April 6, 2011; Spring 2011: Speculative Mania Redux?

Weekly Commentary • Apr 09 2011
April 6, 2011; Spring 2011: Speculative Mania Redux?
David McAlvany Posted on April 9, 2011

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, we are seeing some real change in the markets right now.  Silver is over $38 an ounce.  We have talked about gold-silver ratios.  We are starting to see that thing really shoot up.  But that is not the only market.  Junk bonds are selling like mad right now.  Oil is $107 a barrel.  So, as that changes, does the mindset change in the way people invest?

David: I think that is what is particularly interesting.  We have a bull market in metals.  It is one where if you look at the assets themselves, you are talking about gold, silver, platinum and palladium.  There is a whole host of other things that are moving up in price, but they have a different set of fundamentals that are driving them.  That is where I think we need to draw some distinctions and hopefully will today, between what is happening in the metals and in a number of other markets.  The assets, themselves, each have a back story.  Those assets are being driven by market fundamentals, or variables.  Whether you are in a bull market or bear market, you have to know that that back story is, what is fundamentally getting better or deteriorating.

But there is also something that I think is of a critical nature, and that is the participants in that particular market, in this case, the bull market in metals.  You have individuals, and as the dynamics change, as the market progresses, those participants can also see their mind shift in terms of motivations and the things that stir them on to make the decisions that they do.

Kevin: David, for years we have talked to people about a disciplined approach.  We have talked about the triangle, we have talked about the precious metals, a third being just for preservation, the stability of the triangle, but it is amazing, as these markets rise.

David: Kevin, very early on in my investment career I made mistakes, and when I look back, I can boil them down to a simple few things, things that I should not have done.

Kevin: And you took notes.

David: I did, and as I look back at my investment journal, I have documentation, page on page, of “What was I thinking?”  And you know, in most instances, what I was not doing was thinking.  What I was doing was justifying, or what I was doing was feeling, and there was something that had come over me as an investor, an enthusiasm which could hardly be contained.  Kevin, I look at that, and I realize, “Ah, the mistakes of a young man.”  But they are the same mistakes that you could say, “Ah, the mistakes of a young investor.”  And you can be a “young investor” even if you are 80 years old and are just learning who you are and how you function in the decision-making process.

Kevin: It is either greed or fear.  Let’s just call it what it is.  Conviction scares me in investing, because conviction without discipline, historic discipline, is really dangerous.  Is there a word we could use for that mindset?  When you start to change from discipline to this greedy conviction?

David: I think there is an element here, Kevin, which is unique.  We, of course, have the balance sheet issues, the currency of the day, and globally, the U.S. dollar, is impaired in many ways.  We could actually make a laundry list and spend an hour just discussing the individual things which are driving the metals market.

Kevin: This is the back story you are talking about.

David: That is the back story.  But we also have an overlay with the metals, something that is impacting, not only the metals, but impacting junk bonds, that is also impacting the stock market, that is, to some degree, impacting real estate, in certain sectors, in certain locales around the country, and it is all one thing, Kevin.  It is what John Maynard Keynes described as animal spirits.  If you go back to the Latin, that word spirit could actually be defined as fluid.  It is what drives human thought, what drives human feeling, what drives human action.

Kevin: It is like water running downhill, too.  It just cuts a path and it goes anywhere that there is a low spot.

David: And what we have today is a strange grip on the mindset of investors.  It is a confidence which has no real basis.  It has one reference point, and that one reference point is something that we have discussed in our weekly commentaries and our Friday written comments.  Loose monetary policy is the topic of the day.  Last week we talked a bit about inflation, but there is something that is happening as a result of loose monetary policy, and you can sum it up with one word:  Speculation.

Kevin: I will tell you what, though, Dave.  There are not too many people protesting this loose monetary policy right now.  We are awash with liquidity, the Fed is providing trillions, but there is no hyperinflation yet.  Why should I complain?

David: No, and in fact, if you look at different circles on Wall Street who stand to benefit from the creation of liquidity, they, as you say, are not protesting.  In fact, they are now looking for any excuse to keep the liquidity flowing, because by it they can make their fortune, regardless of the deleterious effects to the system or to the middle class.  They are happy to make their millions and simply move on.

