- Your questions answered part 1 2019. Thank you for a great 2019 and for listening to the McAlvany Weekly Commentary.
Your Questions Answered Part 1
December 26, 2019
“In that phase one of a superinflation or a hyperinflation, stocks do better than gold, just before you get wiped out. Now, are you smart enough to pull the trigger and get out? You’re talking about massive growth and it’s almost like, where do you jump off the roller coaster? Where do you jump off, how do you jump off? If you believe that you can, you probably don’t understand the structure of that ride.”
Kevin: I always look forward to this every year, Dave. At the end of the year, listeners send in their questions. And every year they sort of surprise us because some are financial questions, some are philosophical questions, and then some actually sort of border into science questions, not that we’re scientists, but it’s interesting to see the variation of the questions every year.
David: I think one of the things that has defined our 11-year conversation is that we, as individuals, are curious about lots of things. And that curiosity comes out in our searching for connections between different fields. And sometimes you gain insight from one particular field of study that would seem to have nothing to do at all with where the question originally started. But there is a way to analyze and understanding that comes from seeing things from a different perspective. It’s one of the reasons why when we think about economics we think that macro-economists are somewhat hampered in being able to see the world as it is because they are looking at it through a very limited lens and the questions they are asking are sometimes in a very small box.
Kevin: One of the things that I have found is, if I really look at my circle of friends, the people that I look forward to getting together with, they are curious people, almost to a person. And I’ve found that our listeners are curious people, as well. So why don’t we jump right into the questions and we’re going to make this a two-part program, so you’ll hear this week some of the questions and then next week we’ll pick up with it.
David: Excellent, let’s get started.
Kevin: Our first question:
Recently, I’ve been reading and listening to a lot of information surrounding Deutsche Bank and its restructuring attempts to offload distressed assets. For example, back in July they sold off a lot of them, and then they recently made another deal with Goldman. But of course, nobody wants to buy just the radioactive trash so they have sweetened the deal by wrapping it up in a Frankenstein “capital release unit,” which contains not only toxic assets, but a lot of good, profit-making assets. So Deutsche loses quite a bit of money off of these deals. I’ve heard a figure of upwards of 2 billion dollars in downwind revenue loss for the July selloff, so I suppose the basic premise of my question is, which do you think will happen first? Will these toxic assets explode and bring Deutsche Bank to the brink, or will she end up thrusting herself on a bitter spike? Love the show. Thanks in advance, Nick.
David: Thanks Nick. I think a couple of things to keep in mind: One, the ECB still is keeping interest rates at an incredibly low level, and we still see negative rates in many of the jurisdictions in Europe, and that is one of the things that keeps things going longer than they would otherwise. There is no penalty for running a poor business or making poor bets in a world of free capital. So just like we have seen banks in Japan go on and on and on after the Japanese crisis so many decades ago, part of that was that they didn’t have to pay the piper. And so there is this sense in which we expect to see Deutsche Bank implode. On the other hand, they don’t necessarily have to. We have Fed liquidity in the global markets, we have ECB liquidity in those markets, and I think very telling about the market sentiment in terms of Deutsche Bank today, if you look at credit default swaps, specifically on Deutsche Bank, their senior secured paper, there is no worry in the market today. It is actually priced today, basically, where it was in 2007 when there was no concern in the marketplace. So it is not as if they are just barely hanging on and getting ready to throw in the towel. Looking at what it costs to insure against default on their senior secured paper, it is very inexpensive, there is little to no concern. It doesn’t mean that can’t change very quickly, but things can, and often do, take longer, particularly in a period where, again, the consequences have been taken away because the cost of capital has been lowered as it has been over the last several years.
Kevin: And it’s a strange irony that we just finished a white elephant gift exchange here in the office. Some of the gifts were great. Some of the gifts were something you absolutely would not want to take home.
Kevin: And in a way, that’s how these gifts are packaged from Deutsche Bank and what we saw ten years ago. You really don’t always know what is inside the package. So even though there is not concern today, there could be concern tomorrow, right Dave?
David: Yes, and that is something that we do. We watch on a weekly basis, whether it is J.P. Morgan, or Goldman-Sachs, or Deutsche Bank, looking at the prices of credit default swaps. And honestly, today, there is virtually no concern. It is ironic, as we have talked about on the commentary before, looking at the VIX and other indicators of stress, coming into 2020, according to the market, there is zero reason for concern. Now, how wise the market is, I guess we’ll find out in 2020.
Kevin: If we’re looking back ten years, we will go to Devin’s question. He says:
Why is too-big-to-fail not considered anti-trust?
You know, ten years ago, if you were too-big-to-fail you actually got through the crisis. If you weren’t, you actually didn’t.
