The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: David, both of us ride mountain bikes, and we ride road bikes. There are trails here in the Durango area where you ride up, and you ride up, and you ride up, and you think that you are going to hit the summit, because you can see it up there, and you are ready for the rest, but it turns out to be a false summit, and actually, there is a summit much higher beyond that.
David: Oh, yeah.
Kevin: Most of us have experienced that, but we are experiencing that in the opposite realm with the recession right now. What we heard about was the trough, and we were ready for the break, and it seems that it was a false trough. Actually, what is coming is much worse.
David: Kevin, we are starting from a much worse place, and that is, I think, the point, after 21 months of being out of the recession, technically, if you look at when it was declared over.
Kevin: When was the recession actually over, according to the officials?
David: Back in 2009. We have had some time where we have been on the mend, but here’s the thing: The concern now is that yes, we are, in fact, moving into a double dip. I remember doing a CNBC interview about 3 months ago, and I said, “Going back into a recession is a foregone conclusion. “ And they said, “Wait, wait, wait. What are you talking about? That’s not possible. Look at the statistics.” Well, these are the statistics coming into a renewed sense of urgency. Unfortunately, it is urgency that the economy is not on the mend.
Kevin: So these are the solid numbers.
David: Yes, the economy today has 9 ½ million fewer full time workers employed than at the peak in 2007. We have real GDP which is still below the level reached in the fourth quarter of 2007.
Kevin: And that is with all the stimulus money that came in.
David: That’s right. We have industrial production, which is almost 7% less than its December 2007 reading. We have real retail sales which are 13 billion dollars below their 2007 peak, and we have real personal income, which is more than 515 billion dollars below its 2008 peak. On top of that, we have the S&P index selling at 20% lower than it was in that same time frame. The folks at Hoisington Asset Management put those statistics together, and they are spot-on. We are heading into a recession, and we are heading into a recession, not from a position of strength, but already from a position of weakness, which really argues that this recession will look and feel more like a depression than the last round, even, in 2008.
Kevin: I just read an article written about the greatest depression, that is coming. This was in the Wall Street Journal, not something that is off the main beaten path. They are saying this could really be the greatest depression. Is it any wonder that there are a lot of people sitting around in parks, around the country, who are dissatisfied, angry, maybe they don’t know where to direct their anger, but there definitely is the feeling that maybe this wasn’t a recovery.
David: Kevin, it is understandable that they are frustrated. There is something wrong with the system. The question is: Is the frustration being expressed at a place like Zuccotti Park, or anywhere around the world, being focused on the right thing? This is where I would have concerns, that there is really not a clear dialogue. Dialogue is not ever really allowed. It is just more of an emotional rant, and that is fine. If you need to get things off of your chest, that’s fine. But for it to be productive, it is going to have to be more focused, in terms of what the issue is, and I hope they start looking at cause, and not just effect, because there are a lot of effects, but the real cause – that’s what we need to looking at.
Kevin: David, there are people who are actually holding signs, in and around those parks, that say, “We’re part of the 54% that pay taxes.”
David: (Laughter).
Kevin: I asked my daughter, who lives just a few blocks away from there, if she has actually gone down there, and she said, “Dad, I’m too busy, I’m working.”
David: (laughter) Right.
Kevin: And there are 3+ million people in New York who are just going to work each day.
David: They are part of the market system, going to work each day, making things happen, and there are a few people who aren’t making things happen. The issue is this, and I’m not trying to make any low blows here, but we are talking about leaderless confusion. This is beyond Zuccotti Park. There is leaderless confusion in the White House. There is leaderless confusion…
Kevin: Worldwide.
David: … in Congress. There is leaderless confusion overseas, with the group that is in Brussels. Kevin, this is the issue: We don’t have anyone with clear vision as to where we need to go, and there seems to be a real lack of understanding of what the real issues are. I’m just going to take two stabs at it. One, I think that leadership confusion is a part of the issue. You don’t have decision-makers who are willing to take risks in being wrong, and we discussed that a little with Franck Biancheri. The risk is, in a leadership position, that you may be wrong, and we have folks who aren’t used to taking that kind of risk, and yet, they are in a position of leadership, which means they are really disqualified for the role, but that’s okay, we’ve put them there anyway.
Kevin: Would you say the second thing, then, is an uneducated public? The public doesn’t really know what to ask for, because they haven’t educated themselves on the problem.
David: That is certainly a part of the issue. When you back up a little bit, you can say that this is all about Wall Street, and I’m not going to argue that Wall Street isn’t greedy. Oh, my word.
Kevin: They can be corrupt.
