EPISODES / WEEKLY COMMENTARY

2018 Forward: Gold’s Third & Biggest Wave

EPISODES / WEEKLY COMMENTARY
Weekly Commentary • Feb 20 2018
2018 Forward: Gold’s Third & Biggest Wave
David McAlvany Posted on February 20, 2018
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  • Yields on 10 year treasuries double from June 2016
  • Every 1 % Rise In Interest Costs Us $650 Billion Extra
  • Stock Market: “Buy the dip” culture to change to “sell the rallies!”

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

What people should care about here is the implicit signal of lower quality, and frankly, even mid-tier corporate credit getting sold off even as stocks were rising. So again, back to what does a V recovery look like? A V-shaped recovery on the chart in the Dow, the S&P and the NASDAQ – smart money is getting out, they’re moving out of illiquid positions, and back to the Levine quote, “There has been a regime change.”

– David McAlvany

Kevin: David, the Russian athletes that are at the Olympics right now have been banned as a country, but those who were considered clean and were not doping were included in the games. Now, a terrible development has occurred and they have tested twice. There was a Russian athlete that was caught for doping. Can you guess what sport would be needed to dope up the body for?

David: We live at altitude and we actually get the benefits of natural doping because we create more blood cells at altitude, and it helps with endurance. So I would assume that it is some sort of a cross-country or the biathlete where you’re shooting the gun, you’re on cross-country skis.

Kevin: That’s what I would have thought. But what if it was curling, Dave? Curling.

David: What?

Kevin: Yes, one of the Russian athletes got the bronze medal in curling. He is the guy who does the brush.

David: What’s the point (laughs)? You’re kidding me, right?

Kevin: I’m not kidding.

David: You need blood doping for curling?

Kevin: I guess, I guess. Well, now we know. But it hits me, Dave. We can laugh about things like this and the ridiculousness of the doping, and of course it has been in the professional cycling realm for years, but really, we are seeing in all levels, whether it is politics, finance, economics, we are seeing cheating going on at the most ridiculous levels. I would like to talk about that a little bit later today because there are ways to cheat. One of them is just borrowing money that you say you’re making. That’s one way to cheat. The other is to actually purposely influence markets to make people think that there is no danger. In a way that is a little bit like doping a market.

David: I’m just stuck, though. I’m stuck because we have dopes, we have rope-a-dopes, we have doping, but curling does not fit in any of this.

Kevin: Curling. And for the listener who doesn’t know what curling is, do yourself a favor. Go to YouTube, type in curling, Olympic sport.

David: I understand it is an Olympic sport. Actually, I don’t understand why it is an Olympic sport, but seriously – doping?

Kevin: You know, Dave, another way of cheating, and we have seen this for millennia, and John Maynard Keynes said that this was a form of cheating that only one in a million really understands, but the way that a government can cheat is just by creating more money, creating inflation. I was talking to a friend of mine yesterday and telling them that I have gotten to where I carry with me, at all times, silver dimes, 90% silver dimes from before 1964, because it is an amazing way of showing somebody quickly that the government has completely cheated them.

I can put that little Kennedy dime down on the table and I can say, “Hey, now look at this dime. That dime is worth twelve of the normal dimes that you have in your pocket because it is from before 1964. It has silver in it. Now, it’s amazing because I can take a second dime and put it in front of them and say, “Now, I’m going to give you these dimes, but let me show you. When I was a kid these two dimes bought me a gallon of gas. They are worth $1.20 now.

David: We basically conclude the same thing, that just like it is not sportsmanlike to dope when you’re curling, or when your cycling, and it’s not sportsmanlike to dope the monetary system, and yet, you are talking about a 95% reduction in the value of currency – our currency – as a result of moving way from a stable specie.

Kevin: And those two dimes, which are 20 cents on current money, and they buy maybe 1/10th or 1/12th of a gallon of gas, I can take those two silver dimes and still buy a gallon of gas because it is $2.40 right now here in Durango.

David: Right. It is ironic that the Fed – one of their chief mandates is price stability and yet one of the things that they have guaranteed is the destruction of our currency. If you were graded A through F on your performance, on the work that you handed in, they are not an A, they are not a B, they are not a C, they are not even a D minus. It is the biggest F on the planet because what have they done? Price stability is one of their chief mandates, and they have decimated the purchasing power of our currency and are only so proud to do it right now with a 2% inflation target, and there are some rumblings that they are going to increase the 2% to 3% or 4%.

