The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“I am fully aware that you can confuse conviction with craziness. I am adding to silver positions, I am adding to gold positions, and those do represent something of a cash position in my mind. I am aggressively adding to my shares. There is probably more pain ahead, and I don’t mind that. That is a race that I am willing to run, absolutely willing to run, because I know how the race finishes, as well.”
– David McAlvany
Kevin: David, I was thinking this weekend, whoever is sick of fixed markets? Let’s hear our listeners raise their hands, and even though we can’t see, I am going to tell you, their hands have to go up. But I was thinking this before, what happened in China Sunday night, which is just an overt dump of paper contract gold, purposely, to push the market down. Nobody sells 2.7 billion dollars’ worth of something when there is no volume if they are trying to make money.
David: The counter is, when you are wrong on a trade, you just blame the manipulators for taking it the direction you didn’t think it was supposed to go. And that is where you just have to look at the numbers. You have to look at the numbers, and realize that actually, it is no longer the tin foil hat community that would say, there are people who are manipulating prices.
Kevin: Do you remember when it was called conspiracy theory? Back in the old days people would say, “Oh, you’re just a conspiracy theorist.” Now people are going to trial for manipulating markets, and they get a hand slap.
David: Exactly. You have the U.S. fixed income market which is being manipulated, prices are being fixed. You have the European fixed income market, both government bonds and a few corporates , which are being manipulated and prices are being fixed. You have Japanese government bonds, you have Japanese equities. We have had the LIBOR scandal, we have had both commodities and currency trading manipulation scandals. Again, all of these have taken the notion of market manipulation out of the shadowy world of conspiracy theory into the light of common market prices. That is not to say it is moral, but it still happens.
Kevin: And nobody gets anything but a hand slap, Dave. It’s like, “If I can make several billion dollars on a trade and have to pay a few million dollar fine, what’s the big deal?”
David: As long as the manipulation is to support the established narrative, you find that not much is done to prevent it from occurring again. And, so for any trader in the world, you can look at this. The market move in gold on Sunday night, in the Shanghai and on the New York Globex market, the stunt was obvious and it was a blatant manipulation. A total of 57 tons of gold in the form of futures contracts, not physical metals, but paper contracts only, dumped onto the market in a two-minute period.
Kevin: Two minutes.
David: And it happened to be at a point of lowest possible liquidity. So think about this. When someone wants to get out of a position that they own, a large position, in this case 2.7 billion dollars, it is best to work out of it slowly so as to get the best price and not cause the bid to collapse.
Kevin: And you are going to do it during a time of volume. I mean, you are going to come in in high volume if you are trying to get quietly out of a large position.
David: Always best to sell on an up day. If you are selling on a down day you are just helping drive the price lower, and no, you are not going to get the best price. So, when you move to the least liquid timeframe when there are no buyers to accommodate what you want to sell, and then you bring 2.7 billion dollars of product, and again, I use that word loosely because recall, there was not a single physical ounce of gold moved, but nevertheless, 2.7 billion dollars’ worth of futures contracts, when you bring that to the market, the intent is, to me, obvious, to break down the psychology of the market, moving the price through a critical technical level of support. I think it is reasonable to ask who. I think it is reasonable to ask why. I think we will eventually figure it out.
I think the easiest answer, if you are sussing out the intent, is to point to central banks who are in an all-out war to preserve the financial system, the banking system as we know it, and maintain the perception that all is well. I have used this analogy before when discussing the signal that gold sends in the context of the financial markets. Think of what the barometer tells you about the change in weather, or even an impending storm. It tells you what is changing, and it might even suggest battening down the hatches. But if you can intentionally break the messaging that you get from the barometer, you can pretend that no storm is coming.
Kevin: This brings back memories. When I was a kid, in fact, one of the things that I wanted to inherit when my grandfather passed away was a barometer that sat in the panhandle of Texas – that is where their home was – it sat up on the counter. The panhandle of Texas is tornado alley. Everyone knows it. We were down in the storm cellar some summers a couple of times per week as storms passed. But I remember how important the barometer was to him. He would walk up and he would tap it three times with his finger, and he would look at that barometer, and lot of times he did it with the kind of intent that was someone trying to protect his family from an impending problem. Right now, all the barometers, Dave – it is not just the barometer of gold, but all the barometers are not only broken, but they are being manipulated. A broken barometer just sits there, but a manipulated barometer can actually kill you.
David: And I think one of the things that is accomplished in changing the messaging that gold typically sends is elimination of culpability, and this is what I mean, specifically. You can pretend that when the storm hits, “No one could have actually known it, and the crisis that ensues, yes, it deserves extreme measures to solve it, and yes, we, the central bank community are here to solve these problems, and goodness gracious, we could never have seen this coming.” Well, part of the reason they won’t have seen it coming, and they can claim so, is that gold is not trumpeting from every rooftop that something is not quite right. Gold throws central bank maneuvering into question, and certainly, in terms of credibility, is one of those things that sort of says, as more and more people are coming to the conclusion that you should not have your faith and confidence in the central banks, and again, if you can break that down where your only alternative is faith and confidence, call it the fallacy of false alternative, the central banks win.