David: But here is the issue: Following the rules is important, if you want to stay in business from one year to the next, and many of these shops have been around, not just years, but decades or centuries. Kevin, I think this issue here is that we have seen special interest groups and lobby groups bring pressure on our legislators and say, “Here’s really what the people want, here is what the people need.” To be quite honest with you, Kevin, they don’t represent us. They don’t represent “We, the people.” They do represent particular small enclaves, or constituency groups, but they don’t represent the broad swaths of America, and thus we see legislation change, unnecessarily.
Kevin: And it is being mistaken as an anger toward capitalism. It isn’t capitalism that people should be angry with, it is, as you said, the laws and the lawmakers. I think about Glass-Steagall in 1999, I remember we all just shook our heads around here, because that was a law that was put in place in the 1930s to keep bankers from speculating with money that was guaranteed to be paid back by taxpayers.
David: It is almost a slight repeat of history. We see 2010, 2011, and the angst and ire of the people who are gathering now in the streets and saying, “I can’t believe this was done to us. We were here in the 1930s, we were here in the 1920s, and by 1933, whistle, full-stop, the game is over. We cannot have investment banks and brokerage companies under the same roof, because we can see that they will take their own personal balance sheets, package up the trash, and sell it to the general public without remorse, and do it legally.”
Kevin: And get reimbursed for trash so that they can go do it again.
David: Yes. There was a broken piece in the system. It was fixed in 1933. Special interest groups, by 1999, came in and lobbied for the repeal of Glass-Steagall. More damage has been done in this decade as a result of the repeal of Glass-Steagall than probably any other single point. You can look at, certainly, the malfeasance with Fannie Mae and Freddie Mac, and we can cross both sides of the aisle. Republicans and Democrats have both supported legislation that has impaired our financial system, so there is an understandable frustration with the folks who are involved in the Occupy Wall Street, or Occupy Whatever Street, around the world.
Kevin: Is there an opportunity for people who actually do provide clear leadership out of this movement?
David: I think if they can define what the real issues are, perhaps. But it speaks to the willingness of the people participating to engage in a real dialogue, and to be very intentional and very thoughtful about the process. Look at cause and effect, not just effects. We can pretend that we understand the issue by saying, “Hey, somebody makes too much money.” What made that possible? Step it back 3, 4, or 5 steps, and realize that there is something structural there. There is no problem with someone making more money than I do, or than you do, or than anyone else does. The question is: Is it legitimized on a legal basis? If it is not, then of course, there is an issue. But we are talking about legal function within the system today.
Kevin: David, I was asked the other day at a coffee shop by a gal who is in college. She said, “Tell me about this Occupy Wall Street. What is going to come out of it? Is it valid?” I remembered Frederic Bastiat’s book from the 1850s. He was dying of tuberculosis, and it was a period of time in France similar to now, when people were dissatisfied. He wrote a book, simply about plunder, and the law. It is called, The Law. He said, “There is plunder, which is illegal, and then there is legal plunder.” He said, “There are only three possible outcomes.”
David: This is a book we had everyone in the office read almost six years ago. We are talking about a weekend read, or even an evening read, 60-70 pages. You can get it free online. In fact, I think we will put the link up so you can just click through and read it. You are right, he said that there are basically three kinds of plunder.
Kevin: Yes, the law, which is there to protect the rights that the people have, sets things up in one of three ways, but there are only three ways that the outcome of the law can serve.
David: Right. It is either, first: The few plunder the many. And that is the concern today, that the few are plundering the many. But the law is set up differently, in our opinion, and it is not set up to do that. The second option is that everybody plunders everybody, and that is Margaret Thatcher’s classic comment on socialism. “It works until you run out of other peoples’ money.” All you are doing is, everyone is plundering everybody, and then you wake up one day and realize, “Okay, we’re all broke.”
Kevin: It’s gone.
David: Then, the third option is that nobody plunders anybody, and that would be the focus of the law, that no one plunders anyone, that it is not a justification for the few to plunder the many, it is not a free-for-all where everybody plunders everybody.
Kevin: So the rich don’t plunder the poor, but the poor don’t plunder the rich either, which seems to be the outcry in Occupy Wall Street.
David: And that is what you have to be careful of, is that, in seeking a solution, you don’t just allow the pendulum to swing from the perception of one extreme to the actuality of the other extreme.
Kevin: David, we are continuing today answering the questions of our listeners, and boy, we have gotten some amazing ones. We were talking last night about how the sophistication of these questions has increased year-by-year. We are in year four right now of this program, and the questions are so well thought out.
David: It is not possible for us to handle this in one week, or two weeks. It is just going to be an ongoing conversation for several weeks, so bear with us. We will start with some general comments on the markets and where we are today, and then dive right into the questions, and we will take as many weeks as it takes to go through the questions. Thanks for providing them. If you still want to send them in, that’s fine, too, and we have a stack that may take us from now until next year this time. (laughter) Not exactly, but there are a few questions to answer.
