Podcast: Play in new window
- Heroism & Empathy Worth Remembering
- Current Ad-Hominem Politics Show What We’ve Forgotten
- Sahm Rule & Yield Curve Reversal Signal Recession
“As we march towards the November elections, we could choose to dehumanize people that we disagree with or we can choose to dignify regardless of differences. We’ve allowed the absurdity of a platform-free, policy-light election to move ahead, and instead we’ve invited an ad hominem contest of insults and jabs, attack against the man, and attempt to undermine by avoiding the platform, glossing over policy in favor of personal insults, and aggressive character assassination.” —David McAlvany
Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany.
Well, David, I don’t know that we can ever forget 9/11 each time it comes around every year. There are these turning points in history, and that one in our lifetime was major. And I know for you there were some very poignant personal things that involved New York, the South Tower, the World Trade Center. It’s a powerful, powerful day to go back and remember
David: Occasionally, I have to ask the younger on staff if they even know what 9/11 was. Of course they do because they’ve been told, but—
Kevin: Some weren’t even born though.
David: Twenty-three years ago. I mean, it is a little bit of time. So I showed up early to work at Morgan Stanley Dean Witter, as it has often happened. I was on the phone with a good friend from Smith Barney before the markets opened, and something unusual occurred. We watched the early news of the first plane crash into the Twin Towers. Not long before that, I had completed my training there in the financial district, in the Twin Towers.
Kevin: You had been in New York before that? Yeah.
David: Yeah, in the South Tower. So the accident, it appeared, it was well covered by the news as camera crews, helicopters sort of captured the North Tower burning and live as we watched the coverage. Seeing a plane hit the South Tower, there was a mental shift to that point. It had appeared to be an accident. Kind of what happened was confused. After the South Tower was hit, it was like, “That was no accident.” That was the second plane. We didn’t have the explanation of the first plane.
Kevin: I remember that realization too. I was here at this office at the time, and one of the guys had a TV back in the back corner. In fact, you worked in that office when you came back to the office here, and he said, “Hey, Kevin, come back here” because he knew I was a pilot. He said, “Somebody flew a plane into the World Trade Center.” So we watched, and we thought it was an accident as well until while we were watching, we saw the second plane hit. And at that point, it’s very hard to process, isn’t it? When something happens that’s so out of the norm, I don’t think I really registered when the second plane hit right away. I just was sent into sort of a befuddlement for a few minutes before I started to realize that this was contrived.
David: Panic and fear are things that we experience through a variety of circumstances. And one of the reasons I think of 9/11 and reflect on it is the memory of a man who died in the building, and he didn’t have to die if he had lived selfishly,. He was clear of the building, and very selflessly went back into the building to look for four colleagues. Rick Rescorla was a soldier of fortune. He fought in Rhodesia. He had been in the British military and somehow made his way into the security apparatus at Morgan Stanley and he didn’t care if you were in a $10,000 pinstripe suit, you were going to do what you needed to do in a moment of crisis.
Kevin: Didn’t he run you guys through drills and the people who were with Morgan Stanley?
David: Fire drills were a routine thing and it didn’t matter if you were closing a billion dollar deal, you were marching the stairs. And Port Commission, who owns the buildings, got on the horn and basically said, “Stay at your desk, everything’s fine” and he completely ignored them and took action and went into evacuation mode. He got 2,700 Morgan Stanley employees out of the building. 14 did not make it out, four of his own security contingent, and he went back in. Texted his wife or called his wife, I don’t remember, and basically said goodbye.
I think of what we now see as heroism in retrospect, but when panic ensues, when fear is present, you can either be overwhelmed by it, you can do nothing, or you can operate according to the strategies and designs which have already been put in place. And it’s exactly what he did, saved their lives.
Kevin: Well, and the Port authority, the message in the minds of the people there in the building was, “Stay put. Stay at your seats. Everything’s going to be fine.” This man had enough experience to understand you have to think as an independent when something like that happens.
David: Well, and I think maybe the rationale was you don’t want to stir a panic.
Kevin: Right. True.
David: Which is understandable, but there is a way of, as he did, orchestrate a controlled evacuation.