Kevin: And let’s remember Paul Volcker, who is seen as the great hero central banker, actually expressed in his memoirs just how much control the central bankers have, and he actually regretted not pushing the price of gold down.
David: That’s right. In 1973 he said his one mistake in the 1970s was not to take down the gold price. And frankly, why? It shows too much of what was really going on, and central banks, quite frankly, are all about perception management.
Kevin: I know here at the office, we have been very busy actually selling physical gold and, in fact, the discussion between you and Drew has been, “Okay, what do we do when we start running thin?” But I am going to ask a question, because the price does affect people who have paper gold contracts or gold shares. How do you recognize the bottom of the market, whether it is manipulated or not?
David: If the only thing you are following is the price action of gold, and you don’t look at the details to see that it was actually a manipulated trade through a technical level, the consequence, not only now, but 18 months ago, and closer to three or four years ago as gold was breaking the $1540 level – it was psychological damage that was wrought.
Kevin: Again, Dave, we are talking about paper markets here. Not an ounce of gold, actually, was exchanged when you are talking about the 2.7 billion ounces dumped on the market on Sunday night.
David: Again, it is the issue of perception management, because you are dealing with the psychology of the investment community.
Kevin: You are trying to break a market. You are trying to break psychology. You are trying to disappoint and discourage.
David: That’s right. And this is what Volcker was getting at. His mistake in the 1970s was not to break down a certain messaging that was occurring, that was running counter to central bank policies and what they were trying to implement. So, when you look at how you recognize a bottom in the market, what you are really looking for is the culmination of psychological reactions which are the epitome of, “It can’t get any more negative than this.” That is what they call a capitulation. And it is. It is a reaction to the decline which is all emotion and not necessarily thoughtful. It can be knee-jerk. “I can’t believe it got to this level. What am I going to do? What should I do? Should I liquidate? I think I’m going to liquidate. I’m going to get out of everything.”
Kevin: I have heard this to a degree, not from our clients, because our clients seem to buy for the right reasons, but I have heard this in the news media. Now, let me ask you. Have we reached a capitulation point? Has psychology been broken that much, or is it coming still?
David: You could argue that the physical metals market reached a capitulation last November. The current selling is far more of a futures game, so you have derivative gold products, and traders using those as a tool of choice to access the precious metals markets. This paper trade is still dominating the market and current pricing. And I think that price volatility is what you are seeing. It is there, there is lots of price volatility. But the real metals are still in high demand, and I am going to come back to the issue of capitulation in a minute, but first, just something that we see in the physical market, doing this for four decades, we know something about the physical market – we see plenty of buyers. There are no more sellers today than ordinary.
In fact, because we broker precious metals – that is one of our businesses – and we do this every day – we buy and sell. And to have half of our business as liquidations, and half of our businesses as purchases is pretty normal. Right now it is actually 60% purchases, 40% liquidations, which is disproportionately high. Ordinarily, it is more 50/50. And as we have engaged with people from all over the world, phones are busy, no one is particularly worried, general interest is rising, and I think what we get from our clients is a sense that something is about to change, and that price is not really what they are watching as the defining factor, or certainly the motivating factor, in their purchases.
Kevin: And I think there is one other thing, Dave, that has to be mentioned, and that is that all coins and products have a premium of some kind. There is a mint premium or there is a scarcity premium. If the U.S. mint stops minting American Silver Eagles and there is still demand, all of a sudden you have a premium increase, but look at the $20 gold pieces right now. The premiums have actually been increasing, which means that the supplies are decreasing.
David: Right. In addition to that, and I mentioned this in this week’s office meeting, for people who are today buying Silver Eagles, there is a three to four week delay on delivery. If you are buying silver rounds, probably a two-week delay in delivery; Maple Leafs – a two-week delay in delivery. The physical market is fairly tight. Premiums on junk bags of silver – the bid on a junk bag of silver if you are liquidating it is 10% over the silver price.
Kevin: Whereas we have seen it actually right around spot, just a little above spot in the past.
David: What those premiums imply is that there is robust demand and so in the physical markets there continues to be robust demand even in the face of weakening prices brought to you by your futures price manipulation. So, I think, again, where do we see our clients going? They are looking for what they are most comfortable with at this moment in time. There was an article in the Financial Times this week written by James Grant, and he is talking about how prices are all askew, and there is some confusion in terms of value, and I think this really gets to the heart of what our clients are reacting to, which is, all is not well although everything seems well.
Again, if you had to say, “Why does it seem well?” Because perceptions are being manipulated, and this is actually what was intended. You are supposed to feel that all is well, even though instinctively, if you are a business owner, if you are a business manager, if you are an investor of assets, certainly – and I think investors are actually more clued into this than brokers and those on Wall Street, because you kind of know what works and what doesn’t. Wall Street has the permanent positive bias and investors have, sometimes, the ability to say, “Yes, but it has gone a little far. You know, five or six years without a major correction – wouldn’t it be reasonable to see something of a correction?” And yet, Morgan Stanley comes out this week and says, “The next destination is the S&P 10% higher.” And again, it is sort of when you get to the end of the pendulum swing, everyone projects prices that much higher.
