About this week’s show:
– China’s hard landing is now happening
– 0% rates: debt can’t get much cheaper
– High asset prices are floating on a sea of fiat money
– Receive 50% OFF Macro Watch from Richard Duncan. Promo code: commentary CLICK HERE
Posted on 27 July 2016.
Posted in PodCastsComments Off on Richard Duncan: Creditism Has Replaced Capitalism
Posted on 12 November 2014.
About the guest: Richard Duncan is the author of numerous books including:
The New Depression: The Breakdown of the Paper Money Economy
The Dollar Crisis: Causes, Consequences, Cures
Richard Duncan is an international bestseller that predicted the current global economic disaster with extraordinary accuracy. Richard has appeared frequently on CNBC, CNN, BBC and Bloomberg Television, as well as on BBC World Service Radio. He has published articles in The Financial Times, The Far East Economic Review, Finance Asia and CFO Asia.
Posted in PodCastsComments Off on Richard Duncan: QE4? “They’ll have to.”
Posted on 21 December 2011.
About the Guest: Bill King, has authored “The King Report” for over 18 years. It is an independent view on global, political, financial, and economic factors that influence world markets. Bill’s candid observations and forecast on the economic, financial, and political forces that are impacting the markets have been extremely accurate.
Posted in PodCastsComments Off on When Will the Requisite Purge Occur in the World Economy?: An Interview with Bill King
Posted on 01 June 2011.
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: David, we are coming out of the Memorial Day Weekend – Barbecues, time off, sunshine, bike rides here in Durango.
David: Fantastic bike rides here in Durango.
Kevin: How was your barbecue?
David: I would say it was at least 10% better than last year’s.
Kevin: Okay, now Dave, I understand that you think in numbers a lot, but 10%? How do you know a barbecue is 10% better than last year?
David: Well, by what we call hedons, these measures of hedonic enjoyment, of hedonism, if you will. I would have to say that the meat was better, the barbecue was hotter, and we even had a little smoke going on, a little barbecue chips, the wood chips, and what not. So, I would have to say that, adjusted for inflation, we came out good on this barbecue. Kevin, if mine was 10% better, how would you measure your Memorial Day weekend?
Kevin: (laughter) You know, I wasn’t thinking in percentages, but I just read something, that the Memorial Day weekend barbecue this year cost 29% more than last year, and I have to ask myself: Was this a 29% improvement in the meat that I was eating? A 29% improvement in the tomatoes that were on the burger?
David: Those are more expensive, actually, more than 29%. This was shocking to me. My wife came home and said, “You know I had to request tomatoes on my hamburger?” And I said, “Where were you?” “McDonald’s,” she said. At both McDonald’s and Burger King, now, you get tomatoes only on request.
Kevin: Right, because of the “shortage.” I’ve heard of this.
David: The low end for a box of 25 pounds of tomatoes last year was $5, more typically, $18-20 per 25-lb. box. Now it is between $48-75 a box.
Kevin: No wonder McDonald’s and Burger King don’t want to put those on the burger, because, frankly, they want to avoid having to raise the price of the burger, which is built into it.
David: And that would certainly blow up the dollar menu, wouldn’t it?
Kevin: Think about gasoline last Memorial Day versus the gasoline price this Memorial Day. I think we were paying less than $3 a gallon last year.
David: Last year I paid over $3 for diesel, and now it is over $4, so roughly, a 35% jump in what I paid from last year to this.
Kevin: In other words, using this hedonic message, where things just get better and better with the price, what we are saying is, things are just about a third better than they were last year. I certainly hope the listener felt the same thing.
David: I guess if you factor in hedonic adjustment, then the real inflation, from last Memorial Day to this, was probably closer to 20%, than 29%.
Kevin: Well, what is the government telling us right now? If you look at the market, oil is over $100.
David: Let’s just look at the market real quickly, just as a sort of a recap, coming into the new week. Oil is over $100. Gold is over $1500 – about $1540. Last year it was about $1200 at this time. The Dow is at 12,500, and we have NASDAQ at roughly 2800. The dollar, last year at this time, was about $86 and change, compared to the euro index, and we are at about 74.5 this week.
Kevin: So, a substantial drop.
David: Almost a 14% decline in the currency.
Kevin: You didn’t mention silver. Everyone seemed to focus on this astronomical move when it went up close to $50, but in reality, just a year ago, weren’t we under $20?
David: $18 and change, and we are up from that point, about 116%, so even with a tremendous drop in price off of $48-49, we are still up 116%, year-on-year. Gold is up 28%, year-on-year. This is a pretty fascinating time.
When we look at the market, this is particularly fascinating, because it is beyond price. This is the personality and the people involved in the marketplace. There is a new immunity. If you look at the news from a decade ago, any singular disclosure would have disturbed or destabilized the markets, but today, you have so many things happening, that it seems that everyone has just said, “Well, que sera, sera.” Whatever will be, will be. The future is not ours to see.
This is kind of crazy, because it is as if there is so much bad news that it is now banal. No one cares. No one cares, and they’ve checked out.
Kevin: There is a point, though, Dave, where let’s face it, we are all human, and we are hearing all this bad news on a daily basis, and you get to hear a lot of it here on a weekly basis with the program. We are looking for good news and it is hard to find. But there is a point where you say, “What do you do?” You do what you can do, and then there is a point where you go and spend 30% more for a burger, and about the same amount more for gasoline, if you have it, and if you don’t have it – we have, unfortunately, the highest number of people right now, ever, on food stamps.
David: Over 44 million people, coming up on 15% of the U.S. population…
Kevin: That’s amazing!
David: On food stamps. Kevin, I think this is where people, certainly, in spite of coming into the summer doldrums, need to pay attention. There are a lot of things happening in June, and there are a lot of things that have just been announced, which are worth looking at and being cognizant of, because it does represent shifting sands under your feet. If you are in the marketplace, these numbers really do matter.
Kevin: I have a question for you. Are we growing, or are we shrinking? We get different information on the news, and a lot of times they are talking about GDP growth, but what, really, is gross domestic product running at right now?
David: Kevin, the soundest of the logic is based on your assumptions. You can follow sort of a logical sequence of thought, but sound logic still needs to be based on sound assumptions. You can have good logic, with bad assumptions, and end up on the wrong side of things.
David: We have watched J.P. Morgan, Goldman, and a number of the Wall Street firms, lower their GDP estimates for this year, and it still ignores some of the assumptions that go into that number. We had the GDP figure come out at 1.8% versus what was expected at 2.2%. Of particular note is the GDP deflator. The deflator is the number that serves as the assumed rate of inflation when they are putting together their GDP figures.
Kevin: Surely they tell the truth on the deflator. I would think that the government – they don’t lie.
David: We have the Bureau of Labor statistics which has said that the April figure came in at 3.2%.
Kevin: So even though the Memorial Day weekend was 29% more expensive, everything else comes in at 3.2%.
David: But the Bureau of Economic Analysis actually uses 1.9% as their assumed inflation number, so 3.2 isn’t the number. 6.5 isn’t the number if you are using an older model, which we have discussed. 10.7 is not the number. They are figuring inflation at 1.9%, and as we have said, ad nauseam, on our commentary, understating inflation equals overstated GDP.