Kevin: Well, and look what happened to the rest of the world. For a few days, Dave, it was a unique experience as well.
David: Yeah, I think that global solidarity, if you think of it in terms of sympathy or support, however you’d categorize it, whatever differences you had with the US, they were set aside. There was a common appreciation of vulnerability and susceptibility to loss, uniting the globe at least for a few days. And holding that as a unique experience, thinking about that, a memory of how we choose to act, how we perceive each other, it’s important to me, and it’s important in part because it is a choice.
We can dehumanize. And I guess this brings me to the November elections. As we march towards the November elections, we could choose to dehumanize people that we disagree with or we can choose to dignify regardless of differences. We’ve allowed the absurdity of a platform-free, policy-light election to move ahead, and instead we’ve invited an ad hominem contest of insults and jabs. Against the man—that’s the way it was described at our dinner table growing up, the rough translation of ad hominem. Attack against the man and attempt to undermine by avoiding the platform, glossing over policy in favor of personal insults and aggressive character assassination.
The media is certainly complicit in this. They help create the drama, and it sells well because it’s contention, it’s anxiety. It’s something that gets people to the edge of their seats to what happens next. Who will hit the knockout blow, so to speak.
Kevin: Well, and you’re not saying back away from debate. I mean, I think of the Lincoln-Douglas debates, I think of— Debate in your family actually was a very big part of the dinner table, but you didn’t attack the man. The ad hominem did not come in.
David: No. I was in Washington DC over the weekend, worked there as a 16-year-old on a presidential campaign, and was remembering the families that I knew and had worked with there who prized a discussion and a debate and were always willing to extend an olive branch to the person regardless of how different viewpoints were.
A few years ago, I remember CNBC, Fox Business interviews, I guess this goes back about a decade ago, where they needed to know how I would argue on a particular issue so they could match me up with a counter-argument, create a little on-air drama, like a ringside experience of intellectual sparring. Just do it live. You don’t know what’s going to happen.
The rewarding aspect is that it was about issues and varied interpretations of market outcomes, and it never did devolve into those ad hominem attacks. They liked the conflict, but it was about ideas and market prognostication. The better your data and skill in presenting it, the greater your credibility. You didn’t win points by being rude.
That’s the way I was raised. Have your data. Present on an idea. You could do so with passion and vigor. But it was a battle of ideas and wits, not a battle of personalities. You could complete the dinner debate, and relationship along with respect would be intact, even if you remained on opposite sides of an issue.
Kevin: I was thinking about that. I was at a memorial service for a man that I knew. And we didn’t always agree, but we cared for each other. And what is it, Dave, about being able to disagree with somebody and still care for them? That really comes out when there’s a national tragedy, doesn’t it?
David: Yeah. And I’m not sure what it is about loss or tragedy which strips away differences and allows for a common humanity to be appreciated, for basic respect to be expressed. Why does it take difficult circumstances to draw that out of us when really it is a choice?
Kevin: Yeah, it really is. Well, moving on to the financial markets, we last week saw the yield curve that had been inverted for quite a while, reverse. And now we’ve got some other indications. It’s called Sahm Rule. I’m going to need you to explain that, but there are certain things that occur that almost certainly point to a recession within a short period of time.
David: Yeah. You’ve got the leading economic indicators, you’ve got the Sahm rule, you’ve got the inverted yield curve. They’re all advanced notices that recession is coming.
Kevin: Right.
David: And maybe it’s unfair to see this as recession is coming at some point in the future. There are things that you can’t get around. Even if you live in a command and control economy and can push all the buttons and pull all the levers, you just can’t avoid. And maybe calling for a recession is like having the broken clock right twice a day. Maybe it’s not a genius call.
Kevin: You go, “Yeah, right. Yeah, right. I’ve heard this before.”
David: It’s an inevitability with an indefinite time lag.
Kevin: Yeah.
David: So the Sahm rule, according to the St. Louis Fed, is a recession indicator which signals the start of a recession when the three-month moving average of the national unemployment rate, that’s U-3, rises by a half a percent or more relative to the minimum of the three-month average from the previous 12 months. You’ll have to unpack that.