David: I think it’s a fair question and it points to the fact that, really, we do have anti-trust issues if you’re talking about the financial markets today. This is where you have an odd mixture of not only privatized gains and socialized risks, because that is what we have ended up with through the period of global financial crisis over ten years ago, where too-big-to-fail became even bigger. But there is also something that I think is worth commenting on, and it is one of the weaknesses within free market capitalism. I may be considered a heretic here, but particularly when you look at Austrian economics, there is this sense in which, just let business be business. And yet, there is a tendency toward monopoly. There is a tendency toward control. And I think, ultimately, that is what you have had, is the confluence after the crisis of panic marriages and shotgun weddings and things where, yes, you ended up with too-big-to-fail is now even bigger. Yes, that is anti-trust issues. But we got to those large toobig-to-fail type entities, in part, because of collusion and control natural to as process of somebody who wants to grow a business, and grow a business, and grow a business, and grow a business, and grow a business. Again, I’m not generally critical of the Austrian school, but there is a weakness there, which is you can’t really resolve the problem of monopoly.
Kevin: And isn’t it strange, Dave, that you start with Austrian Economics and it turns into monopoly, but then when it gets to be too-big-to-fail, then it actually hands things over to the central planners. So it is sort of a self-fulfilling prophecy where you lose free market economics because of monopoly.
David: I think that is one of the things that changes is you go from being innovative, growth-oriented, and expanding a particular franchise, to then all of a sudden defending turf, and that’s when it gets political. That’s when you move into the world of anti-trust where you’re actually trying, as a monopoly, to block anyone coming in. You’re guarding your space. And so you can see a philosophical conversion from “I’m a free market capitalist, I love to take risk, and here are the benefits of it over the long term,” to “I’m happy to work with the state to defend my turf.” And that transition – I don’t know exactly where the transition point is…
Kevin: Let’s call it Tesla.
David: (laughs). Okay, all right.
Kevin: Okay, let’s do. So, our next question is from Finland from Antti. Antti says:
What is your view on the emerging double-digit growth New Market logic that has recently formed in the largest market in the world? The market is, of course, called Big Data, and the New Market logic is called Surveillance Capitalism, and has been academically documented by Professor Shoshana Zuboff.
We should have her as a guest.
David: I think that’s a large part of the answer to the question. That conversation should include the author of that book, Surveillance Capitalism. I have seen it, I have read good reviews of it, but I have yet to get through it. So what Professor Zuboff is getting at and what the question suggests in terms of Big Data and there being a new market logic, I think is very important. A couple of general comments – one is that we have to be aware that privacy has been dead now for 1½ to 2 decades. That, I think, is just a flat reality. There was an article, Kevin, that you and I talked about a number of years ago coming from Foreign Affairs Magazine. The title of it dealt with Big Data. And the content was all about correlation.
Kevin: Yes, correlation versus consequence. If you think of the two Cs. We as humans, part of wisdom is to learn about the consequences of certain things and realize that not everything causes everything else, whereas Big Data correlates things. You and I were talking about, let’s say that you bought a particular stock. Let’s say that you went out and bought Apple stock three days in a row, and those mornings you had an espresso. If a computer was matching both of those things together, the next time you had an espresso, it might go out and buy Apple. That is not necessarily a consequence, it’s a correlation. That the problem. When the world starts thinking in correlation, human wisdom no longer works.
David: Yes, I think that is a very excellent point. There is a kind of knowledge and a kind of analysis which is non-numeric, and more and more what we are seeing is just the math. And just the math is not entirely human. It’s not that math is devoid of humanity. It is a part of who we are and the way are minds are structured, but it is not the only aspect of how we arrive at conclusions. I think part of this as we move toward a greater and greater confidence in the word progress, and progress has been defined over the last several, not just decades but maybe even centuries, by the role of science and the role of mathematics. And there is no doubt, that progress can be detailed, it can be highlighted, it can be documented, and science and math have had something to do with it. But we begin to fall in love with it to the exclusion of other things which are equally important.
Kevin: Well, we stop recognizing the decisions. So the market starts to become unrecognizable when it starts making Big Data decisions.
David: I think the presumption of the people who control the data is, okay, we now own the product, the product is us, that is, they own us because they own our history, and to the degree that they own our history they believe, now we can drive consumption, we can drive distribution, we can drive marketing, and everything is done in such a way that it is a different kind of captured audience.
David: Becker Polverini?
Kevin: Yes, Becker was talking about that, how we become the product and they say, “It’s worth it to you. We’re going to give it to you for free for now so that we can later tell you how to buy and what to buy.”
David: But let’s do this. I think, to expand that conversation we come back to a conversation and invite Shoshana onto the program. Perhaps she will join us, perhaps she won’t, but Surveillance Capitalism is a book that is actually on my reading list, and so for 2020 that will make its way into our conversation one way or the other.