Kevin: In other words, even the 1.8% is overstated, using this logic.
David: It is. If we did use the current and understated number, 3.2% inflation, that’s what the BLS gave us for the April number, instead of 1.8%, we would be at 0.56% – just over half of 1% GDP growth.
Kevin: That’s using the 3.2% inflation number, which we know is still understated.
David: Yes, just bumping it marginally from the assumed 1.9% to 3.2% takes it to almost a negative GDP number. Then if you throw in the inventory buildups, which ultimately lower production in the future, you have GDP which would have come in at 0.6% instead of the 1.8%. Any way you look at it, the economic fundamentals driving GDP are quickly deteriorating, and we are just wondering when Wall Street will wake up to that, or if they are just comfortable with bad assumptions as they go about their fairly logical business.
Kevin: David, you are actually giving the benefit of the doubt, even using those numbers, because with the bailout funds, and we have talked about the bailout funds adding 8%, 9%, 10%, to the GDP, we are actually in a very severe negative shrink rate, if you take out the bailout money.
David: Kevin, this is where our conversation with Richard Duncan this last year, I think, was very insightful. He said GDP, whether it is up or down on a given month, or given quarter, or by the end of the year, what it neglects is that we are on life support – that this government deficit spending to the tune of 1.65 trillion dollars, is keeping the economy alive. Without it, the patient dies, and we are in a 1930s-style depression. What is the difference between the 1930s-style depression and today? The government’s ability to add to its stock of IOU’s. We will talk a little bit about that later, in regard to the debt ceiling.
Kevin, the Chicago Purchasing Manager’s Index, which is a good month-on-month look at the manufacturing trends, fell precipitously from 67 to 56.
Kevin: Basically, what this is saying is that manufacturers are less busy, even less busy than what was expected.
David: Truly, at 56.6, anything above 50 is still considered a positive number. What surprised everyone was that the drop from 67 to 56 was the largest one-month drop since Lehman Brothers in the fall of 2008.
Kevin: That’s not just in manufacturing. Real estate has been looking for a recovery now for a year-and-a-half. They keep talking about this period of time when maybe more houses are going to sell, but the Case-Shiller Index just came out, and it looks like the shrinkage continues.
David: We forgot to mention, Kevin, when we were looking at our market review, that the 30-year mortgage is now 4.6%, which is lower by 18 basis points from last year at this time.
Kevin: You would think people would be buying houses left and right.
David: That is really cheap money, Kevin, it is really cheap money. But you are right, the Case-Shiller Index was down 3.61%, and it is generally agreed, even by the National Association of Realtors, that this is confirmation of a double dip in housing. There was one city that had positive year-on-year growth numbers, in terms of the prices that were garnered for a single-family home.
Kevin: Somebody is actually seeing an increase in real estate.
David: Yes, because the economy is as healthy as all get-out. One city. If you had to guess, what would it be?
Kevin: Well, let’s see. It would have to be a city that is not dependent on manufacturing.
Kevin: It would have to be a city that is not really dependent on agriculture or keeping people employed.
David: Right. You could loosely argue that it is dependent on finance, but it is more about collection of bills, than it is actually, creatively, putting deals together.
Kevin: David, there was a city last year, when things were really rough in the economy, (not that they are not rough now), where we walked down the street – I remember it was right after the Easter service, and we decided to walk home.
David: Boom time.
Kevin: It was a beautiful, booming city, and we were saying, “Gosh, there is no economic depression here.” It just happened to be a city that was without a state.
David: You know you are in trouble when D.C. is out of money and you head into a recession in that particular place.
Kevin: So when a politician says they “feel your pain…”
David: Not really. Not really. (laughter)
Kevin: This sounds like Greece, Dave. In Greece right now, there are tens of thousands that are rioting, and they are just completely upset at the political class.
David: I’ve got to be honest with you, though, Kevin, the fact that D.C. is the only city out of 20 that was not in decline – I don’t think that’s funny.
Kevin: No, it’s not funny.
David: (laughter). I have a hard time not laughing, but I really don’t think that’s funny. Political volatility – this is, I think, what we see in Greece, and what we are seeing is that this political volatility has followed on the heels of a public perception of mismanagement of public trust. We are talking about assets which are being spent liberally in one part of the country, and the people are not happy with it. That is certainly the case in Athens, where, on a daily basis, there are protests about austerity, and they want someone to pay, in government. They feel like they have been abused and the trust has been abused, and there has been a tremendous amount of corruption endemic to the state, and their interaction with the EU. Where did all the money go? That is the question. “Where did all the money go? We have added all this debt, and it didn’t go to anything productive. What did you guys do to us?” That is a future question that I think will be asked here, stateside, as well as in other parts of Western Europe, not just in the southern peripheral states.
Kevin: Speaking of mismanagement. Yes, we have political mismanagement. It has almost become cliché, Dave. You were talking about the numbness that people experience. Something that got us into this trouble that wasn’t necessarily political mismanagement, was financial mismanagement, these collateralized debt obligations. As we went into this real estate bust, these CDOs were packaged debts that nobody really knew what they were connected to, that were never going to pay.
David: Right, packaged debts that were certified by S&P and Moody’s as triple-A rated, and then sold into pension funds all over the world, sold into investment schemes all over the world. We use the term schemes, but these actually were schemes, and they are back at it again. This month, June, is the first month we will see CDOs back in the marketplace since 2007.
Kevin: So they are back.
David: And interestingly, Kevin, it is commercial real estate, in particular, that is being creatively packaged and offloaded onto investors. I wonder why. Is there a second shoe to drop in the commercial space? Why would you be getting rid of the paper if you didn’t want to keep it? Why would it have to be creatively structured along the lines of the packaging that was done in 2005, 2006, and 2007?
Kevin: Could it possibly be some of this Arizona desert kind of real estate… “Hey, we have this dream, out in the middle of the Arizona desert. We are going to build this beautiful community – not really near anything – but it is going to be amazing.”
David: Kevin, what you are talking about is the CalPERS property that they bought for 400 million dollars back in 2006.
Kevin: CalPERS, in the California Pension Plan.
David: Correct. They had a dream. They had an amazing dream. This stretch of desert was going to be 42,000 homes, a new model community 60 miles southwest of Phoenix. They bought the raw land for 400 million dollars, and it was, hammer price, last week, sold for 32.5 million.
Kevin: Wow that’s sounds like a little bit of a loss, Dave.
David: It’s about 8 cents on the dollar. A good piece of land, 10,200 acres, but 8 cents on the dollar. Reminds me of what Warren Buffet has often said. “You see who is swimming naked when the tide goes out.” Or better yet, after 20 minutes at the card table, if you can’t figure out who the patsy is, it’s probably you.
Kevin: But in this particular case, Dave, it took California five years.
David: Five years to figure out they were the patsy. It’s a good thing they have billions to burn, and they don’t have any other fiscal issues in the state.
Kevin: We’re taking shots at real estate, but there have been homes sold. There has just been a tremendous amount of foreclosure homes sold.
David: 28% of all homes sold in the first quarter were foreclosures. That is about 6 times higher than a normally functioning housing market.