Kevin: I’m glad that these accountants understand what they just said. Yeah.
David: It basically means the trend in employment is changed and the labor markets are not what they were at their very best, and they’re moving the opposite direction now. So in other words, it’s more time-sensitive than the leading economic indicators and the inverted yield curve.
Kevin: So let me ask, because we’ve had such an unusual period of time since 2011 when Draghi said, “We’ll do whatever it takes.” What that meant was, “We’ll just print as much as we need to print,” and that seems to be throwing these indicators off. Is the expansion of credit both here and around the world, has that been a delay factor for these indicators?
David: Yeah, for sure. I think Chinese credit expansion has thus far held at bay a period of outright economic contraction, and thus far we’ve had a slower rate of growth in China, not an outright contraction. And there you have command and control dynamics. There you have massive credit expansion on track this year for $5 trillion expansion in credit.
The Chinese backdrop in some ways is similar to that in the U.S., government spending and massive credit accommodation—accommodation in the credit markets—has allowed for economic activity to continue. Now, it’s economic activity of a lesser quality, but we’ve still got our 3% here in the U.S., now just below 5% in terms of Chinese GDP growth rates. Downgrades for Chinese growth are coming fast and feverish from Wall Street firms, and it’s not so in the U.S. We are holding steady at about 3% growth. Sanguine views are all about here in the U.S., and that’s even as the yield curve uninverts.
Kevin: Yeah, yeah. So, let’s explain the inversion first. Sometimes we have to remind ourselves. If money’s going to be borrowed for the long-term, usually you’re going to have higher rates. That is a correct yield curve.
So, short-term rates are lower, long-term rates are higher. When that inverts, and it’s inverted for quite a while here, then you have short-term rates higher than long-term rates.
Now, that just uninverted. Now we have long-term rates going back again above short-term rates. That’s an uninversion of the yield curve, and that, when you look at a chart, that always signals recession.
David: Well, inversion’s unnatural, because you’ve got risk in the unknowns, and the more time involved, the more unknowns there are, and that’s what you’re being compensated for, whether it’s inflation risk, or credit risk, or other kinds of risk, that’s why you have this steepening curve where you aren’t paid much today, but 2 years, 5 years, 10 years, 30 years out, you’re paid more and more as time goes on. So, that’s a normal yield curve. When it inverts, you’re being paid today, you’re not being paid tomorrow, and that can be for a variety of reasons.
Kevin: Well, and how long have we been inverted? I mean, we’ve uninverted now, but how long were we inverted?
David: Yeah, some people like the 3-month, 10-year comparison. It’s the 2-year, 10-year paper which was inverted for a record 793 days, and it’s finally uninverted. Inversion, by coincidence, comes prior to recession. It’s not causal. You could describe it as coincidental. A steepening of the yield curve, the uninversion process, dare we say a widening of credit spreads happening at the same time, that uninversion process is much more of a causal factor to business market conditions, which, if the cost of money is getting more and more expensive, it creates a tougher environment for your operator. It can be directly contributory to recession.
Kevin: So, we’ve got these two things, at least. The Sahm Rule, which has to do with unemployment, U3 reversing, and then the uninversion. Is the clock ticking?
David: Yeah, I think the Sahm Rule clock is ticking, the uninversion clock is now ticking. But in spite of those things, you’ve got liquidity conditions which remain so loose and accommodative in the financial markets, time still seems to be on the side of the optimist.
Now, something can shift, and if credit spreads do widen, which basically means that higher risks in the market require a higher degree of compensation for the risks taken, and credit spreads would be if you’re offering investment grade debt or high yield junk paper, all of a sudden the higher likelihood of default is factored into the interest rate that you pay. If you see those credit spreads widen, then corporations will come under real pressure.
Kevin: Yeah, Dave, I can’t help but think of what the loudspeakers were saying in the World Trade Centers, “Stay at your desks, everything’s fine.” And even me, watching the TV here, that first tower looked like an accident. The second one, it took me a little while to process, I have to admit. And right now, when you have a reversal like what you’re talking about, whether it’s the Sahm Rule, the uninversion clock, the stock market hitting all-time highs, these momentum types of things that are happening, that becomes the norm, and it’s hard to actually do something that goes against that norm.