Kevin: And they are thought-provoking. I will start with Alexander’s.
Thank you for your commentaries and enlightening people with what is really going on, not just the official propaganda. With huge U.S. debt, there are two ways out. Inflate the currency, or default on U.S. debt. I can roughly imagine inflation and its impact, but not default. What would default be like? How would the world react? What would happen to precious metals prices?
David, what does default feel like if we were to default, and do we even need to?
David: There is something that precedes that. Why would we default?
Kevin: You have brought this up before. Why do we need to default? Granted, we are bankrupt. (laughter) Most people would have to default.
David: Right, but there is something that has to change significantly before that is even in the cards. Defaulting on our debt assumes that we have already lost the world’s reserve currency status. The privilege that we have to inflate away our debt problems and our liability issues is there as long as, and it is a solution we will pursue, we maintain the world’s reserve currency status.
I can understand, as a foreign creditor, how they would like to see that change. But from an American perspective, we really don’t want to see that change, because it is a privilege, and a privilege is generally something you want to keep. Just like in football, you want to maintain an advantage. I never played football, I played ice hockey, I played Lacrosse, and I played soccer. In ice hockey, I played goalie. They would pull me out when there was a penalty play, because you wanted the advantage of one man up.
Kevin: They would throw one man out, and they would leave the net empty.
David: And then by pulling the goalie during the penalty play, you end up with two extra men on offense to pressure, and with that advantage, you were almost guaranteed to score. It’s the thing where if you can press for an advantage, if you can keep an advantage, you certainly do. I am a little confused as to why anyone in the U.S. would want to give up advantages that we have, and certainly, academics like to think in terms of fairness and in terms of equality and in terms of things like stability. These are the same folks that have no problem with their kids wearing safety helmets just to walk down the street, because what happens if you happen to slip and fall. We don’t want Johnny to get hurt, do we? Life is not like that.
Kevin: That’s true. You do have countries that still compete with each other. Our reserve currency status may not be fair, necessarily, to the rest of the world, but they have benefited from it, as well. I think about when my son was playing basketball when he was a little kid. Somehow the ladies in town took over and figured out that we shouldn’t clap for the kids, at least for one Saturday. So everybody would watch the kids run back and forth, and it was completely silent, and it was absurd. But somehow the county had agreed that one Saturday out of the season none of the parents could cheer for their kids.
Speaking of default, here we are, we are in America, and I don’t want to sound abrasive and bold, but we don’t need to default right now, because we are the reserve currency. But do we, in a way, have a gun to the heads of those who hold the dollars? Because if we did default, or if we were changed from the reserve currency status, either way, their portfolios just go to nil.
David: You are right, Kevin. It is just that it becomes a higher probability event if the reserve currency status is lost. We remain enabled with the “nuclear option.” Default is always there, we can do that, but it is unnecessary at this point.
Kevin: “As long as you leave us with the reserve currency status, we won’t default.”
David: Right, but if we do default, we are really talking about a complete recalibration of risk. The U.S. treasury market, which has been the benchmark for risk-free assets is now giving everyone a second look at what is, or is not, risky. If what you used as a baseline – let’s say you are a builder, and this plumb line, you finally discover, is off by three inches, but you have based everything else on this one particular plumb line, guess what?
Kevin: You are going to build around it.
David: Now you realize that everything you have done has been skewed, and you have to readjust everything. So you could see, Kevin, in the event of a default, the entire world financial system – 10, 15, 20% lopped off, like that – as it readjusts to the fact that what you assumed was a reasonable benchmark for risk-free assets, is, in fact, a risky asset, and everything else is, thus, that much more risky by comparison.
Kevin: So, a Greek default, or a South American country default, is quite different than a U.S. default. With that being said, you would probably still lean toward inflation, even if we don’t feel it fully as inflation, they are going to probably try to control their way through this default through inflation, correct?
David: Oh, sure. Look at the great pains that the Europeans have gone through to avoid European default. You don’t think at least half the effort, or maybe even twice the effort, would be made to avoid default of that form, a hard default, here in the United States? Much better to, for us, continue to throw stones at Europe, and do what we have always done, in terms of our foreign policy – destabilize the rest of the world so we really are the last man standing. If we can draw attention to the fact that Greece is weak, that the Germans have their problems, that Sarkozy, or the next administration, will have their issues, too, with a downgrade in French debt, which is being discussed right now, losing its triple-A rated status, these are issues, which, if we can continue to shine the spotlight on, we will be able to maintain a position of dominance, long past when we probably should have lost it.
Kevin: So, basically, we are not going to go through one of those Saturdays where nobody claps. We are going to probably still try to maintain U.S. hegemony.