Kevin: This next question is from Charles. He says:
I’m a Spanish 29-year-old, and just for background, I have been listening to your Weekly Commentary for about a year now. I got to you through Doug Noland, who I found out about through Real Vision TV. Thanks for all the work you do. It’s highly instructive. My question is, why do specialists of the financial and economics world keep speaking about mistakes – mistakes – carried out by central bankers, as if they were not intended decisions?
Before I go on, Dave, would you answer that part of the question?
David: Sure. I think a part of it is, these are not mistakes according to the textbooks that have been read, according to the philosophies that are subscribed to, or what we could call a textbook bias. And so, they are doing their best work and they are executing on it, and it’s not a mistake. This is good work. When you talk about financial planners, the central bankers, they are doing very good work, in their view. So where is the critique? It is undeserved because not only do we have the work done, but particularly after the global financial crisis they would assess their work as being very effective, and the decisions made ring true in terms of the results having been positive.
And so evidence, or exhibit A, is: did we go into a financial apocalypse? No, therefore what we did is the answer and we knew that because the textbooks told us it would. I guess what we have yet to see, and I think we will see, is that the extend-and-pretend policies they put in place actually didn’t change anything structurally, so will we see longer-term consequences to the decisions that have been made? Yes, I think we well. And what is the timeframe for that? Frankly, it is anyone’s guess. But, and this is coming back to that Austrian school, a part of that is an influence, in my mind, that there are consequences. And part of those consequences, the timeframes can’t be measured because it is not just math. There is psychology involved. There is sociology involved. There are human actors who, at some point are fed up and say, “It worked. Now it’s not working anymore.”
Kevin: Doesn’t it boil down to either central controlling, or individualized control. And we all lean somewhere in the middle or to one side of those areas. We had a guest on, Pippa Malmgren, and she characterized it as saltwater thinkers and fresh water thinkers. The saltwater thinkers were more centralized control, the fresh water were more individualized control, and that’s always a battle. But Dave, the central bankers that we have had on the show, without exception, have been surprising, so when people think these are evil, ill-intended people because they are controlling the world, what you find is, actually, most of them, the ones we have talked to, have good intentions. They are just in a system maybe that a lot of us might not agree with the power that they have.
David: Right. Now, we have not talked to Volcker, can’t anymore. Greenspan, we could. Don’t know that he would come on the program. But both of them change pragmatically at a certain point. If you look at their philosophical leanings and tendencies prior to taking significant public posts, they were very much into market dynamics. Both of them even had some influences which were Austrian-related. Both of them liked gold. And then something changed pragmatically. But I think the coincidence is not just taking public office, it is also significant changes within the structure of finance, and within the monetary system, and they sort of dropped their philosophical idealism and moved toward a more pragmatic approach to managing the system.
And so, we have talked to Paul Tucker here in the last week; Otmar Issing, who was eight years at the European Central Bank, the longest-standing member of the European Central Bank; William White who spent years at the Bank of International Settlements; and I think what you see from our direct conversations is that these are people making educated guesses. And there is art as well as some science but probably as William White would say, more art than science, and they do make lots of mistakes. So I guess a part of my response ties into the next part of the question from Charles.
Kevin: Yes, which is:
Why do we keep giving them the benefit of the doubt, assuming their decisions are made in ignorance, and actually they’re not made in ignorance, but they do have a certain mandate?
David: Yes. And he also says that banking positions, no doubt one of the most powerful positions in the world, getting into those positions requires outstanding skills and knowledge coupled with political capital to climb up the ladder, and it is indispensable to get to the top. These people are not stupid. I totally agree, they’re not stupid, and I don’t think they are intentionally malevolent. This comes back to this notion of a textbook bias and how they are operating on the basis of what they believe to be the best tools for the most pragmatic results. And I think some of those results actually tie to a view of the good life or a perfect world, which may be something that is up for debate.
It’s not necessarily the case that we have to have unending growth. That’s one of the reasons why we talked to Tomas Sedlacek who came alongside of Vaclav Havel in the period of time when the Czech Republic was coming out of communism, and as a 23-year-old prodigy he was giving economic advice for this country which was moving from communism to capitalism. In his book, The Economics of Good and Evil, he highlights that, no, growth isn’t necessarily the end-all and be-all.
And yet, that is where, I think, when we think of decisions that are being made, a game plan that is being put together, mistakes, it is not necessarily the work that is being done that should be critiqued as much as the assumptions that is it based on and the direction that it is headed toward, which opens up the possibility of pursuing growth at any cost. So if the ends justify the means, so to say, then we will do anything we can to keep the economy going and rolling and growing infinitely, including stacking on more debt than ultimately is healthy and sustainable.
Kevin: Wasn’t that Paul Tucker’s point? What we need is, actually, some limitations to these institutions. It may not be the intentions that we can change, but it is the limitations.
Charles goes on:
Richard Werner’s views on the need to fight concentration of power in the hands of a few in the banking world is behind this question.