David: Yeah, so far so good. We’ve got record issuance of corporate debt last week north of $80 billion—
Kevin: So, no problem being seen.
David: Right, and then followed by scheduled issuance of over 25 billion this week, and it suggests that investors are not overly concerned with corporate balance sheets or with interest coverage ratios. It’s interesting because last week’s equity market volatility was sharply focused on companies that could have issues along those lines, where balance sheets could become a focus, and interest coverage might be a concern. And it’s not clear what the disconnect is between the debt markets and the equity markets, but corporate debt markets are wide open, like a fire hydrant, furious fire hydrant open. Last week there was a pause in the equity markets. I mean, we’re talking about a significant decline in some really key areas.
We had NVIDIA, which was down 12.6%. We had the semiconductor index, which was down 12.2, mid-caps off 4.9, the S&P off 4.2. It was, as Doug mentioned on our call on Monday, when you’ve got tech down, and the banks and financials which were down over 5%, it’s telling you something real is happening in the underbelly of finance.
So, at this point, it’s probably not an investor reassessment of balance sheets, of company fundamentals, probably more of your leveraged speculators being forced to reduce their positions as the yen strengthens. And lo and behold, last week, the yen was up. It rallied 2.7% against the dollar, and it’s back to the trading levels that it was at August 5th. And so, we’ve mentioned this previously, you see further evidence of the yen carry trade unwind with the emerging market currencies, where they were depreciating in lockstep with the yen’s appreciation.
So, emerging market currencies remained under pressure. A complex of trades all infused with borrowed capital, that’s what was being cut back last week.
Kevin: So, you said there was record debt issuance last week. Maybe it wasn’t exuberance that was getting people to borrow, maybe it was something else.
David: Post-Labor Day tends to be strong, but to me it seemed a whiff of desperation, at least like they’re up against the clock. Yes, lower rates are coming, yes, the Fed is planning on creating a more conducive environment for refinancing, bringing the Fed funds rate lower, and yet we’ve got credit spreads which are at multi-year lows.
Kevin: So, should they be refinancing now because this may be the best time ever?
David: Right, because if market sentiment shifts, even if the Fed fund rate goes lower, you may not see that pass through to investment grade borrowers or junk borrowers.
Kevin: Yeah, so what we’re talking about here is long rates rising relative to short rates. And so, when you’re talking about credit spreads, right now they’re about as tight as they’ve been.
David: Yeah, and as I mentioned, this is about an additional number of risks being factored in, risk is in the unknowns. And so the farther out you go in terms of time and duration, the more risks you’re accounting for. And there’s some unknowns within the business cycle which have to be considered as well. To this point, they’ve been ignored, they haven’t been considered an issue.
Lo and behold, the NFIB Small Business Optimism this week came in, and to quote the Bloomberg headline, “Small Business Optimism declines by the most in over two years.” So, we’ve got the people who are primarily responsible for the largest number of jobs in this country, small business owners, I mean, expectations were for it to be flat, and it came in two and a half points lower than expected, and there were two components out of 10 which were markedly lower in the survey, and it’s sales and earnings expectations.
So, sales and earnings expectations both cratered. Kevin, if you were to extrapolate that from small businesses, privately held, not publicly traded, extrapolate that to public companies, you might have a late cycle price earnings blowout, where earnings are declining before share prices do, which represents a market swan song. The net expectation: they’re dialing back hiring plans, and that is the chatter that you see amongst the Fed executives is that labor market weakness is a reality, it’s emerging.
And the question the market now has to answer, is that weakness at sufficient scale to inspire a faster pace of monetary policy interest rate cuts? Does that in turn goose the performance of equities, again, where earnings can be dropping and you lower rates, then you’ve got a last moon shot in equities? Or will the rate cuts be too little, too late?
Kevin: Well, and you talked about a price earnings blowout. I think it’s worth pausing here just a little bit. The price that a person pays for a share versus the earnings of a company, the difference between the two is this P/E, and I think historically it’s been around 14 or 15 times, the Shiller P/E index, the CAPE, but last I looked it was at about 33, so it’s about twice what the average is.