Kevin: Dave, we have been doing this show for a few years now.  In 2008, before we had the financial crisis, we felt this euphoria.  These markets were really rising, until all of a sudden they really fell.

David: Well, uniquely, you had the equity markets, which, before the fall in 2008, were doing just fine, right alongside commodities markets.  In fact, I remember some of the programs we did in 2008.  It was just mind-boggling, the fact that rice was up another 20%, what corn was doing, that all of the commodities were moving in lock-step, and it actually was a part of the liquidity component.  Certainly, supply and demand dimensions have their place in the picture.

Kevin: Yes, but it was a bubble, as well.  You have to admit, there was a commodity bubble.  What did oil get to?  It was over $150 a barrel at one point.

David: When I look at equities today, and the enthusiasm that is wrapped up in the equities market, what I find particularly disturbing is that we are seeing massive distribution in that market, and it is not immediately obvious.  So while there is euphoria, while there are also “animal spirits,” as we have mentioned several times before, insider selling, executives selling into the strength of rising prices.  That is, in fact, what they are doing.  If you look at on-balance volume, if you look at volume for the NYSE or individual companies, over the last three months you have been seeing declining volume, even as the price of these equities is rising, which is a very, very precarious place to be for the market as a whole.

Kevin: And that is for the professional investor.  Most people do not watch volumes, and a lot of the types of numbers that you guys watch when you are making these investment decisions.  But let’s return to something for a moment.  I had mentioned before, we are awash with liquidity.  We are seeing these trades that you have called momentum trades, where there is a momentum going one direction, and everyone thinks it is going to continue.  But, in a way, I was joking.  We are awash with liquidity, there is no hyperinflation yet.  Why should we be concerned?  But let’s go back and review.  Last week we talked about inflation, and when money is thrown into the system, it feels fine when you do not have the inflation.  But the after-effect is like a hangover.

David: As you said, last week we talked about the borrower, we talked about the lender, we talked about the saver, and we talked about the asset owner.

Kevin: And not all lose right off the bat.

David: No, we saw that the borrower and the asset-owner can both benefit from liquidity-induced booms and the inflation that often accompanies them.  The parties that are punished in the midst of a liquidity-driven boom are the savers, looking to preserve assets and cash-equivalent investments, or even fixed income investments that are near cash equivalents, and the lender, who generally fixes the rate of compensation on the money he gives to the part taking the loan.

Kevin: And these are really the responsible people in the community.  Those who can lend, and those who have saved, really, should be the ones reaping the benefit of a good economy.

David: The saver and the lender are doing the same thing, they just have a different audience.  They are trying to take a resource and do something productive.  The individual saver is essentially doing the same thing, foregoing some present pleasure for a future benefit.

Kevin: David, you had mentioned animal spirits.  Is there something about the idea of animal spirits that is particularly present in today’s market?  Where are you seeing that happening right now?

David: If you look at the year-to-date gains, say, in the S&P mid-cap stocks, just from the beginning of the year, you have a 9.8% return in the mid-cap stocks.

Kevin: Sounds like a recovery to me.

David: Or the Goldman-Sachs commodity index, which is, of course, heavily weighted to oil, which is up 15.8% year-to-date.  Or you could look at corn, up 17%, or gasoline, up 30%, silver, up 22%.  These are year-to-date numbers!  And here we are at the end of March, we have just finished the first quarter.  For silver, that is on top of last year’s 80+% return for the year!

Kevin: On the gasoline issue, I just spent $70 filling my car up.  I told my wife when I got home, “$70 for tank of gas!”  We have seen these numbers before, but they were always proclaimed as a temporary spike.  Is that what this is now?

David: It is reasonable to ask, are these normal market dynamics?  The reality is that you do not see these kinds of returns on individual assets, or rising expenses, as you say.  Consider feed barley, for instance.  This is fascinating.  There is a current crisis with exports from Russia.  Just as when wheat exports were cut off, barley is not being exported from Russia right now, and here is the issue:  You have Bedouins who normally get their supply of feed barley for their camels from Russia.