David: I guess the point is, beyond the academic bias, which would almost like to foment a psychology informed by the idea of fairness and equality, everyone is special, and therefore, if you are in a developing country, or a developed country, “It just needs to be more fair.” The question is: Are there any politicians today who are thinking about how we can press for the advantage: “Pull the goalie out, put the extra man on. How do we win a point, here?” Again, I realize today, in the context of crisis, we are thinking in terms of, “How do we create global stability? How do we create global tranquility?”
But there still is the issue of who wants America to win. I think this could become an issue in the next election. Who is voting for America? Not for special interests globally, not for the banking interests globally. You see what I’m saying, Kevin. Whether it is Obama or the Republicans, someone in their party – who is it that wants America to win? We are going to have to press for the advantage, because certainly, everyone else is. That came through loud and clear in the discussion with Franck Biancheri.
Kevin: The question goes back to what Ben Franklin said. What are we willing to give up for security and stability? If we could give up our liberty, as Americans, and could give up our property, as Americans, for a relative degree of worldwide stability, is that something that we are willing to do? I can tell you right now, no, my family comes first. My family comes first, my country comes first. I’m not going to give up my liberty for stability.
David: You are not participating in line with what the global elite want, Kevin. This is not right. You need to be retrained. We’ll work on it over the course of time.
Kevin: (laughter)
David: Kevin, I think this is the point, that privilege has led to a sense of complacency and weakness here in the United States. We now take for granted the influence and role that we have played in the world, and are very reluctant leaders, and it goes back to that leaderless confusion. Is there a person, is there a country, is there an organization, is there anyone, who is willing to step up and make decisions where they could be wrong, and they are a willing to deal with the consequences of that?
Kevin: This is an election year. This is the time to start asking that question.
David: Right, and the point that we talked with Franck about a few weeks ago was that we actually see half of the G20 leadership in transition in 2012, so it’s not just our election cycle, but it’s half of the real significant players in the world, that will see a change of leadership, as well.
Wrapping up with the question, like the policy that we saw during the Cold War, of mutually assured destruction, we can default, and that is like the nuclear option in the debt markets. We are not there yet. And we would only be moving that direction if we were losing reserve currency status, and that is not a foregone conclusion. We can see our influence slipping, but we have not lost that role, as of yet.
Kevin: So, default – low probability.
David: Low probability.
Kevin: I am going to move to the next question by Hatim. This is from Hong Kong, David. A lot of the questions that we are reading are from all around the world.
David: Kevin, he says:
This is my third year of listening to your program. Once again, I congratulate you on producing something really special and value-added. Because of the learning process, it took me a while to get on board with a very significant exposure to gold. I put this down to a background in conventional thought, since I have the dubious benefit of an MBA, followed by 30 years of muddle-headed thinking in the professional world of investments. They did not teach us about gold in business school 30 years ago. I doubt if they do today. So, after getting “on board,” my orientation now is when to get off the gold juggernaut, which seems to be just now getting under way. I know it’s too early to do this, but I always like to plan well ahead. You have stated in speeches and in your DVDs that a one-third reduction, in stages, would be the ideal paradigm, but if one could break it down into three stages, a lot rests on exactly when we reach stage 1, stage 2, and stage 3. If your listeners are like me, then much emotional effort has been put into the process of deeply understanding the gold argument. It would be a great pity if we did not get the full benefit of the coming rally and possible blow-off phase. The difference in returns, to your listeners, is immense, depending on whether one is thinking about 5000-dollar gold, or 15,000-dollar gold. I know that the attainable price could be fleeting, and could depend on prevailing circumstances, such as possible gold-buying mania, or the extent of global currency debasement, but in any case, my impossible-to-answer question is, based on today’s circumstances, in a nutshell: At what price is stage 1, at what price is stage 2, and at what price is stage 3?
Kevin: That is an excellent question, David. This is a question that we get all day long, every day. This is not something that Hatim is alone on, but is the answer just a mechanical number? We’ve talked about Dow-gold ratios, but is it a mechanical number, or is there more to it than that?
David: Kevin, I want to start with something that is very important for mature investors to develop into, and it hinges on two words that Hatim used: Full benefit. This is something that is a potential fly in the ointment, if you will. Getting the full benefit of anything is a dangerous, dangerous proposition, and this is why: I have dealt with hundreds, thousands, of investors all over the world, and people want the absolute best price on the purchase side, and they want to maximize the absolute best price on the sell side.
Kevin: That’s human nature.
David: Right, and that’s fine, but there is no such thing as certain knowledge about where the market is, and is going. If you take an appraisal of the information that can be had, which is limited, at best, then you know that you have to be satisfied and be comfortable with some medium-range return.
Kevin: Are you going for the better to be 10% late, or 10% early, rather than to try to time it exactly?