You brought up Sedlacek. Good for you, Charles, because you obviously read Sedlacek’s book. In the question it says:
Sedlacek’s Economics of Good and Evil speaks of this, too.
David: Yes, I think cycles bring into play this balancing between how much control and power central banks have, and I think one of the reasons we brought Sir Paul Tucker into the conversation is because there are, even amongst central bankers, recognitions that these limits need to be in place or they may lose their franchise. So yes, power has been concentrated, but yes, I think they are also aware that if you don’t hand some of it back it will be taken back, because ultimately, there is a social and political response to it.
Kevin: We’ve talked about controlling information and the last part of Charles’ question says:
Controlling information and financial transactions as opposed to previous eras of control of land and resources.
That has something to do with this, too. It overlaps that Big Data question from our other listener.
David: Yes because I think central planners or central bankers assume that the closer they can get to the data and its flows, and almost develop something predictive on the basis of those inferences, on the basis of those correlations, is that they can maybe even define what the next choices will be. So momentum matters. The flow of those financial transactions matter as they sort of move backward, read them and their significance, and then try to project forward how to sort of channel the flows, this is where Big Data and central planning and central banking is all coming together.
Kevin: I’m going to ask my own question. Momentum investing always works for about 90% of the time, and then when it goes wrong it goes terribly wrong because the momentum changes, and the momentum no longer is the direction of the market. It changes the momentum to the other side.
David: It works until it doesn’t. One of my most painful lessons as a young investor, not as a professional, but as someone who had handed the reigns to someone else to do this, the strategy, Insight Capital, I will never forget. Total momentum player, and it worked well through the 1990s and all you could look at was gain upon gain, upon gain, upon gain, upon gain.
Kevin: Like now.
David: But the amazing thing is, at that point of reversal, and this was actually one of the trigger points for me to go to work for Morgan Stanley because I said, “This is never going to happen to me again. I want to understand what happened here.” And my education process, very hands on, on the job training, so to say, began in 1999, 2000, 2001, 2002, 2003. I cut my teeth in the financial markets in the context of a bear market, but it was the front edge of that bear market that got my attention in a major way. It’s one thing to make money, 20%, 30%, a quarter. Gosh, what a modest return 30% in a year.
Kevin: What if this continued, for my life.
David: Yes, but it’s an amazing experience to watch an 80% decline occur in 60-90 days and not to have an explanation. But when momentum stops, as you say, it works until it doesn’t. And when it doesn’t work anymore, it’s dead. It’s dead. And so that loss with Insight Capital was a very significant contribution to me trying to figure out the way things work.
Kevin: This next question is from Australia from Matt. This is a question we get here in the United States here, as well. He says:
Hi. Has there ever been a time when governments have confiscated 401k’s, or as we call them in Australia, superfunds?
David: They are too new a product to have the precedent there, so 401k’s, 43b’s, those types of retirement plans replaced pensions. And they moved what was a long-term liability for a company to a risk asset for an individual. That individual now has to manage that asset into the future. It is basically like an income liability, future income liability shifted to the worker. In essence, it is too new for a precedent. But what is not new is having allocations within financial structures which are bullied, essentially. It’s ironic that we have conversations in the schoolroom today, in the classroom today, about bullying, or even in the workplace about bullying, and maybe even in the oval office, about bullying. But there is no problem when it comes to government making choices that limit options for us. There is precedent for that, and I think we will see that again, where you can choose A, B, C, and D. These are your choices and that’s all you need. Well, that’s a form of bullying and it has happened. The only thing that comes to mind is perhaps back in the 1980s.
Kevin: Yes, when Jesse Jackson was campaigning in 1988. He said, “You know, there are an awful lot of IRAs out there we might be able to help Social Security with (laughs).
David: Exactly. So we don’t have a precedent. There has never been a confiscation. I think people need to be aware of having limited options. And so doing what you can on your own, I think, makes a ton of sense, looking at IRAs and 401k’s, Roth IRAs and what not, and taking advantage of that as much as you can.
Kevin: Don’t run away from them because the tax advantage is too good. You can just be careful and watch them in case something changes.
David: Right. In fact, you know what I would do? This is a very practical point. It’s not part of the question, but I think I should segue to this, and we’ll come back to the actual questions here in a minute. When you look at your IRAs, I would look at 2020 as an opportunity to begin converting, or do as much converting as possible from traditional to Roth IRAs. It’s obviously up for grabs in terms of who wins in 2020. We don’t know how this whole DC trial and things relating to Trump will pan out.
Kevin: But 2024 is still coming.
David: I guess my point is, you know you have 2020 in terms of the tax code that is going to be on friendly terms for you. So from an income standpoint, if you can maximize conversion from a traditional to a Roth, settle up with Uncle Scam without bumping into higher and higher tax brackets, you want to do this judiciously, carefully, with the help and advice, the guidance of a CPA, but maximize the conversion to a Roth so that you’re now, for life, sitting on a pool of tax-free investments. Whatever capital gains you have theretofore would be tax-free.