Kevin: This is literally an issue in Saudi Arabia.

David: This is an issue in Saudi Arabia, and a part of the issue is because they are not shipping it out, the price has gone up 51% in the marketplace.  Again, we are talking about something that has taken place in a condensed period of time.  What is the dynamic that is driving that?

Kevin: So for the guy who does not necessarily have to feed his camel, let’s face it, we need to know.  Are these prices going to continue higher?

David: Over a longer period of time, I think they are, but not necessarily in the immediate, if we were to guess, although the change in demand structures in Asia could distort this.  If you look at what is happening in Japan, they are going to be importing a lot more of specific foodstuffs.  But as the Fed configures its choices here in the next weeks to months, in order to maintain their credibility, in order to prove progress toward their stated dual mandates – the first, of full employment, and their second mandate, price stability – with these numbers we are not talking about price stability here, so exactly which mandate are they fulfilling right now?  It is dual one, and it looks like a dual failure, but regardless, they have credibility to regain.  We think there are going to be some interesting reversals, perhaps in all of these asset classes.

Kevin: So people should be ready for at least a short-term shock to the markets, in which the Federal Reserve may come out and actually act like they are tightening.

David: Yes.  There are different themes in play here.  First, you have speculative investments, which are responding to excess liquidity in the markets, what we were talking about in terms of animals spirits, the fluid driving human thought, feeling and action.  This is really being stirred on by those two things that we have made mention of before:  The zero interest rate policy by the Fed, and liquidity.  Low rates and ample liquidity mean that there is a lot of money out there, chasing anything.

Kevin: The junk bonds, rare art, what have you.

David: So you see these eye-popping returns, but it is not being driven by fundamentals.  It is being driven by excess liquidity. We talked about another theme.  Secondly, we have the effects of liquidity creation in asset markets all the world over.

Kevin: I was just reading that the Chinese have dominated the recent Christie’s and Sotheby’s auctions.  They have been buying Chinese art, vases – huge, huge money, paying for ceramics right now.

David: If money if going to buy less and less, and that is more and more true of almost all currencies, regardless of your currency alternative, then the argument goes – why not buy something of enduring value?  Whether it is canvas, whether it is coin, whether it is actual spirits versus the animals spirits (laughter).  Actually we are seeing Chateau Lafite and Chevaux Blanc go back to their record levels of popularity, and it is the Chinese who are driving it.  The stated rate of inflation there is about 5%.  Anyone on the ground there running a business would tell you their input costs, regardless of the business, are running roughly 20%.  They are dealing with an inflation that is very aggressive, and a business owner in China might look at their options and say, “What are my choices?”

Kevin: We talked about John Maynard Keynes’ theory last week, that he really did not want people saving a lot of money.  As far as his economic theory, it worked best when people were just spending that money, so, in a way, the Chinese are employing exactly what he was looking for.

David: There is sort of a window shopping that occurs in the marketplace.  Each year when you look at year-to-date returns, when you look at month-on-month, or quarter-on-quarter returns, different investors will say, “Oh, that was interesting.  Did you see what oil did this last year? Did you see what junk bonds did this last year?”  And what they do is extrapolate from the most recent time period and assume that the immediate future is going to be exactly like that.

Kevin: That is like somebody annualizing a one-day gain. “Gosh, if I annualize this I would be making 150%!”

David: “Well, I ought to double my bet!”

Kevin: I am going to ask you a timing question, David, because how long will this overstepping occur in some of these speculative markets?  Is it going to last for a long time?  You said people are seeing into the future what they are having today.  Do you think it is going to last?

David: I think this is where we have two themes going on.  If we are looking at things on a very short-term basis, we are seeing an over-heating – an over-heating in the commodities market, an over-heating in the stock market, an over-heating in a lot of different places.  The junk bond market is a classic case in point.  We are looking at spreads over treasuries which were 16-1/2% just a year-and-a-half ago, and they are now about 4%.  So the compensation for junk bonds is the lowest above treasuries that it has been, I think, on record.  What that implies is that there has been this massive volume in the junk bonds as people are chasing yield, chasing return.  Is it because they have thrown caution to the wind?  Perhaps, in part, if it is not their money, but also because they are in a zero interest rate environment, being forced to take greater and greater risk.

