August 10, 2011; The Worldwide Redefinition of “Riskless Assets”

Weekly Commentary • Aug 11 2011
August 10, 2011; The Worldwide Redefinition of “Riskless Assets”
David McAlvany Posted on August 11, 2011

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin:  David, the Federal Reserve chairman spoke yesterday, and I guess he gave some hope to the markets, but let me back up a little bit.  The last couple of days, the Dow was down 634 points, and then, of course, we got our 429-point rebound, because I guess everything was better.  But I’ve been listening to Bloomberg, I’ve been listening to BBC, and I have listened to CNBC.  I’m listening to high-pitched voices, either freaking out or trying to sell America that everything is just fine and this is just an aberration.

We are getting questions from our clients:  “Is there anything different that we need to do from the triangle, anything different that we need to do today that we weren’t doing yesterday?”  That is my question, Dave.

David:  I think investing is often the art of anticipation, where you are connecting dots before you are in the context of pressure or crisis, and you don’t have to react or make radical changes in the context of crisis, to the degree that you have been doing a forward-looking project to begin with, so we find ourselves pretty calm and quiet around here.  What you have described as protocol – that’s what we have followed.  What we look at, as a reference point, in terms of the perspective triangle, which you alluded to just a moment ago, where you have a balanced approach to your paper assets on the one hand, which would be securities-related, your dollar-denominated or liquid assets on the other hand, and the insurance component – precious metals.

We began to see the market sell off earlier this week, and the beauty is, the perspective triangle worked quite well.  We had metals up, not just a small fraction, but at one point, if you combined both the day, and then the overnight trade in Asia, over $100 an ounce on gold.

Kevin:  A huge move, and a lot of it happened while the Americans were sleeping.

David:  In the context of the Dow peeling off 5½%.  Lo and behold, if you look at the perspective triangle, a very simple approach to allocating assets, and where you have stronger risk components, you also have those risk components offset.  That is the beauty.  We don’t have to know exactly what is going to happen, and here is the thing:  We are not making uninformed decisions on that basis.  We are making very informed decisions because there are a whole host of things that we do know, based in history, based in what some have derisively called anachronistic, or too old to be of any relevance, but what we are really talking about is a historical insight of the marketplace.

Kevin:  You are talking about the barbaric metal, in a way, when you are saying, well, that’s not really part of the plan, right?  But you know, Dave, and I don’t mean to cut you off here, it seems that everybody watches the stock market to see how things are going.  But in reality, that is just a small fraction of an overall portfolio.  Just to let the new listener know what we are talking about, the older listeners and our clients, they understand, it is in their blood at this point – it’s a third in gold and sliver, it’s a third in growth types of assets, and it’s a third in cash so that they can pay.  It’s a triangle.  It doesn’t always have to be exactly thirds, but there is a balance there, and there are times when you rebalance the triangle, but you rarely ever would rebalance the triangle when there is a panic in the market, because you are already padded against those kinds of reactions.

David:  It’s like having insurance and having a policy pay.  You don’t buy insurance, for instance, fire insurance, with a forest fire rolling over the hill next to the house.  You do that when there are no concerns, no considerations, and it is a theoretical risk that you are addressing.  Nothing really changed.  I think what is rapidly changing is the perception in the marketplace of the value of paper assets versus real things, in this case, gold, particularly.  I look at the Dow-gold ratio with some frequency, and we have reached new lows for this move.  On the Tuesday trade, with the equity market down and gold up, we saw 6.26 on the Dow-gold ratio.

Kevin:  And that is amazing, because I remember ten years ago, the Dow-gold ratio, which is arrived at by just simply dividing the value of the Dow Jones Industrial Average by the price of an ounce of gold.  When the Dow was 12,000 and gold was $300, the simple math tells you that is a 40-to-1 ratio.

David:  And the issue, Kevin, is this, because certainly the concern we find in our own chests, is at $1750, at $2000, at $2500.

Kevin:  Sure, we think in dollars.

David:  And that seems like a very high price to pay.  It is just critical to turn that around and say, price is not what we are looking at.  It is this exponential purchasing of another asset, in this case, the Dow Jones Industrial Average.

Kevin:  Which is something of real value.  We are not saying to go put all your money in the Dow, but let’s face it, that is the backbone of America.  You are purchasing businesses in America, which, no matter what kinds of ups or down we are going to have, it is probably not going to go back to Mad Max caveman days.  We will probably still have companies that actually buy and sell things.