Kevin: So, basically, the real estate market is consistent, mainly, of foreclosures.
David: A good percentage of the volume has been these foreclosed homes, which, of course, depresses prices of the regular homes that are sold, as well. We have banks that are currently in possession of about 872,000 homes. That is an immense inventory, twice what it was in 2007, so the bank inventories have doubled since 2007, but that is not all. There is about a million additional homes coming into the foreclosure process.
Kevin: So, it is like that tsunami wave coming in after the earthquake.
David: Right, so there will be added homes under the bank inventories, and that is not all. There is a pipeline of foreclosures being fed by an additional 5 million problem and delinquent loans at present. So the idea of recovery – certainly the Case-Shiller Index is saying, “Nope, we’re not going to get it, and we’re not going to see it for the foreseeable future,” but you have a massive, massive volume of homes behind it. So when you look at the 4.6% mortgage rate, that is not indicative of a thriving market. You can’t get a loan today unless you are a pristine borrower, with perfect credit.
Kevin: Which affects housing starts. I have a couple of good guys working on a deck of mine right now, that new artificial decking. These guys are very good at their jobs, but they were honest. They said, “Look, the last two years we have had a really hard time getting work.” These guys are two of the best in town.
David: If you compare to peak numbers, you are talking about housing starts and new home sales, both categories, 75% below peak numbers, with existing home sales being 29% below peak numbers. Again, with those existing home sales, one-third of them fit in the foreclosure category.
We talked earlier about food stamps and the fact that 44.199 million people are now on food stamps. That is up from 26 million in 2007. The problem is not getting better. Unfortunately, the problem is getting worse, and I fear that it is the same cause here as in Greece, and in many places in Europe. We are not looking at primary causes.
Kevin: David, from a federal level, we have Congress debating how much more money to spend, or if they can raise the ceiling, or if they are not going to raise the ceiling. They are really using it mainly as a political tool, right now, to get their message heard. But we have, at the same time, states whose bills are coming due, and they can’t raise their debt ceiling. They can’t print money.
David: And I think we have addressed this before, Kevin. When you were talking about the debt ceiling, and it being raised a proposed 2.4 trillion dollars more this week, Republicans will grandstand, Democrats will grouse about what needs to be done – an increase in taxes is preferred over a decrease in spending. All of this is really a political charade, and in coming back to that one word used earlier to describe CalPERS – patsy – the general public is the patsy if they think that this debt ceiling debate is at all relevant. 20.7 trillion is the real-world number, factoring in Fannie Mae, Freddie Mac and the off-balance sheet liabilities, so the debt ceiling is a little bit of a non-issue, in my opinion. But when we do come to the state level, we are dealing with a real issue, that 2012 is front and center. 2012 is closer than you think, because for most municipals, their fiscal year begins in July, so we are coming into fiscal year 2012, for most municipalities, just here in the next 30-45 days.
Kevin: Are you saying that bailout money was used before to pay state debt, and at this point, that is not there?
David: Essentially, we had state tax revenue, and, for 2012, we had a federal subsidy which is going away. If you recall, last year we had the American Recovery and Reinvestment Act, which pumped 137 billion dollars into state budgets. We had a budget gap of 191 billion, so 191 missing, 137 to fill the gap, and there was only a partial underfunded portion, so the problem is, we don’t have the American Recovery and Reinvestment Act in play for 2012, but we do have a 112 billion-dollar budget shortfall for fiscal 2012. Again, that begins July 1st.
Kevin: Delaying the problem, versus addressing the problem, seems to be the real issue. Look at Greece. Didn’t the CIA actually say that a military coup is possible in Greece at this point?
David: That’s the rumor. The rumor is that there is a CIA report indicating that if things get much worse in terms of social unrest, a military coup will be in play to bring about greater stability.
Kevin: That is a factor that was caused by the same things we are talking about here, stateside. Now we are looking at it in Europe, it’s just that they are a little bit ahead of the game, or starting to see the financial go to the economic, go to the political, go to the strategic, or the military side of things, fairly quickly, and the military side of things could actually come from within, couldn’t it?
David: Yes, and politicians are not wanting to look at how severe this is. Merkel has finally agreed to a further bailout within Greece, which, if you look at what that did to compromise her place in the German state in the last 12-18 months, she may have just ended her political career. Saving the German banks is obviously a priority, and not wanting them to take a haircut, but in an attempt to save the German banks, she is allowing the German public and the European public to essentially pay the price, rather than restructuring the assets that are sitting on their bank balance sheets.
Kevin: David, you brought out last week, and you have brought out in weeks prior to that, the real event is the thing that they are not talking about. They are trying to keep this huge, huge event from occurring, that has to do with credit default swaps and if Merkel doesn’t step in and do something…
David: Then you have a credit event which triggers credit default swap payment, and a whole slew of counter-party problems.
Kevin: That could level things.
David: Right, and we talked about that a few weeks ago. There is now growing conflict within Germany. We have Merkel, who is agreeing to a further bailout. Then you have ministers of parliament who are suggesting that Greece just leave the EU. There is going to be greater and greater conflict between different political factions, whether it is in Germany, whether it is in Spain, whether it is in Portugal, and this is where we see a tremendous amount of volatility, politically, in the whole equation.
Kevin: It is like having a guy at the party that you step up to and say, “Why don’t you just leave, at this point?”
David: (laughter). Italy is not immune from this, either. Berlusconi had tapped one particular mayoral candidate, and he lost the election. Berlusconi’s reputation was on the line. This is seen as a watershed event in Italy, where he is losing credibility, the same way Merkel has, in the different state elections, starting about six months ago, and coming forward to the present.
Lastly, we have Spanish protests which have turned violent over the weekend. This is not a problem that has been solved, and it is not a problem that is easy to solve when you are looking at it from the wrong perspective.
Kevin: Aren’t we at about 40% unemployment for people under the age of 30 in Spain right now? So they have plenty of time on their hands for these protests.
David: That is correct. This is coming from an interesting quarter, but the former central bank governor in Argentina, who was on the scene during the 2002 default and de-valuation, Mario Blejer, does bring an interesting insight into the European debt wrangling. His appraisal of the IMF, the ECB, and the EU understanding of the crisis, is that they are coming at it from the wrong perspective to begin with. They are viewing it as a liquidity event: if they add new debts to old, that will sort itself out, that all they need to do to buy time. Mario is saying, “No, no, this is a structural problem. There is too much debt, folks. There is too-much-debt, and there is no way to pay it off.”
Kevin: It is a little like putting a Band-Aid on a heart attack. It is just the wrong thing, for the wrong problem. It is a structural problem, Dave, isn’t it? You have to get to the very core of the structure. You can’t just keep throwing money at it.
David: Right. But Brussels and Frankfurt had assumed that the Greece bailout last year, 12 months ago, would be sufficient to get them on their feet, and they would be able to borrow from the capital markets and start getting some IOUs back in play. That hasn’t happened. That hasn’t happened at all. This is what Mario calls a European Ponzi scheme.
Kevin: Is Blejer basically saying that they need to do what they did down in South America? Just default?