Kevin: You have talked about back story.  We have two types of back story with the junk bonds.  We have the person who actually just needs retirement income, and they are taking risks that they absolutely cannot afford to take, to just get a monthly income stream.  But then you also have large-scale, billions and billions of dollars kinds of investors, or pension funds, that also are trying to beat inflation.

David: Looking at these dual thematics in a given asset class, taking oil as an example, we have the big picture on oil, where supplies are diminishing while demand is increasing.

Kevin: And we have the Middle East turmoil.

David: But that is the second story.  The primary story is that the long-term supply and demand disparities are going to see the price moving higher, over a longer period of time.

Kevin: That is a good point, David, because even though we are over 100 right now, because of the Middle Eastern situation, we were over 90 before any of this stuff blew up with Mubarak.

David: Let’s say that there is some resolution of the geopolitics in the region.  It does not appear that that is going to be the case anytime soon, but when that fear premium comes out, you could find yourself back at $80 or $90.  That does not take away from the long-term picture of oil being significantly higher over a 3, 4, 5, 10-year period.

Kevin: But for the person who has margined themselves, or taken a loan to bet this market that they are just sure is going to pay off, that can really hurt them.

David: We see the same thing in the silver market today.  The long-term fundamentals for gold and silver are fantastic.

Kevin: Isn’t this a good time to buy?

David: It is.  We see people coming to us who would not have bought silver at $10 because they wanted a more conservative portfolio, but would have bought gold instead.  They said no to silver at $10.  But now we cannot stop them from making a purchase at near $40.  What changed in the mindset?  Is there something happening that is developing here?  This goes back to a book that we read years ago, Jason Zweig’s Your Money and Your Brain.  Fantastic book, I would recommend everyone read it, because it explores you as an investor, and your biggest benefits or obstacles to success in an investment thesis, and so many of them boil back to that lack of self-awareness in the investment process.

Kevin: Reading that book was an excellent exercise because it taught me not to trust my brain.  You have often said, David, “Don’t mistake a bull market for brains.”  And we are in a bull market in some of these markets right now.

David: Right, and it is going to be normal, from a long-term trend standpoint, we are moving closer and closer to that third stage, that final stage in the previous metals blow-off, where we could see gold hit $3000, $4000, $5000 an ounce.  We could see silver hit $120, $130, $150 dollars an ounce.  Is that a reason to go buy it today?  No, I think you need to take a very reasoned approach in light of different ratios, in light of different price dynamics, in light of different technical indicators.  But Kevin, here is what we are watching happening:  We are seeing this temptation occur, in which people once viewed precious metals as an insurance policy, but now they are wanting to cash in their insurance, and it is like going to the racetracks.

Kevin: And leveraging up.

David: They have the number, they know the horse that is going to win, they know on what lap it is going to pass, and win by three lengths!  There is a dynamic change, not so much in the gold market, but certainly in the silver market, as people who said no to the purchase of silver at $10, are coming to us and demanding a purchase today at $40.

Kevin: David, you mentioned three stages.  I think it is worth reviewing, just briefly, what those three stages are in any market, not just gold, silver, copper, oil, but also it happens in the stock market.  It happens, really, in any market.  Can you just briefly explain the difference between the three stages?

David: This is really important because the challenge right now is to balance what is happening in the currency markets and in the commodities markets, and developing what our awareness is over a long period of time, with decisions that need to be made in the immediate.  If someone is allocating assets today, on what basis are they doing it?  What we would like to encourage people to do is to just do it reasonably.  Have some sort of a discipline in how you are approaching the markets.  And if it feels good, I would encourage you to distrust it.