Kevin: And I am ashamed to say, because this is terrible for you and it’s horribly over-priced, but I still every once in a while, because of the commercials from when I was a kid, I still get a Big Mac attack every once in a while. I’ll go down to McDonald’s and I’ll get myself a Big Mac. I remember – we don’t have to sound like old guys saying how cheap they used to be, but a Big Mac right now is going to cost you close to $5.00.

David: And that has become the universal measure for inflation. You go anywhere in the world where they serve Big Macs, they have actually created what they call the Big Mac index. I’m sure you know that. But it is served and priced differently based on currency exchange rates and sure, you have different costs for ketchup and onions and pickles and beef and everything that goes into it. But that is one measure of inflation. Out in California we have another measure of inflation, and you might call it the Big Mouse index (laughs). The L.A. Times is talking about Disneyland raising their prices as much as 18%.

Kevin: Wow.

David: It’s not 1.8%, that wasn’t a typo, they didn’t miss anything. It’s an 18% rise in prices there in Disneyland. They say what happens in California is precedent-setting for the rest of the nation, so perhaps Mouseland is the next indicator for widespread inflation. We’ll have to stay tuned.

Kevin: So you would consider that a leading indicator. The old song, “Who’s the leader of the pack that’s made for you and me?” Disneyland is showing us inflation. Now, we have been talking about interest rates and that may cause people to just fall asleep sometimes. But actually, interest rates are the key measure of risk in an economy, and interest rates do have a material effect on our budget.

David: By 2020 we would predict that you could have a major influence on the budget deficit, just looking at what interest rates do. You have the current average rates which we are paying on our debt which are still very low. We discussed this a couple of years ago, but the average interest rate on all U.S. debt – this is what we owe as a country – stands at about 2.29%. And over the last decade, the quantity of debt has doubled while total interest expense has stayed basically the same because interest rates have come down.

So quantity of debt has increased, interest rates have come down, we’re paying the same kinds of interest numbers in total that we were ten years ago. That is based on 2008 numbers. However, you had this two-year dip in interest costs 2009 and 2010, and since 2010 the interest expense has risen from $190 billion per year to $274 billion.

Kevin: And that is as interest rates have fallen.

David: That’s right. So rising interest cost as interest rates are falling, but still we’re no worse off for it because we are only getting back to where we were circa 2008.

Kevin: You know, Dave, we just had the commercials for President’s Day sales all over TV, and a lot of those sales were zero interest for the first six months. It is so easy to get yourself into a debt problem when you’re paying zero interest or close to zero interest. What you are actually expanding is the quantity of your debt. The one thing you can control if, indeed, you don’t really feel the interest rates, that is something that you can lose control of very quickly.

David: That’s right. So now we have a larger quantity of debt nationwide – private, corporate, governmental – and interest rates creeping higher. A more normal rate would be somewhere between 4% and 5%. So you are right, the variable that we can control is the quantity. Rates are being set by the markets, and the markets’ determination of risk changes that number through time, but quantity is controllable. It is controllable by us, depending on how much debt we want to take on. It is controllable by the Treasury Department and our legislators, who set the budget and determine whether or not we live within our means.

Kevin: But you have to have discipline.

David: And that discipline is gone if you are looking at our monetary system today. Our primary criticism of a monetary system that lacks rules and disciplines is that political agendas routinely blow past what a country can’t afford, and legislators are obviously more than interested in promising the sun, moon and stars to their constituencies. That is how you become a career legislator. But again, they would not be able to do that if they were under a rules-based system.

Do you remember we had that same conversation with John Taylor from Stanford? He came up with the Taylor Rule. He said, “We’re probably never going back to the gold standard but it sure would be nice to have rules applied once again to the management of your monetary system.” Notice, he was not chosen, Jerome Powell was, to run the Fed. But he was a contender.

Kevin: Doesn’t it boil down to living within our means? It’s what we teach our children – not to spend more than they make – but why do we have a government that says, “That is the only way to work?”

David: Again, they have the latitude of over-promising for routine expenditures because of our monetary system. We are likely to find ourselves driving a budget deficit considerably higher following a massive increase in debt that we have had, what we have accumulated over the last ten years, and now you see rates beginning to rise. Should that continue, rates continuing to rise, you will have interest which is a singular line item in the budget which will either cause a displacement of other budget line items, or it will cause a deficit blowout.

