking about just the unlimited direct purchases of bonds, which the ECB has done already, to the tune of 200 billion euros.

Kevin: But they haven’t officially said that that is what they are going to do. They still say, “Well, we don’t do that.”

David: And what they’ve said, like most central banking measures, is, “This is short-term, and limited in scope.” So the unlimited promise of bond-buying – that’s what Issing is particularly critical of, because it goes back to the classic Walter Bagehot book, Lombard Street, written back in 1897, and he says, “This is the advice that needs to be taken,” sage advice that is not being taken by central bankers today. I will just quote from Bagehot. “First, that these loans should only be made at a very high rate of interest.”

Kevin: Right, to punish.

David: “This will operate as a heavy fine on unreasonable timidity, and will prevent the greatest number of applications by persons who do not require it.” That was the bar set. You had to do it at some sort of a penalty rate. There had to be an interest rate that was unattractive, even though this loan was necessary, otherwise everybody and their brother stands in line for free money.

The second point that Bagehot made was, “Secondly, at this rate, these advances should be made on all good banking securities and as largely as the public asked for them” In other words, we are talking about collateral that is pristine. “We want your best pledge security.”

Kevin, let’s say you want to borrow $100,000 from me and you are willing to put up some collateral, and you could put up…

Kevin: How about a mule and my best blanket?

David: Yeah, well (laughter) that, or some sort of a deed for your house. That gets a little uncomfortable for you because then you have family issues if you should ever have to have a capital call, or a margin call, where I come in and take your house. My personal preference would be, if you are going to borrow $100,000 from me, that you put up $50,000 to $70,000 in gold. That, to me, is pristine collateral. I know exactly what I have, and I am giving you a reasonable loan-to-value ratio and I feel like I am reasonably covered. You have a lot of skin in the game and this is a real asset.

Kevin: Right. What you are basically saying – what Issing is saying – is, “We don’t want to have unsecured debt going out.” That seems to be happening right now.

David: And he would be saying, “We don’t want to see the ECB become the repository for a bunch of crap,” in which it just becomes a dumping field for anyone with garbage paper. That’s a problem. That’s what the Fed did with Maiden Lane I and II, and I think he is very wise to say, “Hey, wait a minute. The ECB is different. The ECB has to be different.” Of course, this exposes his Bundesbank conservatism. He does believe that it should be at a penalty rate, and that the collateral should be pristine. Those two qualifications thus far have not been included, and he is saying it would be an utter disaster – an utter disaster – to continue as we have been, and if you make it an unlimited promise, then you are looking at the end of the ECB’s credibility.

Kevin: Do you think maybe he was writing this article in response to a concern with the new Mario Draghi regime, basically, running the ECB?

David: I think, absolutely, because what he has already seen is the promise of short-term and limited, and those are Draghi’s actual words.

Kevin: Short-term and limited – a little bit like short-term taking us off the gold standard in 1971, or short-term occupation of Spain by the Muslims.

David: Yeah, it only lasted for 700 years, and they were actually invited in! There were major political issues in Spain at the time, and they were invited in to bring stability. A general from North Africa was brought in and he said, “Okay, we’ll come – happy to be here – only be here temporarily.” The first clue should have been that he burned the boats, (laughter) and I feel like all of the world’s central bankers have said, “Okay, short-term, limited.” And we should all be noting that they are burning the boats. They are here to stay.

Kevin: So when the family comes over for Thanksgiving, and then stays until Christmas, and then stays until Easter, maybe that’s no longer temporary (laughter), and Draghi is basically saying, “Oh, yeah, we’re just going to do this temporarily.”

David: I want to quote from the Issing article in The Financial Times. They did a great job putting that in there. Issing says, “You’re transferring an obligation of public finance into a monetary phenomenon.  Then he goes on to say, “Stressing the role of the central bank as the ultimate buyer of public debt should be seen as an indication of the pathological state of public finances, not as a sign of strength. Again, it is this issue of, when the ECB makes an infinite promise, you should not see that as stabilizing, you should see that as a sign of pathology. Boy, he’s got that nailed.

Kevin: And David, for people who are not familiar with European central banker-speak, Issing is very eloquent and careful in what he says. What he is actually talking about is that they are transferring this problem, this crap public debt, into pure inflation. I’m just trying to cut to the chase, because that is what it would be, if it’s not temporary. They are going to print the money, they are going to lower the interest rates. It is going to turn into exactly what the Germans said they never, ever wanted again.

David: This is the point that he is very sensitive to. He realizes that a central bank, creating money, is doing that dependent on one variable: Credibility. Credibility is key. If your actions, at any time, create, even on an unintended basis, the consequence of a loss of credibility, then you, as a central banker, are out of a job, and can’t fulfill a function that, by a central banker’s own admission, is absolutely necessary. We would say, maybe not necessary, but again, if credibility is the key, then don’t do stupid things to eliminate that credibility.

Kevin: David, let’s go back and see if what they did, at least temporarily, worked. We talked last week about Spanish bonds and Italian bonds, especially the Italian bond auction, needing to succeed. Well, it did.

David: You are talking about the coordinated effort last week by five to six different central banks, funding money through the ECB to the banking industry.

Kevin: Yes, but the Spanish got to sell their bonds. The Italians got to sell their bonds.

David: Exactly. The yields came back under 7%. French paper was fully subscribed at reasonable rates, as well. The Spanish bond rates, immediately thereafter, were the highest they have been, but the bonds were over-subscribed, so the demand for those bonds was twice the paper on offer. Again, it had a “stabilizing” impact, in the immediate.

Kevin: Let’s face it, Dave. If you knew you were going to get paid on those Spanish bonds and they were offering 7%, or Italian bonds, or what have you – forget the fact that they are from Spain, or Italy, or bankrupt countries. What we are basically saying is that it has the full faith and credit of the United States government behind it, at this point.

David: (laughter) When you have six central banks backing up the ECB, well, five I guess, and then the ECB as well, so six total in the mix, that’s a lot of credibility. Now, guess what? That’s also a lot of credibility to lose if this begins to fade. We see that the actions did, in fact, relieve the immediate funding pressure. It provided liquidity from these foreign central banks to the ECB for further disbursement to the European banks, but, at the end of the day, it’s just a stopgap measure. And yes, it was needed, as the private sources of short-term funding were drying up, but money market managers here in the U.S., for the first time in a long time, were finally engaged with these issues. We explored some of the money market funds that we are familiar with, and have used, and fortunately, the ones that we have used were engaged with this process 18 months ago.

Kevin: So they had already stepped away.

David: Yes, not 18 days ago, when there was an uproar from the crowd, saying, “I think this is going to be a problem,” but they were thinking ahead of it, and they have been eliminating exposure to European banks all along.

Kevin: Talking about thinking ahead, one of the things that we have criticized over the last few years is S&P, and Moody’s, and Fitch, and these guys who are looking at problems, and ignoring them, because of old models. S&P downgraded last week, a number of institutions, did they not, saying that it is now time to look at risk in a different way?

David: Right. Now they are looking at country-specific elements, and funding-specific elements within specific countries, if that makes sense, that would impact the funding of these large financial institutions. These are very relevant risk factors, and on that basis, they downgraded 37 of the world’s largest financial institutions in a single week. Last week, we were talking fireworks. This is fantastic. As a student of financial history, it’s not going to get any more interesting than what we had in real time last week, perhaps until next week (laughter).

Kevin: (laughter) David, we talk about countries. We even talk about large blocks of countries, like the European Union. And then we talk about states and we have talked about municipal bonds. We don’t get, too often, into the individual category, though. Let’s say that the S&P was actually looking at the finances of someone who is in their teens, or in their 20s, these young households right now here in America. What kind of credit rating would they get?

David: They wouldn’t get a very good rating, and this is not just on the basis of not having any exposure to the credit markets, no record to base it on, a track record, so to say. Kevin, let’s look forward to what happens in the stock market over the next two, three, four years – what happens with earnings, what happens to profit margins with individual companies within the United States, and around the globe, on a couple of demographic variables, and that’s really what you were raising, the issue of a young, up-and-coming generation that is not going to have the same wherewithal that previous generations had, and that wherewithal comes from several sources. As we have talked about in last year’s DVD, there was the element of a decrease in savings. There was an average of about 10-12% annual savings in the U.S. between 1966 and 1982, and what fueled the equity bull market from 1982 to 2000 was two primary variables: One was a decrease in savings from that 10-12%, on average, to zero, so you are spending instead of setting aside, and in fact, you are spending through your savings, as well – going back and dipping into the bank account to go ahead and enjoy the here and now.

In addition to that, you had an increase in credit, so people were actually going into debt to consume yet even more. That was the cycle where interest rates were falling all the way through that period of time. You have brought out the fact that it has been about a 30-year dropping interest rate cycle. There is a vast difference between the household wealth of the over-65 set versus someone under 35, and this is really critical. We talked about this several weeks ago, contrasting the over-65 set and the under-35 set, just in terms of net worth. The net worth used to be, back in the 1980s, about a ten-times differential. And you would expect that. Somebody is 30 years on in their professional career. They have been able to buy assets and see them expand in value, and they have paid off some of their debt, so in terms of a total net worth statement, assets minus liabilities equals net worth, they should be about ten times ahead.

Kevin: But that was quadrupled.

David: 47 times! Almost quintupled. That is amazing. The additional statistic we would throw in this week is that 37% of young households have either zero, or negative, net worth.

Kevin: That’s a hard way to start. Right when you get out of college, or right when you get married, you have a negative net worth to start with.

David: And again, you are just taking your assets minus liabilities and that is your net worth. Yes, that is exactly right. College debt, and in some instances, even mortgage debt, are strapping this younger generation with a burden that many older generations never knew.

Kevin: David, that is also a period of time, looking back – there were eras when debt was not as cheap and as accessible as it has been over the last decade or so. Right now, you could get any debt for anything at almost any price.

David: I think the other thing is that the older set went to college when tuition, relative to the average income at the time, was not as inflated. That’s the issue. You have an inflation in education, thus an increase in the total stock of debt that a young couple is carrying, one, or two times, if they are both college-educated, and a first-time home purchase which was not done in nosebleed territory in terms of pricing. That has been the experience of anyone buying a house in the last ten years. These have been the peak prices, so you have paid very high prices, which have not appreciated, plus you are sitting on an outstanding stock of debt that was supposed to propel you forward professionally and give you greater opportunities. And yet, you can’t get past that negative net worth number.

Kevin: And getting past a negative net worth number can happen if you have a job, but unemployment right now is a huge, huge problem with the youth, as well. Teenage unemployment is at the highest level since the Great Depression. It is slightly better than it was in 2009 when it peaked at about 27%, and of course, the employment prospects remain better for the college-educated set. But listen, that doesn’t mean that it is easy, and it doesn’t mean that when you get a job it’s at the number that you thought it would be. I remember interviewing a young man out in Southern California about five years ago. He was a graduating senior at a private institution and he just looked at me very calmly, with a bit of swagger in his voice, and said, “Oh, I would expect $125,000 to start, and who knows what the bonus would be on top of that.” And I’m thinking to myself, “Who are you? What world do you exist in? I’ve looked at your resume, you have zero experience, and the fact that you are just now graduating with a four-year college degree. Someone has spent far too much time patting you on the back, and considering you to be the privileged and the best and the brightest. I am seeing an interesting resume, but not one that is compelling to the tune of $125,000 a year as starting salary. Excuse me.”

Kevin: That kind of salary, actually, would pay back college debt pretty quick. Most of these guys graduate with a pretty strong average debt, don’t they?

David: At least $22,000 to $28,000 is sitting there, and to be honest with you, I’m not sure where that statistic comes from, because everyone that I know carries a debt of $45,000 to $60,000. If they’ve gotten Master’s degrees, or have gone to college and specialized in something post graduate, yes, now you are talking $100,000, $200,000, or $250,000. I know many people in their 40s who still have $120,000 or $130,000 in debt, because they did a professional career advancement course of study beyond undergraduate.

Kevin: David, do you think because this money has been so easily available for that kind of thing, that is why tuition has risen so quickly? Tuition is the one thing that if you were to measure from an inflation index, would scare you to death.

David: Tuition is up 440% over the last 25 years. Kevin, college and university study has become big business, and it’s not so much the quality of education, as it is the quantity of students through the door. How many bucks can we put in the seat? That’s the revenue that we are going to generate on a per-year basis.

Kevin: But are they improving their critical thinking skills? Are they able to actually change direction when they need to, or are they just coming out in that one field?

David: Marc Faber, in a recent report, was pointing to a study done by New York University and the University of Virginia. What they came up with is that while there are more people getting degrees, they were finding at least one-third of all college students graduating had no improvement in critical thinking skills, no improvement in analytical reasoning, and no improvement in writing and communication skills. Kevin, what’s the point? This is like the song lyric, “Sixteen tons and what do you get?”

Kevin: (laughter) Right, “Another day older and deeper in debt.”

David: Even if you are just getting out of college, it would seem. Youth unemployment continues to increase, but Kevin, this is real interesting. For anyone who knows someone in the 18-25 year old range, there is a new sense of aimlessness, and a new purposelessness. I don’t know if it is the additional burden of debt, I don’t know what it is, exactly, Kevin. I certainly view this graduating class coming out now as graduating as serfs, frankly, forced to deal with, now, a conflicting view of themselves as super-special children of super-special people (laughter), and yet, nobody wants to hire them.

Kevin: Right.

David: Which doesn’t seem to be consistent. “I though I was super-special. Everyone has always patted me on the back and told me that I just need to study something that I enjoy so that I could have a job that I am deeply fulfilled in, and nobody seems to think I’m that special. Nobody is offering me a job.”

Kevin: Dave, I wonder, too – this is a generation that was raised on video games, for example, where you’ve got enough golden rings to go to the next level, and then you did this, and you went to the next level, like a Donkey-Kong generation, where you know that if you just do the correct things, and in this case, let’s say, go to college, get a degree…

David: You get to go to the next level.

Kevin: You get to the next level, yes.

David: We wonder what kind of voter is being created through these circumstances. Is it someone who has a skeptical eye to all authority, because they feel like they were misled somewhere along the way and perhaps the dream of being college-educated and launching, and having a life of “significance” on that basis, isn’t really a dream at all, it’s turning into a nightmare for them? Is it, on the other hand, the type of person who is going to be open to grand governmental solutions, who say, “You know, the market – this is what we were taught in our very left-leaning (laughter) college classes – the market has abused us, and government is the only solution?” We think there is going to be a certain openness amongst this new generation, and we just wonder what is going to fill that void.

Kevin: David, it is amazing, when I talk to people in this college town we live in here. Durango, Colorado is a college town. I often ask at the coffee shops, “What is your major?” It is almost overwhelmingly that it has a green leaning. It is some sort of environmental study, or ecology, and when I think about it, I say to myself, “Golly, I don’t know anybody who actually is studying how to produce something. It is just, really, how to save the earth.”

David: And there is no problem with that. I think that is laudable. except that all the funding for most of those programs comes from government grants, so your assumption in your professional career choice is that the government is going to spend the money to get this project going, and that is probably where the fly is deeply in the ointment.

Kevin: Again, David, this is not an indictment of anybody who is age 18-25, if you are industrious, if you are flexible, if you are educating yourself and interested. They say to be interesting, you need to interested, and there are lot of people out there, listening to the program right now, who are very interested, and they are going to get into the job market, but there is a major concern right now. Even for those who are employed, who are engaged – the wages are lower, David.

David: Kevin, we are certainly interested in social commentary, and trying to figure out what the world looks like from a qualitative standpoint for us. There are some quantitative elements here which we are also interested in because they drive us toward where we think the equity markets may be in coming years, and what may, in fact, be a reasonable investment thesis, not just for the next six months, but for the next six, or sixty, years. Are there significant trends that are taking place that will mark this generation and mark this generation’s investment thematics and investment choices?

Kevin, that brings us back around to this issue of students today, because we think they are going to be less inclined to be the robust consumers of tomorrow. Many of them are, in fact, critical of past generations for being over-consumptive, and as you said, Kevin, they do have a green leaning, and maybe that is coming from an educational bias, but they are seeing lots of people, with lots of stuff, and not a lot of happiness. A part of that is because a lot of that stuff, people don’t actually own outright. They do have it, but only because the loan was there and the money was cheap.

Kevin: So there is a positive twist to this, if a person starts to realize, “Wait a second, the world isn’t all about just buying the next iPod.” It isn’t all about the almighty dollar.

David: Exactly, and that period of 1966 to 1982 was a period where people were saying, “You know, I don’t think I need as much. I’m going to save more. I’m going to be smart about tomorrow. I’m gravely concerned about what I see in the world today, and if I’m going to take care of my own family someday, then I know I need to be making wise choices now.”

Kevin: But David, if I went backward in a time machine, right now, to 1966, and knew what the stock market was going to look like from 1966 to 1982, you can bet I wouldn’t be in the stock market.

David: Right, that’s a major concern for us, Kevin, because we have low wages, we have consumption and the impact of these declining trends on corporate profits. That’s been the story, and will continue to be the story, for the next 5-10 years. Labor compensation, according to Morgan Stanley economist, Gerard Minack, is at its lowest level in 50 years, compared to GDP. Labor compensation is on the decline, while consumption has been on the rise. What has filled the gap, Kevin? Comparing consumer outlays to labor income, the real divergence began back in 1970. We actually did begin to see a shift then, which really got into full gear in 1980-1982.

Kevin: I just want to insert this, David, before you go on, because what happened in 1971, on August 15th, was that the dollar went off of the gold standard, and so monetary discipline went out the window at about the same time that you start to see this increase of public spending.

David: And about ten years later, we saw a massive change in general sentiment, and rapid acceleration in consumer spending, which coincided with a change in interest rates right around 1980. Since then, even as wages have been declining, consumption, as I mentioned, has been on the increase. What has the gap been filled by?

Kevin: It’s debt. It’s just pure debt.

David: Yes, cheaper and cheaper rates, and on easier terms. Kevin, if that has been the story, is it safe for us, as investors, to assume that the drivers of the market of yesterday are necessarily the drivers of the market of tomorrow? And we would contend that, no, we will have different drivers, and in fact, some of the things that have been there to prop up and to fuel the market growth of yesterday simply are absent today.

Kevin: David, this newer generation that is going to be fueling whatever markets are out there is not going to be able to take on debt like we have seen in the past, and they are actually going to be experiencing the de-leveraging of old debt. We talked about old debts having to roll over, and new debts having to be taken out. Well, you can’t have the new debt if the old debt can’t get paid.

David: Yes, and sometimes people forget that de-leveraging is just a big word for paying down debt, and then an increase in savings is likely to occur amongst this generation, gradually beginning to see improvement in the national savings rate, as we speak, and that should be thought of in a future tense where the GDP growth dynamics of the last several decades are not being repeated, because, again, the Keynesian model impresses upon the human consciousness: Spend, spend, spend – thrift is for fools. Thrift and savings are re-emerging, Kevin, and I think long-term that is very positive, but short-term, that does mean a contraction in margins for corporations, it does mean a slow-down in sales, it does mean a shrinkage in earnings, and Kevin, that does mean something very tangible for someone who is investing in equities today.

Kevin: David, this is just the revisiting of the true business cycle. Yes, it’s grand, and it’s larger. These huge 30-year cycles, one direction or another, are caused by Keynesian economics, but you still have the contraction healing the economy. It just takes almost an entire adult lifetime for it to happen.

David: If the consumer is less of a driver of economic growth for years, and perhaps even decades, to come, that begs the question: Will government spending, and will deficit spending, be used to make up the difference in future years, as we have seen it done here in recent years? This is the critical point, because if this is, in fact, the case, Kevin, we will have a date with destiny very similar to that of the European debt crisis last week, the week before, and in coming weeks, in coming months, in Europe. This will be coming to a theater near you.

Kevin: The market basically says it’s unsustainable.

David: The growth was unsustainable – can’t do it – can’t be done on the basis of debt, and there weren’t enough savings to draw down from. The good news is that as the consumer does enter an age of thrift and savings, you are setting up the stockpile for growth and investment and a period of expansion in the business cycle in the future.

Kevin: Right, but that’s a long time in the future. Let me ask you about earnings for companies, David, because if, indeed, consumption is going to drop, and if there is less money available, coming up in this next generation, what happens to corporate profits?

David: That’s where they do get eroded, and I think this goes back to Jeremy Grantham’s comments we mentioned last week, when he said that this is probably the peak in the earnings cycle. And here is the interesting thing that he didn’t say, but that you should connect. If this is the peak in the earnings cycle, then this is probably the peak in the pricing cycle, as far as equities are concerned.

Kevin: Last week, David, you said this next year you really do expect several thousand points to come off of the stock market, barring some unforeseen huge infusion of cash, or what have you, from the government.

David, what we are talking about here sounds pretty dire for the market, but we are talking about the United States market. I know a lot of people right now who have been focusing on the emerging markets, and they have been focusing on China, and the attitude is that the United States and Europe may have their problems, but we also have this mentality that the emerging markets and China are going to be some sort of savior. Is that something that you can see happening?

David: Kevin, I think one of the things that is missing today amongst investors, and amongst people in general, is the patience requisite to be a successful investor, and they want to see something happen now. There is so much opportunity over the next 5-25 years, you just can’t expect to be rewarded in the next five minutes, and yet that is what we are used to, Kevin. We have become, and I don’t know how, but we have become like rats in the cage. If we can just tap the button and get the stimulus, tap the button and get the stimulus, tap the button and get the stimulus…

Kevin: It’s that video game mentality.

David: We’re happy, happy, happy, unless we’re sad, sad, sad, and we don’t have a time frame, we don’t have a patience escape, if you will, that would include what is happening now and its implications over the next 2, 3, 5, 7, or 10 years. If these things are the case, don’t worry. Don’t rush it. If you are rushing issues, you are going to find yourself in an awkward position.

What you just raised, Kevin, is a very interesting issue, in terms of the emerging markets, and the myth that they are going to carry the day. Going back again to Grantham’s comments, you remember the younger generation coming of age – low wages, low credit access – that’s the environment we are in. Many are already loaded with debt and simply unable to contribute to GDP growth as past generations have. In a long enough time frame, the good news is that we are talking about a new era of thrift. Even better news is that this prepares the investment world for fresh capital, non-leveraged, and it allows for a period of capital scarcity which drives marginal businesses out. You will see business failure, and that’s not a bad thing!

Kevin: And David, the whole investment strategy of buying low and selling high – unless things are allowed to fall to the low, you can’t ever get that low, and so the very best business cycles, or the very best investments that have ever played themselves out, were purchased during these periods of time.

David: There is a healthy evolutionary process embedded in the business cycle, where bad ideas fail and good ideas get to continue, so the strong survive. And Kevin, we would like to own the strong companies that have survived. We would like to get through the period of time, most like the 1966 to 1982 period of low growth rates, high levels of savings, and emerge again into an environment where savings which are, and will continue to be, set aside, get deployed into value investments. Again, by the time we get there – is this two years from now, or is this twelve years from now? We don’t know.