David: Yes, that would even be ideal, in my mind. It would be better to be 15% late, 15% early, 20% late, 20% early. We are still talking about capturing 60-80% of a major trend. If you can do that, from one generation to the next, capturing 60-80% of a move, think of the Dow moving from 800 points, to over 14,000, and tell me you are not satisfied with 80%, or even 60% of that move.
Kevin: Let’s say you bought at 1500 or 2000 and it moved to 10,000 before you sold. You still would be in the parameters of an amazing return.
David: This goes back to the issue, I think, in which we’ve talked about the Bass brothers, and we’ve talked about the Hunt brothers. The Hunt brothers had an ideal in mind, that they were committed to, whether it was a number, or a principle, or an idea, and when the price of silver hit high numbers, they knew the system was broken, there was no fixing it, and they stayed long commodities, knowing that they would come out the other side being the winners, buying the whole world for pennies on the dollar.
Kevin: They stayed long – pun intended.
David: That’s right, and they stayed too long. The Bass brothers were very pragmatic. They looked at 1980 gold prices and said, “You know what? With the advent of Volker coming in, this is a game-changer. The rules are in the process of change. We’ve got to anticipate the consequences of this,” and they moved out of all the tangibles they could, and actually deployed about two years later, into the equity market.
Here’s the thing, Kevin: They did call the bottom side of the equity market. They did not call the top side of the equity market. They sold way too early, and you can’t say that they were really impaired in that process. Their net worth was still increased a multiple of a multiple of a multiple. It was a major move forward for the Bass family, compared to the Hunt family, and we are not talking about paupers in either camp, but seeing these transitions and being able to capture them, yes, that is critical.
But I think it is also important to know that the Bass brothers, although they went long equities in 1982, did not stay long equities until 2000. They were selling aggressively all through the 1990s, and did not have to maximize the price on the upside, being satisfied with, what to them, was a very strong rate of return. This is, I think, a critical question: When you are going to prepare your taxes each year, when you are going to invest your dollars each year, do you want to be very aggressive, or do you want to be somewhere between not aggressive at all and very aggressive, right in the mid point? To borrow from Aristotle, as we sometimes do, “Virtue is the mid point between excess and deficiency.”
Kevin: David, last week we were sitting out on your porch, and I said to you, “Given the situation we are in right now, where we don’t know whether the currencies are even going to be around in a few years, with gold at a 1:1 ratio with the Dow, which you have historically said is a good time to pare back to one-third of your portfolio, and take your profits on the other, if we were at a 1:1 ratio on the Dow right now, given this situation, would you really sell gold?”
David: Without a doubt.
Kevin: I was thinking, “I don’t think I would.”
David: Well, things are getting worse and worse, and the justification for owning it is now crystal clear. What was once a theoretical construct in terms of potential risk that you needed to hedge for, is now a real-world crisis right in front of us. The horns are blowing. The lights are glowing. This is desperate.
Kevin: But you had pre-agreed with yourself that you were going to at least scale back some if we got to a 1:1 ratio in the Dow. What that would mean today is gold being $11,000 or $11,500, whatever it would be at the time.
David: Assuming that the Dow wasn’t a different price. Correct.
Kevin: I’m just saying, hypothetically, today.
David: I think, Kevin, how someone scales out, again, that 3-stage process that Hatim is talking about.
Kevin: Can you give us a general idea?
David: I think this is very critical, depending on your commitment to this investment class. For instance, if someone has 3% of their liquid assets in the gold market, and we find ourselves at a 5-to-1 ratio, should they be thinking about liquidating a part of their gold holdings?
Kevin: They need 27% more.
David: Yes, I think they have undershot a target, a reasonable target, and they should not consider selling at 5-to-1, they should not consider selling at 4-to-1, they should not even consider selling at 3-to-1. They are underexposed, in my opinion. On the other extreme, if someone is over-exposed to the asset class…
Kevin: Let’s say they have 70-80% in.
David: Okay, so you are describing me. (laughter) I don’t think you were trying to, but…
Kevin: You can’t help that it grew.
David: I know, but here’s the problem: I am over-exposed, and every tick higher in the gold and silver market, it is like climbing a very extended fireman’s ladder. Falling from the first rung – no big deal. Falling from 50-100 feet up, the consequences are more grave. So, yes, you need to, if you can, reduce your risk. It really does tie to the degree of your original commitment. If you are talking about 100% of a portfolio, do yourself the favor and be way early – 5-to-1, 4-to-1, or 3-to-1 in the Dow-gold ratio. Be very early, if you are over-committed. If you are under-committed, don’t worry about it until you are at a 2-to-1, or 1-to-1 ratio. And if you are somewhere in between, as we have suggested, being at a one-third allocation, take your liquid assets and have one-third of them allocated to precious metals.