David: That is exactly his conclusion. Default is a requirement, in his opinion, to return to any sort of economic normalcy. He says, “The real question isn’t whether – but when, and how.”
Kevin, I think this is interesting, because there is not an exact parallel between a state like Greece, and Argentina, going back to 2001-2002, because in the case of Argentina, they both defaulted on debt, and devalued their currency.
Kevin: Because they had the sovereign power to do that.
David: And they don’t have that in the peripheral states. They don’t have that in any of the European states. They cannot devalue.
Kevin: They can default.
David: They can choose to default. That is the difference between the European peripheral countries and Argentina. But Blejer suggests that rather than pretending that this is a liquidity event, and spending money, to little or no effect – default. Start over. And if you are going to spend money, rather than do it perpetuating something that is not going to be workable in the long-run anyway, take the money that you would have spent in the bailout, and give it to the banks. You know that the banks are going to take a significant haircut in the case of default, you know you are going to destabilize the banking system, so go ahead and create a backstop for the banks and financial institutions.
I am not saying this is my suggestion, but certainly, the former central bank governor of Argentina. Again, this comes from an interesting perspective. “Hey, we don’t have the money – default! Hey, we don’t have the money – print!” This is almost serial in South America, but he is saying something very clearly here, which I think is spot-on, and that is, the EU, ECB, and IMF, are viewing this as a temporary problem, and it is anything but temporary. It is structural in nature.
Kevin: David, on a lot of the things that you talk about on a weekly basis, and the guests that we interview, we don’t necessarily agree with the solution when they come up with some of these things like, “Yeah, just default, pay the banks off.” But, what it does is it brings an insight into the problem, itself, because that actually, as foolish as that sounds – just go ahead and default, go ahead and pay the banks what they would have lost – that sounds ludicrous, but actually, it is probably smarter than what is going on right now, which is just printing money and throwing it at a problem that gets bigger and bigger every year.
David: Kevin, there are a couple of EU officials who have argued strongly that they can’t allow a default to occur, because it would just be an utter disaster, and these peripheral countries would never be able to borrow again. “They would be ostracized forever. It is the scarlet letter. You can’t default.”
Mexican debt defaults, and other Latin American debt defaults over the last 20-30 years, corrected the conventional wisdom, which was, in fact, that you would be locked out of the capital markets. That is not the case. The countries that defaulted, quickly, in Latin America, after about six months, had access to the capital markets, because the capital markets – the financial markets – whether it is London or New York – they have a memory which is about two nanoseconds. “Oh, we lost money on you? Oh, but we could garner new fees from doing new business with you? What happened yesterday is irrelevant. What can we do today? What’s the deal of the hour?”
Kevin: So, it is like when the mad parent says, “You are grounded for a year!” And then within about 20 minutes they are back on track doing what they are doing.
David: Exactly. Exactly.
Kevin: David, conventional wisdom would be that when this debt comes due, it is going to have to be paid. Are there unconventional ways that they can deal with this?
David: This is pretty unique, Kevin, because I think in the attempt to avoid default, in the attempt to avoid a dislocation of the debt markets by having some sort of a credit event, what is being suggested currently, with Greek debt, is that to relieve rollover pressure, these debts that are coming due, instead of having to pay cash, pay the principal back on the loan, they are talking about there being no defaults, but no redemptions, either.
Kevin: In other words, I can’t get my money out of my bond?
David: The bond will mature, just as you expect it to. There will be a pay date, but rather than being paid in cash, they will issue you a new bond instead of cash. This is one of the proposed solutions that captures the current audience of bond-holders, and keeps them captured, if you will, as an audience for these bonds.
Kevin: This sounds like something that has happened every once in a while during time of war. War bonds, things like that, where it just goes on and on, without a maturity.
David: Kevin, in essence, they are extending the maturities, but they are doing that, allowing existing debts to mature first, and then issuing new bonds in their place, to avoid that credit event, to avoid the default or credit default swap trigger.
Kevin: And you think that will avoid the triggering of this huge event if they just extend the maturities?
David: But they are not extending the maturities. That is the nuance. It allows one bond to mature, end of contract, beginning of new contract, and they are giving you a new contract and a new maturity date. You may not have been complicit, you may not have been interested in receiving a new IOU instead of cash, but that’s what you get.
Kevin: I guess that’s why we used to call them perpetuals.
David: Exactly. Kevin, the last issue regarding the Greek debt is that when you look at the ten-year paper, as we mentioned, it is 13 percentage points above German paper. We talked about that in recent weeks. But if you look at two-year Greek paper, it is fetching 26%. These are the kinds of numbers that you see immediately before a default. If you are buying two-year Greek paper, it is paying you 26%. For anyone who is income-hungry, you may say, “Wow, that’s attractive.” Just beware, you are getting ready to have your head handed to you. Default is imminent. Granted, somebody who is value-hungry is going to say, “No, no, no, the EU won’t allow it to happen. This represents the greatest bargain since the beginning of time.” Maybe. Maybe. But you have to realize there is risk that comes with that reward.
Kevin, I think one of the things we have to look at here in June is this. This is our advice: Do not go on vacation this month and leave your investments on auto-pilot. Do not go on vacation this month and leave your investments on auto-pilot.
Kevin: What you are saying is, “Watch and be wary.” Why is that?
David: You have the issues relating to Europe, and the issues relating to U.S. credit, all clustered in the month of June. As Juncker, the EU official, has said, details of a further bailout for Greece will be determined by the end of the month. I am quoting Bloomberg here. “We will try to solve the Greek problem by the end of June.” What is interesting is that nothing definite was agreed upon this last weekend. They tried to figure out how to solve the Greek issue and couldn’t get it done, so they basically said, “Well, we’ll get it done by the end of June.”
Kevin: But that money comes due, does it not, in this next month?
David: We have a whole bunch of things coming due. We have the Greek IMF tranche, which is due for repayment June 29th. That is the date when Greece is officially out of money – minor detail. Note to self: Try to find some more money by the end of June. QE-II, here in the United States, ends June 30th, and on that same day they are talking about putting the new IMF chief, who is to be chosen between now and then, in office.
Kevin: So, when it rains, it pours, but you don’t want to be on vacation, and you don’t want to be not paying attention.
David: Kevin, this comes back to the main issue. Not enough has been done over the last 12, 18, 24 months, to look at the real structural issues. Insufficient adjustments have been made and now we have default and restructurings which have to occur, at some point, in Europe. The question is, will they happen in the United States, as well?
Kevin, I think this summer is going to be anything but dull. If we are used to the summer doldrums, I would not expect it this year. Everyone from Mark Mobius, who is the Executive Chairman of Templeton Asset Management, to a number of different asset managers in the hedge fund space, look at what we have done to ignore the structural changes which needed to occur here in the United States, and just as a reminder, here come the CDOs, month of June. Have we changed anything? Have we changed anything, in terms of the real regulation of the derivative space? No. We are in a position now to do a repeat, as we head into the fall, of 2008.