Kevin: For now, what do you see in the market? Are you thinking it is just going to be lethargic? You had mentioned that you thought we would see the stock market come down. That’s not set in stone, but you don’t see great gains in equities for at least the near term?

David: No, I don’t see anything fundamentally driving the market higher, so what you have driving the market higher is what we had last week. Tuesday, we had close to a 300-point move, on Wednesday, close to 500 points – 490 points up on the Dow. Kevin, this was liquidity-driven. Somebody had insider information. In case you think you are playing on an even playing field, understand that certain people sleep with other people, or certain people pay other people, or certain people dine with other people, and that may even be Goldman Sachs employees, sleeping, paying, and eating with Fed and Treasury officials. Kevin, this is fascinating – a fascinating period in time. So just wait around for QE-III, IV, V, and guess what you have? A reason for equity values to move higher. Is that something that is ultimately going to be rewarding for the long-term investor? We would argue, no.

I would just want to come back to your issue of the emerging market myth.

Kevin: Yes, Dave, the subject of emerging markets. We joke about it, that your dad likes to play with you on this one, because he really likes China, but are the emerging markets going to pull this one out?

David: Are they going to carry the weight of the world on their shoulders? Kevin, we have real credit growth in China, which is collapsing, we have the real estate market in China, which is imploding. We have banks, although they are state-controlled, which are still in trouble. Being state-controlled just means that they have more control over the information flow, and they can obscure things much more conveniently, so they can go further down the road. But I would say they are going down the road, limping along more and more as they go. The modern central bank panacea, Kevin, of money-printing, may, in fact, keep the gears churning within the emerging markets, but only with weaker currencies. We are really talking about the cost of growth in the emerging markets being seen and felt in the form of higher inflation.

Kevin: Yes, when somebody says weak currency, that’s sort of a euphemism for costing more.

David: Exactly. So lest we forget, rising inflation in developing countries is very de-stabilizing. The choice to print, and print, and print, has a very different and unsettling effect in places of the world where you are sort of on edge in terms of whether or not you can or cannot feed your family to begin with.

Kevin: David, I know a lot of times people say, “Well, I don’t like the U.S. stock market, so I’m going to go to another market because maybe it’s going to perform differently.” I think that may be a misunderstanding, because equities oftentimes correlate with each other very closely, don’t they?

David: Kevin, that’s the issue. There is some degree of correlation and Societe Generale did a great study on this, but there is always some degree of equity market correlation. What is unique is that you can normally expect one standard deviation, either more correlation, or less correlation. Somewhere between 40-60% is normal. Now we are consistently trading with global equity markets, in lockstep, at about an 80-85% correlation.

Kevin: In other words, when the stock market here in the United States, or in Europe, goes down, you can pretty much count on the Asian market, 85% of the time, going down.

David: It is going to be marginally better, or marginally worse, but they are moving in lockstep. 100% correlation would be spot-on, basically the same market. We’re not saying that’s the case. They are different, but you are only talking about a 15% variance, in terms of the actual numbers, so that they are moving, in the same direction, at the same times.

Kevin: David, last week your level of concern for the European markets and our markets was at almost a peak, and then, of course, the 357-billion-euro bailout came in – whatever you want to call it – the swap lines, what have you. It papered over it temporarily, but you’ve mentioned some things to the guys here, talking very personally, not necessarily about clients, but just to these guys, saying, “Look, this is the year. If there is going to be a Christmastime, for instance, when you are with family, friends, what have you, and they are confused, and they are concerned, this is the time to pull the napkin out, draw the triangle, and just show them the simple solution. It’s not like it’s a magic solution, but it definitely is something that can be simply stated, even a child would understand, but most people don’t do.

David: When you are with aunts and uncles, when you are with brothers and sisters, when you are with distant relatives, I think this is the time to definitely pull out the napkin, Kevin, and say, “Listen, this is real simple, but it’s one of the reasons why I come into the holiday season without the same stress and strain I’m hearing in your voice, and here’s why.”

Over a glass of eggnog, or mulled wine, just explain it as simply as possible. You have the base of the triangle, you have the sides of the triangle, and their performing mandates. This has to do with the expectations that you have, the requirements that you are putting on the asset base that you have. You take your liquid assets and you say, “Okay, I have to maintain my household, I have to pay bills. I have to continue to look for opportunities, manage a business, in addition to managing a household, in some instances, and therefore that right side of the perspective triangle is given to liquidity.”

Kevin, I was reminded of how important this liquidity function is, spending time with dear friends down in the Houston area for Thanksgiving. This is a company that is thriving. It is doing quite well. But, there is not enough liquidity to even make payroll.

Kevin: They are doing well, but they don’t have enough actual cash to pay the bills?

David: Part of it is because they are doing more and more business, and the terms of settlement on each transaction they have is 60, 90, 120 days – they are having to do all the work on their nickel. Yes, they are happy for more business, but as they have done more business, it has depleted their cash, and they don’t have the liquidity to operate.

This is my point, Kevin. Whether it is a household, or a business, don’t neglect the liquidity side of the perspective triangle. On the left-hand side of the triangle, again, we are talking about the mandates that you give them, not the specific things that you invest in, but the theoretical requirements that you put on them. So liquidity is there just to be available – to be liquid!

Kevin: That’s the right side. Then, the left side is the growth side.

David: Growth, or income, and you are talking about stocks and bonds. Again, I’m not going to give you the specifics, here, but you can have an equities or a securities exposure there, and its mandate is growth and income.

The bottom part of the triangle is insurance.

Kevin: That’s the gold.

David: Someone may have more silver than gold, more gold than silver, more platinum and palladium. I don’t care what’s at the base, as long as you are very clear on the mandates that you are giving your assets.

Kevin: That is physical holding of that particular item, something that you are not really looking for a paper contract saying that you have.

David: No, no, because then you would be introducing other elements of risk, and you wouldn’t want to compromise the strength and the surety of that insurance.

Kevin: With that side, no one has ever gone broke with an ounce of gold.

David: This is why you look at this combination, again, back of the napkin, and you say, “I like the fact that if it is an inflationary outcome, I have the base covered. I like the fact that if it is a deflationary outcome and the debt unwind, the deleveraging which we may see, part or total, here or overseas – I’m covered. I have that liquid portion. And I like the fact that if I am taken by surprise and somehow a rabbit’s pulled out of the hat, and we do find ourselves in the middle of a growth cycle again, I have a third of my assets which are able, like the sail, to collect the wind, and be empowered. I have an opportunity, and I have protection, all in one, by taking this balanced approach.”

The critical part is this, Kevin: Too many people are not engaged. Too many people have trusted their financial advisors to come to the table with all the answers, and I’m sorry, but there are very few financial advisors who are even asking the right questions, let alone having the right answers. What we find, in talking with clients, is that they generally are more curious than their own financial advisors, doing more homework than their own financial advisors, and this is why you are coming up with consternation, concern, bordering on the paranoid, where people are saying, “I just don’t think my bases are covered. I’ve been told over and over and over again, ‘Just don’t buy gold. Do anything else, but don’t buy gold.’” That’s the general stock advice that you get from Wall Street.

Kevin: David, indeed, a person should be able to draw this for anybody and explain this to anybody, and maybe it will, this holiday season, ease some tension, and actually help a person long-term.

David: Kevin, I think when you look at how simple this is, it obviously is not complex enough to include every decision that you make as a financial person, entity, business, family, what have you. But it gives you the simplicity that you need to organize your thoughts, to organize your assets, to organize the mandates, and to be able to categorize, and then move from one to the other, and determine whether or not you are making good decisions for that section of your asset base.

Kevin, it’s that idea of moving from simplicity to complexity, and then back to simplicity, that we find a very healthy way of approaching your finances, and this is the reality: When you sit down with your kids and grandkids, it needs to be boiled down to something that can fit on the back of a napkin, when you are trying to teach a life lesson, and you can say, “Here’s what I’d like for you to keep in mind. This is the way I handle my own finances. Obviously, there is more detail than I can share, but I want you to think in these terms, because there has to be a balanced approach. You have to take humility into account when you’re managing money, and as you are given more responsibility, by your grandmother, for example, as we are passing money intergenerationally, here are some principles I want you to keep in mind, and it begins with what we call our perspective triangle. It’s the way we manage our risk, it’s the way we look forward to opportunity, and it’s the way that we would like you, the next generation, to see that.”

Posted in TranscriptsComments Off on December 8, 2011; Massive Emergency Bailout Temporarily Saves European Implosion

September 14, 2011; Handing Over the Keynes to the Kingdom: European Discipline Destroyed

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, we’ve been talking a lot about Europe on our show, and the repeating theme is: Are we going to default? Or is austerity going to work? Where is the next bailout going to come from?

Look at China. China seems to step in almost like a super-hero right at the last minute and say, “Oh, well, we’re just going to go ahead and bail out Europe, one more time.” Is this repeating theme going anywhere, or is this just going to continue, ad infinitum?

David: Kevin, it’s kind of the death from a thousand cuts. We are looking at policy-makers experimenting with things that they have experimented with already, and they have failed over and over and over again, but that does not keep them from doing what Einstein thought was utter insanity. If something doesn’t work, you just have to stop it. Don’t continue to punish yourself with insanity.

There is nothing in Europe that we haven’t already discussed up to this point. The emergent crisis 18 months ago was a part of our conversation then. We included a detailed discussion with the European Central Bank co-founder, Otmar Issing, in an attempt to bring an aerial view to the things happening on the ground in Europe, at that point, in a very developmental stage.

I sometimes feel like we are looking at the issues over, and over, and over again, and my hope is that we are not just aimlessly repeating ourselves. Maybe it is that we are searching for nuance and the differences in perspective, in order to aid – whether it is our listeners or clients – in a decision-making process.

The end goal is for people to understand the times. The end goal is for people to take perspicacious, or wise, action, and be in a position where they can both preserve value and preserve assets, and see them grow. So again, we look at Europe because that is what is front and center today.

Kevin: David, we have had Bill King on a number of times as a guest. He outlines a simple, continually repeating theme that we probably need to understand overlays, as a structure, what we are seeing in Europe. His quote is, “Nations first try to inflate over their debt. Then they seek bailouts that are contingent on austerity plans.” Sounds familiar, doesn’t it? “But the austerity causes the economy to sink, impairing the ability to service debt. Citizens then violently protest the austerity measures, so countries then default and restructure the debt.”

That last step, we have not gotten to. We get right to the edge of this Greek default. In fact, 98% chance of a Greek default, according to the credit markets at this point.

David: Exactly, up from a 91% chance on Friday, so it’s a daily deterioration, and I think imminent has to be the word of the week. These are interesting times, as we watch materialize, in real time, something that is restructuring Europe as we know it, and, potentially, U.S./European relationships via the currency relationship in the capital markets.

We have the British, who are talking about completely restructuring their banks, and doing, frankly, what we described in conversation with Larry Kotlikoff not long ago – basically, ring-fencing the vital parts of the bank and allowing the speculative trade desks to be spun off, or run separately, with the risk managed very differently. There is a reconstructive process happening behind the scenes, and it is a very tricky situation for investors to be in, certainly one where you need to keep your eyes and ears very much open.

Kevin: When we talk about these overlying structures, these patterns, we have seen 3 of 4 steps. We know that when the 4th step comes, as in this particular case, countries then default and restructure their debt. That is the 4th step in this process.

My daughter lives in Manhattan, and the forecast a few weeks ago was that Hurricane Irene was going to come in. I had been planning to go visit her anyway, but we actually moved the ticket up because when you know a storm is coming, you prepare, and New York was not ready for a large storm. Thank the Lord, it passed over New York, as it could have been a horrible disaster.

But it was interesting, watching people prepare. Most people in New York really didn’t do a thing about it until hours before they heard the stores were going to close and the subways were going to shut down. Then all of a sudden people started buying bottles of water and tuna, though it wouldn’t have lasted them very long, and I’m wondering if the Europeans right now are prepared for what’s just about to happen.

David: I think the Germans are certainly trying to limit what would be the fallout from major structural changes within the EMU with membership changing potentially, even within days. When you know a storm is coming, Kevin, you are right, you prepare, and Germany has chosen to anticipate the worst. They are putting together a plan, as we speak, to aid their banks, and they are assuming a default in Greece. So they are now moving into – not triage, because the event has not occurred – but anticipation, “Do we have the supplies we need?”

Kevin: So the question is not if, but when, at this point – for Germany anyway.

David: Exactly, and they need to soften the blows for the banks, because the banks serve as a conduit of liquidity. The banks serve the economy as the connecting point. They are prized more critically than any other industry, particularly in this type of crisis.

Kevin: It sounds like the United States. We prized our banks more than anything else back in 2008.

David: We are on the cusp of an official default, and what that means is that we will see a write-down, or a marking down, of assets on bank balance sheets to reflect the already depreciated assets they hold. This is something that most people may not be aware of. But if you hold something to maturity, you can continue, for accounting purposes, to treat it as if it is a full-value asset, as opposed to something that has been impaired, or something that has lost value in the interim. So when the default occurs, there is an immediate marking down of that paper. It is no longer treated as a held-to-maturity asset.

Kevin: Let me make sure I understand what you are saying. When you give your kids saving bonds, it would be as if they were counting the end-maturity value the whole time, at the full amount?

David: Yes, even if it is trading at a discount. And of course, the Greek paper is trading at an extreme discount today. A default prices the asset immediately, and in the case of the Greek paper we are talking about, it implies a 50% loss, or more, by the assets held. This is different from institution to institution. There are certain institutions that hold sovereign paper on their balance sheets, and then you also have institutions that have branch banks in Greece, which is a different kind of Greek exposure. Particularly, when you are looking at the French banks, there are some that actually have branches, as I mentioned, and some, like a BNP, that are just chock full of the Greek debt, itself.

Kevin: And it’s not just the Greek debt. Since you are bringing up Greeks, we may as well go back to an ancient Greek who said, “Give me a lever long enough, and I can move the world.” The issue is leverage, right?

David: The issue is clearly leverage, because banks profit themselves, and they profit their shareholders, by enhancing their returns via leveraging the assets they have. The investments they have exceed the actual bank capital, and that allows them to see growth as long as they have an economic environment that is supportive to those assets appreciating. But that is the problem. If the assets go down instead, your losses can exceed the entirety of bank capital.

Kevin: That’s called bankruptcy, David.

David: That’s correct. So, to avoid bankruptcy for these financial institutions, governments have been – as we saw in 2008 and are seeing at present – committing larger and larger amounts of funds to supplement bank capital. It is all well and good to say to a bank via Basel II, or Basel III, “You need to raise the amount of capital that you have.” Well, raising capital is difficult to do in a stressed environment. You are basically going to the general public and saying, “Will you give me an IOU?” Or, “Will you be an investor in my bank?”

We will look at this in a minute, Kevin, but we are watching banks in the European context that have lost 40%, 50%, 60% of their equity value since the middle of the summer – just in the last few months – so this is a challenged effort. You can’t go to the general public and say, “Please, extend a loan. Will you? We’re good for it.” Because we are now in an environment where, actually, this is exactly like what bankers do to us. When you don’t need money, they are there to give you all that you want, on friendly terms. And when you need money, “Oh, no, no, no. No, you cannot have our precious capital.” So it is just being played in reverse. This is why governments are so involved, because the market says, “No. Bad bet. Not interested. Can’t have my hard-earned money.” So the government steps in for the sake of preserving normalcy and market stability, and it is pledging to support bank capital.

Kevin: But David, there are strange beneficiaries to these types of crises. If you owned the printing presses, or the company that prints currencies (laughter), these guys are printing like there is no tomorrow, are they not? Isn’t there a printer in Europe right now that is doing quite well? They are very busy.

David: It’s a classic business model, Kevin. Think of the Gutenberg printing press, think of all the good things that have come from printing presses, and there are many good things that have come from printing presses. The things that aren’t necessarily advantageous or attractive all seem to come from De La Rue, which is the British printer that has been responsible for printing currencies for over 150 different countries around the world.

Kevin: So the question is, “Oh, you want more currency? Just put your order in.”

David: (laughter). Now, of course, Kevin, when we are talking about support to the banking industry, we are really talking about digital credits and debits, but what is interesting is that it is already being rumored that a European currency has already been printed. ??… Who is that?

Kevin: Are you being conspiratorial? How strong is this rumor, Dave?

David: Not at all. I think if you look at the Greek leadership, and they know that default is inevitable, that is not necessarily how they are going to posture in front of the press. They will keep their game face on until the very last minute.

Kevin: But it is how they will posture in front of the printing press.

David: Well, that’s what is next, to say, “Unfortunately, we have had to make other arrangements, and will no longer be EMU participants.”

Kevin: I have a question, though, because the backbone of the European Union was supposed to be German integrity, German discipline, Bundesbank background. Even when we talked to Otmar Issing, these guys don’t want to see inflation. What we are talking about is inflationary.

David: It is inflationary, specifically, in the Greek context, but if you look at the original exchange rates, as any of these peripheral countries came into the EMU, if you look at the exchange rate that they had, it was hundreds-to-one, implying that they had been irresponsible with their inflation rates for decades. This is par for the course.

Kevin: So David, Athens airport is still operating. There are reporters going in right now to report what could be an imminent event. Are there other planes that are maybe stuffed full of currency?

David: Kevin, this is the rumor, that they have already printed the money. I don’t know if it is drachma, I don’t know what they are going to call it, but if they break from the EMU, it is to eliminate the debt burden, and they can do that via printing. “We’ll pay you back every dollar, it’s just going to be with a depreciating piece of paper.” We are back to the classic version of devaluation. We are back to the classic version of default. Not the kind that they are being forced to the brink of. They may very well default and have to make partial payments.

Kevin: But this is more South American.

David: This is more of a South American kind of default, where you just print and pay, and print and pay, and print and pay, and it may actually also be a North American version, as we are doing the same thing. But what they are regaining is monetary sovereignty, if they, in fact, leave the EMU. That’s what they gave up when they entered the union. Potentially, Kevin, at the Athens airport you may see transports delivering currency over the next few weeks. We are not positive, but we do know that change is imminent.

Kevin: David, going back to the subject of the Bundesbank, we interviewed Otmar Issing last year and we talked about the discipline of the background that the Germans had faced, and how they didn’t want to go through that again. Bundesbank and German mentality has played very much into the European Central Bank at this point. Is that still the case?

David: That’s what seems to be changing, and I think if there is anything of grave significance in Europe in the last ten days, it is not what is happening with Greece. That is attention-getting, because it is in the news and it defines something that is more of a spectacle, but something that we have been predicting and seeing for some time. Seeing Jürgen Stark resign last week, as one of the key principles at the European Central Bank…

Kevin: He was a Bundesbank guy in the past.

David: Exactly, and he represented a voice that brought stability, that was sort of an anchor, if you will. He says he resigned for personal reasons, and that is fine, but three years ahead of his term ending? In the midst of utter chaos within the European context? After last week being in direct conflict with other members of the ECB over the renewed purchase of European bonds? They have been doing this now for a couple of weeks, specifically, with Spanish and Italian paper, and they are driving the yields down, purchasing these bonds as they are issued, and having some success in doing that. But Kevin, this has been the problem. The Bundesbank judgment is, when you monetize, you will create inflation.

Kevin: We’ve seen it before.

David: Their job as central bankers is to look at inflation very carefully. Price stability is a mandate. It is a critical mandate. Unlike the U.S., they don’t have the dual mandate of price stability and full employment, so they’re focusing on price stability and saying, “No, what you are doing is putting into the pipeline a degree of inflation which we will not be able to contain. We disapprove of the monetization of this debt.”

Otmar Issing, from the sidelines, has been more and more critical of what the ECB is doing in support of the rest of Europe, and the European debt markets. This is what we talked about last week, Kevin. It is because what is implied is a quasi-fiscal union if one entity is now supporting the debt structure of all these individual countries. That was not supposed to be. Maybe it was desired, from behind the scenes. We don’t know. But we know that the original agreement was a monetary union only – a monetary union, not a fiscal union. With Jürgen Stark leaving, we really don’t have a counterweight to someone like Trichet. We don’t have a counterweight, frankly, to someone like Mario Draghi.

Kevin: This is what I’m asking. Granted, he may not act like an Italian, but he has an Italian name, and isn’t Italy the issue right now? (laughter)

David: That actually argues for him taking more of a hawkish view to inflation, and being less accommodative…

Kevin: Because he doesn’t want to look like an Italian.

David: Exactly. “I may be an Italian, I may be a Goldman man, but don’t paint me into that corner. I can do the right thing.” We’ll see how long he can do the right thing. This is the issue, Kevin. Draghi takes the reigns at the ECB from Trichet November 1st, and will his policies be as accommodative? Will he be as interventionist as Trichet has been? Likely, but with caveats. He needs to protect himself, because there is some suspicion relating to his home country, and perhaps loyalties therein.

The question is, the former Goldman man – can he prioritize European stability, or will he ultimately be taking calls from his Goldman cohorts to discuss who thrives and who fails over the next 2-4 years in the Eurozone?

Kevin: Now Dave, are you accusing Goldman-Sachs of possibly front-running, or getting inside information, or possibly even manipulating a situation for a particular outcome, and winning on the bet?

David: They have rolodexes that are impeccably designed, and probably kept under lock and key. This implies nothing, Kevin. They are not ever doing things that are clever.

Kevin: They’re doing God’s work. Isn’t that what we heard last year?

David: Godman-Sachs… (laughter). Kevin, this is the issue. They are so well-placed. We are talking about professional discussions amongst fellow bank CEOs and G20 leaders. These things have to be discussed in order to prevent disorderly chaos in the marketplace. So, “No, we’re not discussing these amongst ourselves, to then go have weekend soirees and figure out how we will personally trade against it, or trade for it. No, we’re not determining who is going to be going long, or who is going to be going short, taking positions in light of what our friend, Draghi, might be telling us.” No, I don’t think we can assume that Goldman will be doing any of that, or that Draghi would be participating. He is a man above reproach, as we have found all Goldman men to be.

Kevin: Let’s get to the crux of the matter, then, on the EMU. Let’s just try to think ahead a little bit. Let’s say we could get into a time machine, go forward a few weeks, a few months, maybe a couple of years. Where are the EMU participants going?

David: The crux is that they have to either move to fiscal union, which is the first option, or they can consolidate around a smaller core. Remember the credit market adjustments that took place as individual countries joined the euro – they saw their credit ratings improve, and they saw their credit costs decline. And what was that in light of?

Kevin: It was basically because Germany was involved.

David: Exactly. They had the benefit, by proxy, of being related to Germany. The recently proposed Eurobond carried the same mark of German credit. That is why people were thinking it was an interesting solution. The problem was that it was an implicit fiscal union, and therefore, on the basis of a referendum vote, was not likely to be approved. This idea of fiscal union is very unpopular. The question is, can the folks who are so for the eurozone get it pulled off without a referendum?

Kevin: David, we have talked before about the price of gold telling the truth on leaders, but so does the interest rate spread between different types of bonds. In the beginning, they were actually giving the rest of Europe the benefit of the doubt, based on Germany being there. But aren’t interest rates starting to tell a different tale?