Kevin: Always, no matter what the ratio is.
David: And here is the issue: If you have done that, then in the context of a bull market, you are looking for the trigger event. You are looking for something that allows you to say, “Okay, the insurance policy that I owned, also known as precious metals, now needs to be reduced, and I am taking the insurance compensation off the table.” You aren’t taking the insurance policy and blowing it up, but you are saying, “Okay, my one-third asset has grown into 50% of my total assets. I am over-exposed. I don’t need that much insurance, I don’t want that much insurance, and by the way, there is a good part of the world which is now selling at a discount. I can take a premium asset and move into a discounted asset, and my purchasing power is leveraged in that venue.
Kevin: Okay, so play the game with me, just for a moment. This is a little like Abraham talking to the Lord. “If there be ten good people,” you know, working your way down.” (laughter) Gold, today, is not 1-to-1, but let’s say gold was 3-to-1 on the Dow. Let’s say gold was $3000-$4000 right now. Do you start reducing your strategy? Today, given the environment that we are in right now, if we were at 3-to-1, David, would you start reducing your gold strategy?
David: I would, and it means that I’m leaving a lot of money on the table. If we, in fact, go to a 2-to-1, or a 1-to-1 ratio, then I’m leaving money on the table. This again, goes back to that issue of full benefit. Am I comfortable not capturing the entirety of the move with my entire exposure? I still maintain an exposure to the metals, I still maintain and am moving toward that idea of full benefit, but it is with a reduced amount. And that is absolutely necessary.
Kevin, I think this is one of the critical functions that investors should not underestimate. Today, with gold at $1600, $1700, $1800 an ounce, in a range between $1500 and $2000, this range – does that represent a threat to the current monetary system, or to the current fiscal decision-makers?
Kevin: But, gold at $10,000?
David: Gold at $10,000, you really have the telltale, which says, “The fiat money system is broken.” Honestly, if we see gold in dollar terms at $10,000, the Fed has lost all credibility. But let me ask you this, Kevin. Will you see a mea culpa from the hundreds – I think there are 600-700 Ph.D.s that work at the Fed – will you see a mea culpa and an admission that, “I guess we got it wrong, I guess our theories were inaccurate,” or will you see them fight like hell to see something happen with the gold market? Now, I am not talking about outright manipulation.
Kevin: It’s hard to publish an apology, and most of these guys are academics. They need to be publishing on a continual basis. Published apologies don’t sell well.
David: No, they don’t. Unless you’ve committed some grave, homicidal crime, and then you get to publish.
Kevin: Oh yeah, that’s right. McNamara. He sold a good book. Yeah.
David: (laughter) Well, the thing is, I think my concern is, Kevin, that at some point, the world monetary decision-makers, not just the Fed, but the central bankers from around the world, realize that all of them, in terms of their concepts, are broke. They are bankrupt. They have lost credibility. And one of the ways of re-establishing trust is to make a concession, and that concession is a partial remonetization of gold. I think that ownership, in this environment, will not be inhibited. I don’t think we are going to see a confiscation of the metal. But to prohibit volatility in the space which is supposed to be, now, the new anchor for this world reserve currency, which may be a basket of 5, a basket of 10, a trade-weighted basket of any number of currencies, including the U.S. dollar. I think gold is that critical thing that re-legitimizes fiat, and they are not willing to go back to a gold standard completely, but they will do it to the degree necessary to regain confidence.
Kevin: Until that doesn’t work, and then they probably have to go to something even more stern.
David: But how do you keep gold from being volatile? People go from owning it at $300 an ounce, to owning it at $5000 or $10,000 an ounce. How do you keep it from being volatile? Raise the tax consequences of owning it, not because you have a surtax each year, which I suppose you could do, but I don’t think that is very probable. We already, in the United States, are punished for owning it. It never sees the distinction between long-term and short-term capital gains. You pay a 28% tax when you liquidate, regardless of how long you have held it. Tell me it’s not possible, and with the stroke of a pen it is very easy to accomplish this – you move it from 28% to 50%, or you move it from 28% to 60%. A number that says, “Of course you can own it, we want your balance sheet to reflect health.”
But the sub-plot here is, Kevin, that you can’t receive the benefit of ownership. Here is the point: If you are trying to maximize returns in your gold portfolio, realize that it is a targeted portfolio. Today, no one cares, but lest we forget, in 1933 it was necessary to bring it in and control it. And then we went one step further in 1961, under Eisenhower, and it was no longer legal for U.S. citizens to own gold overseas. You could own gold legally in the United States up until 1933, and then it was illegal for domestic ownership, but nothing said that you couldn’t own it elsewhere.