You are looking at something that routinely will be between 9% and 12% of our total budget, and it is not unreasonable to see rates rise and see it become as much as 25% of our total budget. Time will tell exactly how this plays out, but I think it is very much worth watching.

Kevin: We continue to repeat – Bill Gross, for years, has said that once the ten-year treasury gets above 2.66, watch out, the shift is going to be in. And yields on the ten-year bonds have really gone up if you look over the last year or so.

David: That’s right. So from the lows of mid-year 2016, June of 2016, ten-year treasury yields have doubled. And they have recently broken above the 2.6 line that you mentioned, and in a matter of weeks have gone from 2.6 to 2.9. So yes, longer-term we see them moving higher, but that will probably be as rates are ripped from the grasp of the Fed, who at some point will attempt, again, sort of economic revival 2.0 via a move back toward the zero bound.

So you have the market speaking today, you have the Fed at some point on the horizon interfering in the market again, and then from that point forward it is a toss-up. It really is a wrestling match between the market and the Fed governors in terms of the ultimate trajectory of rates. But can rates move this fast? Look where they have moved in the last year. Can they move this fast in a short period of time without revealing weakness in a number of leveraged players?

And I include the U.S. government in that. So again, you see rates rising, you see the dollar falling, and it has been just an absolute fascinating thing to watch, greater volatility in the U.S. treasury market than almost any other sovereign bond market.

Kevin: Let’s bring clarity to that because the United States is supposed to be the stability of the world, the reserve currency of the world, which would mean that you would expect the lowest volatility to be in the U.S. dollar, yet we’re seeing more volatility than we are seeing in some of these third world, almost banana republics.

David: Again, maybe that is because we are at the front edge, and we are the first central bank to start raising rates, which would suggest that there is a lot more boiling under the surface elsewhere. European debt is something that we will have to come back to another day, but you have regime change at the ECB which is on the horizon with Draghi leaving and Weidmann being the top candidate take his place, that will likely roil bank balance sheets all throughout Europe as they deal with an adjustment in interest rates and a decline in the value of the bonds that they have held in their balance sheets, assuming that the ECB would back their play to the hilt. Again, that is for another day. We will talk a little bit more about European debt and the ECB maybe next week or the week after.

Kevin: Just to repeat last week, it really was important to look at who will be buying this debt, or who will be loaning us this money. It started out we talked about the reserve currency status as it changed from the gold standard, it turned out that we had Middle Eastern buying because of the oil, and then we had Chinese buying due to the trade surplus that they had. And then of course we had Federal Reserve buying, but now we are increasing the debt dramatically, and we still have to figure out who is going to be financing it.

David: Last year was a cool 550 billion dollars that was issued from the U.S Treasury. J.P. Morgan estimates three times the Treasury issuance for this year, 2018, 1.42 trillion. Rates are moving up. We have seen them move up five times last year. And you have three rate increases which are penciled in for this year. KKR estimates that we could have five increases, and I see here in the last couple of days there is a survey of economists, I think 29 different economists, and their average now is that we will see rates increase four times this year.

Kevin: What about three steps and you stumble? That is an old adage.

David: Yes, and it is not something that has played out circa 2017, but could an expanded budget deficit have any connection to the rates that are moving higher? Yes, the Fed is raising rates at the short end, but we are also seeing interesting behavior as you move toward the five and ten-year, as well.

Kevin: So let’s say that I went out on these President sales, and not just bought one mattress at zero interest for six months, but I went and bought 50 mattresses, or 100 mattresses, knowing that I had virtually no interest to pay on that debt. Now, I would like to put this in perspective with the estimated debt that we have in the United States. Let’s say interest rates went up 1% for those 50 mattresses, or those 100 mattresses that I purchased.

That would be a problem if it went up to 2% or 3% or 4%. All of a sudden what I thought I could afford is no longer affordable. Now, I know that is a silly comparison but let’s go ahead and take the debt that we have doubled over the last ten years, and now we are tripling from our deficit just from the 500 billion to the almost 1½ trillion. Any interest increase is going to have a pretty profound effect, isn’t it?

David: Yes, it is, because when you look at the interest which is required to maintain all of the debt outstanding here in the United States you are not talking about chump change. Total debt estimated in the U.S. is currently about 65 trillion, that is consumer debt, which reached a new high here this week of 13.1 trillion.