David: Over the last 12-18 months, we have watched the spread between German bonds – the difference between German bonds and other European paper – widen further and further, which is just acknowledging the actual balance sheet differences that exist between the various European states. And, just to reiterate, there are really only two choices that exist. There is fiscal union, on the one hand, or a shrinking membership role, and a number of countries would be leaving of their own accord, not pressured out, preserving the EMU and allowing it even to become a better currency alternative on the open market.

Kevin: If you had to take a bet, one way or the other, right now, is fiscal union on the horizon? Or are we going to see this consolidation and remaining a monetary union?

David: I think a fiscal union is possible as long as it avoids a public vote, because that would never pass. It would never pass muster, so we are talking now about the cigar-filled, oak-paneled rooms, where men and women are making decisions behind the scenes, and “We have approved, for your benefit, the future of Europe.” The Lisbon Treaty is a part of this, Kevin. It can’t go that way, unless it is done surreptitiously.

Kevin: So whatever happens, they are going to have to find a way of increasing efficiency to continue to move. They are completely immobile at this point.

David: Well, if they scrape the barnacles off the bottom of the boat, they will find that efficiency, and that is essentially taking the peripheral countries out, or voluntarily letting them leave. This is an interesting thing, Kevin, because a lot of the power-hungry folks in Europe, the true socialist elite, don’t want to concede defeat in any part, and they are using very strong language – the term, “irrevocable,” regarding the commitment to the EMU. It was voluntary up front.

Kevin: Yes, when did it become irrevocable?

David: Well, that’s what is interesting. They are saying the treaty signed cannot be undone. I don’t think we have the complexity there in Europe that we had with the federalist north and the states’ rights south, here in the United States, several hundred years ago, but we do have this strange, “No, we’re in control, and you may not leave. We’re not approving that.”

Kevin: David, it’s Hotel California. You can check in, but you can never leave.

David: Well, I don’t know what is going to happen, Kevin. Nobody does know what is going to happen. But we do know that there are advantages to being able to inflate away your debt. We do know that, politically, austerity measures are death to the existing parties in power. You can’t tell the Greeks that they are going to be the ones that suffer. You can’t tell them that and expect to be re-elected. That is what we are seeing fall apart. It is political chaos, because the only thing that the Greek government can do is put in place austerity measures – fiscal measures. They lost their monetary tools. The contrast between us and them is so significant, because we can bandy about different fiscal measures, we can talk about the jobs creation program last week…

Kevin: And we can just print reserve currency.

David: And then we can just print, and print, and print, and we can pretend to try to solve the problem. Kevin, what is the cost of Obama’s new jobs program?

Kevin: 477 billion, amongst friends – especially if it’s already paid for.

David: I know, well, that’s what he said, originally. But it actually looks more like a 421-billion dollar tax hike.

Kevin: Oh, so it wasn’t already paid for.

David: No, no, no. If you look at it, this is what drives me crazy with politicians. They can’t just speak the simple truth. They have to pack it with so much ethos, they have to pack it with so much pathos, you feel guilty. “I’m abusing the elderly, and young children, if I don’t approve this jobs program!” Kevin – 477 billion dollars? And he thinks he is going to create half a million to two million jobs? That’s a million dollars per job created. A million dollars per job created, or if he does actually create two million jobs – 250 million.

Kevin: Maybe we just send people millions of dollars and just say, “Retire.”

David: Why don’t you find 10 million people that need an extra 50 grand? Because it’s going to end up making its way into the economy far more effectively than the government bureaucracy trying to “create jobs.” Kevin, this is the insanity.

Kevin: You’re just a Negative Nancy, Dave. You’re a Debbie Downer. I’m sorry, this is the wrong way to look at it, you should be supporting your president right now.

David: I would like to support the president. I would like to support a statesman. I would like to support leadership. I would like to support ideas that don’t have negative consequences. And Kevin, I fear what we are facing is the ultimate demise of our American dream, up and until we have adequate leadership to draw us out and through the other side.

Kevin: David, you are talking about how much it costs to bring about just a single new job under the president’s jobs plan, but the problem is, we are also paying for jobs over in Europe. We are talking about European bailouts, and Germans, and we are talking about austerity, and then we are talking about the ECB having a new lease on life, but what about us? We have spent an awful lot of money, more than the Chinese, more than the Russians, in the bailout of Europe.

David: And this was an interesting disclosure this summer. We found that, actually, we were very, very active in supporting foreign institutions in the 2008 period, via the Fed swap lines, and this is, I think, what we will see open here in the next few months, liquefying the world, the U.S. being the lender of last resort, and very ironically, the world’s largest debtor, in those moments of crisis, also being the world’s largest creditor at the same time. It is the ubiquity of our currency, and the limitlessness of it, that allows us to lend very short-term, overnight, via digital credits and debits.

Kevin, I think this is the stability component which the Fed has scripted for itself. It is going to spend an infinite number of dollars to maintain stability in the international markets. And we have, right now, in front of us, something that is begging for those swap lines to open. French banks are under pressure. German banks are under pressure. Why? Because of the assets that they hold via Greece. It is a strange web of interconnectedness, Kevin, but French banks have been under pressure since June 15th. We had Societe Generale sell off by 55% — 55%! Their stock is down 55% in a matter of months. BNP Paribas down 42%. Credit Agricole down 45%.

Kevin: David, recall 2008 here in America. We are seeing these same types of things happening right now in France.

David: Right, and this is what we were talking about last week, Kevin – the idea that a number of these institutions will have to merge to survive. The question is, what gets them through a moment of crisis where there is panic in the marketplace, and good reason to jump ship as an equity owner? Looking at insolvency, looking at your liabilities exceeding your total capital by 2, 3, 5, 10 times, because your equity has been sold off so precipitously. That is why the Fed is there. The Fed is there to make sure that the world does not come unglued financially. Does this have echoes of 2008? Yes, only we are not talking about single institution stability, Kevin, we are talking about entire countries, not just singular institutions.

Kevin: This is, in fact, a worldwide default, if it is allowed to go on. We have been joking about planes coming into Greece and replacing the currency, we have been talking about the ECB having a new lease, we have been talking about all these things, but they are highly, highly inflationary. Let me use a different word: Currency devaluationary. In other words, the European currency has been falling in its buying power. The U.S. dollar has been falling in its buying power. The only currency that really wasn’t falling in its buying power was the Swiss franc until they pegged the currency last week.

David: To the euro. Yes, so Kevin, I think the peg, at one point, also, is an interesting scenario. I don’t know that there is the resolve with the Swiss National Bank, or the depth of pocket, to continue to write the check and maintain that stated peg.

Kevin: What you are saying is, they may print money for a while to try to keep their currency down and stay pegged to the euro, but if the euro falls too far, do you think the Swiss might still break away?

David: The question is, how much money are they willing to spend in that effort? They could ultimately destabilize their own price stability, if you will, or purchasing power, in their own country.

Kevin: But you are not going to count this as a stable hedge, right now? In other words, you are not going to tell a client, “Hey, go buy the Swiss franc because it may still be a better hedge than another currency?”

David: Here’s the irony. It now stinks, like all the other fiat currencies. It just happens to be a better bet than the U.S. dollar, and other things that stink even worse. It is question of lesser evils. It is not a question of greater goods. That is where, I think, we come back to the gold bull market and see a duration for this market, as years – years. Why? This is really the point. It will endure as long as the Keynesian bias, long dominating the halls of the Fed, long dominating the halls of the Treasury, long dominating universities – as long as the Keynesian bias remains.

Kevin: And the Keynesian bias is, print money, or change fiscal policy, but basically, stay away from gold, stay away from discipline. We can spend hours talking about what currency is the best currency, and what is going to happen next to this paper market, or that paper market. Why is it that people avoid gold, which seems to be a natural answer. We are seeing the Europeans, at this point, start to compete with us, as far as buying gold. We have been buying gold from Europeans for years – your dad’s company, and now you run the company. That’s where we have gotten a lot of our gold. The Europeans are starting to finally wake up and say, well, maybe it’s not in Europe. Maybe it’s not in U.S. dollars. And maybe, after last week, it’s not in Swiss franc.

David: It was interesting, when I was down in Argentina, I ran into a German family that was on vacation. He worked for BMW, had been working for BMW for about 30 years in their HR department, and loves the company, loves the euro, loves the ease with which he can go from one country to the next. I asked him, flat out, what he thought about the stability of the euro, and he said, “It will always be stable. It has to be. Nobody wants to go back to changing currencies at borders.” I was thinking to myself, “Is that your only perspective? It’s just an issue of convenience?” There are deeper issues here. When we are talking about issues of convenience, that is one of the things that has had gold on the outside and U.S. dollars on the inside.

Kevin: Sure, because you don’t go to the grocery store with an ounce of gold.

David: Exactly. We have these biases on the basis of patterned behavior and ease of use, or convenience, which do dictate how we feel about certain asset classes. Gold, Kevin, is going to continue to remain front and center as a priority in peoples’ portfolios as long as we have negative real rates of return. We have talked, how many times, about Gibson’s Paradox and the Summers-Barsky Thesis.

Kevin: Right, which is simply if interest rates are too low, and inflation is too high, it’s not going to work.

David: If what you are earning on your investments, what you would qualify as your productive capital, what is supposed to be growing in terms of capital gains or providing income, if your real rate of return after you pay your taxes, and after you account for inflation, is negative, strip out all the reward – why did you take the risk? It did not make sense. So market participants come to the conclusion, in a negative real-rate environment – “I’m gonna opt out. At some point I will re-engage, when I can put my capital to work productively, but until that point, don’t force me to take risk without reward. Strip away the reward, and I’m just not gonna play.”

That is the growing awareness globally, Kevin, as we see interest rate suppression, not just in the United States, but in Europe, as well. We have seen the Europeans – Trichet just recently has qualified with the most recent inflation numbers. That is largely a balanced issue. They are no longer concerned about inflation. What he is doing is trying to set Draghi up to, in the first few months of being in office, be able to lower rates below the 1.5%, and again create that same, almost zero interest rate environment we have here in the United States. It ends up driving investor interest into gold, because there is a frustration. Where do you go when real world inflation, not the stated rate of inflation, but real world inflation, is nearing double digits, and taxes are on the increase because governments are desperate for revenue? You go to a place where you don’t have to take risk, or at least, in that environment, it is deemed as less risky than your other alternatives.

Kevin: David, what we have seen is about 80 years of a flawed system, the Keynesian system, that started out looking like it was working because of other factors. But really, Keynes talks about printing worthless money, spending it, and lowering interest rates when they shouldn’t be lowered. We have seen where Keynes has gone wrong. We are coming to a turning point. I think back to a great interview we had last year with a man named Hunter Lewis who wrote the book, Where Keynes Went Wrong. I think maybe it would be time to revisit that.

David: Kevin, just the discussion, because so many of Keynes’s ideas are assumed to be true. It is the basis upon which our policy-makers behave and act and think. And again, we never want to be construed as being disrespectful to the folks at the Fed and the Treasury. We are talking about people who earned their degrees, worked hard, stayed up late nights, drank lots of coffee, I am sure, in putting together what they thought was sort of their personal magnum opus. The problem is that good logic, with bad assumptions, ends you back with mistakes – mistakes. So we are not faulting their logic, we are faulting their assumptions, so many of which are based on the ideas of John Maynard Keynes.

Kevin: That is what makes it so hard to learn economics, to be honest with you, because Keynesian economics doesn’t make sense. You can get something for nothing? Money does grow on trees? And that’s okay? Because my parents didn’t tell me that.

David: I think you are right Kevin. Bringing Hunter Lewis back into the equation, and having him explore with us, again, where Keynes went wrong, why the Europeans, as well as those in the U.S., continue to bow to the throne of a dead academic? And are there better sets of ideas out there? Kevin, I don’t know what the revolution of ideas will look like, from a business standpoint, they view the gold bull market as something that is limited in scope, that the next 2-3 years, perhaps, will see its ultimate peak price.

But, when I consider how hard it is to see ideas change, and the fact that we are really talking about the death of an ideology, and until that ideology or world view changes, gold will have its place front and center, because that is, in fact, what is driving the price higher – the abuse of the Keynesian system. Now we are talking about an extension of 5-10 years. I don’t know.

We need a revolution of ideas, and the part of me that likes capital gains doesn’t mind seeing Keynes win the day. But the other part of me that says, “I love my children, my children’s children, and my children’s children’s children, and I want them to inherit plenty, not want,” wants to see change now, and wants to see the end of the gold bull market now, because it’s a better place to live. It’s a better place to exist. It’s a place that is based on right ideas, versus ideas that just seemed intelligent when they were adopted.

Posted in TranscriptsComments Off on September 14, 2011; Handing Over the Keynes to the Kingdom: European Discipline Destroyed

May 25, 2011; Debt, Derivatives and Dominoes

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, gold has been going up in dollars for the last few years, but something that a lot of times people do not pay attention to, is what is happening in other currencies.  Right now, isn’t gold very, very reactive to, for instance, the British pound, or the euro?

David: Kevin, characteristic of this particular bull market is gold and silver appreciating in every currency around the world and we have talked about this a number of times, in which we have basically said the inflation that we experience here in the United States is a rather benign thing, whether it is the single digit, which the BLS confesses to, or using their older models, as high as low double-digit, 10.7%, using their 1980 methodology, and it still, relative to our national income, and the average income for the average American, is insignificant.  But what we see, globally, is inflation on steroids.

Kevin: Are we seeing gold reacting to the inflation that other people are feeling overseas right now?

David: That is exactly right.  We see increased physical demand for metals other places in the world.  If you look at the U.S. market, it is still a dominant paper trade, where people will trade contracts, people will trade options, but the physical metals are really not important to most people here in the United States.  Globally, because they are experiencing on-the-street inflation, you are dealing with individual investors who are saying, “I’ve got to do something to protect myself against inflation, and against the demise of my home currency, whether that is the rupee, whether that is the pound sterling, whether that is the euro.

In every currency, globally, gold is moving up, silver has been, too, factor in the correction, and they are both in a strong up-trend.  Today, you have gold higher, at the highest levels they have ever been in euro and British pound terms.  We have just broken out to new highs.  This is similar to the U.S. market.  We are fairly fixated on ourselves here in the U.S. and don’t realize that gold is in a correction here, and it is not in a correction in other parts of the world, namely, the second largest economic block on the planet, and then, Britain, as well, the previous heavyweight in the monetary world.  We are in a raging bull market, across the globe.

Kevin: Dave, you and I were talking just recently about how in the United States, the public here is so numbed right now with QE-II and this talk of possibly a recovery.  It is like morphine that has numbed the body, and we are not matching the tempo of the rest of the world.  The tempo of the rest of the world is to buy gold and hedge against, not future inflation, but actually, hedge against the inflation that they are experiencing right now.

David: It is always a forward-looking project, too.  It is real world in that they are experiencing something of a money panic today, but it is with the outlook not really changing.  When they look at their monetary authorities, they come to the same conclusion we should here in the United States.  It’s the same song, it’s just a different verse.

Kevin: David, today we were talking to Trader Roy before we came into the studio.  This is a man who has been directly involved in the precious metals business as far back as the 1980 bull market.  He put things in perspective.  Back during that 1980 period, gold, you would think, was trading in extremely high volume.  People understood gold quite a bit at that time.  Gold shot up to $850 an ounce.  But about 3½ billion dollars of gold was traded per day.  He put that in perspective.  He said, “If you want to see what is really going on right now, guys, 38 billion dollars worth of gold is trading on a daily basis right now.”  Yet America is asleep.  It is not this hyper-energized understanding of gold like it was in 1980 when it was sky-rocketing.

David: Kevin, that perspective is interesting.  We have basically seen a ten-fold increase, a little bit more, from 3½ to 38 billion in gold traded per day.  Two-thirds of that, consistently, from then until now, was paper, one-third, physical metals.  Then, as now, we were trading about two-thirds of all volume in gold on the paper side, with about one-third being physical metals.  What was 1 to 1.2 billion dollars traded in physical metals in 1980, is now 12 to 14 billion dollars of physical metals traded every day.  That is a big increase, but then, remember this, too.  The world’s monetary aggregates are not up ten-fold, as the trading in gold is up ten-fold.  They are up twelve-fold.  We have far more liquidity in the marketplace today, and I think we will continue to see higher volumes in the metals market traded.  The biggest transition ahead is when we see two-thirds traded in paper, to two-thirds traded in physicals instead.

Kevin: Right now, physical trading is probably about 3-4 times what the entire gold market was, paper and physical, before, on a daily basis.  When he was putting this in perspective, Trader Roy said that it is actually these large hedge funds, and some of these larger institutions that are buying physical, and moving away from margin.  They have been burned with the rule changes at the commodities exchanges.  The strut that we saw in the metals just a few weeks ago was actually precipitated by a man-made event.

David: Kevin, we are going to talk today about debt, derivatives, and dominos.  These three things – debt, derivatives, and dominos – relate very well to the gold market, because as we explore this morning, the growing interest in the physical metals by the commodity trading advisers and the hedge funds, is not on the paper side of the trade.  They have, in the post 2008 world, become suspicious of counter-parties.  They don’t want to borrow money and have to pay back on short notice.  They don’t want to be any part of a rigged game.  They know how well rigged games can be played, and if they are not the ones calling the shots, they are going to be the patsies.  They are going to be the ones taken advantage of.

The reason why people are moving into gold today is on the basis of an insurance policy being necessary in the context of a concerted, global, competitive devaluation in currencies – not just the dollar – but as we have seen even today, with the euro, gold price in euros, and gold price in British pounds.  This is a devaluation globally.  We are seeing that response in the marketplace, but people aren’t playing games any more.  People aren’t wanting there to be any added risk variables in the metals that they hold.

Kevin: When you say people, you are actually talking about sophisticated investors.  The people down on the lower levels of investment right now are being fueled by risk and speculation and shooting for higher returns.  It is the large hedge fund manager right now that is battening down the hatches, is it not?

David: In the late summer of 2008 we had an interesting conversation with Bill King up in Chicago.  He has been in the commodity pits.  He has been trading in the financial markets and has been a guest on our program a number of times, and off-air, he commented that he had paid off his house recently, and had added a few ounces to the gold stash, and the interesting thing was, these guys have good instincts, and we are seeing a growing number of commentators, writers, traders, looking at this period of June to October as absolutely treacherous, where we could see a turn in the stock market.  What is the precipitating event?  We don’t know.  Is it the end of QE-II?

Kevin: Or could it be the European situation – Greece?

David: It could be.  We are going to talk a little bit about the European situation today, because it is really critical.  There are some undercurrents that are worth taking an appraisal of, and that is where we are going to begin talking about debt, derivatives, and dominos.

Kevin: Before we get to that, David, let me ask you a question.  When you were in the Bahamas earlier this year, silver was really perking and starting to show quite a bit of potential, but when asked if you could only own one investment this year, your reply was gold.  Can you explain your reasoning?  There were people who had stocked up on silver and it had paid off, but you still said gold first, without detracting from silver.  Explain.

David: It was interesting, Kevin, several participants were visibly surprised, and they stood up out of their seats and said, “Well, what about silver?”  They wanted to know.  They had already placed their bets and wanted to know immediately.  My response was that while I like and continue to own significant amounts of silver, we are moving into a period of international financial dislocation, similar to 2008, with differences being that the governments who were there to bail out the financial markets don’t have the balance sheets that they had then.

Kevin: They’re out of bullets.

David: Exactly.  To step in and bail out the markets this time around will look quite a bit different.  Silver would be fine, and I think will be fine, eventually, but gold was, and is, and will be, more of a solid choice based on its appeal in the midst of crisis.  Real money moves to that particular metal, gold, when other assets are not providing real returns, and silver tends to follow that trend.  I had no idea silver would run as it did in the first quarter of the year, but I am confident that gold will be the standout for 2011.

Part of this does tie directly into what we are talking about with Europe.  We had Italy, who was put on negative watch.  When a company puts a firm or a country on negative watch, whether it is Standard and Poor’s, or Fitch, they are giving it a one-third probability that over the next two years, that entity will be downgraded, so Italy has been put on negative watch.  Last week we had Greece downgraded three notches.  We covered this in our weekly comments on Friday on the wrap-up.

This is what we think is happening.  Greece has been an issue within Europe, and the fear there is that contagion will spread within the banking community if there is a reduction in the value of the assets held by those banks that are, in fact, Greek paper.

Kevin: There is a musical named Grease, and I keep hearing in the back of my head, “[Greece] is the word, is the word, is the word…” because really, that is all you see right now on television.  It seems to be the focus, not only of the Europeans, but it seems to be the focus here in America.  Those two don’t necessarily seem tied together.  But are they?

David: There are two things going on.  First of all, we have just the nuts and bolts of the way that a bank would buy different sovereign paper.  We had the opportunity to distribute mortgage-backed securities and agency paper for a number of years, and we have investors all over the world look at it and they said, “Okay, wait a minute.  I can buy treasuries that yield “x” percent, or I can buy agency paper, which has the implicit guarantee of the U.S. government, not explicit, like the treasuries, but the implicit guarantee, and I’ll earn an extra 150 basis points, 1 percent, 1½ percent more.”

Kevin: That sounds awfully familiar, David.  Let’s face it.  That has happened here in America a number of times, and it just blew up in 2008.

David: Right.  The same thing was done in the context of the European banking community.  You could buy euro-denominated German paper, or you could buy euro-denominated Spanish paper, or Greek paper, and earn a little bit more.  But one of the things that you were assuming was that Frankfurt had your back, and that the ECB would not allow failure.

Kevin: When you say Frankfurt had your back, you are talking about the European Central Bank?  That is where they are headquartered.

David: Correct.  This is the issue.  You had almost an implicit guarantee with these peripheral countries, where you may have made a little bit extra, and it made sense from a liquidity management standpoint.  For managing your float at the bank, you wanted to maximize the deposits.  So, to get paid a little more for really not taking any more risk, because, after all, the ECB had your back on that, it just made sense.  So you bought Greek paper, you bought Portuguese paper, you bought Spanish paper, you bought Irish paper, and that is what is chock full in these banks.

There are two tiers that we are going to discuss real quick.  One is an obvious exposure that these banks have, and that is, directly to this country-specific, euro-denominated paper.

Kevin: They bought paper that the country may not pay on.  That is considered a default.  That is the obvious risk.

David: Exactly.  When paper is marked down, if those banks have to take a loss on the paper, or it has to be marked to market because it is trading at a lower level than its original face value, it affects that banking institution’s leverage ratios, or “capital adequacy ratios,” as they like to call them.  Capital adequacy ratios are just tier-1 capital, plus tier-2 capital, divided by the risk-weighted assets on their balance sheets.

Kevin: But for the guy who doesn’t understand that equation, let’s face it.  Credit default swaps are here to help us.  We have insurance against these events, so this obvious default risk really shouldn’t be an obvious default risk, because there are credit default swaps.