There should be a natural anxiety when it comes to looking at your hard-earned capital – the blood, sweat and tears which you can put in a dollar-figure term.  When it is easy to spend it, something is not right.  You should be calculated, you should be cold, you should be asking yourself the question, “What happens if I have to go back and re-earn those dollars? How many years will it take?  How many decades will it take?”  Do not be trite or trivial with the amount of effort that has gone into saving that resource.  Just because it feels good, just because it looks good, just because a rate of return was this last year, does not necessarily mean it is going to be the same the next.

Kevin: Don’t mistake an emotion for a gut feeling.

David: We have long discussed the notion of a bull market having those three distinct phases.  You have people entering into a bull in each period, different kinds of people, and it kind of typifies that period.

Kevin: The first period actually almost goes unnoticed.

David: Yes, it is the maverick investor, somebody who kind of keeps it to himself.  Maybe he shares it with a few friends or family members, but he thinks something is different, and he does something about it.  Buying silver at 5, 10, 15, 20 dollars – that would probably define it.

Kevin: I think about the late 1990s when people were buying gold and silver.  They were not really buying into a bull market, it was just about to begin, but that was the beginning stage of the first phase.

David: I remember sitting with one of the brokers that I worked with at Morgan Stanley – this goes back quite a ways, Kevin – and having a conversation with him.  Oil was about $10.  He was a technical analyst, he loved charts.  He was one of the only ones in the office who liked looking at charts.   He said, “You know, this is interesting, I think if we break above 12, this could get very interesting.”  And he began to load client accounts with a long exposure to oil.  This was sub-12 on the oil price.

Kevin: Not a bad price to be buying a barrel of oil, since it is over $100 right now.

David: No, but out of an office of 65 brokers, everyone thought he was insane, absolutely insane!  “Why are you looking at oil?”  Of course, they were on the oil bandwagon by the time it got to $30 or $40.  But that describes the second phase.  The second phase is where the Wall Street firm, or the average Wall Street guy says, “Okay I see your point, you know, there is some momentum here.  I see that there is a case to be made.  I’m not going to be the first in, but I don’t want to be the last one in, either.  Don’t leave me out on this, I think there is some money to be made here.”

Kevin: But it is still pretty much professionally oriented.

David: It is.  But the last phase, the final phase, is the Main Street participant.  Each of these kinds of groups helps us define the phase we are in.  I don’t know that we are quite to the Main Street participant, Kevin, but we are getting awful close in terms of the gold and silver market.  That means that we still have another 2, 3, 4, maybe even 5 years of a bull market ahead of us, particularly because this is global in scale.  But if you think of the oil market, at 120, to buy oil, or to buy oil stocks today at 120, your risk is 3-4 times greater than buying it at 35.  And your reward, although oil may go to 150, or to 200, your reward is miniscule in comparison to what it would have been having purchased at an earlier price.  So you have to balance, as an investor, what is happening in this complex.

As prices appreciate, not only does the risk side of the equation increase, but the reward diminishes.  So how is it that you are functioning inside of a bull market?  We spend a lot of time here in the office talking about that – strategizing, both reduction strategies, increasing, maximizing ounces.  There are so many different ways to operate inside a bull or bear market, but the very best way is to do it with your mind engaged, and not necessarily your heart leading the charge, saying, “Gosh, this is a sure way to make money.  You’ve just got to try this!”

Kevin: David, since you have picked silver out, though there are a lot of markets rising right now, let’s talk specifically about the discipline with silver.  Talk about the last 20-30 years, the last 100-200 years, as far as ratios of silver to gold, because that is one of the classic disciplines that we have talked to our clients about.

David: Kevin, let’s look at recent history, I think that will be most helpful.  If you look at the period of 1986 to the present, take the price of gold divided by the price of silver, and that gives you the ratio.  That ratio has fluctuated between 80 and 40 during this period of time, this particular time-slice.

Kevin: There were excursions outside of those numbers, but it is pretty much between 80 and 40.