In 1961, that was not the case – then, you were not allowed to own it overseas. There was no way to control that in 1961, it was very much an honor system. You weren’t allowed to own it, but there wasn’t really the network of control that we have today. Today, if they make it illegal to own anywhere, they are going to know about it, unless you are living in some backwater country, willing to risk your life, living in an environment where theft and chaos is more or less a daily event.
Kevin: David, this may seem like a silly question, because we know that right now, it is really our only safe place to be, but why does someone own gold if they are going to have that much control in the future?
David: I guess what this argues for, again, is realizing that this asset class is critical for the times. What I’m trying to say is that insurance is particularly critical for the times. We don’t know what the future holds, which is why we continue to own the insurance, beyond any particular price point. Reducing a metals position by a third, initially, and then by taking your remaining stock and reducing it a third, yet again, and then taking your remaining stock of metals and reducing it by a third, yet again, still leaves you with skin in the game, but you have been very decisive and strategic in taking some money off the table.
It is not just because we want to maximize our gains, but there is a growing risk as the price of gold goes up, which is not a risk that applies to other asset classes, and it is the growing political risk of owning the asset. You, as an investor, become a target to particular changes in legislation, and I’m thinking, particularly, in terms of tax legislation which will go from bad, to even worse. You may find yourself owning gold at $10,000, with the ability to only realize a $5000 price after tax, or let’s say that the tax penalty is at 75% of your gain, and you may, again, own it at a current market price of $10,000, but only be able to receive the after-tax benefit of $2500. Better to anticipate the change in rules. Better to be early, than late, because one minute late is something that is a true game-changer for someone who thought they had all of their bases covered.
Kevin: Is this not why we should continue to read and study, and hopefully our listeners will continue to listen, because we will be discussing these things as they progress. Dow-gold ratio is something we have talked about for four years on this program, and for twenty-some odd years with our clients, so this is not new. I do want to throw a caveat in, and it actually answers one of our clients’ questions. It is a simple, short question.
David: Before you go there, Kevin, I think it is important to underscore that what we are talking about moving from is an asset class that represents stuff. Gold and silver – it’s real stuff. When I imagine coming out of gold and silver, it’s not to move into fiat paper. It’s not to move into anything other than real stuff. When I look at a company like 3M – the land, the plants, the infrastructure – if you toured half a dozen of their facilities, if you toured dozens of their facilities, you would be amazed at the scale, the scope, of not only the acreage they own, the concrete they have poured, the steel girders they have erected, but we are talking about assets, we are talking about real things, and if I can exchange my real things for their real things…
Kevin: At pennies on the dollar.
David: … at a discount, it becomes compelling. I would not consider moving from stuff, to paper. Why? I think that is the challenge that most investors have – thinking about why they would sell their gold for money? That is not the point. We are talking about an exchange of value, from real stuff to real stuff, out of a premium asset, into a discounted asset.
Kevin: This bring up real stuff to real stuff, because gold assets – the stock portion of gold, what is traded on the stock market – actually represents mines. Those can be real, and we do have a question from Dawn, who says:
“How about a discussion of gold and silver stocks, versus gold bullion?”
Now the caveat is this: Any time we are talking about gold on this program, correct me if I am wrong, but we are talking about gold, real gold. I have had people call in and say, “Oh yeah, I’ve got my gold, I’ve got my gold stocks, I’ve already got it taken care of.” Wait a second. We aren’t talking about ratios changing with gold stocks. We are not telling you that that is your preservation hedge.
David: No. In fact, if you look at the last ten years, an investor has suffered greatly being in gold stocks. Depending on when your purchase was, if you purchased in 2000, 2001, 2002, that was an era in which I worked with Morgan Stanley on the west coast, and we bought a lot of gold stocks for clients in that period of time. Those people have done very, very well with those low, low-cost bases.
Kevin: But can that be counted as the bottom third of the portfolio.
David: It’s not a substitute, because we are talking about an industry that has, for 20 or 30 years, lacked the ability to attract top talent. We are talking about management teams which are not the best of the breed, so to say. There are much better people running companies like Heinz and Campbell Soup, and again, 3M, not because they are my favorite, but because they are just a huge company that has been around and done a good job for a long time. They have good management in place, and that is not the case with most of the gold miners. There is management risk, there is resource nationalization risk, and there is environmental risk.
There is a huge mine up in Alaska today that is not making headway, one of the best gold assets on the planet, literally, and they are not making any headway because they can’t make it past some of the pre-feasibility studies and environmental approvals. There are these issues where, in theory, it is a leveraged play on gold, but in practice, we are talking about, basically, higher beta, higher risk, for the same asset class. And the question we would have is, “Are you categorizing the purchase correctly?” If you want to own gold stocks, do it in the growth portion of your portfolio, the left side of the triangle, but don’t substitute that for insurance. Insurance is the base of the triangle and serves a very unique function. It is not for speculation. It is for insurance – period.