David:  And I’m not a fan of General Electric.  With this next comment, I don’t want to be construed as a GE fan, but it is one of the Dow components which has been around for over 100 years.  It is the only remaining original Dow component.

Kevin:  Thomas Edison’s company.

David:  The fact that they are half financial, half industrial, today, is maybe a disappointment.  It certainly is what fed their profits for at least the last 15-20 years.  Here is the issue:  At the beginning of the decade, a modest sum, $30,000, would have bought 500 shares of GE.

Kevin:  Or 100 ounces of gold.

David:  Or 100 ounces of gold.  Today, your $30,000 in GE shares would be worth quite a bit less, about 2/3 less.  GE shares aren’t selling at $60 a share anymore, they are selling at $16, and there is real sadness in that, unless you were the person who chose to own the 100 ounces of gold instead.  In which case, today, you are exchanging the same original value, in terms of those ounces of gold, not for 500 shares of General Electric, but for over 11,000 shares of General Electric.  This is the point.  Gold preserves your purchasing power during periods of duress, whether that is in dollar terms that you are purchasing, or in terms of real things, whether you are translating that value into houses, or acres, or shares, or bond certificates.

This is where I don’t care what the asset is in question, but we do have to have some relevant, relative value equation upon which to make clear decisions, because price becomes irrelevant in the case of instability.

Kevin:  Let’s face it.  The dollar is shifting sand, the euro is shifting sand, and the Asian currencies are shifting sand.  We have brought this out in the past, we are completely on what is called a fiat currency system, which means they just print more.  Without going into too great of an analysis, what Bernanke said was that we are not going to raise interest rates until the middle part of 2013.  What he is basically saying is, “Here is some free money for another couple of years.”

David:  The temptation is this, Kevin, and I think why I started the conversation today with the Dow-gold ratio and the perspective triangle, is that there are really only a couple of things that people need to focus in on, and the white noise in the markets, which would include a significant announcement from the FOMC, is insignificant because of what is already in play in the marketplace.

Kevin:  David, you are talking about noise, and the noise doesn’t just come in the stock market.  It can also come in the metals markets.  When things start sky-rocketing, you start hearing, “Oh, it’s never been so high, and this is the time to get out.”  But that actually can be noise, too, because there is an overall trend, there is an overall plan, and this is my question:  Do you have an end-game strategy?  Is there an exit strategy, or a re-allocation strategy? And would you re-state what that would be?

David:  Oh, we do.  We absolutely do.  The question is, do our listeners, and are they thinking ahead?  Because I think the art of investing is an anticipatory work.  This is something that I learned from my dad years and years ago – you look ahead and you try to see the end from the beginning, whatever that is.  If you are looking at political altercations, if you are looking at geostrategic relations, if you are looking at market machinations – whatever it is – you try to see the end from the beginning, and then step back to actions that need to be taken today.

I think the plain question for our listeners to consider is:  Do you now understand that one of the greatest wealth transfers in world history is unfolding in front of us right now?  And if you have not already acted, up to this point, to protect assets, it is not too late, although it is our opinion that it is getting later by the day.  With what we in front of us, barring the discussions from the FOMC, at the end of the month we have Jackson Hole, so the Fed has another opportunity to do some sort of a “Hail Mary,” if necessary.  We will just have to wait and see.  The question is:  Do you realize it is insignificant?  We are dealing with a bankrupt company, this is Corporation USA, and our shares are being sold off in the markets today.  While the Dow went up 400 points on the back of the FOMC announcement, did you see what the dollar did?

Kevin:  It just tanked.

David:  It’s in the toilet, Kevin.  It’s getting flushed.  We are watching people overseas saying, “We got it.  We understand exactly what you are doing.  We understand that this is positive for the equity markets in the short-run.  We understand that being accommodative, and being willing to step in, you may announce a Quantitative Easing III.  We may understand that that is short-term beneficial to the bond market, but we understand the direction here.  We understand that the dollar is going lower.”  That is a course that has already been set, Kevin.