David: Tier-1 capital, you are supposed to have a 4% cushion on, so if you want to put it in laymen’s terms, rather than CAR, and all the fancy names that go with it, you need to have a cash cushion, and if the bank doesn’t have an adequate cash cushion, they are in trouble.  What is considered an adequate cash cushion for tier-1 capital is 4% cash.

Kevin: That doesn’t sound like much.

David: Not much.  For tier-2 capital, 8%.  So what happens is, if you have a bunch of assets that you own, and they get marked down in value, all of sudden you don’t have as much in terms of your leverage ratios, or capital adequacy ratios.  They change in light of the impairment to the asset.

Kevin: So you have to raise liquidity somehow.

David: You have to raise liquidity, so what ends up happening is that you precipitate either a liquidity crisis, or a solvency crisis.  This is what they are trying to avoid in Europe.  They don’t want to see a replay of 2008 where they see one or the other, a liquidity crisis on the one hand, a solvency crisis on the other.

Kevin: Isn’t that what happened to AIG?

David: That is what happened to AIG, and this is where they are concerned about contagion.  If one institution is impaired, others with similar exposures can see that sort of classic run on the bank, so if the bank doesn’t have adequate liquidity, you could have depositors taking out more money than is actual available liquidity, and that causes a real problem for the bank.

Kevin, what you were alluding to earlier, credit default swaps, or CDSs, this is the second part of the problem.  The first problem is pretty nuts and bolts.

Kevin: It’s just a lack of liquidity.

David: Yes, and if you take a loss on assets, it can impair your management of the remaining assets, and in fact, your liquidity, or even solvency, in a worst case scenario.  Where there is further complexity in this instance, is with derivatives.  Derivatives feature prominently in this equation, as credit default swaps have become more popular over the last ten years, in particular.  They have served multiple purposes.  They have helped off-load risk.  They have helped hedge out certain parts of risk, and they have also allowed for speculators to come in and make what you might call unidirectional bets, where you are hoping that the market is going to work for you or against you.  It is basically a way of shorting a particular asset and profiting when that asset goes down in value.

Kevin: For the guys who are positive on derivatives, a lot of times they are positive on derivatives because it is supposed to bring safety to the market.  That’s why I brought it up earlier.  When these things happen, there should be some sort of insurance against that and that insurance, like any insurance type of product, needs to be spread out over a broad spectrum to reduce the impact in a single area.  We saw that go terribly wrong in 2008.  Are CDS-derivative types of products built into this European paper?

David: That is the issue, Kevin.  AIG covered, or insured, as a counter-party, a number of bets, which they were required to pay on in the event of insolvency or default.  This turned a low probability cash requirement at AIG into a real-time liquidity shock.  The sums were staggering, and the requirement to pay was immediate, which forced the demise of the institution.

This is the issue.  If we see a default, and the ECB is fighting against this, they don’t want to see any form of default restructuring.  They have a whole number of new names that they can call this, but any kind of default at all will trigger a credit default swap payment.  The question is:  Do those counter-parties have adequate liquidity?  Can they make payment on short notice?  Or are they invested such that they cannot actually get to the capital they need to make payment on that insurance policy?

Kevin: This is why they call it a contagion.  It spreads like the bird flu, or something like that.  It doesn’t just affect a single institution, or even a single country, or even a single euro-group like Euroland.  We are talking about a worldwide contagion that could be triggered by a single country going into default.

David: Sure.  What was the lesson learned from 2008 from AIG?  You have to pay attention to your counter-party risk.  Know who is making one-way or unidirectional speculative bets, as well as who is hedged, and with whom.  In other words, who has taken the other side of the bet?  You think the asset class that you are interested in, whether that is a Greek bond, or an ounce of gold, owning those things, to you, as an investor, for one reason or the other, may make sense.  Who is betting against you?  It is interesting to know who is betting against you, because you need to know how deep their pockets are.  They may be able to hold the trade longer than you are, and force you to close out the trade.  They win, you lose, because they had deeper pockets.

Kevin: This takes us back to the gold issue.  Actually, you eliminate counter-party risk when you buy an ounce of gold, because it carries with it, its actual buying power everywhere it goes, and you really don’t have to know who is betting against you.

David: It is no one else’s liability, and I guess that is the point of owning physical, versus paper, gold, in any form or fashion.  That is what I think is happening at the institutional level.  CTAs and hedge funds are realizing that counter-party risk is involved in virtually every asset class they touch, with one exception.

Kevin: And that is gold.

David: You could even look at a treasury bond and assume that there is counter-party risk in the sense that you are counting on the treasury to remain solvent and make payments on that investment.  If they are no longer around, or are impaired, or they restructure, as we are considering with Greece, as we are considering with Spain, Portugal, Italy, Ireland, and a number of other European countries, then your counter-party risk is there, as well.  There really is only one asset, physical metals, that has no counter-party risk.

Kevin: Since gold is not an IOU, and what we are talking about is the default, possibly, of IOUs, you would think that the banks would be out buying gold and trying to hedge themselves, but the banks are loaded, aren’t they, with this IOU counter-party risk?

David: This is what we see throughout Europe, where the retail franchise banks loaded up with this European paper.  It made sense, on the same basis that buying mortgage-backed securities and agency paper made sense, because it paid a little bit more, and the risk didn’t seem to really factor in.  Granted, we may look at that differently today, but throw on the lens of analysis that would have been used 3, 4, or 5 years ago, before sovereign debt crisis was even in the vernacular.

Kevin: We would buy something with the seal of approval of the European Central Bank.  Let’s face it, it was a completely new currency, it was a currency that finally unified the other currencies.  These guys basically gave the thumbs-up that they would be behind it.

David: And the interest rates on those loans were reflective, not of the individual country’s specific credit risks, but rather, of a collective obligation to pay, or a collectively assigned credit rating, an average, if you will, of the good, and the bad, to the benefit of the poorly rated countries.

Kevin: Did these banks add any of these credit default swaps to the list, partially to insure against problems, but then, partially to enhance the return?

David: Let’s say that I have 100 million dollars worth of Greek paper on my balance sheet.  I own the paper, I am getting paid by the Greek government regularly, and that is fine, but I do have some concern, so I decide to hedge that part of my portfolio, not completely, but I hedge a part of it.

Kevin: No different than a wheat farmer, who possibly will hedge his crop just in case something happens.

David: I can buy credit default swap on the Greek paper that I own, and in the case that they do default, I lose on one side of my investment portfolio, gain on the other, and suffer less by having the insurance policy in place.  That is the role that a credit default swap can play when used as a hedging instrument.

Kevin: If that was the only way the credit default swap market worked, it probably would work to a high degree of substance, but in reality, traders come in and start speculating on these credit default swaps, people who aren’t hedging against anything, they are just betting against something.  Don’t you need to know who took the other side of that bet, and how much control they have over the outcome?

David: I think that is where we are beginning to see a very interesting sub-story, if you will, within Europe.  We have the ECB, and they are not wanting to allow for any default, whatsoever.

Kevin: Why?  Let me ask you, because restructuring is something that we have seen many times before.  Why is there such a fear of restructuring this debt?

David: If you look at the Latin American debt restructuring in the 1980s, and the Brady plan that was put in place, it was very common to see debts restructured, and a 40-50% reduction in principle payments.

Kevin: Adding also to the maturities, or the length of time that it pays, right?

David: Sure, you could restructure a number of different ways, whether it was just a simple haircut, or changing the terms of the loan itself.  There are some interesting things happening in Europe.  I think the question remains, “Who has taken the other side of the bet?”  Not as a hedge, but as a speculative bet.

Kevin: Are we about to go cloak and dagger here, a little bit?

David: A little bit, because what we have found with Wall Street, and particularly, the financial gurus of our day – when you meet a child who is both bright and clever, you always keep your eye on him, because he is smart, but he may be too smart for his own good.

Kevin: Are you talking about the golden boy, or maybe the Goldman boy?

David: Or the Goldman boy. (laughter)  Kevin, the reason we bring up this concept of cleverness, is because what we have seen become more and more common in the financial arena is rigged games, where you are not just betting on the future appreciation of a particular asset class, or its decline, but you structure it in such a way that you can’t lose.  We watched a number of shenanigans occur and we mentioned this a few weeks ago on the commentary, back in 2001, with Goldman creating those 13 currency swaps, and covering over just how bad the Greek debt problem was then, as they were coming into the EU.  There has been some obfuscation and some subterfuge already put into the context of Europe, with Goldman being involved.

Kevin: Goldman-Sachs keeps coming up in non-financial press.  Rolling Stone Magazine has had multiple articles on Goldman-Sachs, how not only do they package an investment and sell it to somebody, then they bet against it, because they knew exactly what was going to happen, that it couldn’t possibly pay off.  That is criminal.

David: I guess what we are looking at is a kind of division of interests between the ECB and the euro-banks, on the one hand, worrying about their solvency, worrying about their capital adequacy ratios, and then London and New York, who have taken out bets on the demise of these peripheral European countries.

Kevin: They are betting against it and they are ready to rake in the winnings.

David: Pounding the drum – “Default, default, default, default.”

Kevin: David, let me get this clear.  The European Central Bank really would be the loser if there were defaults at this point.  They don’t want to see defaults.  They would like to see the thing with Greece work out – Spain, Italy, whoever.  But you have Wall Street, and you have London, not the entire market, but the people that we are talking about, would benefit dramatically, if there was a default?

David: I guess the person to ask about who would benefit the most might be Mario Draghi.  Mario is an interesting character.  If you look at his CV, he is eminently qualified to be in the financial spheres within Europe, and he is being considered the likely European Central Bank presidential replacement for Jean-Claude Trichet.  Trichet’s term ends in October of 2011.  So we have an interesting changing of the guard.  Whoever is on the selection committee is hard at work now putting together the short list of candidates to be approved to become the head of the ECB.

Kevin: Help me on this, though, David.  Isn’t Mario Draghi an MIT-educated Ph.D. in economics, brilliant guy?  But he is also Goldman.

David: He has a lot of real-world experience, a lot of academic experience, but some of his real-world experience, the sign of approval, or the seal of approval, if you will, came from his tenure running Goldman-Sachs as a managing director in Europe between 2002 and 2005.

Kevin: This sounds to me like putting the Fox in the hen house.  If the ECB doesn’t want to see default, and Goldman and the guys in London and New York are betting against it, why would you put a Goldman man in the ECB?

David: Right.  And would Goldman take proprietary positions that benefit from the demise or the impairment of a client?  We need to go back and ask John Paulson this.  When he made his cool 3½ billion dollars on a single bet, was it genius, or was it a rigged game?  Again, signs of the times, but Wall Street has become a collection point for the particularly clever, not the particularly trustworthy, and that is an unfortunate state of affairs.  But you find people who are setting up bets that they can’t lose on, and certainly Paulson is one case in point, with Goldman being complicit in that case.  The genius of what these men are doing is that they are structuring them legally.  That is where, if you can skirt the legal issues, although you might consider it criminal, although from the common sense level you would consider it fraudulent, all the I’s are being dotted, and the T’s crossed, to be considered above-board, on a technical basis.

Kevin: This reminds me of the late 1980s, when you had these guys coming in, like Carl Icahn, these hostile take-over guys coming in, tearing apart single companies, large companies, and selling off the assets, and actually, you would think the take-over was to save the company, but in reality, it was just to put money in the pocket of the guy who took it over.  It seems to me like this has been transferred from a company scale to a country scale, or even a continental scale.

David: I guess that is what is in play here.  If you wanted to draw the lines between the interests in Frankfurt, and Frankfurt representing the European Union and the European banks, and those interests being very different than what you would find in New York and London, wherein it doesn’t matter the way the market goes – we don’t live there, it’s not our country, it’s not our currency, it’s not our way of life.  It’s simply this year’s way to make profits, whether that is profiting on the up-side or profiting on the down-side.  It appears that the London interests and the New York interests are deeply opposed to the Frankfurt interests and the ECB.  The ECB is arguing against any sort of default or restructuring.  What is interesting is that they are now calling it, not restructuring, but re-profiling.

Kevin: That’s the latest euphemism, isn’t it?

David: As you said, Kevin, the ECB and the European banking community are the ones that lose in a scenario of default.

Kevin: But for every loser, there is always a winner.

David: You are right, and the winner is clearly not Frankfurt.  It’s not the ECB.  It’s not the German, Italian and French retail banks that hold that sovereign paper on their balance sheets and whose books are currently under pressure.  The winner is the person, or the financial organizations, that have bet against the peripheral countries, making this unidirectional speculative bet on a soft restructure, or as they are now calling it, the re-profiling, or whatever kind of default.  It has to be categorically a default, sufficient to trigger payment, as legally required by the credit default swap contract.

Kevin: In a way, we actually have a war going on right now between Europe, Britain, and America.  It seems to be very similar, but this is just being played out in the financial scheme.

David: Right.  Continental Europe versus everyone else.  And everyone else really doesn’t care about continental Europe, unless you are talking about a currency alternative, in which case Asia certainly cares about the direction of Europe, and on that basis, I think the harder you see the European banks pressed, and the ECB pressed, to bring about a default with the sovereign paper, you may see China just step in and spend 100 billion.  You may see them come in and spend 500 billion.  They certainly have the money to do it.  The Chinese wanting to see the dollar decline over a longer period of time would imply that they don’t want to see the euro crater, and will act as something of a backstop.  They may be the knight on the white horse, stepping in to save continental Europe from a debt or default restructure.

Kevin: What an amazing complexity that has been added to this spectrum.  It really is.  If you go back and study the makings of a World War I, or a World War II, from a military or political standpoint, it is very complicated.  We like to simplify it and say Hitler was a bad guy, and he was, but it was far more complex than that, being played out in the financial markets, and especially the derivatives market, which, when you add it all up, is the greater part of all the money markets out there.  We have talked over a quadrillion, when you count all the money.  We have Asia working in their best interests, possibly.  That would be a surprise if they come in on a white horse.  It certainly would shock the markets.  We have Goldman-Sachs working their way into the very thing that could be their pay-off, which is Mario Draghi.  How do you hedge against these things, David?  I guess it brings us back to gold, right?

David: I think you do want to look at your counter-party risks and realize that every asset class that you own, whether it is a stock portfolio, a currency portfolio, a managed futures portfolio – whatever it is, you’re dealing with institutions, and if you haven’t adequately hedged that institutional risk, or counter-party risk, you don’t know the context that we are in.

Kevin, you are right.  We have Europe fighting New York and London.  Europe is fighting what appears, more and more, to be a rigged game, one in which the Goldman-Sachs boys, along with other global financial speculators, are playing for keeps, again, in an already-rigged game.  They know how bad the numbers are because they came in with these sovereign entities and helped obscure, originally, just how bad it was 3, 4, 5, 6, 7 years ago, so they know exactly what they are betting.  They have put together the portfolios which they can now short, and profit from.

Kevin: And now they are sending their man in, Draghi.

David: This is if – if and when Draghi comes to the helm of the ECB, you will have your default delivered over to London and New York hedge funds.  Goldman will make a killing.  Goldman may play for keeps, and this is what will be interesting.  They stand to benefit in two ways – one, certainly, financially.  If Draghi comes in, as a former Goldman man, you know that the EBC’s hard stance on a default or restructuring goes away, and the logic of default, the logic of restructuring, all of a sudden, becomes a part of the ECB tune.

Kevin: Are they doing this all for profit, David, or is there more?

David: No, because frankly, London and New York benefit more significantly by translating that money and profit into power within the Eurozone.  Certainly, money means something, but it means less when you are making billions a quarter.  Power is the next best thing, frankly, to being God in a kingdom of your own making, and that is what Goldman has a vision of.  And we are not just picking on one firm.  There are other firms involved in this particular game.

Kevin: Sure.  J.P. Morgan, Morgan Stanley.

David: And there are tons of hedge funds that are on board as well.  It is not difficult to see that we have mismanaged our own books here in the United States.

Kevin: Let’s go mismanage the ones in Europe.

David: Right.  What you have is the new form of financial wizardry – setting up a package of securitized products that you can’t lose when you bet against.  That is amazing.  That is absolutely amazing, and something that will ultimately change, as there is a public uproar against it.  This was never meant to be.  If you go back to Greenspan’s speech in the 1990s about how wonderful derivatives were, he envisioned derivatives for the financial market being, as you described, Kevin, a way that someone who brings in corn, or wheat, or soy, is able to hedge their current production and lock in today’s price so that they don’t have to experience the vicissitudes of the market – the ups and downs and volatility of the commodity trading pits.  They were essentially hedging.  That is what derivatives were intended to be.  They have become, truly, financial weapons of mass destruction, and the war that is being waged is continental.

Kevin: David, one of the ways that the average guy can actually measure risk, like the risk of default, is by watching interest rates.  Don’t the credit default swaps, in some way, let us know what the likelihood for these various countries is, for some sort of default or other kind of non-paying event?

David: This is why we are talking today about debt, why we are talking today about dominos, and the falling of one domino leading to the fall of another, why we are talking about derivatives, and derivatives being central to this fall of the dominos within the debt markets in Europe.  It is because we already have credit default swaps, the insurance that you pay against default, at higher rates than we had a year ago, when the ECB was bringing out their 1.1 trillion-dollar or 750 billion-euro bailout.  This was the giant shock and awe – “We are going to change Europe, we are going to backstop every country, there will be no defaults, we are going to implement austerity, and here is all the money the world could ever want to fix the problem,” and yet, 12 months on, the situation is worse, and the probabilities of default, as indicated by credit default swap pricing, is even higher.

Kevin, takes these countries in Europe as the primary example.  In Greece, if you have a million dollars that you want to insure, it is going to cost you 147,000 per year to insure it.  That’s almost 15% to insure something that pays 16.7%.  You are eking out a marginal profit, but you have to insure against default.  It is costing you almost 15% to insure against default.  In Portugal it is better.  It is only $67,000 for every million dollars, or 6.7%.  In Ireland it is 6.6%.  In Spain it is 2.68%.  In Italy it is 1.69%.  So you can see where the concern is most concentrated, Greece, Portugal, then Ireland, ultimately Spain, the real revolution will be over the next few months as we see things materialize, particularly in Spain, and it goes from the bottom of the list to being near the top of the list.

Kevin: Let me ask you about that, because some people that I have read and we have talked about, Greek debt isn’t necessarily the big issue.  Even Portugal debt is not really the big issue.

David: It is because they don’t have that much, to speak of.

Kevin: But Spain is a different issue, isn’t it?

David: Spain and Italy are two borrowing giants.  There are tons of paper, and that is the issue.  Again, on the basis of contagion, it is not that you have to worry about Greek debt default.

Kevin: That wouldn’t take the ECB down, or the Euroland down.

David: It wouldn’t.  It doesn’t destroy the euro project.  Portugal, if you face default or a restructuring in Portuguese paper, again, it doesn’t impair the EU project.

Kevin: But these are the dominos that you are talking about, one domino leading to another.

David: Exactly, and the big one that you can’t recover from, because there is too much debt, is Spain, and then Italy, even more so.  But with Spain, since 2008, you have 17 autonomous regions, like our states, practically, which have doubled their debt, to 160 billion dollars.  You have municipal debt, so the cities within those states, which have debt that is right around 50 billion – 47 or 48 billion – and then central government debt, which in dollar terms, is pushing 700 billion dollars.  This is in addition to about 37 billion dollars worth of debt that hasn’t been factored in because it is being considered as unpaid bills and things of that nature, so they haven’t actually added an extra 37 billion to the negative side of their balance sheet.  Spain is a far bigger problem than Greece, Portugal, and Ireland.  Contagion, spreading to Spain, would be terminal for the EU project, as we know it.

Kevin: David, since we are on the subject of musicals, we talked about Grease, but I think maybe [Greece] isn’t the word.  It’s the rain in Spain, but we just don’t want it to fall, do we?

David: Unless it’s mainly on the plain.

Kevin: That’s right.

David: I think, Kevin, when you look at the debt that is in Europe, this is not a European problem only.  We have that clearly in the United States, too.  Our balance sheet is just as impaired as many of these European countries.  We have what they don’t have, which is an exorbitant privilege, as Barry Eichengreen has described it – that of world reserve currency status.  As that gets chipped away at, we are in the same boats as these folks are, too.  We have the Chinese Central Bank advisor saying just this last week again that he eventually expects to see a default of U.S. paper.  That may be a far-fetched notion for U.S. investors today, and maybe that is something that will only happen on a 5, 10, or 15-year time frame, but when you see a revolution in interest rates, when you see a revolution in the bond market, these things never happen gradually.

Kevin: David, I think probably one of the greatest signs of seeing that our sovereign debt is going to be defaulted on is watching the Goldman guys.  If we knew that Goldman started betting against the dollar ever paying up, we probably should run for the hills, shouldn’t we?

David: We already have the PIMCO guys saying, “We don’t want any part of the U.S. treasury market, which is a first strong indicator that short positions will be building over the next few years.  I think as we look at modern finance as a truly rigged game, this is where the smart money begins to figure out who their counter-parties are, and how they can insure against default, whether it is domestically, whether it is with their own currency, whether it is with a particular financial institution, that is where individuals and institutions and hedge funds, and even central banks, are all turning to gold as that insurance.


Posted in TranscriptsComments Off on May 25, 2011; Debt, Derivatives and Dominoes

May 18, 2011; Warm and Contented in a Cocoon of Untruth

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, it seems that every time a sort of criminal act that is called a financial necessity occurs, Goldman-Sachs seems to be in the mix.  I thought that was just here in the United States, but we are starting to hear things about Greece and Goldman-Sachs.

David: When you go to the Morgue, you are asking the question, “How did we get here?  What happened?”  That is basically what we have in Europe.  As we go to the European Morgue – how did we get here?  Why do we have the problems that we have with Greece, with Spain, with Portugal, with Italy, with Ireland?

Kevin, it is interesting – you suggested, and it is accurate, Goldman was a part of it.  Going back to 2001, Goldman created a number of currency swaps, 13 to be precise.  These were off-market derivative contracts, and they were swapping yen into euros.

Kevin: Why?  What is it that a currency swap would have done in 2001 that would have aided Greece in some way?

David: These were specifically done with the Greek government and they were to conceal the true size of the nation’s debt.  This comes from the European Union’s statistics office, reported by Bloomberg.

But the point is, you have an organization which is purposefully creating fraudulent data and perception in the marketplace so that Greece can be welcomed into the euro, Greece can be viewed as a stand-out citizen, future contributor, to the European Union, and with a pristine balance sheet.  This is one of the things that cost Arthur Andersen its very survival.

Kevin: Sure.  It’s deceptive accounting.  It’s purposeful, deceptive accounting, because Greece had to have a certain look before they entered into the European Union.

David: What is particularly interesting, Kevin, is the ECB fears this information being discussed openly.  They have moved to block disclosure.  In fact, there is a court case, right now, being heard in from of the EU’s general court, and the ECB is trying to get it dismissed.  This lawsuit is seeking to disclose the actual use of these derivatives, set up by Goldman, with the Greek government, in order to hide the real financial condition of the Greek government at the time.

Kevin: Okay, Dave, it is easy for us to sit over here in the United States and look over at Europe and say, “Boy, those guys are absolutely messed up,” but he who is without sin needs to cast the first stone.  This sounds to me like what our government has done with the FASB rules.  They don’t really want true accounting to show up because, boy, it’s an ugly picture.