Now, when you talk about a price earnings blowout, you can have the P/E be wide if earnings are low and prices are high, or you can have it narrow. Either one can move toward the other. In other words, prices can come down, earnings can go up, and it can actually stabilize if you just grow out of the cycle. What you’re talking about here, though, a price earnings blowout would be if earnings start to fall, we’re going to go beyond that 33.
David: And yet, if prices have that Wile E. Coyote moment where they’re suspended in air, even as earnings have already hit the gravity skids, then you have, again, it’s just numerator and denominator, dividing one into the other.
Kevin: And it could fill the vacuum pretty quick.
David: You can go from 33, to 43, to 53, to 103. I mean, your price earnings multiples can blow out. And that’s exactly what we had in the year 2000, where earnings declined but prices and the ebullience in the market remained relatively high, and then caught up on the downside.
Kevin: That Wile E. Coyote picture is exactly the picture. I mean, because he runs right out, off of the cliff, but what happens? He hangs for a second or two, and then you actually see this.
So, you brought up NVIDIA. It’s all been momentum. I mean, everything has been momentum, and momentum is really— That’s another Wile E. Coyote/roadrunner kind of thing, when you see the rock rolling down the hill or what have you. The momentum builds and builds until the momentum shifts. And momentum, when it goes one way is really exciting if you’re making money, how about when it doesn’t, or when it goes the other way?
David: Well, so I mentioned earlier the cracks and the complex of the leveraged speculator in that community. Again, the evidence last week, 2.7% appreciation in the yen, decline in emerging markets, and then follow through with the most popular momentum-oriented trades, overcrowded for sure, semiconductors, the NDX, and NVIDIA, again, as I mentioned, off 12.6% last week.
The question beyond the highly leveraged speculator is the non-leveraged investor and their reaction to volatility. Momentum goes both ways. Downside momentum has yet to gather steam, but with the S&P 500 trading below 5,500 and the August 5th lows needing to be watched closely—again, we’re talking about 5,200, just below 5,200. The other indices you could watch: the Russell 2000, about 2,000 points; the NASDAQ at 15,700.
Kevin: So these are numbers that we should be watching?
David: Exactly.
Kevin: To see if they hold.
David: 5,200 for the S&P, 2,000, coincidentally, for the Russell 2000, and NASDAQ at 15,700. We still have a little bit of gap between here and there. There’s cushion left for all of those indices, but those are the numbers that need to hold support.
So we’ve got September 18th. The market is expecting only one 25 basis point cut, with an additional—this is really interesting—the bond market today is pricing in three additional cuts by year-end. What would inspire the Fed to cut another 75 basis points, actually a little bit more than that, by December? You tell me.
This market obviously could go either way, but those price levels are key. If they don’t hold, its massive tactical damage and massive sentiment damage amongst your investor community leading into a volatile election season. So October, we’ve said this before, October could be dangerous. Balance your cash positions in gold holdings accordingly.
Kevin: Sometimes you can see something coming and you need to plan accordingly. I was watching Monday Night Football, the first one of the year, and it was San Francisco playing the Jets. And San Francisco went to the Super Bowl last year, but it was a very interesting story. They’ve got a quarterback named Brock Purdy, and he was the very, very last pick as far as the picks go on the draft, and so they didn’t have to pay him much. They signed a four-year contract, and it’s less than a million bucks a year. That’s just a drop in the bucket for an NFL quarterback. So Brock Purdy, he stepped up and surprised, and he took San Francisco to the Super Bowl and he only made $934,000. The guys he’s throwing to however, as far as allocation of funds, Aiyuk is the name of one of his receivers and he’s got a four-year contract for $120 million.
So Brock’s making less than a million, he’s throwing the ball to this guy who’s making $120 million. And San Francisco knows that they’ve sort of had the Cinderella story, and now they’re going to have to step up to the plate and everything’s going to change. So Brock is going to probably have one of the largest contracts coming. It may not be quite as much as some of the other quarterbacks yet, but San Francisco knows the guys who are planning for the next few years, they’re not going to have this Cinderella story where they can just spend $120 million on a receiver when they’ve got a quarterback that’s almost free because Brock has proved himself.