I remember the Aiden sisters were talking about gold being $3,000 back in 1980 when it was $850. And everyone’s price projections get blown out at the end of a pendulum swing. Right now, price projections for gold are that it is going to $700, $500, $200, zero – the price projections keep on going down, down, down, down – and that is what you typically see at the end of a pendulum swing. Remember, the same Wall Street firms, including Société Générale, I asked their chief analyst when I was in China, in the Q and A, “Were you projecting higher gold prices, let’s say circa 2010, 2011, and 2012?” And he said, “Well, of course. Of course I was.” And I’m thinking to myself, “So you were projecting higher prices as we were reaching a peak.” In other words, gold is $1900 and you are calling for $3,000 gold, $2500 gold, $2100 gold, and yet, now that gold is moving down, the only thing that you can see is prices going down initially, down further after that, and after that even further, it is going lower. It doesn’t make any sense because it is what analysts do. You have that in the stock market today. The stock market is high, it must be going higher. Gold is low, it must be going lower.
Kevin: Something I appreciate, Dave, talking to clients who have a well-grounded thought process and a long-term view, and I want to talk more about the long-term view later in the program, but I haven’t really sensed that price is their main motivation.
David: You mean the gold buyer today?
Kevin: Not just the gold buyer. I’m talking about the gold buyers because they are clients of ours, but I’m talking about just the overall philosophy of saying, “I’m not really watching price. What I am doing is, I am taking the facts, and I am making a good decision based on facts, not on manipulated prices. Now, the question comes in almost every conversation. If you didn’t have gold, let’s talk about the other assets. What do you feel comfortable with? Do you like the dollar right now?
David: I like the dollar better than emerging market currencies. On a relative basis, it is better than emerging market currencies.
Kevin: But in the long term…
David: In the long term, you know the Fed’s record, and you also know that they haven’t sorted out the accumulation, not only the nine trillion dollars of debt that we had before Obama came into power, but also the nine trillion that we have added since he came into office. And so, we have a lot ahead of us, and we don’t know exactly how we are going to deal with it in a higher interest rate environment. So no, I am not particularly interested in the U.S. dollar on a long-term basis. On a short-term basis, it’s fine. Long term, no. U.S. treasuries – this is a disaster waiting to happen.
The fixed income universe – the only reason you are not going to lose your head tomorrow is that central banks are intervening – as we started by saying, there is more market manipulation, and this is what everyone does, it is not even illegal, governments are doing it, so how could they prosecute it if they are the ones who are fomenting, fixing prices, and fixed income and corporate bonds and Japanese equities and commodities and currencies? The only thing protecting you is government intervention and the question does linger, it should linger in your mind, “How long can that last?”
Kevin: So, that’s the answer to my bond question. I was going to say bonds, now let’s go to stocks.
David: I read Andrew Smithers over the weekend, and he is asking the same question about CAPE, the Cyclically Adjusted Price/Earnings ratio, and the Q ratio, and he is still saying these are very, very expensive prices to be paying, so I missed a year’s worth of growth. Do you realize what happens when you get set back 20 years in terms of price volatility to the downside? I would rather miss a year’s worth of growth than to have to start over. And I think that is what we are coming up against. I think that within the next 12-18 months, you are going to have a number of people in the financial markets, in a generic stock and bond portfolio, who financially have to start over – have to start over. So, do I like cash? As Smithers would say, I would rather take my 5-10% inflation hit than my 40-60% capital loss, which is, in his mind, a guarantee, statistically, at this point, if you are just in a general equities portfolio.
So, where else would I rather be? Back to your question. There are small niches – private equity is one of them, and I am actually part of a private equity company in Kansas City that looks at small, privately held businesses.
Kevin: Sort of outside the purview of manipulation.
David: Well, anything less than 20 million dollars in market value is off the radar screen. Keep that in mind. If you want to stay off the radar screen, stay under 20 million. You are probably under the radar at 100 million because Wall Street is only interested in doing billion dollar deals and doing half billion dollar deals, because the same due diligence goes into a million dollar deal as goes into a 500 million dollar deal. It should, if you are a careful investor. And so, if you are looking at the total return, why not just do billion-dollar deals and neglect everything else? I think it is a fascinating space to be in because there are enterprises that have been well run for 20-30 years, for 5-10 years, that need capital partners in order to grow and can’t access Wall Street dollars. So there are niches, but I will tell you this. They are few and far between.
Kevin: They have to be carefully looked at, because that would be venture capital, in a way, wouldn’t it?
David: Except that we are not at the front end of most of those enterprises. Dealing with existing businesses puts us in a slightly different position in terms of a risk profile. Venture capital is sort of starting with nothing, hoping that it becomes something.
Kevin: This is something that actually exists that now needs just a little bit more fuel.
David: Exactly – to gain more momentum.
Kevin: Well, you have me intrigued on this capitulation thing because, again, people, in their minds saw gold go down and it is intriguing to hear the word capitulation being in November for the physical metals, when actually, people are calling right now going, when is the gold price going to stop falling? So, explain capitulation – why do you see the capitulation already occurring in the physical markets?