David: It’s true, Kevin.  There are a lot of similarities between the way we account for things, or want them viewed, by our foreign creditors, so truly, there is no one who is lily-white here.

With today’s conversation, we are going to talk a little bit about Greece and Portugal and the euro.  We have some ground to cover in talking about the dollar, gold and silver and the correction they are in presently, some dynamics of the Dow and the S&P, a strong look at U.S. consumer inflation.  Of course, it is on everyone’s mind what is happening with the debt ceiling and how that will be resolved and what the implications are.

Kevin: It doesn’t sound like there is a ceiling, David.  It feels like that ceiling just keeps getting raised and raised as government retirement funds get lower and lower.  But I would like to hear from you on that because I wonder how they feel.

David: Back to Greece and Portugal, in particular.  The 78 billion dollar euro bailout is moving forward for Portugal, and what is unprecedented is this:  They are requesting, or requiring, that private bond-holders keep what they own.  In other words, no liquidations are allowed.  That is the first time that this sort of voluntary pledge has been requested from private creditors.  So, is it a requirement?  Not necessarily.  But it certainly is a strong request.

Kevin: They will strongly frown upon anyone who wants to cash in their absolutely fine and perfectly liquid bond.  They just can’t cash it in.

David: Right.  So, it’s being put out there as almost a condition for this guarantee of 78 billion euros for Portugal.  And at the same time we have Greece, which is in what they would call a soft restructuring as we speak.  This morning they are looking at extending the maturities of their loans, or of their current debt.  That is not unlike you and I, here in the United States – if we took a 30-year mortgage and turned it into a 50-year mortgage, our monthly payments would go down.  We would still have the same debt to pay, and we have actually more in interest payments.

Kevin: Like turning chickpeas to hummus, I mean, it’s a Greek thing you do anyway, isn’t it?

David: (laughter) Well, extending maturity, certainly, and it is not the first time that there has been a restructuring of Greek debt.  But in Europe, I think you would have to go back to 1948 to see a major restructuring.  But now they are not calling it a restructuring.  It is actually a soft restructuring, because it is just an extension of maturities.  Call it what you will, it is the first stage of the inevitable, which is a restructuring, and a form of default.

Kevin: Well, it’s unpayable.  It’s like a lot of the debt that we have talked about.  It’s unpayable.  It’s just how do we extend this to make it go a little bit longer?  If the complicit deception was revealed, what are some of the names that would probably surface to the top, just like cream, surface right to the top?  There are some names right now that are nervous that there would be accurate reporting in Europe.

David: Well, and I am sure that those are the people who have been calling the ECB and calling in favors.  If I were Lloyd Blankfein, I would be a little bit upset right now.  If I were Hank Paulson – good old Henry was head of Goldman-Sachs, also at a period of time where those kinds of currency swaps were being orchestrated.

Kevin: They sure are clever.  They are good with numbers.

David: But you see, they are not an accounting firm, so they can’t be held responsible for the deals they put together.  They are a deal-making firm.  That’s what they do for a living – they put together deals.  So why should they be judged for doing what they are supposed to do?  It is their M.O. in the marketplace.

This is where we begin to see a breakdown in trust.  We have already seen it with individual institutions, where authorities who are hiding things, get caught hiding things.  The ECB is betting a lot and sticking out its neck in trying to protect this information.  They realize that there are unintended consequences.  There are huge consequences to knowing what those deals consisted of.

Kevin, I think we would blush if we knew the back-alley deals which were done between the Fed and differential financial institutions, between the financial institutions and overseas central banks.  It is just one of those things where, as we work through this cycle, as we talked with Neil Howe last week, and we get through what he considers the fourth turning, we will get full disclosure, and it is not going to be pretty.  And my hope is that we don’t end up with a Robespierre and a guillotine.  But there is going to be a lot of anger and frustration because of this inside dealing.

Kevin: Not just in Europe.  The spotlight seems to be focused there just temporarily right now.  They are still going through their trouble.  We have talked over and over about the problems with the dollar.  The dollar, during this period of time, even though both currencies are fiat currencies and they are falling long-term, the dollar seems to be rising right now, and that is affecting the gold market and the silver market.  We seem to be in a correction in the metals right now.  We have seen corrections in the past, in the bull market back in the 1970s, but there was a point when we didn’t see corrections.  Can you take us through that a little bit?

David: I hate to sound like a parrot, but it was last year this time that we were talking about the seasonal correction of gold, usually a strong finish into the spring, and then when you go into the summer months, and traders are taking vacations, for lots of different reasons, you have a seasonal correction in the metals.  This year we got an extra boost with the CME changing margin requirements, we have talked about that in recent weeks.  It is these seasonal corrections that you can begin to anticipate, and as a trader, as an investor, take advantage of.  My one concern is this:  As you move further into a bull market, those seasonal corrections don’t appear.  I am thinking of 1974, 1975, 1976, and 1977.

Kevin: David, we are getting into family history now, because the origins of your father’s and mother’s starting of this firm were in the 1970s.  That was remembered as the last great bull market in gold until this one, and there are a lot of patterns to learn from.  Fortunately, you were raised in that period.

David: Yes, and it was those years up until 1977 when you could expect seasonality – a soft patch in the summer months, very expected, very predictable, you had taken two steps forward, one step back.  Gold had been in a bull market for many years and had gone from 35 dollars to over 165 dollars.  And then as we moved into 1978 and 1979, if you were expecting a correction to come, it wasn’t there, it didn’t materialize.

Whatever the bull market is, whether it is real estate, whether it is technology stocks, whether it is gold and silver in this particular case, when you get to the final phase of a bull market, seasonality goes out the window, and technical traders, who consider themselves geniuses up that that point, get left out and are on the sidelines for the big moves.

Kevin: For the last 30 years, we have talked to two types of people who remember those years, if they were adults.  There are those who said, “Gosh, I was so close to buying, but it just kept moving up.”

David: “I could have bought it lower, the price was moving up, and I thought, surely it is going to correct, it will give me an opportunity.”

Kevin: It was coulda, shoulda, woulda.  But there was also the guy who finally said, “This thing is just going to go up forever,” and at 850 bucks he bought gold and really didn’t see $850 until just a couple of years ago.

David: Right, and I think some of the important work we do on the program here, because we are trying to identify trends, as well as transitions, and the trends remain in place for the metals.  The transition points, we have not yet seen, but we are looking at them and looking for them, feverishly, every day.

As we move further into this bull market, I am getting less and less sleep.  I am concerned, because these are dynamics which are quickly becoming third-stage bull market dynamics.  I think the last move in silver up to $50, from $17.50 to $50, was a foreshadowing of what we will see in the gold market, and ultimately what we will see in silver, taking it to much higher prices, $50 being left behind in the dust.  This is a transition – an intellectual and emotional transition point for clients, as they look ahead and realize that the market dynamics are changing utterly.  If they are assuming that the markets are going to remain rational, if they are assuming that they are going to remain predictable, with sort of a two steps forward, one step back, they are sorely mistaken.

Kevin: But, at this point, we do have a luxury that we may not have down the road.  We have a luxury that we are, wouldn’t you say, in a correction right now?

David: I think the probabilities favor this being the last seasonal correction in this particular bull market, wherein next year and the year after, as we move to 2012, 2013, and 2014, things begin to move at a pace where it simply blows your hair back.  I think what we see now, off of a peak of $1577 on the gold price, is roughly a 10% correction.  That would take us to roughly $1420, and I think that is where we see an excellent entry point.  Between $1450 and $1420 if you are not aggressively buying, I think this is going to be the low point for the year.  You have the 200-day moving average, which is a little bit lower at $1365, and it is moving higher every day.

We have a number of technical supports which are actually rising to meet the current price of both gold and silver, I think, make a compelling case for entering the metals over the next two, three, four weeks.

Kevin: So you are basically saying we are 5-10% away from a bottom that we may not see for the rest of this bull market.

David: I think 5% on gold, probably 10% on silver.  We are sitting at around 33 and change today on the silver price, and I would be aggressively buying between 35 and 31.  Why not just pick 31 and say, hey, it’s a better number, it’s a better entry point?  Because there are enough clustered reasons at that price for every trader and their brother to be entering the market at the same time, and you would have to be so fast on the trigger, by the time we get to $30-31 an ounce, that I don’t think many investors will actually take advantage of that pricing.

Kevin: So what you are saying is, it is actually a good idea to buy maybe a little early, or sell a little early, in the quiet, than when it is just a roaring crowd.

David: What you just suggested, Kevin, is utterly, utterly important for clients to remember.  It is not just on the purchase side, but on the liquidation side.  You always sell too soon, you always sell too soon.  If you leave something on the table, and you feel you could have made more money, you really don’t know what you are doing as an investor.  That is the only way you make money as an investor, by leaving something on the table, because when the masses try to move to the exits at once, the odds are against your being able to move out of any market.

Look at real estate today.  There was a time when you could sell your house in roughly weeks.  We sold our house, by a sale by owner, in a matter of weeks when we left California.  Now, if you have the greatest representation in the market, someone with 25 years of marketing and sales experience in real estate, you couldn’t move your Southern California home in three months, six months, maybe even year or two.  We are talking about a change in the dynamics of the market, where you have liquidity up until a point, and when the market turns, liquidity goes away, unless it is at an extremely discounted price.  That is not where we are at today, Kevin, but as you suggest, as you look ahead and say, “Okay, higher prices in this particular bull market – Sell too soon.”  The old adage from Mayer Amschel Rothschild, “Buy when there is blood in the streets, and sell too soon,” is something that I think clients can keep in mind.

Kevin: Dave, this brings up a good point.  We are all hopeful people.  As Americans, we want to have hope.  The market name for a hopeful market is a bull market.  The market name for a market in despair, or a dropping market, is a bear market.  The bulls, especially, love to run in a crowd, but you have to be a solitary-minded person, whether you are a bull or a bear, to get in, or out, at the right time.  So, David, in a nutshell, what you are saying is this may be the opportunity, the last real correction on these markets before we start seeing just pure up-moves.

David: On its way to $2000 gold and $100 silver, yes, I think so.

Kevin: Something that I know you watch that a lot of investors don’t, is the volatility index.  Is the volatility index telling us anything right now about the stock market, the paper markets?

David: I know we mentioned this a couple of weeks ago.  The VIX was at about 14.5 and it is currently at about 18.5, so we have seen a 27% move in two weeks, in the volatility index.

Kevin: What you are saying is more volatility, and that is usually a shaking before a breaking.

David: Yes.  Essentially, when the volatility index gets down to 10 or 15, you are just begging for a correction in the stock market, because what it tells you is that everyone is already loaded to one side of the boat, and it is the bullish side of the boat.  Everyone is assuming that it is all blue sky from here, and it is only happy days that will be here from now to the foreseeable future.  What you generally see, at that point, is an inflection, and this coincides with the end of the positive six months of stock investing.  They say, “Sell in May, and go away.”  Why is that?  Why is that an old Wall Street adage?  Sell in May, and go away.

Kevin: Is there a seasonality to the pattern?

David: There is, and basically, the good six months of the stock market end in May, and the worst six months just begin.

Kevin: Remember October.  Every year.  Remember October.  Almost every year, it’s a bad month.

David: We are in the negative seasonable period.  We have the VIX, which tapped a low at 14½ and there is nothing really compelling there in terms of value.  Would we suggest a correction in the stock market?  I think we are slotted for one.

Kevin: How about emerging markets?  That is something that people watch, because they are so darned exciting.

David: Well, this is sort of a balance sheet issue.  As you look at the U.S. balance sheet, as you look at the European balance sheet, everything is being skewed toward healthier balance sheets elsewhere.  It is not that you have less risk or less volatility in the emerging markets.  In fact, you have more risk, and more volatility in the emerging markets, but you have a lot of companies who are generating tons of revenues overseas and have relatively healthy balance sheets.  I think that has pretty much been priced into those shares, so even if you could make a case for investing in the emerging markets, as opposed to the developed market world today, I think you are talking about rich premiums, and that is not where you make money.

You make money buying at discounts and selling at premiums, not buying at premiums and selling at even higher premiums.  That momentum kind of trade is what gets people in trouble, and I would suggest that whether it is the developed market or the emerging markets, you have plenty of risk that you are taking and putting into your portfolio, if you are out buying equities, here, or yon.

Kevin: So, really, in the stock market, or any financial market where you are trying to make money, you don’t want to buy something that is accurately priced.  You want to buy something that is underpriced, and what you are saying is, even if they are not overpriced right now, they are full.  They are full of accuracy.

David: I think the best work that is being done right now is contrasting the developing world with the emerging world, the developed markets with the emerging markets, and it is by contrast that they are saying, clearly, this makes much more sense going to the emerging markets.  If you look at GDP growth rates, they are off the charts.  I guess what I would remind people of is that within the investment, you want to know what your real rate of return is, so while you may not be tied to an overseas tax regime, you are tied to the overseas inflation rate.

So if you are seeing, and if you are buying a particular company, if you are looking with interest at an overseas market, and you are looking at a growth thematic that you think is compelling, because there is a 10% year-on-year growth rate, remember what the inflation rate is, as well, and subtract that out of the growth rate before you get too excited.

Currently, the inflation rate in China is reported to be 5.4%, with a growth rate still almost double-digit.  The problem is, they fudge the numbers just like the Bureau of Labor Statistics has fudged the numbers on inflation, and a more realistic view of inflation in China is somewhere between 10% if you are conservative, and I would suggest, closer to 15%, putting your annual growth rate at either flat, to negative – not positive double digit.

This is where an investor has to back away from the emotion of investing in a headline number, something that is very attractive.   “A double-digit growth rate?  China has to be remaking the world.  This has got to be the greatest thing since sliced bread.  I want in, I want in, I want in!”  Slow down.  Ask yourself the question, “What’s the real rate of return here?”

Kevin: That’s exactly right, David, if you lose the value of the buying power of the currency that you are in, you are not gaining, you are actually still losing.  Let’s bring this back close to home.  Here in America, people are excited if they get 3% on a CD at the bank, maybe 4%.  They are pushing it into maybe the more risky bank accounts.  The rate of inflation right now is being reported at about 3.2%.  How does that actually play out in real rate of return?

David: Sure.  And before we go there, Kevin, just in fairness, this isn’t to pick on China.  You could say the same is true of Brazil and India, with rampant inflation in those countries, the recent correction in gold and silver, and you have bullion dealers in Mumbai and Chennai who can’t keep their shelves stocked with even the most basic bullion items, in either gold or silver – not just jewelry, but investment demand products where you are talking about bars and coins.

There is a real world inflation happening, globally, and if the price gives at all, those who are most aware of the inflation, and are sensitive to it, buy with both fists.

Kevin: And those people are not speculating on price moves, these  people are just trying to hedge themselves against the buying power of their currency being destroyed.

David: Essentially, it is the masses trying to take the other side of the bet.  If government is going to destroy currencies, then they have to take out an insurance policy on their savings.  But the Bureau of Labor Statistics – Kevin,  you mentioned our current rate.  April’s numbers put our inflation rate annually at 3.2%.  This is where we find a shift.  Congress has ordered the Bureau of Labor Statistics, pressured them over the years, to change their methodology, the way in which they measure inflation.  This is not just a group of academics at the Bureau of Labor Statistics saying, “We’ve found a more efficient way to do this.”

Kevin: They are being pressured.  There is a reason, too, for that, David.  What is the reason?

David: Congress made the call in 1980.  Congress made the call in 1990.  This methodology has changed, so, while we look at an official rate of 3.2%, if you go back to the official methodology used in 1990 by the Bureau of Labor Statistics, our rate of inflation today would not be judged at 3.2%, it would be 6½%.

Kevin: 6½?  Now, that was using 1990 methodology, but that had already been changed from earlier.

David: You are right, and it gets better.  The 1980 methodology would put our today’s inflation rate at the official Bureau of Labor Statistics inflation rate at 10.7%.  So are we looking at 3% as a real-world inflation rate, or 6%, or 10%?  And it boils down to how you want to, and how you choose to, measure the number.  This is the interesting thing, Kevin, because by this appraisal, Volker was fighting the boogie man.

Kevin: Right, because there wasn’t inflation.  If we use today’s numbers, we might have even had deflation when Volker was out there.

David: Yes.  His efforts were a farce.  In retrospect, there was no inflation in the 1970s.  We need to go back and tell that generation that what they were experiencing was a mirage.  It simply didn’t exist.

Kevin: It reminds me of today.  They are telling us, as long as you don’t eat food, and you don’t put gas in your car, we really don’t have inflation.

David: That’s right.  On a steady diet of iPads.  That’s the issue, Kevin.  Either the methodology was right then, or it’s right now.  Either there was no inflation then, and there was a boogie man, or the numbers that we are talking about today, 3.2%, that is the mirage.  That is the fiction.  That is the farce.  And we have a whole investment community that is assuming we have exactly what Ben Bernanke, just two weeks ago, said we had.

Kevin: Yes, they have financial TV that shows them that not only is it transitory, but they can be a “bull for another day.”

David: Inflation, in my opinion, will inflame a popular revolt, in no small part, because people will determine that their government has intentionally lied to them, and for decades has gotten to cover up their balance sheet insolvency, creatively producing a GDP figure which was not real.  And we have said this many times before on the program, that if you understate inflation, the other side of the equation is that you are overstating GDP.  So whether it is an emerging market problem, or a developed market problem, we have central bankers the world over, we have statisticians the world over, who know how to grind the numbers through the machine to come up with a number that is sellable.

Kevin: So, David, it really is a credibility issue.

David: When the crowd actually starts to see that prices are rising beyond what they can keep up with, there could be a major revolt.  When you don’t trust your government, you don’t trust their numerous representations and promises, including the dollar system, including the system of government debt obligations and the idea that long-term promises or liabilities will be paid out, you are talking about a breakdown politically.

Or if you are not talking about a breakdown politically, an actual political revolt, you are talking about a revolt from the currency, itself, and that is the dynamic that you end up with, super-inflation or hyper-inflation.  It is actually not the Fed printing more and more, it is the Fed printing more and more until a threshold has been reached, and that threshold is one of confidence and credibility.  When confidence fails, when credibility is lost, then you have a revolt of the masses out of a currency.  They simply want out, at any price, and they are willing to buy anything, at any price, because they don’t want to hold the worthless scrip in their hands.

That’s where credibility becomes an issue.  This is a generational crisis, in that we have a fully entitled public who is looking to those long-term debt obligations, those long-term promises, and we have the majority of our population now on the dole in some form or another.

Kevin: Over 51%.

David: Let’s assume that it is 100 million people across the country who are going to be dealing with the greater likelihood of broken promises.

Kevin: Right.  We have talked about the entitlement mentality before, and it is easy to point a finger and say, these people are taking money from us, and it can’t be supported.  But actually, I was just talking to someone the other day about entitlements.  This was a sweet lady who is retired, who does not want to see her retirement cut, in the form of Social Security.  These are not bad people, all of them across the nation that are in entitlement types of programs.  They are people who built the entire structure of their retirement plan based on the government paying out when the time came.

David: Yes, the social safety net meant that they could spend more and save less because they knew their retirement was going to be supplemented by Social Security.  This was the promise.  This was the social contract, and it is the contract that may be broken.  We have the debt ceiling, which is certainly in our listener’s minds – use  of federal retirement funds – that is what is being used today to supplement debt financing.

Kevin: That has to be a concern.  When you are a federal worker, you are working for that retirement, most often.

David: And I guess, Kevin, what Geithner has chosen is to keep the gears of government churning by actually borrowing from federal workers’ retirement funds.  I find this fascinating, because it is the first time since this crisis began, that you get a true picture of the snake eating itself, the snake eating its tail.  It almost makes me smile, thinking that now the public sector gets to worry about the solvency of the U.S. government, as they watch their retirements, even in small amounts, get spent just to keep the game going.  Now they know what it is like for the rest of us.

Kevin: Actually, they have skin in the game this time.  You are right, in the past the federal workers have seen the markets go up, the markets go down, they have heard this, they have heard that, but in reality, it hasn’t affected their retirements, it hasn’t reflected on their salaries.  Public worker salaries have gone up, while private sector salaries have gone down.

David: (laughter) It is going to be interesting to see how long the federal employees stand for their retirement funds being used to fund the functions of government.  They will pressure for a higher debt ceiling.  The reality is that the debt ceiling is a farce to begin with.  We absorbed Fannie Mae, and Freddie Mac.  We have off-balance sheet liabilities, so 14.3 doesn’t even matter, we are already at 20.7.  This is gamesmanship.  This is brinksmanship.  The Republicans get to show that they are fiscally responsible by saying we need to cut the budget.  Kevin, the Republicans never made a dollar they didn’t spend a dollar-fifty on.  The reality is, they are no more fiscally responsible than the Democrats, but this does give them an inflection point, coming into the next election, to say, “See it’s not our fault.  We asked for responsible government.  We asked for smaller government.  We asked for responsible spending.  And it’s the Democrats’ fault, therefore put us in office.”

Kevin: So, the irresponsible behavior continues, whether it is Republican, or Democrat, maybe even Libertarian as we are starting to see that movement.  There has been a warning, however.  If that irresponsible behavior continues, there is going to be another financial crisis.

David: Stanley Druckenmiller, probably an unfamiliar name to some, was the partner with George Soros at the Quantum Fund, who helped break the Bank of England, and break the pound sterling.  He was actually pulling the strings, and making those trades happen, as the main trader with the Quantum Fund.  He was recently reflecting and shared these ideas with the Wall Street Journal.  “A financial crisis is surely going to happen, bigger than the one we had in 2008, if we continue to behave the way we are behaving.”  The Wall Street Journal went on to say that the real problem to be solved was Washington’s spending addiction.  The results would, in Druckenmiller’s opinion, be catastrophic, if we didn’t address that behavior.

Kevin: I wonder if he is going to bet against the dollar like he bet against the pound.  I think they made a cool two billion bucks, he and Soros, when they did that, didn’t they?

David: (laughter) Well, I tell you what.  If he is not betting against the dollar, somebody will be, and they have good reason to.

Kevin: David, we were told that this country is a republic, and we are now told it is a democracy, but if it were really the populace that was being asked about raising the debt ceiling, 47% of the people are not even for it, and actually, it is a minority of them, way, way down the list, that would like to see the debt ceiling raised.

David: You are right.  In recent polls, 47% of Americans responded that they did not want to see the debt ceiling raised, 19% thought that it was okay, and I’m guessing that the remainder probably don’t know what you are talking about, but would likely take to the streets if their monthly check did not come in.  The dark side of democracy is now a present tense reality.  The majority have nothing to lose, and everything to gain, by voting for government largesse.  As a society, you mentioned a few minutes ago, 51% are receiving some form of funds from the federal government.

Kevin: And they don’t want to see that stop, no matter how painful we have to make it for everyone else.

David: 47% of the population pays no taxes, yet we have universal suffrage.  This is a strange reality.  You don’t pay, but you can play.