Now, where I’m going with this is this: we have already talked about the Sahm rule. We’ve talked about the uninversion of the inverted yield curve. We know there’s a recession coming. We know that people are borrowing more than ever. What exposure do households have if we know there’s a change, how exposed are the households to the equity markets if we see this Wile E. Coyote thing happen?
David: More exposed than at any other point in investment market history.
Kevin: They need to be taking action now.
David: Yeah. Well, a question my colleague Morgan raised recently, household allocations to equities have hit all-time highs. It was 30% at the market peak in 1968, the great bull market, 1949 to 1968, 38.4% by the time you got to the year 2000. And in the second quarter of 2024, we got to 42.4% as a percentage of total financial assets allocated to stocks.
Kevin: So households. Household, the allocation to stocks is almost 50%. It’s 42 point—what did you say?
David: 42.4%.
Kevin: Okay.
David: The highest it’s ever been as a percentage of financial assets allocated specifically to equities. And my question is, who’s left to continue the buying?
Kevin: There’s the vulnerability.
David: We have for a long time commented that bear markets are over when selling is exhausted.
Kevin: Right.
David: Bull markets on the other hand are over when buying is exhausted. The nice thing about leverage is that it provides an extra boost on the buying side beyond what someone can afford. So this is where the earlier comment about cracks in the leveraged speculative community are important because we have had some exaggerated buying in the marketplace. The relative importance of the leveraged speculator at a market inflection point is considerable. And if the non-leveraged investor loses heart, watch out below. The US economy, okay, it’s underperforming China in percentage terms, but it’s also far less vulnerable to a major decline, with a wider base of consumption undergirding its growth.
Recession here? Yeah, that’s a possibility. And the Sahm rule and the uninversion of the yield curve argue for that, so you could say it’s even likely. Depression is far more likely across the pond. And the D word—deflation, that is—is now escaping the lips of leading central bankers and economists in China—of course quietly because free speech can get you in trouble in that part of the world. Using the D word is regarded in the Chinese East like yelling theater in a fire is here in the West. Right, you can reverse that, I just wanted to make sure you were listening. Fire in a theater. So I think Bloomberg ran an article yesterday, as a matter of fact, “China’s deflationary spiral is now entering a dangerous new stage,” and this is where they are in a different boat altogether.
Kevin: Okay, so China, if we talk about going into a recession, we’re sneezing here and they’re catching pneumonia in China, is basically what you’re saying?
David: Right, reversal of what we had in 1997, 1998. The Asian contagion, the flu there equals a cold here. Now we’ve got the cold and they’ve got something far worse. China is in a different boat. The engine of growth—that is the real estate land conversion and development which goosed them into the double digits for year after year—it’s been impaired, and that’s been the case for a couple of years now.
The last and greatest of the developers, it’s spelled Vanke, but pronounced Wonka, is coming under a fresh round of financial pressure. Yields on—I’m just going to call it Vanke—debt, north of 22% this morning, and that’s for the first time since April. Last week, the yield was 18%. It’s a rapid deterioration. They posted their first semiannual loss since 2003, so in over two decades, according to Bloomberg, and sales continued to decline month over month and year over year.
Kevin: Well, does this become another Evergrande, where you see yields go from 5 or 6 percent to 10 to 18, talk about momentum, cumulatively just watched the fail. Is this why the Chinese have had to add $5 trillion to their economy just to keep these things from happening?
David: It’s the one to watch because it’s the last one to play catch up on the downside in terms of their yields. And you’re right, the Chinese financial market context, 5 trillion last year, another nearly 5 trillion this year in credit market expansion, that’s managed to keep the country’s GDP growth numbers above water. It’s still a quality of growth issue. Those are not yuan directly infused into the housing sector or into the bank accounts of hurting households. It’s basically today going into subsidized product manufacturing, which is its own problem adding to global trade tensions.