David: What is capitulation? It is when the vast majority of investors can no longer take the pain. They can no longer take the pain. And they are basically saying, “Can I extract some value, any value? I’m not going to put this in as a limit order, give me anything. I just want to make sure I have two cents versus zero, before this asset hits zero.” And curiously, the physical metals market, as we mentioned earlier, is seeing premiums in a variety of silver products, no real sellers of gold. The weakness still shows up in the futures market where the shorts are bold, and if you are looking at the futures market, those guys on the long side, they are kind of old and growing cold, no one is there to buy, you have more sellers than buyers, so the price is being pressed lower.
That is actually not a place where I am expecting to see capitulation because most of the activity is opportunistic short selling, and ultimately, the short sellers have to cover their positions, so it is going to create the equivalent of a synthetic purchase in order to cover their short position. So, where you do see capitulation is in the mining shares, where people have owned, let’s call it a non-expiring call option on the price of gold, something that has major leverage to a move in the price of gold, and of course, leverage moves both ways. The price of metals drops – what happens to the theoretical margins of those companies? They simply disappear. So, capitulation is happening as we speak there. As I mentioned, it has already occurred, I think, November of last year in the physical metals market, but the shares, the mining companies are nearly there now. We will talk about the average gold shareholder in a minute.
Kevin: Well, when you see manipulation in the market, Dave, you almost always see the news services come out and they try to give a reason for what just occurred. It is not just a manipulation, not just crashing the market purposely. The Chinese came out and gave a very respectable figure as to how much gold they have accumulated since the last time they have reported, and I think we need to talk about that, because one, it is probably completely fictitious. It seems to be the perfect amount of makeup on the girl – not too much, not too little, it is just enough to be accepted into the international community.
David: Well, right. And I think that is the purpose of the $1658 number. You went up from 1,054 tons to 1,658 tons. Bloomberg’s most conservative estimate was 3500 tons, and many in the financial community had assumed that they would announce a 6,000, 8,000, or 10,000-ton number. They have been accumulating. You look at their import/export numbers, you look at their production numbers. They are the largest producer of gold in the world at over 400 tons per year, and from 2009 to the present, you are looking at well over 2,000 tons just created on their own home turf, let alone what has been imported.
Kevin: And they don’t sell any, they buy it.
David: But here is the issue. You are talking about a political maneuver. They want to join the SDR system. Less than 2% of global trade is done in yuan or renminbi terms, and they would like to increase their market share, so to say. They would like to increase the traffic through their currency. They know that to be involved in the international economy in a more robust manner is to have their currency floating in a more universally accepted manner. And so, what does that entail? For them, it has included getting the IMF approval, the international monetary fund approval to be in the SDR system, the Special Drawing Rights system, which is a basket of currencies. And, if you think about it, they are going to the Europeans because the Europeans are the head of the IMF and saying, “Listen, we would like to be in this club and we think that we are stable enough – please ignore our stock market the last few weeks. Please ignore that. We have it completely under control. But we do have enough gold to legitimize ourselves. We have a lot more than Britain, we have a lot more than a lot of other countries.”
Kevin: “And a little more than Russia.”
David: “But not as much as you guys in Europe, not as much as you guys in the U.S.”
Kevin: “We’re no threat to you.”
David: “We’re no threat to you.” The 1658 number is a “we’re no threat” number. It is enough to be legitimate, but it is not too much to make you uncomfortable.
Kevin: I’m going to tell you, Dave, there is a softball team here at the company. I’m not part of it, but the guys who play – they hate sand-baggers. And there is a team that they play that showed up, a little bit like the Chinese did, “Oh, we’re not very good, we need to be in this league. This is the league where we will probably be able to win a game or two, maybe.” And of course, they came in and swept that particular bracket. You know why? Because these guys are 22 years old and they are absolutely super fit and they play softball all the time. But they decided to sandbag. This is sandbagging, Dave, because we can count the ounces. I am going to tell you right now, in 2013 when they crashed this market with paper, 700 tons of gold came out of one of the ETFs. All 700 went to China.
David: Right. In a single-day purchase, you don’t find that quantity being bought by individuals, because quite frankly the decision-making capacity of the mass takes a little bit longer than that. “Do I want to own it? What has just happened? The price of gold is falling. I think I do want to own it. How am I going to buy it? Am I going to buy a bag, am I going to by a coin, am I going to buy a bar?” The man on the street doesn’t make an instantaneous decision, the central bank does. And you are right. ETF gold that was liquidated in that period went to China. It was melted down, 400-ounce bars, and was converted to kilo bars, and went to China. And no, it did not go into individual hands. But some of it, I am sure, did, eventually.
Kevin: Let’s talk about the kilo bar real quick. I know this is a side note, but why in the world would China have kilo bars if they thought that the central banking community was in control? Central banks trade 400-ounce bars, not kilos.
David: And that is, I think, redefining the role of the central bank in China, and the future of gold in the world financial system, to basically look ahead and say, “We understand that the 400-ounce bar is an anachronism. It is no longer relevant because we are going to need to trade in a smaller format.
Kevin: Which is 32 ounces.
David: The question is, why would you need to trade in a smaller format? And I think the answer is implied. With gold trading at higher prices, a kilo bar is what will be a normal-sized transaction amongst central banks. The 400-ounce bar, I think, will remain an anachronism, and I think it also suggests the role that gold plays as a crossover asset between the central bank community and the general public. Because remember, it was 2009 that individuals eclipsed, for the first time in years – decades – central bank holdings of gold. So, really, the balance of power was shifting toward the people, away from a controlled environment, if you will, and I think the Chinese are very savvy to position themselves at the center of the people, the people’s demand for gold, and the role of gold within the central bank community. I think they are positioning themselves very well. Kilo bars are a part of that story.