Kevin: And this is something probably to consider, even for people who are very experienced in the financial and economic markets, because we have all been set to a pattern. I know, after decades of watching these markets, both of us, in the summer, usually, watch the Europeans go on six-week holiday. There are a lot of things that are built into the system to sort of relax the system during the summer months, and then of course, you have pointed out in the past that the fall comes, and it can be tumultuous. But in this particular case, I don’t know that the Europeans have that six-week luxury that they have had in the past, and it is the same thing here in America. It may be a long, hot summer, but not because of relaxation.
David: No, I think, June to October, 2011, will be a time frame to remember. It might, in fact, be seared into an investor’s memory.
Posted in TranscriptsComments Off on June 1, 2011; Numb and Number: The Dangerous Non-reaction to the Current Crises
Posted on 17 February 2011.
with David McAlvany and Kevin Orrick
Kevin: David, as promised, we are talking to you right now in Nassau, Bahamas, but you are there after having been at a conference in Orlando. I know there were 10,000-12,000 people at the Orlando conference. Tell us a little bit about that before we move to the Bahamas conference.
David: Kevin, I think there are several things that are worth mentioning. It was an excellent conference. We had a fantastic time meeting with clients, McAlvany Weekly Commentary listeners, the newsletter subscribers – just a wonderful, wonderful group of people. We had about 140 of our people who showed up to the conference, out of that 10,000-12,000.
I had a room that we packed out. Seating capacity was about 175, and there were well over 200 in the room, with standing room only. But the scale of that, I think, is worth mentioning, because this was a conference of very interested investors, people who are trying to figure out what is happening in the world, what is happening with their portfolios, what they can do to either preserve or grow their capital. Of the 10,000-12,000 people, if you take out the 140 people who already know us and would, of course, be interested in the topic that I was speaking on, specifically, precious metals, that leaves between 60 and 70 people, out of the 10,000-12,000, who have even a passing interest in the metals. I think that is very, very telling.
It was encouraging to me, and I guess when I say it is encouraging, that probably needs some explanation. It is encouraging to me because, for that few people to be interested in metals, after a 10-year move in the metals, ten years of an average of 12% gains per year, some years a little bit more, some years a little bit less, it is surprising to me that the general public still has no interest whatsoever in gold and silver. That to me is a strong indication.
Kevin: From a bull market perspective, that is very, very encouraging to the owner of precious metals, because that shows, as you have said many times, we are definitely not in that third phase of the bull market where shoe-shine boys are coming in and buying gold and silver coins. We are still at that phase where the general public is wanting to know how you day-trade tech stocks, I think.
David: I think probably the greatest success at the conference was folks selling software platforms for how to trade your way into millions – exactly what you just described, Kevin. “How can I take my $5000 thousand in savings and turn it into $5 million over the next 18 months?” Not only is this an unrealistic appraisal of how money is made and grown, but it is completely unrealistic in terms of an assessment of risk in the market. Really what it boils down to is that people want to be told exactly what they want to hear, which is, “You can make your millions without blood, sweat, and tears. You can do it with a subscription of $39.95 a month to our software package,” or something like that.
It was interesting, if nothing else, from a sociological perspective, and just as an anecdote I thought I would share that as we open this morning. The breath of fresh air was the remarkable people that we got to spend time with, both at the main presentation, and then in the subsequent questions and answers, a private session with about 30-40 people, and then also the consultations which we had with a number of our clients. We were busy for four days, back to back.
Kevin: Let me go ahead and reduce this broad scope down to the fine point. Out of 10,000 to 12,000 people who were looking at software platforms to quickly trade, there were, as you said, this 200 or so people who really were interested in maybe taking a reality check and saying, “Okay, where are we really?” Let’s take that and put a fine focus on that and talk about some of the questions that came out of that select group – that 200 people. I know you did question and answer sessions, both in the general sessions, and then also privately, when you met with clients one on one. What were some of the predominant questions that were coming up at the time?
David: I think it is important to look at those questions and share them. John Maynard Keynes used to compare the market to a beauty contest. He basically said that what is being determined is not who the prettiest girl is, but the market is essentially betting on who the judges will determine the prettiest girl is. It is one step removed from reality.
The reality of the market, the reality of the economy, is secondary in some sense to how the participants are going to bet. It was interesting, with 10,000-12,000 people betting uni-directionally, with great confidence, that the economy had already recovered, I opened up the presentation by saying, “While I have my prepared remarks, I am very interested in what is on your mind. Why don’t you ask a few questions and I will include the answers to those questions in my presentation today.”
The very first question that was asked was this: “If the economy is recovering, why do I need to own gold, and why would you expect the price of gold to continue higher?”
Kevin: If the economy is recovering, David, and we do not feel, necessarily, that that is the case, but let’s say it is. If the recovery is truly in action right now, what was your answer as to why a person would own gold?
David: Kevin, as you have pointed out, our case would be that it is not recovering, that there are, on a very surface level, indications of recovery, but when you scratch beneath the surface, and it does not take much scratching at all, you find that the real story is nothing like that, that recovery is not anywhere close. A lot of that has to do with the discussion of our fiscal status, what is happening on the U.S. balance sheet, the fact that in recent hours, we have gotten the fiscal year 2012 budget, and it is a blowout. Instead of 1.5 trillion in deficit, we are looking at 1.65 trillion in deficit.
We are looking at greater headwinds, in a time period when we are rolling over 70% of our debt, we are adding to our total stock of debt, not what the CBO estimated at 1 trillion per year, but between 1.5 and 1.75 trillion per year. This is the reality. The economy is on life support, but it sure does not appear that the patient is having any problems, whatsoever, mainly because government spending has stepped up to the plate and is filling the gap that the consumer once filled. Basically, 10% of GDP disappeared, the consumer went away, and the government stepped in.
Something we have talked about in the past is what Richard Duncan described as the shift from capitalism to debtism, which was destroyed in 2008, and now we move toward statism, wherein the state plays a greater role in the marketplace, and certainly, a predominant role in the economy.
Kevin: If it is truly a shift from capitalism, to debtism, to statism, there seems to be, as you said, this perception of a numbing that we have talked about in the last few weeks, of the body apparent, as far as the economy goes. This numbing is allowing people to think that it is a recovery. Let’s just hypothetically look at something, David. Just pretend with me for a moment, that we truly are in a recovery, that it does not grate against your nerves that we are completely ignoring the facts, but let’s just hypothetically say we are in a recovery. Is there a reason or a place for gold, if truly, a person believes we are there?
David: A part of the issue with us being in a recovery is that you then have to fall back very heavily on the skill set that the Federal Reserve has. They have created a massive amount of liquidity over the last few years, and in fact, if you look at the total amount of government liquidity provisions and guarantees, since 2007, 50 different initiatives have been put in place, and since 2007, 23.7 trillion dollars has been committed. Only about 3 trillion of that has been spent, but 23.7 committed to hold up the economy. On par with 1932? Not by a long stretch. We have seen the government be more active here than in that 1932, 1933, 1934 period where the alphabet soups were launched, all the government agencies which came into existence in the FDR period.
But you ask a good question. Let’s assume that we are recovering. There are certainly things that we can point to that would indicate there is a recovery. Auto sales have been stronger. GM reported a 22% increase in January. Retail sales in January were strong, and that is one way of looking at it. Again, with retails sales, if you take out an inflation component, you realize that retail sales actually did nothing, whatsoever.