Kevin:  This is why gold and silver are going up, but there is a point, and you have brought this out in the past, when you start saying, “We are going to always keep a third in metals, we are always going to keep a third as that investment base.”  But a lot of these clients of ours, started with very little means, who are people of means at this point.  This last decade has been very good for the person who had a triangular strategy, let’s say.  They have maybe lost a little bit in the stock market, but they have quadrupled to quintupled in gold, it has gotten to be that big, though there is a re-allocation time.

David:  That is certainly not the case on our wealth management platform.  It is not necessary to lose money in challenging times.  It is necessary to remain engaged and assume that the market is going to do you no favors, and I think that is the disconnect with most Wall Street firms.  They are betting on “the market,” and that is the problem.

Kevin:  Right, and I was talking about people who don’t have money with Wealth Management.  The wealth management platform has done very well, even in the crisis years, but, still, let’s say that wasn’t the case.  Let’s say that there was a loss on one side of the triangle.  The triangle grows and expands in ways that sometimes have to be re-allocated and this is where I was going with the exit strategy.  We always recommend a third in insurance, but when do people actually start to look at reducing their gold position a little bit and moving into other areas?

David:  That is a question I am getting a lot these days, Kevin, certainly, as the price of gold gets higher.  I was on with CNBC, and Market Watch asked the same question:  “What is your idea of the direction of gold from here?  Surely, it can’t go higher than it already is.”  The challenge, intellectually, is to see that this may, in fact, be a low price, not a high price.  Again, I think all of these judgments are based on a particular solid reference point.

We are watching this happen right now, Kevin.  With the downgrade in U.S. debt from AAA to AA+, this is an issue.  We took the plumb line, which everyone measures risk against, and we changed the plumb line, which changes the way everything else is measured.  This is the knock-on effect.  We have downgrades which have begun in Oceanside California, in Atlanta Georgia, Miami Florida, Irving Texas.  There are about a thousand individual issues, just as the tip of the iceberg, which have already received the same downgrade from AAA-rated.  These are municipal bonds, were AAA, now they are AA+.  This is the issue.

Kevin:  So the dominos have begun to fall.  It’s not just a U.S. government debt default, which I should say has always been treated as the risk-free trade.  In other words, if you are going to get out of anything that has risk, and go somewhere, historically, people have just gone to Treasuries because they say, well, it’s a risk-free trade.  A little more dangerous might be municipals, but those have been downgraded, as well.  Then there is Fannie Mae, Freddie, and the mortgage downgrades.

Something interesting, Dave, and you can jump back in on this, but Warren Buffet came out and said that this S&P downgrade was politics, that it was just bending to the Tea Party people.  But what is interesting is that Moody’s and Fitch, these guys haven’t downgraded.  In fact, Moody’s came back in and said, “No, no, no.  They are still AAA.”  But guess who owns Moody’s?

David:  Tell me.

Kevin:  Berkshire.

David:  Oh…..

Kevin:  Which is Buffet.

David:  Well, isn’t that curious?

Kevin:  Let’s face it.  Buffet has not been the genius that everybody paints him to be.  In 2008 he completely missed the crash.  At this point, he is saying, “Don’t bet on a down economy for the United States government.”

David:  Kevin, here is the genius of Buffet.  He knows when to be in the market and when not to be in the market.  When he originally started investing, he determined that, early on, he was smack dab in the middle of a bear market, and he gave investor money back and he called it quits.  He closed the business and walked away.  But let’s not mistake brains for a bull market, because what did he do when we came into the bull markets in the 1980s?  He began to find undervalued companies and he participated in the revaluation of those companies to higher and premium numbers, but guess what was supporting his success?

Kevin:  It was the greatest bull market in American history.

David:  And is it any surprise that he has been having a hard time making money in the last ten years?  Granted, he has a few companies that throw off a tremendous amount of cash flow.  Those were some of his crown jewels, if you will, in terms of purchases, but whether it is mistaking brains for a bull market, or treating hope as an investment strategy…

Kevin:  Well, is hope an investment strategy?

David:   No.  We have some investors who are paralyzed by making decisions even under normal circumstances, let alone in challenging times.  Others seem to think that the world should function in accord with their expectations.  It is usually a fairly sheltered individual, I must say, but it is those people who simply cannot believe that events would occur in a manner inconsistent with what they anticipated.

Kevin:  David, what it reminds me of is the movie, Titanic.  They did a great job of showing the disbelief on the captain’s face.  That boat was not going to sink, not under his watch.