Kevin: I would love to see how much physical gold actually got transferred to China after this drop on Sunday night. The market shut down for 30 seconds twice. Is that just another glitch like the New York Stock Exchange a week-and-a-half ago? Why did they shut the market down for 30 seconds twice while the gold was plummeting?
David: It is an exceptional amount of volume in a very short period of time, and they do have natural circuit breakers in place. It is an exceptional amount. I think that goes to the point. You can find these points on the chart because they are frozen in time. You have 30 seconds twice which freezes it and says, “Okay, what is going on here? This is not normal trading activity. We have preprogrammed a shut-down of the market if too much comes at once because we don’t know what the heck is going on.” That is my point. This was not a normal liquidation. This was intended to damage psychology. And lo and behold, guess who ran with it? In the next 48 hours, I have read over 30 articles talking about gold going lower, a collapse in the price of gold.
Kevin: Zweig said it is going to go the way of the pet rock.
David: Well, it is nothing more than a pet rock. And so, if you like pet rocks, then you would also have a lot in common with the average gold holder. That was Zweig’s comment in the Wall Street Journal. But note that he is publishing in the context of 30 other articles, all – all – negative on gold. If you read the guys like Hochberg and Prechter and those who fancy the ideas of socionomics, where there are social indicators that tell you that you are out of turn in the marketplace, 30 negative articles in 48 hours on the gold price, implying that not only has it collapsed, but it is going to collapse further, it gives you a pretty good indication that the pendulum has swung about as far as it is going to.
Kevin: Yes. Alright, I am going to shift here, because we are not just talking physical gold. Gold shares are affected every single time we see something like this.
David: It is a different set of players. It really is a different set of players. The investor in a gold company is seeking a return in excess of a move in gold, understanding the possibility of big increases in the margins of those business, that is, the money made in excess of the cost to produce or mine the metals. So, with the rise in the price of the commodity, these companies do incredibly well – incredibly well. And it also works in reverse, with a collapse in margins occurring as the commodity price moves lower. So, this is something that Wall Street can wrap their minds around. Miners are either cyclically loved, or cyclically hated, because you can discount your cash flows, you can do your typical modeling on a company. And today, you know what? Wall Street hates them.
Kevin: They have no time for them.
David: And I think it actually offers great insight into the Wall Street expectation for gold, as the minors are selling more cheaply now, and after the last 30 days, relative to gold, than at any time in recorded history. So, you have had an exaggeration in the selloff in shares, but really, the only participants in that space are the Wall Street types who are looking at the expansion in margins, and again, their typical textbook modeling for a company. Always watch for market extremes. They are telling you a lot within a little.
Gold, the physical metals – they really don’t understand, and they prefer to mock it, because again, you can’t apply a discounted cash flow model to it. Five times this morning, whether it was CNBC, Bloomberg, either the television or the radio, or in newsprint, I heard someone say, “Yeah, but gold doesn’t pay a dividend.” Do you know how many times I have heard that? It is the classic, “Doesn’t pay a dividend, it is not this, it is not that.” Gold stocks, they do understand, and are rightfully shunning if their long-term expectations prove correct, lower gold prices – if that turns out to be accurate – lower gold prices this year, the next year, the year after that, the year after that. Guess what? The trajectory of gold stocks is also going lower if they are right.
Kevin: Yes, but let me throw this out. Wall Street usually is late to the party on gold shares, which is what they do understand. And I think the main reason, Dave, is because they don’t understand gold. And since they don’t understand gold they seem to come into the gold share party right at the end, and that is why people hate gold shares at lot of times. People who don’t understand gold, whose brokers finally put gold shares in when gold is $1900, let’s say, at that point, that is the wrong time to come in.
David: Sure. Exactly. So, you see an expansion of margins for a lot of these companies from the 2002-2012 period, and some of their share prices went from a dollar, two dollars, to 20, 30, 40 dollars. And if you own them at 30-40 dollars, and they are back to two, you are not real happy with it – not real happy at all. This is, I think, very important. Because the street lacks an understanding of gold, I think it has led them to an errant conclusion on the trajectory of gold stocks, and I think you are looking, over the next 90 days, at a window where that asset class, in particular, if carefully acquired, will multiply wealth considerably over the next several years. Instantaneously? No. Are there going to be a number of companies that fail? Absolutely.
Kevin: This is where carefully comes in.
David: Well, sure. And the over-indebted ones – they don’t stand a chance of surviving. But if you look at the Barron’s gold mine index, it is presently 21% below the low it has held since 1942. These are records, folks. These are records. And again, always watch for a market at its extremes. They are telling a lot in a little. Actions that will help you in the long run usually run contrary to the feelings that are most easy to feel in that moment. Records on the high side, if prices are high, what do you feel? Greed. If records are being marked on the low side, what feelings does that evoke? Fear. My suggestion is that you should always operate in the opposite. If you are feeling greedy, act scared. If you are feeling fearful, act greedy. Does that make sense?