In fact, the Financial Times ran a nine page article last week on how the Chinese are aggressively seeking to disguise themselves as Mexican, Hungarian, and Singaporean companies to avoid the trade wars directly ahead of us. Shift production overseas, you use overseas domiciles to get off the trade warpath and maintain your exports. There’s two different electric vehicle companies that are seeking to move production from mainland China to Mexico so that they can export products direct from Mexico to the US in what is known as jurisdictional arbitrage and avoid any of the tariffs.
Kevin: Isn’t it interesting how you can go back and look at all of history and you see trade wars and tariffs ultimately get people’s interest into various countries that end up in world war type of settings when you go—when kinetic warfare actually starts out. I’m thinking about China. If China is going into a depression, where do they go but war?
David: Yeah. And trade wars, how different are trade wars from currency wars? We mentioned Vanke or Wonka, it’s the most important story coming out of China. If it fails to right itself, deflation is all but inevitable and depression a far more likely outcome within China. Stock markets in Shanghai and Shenzhen are in their fourth year of decline, and that has created a lot of discouragement in the investor community. It’s driven a lot of interest in gold alongside the central banks, that the local populace in China has scurried towards gold because real estate’s not a good option and stocks have been so disappointing. But believe it or not, those indices, the Shanghai and Shenzhen, are setting up to be very attractive. They’re already depressed after four years of decline, if they get a final six to 12 months of despair, you’ll be looking at enterprises that are selling for 10, 20, 30 cents on the dollar.
Kevin: So if you’re willing to reach in and possibly get your hand cut off with a war, it’s a good deal.
David: Well, that’s the problem because you had similar, not similar dynamics, but similar pricing in certain Russian companies just prior to the Russian invasion of Ukraine, and it became uninvestable. Geopolitical risk and the possibility of military conflict with the West may keep Chinese equities from being investable, but there is deep value emerging there. From an asset management perspective, it’s outside of our scope of interest. But from a price to book perspective, it is a curiosity. It’s already in the value zone.
Kevin: So China prides itself, and actually runs, on a command and control model. If Wonka or Vanke, however you want to say it, if they fall apart, is that an indication of the command and control falling apart?
David: I think that’s why it’s key. It’s not because Vanke holds the keys to the Chinese economy, but more because losing control of that company, the stability of that company, the yields that that company has to pay for its debt, it’s signals a loss of control. And that kind of signal in a command and control environment, it’s a bad setup. Economic pressure and loss of hope in a totalitarian regime that doesn’t allow for free speech, it tempts fate with revolution, is the only means of the populous expressing their discontent.
So either depression leads to a severe curtailment of freedom and a major social crackdown on the mainland or scapegoating takes Chinese attention away from local pain and towards the agitating neighbors. And take your pick, Taiwan, the Philippines, Japan, I mean anymore on a weekly basis, the Chinese naval presence in the South China Sea grows—and grows more aggressive. And it’s just, again, it’s a question of who they’re ramming and getting in the way of, whether it’s Japanese maritime interests, Philippine maritime interests, even Vietnamese maritime. I mean, they’ve basically laid claim to sovereign territories of these other countries. And it’s leading to maritime fisticuffs.
Kevin: Sometimes when talking to clients, they’ll say, “Well gold, does it track commodities or is it money? What is it?” There are times when gold and commodities do track together because gold is a commodity. But when you have things slowing down worldwide, a lot of times you can see commodities falling. And if fear is rising, gold holds. So gold is money first, a commodity second.
David: Yeah. Commodities as a whole did not fall as much as the equity markets did last week. Bloomberg Commodities Index fell 2.5% last week, it is at a three year low, so it’s at a low level compared to the S&P dropping 4.2% off of near all-time highs. So different ends of the spectrum to begin with. But last week’s performance for commodities versus gold was noteworthy. Chinese demand for industrial commodities and oil is weakening. So you’ve got crude, which was off 8%, copper last week 3.3%, nickel 4.4%, zinc 6%, iron ore over 7%. The equity market weakness was uniform globally, not just in the US, not just in the semiconductors, not just Nvidia. Very, very notably, gold finished the week flat.
Kevin: It did not operate like a commodity.
David: So the difference in performance was a strong signal that safe haven buying is alive and well.
Kevin: Yeah.