But this is me digressing, and perhaps deconstructing the recovery argument. Let’s stay on track and assume that it is recovering. If it is recovering, you really have to have faith that Ben Bernanke is going to take away the liquidity and shrink the amount of liquidity in the system very aggressively, and, if he does not, then what we will find is an inflation that is out of control. He is running on the assumption that he has the reins in hand, and that inflation, like a mighty stallion, is something that he can rein in and control. Better the inflationary stallion, than the deflationary dead horse, in his book, which he cannot do anything with.
But there is a grand assumption there, Kevin. It is a grand assumption, and it would be the first time in Fed history, in fact, the first time in central bank history anywhere in the world, where inflation was, in fact, fine-tuned, and the Fed was able to contract liquidity at precisely the right moment to prevent a super-, let alone hyper-inflation, but more probably a super-inflation, as a result.
Kevin: It seems like an anomaly that a recovery at this point, a true, honest-to-goodness recovery, with all the money that has been created, could actually become the Fed’s worst inflationary nightmare. Is that what you are saying?
David: It could become an inflationary nightmare. The problem, again, with the idea that there is a recovery, is that the statistics used to support that notion are, themselves, flawed. As I mentioned, with the retail sales figure, if you take out inflation, the inflationary impact, there really is no improvement in the January numbers. If you are looking at GDP growth, with an understatement of inflation, you are overstating GDP, and on top of that, you have to subtract out the amount of government spending that is taking the place of private sector consumption – propped up aggregate demand.
Is it healthy for government to take a permanent place in the economy, larger by 10% of total GDP? Is that normal? Is that healthy? Is that the sign of a true recovery? I do not think so. That does not mean that money cannot be made, and I think this is the big difference. The financial markets can behave very differently than the underlying economy.
This is where bankers, whether it is bank bonuses or bank profits, or the financial sector in general, moving toward some sort of recovery internal to themselves – that is possible, when you create the kind of liquidities that Bernanke has created. When you create that liquidity it has to go someplace.
We are talking about a misallocation of capital. To the degree that that capital is misallocated, you will see someone benefit, because that money is going to end up in somebody’s pocket, but it is not Joe and Suzy lunchbox, it is not the man on the street, it is not the woman on the street, it is not the family out there in middle America trying to make ends meet, experiencing real world inflation, in spite of the CPI lies. This is the disconnect.
We do see the stock market rising. Why is it rising? Is it because of fundamentals which are supporting a recovery in company profits? Absolutely not. It is simply because you have money flowing from the Fed into the financial system, and it is distorting values.
Kevin: David, we have talked so often about the negative effects of inflation, but you just mentioned something that is interesting, that the underlying economy may not be necessarily pointing to the way the financial markets react, at least in the short term. Of all the negative effects of inflation, what would you say would be deemed a positive effect, even if it had a long-term bad outcome? What are some of the positive effects of inflationary policy?
David: Kevin, there is an issue in defining what I mean by positive, because there is a positive effect for speculators and short-term investors, because there is this distortion of money going places that it really should not go. There is “money to be made” as a result, but it really is of a speculative nature, and ultimately, we still have the debts to pay.
Ultimately, our debt-to-GDP numbers, when you factor in Fannie Mae, Freddie Mac, and our off-balance sheet items, are well over 140% of GDP. If you factor out Fannie Mae and Freddie Mac, and the off-balance sheet items, we will exceed 100% by the end of the year. We are well beyond the Reinhart and Rogoff threshold of 90%, wherein the red lights are going off and you have caution signs everywhere.
The economy is, in fact, in an ugly place. But that does not mean that money cannot be made because of misallocated capital, because of the liquidity pushes. That is what we are seeing show up in the commodities market. That is what we are seeing show up in the emerging markets, to a lesser degree, now.
Kevin: I have been to carnivals in the past where I get suckered into playing the darts game where you throw the darts at the balloon, and most guys think that they can either shoot hoops or throw darts, so you pay your buck and you throw the dart and you pop the balloon, and they say, “Wow!” and they hand you some little thing that is probably worth a quarter.
Then you pay another buck and you throw the dart and you just keep doing that, and by the time you are into this thing, you may be $25 or $30 into a game where you are winning a stuffed animal that probably cost the carny all of $3. In a way, you may feel like you are coming away with something, but as far as what was being taken away to get that stuffed animal, you have lost $30 to get a $3 stuffed animal. Is that a little bit like what we are talking about here, where we feel like there is recovery, we feel like these things are occurring? But you were talking about the government stimulus actually making up far more than the consumer spending deficit in terms of GDP right now.
David: If we are talking about the positive effects of inflation, because it is stimulus, which is artificial in nature, I think you have to question the enduring nature of it, and what is its long-term impact? That is where it becomes much more questionable. We had many questions while we were at the conference which related to the direction in particular markets, whether it was gold and silver, the dollar, emerging markets, lots of questions there, U.S. equities, bonds, municipal bonds, things of that nature, a number of questions which relate to a reduction strategy.
These are people who, at least those who attended that we knew and had a relationship with before, were interested in a reduction strategy in their metals position on a 3-5 year time frame. Not today, but as the market matures, and as gold and silver see higher prices, they wanted to talk about our plans and our strategies – what our organizational strengths are, and what we have been discussing with clients now for a couple of years, in anticipation of a transition in the marketplace. Again, not here, today, but something on the horizon.
Kevin: That seems to be one of the things that distinguishes you from a lot of the other precious metals dealers at these various conferences around the country. You have a tendency to want to start talking about when they should sell their gold, oftentimes before they have even bought their gold. For the new listener, for the person who is not familiar with the reduction strategy, could you give, in short order, a little bit of what you tell these audiences, as far as what to do when it is time to sell some of the gold?
David: Yes, and that is certainly in the context of what we think is the market direction for the precious metals. We will look at some of the other asset classes in question, too, but for gold and silver, we remain in a bull market. The notion that CNBC, and MSNBC, and the Wall Street Journal, and the Financial Times, and the Economist, have written about with great frequency, is that the bull market in gold is near an end because it is in a bubble stage, and there are so many people in that trade, and it is such a crowded trade. I think they just need to go to the money show. As writers, they need to do a little bit more due diligence in terms of the man-on-the-street, and the investor-on-the-street, out there trying to make these decisions. There is virtually no one interested in the metals.
It really was surprising. I would guess that if that kind of a financial conference was held in Europe, in the Middle East, or in Asia, you might find something very different in terms of interest. But I don’t know. I have seen other reports. Recently Marc Faber was at a conference in South Korea, and he asked, out of a thousand people, who owned gold today, and two people raised their hands. This is hardly a crowded trade, if you are talking about an investor with, whether it is 100 thousand dollars or 10 million dollars – very tepid interest, at this point.
We see gold as in the second of three stages, with it maturing, probably over the next 5-7 years, maybe on a shorter time-frame, maybe even on a little bit longer time frame, depending on how many people come into the demand side of the equation. We know that supplies are even more limited today with mine supply continuing to taper off, even while some demand is increasing here and yon. It will be interesting to see what happens when the average consumer decides that they want to own a few ounces of gold or silver.