Kevin: You get to vote, even if you are not paying taxes.  It seems wrong, and I am sure there is quite a bit of a debate that we could participate in as to whether that is right or wrong.

David: To remove ourselves from the current discussion, something Alexander Tyler said more than decades ago.  Have you heard of voting yourself the treasury?  That’s the last chapter of a democracy.  When politicians determine that they can distribute funds in such a way to buy themselves votes, and people get addicted to that money, that is the end of a democracy, and in Tyler’s opinion, that is what leads to a totalitarian regime.

Kevin: I guess the way you keep the crowds from getting too upset right away is you continue to feed them, I guess bread and circuses, and you really have to control the flow of information, don’t you?  You have to control the press, to some degree.

David: That was a concept that Harold James talked about in a recent article, a historian and professor at Princeton.

Kevin: And a guest of ours.

David: In his article, “Machiavellian Economics,” a great title, he says that, in the past, Europeans avoided or controlled crises by controlling the press and controlling the information that people had.  How much did they know?  What did they have to respond or react to?  And he illustrates, using Mussolini’s fascist government, which controlled the press.  During past crises, the Italian banks, although equally insolvent to their counterparts in Germany and Austria, fared quite well.  James says the deception might be a source of comfort.  We might find ourselves, in fact, warm and contented in a cocoon of untruth.

Kevin: That really rings true.  If you think about society right now, in a way, we are all warm and contented in a cocoon of untruth.  Even in the Greek situation over in Europe, they don’t want to see the truth, because once the truth comes out, it is not comfortable.  You are no longer contented.

David: How about the FASB rules and marking-to-market bad debts on U.S. bank balance sheets?  We want a free pass.  We do want greater financial stability – but transparency?  Well, I guess we could use it, but it would come at a price, wouldn’t it?

Kevin: It makes me think, you can be warm and content for only so long, with untruth, and then when you start seeing the truth – Hitler took his lesson from Mussolini, but he took it a step further didn’t he?

David: Yes, he said that the ultimate cause for reichsmark stability, and currency stability under his rule, was the concentration camp.

Kevin: So I guess you didn’t have to be warm and contented at that point, you just need to be on his side or in the concentration camp.

David: And if you disagreed with the establishment, there were certainly ways of addressing that.  It is Harold James’s simple reminder, and he says this in his article, that massaging the truth is eternally appealing to modern governments, so whether it is the Bureau of Labor Statistics, and we can joke about the Bureau of Truth, something that is very sort of 1984-esque, in terms of the numbers that we get and what we are to believe about the state of our union, but frankly, this kind of misrepresentation – this is the stuff that revolutions are made of.  And this is where we begin to see revolutions, whether domestic or international.  We are beginning to see a revolution in the treasury markets.  We are now looking at the most recent tick data, the treasury flow data.  Five months in a row, foreign holders of treasuries have moved away from treasuries.

Kevin: That brings up a good point.  We were talking about controlling the press, controlling the crowd.  You can do that in your own nation, but when you have another country that is converting a currency to another currency, such as converting the euro to the dollar, or the yen to the dollar, whatever it may be, if they are converting, and they are feeling, directly, the true inflation rate by the devaluation of the buying power of that currency, they are not going to want to buy our treasuries.  So what you are saying is, for the last five months, foreign holding of treasuries is declining, not increasing.

David: Right, there are two components to that, Kevin, that are particularly important.  One is the central bank liquidations, and the other is the private party purchases.  Central bank liquidations have been consistent.  For five months running, central bankers are determining they want less and less exposure to the U.S. dollar, and that includes the Chinese Central Bank.

So we do have funding issues in that regard.  On the other hand, we do have euro weakness at present, and we have seen private parties, individual investors, coming into the U.S. treasury market, I think in anticipation of an unwind in the banking sector in Europe, and perhaps a liquidity event like we had in 2008.  So what do they want?  They want treasuries.  A bit of a divergence between private party purchases and central bank liquidations.  The trend, from central banks, is very interesting five months running.

Kevin: Let’s face it, David, we have talked over the last few months about trends, but we have not had a 2008 kind of cusp event occur, like the 2001 September attack.  We feel like we are coming up to something, but it hasn’t happened yet, and we are starting to see the criticism for those who are guarding against it.  So when oil goes up, or gold goes up, it is being blamed on speculators.

David: How about this?  Try this on for size.  Let’s blame Bill Gross for causing a decline in the treasury market because he is no longer an owner of treasuries.

Kevin: He said that just a few weeks ago.

David: The question is, should we actually blame him?  The answer, I would say, is, emphatically, no.  He is not responsible for a decline in treasuries.  He is not responsible for the over-spending the government has done and had as a sort of M.O. for 40 years or longer!

Kevin: David, if he was a true gentleman, he would stay where the game is.

David: He would respect the gentlemen’s agreement, which is, don’t cause panic, absorb a few losses here and there, but just move forward.  Kevin, what he is looking at is the same thing that our foreign central bank creditors are looking at.  Let’s go back to that original Bureau of Labor Statistics methodology, which counted inflation in 1980 at 10.7%, today’s inflation at 10.7%, a paltry 4% return on a long bond, with inflation of 10%.

Kevin: That’s a 6% loss, even using simple math.

David: But the thing is this:  On your 4% rate of return, you still pay taxes, before you get robbed blind by inflation.

Kevin: So it is a 7% loss, it’s an 8% loss, but it’s a loss.

David: And so Gross is saying to himself, “This is absurd.”  Someone is going to realize that this is absurd and there is going to be a rout in the bond market because this is not sustainable.  We are talking about a negative real rate of return of between 5% and 7%.  That is not sustainable in the investment market.  The only people who sign up for a voluntary gift of 5% to 7% to the marketplace are idiots!  And that is the kind of investor who is moving into treasuries today, according to Bill Gross.  The question is, will he be blamed because other people take losses in the treasury market, and he was telling the truth?  We have this strange social construct where if someone wins, and I lose, I have to find someone to blame.  It wasn’t an error in my judgment, “It was them that did it to me.”

Kevin: Right.  If you think about it, there are people right now who see this coming, who will own gold at the time, who will own silver, they will maybe own oil.  They will be called speculators.  They will be called dirty speculators, ruining the market.  Right now, we are already hearing this from the press.  Talk about a controlled press.  But David, when peoples’ families can’t afford to eat because of inflation, and somebody down the block hedged ahead of time and is doing just fine…

David: They are going to catch the blame.

Kevin: There you go.

David: Kevin, I think that is an interesting thing for investors to be aware of – a changing social dynamic in the investment markets.  It is something that we talked about a little bit in Friday’s comments, our weekly wrap-up comments on the Wealth Management website.  “It’s not me, it’s you,” was the title of it, because frankly, it is speculators who are being blamed, in many regards, for changes in the commodities markets.  Kevin, it’s not me, and it’s not you, being branded as speculators, not actually speculators, but being branded as such, that is causing the upset.  It is the fiscal and monetary policies implemented by Washington, and every other power center around the world, and that is what investors are going to have to come to terms with.

Kevin, as we mentioned earlier, we are seeking to understand the trends that are in place, and the potential transitions ahead.  This is what we are trying to do on the McAlvany Weekly Commentary.  We are not responsible for the trends, we are simply following them, and as I mentioned in Friday’s comments, it is like flying a kite.  You can’t be blamed for the wind, and it is foolishness to take credit for it, if you are just holding onto the string.  This is going to be a wild ride as the wind picks up.  I am not responsible for it, but I am glad to participate in the ride.

Kevin: I guess we are just telling our people to just go fly a kite! (laughter)  If it’s windy, go fly a kite. (laughter)

Posted in TranscriptsComments Off on May 18, 2011; Warm and Contented in a Cocoon of Untruth

May 4, 2011; A Bird’s Eye View on Afghanistan, Derivatives, and the Precious Metals Market

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, of course, on everybody’s mind right now is that Osama is dead. The question, after we go through the celebrations and the reflections and all the different things that we go through after a decade of dealing with this issue is, “How relevant, really, is it, and what does it really reveal about what we should be doing, as far as analysis for the future?”

David: Kevin, I think the question that has been asked by many people is, “Why are we in the Middle East?” That has been asked many times. “Why are we in Pakistan and Afghanistan?” We have had an excuse for ten years – pursuing Al Qaeda.

Kevin: Nothing like a bad guy to have to chase across the West, or the East, in this particular case, and now that we have strung up the bad guy, what do we do next?

David: Right. I think, Kevin, it is always important to look at underlying stories when you are trying judge political decisions, and even geopolitical decisions. The classic example would be the Panama Canal. It was not supposed to go through Panama. If you look at the lakes that are strewn all throughout Nicaragua, that was the original plan, and there would have been very little excavation required to take the route through Nicaragua.

Kevin: So Panama was never the original intention, it was Nicaragua. What changed that thought process?

David: It was actually an orchestrated revolution coming north from Columbia, combined with a major PR campaign directed to the House and the Senate. It was a masterfully done job. For the details of the story you could look at a chapter from Our Crowd, a book written, I think, in the 1960s. It is a fabulous telling of the tale of how politics and money intertwined. That may seem like a strange way to look at Osama being taken out of the picture, but frankly, when you look at Afghanistan, it is important to understand who their neighbors are, and what role they have played in the last decade in the energy world. It is not actually Afghanistan that you should have your eye on, it is Turkmenistan. Turkmenistan has the fourth or fifth largest natural gas fields in the world.

Kevin: In other words, we, again, are taking our analysis to that three-letter word, oil.

David: Or natural gas, but it is energy. The problem is, Turkmenistan sits on the eastern side of the Caspian Sea. It is land-locked. It is not next to anyplace where they can back up a truck, so to say.

Kevin: But they have gas.

David: They do have gas, and the only way to move it is either by rail, or by pipeline. The traditional pipelines have gone north to Russia, and with the fall of the Soviet Union, that changed the calculus, if you will. It became of greater interest, to the rest of the world, where that natural gas flowed. It wasn’t going to, necessarily, be, or exclusively be, to the Soviet Union. There have been proposed pipelines from Turkmenistan. The most famous one is the TAPI, which stands for Turkmenistan-Afghanistan-Pakistan-India pipeline.

Kevin: Other than Turkmenistan, the other countries are the ones that we hear about in the news, why our military is stationed there, but the why is rarely ever talked about as far as oil or gas or pipelines. It is usually Osama, or terrorism, or Taliban, or Al Qaeda.

David: The Taliban were largely in control through the 1990s in Afghanistan, so in the negotiations for the TAPI pipeline, going back into the 1990s, you had two groups: An Argentinean company, and then a U.S. company (wink-wink-nod-nod), Unocal, which was vying for the rights to put in the TAPI pipeline and operate it. The interesting thing is that negotiations broke down with the Taliban in July of 2001.

Kevin: Okay, now wait a second. You are talking about negotiations between a U.S. company, an Argentinean company, and the Taliban? They were actually talking up through July of 2001?

David: That’s right (laughter). What is interesting is, immediately following the 2001 invasion, post 9/11, moving into 2002, really, the interim president, President Karzai, met with President Musharraf, in Islamabad, in February of 2002, and they announced their agreement to cooperate on the proposed pipeline. So you have what went away as an option, now back on the table as an option, and it looks like we are going to continue to move forward.

The real question I have is, why are we in Afghanistan and Pakistan? Are we likely to leave the region, given the fact that we have, essentially, a strawman? The reality is, now that he is gone, we are not likely to see a change in troop allocation from Pakistan and Afghanistan, insofar as we still have an interest in the TAPI pipeline, and seeing that it is operated in a way that does not change geopolitical calculus. You have to have certain players. In this case, the pipeline goes to India, ultimately, which, if you are looking at Asian calculus, we are more interested in reinforcing the relationship with India. One of the proposed pipelines would actually go through Uzbekistan and go to China, instead, which again, leaves us in a lower power position, if you will. If this can be orchestrated in such a way where we benefit, whether it is just that of leverage, or actual cash flow through a U.S. corporation, that leverage is something to keep in mind.

Kevin: There is something that has been interesting to me over the last 48 hours since we heard about Osama. I thought my kids, who are in their young 20s, would have really keyed into this, because they were 10 or 12 when 9/11 went off. But in reality, enough time has passed that they were introspective in completely different ways. I don’t mean to say Osama was old news, but he was an old excuse to be in a place, and we now have to come up with a new excuse. It will be interesting how this plays out.

David: The reason why we are champions of the TAPI pipeline is that the alternative, which New Delhi could consider, comes, not from Turkmenistan, but from Iran. So it goes through Iran-Pakistan-India, or Turkmenistan-Afghanistan-Pakistan-India, and if you can avoid going through Iran, there are obvious benefits in terms of U.S. foreign policy. We have been supporters of the TAPI pipeline, not the IPI pipeline. Again, was this about Señor Osama? No, in fact, he was, in my book, a strawman.

Kevin: Then, considering the volatility that we are seeing in the market, we are seeing the analysis come out, and they are saying oil prices now are going to be on the downslide because Osama is dead, and gold and silver are going to go down. We are going to have volatility in these markets, and excuses for volatility in these markets, but we have to keep a broader perspective, do we not?

David: I think you could look at that in relation to the silver and gold markets. Something happens and maybe it is a reaction to fewer tensions in the Middle East because we are ahead of the curve in terms of our efforts with Al Qaeda, and that is why gold and silver are selling off – the fear premium is being taken out of those markets. No, not really. The CME changed margin requirements twice last week, and once this week – a 9% increase, a 10% increase, followed by an over-the-weekend announcement that went into place, and then finally, the third announcement of a 12% hike to maintenance margin and initial margin requirements.

Kevin: Let’s put that in perspective. To go out and buy a futures contract, you have to put a certain amount of money down, very much like a mortgage on a house, and when you have that money riding, that market can go up. You can make quite a bit of money if you are long in that market, or it can go down, and if you were betting on the up, you can lose money. But what you are saying is, the margin, the amount of money that the investor had to come up with, has been raised. That seems like manipulation, David.

David: I like the housing analogy, Kevin, because basically what you have, if this were the happen, theoretically, there is a parallel here. The bank calls you and says, “Well, you did put 25% down on your house as a down payment, but send us an extra 9%.” And then the same week, “Send us an extra 10%.” And then the next week, “Send us an extra 12%.” And you are saying to yourself, well, I don’t keep that kind of cash around. And here is the point: In the silver market, if you can’t hold the position, if you don’t have enough liquidity, if forces a liquidation.

Kevin: That is what happened to the Hunt brothers 30 years ago.

David: And you can move margin to 100%, where you go from a leveraged position, 5 to 1, to where you are not allowed any leverage at all, and you have to come up with a tremendous amount of capital, and it has everything to do with liquidity. This is the beauty of running the exchange. If the house begins to lose, guess what the privilege is of those who run the house?

Kevin: They can shut the game down.

David: Or change the rules in the middle of the game. It is fascinating.

Kevin: David, you are going to be talking in Las Vegas in just a few days, and it reminds me of these casinos where you walk in, and if you are losing money, they serve you free drinks. If you are winning money, the free drinks may slow down just a little bit, but if you’re really winning money, they ask you to leave.

David: And they want to know who you are, because they are going to keep an eye out for you, and they don’t want you to return.

Kevin: Well, okay, David. Taking it from the volatility issue, there has been something that a lot of people are saying will decrease volatility in the market – a change in Federal Reserve policy, where we actually have not a secretive Fed, but a very vocal Fed. Ben Bernanke just came out and said, “This is what I am going to do.” What are your feelings? Does that remove volatility from the market?

David: Kevin, this is what we were talking about on our Friday comments. We write those on our Wealth Management website, mwealthm.com, if anyone is interested in reading them. But the gist is this: You have the Fed, which has been very secretive since its founding in 1913, and it is really not the business of the market what the directors of the economy are going to do. That has been a respected and appreciated position taken by both the general public and the Fed.

Kevin: Partially because they have so much effect in the market. If somebody knows what they are going to do, it is called discounting in the market. They can just go out and buy or sell what they need to be ahead of the game.

David: I think what we end up having is academics who aren’t necessarily market practitioners – not to discount their intelligence, they are highly intelligent – but they are so focused on one particular nuance of monetary management or fiscal management, as it were, that they do not see what the impact would be of transparency. Certainly, at a popular level, you and I may want more information. We may feel that they have hidden things from us and therefore they should disclose. I think there is some benefit to us, as individual citizens, to know what they are doing.

Kevin: As long as everybody knows at exactly the same time, and has the same tools to react.

David: Our problem with the full disclosure is really this. It is not as if we are just curious citizens. We are also curious speculators. And as curious citizens, it helps us sleep better at night knowing what is happening, and in an age of deceit and lies, transparency and truth are like a salve. We feel comfortable with what they are doing. That has its own merits, and I think they are using that to their advantage, but the disadvantage is that we are equally speculators. Give me information as to how the economy is going to be managed, and I know how to leverage a bet.

So what happened here, with an academic doing what appears to be the right thing, in terms of transparency, is reminiscent of what happened in 1999 when Alan Greenspan was making his best efforts to say, “The derivatives market is a wonderful thing. It is going to reduce risk in the marketplace by allowing investors to choose what portion of risk they want to take on, and what portion they want to sell off and allow someone else to shoulder.” Essentially, we are sharing the risk versus having one institution bear the full brunt of one particular calamity. So, in theory – just as our current Fed president is doing – in theory, judging and appraising the situation and moving forward with a new policy, we had that same thing initiated, actually before 1999, he just gave public comment to it. The problem was, in actuality, we have seen a market go from less than 10 trillion, to now with a notional value of 231 trillion just in the United States. It is 15 zeros.

Kevin: Fifteen zeros? You are talking a quadrillion.

David: One quadrillion. I mean, I pause, because I don’t know what that number means, really.

Kevin: And talking about spreading the risk…

David: …but that is the global derivatives market.

Kevin: Where is AIG now? Where is Lehman now? Granted, AIG got an awful lot of bailout dollars and some of these institutions did, but the risk, itself, was not eliminated, it was just broadened.

David: I think this is what you end up with in the speculative community. Given an opportunity of shedding the risk, and sharing it with someone else, what do they do? Reduce risk across all of their bets? Or know that they can increase their leverage and increase their bets because some of the risk has been deferred to another party? In fact, what was intended to lower total systemic risk has increased it, because individual companies say, “That’s not my problem.”

Kevin: Even without the derivatives market, with the mentality of the people right now, there is an optimism in the market that is amazing. One of the ways that you watch how people are responding to the markets and their fear of risk is just funds that make money when everything else goes down, like a bear fund.

David: Did you know the Rydex bear funds have the lowest investor participation at any time in the last ten years? Couple that with the volatility index, which is your ratio of puts and calls, and what some people would call a bear index, or a negativity index, and it shows you how many people are betting against the market, or for a rise in the market. When it gets to 10-15, that low number means everyone is on one side of the boat and they are betting that things are going to be very good from here and there is no reason to have a short position out there, to hedge risk against decline.

Kevin: David, systemic risk is one thing, but in a way, with these institutions that are taking on so much risk, we are redefining “too big to fail.”

David: Look at the top four, whether it is J.P. Morgan Chase, Citi Group, Bank of America, Goldman-Sachs. They still have the most exposure, according to the comptroller of the currency, end of year 2010 – the numbers are just out. You have banks which have, on average, between 1 and 1½ trillion dollars in assets, and yet all four of them have more than 40 trillion in notional value of derivatives exposure, with J.P. Morgan leading the pack with just shy of 80 trillion.

Kevin: So you are saying they have 1½ trillion, or less, actual, real, on-the-books money, or exposure, but the derivative exposure is 25-30 times that.

David: Correct, Kevin. They are cumulatively a large part of that 231 trillion domestic derivatives problem.

Kevin: For institutions.

David: Correct.

Kevin: Plus, a few others make up a quarter of a quadrillion dollars of exposure.

David: But if you want to look behind the scenes and see what is being done in politics and why things are, or are not, being done, follow the money. Again, whether it is the TAPI pipeline, whether it is going back to the Panama Canal a long, long time ago, this is where the rubber meets the road. We have a derivatives nightmare in front of us, and it is not something that we particularly want to face, because, and we have talked about this in the past, Kevin, it is a little bit like a nuclear reactor. We had a meltdown with Chernobyl, caused by what?

Kevin: It was actually a safety check that triggered things. You know what? It was the same thing with Apollo 13. They did a cryo stir and then all of a sudden, boom! The side of the service module blew out.

David: Okay, somebody is following NASA, and I appreciate that it is you.

Kevin, this is the issue. We have had the Dodd-Frank bill, which could have had teeth to help regulate this systemic and institutional risk problem, relating specifically to derivatives. And instead we have chosen opacity. This is the same thing we did in 2004 when there were several congressional hearings dealing with Fannie Mae and Freddie Mac, and guess what happened? “Be quiet. Don’t say anything. This is politically motivated. This is race-driven. Why are you all over Franklin Raines and his management of Fannie Mae?” In those hearings they went so far as to play the race card and say that Fannie Mae should not be scrutinized. Any scrutiny that was being brought against the company was a direct result of racism – Franklin Raines, the CEO and Chairman, being criticized on the basis of race.

We have had the opportunity to be transparent. We have had the opportunity to look at the facts before there was a crisis, and each time we get close, there is a reason to not go there. We don’t want to go there, not with the derivatives, no we don’t, because we don’t know what kind of worms we will find in the can, and we can’t afford to find out, because at this point we are talking about something that dwarfs the national economy.

Kevin: And it could cause a Chernobyl. It reminds me of something. Most people now who are listening have moved from the old TV to the new HDTV, which are fascinating because when you are watching football, you can practically see the actual blades of grass. It is just amazing. But I will tell you, some of these actors and actresses that I thought were just pretty darn good-looking, I can now see the pores in their skin, and I can see the imperfections of the makeup, and I say, “Oh, this was not made for HD.” (laughter) If you think about it, with the derivatives markets, if you really zoom in close, it is really ugly. It is not a glamour photo anymore.

David: Kevin, if you are looking at these four institutions, J.P. Morgan, Citi Group, Bank of America, and Goldman-Sachs, they have credit exposure as a percentage of risk-based capital – that is tier 1 and tier 2 capital – which is very popular to discuss in Europe and within banking circles, which for Bank of America and Citi Group, is roughly 200%, J.P. Morgan closer to 300%, and Goldman-Sachs, roughly 600%. If you want to understand the risks inherent to the financial system, as they remain unaddressed, you have to look at the derivatives market.

Kevin: We have interviewed Richard Bookstaber a couple of times. Richard was a key voice in front of Congress on how to bring transparency to these derivatives. Each of these derivatives is its own unique kind of being. Some of them are pages and pages of contract. How in the world do you bring transparency to something that is uniquely written?

David: It is uniquely written, Kevin, but we think the world is small when we ponder the 7 degrees of separation. In the derivatives market, it is 2, perhaps 3, degrees of separation. You have Greenspan’s speech, which we mentioned, in 1999, to the Futures Industry Association when he said, “These new financial instruments are increasingly important for unbundling risk.” What that neglects is the market reality, not the academic truth or insight that he may have brought, but the market reality, which is that if you can cover losses on the downside, speculation increases. So while in theory derivatives make the market a safer place by spreading risk across multiple institutions, in practice it becomes a license for speculation, and it ends up tying all financial institutions together, wherein if one is impaired, they all have exposure, either directly or indirectly.