Kevin: We would encourage you to give us a call. We can help you with that. 800-525-9556. We can help with that.
David: You’re right, 2024 is looming out there. Should Trump win you can have four years to get it all converted because at the end of four years I can guarantee you the political pendulum is swinging. So it’s either swinging hard in 2020 or it’s swinging hard in 2024. Many people focus on what they make in terms of their investment returns. I would like for you to say, it’s not only what you make, but it’s what you keep at the end of the day. So tax efficiency is very important. One of the ways that you can maximize tax efficiency in your total planning initiative is to look at this kind of conversion from traditional IRA dollars into Roth IRA dollars.
Kevin: Talking about the pendulum swinging at some point, this next question is from Mike. He says:
What exactly, as far as you can tell, would a global financial reset look like? What impact would a 100% billionaire tax have on the economy, good or bad, as proposed by cancelbillionaires.com. The government confiscated gold in 1933 on the basis of national security, and it could easily again. What signs should we look for of impending confiscation?
David: I think a couple of things. One, I want to clarify, you might think it was on the basis of national security they confiscated gold, and you might infer that from the name of the act, the Trading With the Enemy Act. So that was there, but what were they actually accomplishing? They were accomplishing wrapping their arms around the money supply. They were basically moving the keys of the kingdom from the Senate to the Federal Reserve System. The Federal Reserve System had been around for 20 years, 1913 the founding of the Federal Reserve, passage of the Federal Reserve Act. But there were still limits in terms of the ability to create enough liquidity in a market downturn, and so you have the Fed pounding the table between 1929, 1931, 1932, that although they have been given the mandate they haven’t been given the machinery.
And so, by getting gold out of the domestic trade we created a two-tier system, one where we were still settling our obligations in gold with foreign creditors, but domestically you couldn’t own it. And the purpose, really, was not national security. Again, the title of it, the Trading with the Enemy Act, might have implied that, but the real objective was, now we can inflate. Now we can devalue our currency. And you were in the context of a major global competitive currency devaluation and tied to gold we all of a sudden were the strongest currency, where the pound sterling had already been devalued. So we now are standing out like a sore thumb. The dollar was priced too high, we devalued by 65%. That was the purpose.
Kevin: That’s the gold confiscation, but what do you think about a billionaire tax? I know some people are talking about it.
David: I think one of the things that is important to keep in mind is there are unintended consequences. You say, well, this policy solves this problem and it is by matching up dollars and cents. I don’t have enough, you have too much, but we can make the math work. What you end up doing, if that is what you choose to do from a policy perspective, is shift the incentive structures within the market economy, and now all of a sudden reward for risk is something that is really a challenged concept. At what point do those rules, or the arbitrary nature of it being a billion dollars today, when does that get rolled back? And by the way, billionaires are a new thing for us. We could have said the same thing and gone after the tenth of the tenth of the tenth of the 1%, and that was the millionaire class.
So as time goes on, as we continue to devalue our currency, we have gone from let’s go after the rich, rich, rich, the millionaires, to now let’s go after the rich, rich, rich, the billionaires. At some point it’s going to be let’s go after the rich, rich, rich, the trillionaires. Because still what we have is a structural problem within our system, which is we can create an infinite amount of currency and credit because of the fiat nature of our money. That’s really one of the side issues, we have an arbitrary measure of monetary value and of wealth with our currency system as it is. I would be very cautious to go after the billionaires, even if you can. And I don’t go here, but even if you did want to make the case that there is something unjust about them having so much more, again, that’s not my shtick.
But if you wanted to make that case, be aware of the fact that you are pulling the rug out from underneath one of the most powerful things that we have in the United States of America, and we have it here more than any place in the world. And that is, you can take risk and there is reward for it. If you try, and fail, you get to try and try and try again. That’s not the case everywhere else, too, because not only do we have a market system that encourages risk-taking and the potential of reward, but in the case that you fail, you don’t get a black mark, where you do in Europe. I know many people who have failed in their business ventures in Europe in their 30s and 40s, or even earlier in their 20s, and you’re not allowed to open up banking relationships. You’re not allowed to have a certificate of being in business on a second or third basis.
It’s like the scarlet letter. We don’t think of the scarlet letter anymore because it relates to morality and we have a much looser morality today than we have ever had, or maybe that we have had in 100 years, or whatever, but my point is, no one is wearing a scarlet letter because of some misdeed of the past. And yet, there are places in the world where, from a business standpoint, you wear a black letter, the bankruptcy letter. And you’re never allowed – you’re shamed forever. We have this dynamic market in the United States, and I think it is more dynamic than any other place in the world, and to be introducing something like a billionaire tax, you’re beginning to restructure what makes this place different and so vibrant.