You are right, though, Kevin, when we talk to clients, it is with the idea that we want them to see the end from the beginning. Making the decision to invest in any asset class entails a very thorough process of, “What am I going to buy? What is the reason why I am going to buy it? Is there a time and place that it makes sense to sell it? What would be the environment? What would be the background information that I would need? If I am wrong about this purchase, and it actually goes down significantly, is there something that I should consider as an exit strategy as a means of preserving capital?”
In other words, we embrace the client’s perspective, saying, “Don’t you want to know when it is time to sell?” Being a full-service company certainly helps with that, being on the asset management side and having an appreciation for equities, for bonds, for foreign currencies, for the traditional asset classes. Gold and silver, for us, is an asset that we understand in a larger context.
Kevin: That being said, because of course, you never tell a person to put 100% in any one direction, it takes me back to the triangle where you have it broken into three different mandates. One is a preservation mandate, one is a growth mandate, and of course, one is a liquidity mandate. That brings the attention to the other markets. Could you give an idea of what direction you think the various markets are going? You mentioned municipal bonds, you mentioned equities, you mentioned the emerging markets, of course the currencies, and then you have been talking about gold and silver. So take your pick, the order that you want to take them in, but those are all asset classes that I think people would like to have your read on right now as to where you think they are going.
David: We will have to start with U.S. equities, because I think that is where there is the most confusion, with the introduction of liquidity, QE-I and QE-II, with the accommodation that the Fed and the treasury have provided to the marketplace. The stock market has responded very strongly to the upside and I think that may continue for some time, but that is the problem with artificial stimulus. You have no idea when it runs out.
Literally, we, today, are running on fumes. The question of when we simply run out of steam altogether, I do not know. I really do not know. But the reality is, it can continue in this vein, and certain market participants are factoring in the inflationary impact and trying to hedge themselves by owning equities, as a partial hedge against inflation.
My own view is that we should look at the corporate managers and corporate executives who run these businesses, and it is still astounding to me that in any week in the last six months, we have had corporate executives jumping ship, and not on a small scale. With great frequency, we have talked about the buying versus selling in these companies, those ratios, and they remain off the charts.
Kevin: Corporate executives are still selling more shares than they are buying, of their own companies?
David: I think they realize that the economic headwinds have not gone away. I think they realize that their businesses are not, in fact, in recovery, and they are doing everything that they can, personally, to clean up their own balance sheets. Selling off equities as they are being driven to higher prices by the current lemmings in the markets is an opportunity for them to take some profits and pay down debt. If they have a third, or fourth, or fifth home, which many of the corporate executives do – guess what? They want to pare down that debt and own them outright.
If we shift over and look at the liquidity mandate in our perspective triangle, the dollar is, you could argue, due for a rally. Whether it ever gets one or not is something that remains to be seen. The dollar has been weak relative to the Japanese yen. The dollar has been weak relative to the Swiss franc. The dollar has been weak relative to a handful of currencies. We will have to see if 2011 holds a rally in the dollar, but not on the basis of fundamentals. I think as we look at the balance sheet of the U.S., it is something that is insolvent. We are talking about short-term versus long-term trends. Short-term, the dollar could rally. Long-term, I think it pays a severe price, with a 30%, 40%, or 50% reduction from these levels.
Kevin: Wouldn’t a dollar rally actually be, partially, because of the weakness of the other currencies that it is being based on? Europe is not out of the woods yet, and that is one of the major currencies that weights the valuation index of the U.S. dollar.
David: That is correct, and when we look at the emerging markets, also as an asset class that people were asking about at this last conference, if you look at the underperformance of most of the equity markets throughout Asia in the last 6-12 months, I think you have a telltale there. They were overheated on the upside coming into 2008, never fully recovered, and remain anemic in their growth, and that is in spite of a massive amount of liquidity which has been thrown into the market.
If you look at how tepid the response has been on the Shanghai exchange, just as an example, with the trillions of dollars which the Chinese government has provided to the marketplace, I think it is very telling. I think it is very telling, and it says to me, if that is the best you can get for the equivalent of a 4-trillion dollar stimulus, 1 trillion in actual point of fact, but on scale with a 4-trillion dollar stimulus here in the United States, as their economy is one-quarter the size. What you are really talking about is a market to run from – run away from as fast as you can.
The story of the emerging markets is a story that will continue to emerge over a 15-20 year period. Difficult to play the patience game as an investor. The emerging markets will be very rewarding if you have 20 years to wait. I think they can be very punishing if you want to stick around for another 12-24 months.
Kevin: That has been one of the points that Stephen Roach has made in the past when we have interviewed him. Stephen Roach is very bullish on China, and Asia, in general, as a potential, but again, he said, “Patience,” just like you did.
David: Transitioning to municipal bonds, I think that is an area that has been sold off very heavily with concerns of defaults, with concerns of bankruptcy, with concerns that the same kinds of fiscal woes that the federal government has, the state and municipal governments have, as well. The difference is, they do not have a printing press.
Having said that, we have seen a severe decline in those municipal bonds. For probably 18-24 months we have encouraged clients to limit, or eliminate, exposure to municipal bonds. They have been sold off severely. I would guess that over the next 6-12 months they may see a recovery in value. Our encouragement to clients is that they take the next 12 months, and if we do, in fact, see a recovery in value in the municipal markets, sell into that strength, exit any large municipal positions at this juncture. Because just like the federal government issue, the state and municipal issue does not go away.
I mentioned this in the context of my comments, but if you took the State of Illinois and fired every state employee, where you basically had no current cash outflow to pay employee salaries, you would still have, in the State of Illinois, a 5-billion dollar annual deficit, because of all the pension liabilities, and medical liabilities, to former employees of the state. The municipal issue is not something that goes way. You may see a dead-cat bounce in the muni market, and then I think you still have to face the music when we get into 2012 and 2013. So I would be aggressively, aggressively cleaning up a muni portfolio should we see a recovery here.
Kevin: That takes us, then, to the people who actually can print money. We talked about municipal bonds not being able to be funded with printed money by the state, because the state cannot print, but the United States can print, so that takes us to government bonds. What is your thinking on long-term, mid-term, and short-term bonds? Maybe you could explain that a little bit, and where we are going from here, from a yield-curve perspective.
David: When you look at the bond market, you have to wonder how many hats exist, and how many rabbits can be pulled out of them. The bond market and the currency market have been a real question mark. What is going on there? How do we understand it? If there is something that will allow us to preserve reserve currency status, and the IOUs which we have issued, can we maintain them? Can we actually make payments on them? Will we ultimately pay our creditors back, some value, or full value? These are all questions that swim around in the backs of our minds when we are contemplating the U.S. treasury market, particularly.
When you look at the bond market today, it is worth looking at our current liabilities, north of 20.7 trillion, and our total unfunded liabilities, which bring us closer to 70 trillion, and you certainly do not see those liabilities showing up as a weighty issue when you look at current yields. They do not factor in the risk of default. They do not factor in anything at all, really, when you are looking at 4.5, 4.6, on the 30-year treasury.