David: Between 80 and 40.  On the high side it actually got to 100, but on the low side it has been capped at about 40, 40-to-1.  That defined the period from 1986 to present.  Now, in the period of from 1963 up until 1986, it was a different dynamic.  There was something going on in the marketplace which was very unique.  If you look at the devaluation of the currency, if you look at what happened with the Kennedy administration in the 1960s where they began to pull silver out of coinage, and you went from a 90% silver content for dimes, quarters, 50-cent pieces, to 40%.  These things were changing, and people were very aware of that kind of devaluation, because it was obviously a currency devaluation.  The demand for silver was very high during this period.  From 1963 to 1986 the ratio was between 20 and 40.

Kevin: So, it was a lower ratio as far as the way you measure it versus gold, but that means that silver would be more valuable versus gold.

David: Right, and this is the confusion today.  We find ourselves at close to $40 an ounce, and we find the ratio at just under 40.  The question is:  Is this a false breakout in silver, wherein we see the ratio drop back to the most recent historic range, which would be 1986 to the present…

Kevin: The last 25 years.

David: And would be between 40 and 80?  Or, are we reverting back to that earlier period, where the demand for silver was enough to redefine the relationship to gold, and make it a priority in every portfolio, and where the volatility, still volatile in nature, but was between 20 and 40, instead of 40 and 80?

Kevin: David, we have had other people on the show who have talked about 16-to-1, or even greater ratios, but those are types of things that we have not seen in many, many years.

David: We have not seen them in a long time, have not seen them since the Hunt brothers’ days, or you would have to go back to the 1800s, or 1700s, to see the ratio reflected in the monetary supplies where they were actually having a dual, or bi-metallic currency, gold and silver, and they tried to keep it in balance, roughly in line with the in-ground ratio, somewhere between 15 and 18.

Kevin: But the moral to this story isn’t necessarily picking exactly the right ratio, it is picking a ratio and sticking to it, no matter what your emotions say at the time.

David.  Yes, I remember having a conversation with some folks, and this goes back about a year-and-a-half, not that long ago, the gold-silver ratio was 65-to-1.  So, they were allocating more to the metals and the specific decision was made, “Let’s add to silver on the basis of the ratios.”

Kevin: But they had gold, they just added silver this time around.

David: Exactly, but we discussed a year-and-a-half ago, we are adding a significant chunk to silver today.  When the ratio gets to 40-to-1, you will have received some benefit from being in silver versus gold.  Net of taxes, net of transactions costs, that is great.  You should be moving a part of that to gold.  And then at 30-to-1, you should be moving some more of that silver to gold.  And at 20-to-1, you want to be moving a little bit more of that silver to gold.

Kevin: But this was pre-decided, and pre-discussed.

David: It was.  So lo and behold, a week ago, I was in the Denver airport flying from Denver down to Dallas, and I had a conversation with a client.  “You remember we discussed 65, 40, 30, it is ultimately going to get to 20-to-1, and I am okay with leaving money on the table.  I am okay with not maximizing the entire amount that we have allocated to silver.”

Kevin: So what did they tell you?  You’re crazy?

David: No, they said, “Go for it.”  Of course, this is the discipline of investing, you have to have a discipline of investing.  And I loved hearing this feedback from the client, “Oh, that’s great, this is just what we planned.”

Kevin: Because you told them ahead of time.

David: You have to have a plan when you are investing.  When you buy something, what is your exit strategy?  When you buy a piece of real estate, do you buy it with the idea that this is your dream home and you will never have to sell it?  Or do you have some realization that liquidity is important?  It is always important to keep liquidity in mind, Kevin, and what we try to do with investors is bring some structure and clarity to what that is.  I am not negative on silver, I am not negative at all.  I own a lot of it, will be happy to own it all the way to 30, all the way to 20, and if we get to 10, I will still own some silver and be happy to own it.

Kevin: This brings up another point.  We have been talking about a gold to silver ratio.  What you are swapping out of when you swap out of silver to gold, or vice-versa – you are still staying in something that is not paper.  One of the things that is really confusing the markets right now is:  What in the world would you sell anything for, with all this paper that is being printed?