Kevin: So consumer debt is 13.1 of that.

David: Of that 65. Fortunately, credit card debt is still under a trillion, but it is getting close to it. But back to the back of the napkin math, if you take a 1% interest increase on the total stock of debt, 65 trillion dollars, again, simple math, 650 billion dollars in interest costs for households, corporations and governments. So the direction of rates, if it continues on the current course, is going to have a major drag on economic growth.

We have been arguing for the last several months that the fragility and instabilities within the financial system and that the economy is seeing things pick up. But you know what? These things are not completely disassociated. So with interest rates increasing, this component within the financial system, does it have a negative reverberation into the economy? Yes it does. 650 billion dollars in extra costs for households, extra costs for corporations, extra costs for government. That’s a really big deal.

Kevin: That is 650 billion dollars per 1% interest rate increase that can no longer be spent in the economy. Now, I know the argument is that now we have reduced taxes, we’re tripling our deficit, basically, and we’re saying those reduced taxes are going to make up for it. It is hard to imagine that because, really, if you have interest rate increases, you are already sucking that extra money out of the economy.

David: Current estimates are that we increase our debt by a minimum of 10 trillion dollars over the next decade. That would take us from 20 to 30 trillion. Those are the official government numbers. And that includes the full benefits of the tax cuts which are supposed to increase economic activity. So we are talking about, on a net basis, and extra trillion dollars per year added to our debt load, so cumulatively, over the next decade, bringing us to 30 trillion.

Kevin: That’s the United States. Let’s look globally. What is global debt at this point?

David: Same issue on the global scale. Global debt, according to the Institute of International Finance reached 230 trillion dollars last year, nearly a quarter of a quadrillion. That is up 16 trillion globally in one year – 16 trillion global debt grew last year. That puts us 327% debt-to-GDP. We have a number that, if you just pause and think, 327% debt-to-GDP on a global basis, most economists would agree that that exceeds the economic capacity of the globe to keep up with or to stay ahead of.

Kevin: In other words, you’re sinking quicker than you can dig yourself out.

David: That’s right. So when you shift focus and pan out to the broader world, the only thing that is positive there is that our debt problem in the United States, here in the U.S., seems insignificant relative to the rest of the world, 106% debt-to-GDP versus 326%, we don’t seem so bad. It’s not like we’re the worst offender.

Kevin: But here in the United States, as we have mentioned many times this last year, most Americans are not buying gold. Now, we have talked about how overseas, yes, that may be different. But gold is your defense against this.

David: One more point is that Carmen Reinhart, who joined us on the Commentary last year, co-authored a book dealing with the thresholds of debt in a particular economy, and the historic studies that she came up with were that any time your debt-to-GDP figures exceeded 90% you were moving into a period of instability. And in virtually every case, eventually, exceeding that 90% level meant destabilization of the economy. So being at 106%, again, I don’t want to lose some very important emphasis here, yes, we are better off relative to the rest of the world, but no, we are no better off in terms of being in a safe place versus a dangerous place, crossing that 90% threshold categorically puts us in a dangerous spot in terms of debt-to-GDP here in the United States, and we are the ones who smell like a rose.

Kevin: Remember, Dave, when you were talking to Carmen after the interview and you just asked her, “What are you doing?” She said, “We’re getting out of debt, we’re buying real estate, and we’re looking at gold.”

David: (laughs)

Kevin: So Carmen Reinhart – this is a woman who helped influence Fed policy – sees the handwriting on the wall, as well. But go back to what I was talking about because the Americans are not buying gold. The Europeans, the Asians, the Middle Easterners are. And there are people that we know that have an inside view on that who see the same thing.

David: Yes, last week I spoke to Roy Freedman, my friend who has been trading gold actively for 30 years, and he confirmed a lot of business is being done in gold, in Europe and Asia – no real surprise there – but the refinery he now works for is seeing demand pick up. Demand is not picking up in the United States. It is just picking up everywhere else.

We also talked about where gold is likely to be by year-end. This one is significant – $1400 and higher by year end is his professional opinion, with a good possibility for a near-term correction to say 1240-1250, but $1400 is the territory that signals to the world that gold, in U.S. dollar terms, is back, and back in a big way.