Kevin, you and I both know that we have lived beyond our means as a country for the better part of 40 years. You could probably trace that date back further, but at least the 30-40 years of the last credit cycle, we have lived well beyond our means. The bond market is the way that we have supported our lifestyle. It is the way that we have maintained dominance on the world scene, and you have to assume that a capitulation of the bond market would be really a sign that we have reached the end of the things that we have taken for granted for many, many decades, whether it is dollar reserve currency status, or the U.S. equity markets being the most liquid and deep financial markets in the world. Some of these things could begin to be called into question if the bond market collapsed.
You have to know that the Fed and the Treasury will defend that market tooth and tong. I just want to tie this into another question that was asked about IRA assets and whether or not the government would confiscate or utilize IRA assets to prop up the bond market. My response, I think, took several people by surprise, and it was that I do not believe the federal government will utilize IRA assets to do that because they are yours, they are mine, they are “self-directed,” they are the individual retirement accounts of individuals all across the country. When you begin to toy with those things, I think you create a lot of, shall we say, political volatility? That, I do not think they can afford to do.
But what they can afford to do is capture 15 trillion dollars from the pension funds and do so as a knight on a white horse. We have suggested this in the past, but it is becoming much more crystal clear to me, that the bond market will ultimately be defended with a very large resource to back it, and interest rates could very well be defended at low levels and prices propped up in the bond market, well beyond the time frame that would be natural or normal, with 15 trillion dollars’ worth of a war chest. I think that is where you look at the pension funds, and with some volatility in the stock market, if you assume sort of a step-sequence, the first shoe to drop may be a 10%, 15%, 20% correction in equities, which creates an even greater problem with underfunded pensions.
Then I think the government has an excuse to come in and blame pension fund managers for mismanagement. Whatever the scapegoat is, whatever the justification that is given, they will plead their case with pensioners, saying, you can either have 40%, 50%, or 60% of your pension as it is on track to give you now, or we will guarantee 100% of your pension, but we do need the 15 trillion dollars in assets to manage appropriately.
Kevin: That would be done in the form of some sort of an annuitized payout? Is that what you are saying? They would give you a longer-term guarantee as long as those pension fund monies would go into treasury bills?
David: That is exactly what happened with the Social Security Trust Fund. It got spent on whatever it needed to be spent on, and got turned into a long-term liability. They captured a present asset and turned it into a long-term future liability. For them to do that – this is the government doing what is normal to them. Theft is not new, but you have to do it under the right guise, and there has to be enough desperation to get away with it. I think the pensions are the perfect place where they will actually be able to justify it.
The reason I mention it is, in answer to the question if IRA assets are at risk, I would say, not they are not – not up to, or until, pension assets have already been taken, and then we might revise our view on the vulnerability of IRA assets. The pension assets are the low-hanging fruit, and that is what would be grabbed first, but it has huge implications for the bond market, because I think you could spend quite a few of those trillions in supporting the bond market, and again, distorting the notion of risk or the indication of risk in interest rates and the long-term treasury market.
Kevin: In other words, it is a form of carry-trade. It is saying, we can keep interest rates unusually low to stimulate the rest of this economy, as long as there are funds, as you said, the low-hanging fruit, that we can force through the machine. We have talked about the need to sell debt worldwide. But in reality, we have grown less and less dependent on international buying of our debt, at least through this crisis, because we have just been buying our own debt with whatever assets, or what looks like assets, that are hanging around.
With that being the case, there is an end to that game, and that takes us finally back full circle to where we started talking: Gold and silver. The direction for the market in gold and silver this year is something you have not really addressed, necessarily. We have talked about the long-term direction, but what are your thoughts about the market as we sit right now?
David: To the degree that the government defends the bond market, I think they have more ammunition than the “bond vigilantes” do, and the assumption is that the long end of the curve will steepen and you will see interest rates spike. This is the devil’s advocate position on a spike in treasury rates, which I think would be normal and natural at this juncture, but could be contained. If they are willing to defend the bond market and keep mid-to-long rates down, I think the bond vigilantes really take on a different complexion, and instead of seeing high interest rates and low bond prices, where that market becomes utterly manipulated and a non-market, I think you see the same sort of vigilantism show up in the gold market.
If you do not have interest rates indicating real risk in the bond market, it is going to show up someplace else, and that is where I think you see gold and silver as a barometer – a barometer for instability, a barometer for insolvency, a barometer for inflation, a barometer for a lot of things, and I think you could almost consider the gold market and gold investors to be the new bond vigilantes.
Kevin: Let’s say we are looking at gauges on a dashboard, and the bond market is one gauge of rising risk and rising interest rates. Then we have another gauge that is the gold price, but it is actually probably one of the smallest gauges on the dashboard. What you are saying is, better to artificially manipulate the big gauge, the bond market gauge, the interest rate gauge, and go ahead and let that gold gauge spike, because not too many people are actually paying attention to that. Is that what you are saying? It is robbing Peter to pay Paul, but nobody is paying attention attention right now to one of the gauges.
David: I think you are exactly right, Kevin, and that brings us full circle to the original observations about the Orlando conference and the fact that investors today could care less about the direction of the price of gold. After ten years of a sustained bull market, it really factors in as irrelevant in their minds. It is not something they have had interest in, nor will they in the future, until it is something that they are forced to purchase by necessity.
Kevin, next week we have Marc Faber on our program. I would like to quote something that was in his recent newsletter, a quote from Joseph Schumpeter: “The modern mind dislikes gold, because it blurts out unpleasant truths.” I think, Kevin, that is essentially why you have investors today still tied up in a world of hope, which is normal, it is human. I think that quote goes a long way toward explaining why people neglect the gold market, because it is unpleasant to consider the reasons why gold has moved higher in the last ten years, and might continue to over the next 3, 5, 7 years. It is more of a psychological blindness. It is something that people do not want to come to terms with, because it means that the world we live in is not quite as stable, safe or beautiful as they want it to be.
I certainly agree with them, I would like to see it more stable, more safe, and more beautiful, and maybe we will see those transitions in the next 3, 5, or 7 years. That has been our contention, and that is one of the reasons why we are here in the Bahamas today, to look at things from a global perspective, looking ahead, exploring different ideas as we consider transitions away from the metals in future years, with a very global perspective, we look at asset management and have to consider the direction that the world is going from a demographic standpoint.
We mentioned earlier that we consider emerging markets to be a huge bull story, just something whose time has not yet come. To be early on that theme has been painful. Fortunately, it has not been painful for us, nor do we intend it to be.
We are here in the Bahamas considering what it means to be a participant in the global financial markets, looking at asset management, at individuals’ lifestyles, in an international context. That is what we call our inner circle briefing. We have joined our partners from Switzerland, from Wealth Management and BFI Consulting, for an excellent two-day seminar. Perhaps next year some of our listeners would like to join us. We have a packed house this year, and look forward to the audience next year.
Kevin: David, I know you are heading to one of those conferences right now, so we will go ahead and wrap it up.
Posted in TranscriptsComments Off on February 15, 2011; Are Gold Buyers the New Bond Vigilantes?
Posted on 20 January 2011.
The McAlvany Weekly Commentary
With David McAlvany and Kevin Orrick
January 20, 2011
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.
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!
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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