Kevin: Another factor that was used for the drop in gold was the strength of the U.S. dollar. We have talked in past programs about how we here in the United States, a lot of times, are viewing things almost like being in a room with no windows. We say, “Well, this is happening because we are basing everything on the dollar.” Other currencies don’t necessarily tell the same story, but the dollar strength is affecting not just gold, it is affecting platinum, palladium, copper, iron – we talked about the drop in commodities.
David: And I think there is a nuanced approach to the commodities, because one, each of the commodities does have its own supply and demand dynamics, and so you do have individual stories like iron ore and copper where production continues to increase, and it doesn’t matter what is happening on the demand side, supply is on the rise. You have other stories – you need to go through corn, copper, sugar, wheat, oil, platinum, palladium, silver, and a lot of them, to figure out what the unique elements are. But I think when you look at the rise in the dollar it is pressuring commodity currencies greatly. So, you have loonies, that is, the Canadian dollar, the Australian dollar, the real in Brazil, the South African rand, the ruble in Russia – all of these currencies, and there are a few more, vis-à-vis the dollar, are moving down toward double-digit losses this year, which incidentally, advertises gold very well in those regions of the world.
Kevin: Sure, gold is going up in those currencies.
David: At least it is holding its own. It doesn’t look bad at all. We see gold at new lows in U.S. dollar terms, but to the Europeans, the Japanese, and for many of the countries we just listed, many of them see a fairly stable gold price for 2015. It is wise to remember that someone else may see things differently than you, simply by standing and observing from a different vantage point. That is small consolation to the gold holder here in the U.S. who references things in U.S. dollar terms, but do recall that panic selling is an event that occurs when someone believes there is reason to panic, and the rest of the world doesn’t have a reason to panic out of gold. In their own currencies, overseas investors might just as well panic into gold.
Kevin: Let me ask you a question then, because the talk for years now has been about when we are going to raise interest rates. You raise interest rates, you strengthen the dollar, you weaken those currencies even further. So, when does the Fed raise rates?
David: So, then we come around to that issue, and yes, it is on the horizon. Is it September, is it December, is it 2016? And I think much too much is predicated on the rise in rates. An actual rate increase, which is different than a suggested rate increase, which is all we have had so far – that is going to continue to put downward pressure on the exchange rates, currencies as far flung as Indonesia and Russia, Brazil, Canada. And I guess the one positive element there is that for their tradable goods sectors it will improve their trade. So, if you are an international exporter in any one of those countries, the cheaper currency improves your competitiveness, but it is very disruptive to financial markets – it is very disruptive to financial markets. So, again, if we go from a suggested rate increase to an actual rate increase, I think you are looking at carnage in the emerging markets.
Kevin: Well, doesn’t money flow out of those countries, though? When the United States starts offering higher rates on their treasuries, money flows out.
David: That is what I am talking about. The disruptive nature of an increase in U.S. interest rates and strength in the U.S. dollar is that it sucks hot money from the developing world back to the developed world, and as hot money exits it creates disruption in those currencies. How many exits are responsible for numerous financial crises over the last three decades? And so, a significant rise in the dollar, should it occur, is a major trigger for cross-border capital flows, and it is a major equity bond market and currency disruptor.
Kevin: I think it is important to define what hot money is. When we look at bank reports – we do the bank ratings, we had a lot of calls after the program where we offered bank ratings, but one of the things when we do a bank rating is, we look at the hot money index, and the hot money index is basically money that is not necessarily loyal to that bank, it is opportunistic, it is looking for the best return. And so, there is a large block of money in the world right now that really will move at a whim if the interest rate, and the safety tied to that interest rate, improves.
David: The interesting thing is, you can say, “Well, that is going to hurt them, and it is not going to hurt us,” except that we have an intertwined financial community. And so, what happened in China the last few weeks has ramifications far greater than the subprime crisis here in the United States, for them, and certainly for us, and for the world financial system. To see an unwind in Thailand – well, we had that in the late 1990s. To see an unwind in Vietnam, or Indonesia, or South Africa, or Russia, or Brazil – these are things that have cross-border implications and capital market implications. And I say again, we have seen a move in the dollar in anticipation of a tightening monetary cycle in the United States. If there is anything in the financial markets that has become consensus, it is that we are going to have this. Right now it is only a suggestion, they have yet to do anything. After nine years, nothing remotely hawkish has been done. You can talk hawkish, but nothing has been implemented that is directly hawkish.
Kevin: Let’s say they do. Let’s say over the next couple of months that comes in. Maybe it is even a quarter of a point rise, but what happens there?
David: I think the world economy is in chaos. Again, the problem with the world economy being in chaos, even if we are faring better in the United States – it is still an interconnected financial world – everything takes a downgrade. So, what if words are replaced by actions before 2016. The real disruptions to financial markets come after a series of hikes, not just a single hike, not the initial one, whenever that occurs, if that ever occurs. The initial one is likely to represent a modest and tentative commitment. You know this, we talk about this all the time, the elephant in the room is the amount that our debts in the United States have expanded since 2009. Try to consider the cost to raising rates when you have piled on an extra nine trillion dollars in domestic government debt.
Kevin: You have to pay interest on that debt.