I mentioned last week I was working on an article for Don’s newsletter, the McAlvany Intelligence Advisor. That will go out in the March newsletter. We’re happy to send an electronic version. If you prefer a hard copy just let us know. Call our office and we will get that out to you.

Kevin: Dave, it is important for any gold owner to get this article because it does address some of the fallacies that people have about why gold moves relative to the dollar.

David: The third wave of buying, as I describe it in the article, has already commented. The first two fit the classic two-step process of the Maverick first coming in, the Wall Street participant being second in line, and that pattern we have seen in many other asset classes, as well.

Kevin: So would you say the first wave was from the early 2000s to 2004-2005?

David: I would stretch it out to even 2007. And then you begin to see Wall Street really come into the market in 2006-2009 in earnest in reaction to the global financial crisis and rumblings just before the global financial crisis.

Kevin: Right up to 2011. During wave two Wall Street was actually saying that gold was a good investment right at about $1900.

David: That’s right, and for the first time in 25 years they were beginning to have some positive and happy thoughts about it. But the third wave reflects what is an already tightened supply from those earlier moves and a massive increase in demand in a short period of time, and very little time remains, in my opinion, before the neutral to negative sentiment which still exists with gold, certainly here in the United States, shifts to – I guess the only way to describe it would be rabid bullishness.

And to say that, I have to qualify it because in a third stage for gold, you have to understand that gold is not like other assets in this regard. People buy it out of greed, and people buy it out of fear. So there is a rabid bullishness, but it also reflects rabid bearishness from someplace else. And there is a confusion there in terms of motivation. Some people just want protection, some people just want to make money, and they all get thrown into the same gold bull blender.

Kevin: Let’s go back to economics 101 because there is a term that everyone learns when they take macroeconomics. It is called elasticity. Elasticity in a market just basically says that if there is more demand, if you have a product that you can just ramp up your supply as the demand comes in, that is an elastic supply. There are many things, however, that are inelastic. In other words, you can’t just ramp up the amount that is produced. And gold is incredibly inelastic when that bullish sentiment hits.

David: That’s right. Let’s say, for instance, that I am Cray Supercomputers, and I’ve been making supercomputers for the U.S. government for decades. And Cray cannot crank out these massive supercomputers millions at a time, or even hundreds of thousands at a time. But if there is demand for their computers, guess what they can do? They can issue as many shares as they want of their company. So on the one hand they sell a product which is inelastic, but they have something that they can produce an infinite amount of.

Kevin: Sort of a paper distribution of ownership.

David: That’s right. So if they want to issue a million new shares of Cray, the company, they can do that, but the actual physical is more limited. And you see that with the physical metal, as well. It is as inelastic as art or real estate in the sense that you cannot produce more of it just at the drop of a hat. I think there is a two to three year window for this where precious metals, because of that inelastic supply, and an increase in demand from fragilities that are revealed in the financial markets from 2018 to 2020, you see exponential moves.

So a large part of the migration to gold is going to mirror aspects of the first wave and the second wave, but be exaggerated by a growing audience of investors who comes to the conclusion that following the pied piper of Wall Street was not such a good idea. Obviously, this does assume that prices in the equity market cannot and will not rise forever, so current trends, I am assuming, reverse, and that feeds the audience of gold ownership pretty significantly. But our firm opinion is that Wall Street practitioners, the smart ones, are right now positioning themselves for the exits from the stock market. Main Street is still listening to the pied piper’s tune.

Kevin: Just thinking, in my own personal life, if I go into a room with a lot of people, and I know I may have to leave early – actually, I’m thinking about a three-hour long movie, too. My family hates that I love to sit toward the end of the aisle if I know it is going to be a three-hour long movie, because I’m probably going to have to go to the bathroom at least once.

But Wall Street – you bring up a great point. The practitioners know that only the first guys are going to be able to get out intact. It’s the same thing with buying gold. You have Wall Street practitioners right now that are positioning themselves near the entrances of the very small rooms that contain gold. There is just not that much physical gold there, so you position near the exit if you have to get out of a room, you position yourself so you can be the first one if you’re going to try to have the physical product.

David: It was over a month ago that we were talking about the stock market and how traders were testing for a top, and we had a series of days – I remember a particular Wednesday in which the stock market traded to a new all-time high and then closed lower for the day. And from a technician’s standpoint, that does indicate that the insiders, those who are operatives, operators on Wall Street, are testing for a top. They’re fishing for a top, and trying to figure out if they should get out or if there is going to be enough momentum to continue to support a move higher. And if there is not continued momentum to support a move higher, then they know how to hit the exits.