Kevin: Our next question is from Gwen from Central Virginia. Dave, this is a question that pertains to one of our favorite subjects, and that is, how do we value gold relative to other things like the Dow? The question from Gwen:
Over the years you have said that once we reach a Dow-gold ratio of between 5-to-1 and 1-to-1, that we should begin liquidating our gold and silver positions and move into other asset classes. I know in the late 1970s, or the early 1980s, that would have been a great move. But what do you think this time? Do you think this time is different? The problems we face today so much more serious than 40 years ago? I think we could go beyond 1-to-1 Dow-gold ratio with the current bubble, and when it bursts, with this in mind, do you think it makes sense to hold on to a significant portion of your precious metals holdings until we get to a 1-to-1 Dow-gold ratio, or beyond? What are your thoughts?
David: I want to start with something maybe off the beaten track, and it is, when you are organizing your assets you are organizing them according to certain mandates. That’s my view, where you have a certain percentage allocated to liquid assets. This is what we call our perspective triangle. I love the simplicity of it because you can communicate it to kids, grandkids, or anyone, and it’s just clear how you save, why you save and what you do with your money. So the how, what and why fits neatly into the perspective triangle. So this is different than your typical pie chart where you’re saying just have a little bit of everything, the mélange approach to investing. And certainly, there is validity there to the degree that you’re just talking about the merits of diversification.
But what I like about the perspective triangle is you’re lining up mandates. Cash is liquidity. That’s the liquidity mandate, and it serves its own purpose. I’m not going to go into this, there are plenty of things we’ve written about this and talked about this, but I just want to give an overview, because liquidity is one thing, left side of the triangle, the opposite of liquidity is growth and income – stocks, bonds, what have you. I am more concerned about the mandate than I am the particulars, at least for a high level overview of what these parts are doing for you.
The base of the triangle is what we call insurance and that’s where gold and silver sit, and the insurance mandate is there regardless of the market environment. You always have a little bit of it.
And here is where it fits into, Gwen, your question, because you’re asking about the Dow-gold ratio. Let’s say you had a certain percentage in stocks and bonds, a certain percentage in cash, a certain percentage in gold and silver, so let’s just take that, for the sake of argument, as a very basic asset allocation. Not a lot of color, not a lot of detail, but let’s just speak in general terms. Now, you get to a Dow-gold 5-to-1, or 1-to-1 ratio, and what happens is that insurance component there at the base of the triangle, you might have had an equilateral triangle at the start, but now you have a very much isosceles triangle. The growth of gold as you get to a 1-to-1 ratio, expands out that base so large and so wide it requires that you take action.
Kevin: You reallocate.
David: So I think one of the things implicit, Gwen, to your question, is, when we get to a 1-to-1, and we’re out of gold, what if it goes lower, and shouldn’t we have kept it longer? My point is, you’re creating a problem that I don’t have, because I’m not eliminating my gold position, I’m reducing my gold position. So when I talk about a 5-to-1 or a 3-to-1 or a 1-to-1 ratio, that is a gradual reduction. You’re easing out of a position. This is what we love, on the Wealth Management side, to call an incremental approach and an incremental approach to either buying or selling. And that incremental approach is, you’re selling a portion at 5-to-1, a portion at 3-to-1, a portion at 1-to-1. That does not mean that you’re out of the asset class.
Kevin: You’re just rebalancing the triangle.
David: Why would you want to eliminate the insurance that is implicit to your total wealth picture? Now, you may reduce it because it became disproportionately large. So you’re scaling back versus scaling out. Does that make sense?
Kevin: Rich asks a question about the repo market. We’ve been talking about this liquidity infusion, Dave, so here is how it goes. He says:
I admire your thoughtful and in-depth discussions every week. Yours is a knowledge built on genuine exploration of ideas and attempts to unpack questions to reveal all they encompass. Your appreciation of history is also impressive. My concerns are that recent repo life support activity by the central bank is a potential indication that something is deeply wrong with the money market arena.
Oh, ya think?
Overnight liquidity appears to be at a premium right now, evidenced by the demand for these loans. Is this the markets showing they’re concerned about counter-party risk, and is this the canary in the coal mine?
David: Clearly, it shows stress and strain in the market, that the Fed at the tail end of the year has had to come up with an extra 500 billion dollars in overnight liquidity. Just think about that. We lose track of what these numbers mean, but half a trillion dollars, just to make sure that money markets and banks function smoothly through the end of the year, that is astounding. So yes, you’re right, to a degree it is a canary.