David: And about half that amount in corporateland. So, nine, four, add up a little extraneous stuff here and there. Let’s say that we have added, in every nook and cranny, an extra 15 trillion dollars in debt since 2009. A quarter of a percent increase in rates is the equivalent of 37½ billion dollars in new interest costs. And that is a modest increase in interest rates. But you are talking about just shy of 40 billion dollars. A 1% increase in interest rates is the equivalent of an extra 150 billion dollars in interest payment – interest payments!
Kevin: What if it is even more than that? Let’s say it is half a percent, three quarters, even one percent?
David: Well, hey, I’m just talking about the new debt that has been acquired just since 2009. I am not talking about the old corporate debt. I’m not talking about the old government debt that predates, we are just talking about the extra expense that we have in the new era, where again, we started with a debt problem, we still have debt, in a monetary tightening cycle. I think the reality is this is an environment where the wheels begin to come off – the wheels begin to come off. So, again, if a quarter of a point equals 37½ billion, one percent is a better part of 150 billion. And this is where you realize, yes, normalizing rates may be a good idea, but it is expensive if in the interim you had added a tremendous amount of debt to your balance sheet.
Kevin: You know, Dave, we talk about people looking at these prices in these markets – they just don’t make sense, and really, it does make the most sense to continue to stay the course and run the race the way we should run the race. I was reading an Iron Man or Triathlon training document that said, “Absolutely, run your own race. Don’t let someone running past you faster change the pace that you have worked so hard to get to.” Because what we are talking about is a long endurance race. I will give you an example. An Iron Man starts with a long swim, longer than most of us ever do. And then it goes to a long bike ride, longer than most people do. And then it goes to a long run. Now, that is not three days, that is in one day. And so, if you get your pace out of line because you are responding to the outside environment, you are not going to finish the race.
David: Well, the reason you bring that up is, I threw out a challenge here in the office to do a half Iron Man next year.
Kevin: In Kona, Hawaii. This is the granddaddy of them all.
David: Yes, I said, “I’m going to do this in June. If anybody is interested, just let me know. We’ll all sign up and we’ll all compete. It will be a fun time. Twenty people in our office are signed up to do it.
Kevin: (laughs) I don’t think you expected that.
David: No, I did not expect it. Twenty people in our office are going to swim a mile, bike 56, run a half marathon. And you are right, running your own race is very, very important. When you see a friend whose portfolio is growing leaps and bounds, run your own race. Run your own race. Because here is what happens. In 100 meters in a pool, let’s say a fast swimmer can do it in a minute and 30 seconds, and it takes me two minutes and 30 seconds. I can say to myself, “He is going to win, and I am going to lose.” And yet, I have no idea if he can sustain that pace for a mile, or two miles. He may be wearing himself out, and he may be in a very vulnerable position where he can’t even finish the race because he is going at a pace that is ultimately unsustainable. Run your own race.
Kevin: I remember when my son raced mountain bikes professionally. The guys at the start who just absolutely pumped straight up the hill – now, mountain bike racing, the version that my son was riding, was straight up, if you can imagine, ski hills. These were virtually straight up ski hills, and down, and straight up again, and straight down. These things would go two or three hours of riding up and down mountains. But the thing is, the guys who started the race the hardest usually were not the guys that you would ever see on the second or third laps, or rarely ever at the finish.
David: I’ve done this before! I did a Sprint triathlon probably 20 years ago, and it is race day, there is a lot of adrenalin, and you want to win. And it is like being a novice trader. “Hey, I just want to make money. Show me where I can make money. I want to make money right now. I want to win, I want to win, I want to win!” I got out of the pool and I swam 200 meters, and I started to die. Lactic acid built up, instantly.
Kevin: That is a horrible feeling in water, because you think you are going to drown.
David: Well, I had a lot more to swim, and that didn’t even include the bike and the run after that, and the lactic acid had already built up. I was dead for the entire race because I wasn’t running my own race. I was looking at everyone else, everyone else was enthusiastic. We got in, and we got in over our heads. I was going way too fast, I was pressing the pace.
Kevin: So, the analogy we are going for here is to tell a person, make sure you look at the facts and stick with your long-term plan.
David: Exactly, because where you are right now has no bearing, whatsoever, on how you finish this race. And I think the analogy is particularly apropos because, you know, where gold is at, where silver is at, this is particularly painful – it is very painful. That doesn’t mean the race is over. I think you should take the next step. I don’t think you should quit. I think you should run your own race and stop comparing yourself to the performance of other people because in the end, you don’t know how they are going to finish, and you don’t know if the pace they are setting is at all sustainable.
And I will tell you this. In this current environment, the only thing that represents wind in their sails is the artificial juice they are getting from the Fed. That is not sustainable over a longer period of time. Market interventions that affect psychology in the short run – very effective, very powerful, but ultimately not sustainable. We need real growth to re-emerge. We need entrepreneurship to re-emerge, risk-taking to re-emerge, we need a new capital cycle to begin. And we are a long way from that. We are at the end of a long-term experiment with leverage, a system that has never seen this kind of leverage built into it, and that, ultimately, I don’t believe is sustainable.