Kevin: So they tap, tap, tap that resistance level.

David: That’s right. We were talking about that a month ago before the 3000+ point sell-off in the Dow. Fred Hickey, who has 20 years as a Barron’s Roundtable contributor, said recently that every bear market begins as a healthy correction. We just had a healthy correction, 10% in just a few days, but actually, a real healthy correction is probably 20-40%.

Kevin: Barron’s is a magazine that was relatively conservative and fair toward the markets for many years. I remember interviewing Alan Abelson several times before he passed away. What an amazing guy. But Barron’s, the Roundtable, has changed dramatically. It is looking more and more like mainstream media. You used to have contrarians on that Roundtable, Dave. You mention Fred Hickey. He was a contrarian, and sometimes he spoke his voice out even though the others were saying, “Oh no, we’re bullish.”

David: Richard Russell got his start with a Barron’s column back in the 1950s when I started on Wall Street. Around the turn of the millennium, 1999-2000, my dad insisted that every week I read Alan Abelson as one of the clearest thinking, most skillful…

Kevin: And eloquent. What a wordsmith.

David: Absolutely. And he did join us on our Commentary a number of times. But it has been fascinating over the last nine years to see Barron’s chase off any contributor to their Roundtable discussion, which happens twice a year, who even has an occasionally bearish view. So Marc Faber is gone, Bill Gross is gone, Fred Hickey is gone, Felix Zulauf is gone. And in their place you have a bevy of market analysts who are far more homogenized and inclined toward modern portfolio theory.

This, I think, is a very important point because what Barron’s has done mirrors the mainstream media’s attempt to create controversy and argument on air or in print with a variety of guests, which makes for the appearance of objectivity and the search for truth when nothing could be farther from the truth. They don’t care. It’s entertainment, it’s Kabuki theater. That’s not what they are really after is objective approaches to reality. What they want to do is sell tickets, because this is bread and circuses, baby.

Kevin: Starting in early November you listed 30 different ways of seeing that the market was over-valued. One of them was margin debt. I remember when we were traveling and talking to clients personally in the conferences. You cut that list down because it took too long to go through, but each one was a compelling reason that the market was over-valued, starting with margin debt.

David: So a blast from the past, that’s where we spent some time in 2017 and 2016, too, because we went right through, like a hot knife through butter, previous levels that had been unimaginably high. 2007 with 350-400 billion dollars borrowed to speculate in the stock market. It was a shock to see the number reach 500. And then last year, 2017 margin debt, we added 113 billion in the year, 21% increase year-over-year, totaling 643 billion dollars of borrowed money.

On top of that, consider that you had January of this year, ETF inflows, Exchange-Traded Fund inflows, of over 100 billion dollars, which helped the asset basket in exchange-traded funds exceed 5 trillion dollars the first time. Again, you’re right, we were traveling and we wanted to share the mélange of 30 different indicators of excess in the equity and bond market, buttressing our idea, our notion, that we are at a critical inflection point in the financial markets.

One of the things that we mentioned of those 30 was low levels of cash. So I see TD Ameritrade’s CEO said here in the last ten days, quote: “I’ve never seen client cash levels this low.” And that’s the end of his quote. But I’m sorry, do Wall Street practitioners know how to read between the lines on that? Absolutely. But very few of those practitioners have the willingness to move the opposite direction from their cohorts and risk short-term underperformance. The majority would rather risk suffering together, for which there is no blame, rather than suffer alone, for which they will be handed a pink slip.

Kevin: When cash levels are low in an account, there are two things that have to be taken into consideration. One is, as you go down to the last 2-3% of an account being un-invested, in cash, what that means is you have about 2-3% more that you can go buy with. Now, that may not really play itself out other than just lower and lower rates of increase, but the second element is critical, and that is if everybody is 98% into the market, and the other day you had mentioned that they actually were over 100% into the market based on margin debt, then what you have is a complete absence of cash to buy the dip. This has been the mantra now for the last few years that people are just learning, you just always buy the dip because you always make money after buying the dip.