Kevin: Being a father makes me realize that these guys, academically, may think they are right, but as a dad, if I covered all of my kids’ losses from this point on, it is going to increase risk. Real world or common sense sometimes trumps what is written about in long thesis for Doctorates. But here is one thing we do know. The academics love to come up with a solution that includes printing money. And then they love to academically tell you that it does not turn into inflation.

David: If you read last week’s Newsweek, in Niall Ferguson’s article he said that the Fed may deny it, but Americans know that prices are rising. Inflation is back. “I can’t eat an iPad.” This could go down in history as the line that launched the great inflation of the 2010s. It’s eggs, it’s milk, it’s bread, it’s meat. These are the basic American foodstuffs, and they are all grain-dependent. We have had, not only the money-printing on the one side, but we have had pork-barrel spending on the other, creating this whole ethanol craze, which is driving the price of basic foodstuffs, the stuff that we eat. Did you eat eggs this morning? Did you have milk with your cereal? Perhaps a slice of toast? Maybe you are the steak and eggs guy. Guess what? Now you have double the expense, both on the steak, and the eggs, side.

Kevin: I’m just eating quail eggs, that’s all I need to do. I mean, why buy the regular egg, if inflation is making it smaller?

David: The irony is that now pork-barrel spending is driving the price of pork through the roof. A pound of sliced bacon cost today $4.54 compared to two years ago at $3.59. That is a 26% increase in two years.

Kevin: I just recently heard on BBC on the radio that the IMF says that food prices have actually risen 36% worldwide over the last year.

David: It is interesting that households have less and less to spend on basic things, and at the same time they are in a pickle with Congress having to consider raising taxes. We are in a bind. We do not have enough money coming in. We have to increase revenues. Cutting spending is probably not going to happen.

Kevin: And they are not going to cut entitlements.

David: What you have, basically, is a second or third act in the fiscal crisis nightmare. What we have is something that is unsustainable, both in terms of a rising cost of basic foodstuffs, and basic expenses, set against rising taxes. It has to happen. It has to happen. I am not for it, because I do not enjoy it, but I see that it is necessary, to some degree. It was David Walker who suggested three parts cuts for every one part increase in revenue, in other words, an increase in taxes.

The reality is, they are going to ignore Walker now that he is out of office, just like they ignored him when he was in office. That is probably medicine I could take: Three parts of a cut to current spending, to one part increase in taxation. The point is, and Thomas Donlan made this very clear in last week’s Barron’s article: Our taxes barely cover our social welfare programs. Basically, everything else is being put on credit. If you look at our current deficit spending, if you look at where current outlays are going, we are spending as much on social welfare programs as we have in income. We don’t have enough for anything else.

Kevin: David, I hate to be the bearer of bad news, so I am going to let you be the bearer of bad news, and I hate to have people turn the program off just completely depressed, but would you just tell the listener how much they would have to raise taxes at each of the tax levels to even cover what we have already spent?

David: Not to catch up on debts, not to pay off the national debt, but just to pay our budget, to pay what we are spending now and can’t afford, we would have to see corporate taxes go from 35% to 88%. 35% is an unrealistic number since there are so many ways that the multinational corporations get their effective tax rate to less than 10%. But assuming they were paying their way, and they were at a 35% rate, that would have to be bounced to 88%. The top tax bracket for individuals would have to go from roughly 35%, also to 88%.

Kevin: The “wealthy” would have to have an increase from 35% to 88%.

David: Mid-tier income earners would have to go from 25% to 65%, and the lowest-tier, 10% currently paid in income tax, would have to jump to 25%.

Kevin: So for those who are saying, “Let’s stop printing money, let’s stop throwing newly-printed inflationary money at the system,” that is the other side of the coin.

David: Right. Or you could look at this differently and say, “Let’s stick it to the wealthy. They have so much money, they can pay. They don’t need their income, they have so much in assets, just let them eat what they already own, they don’t need income.” If we taxed 100% of the top 2%, which is anyone earning $200,000 a year and more – if we taxed that 2% at a 100% tax rate, that would help us to the tune of 300-400 billion, which is a fraction of our current deficit spending.

The reality is, we have to tighten our belts, and we are not willing to. This is why we are not willing to: Government is not willing to because government is growing to the point where they are the leviathan. They are the monster which is, in the immediate future, going to be consuming upwards of 60% of GDP. If you harken back to Woodrow Wilson, he said, “Liberty has never come from government. Liberty has always come from the subjects of government.” The history of liberty is a history of resistance. The history of liberty is the history of the limitation of governmental power, not the increase of it.

This is the problem, because the fiscal crisis is compounding. We have the folks at Cato, specifically Michael Tanner, who says that by the mid part of the century, we will have 60% of GDP which is going to go just for the operations of the federal government. We are on a financial death march.

Kevin: It is like an animal eating its own young. There will be no generations after that if they are eating their own young.

David: It is wrong, I think, for us to focus on our current debt levels, because that is a smaller piece of the bigger problem, the bigger problem, again, going back to the Cato research and Michael Tanner. The larger disease, he says, is a rapidly growing government that is consuming an ever-larger share of our national economy.

Kevin: But if you have everyone employed, let’s say we have high employment numbers, and a healthy economy, you probably could have tax increases, whether we like it or not, but our employment picture does not seem very clear right now, and it is certainly not improving.

David: No. In fact, a lot of the jobs that have been taken overseas are going to stay there. If you look at multinationals – and this was from the Wall Street Journal – since 1999, U.S. based multinationals had eliminated 3 million jobs here in the U.S., while at the same time creating approximately 2 million jobs outside the United States. The jobs eliminated were permanent replacements when they moved the 2 million overseas, and there were major efficiency gains and savings in terms of pensions, medical, this and that. If you look at the way corporate America is structured today, and it has made sense for corporations to move overseas with their operations, but the difference between 3 and 2, is 1 million, which is what they have described in the past as productivity gains – those are gone. As we have improved technology, as we have created supply chain efficiencies, we have just eliminated a lot of jobs that didn’t need to be there as technology has improved.

Kevin: We have talked about the reduced buying power of the dollar, and we have talked about the need for increased taxes, and really, no matter how much we increase them, we are not paying the bill. Then we have also talked about employment, and that is a problem right now. It is not getting any better. David, there was man that you knew. Before he died in 2004, he made an outrageous statement. His name was Sir John Templeton. He said that before the real estate fall was over, the prices of houses would fall 90%.

David: Here in the United States.

Kevin: And he said that when that happened, he would be a buyer. Where are we in the housing market right now? We certainly have not had, in dollar terms, a 90% drop.

David: I had to scratch my head back in 2004 when he made that statement, and it has begun to make sense, as you have seen mild depreciations in real estate across the country, the price of the average single-family home has come down, but the price of gold or real money has gone up considerably, and will continue to. It is very reminiscent of the 1970s. Between 1970 and 1980, the average single-family home, at the beginning of that decade, went from costing 600 ounces of gold, to about 80 something.

Kevin: This is getting back to measuring in real value.

David: Yes. But it was roughly an 85% devaluation of the U.S. housing market, in gold terms, and then it returned from that 85-ounce level, up to about 600, actually a little bit north of 600, starting in 2000 or 2001.

Kevin: 600 ounces of gold for a median-priced home.

David: Now we are at 120 ounces. We have seen an 80% depreciation. We are knocking on the door of Sir John Templeton’s guestimate of a 90% devaluation in U.S. home prices. But not in dollars terms, which is interesting, because he didn’t make that clear, but it has happened, yet again. Maybe it is 86%, maybe it is actually the 90% number that he called for. What it implies is an easy target price for gold in the 2100-2300 range, maybe with a spike to numbers that are half again as high as that, or maybe even twice that number, before housing is actually at the bottom.

David: But again, you do not have to see a collapse in housing prices nominally. Maybe it is another 10-20% decline from here in nominal pricing. So it goes from $180,000 to $150,000. Or $130,000. But we are not talking about a collapse in prices, unless, I guess, you are talking about Detroit. But we have in front of us significant opportunities, and I think it takes, in our opinion, a bird’s-eye view to recognize the changes that are happening. We want to explore more in coming weeks what it means to take a bird’s-eye view, and see, as John Templeton did, what was a 90% coming devaluation in residential real estate in the United States.

Kevin: David, you know I am a private pilot. My house looks very different from above. Sometimes a bird’s-eye view really does require a completely different perspective than the day-to-day. You were just telling me about some clients, some friends of yours, who are in real estate, and in real estate development that have done that for many years, but they do something very, very unique. They take a bird’s-eye view, literally.

David: I know a man who learned this trade from his father, in real estate development, specifically. Real estate is, of course, about location, location, location – to grasp the importance of a locale, or to judge a future direction of development trends, demographic shifts. What is unique about this family is that they consider, almost on a subconscious level, the topography, the distance, the elevation. Again, they do this by getting a bird’s-eye view. The family owns a helicopter and they regularly explore for future options by getting a bird’s-eye view of an area and seeing something that other people who, ten feet off the ground, would never see.

Kevin: So, from a real estate developer’s point of view, they are sitting side by side in a helicopter looking at the potential of the next great growing area that they can go into that maybe the guy on the ground never sees.

David: It is almost as if geography shrinks with altitude. Relationships seem clearer between communities. Natural traffic flows, or anticipated growth patterns can be seen, as you are seeing cities and townships bust at the seams. Do you get those numbers from the town fathers and the economic numbers they are crunching? Or is it something as simple as getting in a plane and seeing what you see? Does that make the difference? You realize, actually, between two cities, you can be spitting distance, depending on how the wind blows if you are 5,000-6,000 feet up.

Kevin: David, that brings me to a question for you, and a response to a book that you put me onto, that I really should have read many years ago. It is a book called, The Fourth Turning. It is a theory, as you know, of historic cycles. We are talking about bird’s-eye views; a lot of our clients are not real estate developers and they are probably never going to fly a helicopter, but it seems that history has patterns very similar to neighborhoods from the air. If we understand the pattern, we can be ahead of the game, or even if we are not ahead of the game, we can be consistent to the season that we are in.

David: It is very similar to getting that bird’s-eye view. If you can enter the present tense and current events, not unlike what happened this week with Osama bin Laden, from a historical perspective, I think it does the same thing as shrinking geography. You shrink history, and you realize, we are only a few generations from 1517 and the pounding of the 95 theses onto the door at Wittenberg – revolution, if you will, in theological, and ultimately, social and political regimes. That is only six lifetimes from us – very, very close. I think to understand the present tense, you do have to get a little bit of an elevated view, and we can do that through looking at the cycles of history.

Kevin: Speaking of cycles, there are seasons within the cycles, and when somebody says, “Is this Osama bin Laden thing the epoch-changer? Is this the big game-changer?” In reality, if a person understands the season we are in, they will realize – no, it is a blip in history.

David: As important as it may be.

Kevin: It is not a game-changer.

David: Not a game-changer.

Kevin: There is spring, summer, fall, and winter. If you don’t understand the season you are in, you are going to be inappropriately reacting. I will use an example. My daughter lives in New York, and my wife, yesterday, was packing a big box of summer clothes. Why? It is still cool in New York, but she understands the summer season is coming, so we are going to send Shae the summer clothes and she is going to send the winter clothes back, not because right now she needs them, but my wife knows she will.

David: It’s coming, Kevin. This book Neil Howe wrote in 1997, The Fourth Turning – we are going to explore some of these ideas with him. How can our listeners gain that bird’s-eye view of the marketplace, and better understand current events in a historical backdrop? We will look at that this next week.


Posted in TranscriptsComments Off on May 4, 2011; A Bird’s Eye View on Afghanistan, Derivatives, and the Precious Metals Market

January 20, 2011; Perceptions Are Not Reality: U.S. Investors Are Being Duped More than Most

The McAlvany Weekly Commentary

With David McAlvany and Kevin Orrick

January 20, 2011

Perceptions Are Not Reality:

U.S. Investors Are Being Duped More than Most

Kevin: David, a preview of coming attractions:  There are a couple of guys that you have been wanting to talk to.  George Friedman is a New York Times best-selling author of books that we have recommended in the past, he has one coming out in a week-and-a-half or two weeks, and I know you wanted to talk to him.

David: Kevin, for us, many of the things that we consider important are context-related.  What is the context that we are in?  What is the context that we are going to be in, as things unfold, next week, next month, and next year.

Kevin: Be it economic, financial, or in George Friedman’s case, political, and geopolitical.

David: And a part of understanding or appreciating risk is not necessarily predicting what a certain outcome will be, but understanding what may occur, and if it were to occur, then what the consequences would be.  Certainly, that is where Friedman shines, in saying, not necessarily, “This is how the world will be in the next ten years,” but “Here are some considerations for you.”

That is just fantastic for our kind of dialogue, because we do not know what is going to happen six months from now, or six years from now, but we can certainly look at risk variables and say, “If these things fall into place, then we have a better idea of what the consequences will be.”

We want to include him in the conversation again.  He is shrinking the picture back a little bit.  His New York Times best-selling book a few years ago, I think 2008 was the release, was titled, The Next 100 Years, and then we will be looking at his newest release at the end of the month, The Next Ten Years.

Kevin: What I love about reading George Friedman is, it is like reading a chess strategy book.  He seems to understand the relationship of the pieces.  In this case, the pieces would be every country in the world.  You cannot name a country to George Friedman without him giving you insight as to the relationships and the consequences, and the unintended consequences, of various strategies and policies with those countries.  Really, I would imagine he brings that kind of strategy to think tanks across the nation.

David: What is interesting about this book is that he centers his analysis on Machiavelli’s The Prince. He gives you a view of statecraft, which is, at the same time, effective, but very uncomfortable.  As you read it, as you consider it, there is something that makes you want to shiver.  You just say, “Are there people like this around?”  In point of fact, there are, and have been, for hundreds, if not thousands, of years.

Kevin: Unfortunately, of politics, when really looked at through a fine glass, it can be said, “You know, that is a dirty, dirty reality.”

David: It is.

Kevin: Now, with Friedman coming on, that covers the political and the geopolitical.  I know that there is a prognosticator and technician who has just been excellent for three, maybe four decades:  Ian McAvity.  That is next week for the gold look.

David: As a family, we have been reading his deliberations for at least 3-4 decades.  He is one of the few, like my father, who has been in and around the precious metals area, as a specialist, but also as a technician, almost since the beginning of time.  We want to ask him some questions, and it will be interesting to get his perspective on the present state of the markets, and perhaps he will prognosticate as to where we go from here.

Both of these men I have a great deal of respect for, and it is with great anticipation that next week with Ian, and the following week with George, that we carry on a deeper conversation.

Kevin: I would encourage the listeners to definitely not miss the next couple of weeks.  David, shifting to the stock market, people just feel pretty darn bullish right now.  In fact, aren’t we starting to see the numbers topping out and hitting some high numbers that we have not seen in quite a while, as far as sentiment goes?

David: When we bring things back from what we were suggesting with Friedman and our conversation in the next few weeks, when we bring those back into the investment arena, this is where it becomes particularly interesting.

Every week this year the chorus of bullish sentiment has gotten louder and louder, and the primary conversations among Wall Street analysts and talking heads are about whether or not GDP growth will be 2½% this year or 3%, whether it be 3½%, or perhaps 4%.  What is surprising to me is that they are neglecting the fiscal prop of deficit spending, which is equal to roughly 10% of GDP.

Kevin: In other words, the GDP that they are talking about is not based on growth of business right now.  Really, if you look behind the curtain, it is based on how much money the government is pumping into the system right now.

David: What is fascinating is that if you took away government spending as a component of GDP, and essentially, I am talking about deficit spending, not total government spending, just the deficit portion, instead of talking about positive figures of 2½%, 3%, 3½%, or 4%, what you are quibbling over is:  How negative are we?  Are we negative 6?  Are we negative 8?  Are we negative 5?  But we are in a situation where, just as Richard Duncan reminded us last year, if you take away government spending from the equation, the contraction in GDP is depressionary, it is not recessionary.

Kevin: What you are talking about is, rather than quibbling about positive GDP growth, we are talking about shrinkage, and we are talking about a contraction.  With that being said, is that not the definition of depression?  Shouldn’t we be looking at how much we are shrinking right now, and actually treating this as a real case, instead of something that is just being masked?

David: I think what we want to hit on in several different areas today, is the things that are being masked, the things that are considered to be true and perfect realities, a reflection of health and strength, when in fact, we have something far less than that.  It is interesting because the market is not taking that into account.

So with that Friedman style of risk analysis, one of the things that can hurt you that you are not thinking about today, and I am not suggesting that this will come as a surprise to our listeners, but these are the things, these are the elements, as we discussed today, Kevin, that will impact the market negatively with an upset of expectation, with a change in course that came from out of the blue, seemingly, when in fact, there was nothing of an element of surprise there to begin with.

Kevin: Speaking of not having an element of surprise, the debt is really what is fueling this “Positive growth.”  Are they going to raise the debt ceiling, or are we going to actually start seeing some austerity?

David: I want to start by looking both at the fiscal and monetary side of things.  The debt ceiling will have to be raised, as we run up otherwise unpayable bills, to the tune of now 100 billion dollars per month.

Kevin: What’s a hundred billion here and there?

David: I want to start by looking at the fiscal and monetary side of things, because, of course, the debt ceiling will have to be raised.  We are running up bills that are otherwise unpayable, to the tune of 100 billion dollars per month.

Kevin: A hundred billion a month that we cannot pay, but hey, let’s do it next month, or the next month after that.

David: We can finance it.

Kevin: Sure.

David: At this rate, this is what the Congressional Budget Office has estimated is our trillion dollars a year.  That turns out to be, actually, quite conservative, because our current run rate is 20% higher than that.  We will be at 1.2 trillion without skipping a beat, and again, we are already pressing the recently raised cap on debt, which was 14.3 trillion.

Kevin: That blows my mind, because it just feels like yesterday, and it really was almost yesterday, that we were talking about a 9 trillion dollar debt, and we were appalled.

David: Right.  The republicans, with the new reshuffle in Washington, were promising 100 billion in spending cuts in past weeks.

Kevin: Did they do it?

David: No, they have already backed the number down to 60 billion.  So, with the realistic numbers coming in, I think, and you think, and again, what we would consider realistic, is probably much lower than that.  What are the cuts going to be?  Is it 100?  No.  Will the cuts be 60?  No.  Will the cuts maybe be 40 or 50?  Okay, well, they can feel good about thinking in round numbers – call it 50 billion dollars.

Kevin: David, what does Doug Noland have to say about this?

David: It is interesting.  He says, “The U.S. government debt is being mispriced, over-issued, and misdirected, ensuring only deeper economic maladjustment and financial vulnerability.”  He points out that in just over 27 months, the federal government has increased its, or you might consider it our, liabilities, by 4 trillion dollars.

Kevin: Well, at least they found something that they are good at.  They can spend money.

David: They can spend it.  I know a lot of people who are good at that, actually.  The problem is, most people have a piper to pay, and in this case, we are just passing it off to the next generation.  We are living today on tomorrow’s dime, and that is a problem, Kevin.  27 months to rack up an extra 4 trillion dollars.  It is not like that number is going away, and we are aggressively cutting.  In fact, we are adding a hundred billion dollars a month to that debt.  The question is:  Is there any debate about whether or not we will raise the limit of our debt ceiling?  Of course it is going to go higher.  It has to.

Kevin: The crazy thing, Dave, and we talked about this on last week’s program, is that you can do this federally, because they print money, but the municipal bond market continues to show signs of life.  This is a market that was really never intended to be a market, was it?

David: We see, exactly as you say, Kevin, similar issues in the municipal market, which is a much more constrained market.

Kevin: And they cannot print money to get themselves out of trouble if they overspend.

David: They cannot print money, and it is a market that was never intended to be a two-way market, where you can both buy the product, and if you choose to, at some point, change your mind about what asset you want to own, go to the market, and sell it.

Kevin: So, unlike a stock, which was designed to buy and sell freely, municipal bonds were purchased to be held to maturity.

David: They really were, and the dynamics in that market end up coming unglued when you have mass liquidations.  It is not as big as the treasury market.  Obvious there is only about 2.7 trillion dollars in the market.

Kevin: Only 2.7 trillion, that is 2.7 million million.

David: It is long-term paper.  As we mentioned, it is intended to be long-term paper – distribution only, not return.  You should never sell it back.   This weekend I was studying over the individual securities that were making new highs and new lows in the markets, and I could not help but notice that at least 40% of the securities which were moving to lower lows were municipal bond-related.

Kevin: So somebody is seeing this, because if 40% of the lower lows are municipal-related, then it is not just you who is seeing it.

David: And I would just remind listeners that our conversation at the end of last summer and early fall, was that we were seeing record purchases of municipal bonds, and it made no sense to us.  We said at the time, “They are mispriced.  This is absolutely asinine.  How can you have things falling apart in Europe, and an assessment of unpayable bills, revenues that do not match expenses?”

Kevin: That is right, taxes are not keeping up with last year, or the year before, so how in the world can municipal bonds pay?

David: And the commentary at that point was, this is an example of how inefficient the market is, not how efficient it is, because according to the efficient market hypothesis, these should be pricing in – these securities and all securities should be pricing in – all known realities, and yet you had the masses going into municipal bonds on the basis that we were going to see a change in tax rules at the end of the year, and it does not matter what the stability of those municipalities would be, we want to save an extra 3%, 5%, 7%, 10%, in total tax burden by buying something that is tax-free in nature.

Kevin: I was talking to a client yesterday who had referred someone to us who really still thinks very much like Wall Street, which has not really gotten its head around the fact that this is a recovery that is not really a recovery.  The Goldman Sachs guys had flown in to actually give him advice for what the money is going to do, and it was almost all municipal-related.  They are putting him into municipal bonds right now, many millions of dollars, because of the tax advantage that they say he is getting.

Address the tax advantage versus the principle danger, and I am talking about the principle danger in this case.

David: You have just hit the nail on the head, Kevin.  It does not matter if you save yourself 3% in taxes, if you walk away from 10% in capital losses.  You are only proud of the capital gains or the income efficiency of a municipal bond…

Kevin: Look, Ma, I’m not paying any taxes.

David: Right!  Look, Ma, I don’t have anything in my account, either.   There is that issue, which has to be addressed, in terms of potential defaults.  Are we talking about hundreds of municipal defaults?  I would say dozens.  But the problem is, the fear factor in that market will ultimately precipitate … and this is why it goes in the context of our fiscal discussion today.  It goes into the context of what will be assumed by the taxpayer as a long-term liability.

Kevin: Well, then let’s shift to the Treasury bill for just a moment, because the Treasury bills are produced by the Federal Reserve and the federal government.  One of the main buyers of U.S. Treasuries has been our banking system.  They have been given the money for bailout, and then they turn right around the buy Treasuries.  It has been sort of a marriage made in heaven, even though it keeps them from giving loans to people like you and me.