David: Right, and that is where the currency markets are, to some degree, driving the commodity super-cycle, at least as this substructure or support to the market.  All things paper, had for decades, captured the imagination.  Call it the last generation of investors.  This was really a blind faith in paper, and the priesthood of paper, which you could describe as the Fed and Wall Street, to some degree, the world of central banks, monetary authorities and the paper pushers from Wall Street.  Currencies have been extended a confidence which, frankly, is devoid of historical warrant.  If you look at the abuse of money systems, the abuse by monetary authorities of those money systems throughout history, you would say, “Why do people have confidence in any fiat currency?”

Kevin: It is simply the carry-over of money, at one time, just being a receipt for something real, like gold.

David: That is right.  There is some confusion, because right now there is a growing awareness, and a growing demand, for the metals.  On the other hand, there are these overlaid dynamics.  Let’s take the animal spirits we discussed in the marketplace – massive liquidity provided to the marketplace.  What do you think the response will be if Mr. Dudley, Mr. Bernanke, all the Fed chiefs, come to the consensus here in the next few weeks that we do not need QE-III, that QE-II was successful, that we are being smart when it comes to an awareness of inflation?  They look at all the same numbers that we do, Kevin, whether it is barley, whether it is wheat, whether it is corn, whether it is silver, whether it is copper, whether it is oil, and they need to prove their credibility that they are aware of inflation.

Kevin: And there are whispers of inflation around the world right now, but there are not screams of inflation.  At this point, they are starting to get the hint that they may be unpopular.  Is there a word right now that would characterize what is going on, though, up to that point where they announce tightening?

David: There is speculation in the market.  There is speculation in junk bonds, there is speculation in the stock market, although the insiders are jumping ship.  There is speculation, even in the gold and silver market, and I would argue far more in the silver market than in the gold market.  But this is speculation which has been driven by liquidity.  We talked about the under-story, or the back-story, being far stronger for the commodities, than for instance, the junk bond market or the stock market.  So the back-story is very different, very different.

But there is this overlay where all asset classes are getting a little extra boost because of the liquidity provided by the Fed.  If they do not finish QE-II, which is supposed to be completed by the end of June, and they finish shy by perhaps 100 billion dollars, all of the speculative community will lament the fact that their feed is gone, that their liquidity is gone, that which was fueling their gains has gone away.

Kevin: So that could be that temporary market shock that we are taking about.  You could actually see a correction in many of these markets, at least temporarily, because these people have been used to free money.

David: So the next few weeks to months you see some market peaks put in.  This is all speculation on my part, Kevin, in terms of a  “guestimation” of what happens over the next 6-12 months.

Kevin: But not changing the long-term trend.

David: It hasn’t changed the long-term trends.  We remain in a bear market in equities.  We see a push higher in equities as a result of the liquidity created.  Guess what happens?  They pull the plug on QE-II, and equities are impaired because that is the only thing propping them up.  The bond market – if you look at what is holding up the treasury market, and largely what has fueled the junk bond market, you could see credit spreads widen significantly between now and the middle of summer.

Kevin: If that credit spread widens, everybody who bought junk bonds at this lower rate is really going to get hurt.

David: Right, but you could also see a silver owner, gladly stepping in and buying at 40 – they may have the opportunity to lower their average cost at 30.  We are not talking about the end of the bull market in gold and silver.  What they are setting up is the justification for QE-III.  In the long history of the Federal Reserve, going back to 1913, nothing has been more damaging to their credibility than what was announced last week in terms of the distribution of funds to international banks, even the Bank of Libya, if you can believe that.

Kevin: It is amazing, we are losing value in our money as we print more money, but it is not coming here, it is going overseas.

David: We bailed out the world.  Our Federal Reserve – and the taxpayer is the backstop to the Federal Reserve – our Federal Reserve was bailing out the world, and they viewed that as their mandate?  Their dual mandate, and you could argue that there should only be one, or not at all, if the Fed did not exist, is that of price stability and full employment.  A growing number of Fed chiefs are saying, “No, it should not be full employment, because that is what compromises our political separation from the system.”  With having full employment, of course they would have to be sensitive to what the Senate and Congress are saying.  This is where they feel pressured and would like to go back to the single mandate of price stability.