Last week in one of our Wealth Management meetings, Doug Noland commented that right now you have risk-on in the marketplace. Risk-on, meaning people are more than willing to push prices of stocks up, as we talked about earlier, credit default swaps on Deutsche Bank, Goldman-Sachs, J.P. Morgan, and the spreads between high-yields and treasuries, and a number of other measures of stress or strain in the market are suggesting that there is no stress or strain in the market now. So you have kind of a mixed message because on the one hand the repo markets are telling you something is not functioning in a healthy way. True enough. And the Fed is willing to acknowledge that and make sure that that market is backstopped so that there are no surprises. But there will not be an implosion in the repo market unless you move from risk-on to risk-off. And this is one of Doug’s key points. The environment is different. Right now it is risk-on, so you do have the potential for greater repo issues, but you’re not going to see them emerge as long as there is a low level of concern in the marketplace. You see the shift toward risk-off where people aren’t as enthusiastic owning stocks. There is more concern about default. That’s within the marketplace, individual companies, sectors, etc. And then all of a sudden the repo jitters – it becomes very serious.
The last thing I will say on counter-party risk and the concern about counter-party risk was highlighted in a Bank of International Settlements paper just a few weeks ago where they go on and on about why the Fed was doing what they were doing. And in this Bank of International Settlements paper – again, BIS is out of Basel, Switzerland, and they’re the central bank to the central bankers. One of the things that they noted – it was the last paragraph, or maybe the second to the last paragraph in a lengthy paper, was to say, “But we have other people showing up in the repo markets, and the fact that the hedge funds are getting some of their liquidity here is reason for concern.”
That right there, Rich, is where I would underscore, underscore, highlight, exclamation point, exclamation point – because it’s no longer just banks and money markets who are getting liquidity, it is a different kind of counterparty, it is a different kind of entity that is taking risk, and these are folks who have no problem taking 10, 15, 20 times leverage, getting the free money, investing at high stakes. And yes, there can be implications if something goes wrong in the bets that they are making. And the BIS is aware of it, the Fed is aware of it. These are pending issues, they’re structural problems which have not been fixed. And again, it’s good today, it gets really messy tomorrow, if you have the same Fed commitments and BIS concerns in the context of risk-off versus risk-on.
Kevin: So speaking of canaries in coal mines, follow the money. If there are liquidity problems, usually that’s a canary, right? Next question:
You mentioned that the questions are getting somewhat more complicated year after year, so I decided to ask a rhetorical one, in other words, without the need for an explicit answer.
Dave, you may have some comments on this anyway so let me read it through.
You know that by law the executive branch can initiate a military intervention against a foreign country without permission from Congress for up to 90 days. You may know that 80 years ago the state of the military hardware back then, half of Poland has been overrun by the army of the Third Reich, and the rest of its neighbors.
We do know that and we have talked extensively about that with clients in the past.
In other words, it’s quite a serious matter that no majority from Congress is needed for a military adventure abroad. If I may borrow the words from a former congressman, now even though they don’t comment on the matter in the media or in speeches, can you imagine how that power of the oval office is perceived in some other countries by their leaders? I doubt that they would call it a democratic process.
So granted, it’s a rhetorical question, but Dave, there are times when we go to war and Congress is not involved.
David: I think that points to one of the many ironies we have about our system and the way it functions practically in the world while we’re sponsors of democracy hither and yon and we try to bring that as representatives to the rest of the world. The irony is we don’t have democratic processes in many instances, and this is one of them. So the military adventure or military adventurism is there. War is always an option and I think one of the things we have to consider in the years ahead is the way that war is an option for political reasons as a distraction. I was fascinated, the last week or two weeks, with the most recent passage of the military defense spending bill we now have another branch of the military.
Kevin: Now it’s space.
David: So why is that important for me? Ultimately you’re talking about new fiscal pressure and I agree that there is an inference here in the question or comment or rhetorical statement or whatever, that other countries and leaders around the world may not like what we are doing. I think that’s fair. And yes, we are kind of in other people’s business. I think that’s fair to say.
The other thing that we should keep in mind when it comes to our military adventures is that sometimes they serve a purpose, and not necessarily a good purpose. But again, if you look at this from the standpoint of, “We’re pawns on the larger chessboard, and there are players who are calling shots that implicate us, both from a fiscal standpoint and even longer-term military commitments. Look at the Lusitania. The sinking of the Lusitania was very critical for the move into a world war. Pearl Harbor was very critical to our moving into a world war. Tonkin Bay. These are things that happen, and we have military responses, and then they have fiscal and monetary implications.
Kevin: And then we had the strange 9/11, which had nothing to do with Iraq, but it did help give the momentum into Iraq.
David: Precipitated involvement in Iraq, and you’re right, there was energy needed to pass the Patriot Act and it wouldn’t have passed otherwise. So you have all of these events that occur, and a military response, and no, there is not a democratic process involved per se.
Kevin: I think what we have seen in the past is, even if a president sends troops to war without Congress’s approval, if we need to be in a place according to the powers that be, there will be an incident that causes the public opinion to be motivated to go in.
David: That’s exactly right. If you’re thinking back to how many of these things relate to each other, perception management, control of public opinion, getting people on the right side of history, so to say, if you can move the needle on getting people on the right side of history, which is basically swaying public opinion on any particular issue, then you can do anything you want, and politicians know that.