David: Before we move to that, because that is a critical point, we did see a move this last week by the legislature in Illinois, moving the state income tax up from 3% to 5%, and even doing that only solves a small part of the problem, because the biggest issue with these states and municipalities is the long-term liabilities.

You have a current cash-flow issue, which is real, today.  They have to get caught up on vendor bills that have been unpaid for months now, but the longer-term issue is that they have these legacy liabilities which will be with them, and have not been solved.  Nothing has been changed in terms of the pension liabilities, in terms of the health care liabilities, in terms of the things that they have promised out.  They have assumed strong economic growth would be buttressing those payouts, and in fact, we are in an environment where that just is not the case.

Kevin: If revenues have been dropping, it is because people are making less money in their businesses.  To raise taxes does not necessarily mean they are going to make more money in their businesses, they are just going to take more of what a person is making less of.

David: That is right.  You are not really solving the problem.  You will generate a few more dollars in income, but it is not a structural change, and it is not that sound in terms of solving the larger issues.

As you mentioned, Kevin, with the Treasury market, there have been a number of things which have been changing over the last 24-36 months, which are uncomfortable and inconvenient.  One of them is that you have 70% of the debt which has to be rolled over, over the next 24-36 months.  That, in itself, is a major issue – the rollover issue.

Kevin: This is debt that already existed, it does not help us a bit, it just has to roll over.  This is nothing as far as the new debt that needs to be taken out.

David: And those new funding requirements were what we were speaking of just a moment ago, roughly 100 billion dollars per month – if you annualize it, between 1 and 1.2 trillion dollars in new funding requirements.  Then you have what we mentioned a few weeks ago, Kevin, the Chinese demand, or lack thereof, in the Treasury market, as a consequence of them changing their requirements for repatriation of capital.

Kevin: Yes, but we still have the banks.  Aren’t the banks buying Treasuries?

David: And that is the point.  Now you have bank liquidations which are piling up, as well, on top of the Treasury market…

Kevin: So the banks are selling Treasuries.

David: Because they have bought, hook, line and sinker, that we are in recovery.  The recovery story has been bought by the bank heads, which on the one hand, will be effective in terms of getting them to loosen the purse strings and begin to lend, so there is a very positive element there.

Kevin: Yes, but what about speculation?  At one time, after the Great Depression, of course, laws were put into place to keep banks from speculating in markets.  Is speculating coming back, or have we gotten regulations to keep that from occurring again?

David: I do not know that they are speculating in that regard, but I do think that they are increasing their risk profile and moving to securities that have more income to generate, so if they can still borrow from the Treasury at ridiculously low rates, and invest at slightly higher rates and leverage that up, they can increase their rate of return from 12-15%, to maybe a 16%, 17%, or 18% return, when all is said and done and the leverage is working for them.

Kevin: If the Chinese demand for Treasuries is dropping, and bank demand for Treasuries is dropping, what happens when we cannot sell Treasuries as a country?

David: This is what forces the monetization issue to a very uncomfortable and dangerous level, and we will talk about this in a little bit, but monetization is becoming commonplace.  It is something that was on the tips of our tongues two years ago as a theoretical possibility, and now is taken for granted as normal functioning in the marketplace, and therein is the danger.  We are reconsidering, we are recreating, the context for investments, and all of us are considering what is, today, normal, as normal, and it simply is not.

Kevin: An analogy for monetization, for the new listener, or for someone who does not really understand it:  It is the production of Treasury bills, offering them to the market, and the people who produce them buying them back themselves.  That reminds me of when my kids would have certain fund-raising campaigns, and instead of going door-to-door, oftentimes the parents ended up just buying all the stuff and you had the house full of this stuff.

David: Chocolate bars, or whatever.

Kevin: Exactly, so not only was it not a fund-raiser, but it was a fund-depleter.

David: I think that was a part of the gig – they knew there was a captive audience.  And in this case, also, there certainly is a captive audience.  At the Fed, as we get into the monetary side of this equation, we can expect to see their balances shift  significantly.

Kevin: If we are buying all this back, what happens to our credit rating worldwide?

David: This is a big deal.  We have the S&P and Moody’s agencies both warning on our credit ratings, and they are looking at the next two years, the next 24 months, as very critical, for either a real turnaround, or a negative watch or downgrade.  That is echoing our concerns over the U.S. deficits and what is compounding when you bring in the municipals, when you bring in the rollovers of current debt.

The issues that we have been talking about – it is not that S&P and Moody’s are unaware, it is just that it takes them a long time to do anything about it.  This is the week that they just moved Greek debt to junk status.  Now, how long has it been junk?  It has been junk for some time, but it took them a very long time to acknowledge it.

Kevin: And they are talking about the United States – lowering their credit rating.

David: Again, it is something that will take some time, but it is certainly on their radar.

Kevin: If something does happen so that the dollar is downgraded, would that not be a very large paradigm shift?  There are some major things that have occurred in the last century, but the U.S. dollar is the reserve currency of the world.  If it is downgraded, what are the effects?

David: Yes, it is very similar to the Berlin Wall falling, in terms of its recalibration of relationships and importance thereof.  If you look at Europe, if you look at the balance of power in Europe, in the Middle East, many things changed at the end of the Cold War, as the Berlin Wall came down and Communism ended shortly thereafter.  It was that kind of change, that recalibration, that I think we can expect should the dollar lose its reserve currency status.  It is of massive, monumental significance.

Kevin: Even if we keep the reserve currency status, there is a certain relative value of the dollar versus other currencies.  I think it is running close to about 78 right now on the index.  What is your thought on the future of that index, or that price level?

David: Looking at the dollar, we watch the 78 level as a very significant price.  It needs to hold up, or short-term pressure is going to take over, and we could see the currency back up toward about 72, potentially lower.  The dollar is, unfortunately, weaker than expected, and we would have expected, with all the things happening in Europe, and the decline in the euro off of 140 – it has lost a significant amount in a very short period of time, with the resurgence of concern with the European debt crisis – that is something that we would have expected to see show up more dramatically in the dollar, as an opt-out vehicle.  In fact, it has not been that impressive.

Kevin: How about the Chinese currency?  They are taking a little bit of heat for our own problems, aren’t they?

David: That is something that is certainly present, center-stage, now.  The Chinese are getting very vocal about the dollar-based international monetary system, and the point that has been made publicly in the last week or two, is that that system is a thing of the past, not of the future.  A part of that, I think you can assume, is a verbal jousting.  It puts the U.S. on a different footing in terms of the relations that we have and the negotiations that we are continually in with the Chinese, because we take the other side of the argument, not you and I, but the U.S. position, officially, is that most of the global instability which has been caused over the last 2-5 years is because of the trade imbalance with China, and specifically, the Chinese currency being undervalued.

Kevin: Isn’t this one of the reason why you wanted to talk to Dr. Friedman in the next couple of weeks?  He takes the view that the United States, with all of its troubles, is still going to probably be the hegemon of, at least, the next decade.

David: He does.  He looks at the next decade, and frankly, the next 100 years, and argues that the dominant position of the U.S. is not in question.  From a political standpoint, geopolitical standpoint, even an economic standpoint, considering the gap between us and China, they would have to see an explosion of growth continuing at the level that it has been at, 10%, 12%, 15% GDP growth per year, for another 30 years to begin to match us, before they could even raise us one.

Kevin: Whether we agree, necessarily, or not, with the authors that we talk to, it is to show the other side, because there are very valid points in Dr. Friedman’s book, just as there were valid points with Stephen Roach, talking about the rise of China over time, if they do the right things.

David, I am going to shift gears here a little bit.  The Federal Reserve runs a balance, and their balance is growing at this point.  It is in the trillions, is it not?

David: Sure, if we are transitioning to the monetary side of things and away from the fiscal, you have the Fed balance sheet, which is now at 2.47 trillion, and that is after last week’s increase of 32 billion.  The direction of that balance sheet is decidedly higher, and that is a given between now and June, because of Quantitative Easing II, which has already been announced, promised, etc.

Kevin: So, their balance sheet increases in size as they purchase these off of the open market?

David: Yes, and the question is, whether or not it will explode higher after June, with a Quantitative Easing III, or whether or not there will be some sort of a plateau and it will stay flat.  Really, the only thing that will keep Quantitative Easing III in check is the bond market beginning to revolt in earnest.

Kevin: Is that something you expect?  At this point, can you make that call early enough in the year?  Would you expect QE-III at this point, or sometime in the middle of the year?

David: It is difficult to say.  We suggested this months ago, that it is very possible that treasuries could begin to trade in black pools and there could be a hidden component in the Fed balance sheet, where we do not know what is being bought, or where it is going, so that it looks like there is relative stability on the Fed balance sheet.  Meanwhile, it is expanding exponentially, to the chagrin of our creditors, who would like to know what is happening, but they are having to connect dots that do not exist, because we have just removed them from the equation.

Kevin: Is this a little bit like what happened with Portugal?  Last week you pointed out the danger in Portugal, and then all of a sudden, it seems to have been swept away, and there does not seem to be a problem.

David: I guess this is one of the things that concerns me, as a contextual issue: When we look at monetization, here in the U.S. it has been largely a cleanup operation.  We are just picking up the remaining pieces from each treasury auction, that which represents excess, and it just gets shuffled away onto the Fed balance sheet.  It is no big deal, it is a few billion here, a few billion there.  Given the size of our economy, it is really not that big of a deal.  Given the size of our monetary supply outstanding, it is really no big deal.  Nothing fundamentally is changing as long as we are just picking up scraps.

But the point is, we are taking it for granted, and I think this is one of the things that disturbed me last week, and Nomura Securities was good at pointing out the extent of European Central Bank participation in the bond market last week, and in weeks previous, but with Portugal, they had a much smaller bond issuance than we would have here in the United States, but again, it is just a difference in the size of the economy and their funding needs.  They offered roughly 1 to 1¼ billion euros worth of bonds to the market, and it was a successful treasury auction, everything was taken, and Bloomberg just kind of moved forward.  There was no comment, no issue – obviously, the European bond market was stable.

The issue is this:  Nomura Securities pointed out that a billion euros of the participation came from the ECB.  We are not talking about cleaning up scraps here, Kevin.  We are not talking about a cleanup operation like we have in the U.S.  We are talking about an 80% purchase, in rough terms, of the Portuguese debt, going straight to the ECB, the European Central Bank.

Kevin: I wouldn’t call that a successful auction.

David: That is not a successful auction!

Kevin: No.

David: That is a failed auction, and the point is, nobody even batted an eye at it.  Everyone was saying, “The European bond market is as stable as they come.”

Kevin: Must be a recovery.  We must be fine.

David: Now, there has actually been a change in the last few days as yields have begun to creep up.  The better evidence is not in the pricing of bonds, which can be manipulated in this manner – through monetization, you have an utter mispricing of sovereign debt on a global basis.  But what is not mispriced, and what is not lost on sophisticated investors, is the cost to insure against default on any of those bonds.  A much better picture of the instability in the sovereign debt market is in the CDS market, the credit default swap market.

Kevin: You mentioned that last week, that the prices were just sky-rocketing.

David: Right, even while you have relative stability in the price of bonds, as a result of this monetization feature, if you will.  It is a new feature, it is an enhanced feature of the bond market, and it is one that, according to the powers that be, we should all be very excited about.  It represents a new form of stabilization – a new form of not just stabilization, because that has a negative ring to it, but of stability.

This is the point.  The market, whether it is the bond market or the stock market, is assuming relative stability, and we are now moving into an era of peace and calm.  This era can end in two seconds.

Kevin: That peace and calm is being manufactured by governments going further into debt.  This is not people actually going out and saying, “Hey, honey, let’s go buy some Portuguese debt.  That sounds good to me.”

David: All these things depend on how you want to read them, how you are inclined to read them.  Granted, maybe we are pessimists and like to call ourselves realists, but the reality is, if you are an optimist in this environment, you have far more to lose than to gain, because the fundamentals do not support you.

Let me just give you one example, Kevin, with Intel:  Blockbuster results.  They did a year-on-year comparison, showing that from last year to this year they are up 47% in their earnings.  The problem is, they took a one-time charge last year, over a billion dollars (laughter), which lowered their number, which makes the relative comparison that much more significant.  Not only that, they played with their tax numbers.  In addition, they had 1.5 billion dollars which should have shown up as revenue on the income statement, and it was not expensed.  Why?  Because it went out the door as stock options.  You have play in these earnings figures of roughly 3 billion dollars, which takes a 47% earnings gain and shrinks it to about 7% when all is said and done.

Trust me, Kevin, this was not lost on a handful of sophisticated investors on Wall Street.  The company was not rewarded for those blockbuster numbers.  How did the stock perform in the days that followed the announcement?  1%.  2%.  There was no news.  Why was there no news?  Because enough people know how to read the numbers and see what was going on there.  However, that did not prevent the media from manipulating popular sentiment and suggesting that there was a massive recovery in tech.

Kevin: You just spoke about sophisticated investors seeing through this.  There is a generational issue here.  A lot of the people who are making the decisions, the people that we see on T.V., the people who are actually buying, and writing, and  this whole organization of the financial markets, they are really of the middle-aged generation.  You have a few old-timers who are concerned.  It reminds me of the movie, Wall Street, the first one, with Michael Douglas.  They came out with a second one this last year, but in the first one there was an old-timer in the office, and he was warning, continually, saying, “No, no, no, you don’t want to do this, you don’t understand, I have been here before.”

One of the guys we have talked to many times, David, is Alan Abelson.  You have had him on the show in the past, and hopefully, maybe we will have him on the show again.  He is an old-timer.  He has written for Barron’s for about 50 years.

David: 56, almost 60 years – a long time.

Kevin: He is saying, “Don’t get fooled by this one.”

David: Kevin, that leads us to an important issue, which is, there are a certain number of people who are feeling better about the markets, and this is true of frankly too many people all at once.  I think that is what Alan Abelson was getting at in his recent Barron’s article.  You mentioned he has been a guest on our program.  He looks at a couple of different figures:  The AAII index of individual investors is registering about 52.3% bullish on the market, with about 23% bearish, and, as Alan says, the remainder are either comatose or on the fence – they are just not paying attention, they do not get it, they do not understand, they will never make a decision.

The point is, those numbers are getting high compared to past market peaks.  More worrying is the investment advisors, polled by a group known as Investor’s Intelligence, which is the name of the organization, it is not an appraisal or a measure of the actual intelligence investors are employing at this point.  The poll puts the bullish sentiment at around 57.3%.  Again, for perspective, the peak in October of 2007 just before the radical decline in the market was 62%.

Kevin: 62% of the people who were polled at that time were bullish on the stock market, and that was the very top?

David: And we are at 57.3% currently.  We are within spitting distance of there being the near-unanimous vote for all the bulls being in, and there being no one left to buy.  That is the point.  Everyone who was looking for a reason to buy, has bought.  What is the next set of reasons to buy?  Is it Quantitative Easing III?

Actually we are all bought up on the basis of Quantitative Easing II, and there certainly were powerful expectations of economic growth as a consequence of Quantitative Easing I – sorry, market, it did not materialize as expected – and that is certainly being factored into the price of stocks today, with the advent of Quantitative Easing II.  We have yet to see if there is real impact to economic figures as a result of the liquidity created and put into the system.

Kevin: That is quite a spread between bullish and bearish sentiment right now.

David: And the spread between bulls and bears is at 38%, with the danger area, according to the guys at Investor’s Intelligence, being anything north of 35%.  So if you are comparing the bulls to bears, and looking at that difference, and if the difference is higher than 35% – “Danger, Will Robinson!  Danger!”  The red lights are flashing, and investors should be aware of it.

The problem is, this is about the time that no investors care, and that is the point.  We look at the VIX, the volatility index, and it is at lows – it is between 15 and 16.  This is the point where the market usually turns, and the volatility index spikes.  Why?  Because people have been buying calls, and not puts.  They have been going long the market, speculating that things are going to be going up, ad infinitum.  Again, the last bull to purchase is what precipitates the decline, because there is no one else to push the market any higher.

Kevin: It reminds me, David, when you want to pick a good restaurant, or pick something to do, oftentimes you want to follow where the long line is, because that is a good indicator that it is a good service that you are going to get.  It is the opposite with the markets.  If you see a long line at the markets – I remember the tech stock long line back in the 1990s, and the real estate long line back in the mid 2000s.  That is not the line you want to get in, is it?

David: No it is not, Kevin, and just for the record, we are not contrarian for contrarian’s sake.  Frankly, it is a term that has lost most of its meaning.  But we are suspicious of structural recovery when structural issues have been neglected, they have not been addressed at all, so for the argument to be made that we are entering into structural recovery, we think there are some things that are significantly wrong with that.

Again, we are not trying to be dilettantes, and just take the opposite side of any particular trade, it is just that we do not see it adding up.  In fact, the risk far outweighs the reward in this environment.  Classic:  Richard Russell says this in several reports in the last week or two.  He said:  “Why would I buy the stock market today, with the average dividend yield at 1.86%?”  Charles Dow, the father – literally – the father of Dow theory, and of the Dow Jones Industrial Average, would not touch it with a ten-foot pole, anytime – anytime – the dividend yield slips below 3%.

Kevin: And it is about half that now.

David: Yes, plus or minus a little bit.  This is an era where buying guarantees losses over the next 10 years.  There are a number of different analysts out there who have projected that over the next 10 years the maximum growth will be about 3.3% per annum.  That includes dividends, that includes everything, and those are nominal figures.  That is not a real rate of return.  When you suck out inflation and your taxes on that basis, you are upside down.

Kevin: That brings up an excellent point.  So far, we have talked about the economy, we talked a little bit about the coming talk on politics and geopolitics, but there is something that sucks the life out of any rising market, and that is inflation.  We have not really seen huge signs of inflation in the grocery stores yet, but is it coming?

David: The December numbers for both PPI and CPIU and CPIW were unexpectedly higher.  That, I think, needs to be paid attention to.  There is also anecdotal evidence, in the developing world, of food and fuel prices, increasing tensions.  Again, these are political and social tensions, as a result of not being able to fill bellies.

Kevin: Tensions may be an understatement.  There are riots and deaths at this point.

David: True enough.  While there is criticism of local politicians not doing enough to contain food prices, and provide ample supplies to the general public, there is the new dot which is being connected, which is, these prices would not be rising if it were not for crazy monetary policy in the United States.  If they were not running the printing presses, we would not be paying the price.

The issue for us is this:  As Americans we have the luxury, having had an above-average annual income compared to the rest of the world, of being only inconvenienced by this.  It is no big deal for food costs or fuel costs to rise by 5%, 10%, or 15%.  It does not destroy our social fabric.

Kevin: We still eat, we may just eat a little differently, whereas in a third world country, they may not eat at all.

David: Exactly, and that is the point.  There is an immediate something that has to be fixed.  For us, we have credit cards we can put our added expenses on, or we can cut back on part of our budget and reallocate to another.  For much of the world, this is a question of going home tonight and not having anything to put on the table for your children.

Kevin: Our system has been based on conspicuous consumption.  In fact, if you think about when President Bush said we need to spend money to pull this economy out, we have been encouraged that that actually is how we do the world some good – to consume.

David: It is these marginal increases in basic foodstuffs that are financially putting a number of people around the world to the wall, and it is, as you mention, creating riots, protests, a heightened awareness of the divide between rich and poor.  So you are right to raise the issue of conspicuous consumption, because in the context where you have those who are not able to put food on the table, with those who can afford two, three, or four new Louis Vuitton bags for their luxury travel collection – guess what?  What you have is two versions of vulnerability.  One version of vulnerability is those who just cannot feed themselves, and the other is the vulnerable nature of the haves being put against the wall by the have-nots.

Kevin: Which we have seen many times throughout history.  You can just look at France, for example.

David: It is not to say that the judgment of the crowd is accurate or reasonable.  It is just to say that it is a dangerous component, and when you have a crowd that is angry and upset, they are generally looking for a scapegoat.  How do they prove their point?  How do they express their anxiety, frustration, anger, etc.?

That is what we are concerned with, coming into this year.  We stated a few weeks ago, and we also stated in 2010, that social tensions are something that we need to be very, very deeply aware of, certainly in the Third World, because it reconfigures geopolitical alignments, but also here, even in the United States.

While we are talking about the developing world, it is important to note that these consumption trends, in some regards, are constrained by what people have to buy to put food in their bellies, but there are some other trends that are important to recognize, too.  The World Gold Council pointed out for 2010 a radical increase in importation of gold.  That does not usually happen – and this is the main point – it does not usually happen when the price of gold is increasing, because the primary demand in India for precious metals is for the purpose of jewelry.  But 2010 redefined the gold market in India.  We went from 557 tons imported into India in 2009, to 800 tons in 2010, and the two components were investment demand rising by 73%, a component which is pretty rare, and not that popular in India.

Kevin: Theirs is jewelry demand, is it not?

David: And normally, there are less consumers of jewelry as the price goes higher, and yet, even reaching record prices in the gold price, there was a 62% increase in jewelry demand in India.  So there is a recalibration of thought, and a lot of this does have to do with an inflationary trend.  People are feeling it, people are looking at it, and I think we need to look at the leading edge of those decisions, and an awareness of inflation.

What I am saying is, I would look at this as a leading indicator, if you will, for an inflationary awareness, on a global basis, and you need to look where it is exacerbated and more dramatic – the impacts of inflation, people’s awareness of it, people looking at the man on the street and saying, “I can see that he is angry and frustrated, and I know why, and it does not bother me, but I am going to do something to protect myself all the same, because the awareness of inflation is here, it is now.”  Again, we are not that aware here in the United States.

Kevin: It is Asia, and to a small degree, Europe, but it is mainly Asia and the Middle East.

David: And a part of the reason why we are not aware, is because of that same issue we have been talking about all day today, which is that context is being redefined all around us, in such a way to put us at ease.  The CPI says there is no inflation, while there is inflation.  The consumer sentiment numbers say that everyone is happy, when I know people are not.

As that reality is being redefined, and being obscured for us here in America, we need to look at what others are doing, and why they are doing it.  As we suggested a few weeks ago, considering something as dramatic as redenominating, if it is important for the Indians to redenominate as a consequence of inflation, and they are at the leading edge as an inflation indicator, where they are seeing the consequences of our inflation here, just as the Chinese are seeing the consequences of our inflation there, the demand for gold as it rises globally, unfortunately, we will be the last ones to have an awareness of inflation because our reality has been redefined.

I think it really is important for our listeners to grasp the idea of denomination, denomination, denomination.  What are you investing in and why?  What is it denominated in?  Just like real estate, the critical variable being location, location, location, in 2011, 2012, and 2013, your economic stability and viability will be defined by denomination, denomination, denomination.  That is one of the things we will look at with Ian McAvity this next week as we look at the precious metals market, specifically, from a technical perspective, with a specialist who has been doing this for 50+ years.

Posted in TranscriptsComments Off on January 20, 2011; Perceptions Are Not Reality: U.S. Investors Are Being Duped More than Most

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