Kevin: David, this is one of those opposites that have been presented to the Federal Reserve.  “We want full employment, but we also want you to keep the price stability of the dollar intact.”  So you have those two mandates, but to get full employment, they have to continue to pump money into the system.  That, of course, drops the value of the dollar.

David, we have talked about inflection points, or cusp types of events, where something is building pressure in one direction, and then immediately shifts to the other side.  Are we either at an inflection point, or can we expect significant reversals in these markets, including in commodities?

David: Kevin, we are at an inflection point.  We either see a ratcheting up in price, specifically of gold and silver, of copper, of everything physical, as we go into a tailspin, in a sort of monetary collapse – we are either at that point now, or that point is still 2-3 years out, in which case you can expect volatility, and we may equally be at the inflection point where we take a breather.  Over the next 2, 3, or 4 months – I am not saying tomorrow – but over the next 2, 3, or 4 weeks, even, we could see the price of silver give back 25%, we could see the price of gold give up 10%, we could see the price of copper give up 10-15%, we could see the price of oil give up 25%.  Where there have been major moves, there is greater risk and less reward in any of those asset classes.

Kevin: So, if I were to allocate money today in a single investment that would provide me first, with safety, and then second, with reward, which one would it be?

David: I would still pick gold, and I think even looking at volatility in the stock market versus volatility in the gold market, I would rather own gold today with a 10% downside, than the stock market with 20-50%.

Kevin: Or the currency that you are trading for.

David: Right, because then you have the double whammy of not only market volatility, but currency downside, as well.  When I look at the stock market today, Kevin, we have talked about Tobin’s q, we have talked about the replacement value of assets for a company, and this is where we find a 65-70% overvaluation in the stock market today.

Kevin: Still overvalued.  We are at a number right now that we were at 11 years ago in the stock market, and it is still overvalued.

David: It just begs the question, what are investors thinking?  What are they thinking?  The only thing that drives prices from 12 in change, to 15,000 or 20,000 on the Dow, is liquidity, is an inflation which turns the world upside down.  That is not to say that asset prices cannot benefit from that inflation.  They can. But the question, again, is – relative to what?  Relative to a currency that is losing value, or relative to a measure which is consistent through time?  That is what we discussed last week, with gold being that measure.  If I had to look at both the reward side of the equation, and the risk side of the equation, if I had to choose one asset class today, it would have to be gold.

Kevin: And you are not saying that it is time, necessarily, to sell silver for cash, you are just basically saying, “Look, don’t go out and margin it at these levels.”  Long-term, you made the comment earlier in the program, that you see both of these metals much, much higher.

David: I do, Kevin, whether it is silver at $100 or $200 an ounce, or gold at $3000, $4000, or $5000 an ounce, the balance that an investor has to strike is between the appeal of money in their pocket, that potential reward, and just keeping what they have.  I think when you look around the world, whether it is the Middle East, whether it is Asia, whether it is our own balance sheets, you still have not accounted for all of the risk that is in the marketplace today.  To see the Dow at 1204, to see the general equity indices trading at these kinds of levels, people are assuming the best, and assuming that the worst is no longer an option, that it simply cannot occur.

Kevin: We have talked about discipline without conviction.  In other words, you can be convicted that a market is going up, but just don’t let it affect your pocketbook.  But the disciplines that we are talking about – we have talked about ratios on gold to silver, we have talked about ratios on Dow to gold in the past.  All of these disciplines are developed out of historic data, not future prediction, aren’t they?

David: Kevin, just as we started the conversation today, much of our reflections internally, some of them boil down to anecdotes, where we have clients calling us, and there is something changed, a sentiment that has changed.  This is where we think that a client needs to still focus on the primary mandate, just like the primary mandate of a family doctor – Do no harm.  You need to focus on your primary mandate of asset preservation first, and growth on a very secondary basis.  If that is not the way you are structuring your decisions at this point, then realize that you are preparing yourself for either a tax loss, radical volatility, or a long game of patience.

Kevin: So, if you are looking at the two P’s of investing, you have either profit or preservation.  You would say preservation should still be the first discipline.  That is, “Do no harm,” and then profit after that.

David: That is right.

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