Kevin: Our next question comes from a man who calls himself a midnight gardener. He said:
I recently had read a blog post that said “hyperinflation will fix that.” Without trying to break down the content of that post, do you think hyperinflation will help fix at least part of what ails the U.S.A. at this time? If hyperinflation does occur, I suspect those who hold gold will be much happier after such an event than stock market dwellers. By the way, I very much enjoy the weekly podcast.
What do you think, Dave? Hyperinflation – are we on the cusp of it, or is it something that they have learned to manage?
David: My opinion that hyperinflation is one of the most devastating things that a country or an economy can experience. So whatever it fixes in terms of having too much debt, it harms in a thousand other ways. I think to get a real human picture of the consequence of hyperinflation, reading the book, When Money Dies, is absolutely critical, because it’s not about the math involved, it’s about the human tragedy and the stories involved in the context.
Kevin: Adam Fergusson?
David: That’s right. Again, on the surface it does solve a debt problem. It just makes it all go away. But I think there are greater social and economic things that occur through that that would be absolutely devastating. To some degree we are sort of tempting the fates with it with the current monetary machinery in play. In terms of high rates of inflation, or let’s just say an orchestrated devaluation of the currency, and that being good for gold, I’m not optimistic about that. I’m pessimistic about that, and a part of it comes from a book that I read. I was going to meet Larry Kotlikoff, who teaches at Boston University in the Economics department. I was going to his house in Boston and he texted me and said, “Listen, I’m going to be about 20 minutes late. Can you just circle for a minute?” And so I did. I went around his neighborhood, circling, found a used bookstore.
Kevin: Oh, you found a bookstore, Dave?
David: I did, and I found a book.
Kevin: You just happened to have run into a used bookstore. That’s your passion.
David: This is a book written in the 1960s and it was a collection of essays including an essay from John Exter. My dad knew him and he was a part of the inner working of our financial world in the 1960s and 1970s. The Exter Liquidity Triangle was something that my dad always liked to use in his presentations back in the 1970s. But there was also an essay in this book by another central banker, and the debate was, “Should we devalue the currency like we did in the 1930s? If we do, we have to penalize the speculators.” And specifically, they were saying, “People who own gold, we’ve got to raise the bar such that they can’t profit from the devaluation.”
So there is this policy reality that if you see an orchestrated devaluation of the currency, on a major scale, not like 10% or 15%, but if it’s 50% or more, then I think all of a sudden you also have a policy attack against anything that represents a port in the storm, so to say, something that provides you an out, or protection, from that devaluation, you can guarantee that government will move against that. Otherwise they are dealing with a mass stampede. The policies, for them, of devaluation, only work if they have a captured audience. If they give you options of how to opt out, then all of a sudden the policy is less effective. So that was the debate going on in this book. I was just paging through it and I thought, “All right, I’ve got to buy this.” It was fantastic.
Kevin: Isn’t that the reason why people who had collectibles at that time, whatever it was, whether it was coins or other things made of gold, actually benefitted from the devaluation in the 1930s? It was the bullion owner that didn’t benefit. They just went ahead and took it.
David: Right. So I guess what is fair in the context of the hyperinflationary comments in the contrast between gold and stocks is that stocks tend to outperform on the front end of a major inflation or hyperinflation, and gold plays significant catch-up. So if you sort of broke it into phase deterioration, or put it on sort of a hyperbolic curve, there is a long period of time where stocks are a superior inflation hedge to gold. And then somewhere as you reach the steepness of the curve, stocks become worthless, you go from maintaining a good bit of your value to maintaining some of your value, to maintaining no value at all. And then all of a sudden, again, on the steepness of that parabolic curve, gold maintains all of your value while your stocks are worthless.
Kevin: And again, that’s the Germany model. We saw that, Adam Fergusson talked about that, and several other authors talked about that.
David: Not that our Tactical Short is oriented toward these kinds of extreme outcomes, hyperinflation or what not, but I think it is worth recognizing that there are phase shifts, and there are phases of deterioration, whether it is within the financial markets, or within the monetary system, or within the banking system, and you have to play each of those phases in a different way. It’s not enough to say, “I own stocks, I’ll be fine.” Or, “I own gold, and I’ll be fine.” If you’re just looking from beginning to end, yes, own gold, you’ll be fine. But there is this interim period where you think, “Well, gosh, maybe I should own stocks. They’re doing so much better.
Yes, that’s right, they do. In that phase one of a superinflation or a hyperinflation, stocks do better than gold, just before you get wiped out. Now, are you smart enough to pull the trigger and get out? Because you’re talking about massive growth and figuring out – it’s almost like where do you jump off the roller coaster? Where do you jump off, how doyou jump off? If you believe that you can, you probably don’t understand the structure of that ride.