David: With what? With what? Again, we’re talking about a system that is doped, we’re talking about a system that is being gamed, and it is dangerous when you look at some technical indicators which suggest there are people who get what is going on here. Having already violated the December lows in the stock market in the major indexes here in the first quarter of 2018, we really have a likelihood of a tough year ahead. That is what it tells us.

If you want to refer to the stock market almanac, this is the kind of thing that you would say, “Well, we violated the December lows here in the first quarter. That should tell us that 2018 is going to be a tough year. But the majority of analysts are still sticking to their guns that this is going to be yet another up year in the stock markets. We had the V rally from 1300 points lower on the Dow.

Kevin: How do you feel about the V rally because that usually indicates somebody came in and saved the market?

David: It’s not encouraging to me because sharp sell-offs are very typical in a bear market. I just want to go back to Fred Hickey’s idea. Every bear begins as a healthy correction. But more typical of a true low in the market is a grinding price recovery over a longer period of time. Sharp recoveries smack of intervention. Sharp recoveries smack of the psychology which is dismissive of any reason the market would have gone down in the first place.

So the market is down 3000 points. It was a technical glitch, it was a VIX blow-up. Now we’re off and running, back on track where we were before. Again, it is dismissive. Sharp recoveries are that way, and I think what you are seeing is that insiders get to prop up and begin to get liquid. And what are they doing? I think you are absolutely going to see them sell shares and do what is nothing more than a sucker’s rally.

Kevin: There is this philosophy, and you can hear this mantra, like I’ve mentioned, repeated over and over, the BTD – buy the dip, buy the dip, buy the dip. That philosophy, at some point, when you know you’re in a falling market and the people realize it, can turn into a completely different mantra, and that is – sell the rally, sell the rally.

David: Right. The kind of strategic positioning for the exits that you were describing, going to the movie and being aware of nature and nature’s calls as echoed by Brian Levine. He is the co-head of global equity trading at Goldman-Sachs. He said this last week, quote: “I’ve been amazed at how little capitulation selling we’ve seen on the desk.” This is an equity trade desk. That’s what he is talking about. “The buy-the-dip mentality needs to be thoroughly punished before we find a bottom.” Then another quote, he said, “Longer term, I do believe this is a genuine regime change, one where you sell the rallies rather than buy the dips.’

Kevin: So it’s exactly the opposite of what that mantra has been. Now, the Federal Reserve has always stepped in. I remember in 1987 they had tools at their disposal because they had high interest rates. Now, if you’re a central banker and you have a crash, there is really nothing better than to come in with already relatively high interest rates because what can you do? You can lower them.

David: Accommodate, yes. Barry Eichengreen, in a recent Project Syndicate article, was considering the recent market sell-off, comparing to the 1987 market sell-off. It was both extreme, 10% in a short period of time, 22% in a short period of time. And his conclusion – this is actually a Ph.D. quality observation here, I think – that there is less room to maneuver monetary policy now than there was then. Why? Prime rate was 9% then, Fed funds was at 6% then, and you’re still hugging close to zero now. So we look at the raising of rates and we have talked about the five steps up last year, and a potential 3-5% this year. What is going on there? Raising rates now may be only to lower them again in the coming months, so they do, in fact, have a little bit of ammunition.

Kevin: You brought something intriguing up last week, Dave, and it is disturbing, but chaos worldwide sometimes is a benefit to the United States. We talk about volatility in the treasuries. The treasuries become something that people want worldwide, U.S. treasuries typically, when there is instability in the world. Right now, I’ve been trying to make a heads-or-tails sense of what is going on in Syria, Turkey, Iran.

The fights that are going on right now involve Russia and the United States sometimes allying with Bashar al-Assad, sometimes being against him. ISIS. All of this stuff is becoming far more complex. You have a war going on where you have people who are allies one day and then enemies the next, and then allies the day after that, only for short-term gains. The United States normally would intervene dramatically in something like that back in the old days when we had trade deficits with the Middle East. Remember when we were buying all of our oil there.

David: Yes, and there was something of a “virtuous” relationship, or it was certainly a relationship of convenience, that we were able to fund our deficit with petro dollars.

Kevin: We would go protect the oil.

David: That’s right. And that was the quid pro quo. We provided F16s and a carrier fleet in the Middle East, there in the Mediterranean, and that guaranteed some stability in the region. And for that, they were willing to pump enough oil to keep prices low, and with the revenue they received they were also willing to recycle that into U.S. treasuries and fund our budget deficits.