David: You’ve got central bank demand complemented by investor demand. And I think that’s a recipe which sets up nicely for considerably higher prices. How high? I don’t know. But how low do global currencies go in a beggar-thy-neighbor fight for trade supremacy.
Kevin: Well, and I wonder too how far does gold go in the face of equity markets weakening?
David: Well, and that’s another factor, isn’t it? Do you see investors flock to that particular tangible asset in the face of equity market weakness? I think you very well could, certainly you’ve seen that trend set in China for three years running.
The set-up year end 2024 is amazing. Three weeks now with the price of gold near or above $2,500 an ounce and maintaining this new plateau. It’s working off the overbought conditions in the gold market. We’re waiting for a better price entry. That’s what we hear from so many people as we talk to them, I think it’ll pull back. And I’ve been talking to investors who’ve been waiting since $1,850 for a more ideal price or since $2,200. So far it’s not working for them. And I think the best strategy if you’re approaching the gold market today is implement a dollar cost averaging approach, where if you have a certain figure that you want to allocated, then just do it in tranches.
Kevin: Well, let’s talk about the physical versus the actual price that people see all the time. Because when you do get into a crisis economy, like 2008 when we saw the stock market crash. The price of gold came down. The problem was, one, you couldn’t buy physical gold, and two, you couldn’t buy physical gold for really any less than before the crash.
David: Yeah. What’s curious about that, and it’s just a detail that most people outside of the gold space don’t know about or appreciate, is that the price of gold as you’re looking at a quoted price is driven off of futures contracts. And so these are leveraged 2, 3, 4, 5 times. So your leverage community who wants either to hedge production or speculate on the price, if they’re for one reason or another forced to limit their leveraged positions, and it could be because they’re overexposed to the AI thematic or because they’ve borrowed too much in yen or because of any number of reasons, maybe they’re too exposed to the basis trade. If they have to de-gross, if they have to shrink their total positions, they can do so and it can impact the price of gold in a dramatic fashion.
That is different than going to the physical gold market and buying the product, where if there’s sufficient demand for that physical product, the premiums that you pay for that product go up not down. And so even though you’ve got a price drop, the premiums pop and you get no discount. So I think one of the things that I would do as I’m strategizing and allocating dollars to the metals today, yes, the dollar cost averaging strategy makes sense, but I would look for value where premiums are compressed.
Kevin: And they still are, premiums are very low right now.
David: Yeah. Those low premium pockets are places you can most safely allocate cash today. And again, futures market volatility in price, sure, can knock the stuffings out of the gold and silver markets. But as we’ve seen in past periods of acute decline, just because the spot price is lower, it doesn’t mean that physical market prices match that.
So to give you a couple examples, your old bags of 90%, what they sometimes called junk silver, very cheap today. Well, those premiums, even though they’re low single-digit today, can rise to 20%, 30%, 40% over the silver price. So given demand for a scarce item, you may not be able to get it at the cheap price you’re hoping for as the spot price drops. In fact, the price may be higher. So this is the confusion I’m talking about, and hopefully we clarify a little bit of this, there is a place where I would be very opportunistic in purchases, and it’s where those premiums are today very compressed.
Kevin: Yeah. And Dave, I like to go back to the story of the bread. Over and over and over I tell that story that one ounce of gold over the long run typically buys one loaf of bread per day for a year, 365 loaves. And this thing’s worked for thousands of years. So what we’re talking about is we’ve got a long-term trend on gold, don’t get too focused on the short-term price.
David: Right. And I think if you’re looking at the fiscal problems, if you’re looking at monetary policy dysfunctions as the first and most obvious drivers of the price in this continuation of a bull trend, add to that equity market dislocation or geopolitical stress intensification, adding those to the first two factors, I think it makes for an explosive combination on the upside.
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Kevin: You’ve been listening to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany. You can find us at mcalvany.com. And you can find us also on the phone at 800-525-9556.
This has been the McAlvany Weekly Commentary. The views expressed should not be considered to be a solicitation or a recommendation for your investment portfolio. You should consult a professional financial advisor to assess your suitability for risk and investment. Join us again next week for a new edition of the McAlvany Weekly Commentary.