Look, a variety of indexes have already peaked. You have progress, dating back to November of last year, March before that – the peak in those indexes – these are equity indexes – coincides with the rush to sell gold. November marked the lowest trading level for gold until this week. Gold’s at new lows. Those indexes are still failing to get to new highs. Do you see what I am getting at? There is a bit of a disconnect. So, we put in new highs back then, and those have not been surpassed. We have just surpassed the lows in gold, specifically, for those indexes. We are talking small caps, we are talking S&P, mid cap 400, the Dow Jones Transportation Average – these are the indexes which are suggesting nonconfirmation for equities moving higher.
Kevin: An interesting example of that is silver. Talk about gold manipulation, somebody manipulated gold purposely. But silver – somebody forgot to manipulate silver.
David: It sold off in tandem, but nowhere to the degree – it tends to be the weaker sister of the two metals. And yet, you are right, it wasn’t in the crosshairs in Shanghai and on the New York Globex market. So, actually, silver, in the precious metals space provides the same sort of nonconfirmation for metals going lower, as it has held above its previous lows thus far. Maybe it doesn’t, but thus far it does.
The NASDAQ, if you look at that, is the standout. It is the standout in terms of out-performance to the upside. It is sort of blowing a top. Led higher by Google, you look at any peak in the market, peaks are very lonely places. And we wonder if the NASDAQ’s race isn’t petering out. Maybe it adds 50 points. How much more can you gain? I guess that remains to be seen. But we think that you are looking at a very rocky third quarter. And I expect to see a reversal in equity prices, that is, moving lower over the next six to twelve months, with gold breaking its downtrend, moving inversely to the stock market. So, stocks moving lower, gold moving higher. What are the pundits saying? (laughs)
Kevin: Well, they are mocking gold and they are loving stocks.
David: Nothing but positive things to say about stocks, nothing but negative commentary on gold. This goes back to, again, pundits are cruel to the gold owner, and there is nothing but downside, and you usually see the gloves come off at these sort of market extremes. Financial commentators are trapped in what I think is sort of a typical psychological homogeneity. And that is common in every market extreme. Stocks are at highs. You are going to see everyone saying, “They are high and going higher.”
They said the same thing of gold in 2012. Your Bloomberg commentators – there was homogeneity in the view, “Gold is high, and going higher.” You can’t argue with an 18% rate of return, annual returns for the last decade, they looked like fools having not commented early on, so they join the bandwagon, and there is a homogeneity to the psychology – negative for gold, positive for stocks. When there is homogeneity, be cautious, be careful, probably sell, and go the opposite direction.
Kevin: I think of two articles, in particular. I think all the way back to my first year here, 1987. The stock market was hitting new highs. Everyone was saying that it was just going to the moon, and the price earnings ratio was completely out of whack, and Fortune magazine came out with an article that said, “This time it is different. Price/earnings ratios don’t really make a difference anymore on stocks.” Now, of course, it crashed in October of 1987. It was the worst crash that we had had since 1929. But now I think back to the 1999 article in the Wall Street Journal that just trashed gold. It said, basically, “As long as we have Greenspan and the dollar, and the Greenspan dollar, why would we ever need gold?” That article was written when gold was a little below $300 an ounce, and if you look at the chart, it is not long after that that gold had bottomed, the capitulation had occurred, and gold now is between three and four times that price.
David: It is interesting, I think it is dangerously absent from the pundits’ commentaries today, along with their sort of gold slugfest – they are not willing to connect the dots in the large commodities complex. You can look at the supply-side dynamics in a number of commodity prices, but no one wants to look at cold, hard reality. The Bloomberg commodity index is at a 13-year low. You don’t get to these levels without being in a recession. So, think about what the entire commodities complex is telling you, including Dr. Copper, oil – gold, too. It is suggesting that we are already in a recession. Meanwhile, you have the stock market pretending like interest rates are getting ready to rise because we are not only out of a recession, but back into a recovery mode.
Kevin: You can’t raise interest rates in a recession. If you are a Federal Reserve Chairman, or on the board, you cannot raise rates in a recession. They know it is a recession, Dave.
Kevin: This runs contrary to the recovery theme, so the way that the commodities index being at a 13-year low is massaged is very, very carefully; very, very carefully. But again, I think you are dealing with a community that is trapped at the far end of a psychological pendulum swing, and that is one of the reasons why they see recovery, and only recovery, and gold is irrelevant, and always irrelevant. Again, I would suggest whether it is Jason Zweig – he could even re-read certain sections of his own book, Your Money and Your Brain – great book, but I think he should review it.
I am fully aware that you can confuse conviction with craziness. I am adding to silver positions. I am adding to gold positions. And those do represent something of a cash position in my mind. I am aggressively adding to mining shares. There is probably more pain ahead, and I don’t mind that. That is the race I am willing to run – absolutely willing to run – because I know how the race finishes, as well.
When the markets turn it is going to be easy, in retrospect, to see how sentiment was at an extreme and was irrational – irrationally negative in the gold and silver space, irrationally positive in the equities space. But you don’t have that kind of definite, concrete knowledge until you are a little bit down the path, and it is behind you. We still probably have more pain ahead. How much? I don’t know, and I don’t care. We are very, very close to a bottom. No one knows the end of it until you are past it, and are already moving higher. I guess we will have to wait and see when, exactly, that is.