Kevin: Isn’t it odd that our trade deficit actually is expanding right now even though we’re producing a lot of oil?

David: Yes. Here in the last week to ten days we have domestic crude production which has topped ten million barrels a day. Again, it’s odd because we’re importing less oil and yet the trade deficit for December widened to the largest in any month going back to 2008. So 53 billion for the month. The exports were 2.3 trillion dollars for the year, up 5%. You raise a very interesting issue as it relates to foreign policy. There was an age when existential threats in Israel and Saudi Arabia meant something to us, and it appears that our foreign policy was then, and may now, be just feigning interest in others, while what we are, actually, is just predictably insular to others’ concerns. You have Syria, you have Iran, you have Iran now claiming to have a nuclear device.

Kevin: Isn’t that something that they had been denying?

David: Right. And the Obama boys at the State Department, in his era, said that that would not happen if we just eased pressure on the Iranians and gave them billions in U.S. dollar cash.

Kevin: So is this innocent? Is this just not really understanding foreign policy?

David: I have no idea because, honestly, I don’t know how dark the heart of man gets as it is reflected in public policy and international relations in the D.C. beltway.

Kevin: Let us go dark for a moment

David: You would have to consider, if it is not naiveté on the part of Democrats in the past administration, it may be duplicity in chaos, chaos opening the door to long-term governmental “protections” for the people when they are under the next round of terror threats. If you step back and say, “We think the best of the human beings that run our government,” recognize that most of them are probably not human beings anymore. They lost their souls so long ago they can hardly be categorized as things like you and me. They’re not cyborgs, but I’m not sure that they have souls either.

Kevin: They have yielded to a system that is larger than themselves. Let’s give them that.

David: So maybe it’s just money. Maybe it’s not any more complex than that.

Kevin: But don’t we errantly assume that war is something that we would avoid at all costs?

David: No, war is good for somebody. The war on terror has helped justify some of the longest military engagements in U.S. history. Beware the military industrial complex. Wasn’t that a quote from, I think, in the 1990s, some radical right-wing militia guy?

Kevin: No, no, no. That was not a right-wing radical militia guy, Dave. That was a president who had been a general in World War II.

David: Right. Retired military general turned Commander in Chief in the 1950s. Yes. So it is unclear to me how we as a country intend to engage our overseas friends, our overseas enemies, maintain our existing commitment, but it is perfectly clear that chaos is the friend of our empire.

Kevin: Whether purposeful or not.

David: That’s right. Maybe this goes back to that old phrase, “In the land of the blind, the one-eyed jack is king.” I think of volatility in the stock market. If we see a little bit of volatility here, there is going to be a lot more in the emerging market. If we have currency chaos, it will be more exaggerated elsewhere, and that will be to our benefit. I think of our debt figures. On a relative basis, we are on a better footing. In absolute terms, it is not a great position – 106% of debt-to-GDP versus 327. But again, on a relative basis, we end up smelling like a rose.

Kevin: Here in America, you have brought out that we have not had a sentiment change, necessarily, in the buying of gold. We haven’t had a sentiment change, probably, in the stock market, even though people are a little bit more nervous. We do have a sentiment change, though, in a market that has concerned you now for the last year.

David: Absolutely. And as I’ve compared notes with Doug Noland, who manages our Tactical Short, this was probably one of the most telling signs last week, because you have the sell-off in the stock market, and then a recovery rally last week. But what is happening simultaneously, which is absolutely critical to note?

This is in the category of last, but certainly not least, for today’s comments. We finally saw sentiment shift in fixed income last week. Stocks recovered more than half their peak-to-trough losses. Junk bonds were finally seeing major outflows, billions of dollars coming out of the junk bond space, the high-yield space.

Is risk appetite shifting? Are investors shoring up? Are people getting liquid? Are they moving out of the areas which they know in the future are going to be less liquid than others? What people should care about here on this point is the implicit signal of lower quality, and frankly, even mid-tier corporate credit getting sold off, and it was sold off aggressively last week, even as stocks were rising.

So again, back to what does a V recovery look like? A V-shaped recovery on the chart, in the Dow, the S&P and the NASDAQ, I don’t like it because there are other accompanying factors which suggest smart money is getting out, they’re moving out of illiquid positions, and back to the Levine quote, “There has been a regime change.”

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