Kevin: A couple of weeks ago you said that gold stocks are starting to look attractive for the growth side of the triangle. You have said that you like gold stocks, to a degree. Why don’t you answer to that?
David: Kevin, let me give you an idea of what that looks like. If you take the current gold price, and then take one of the gold stock averages, XAU. Divide those into each other. We like these ratios, we like these relative comparisons. Take the price of gold today, and divide it by the XAU – that’s a gold share index – and you end up with 8.8. What we are really looking at is an under-valuation of gold stocks, which has only been at this level three times in the last several decades.
Kevin: Relative to gold bullion.
David: Relative to gold bullion. Gold bullion has been the better growth investment, up to this point, and that may continue to be the case. We don’t know. There is an argument made, and I remember a conversation with Ian McAvity, in which he looked at this in the 1980s and said, “We thought that was the case. We thought that, consistently, gold stocks outperformed. We did our regression models and figured that, actually, it’s not the case,” and so they launched the Central Fund of Canada, which is a blend of physical gold and silver, saying, “We’d rather have a little bit of upside to gold, with a silver component in the mix, than play the gold share indexes, or the gold share market, anymore.” Here is a guy, seasoned in the business, who says, “It was a good idea in theory, but it actually doesn’t play in practice all the time. It’s not consistent enough for us.”
You can catch these periods of time, though, Kevin, where you are at extreme under-valuation, and I think it could get a little bit more extreme. If we get to 9 ½ or 10, again, taking the gold price and dividing by XAU, at 9 ½ to 10, I think the downside is fairly limited, and the upside is fairly grand, in terms of the gold shares relative to gold. But understand, it is not the same thing as physical metals. We are talking about something that will keep you up at night. We are talking about something that, if you don’t have an ulcer, will give you one in a matter of days or weeks, and if you have a cast iron stomach, then you will get an ulcer in a matter of months. We are talking about risk upon risk, upon risk, and it really does take a different kind of investor to engage that market.
Kevin: David the volatility in gold shares is huge compared to even gold bullion. So do people focus on the wrong thing, at the wrong time? Let’s say they transition from gold bullion ownership, which is very long-term trend oriented, and then all of a sudden get whip-sawed in the shares market.
David: Sure, let’s take 2008 as an example, Kevin. Gold was off, at its worst, by about 30%, and it recovered by the end of the year, so that in the calendar year of 2008, gold finished up about 5%, even with the downside volatility. Well, with a maximum downside of 30% in the year 2008 in the physical bullion price, gold shares, many of them, were off 70, 80, even 90%.
Kevin: That will take your breath away.
David: It will not only take your breath away, it will tell you, instinctively – and this goes back the lizard brain, “I’ve got to survive,” fight or flight – you are fleeing.
Kevin: Your mouth gets dry.
David: You are concerned you are not going to be able to retire, with those kinds of losses, and reasonably so. But you can, experiencing that kind of volatility, say to yourself, “I think the trend has changed with gold,” and you would be mistaken. Just as someone who buys into the futures market or options market begins to shrink their time horizon, and doesn’t care about the long-term trend for gold, but is more concerned about the short-term trade – “What’s it doing today? What’s it doing tomorrow? What’s it going to do by the end of the week? I’ve got options expiration next month. If I expire, and I’m not on the right side of this, I lose everything!”
Kevin: David, we call that “noise on the mean,” because you are just paying attention to the noise. It has nothing to do with the major trends.
David: And that is where we would encourage clients to focus on the long-term trend. This is the importance of physical metals, even above gold shares or anything else. Going back to Hatim’s question. If you wanted maximum benefit, you would play the futures market, and you would be leveraged 5 or 10-to-1, and you could make a killing, but more often than not, you would get killed. You are fodder for a machine and a game that is played for the benefit of the house. Playing the futures market is not dissimilar to going to any of the major gambling casinos. The house is in business to make money for themselves, and you pretend to be a major player, and continually feed the profits of the house.
Kevin: But if you buy for the long-term trend, the house doesn’t play.
David: The house is not involved, which is why the physical metals is really where you want to consider core positions, and anything that you do beyond that is ancillary. It is secondary, and you don’t have to worry about the volatility as much because the commitment should, in fact, be less. You should not confuse the volatility of the gold shares, or the shortness in time frames, of the futures or options market, with the long-term trend and receiving the benefit of the long-term trend, which is what you are going to have with gold bullion.
All that said, yes, absolutely a fan of the gold shares. You want to buy them right. If you don’t buy them right, you will be playing the patience game, and will learn to hate gold, the physical metal, very quickly, by having bought it at an incorrect time.