David:  “Not my boat.  I’ve studied the diagrams.  I know how this boat was made.”

Kevin:  He couldn’t believe it.

David:  Not possible.  And by the way, not this captain.  “I was chosen to be the special one.  I was chosen to navigate these waters, because I am the best, and I can’t have my boat sink.”  This strange disbelief, where it is simply not possible that I am wrong, because my construct, my belief and view of the world as x, y, or z, is unchangeable, it is immutable, it is perfect.

Kevin:  That is the narrative.  As you talked about with Martenson last week, we all have a narrative, what we see as normal.  The narrative is that everything is going to be fine, we are just in another fluctuation on the up or down side.

David:  I keep on encountering Wall Street brokers who pretend to be the captain of a ship, with no real sense for piloting, whatsoever.  And I wonder if it is deluded to think, “Not my boat.  Not this captain.”  The context is different.  We do have massive icebergs.  They have to be avoided at all costs.  That is why our fixation, for the last decade, or even four, has been on preservation of wealth, with growth being a secondary motive.

Kevin:  Dave, I want to go back to the narrative question, because we really do all operate with a particular paradigm and a particular narrative.  We have talked about Structures of Scientific Revolutions, a book by Thomas Kuhn, and how long it takes to change our minds on something, or black swans when all you have ever seen is a white swan.  The narrative that is going on right now is costing people tremendously, as far as their future wealth.

David:  Yes, I have been impressed of late with the power of self-deception.  I am reminded of some papers that I wrote back in the college days.  I had one combined course, it was a psychology, theology, and philosophy course, and the paper was on self-deception – the single best class I took in four years.  We looked at the ability of an individual to devise an imagined reality, which becomes concrete in the mind’s eye, something that they can bear witness to, swear is true, and yet it is based on either false inputs or misinterpretations of reality.  I look at Wall Street today and I think they are living a self-deceived existence, where it simply cannot be the case.  Again, the captain is telling himself, “I know this boat from stem to stern.  I know this boat, I saw it built.  I was there, we launched it.  It is not possible, not on my watch.  I’m the best captain in the world.”  This is the kind of belief that dies hard.

Again, coming back to the concept that hope is not an investment strategy, for an individual to look squarely in the eyes of their broker and say, “You don’t have a clue, and I’m very uncomfortable in this moment, because while I thought that you knew more than I did, it turns out that you know less than I do, because you can’t even tap common sense in this moment.”

Kevin:  It reminds me that you have to have some sort of basis that is outside of yourself to check your facts.  I’m thinking of the Bible right now.  In I Thessalonians 5, Paul says, “Test all things, and hold fast to that which is good.”  In Acts he says, “Those in Berea were more noble than those in Thessalonica,” because they heard what was said with readiness of mind, and then they checked the scriptures daily to see if what was said was true.  So they didn’t even trust themselves, they didn’t even trust what Paul was saying, without going back and saying, “Wait, this is what we have accepted as our structure of belief.”  When it comes to the markets, there are historics that you can go back and look at, there are ratios that you can go back and look at.  As you mentioned before, there is psychology that you can go back and look at, but you have to be careful with the narrative and say, “Am I deceiving myself?”

David:  I think we have groups focusing on primary issues in the markets today.  Of course, we had a downgrade last week, and CNN, Friday night, shortly after that, declared that the downgrade was already priced into the market.  (laughter)  There would be nothing significant that happened because it was already priced into the market.

Kevin:  I guess they were wrong.

David:  Well, it was the first day of trading, going back to 1941, where we were not AAA-rated, and it is supposed to be priced in.  The irony is that what was priced in was the “inevitable” recovery, with the double-dip being the view of wingnuts and Tea Party freaks.

Kevin:  Yeah, the Tea Party freaks are going to take the blame for everything real, probably, for the next two years.

David:  Right.  And as a reminder, the debt ceiling was never the issue, I guess we have said that already, but deficit spending is catching up with us, and negatively compounding the debt burden we already carry.  We have deficit projections which are a trillion plus per year for a decade.  Did we mention that they were assuming positive growth in all of their projections?  Take away the positive growth and your deficit projections per year end up being larger than otherwise assumed.  How quickly do we get hit by the exponential growth curve when we are looking at our national debts, Kevin?  This is something that I think investors are realizing, and what are they opting for?  They are opting for gold.  Again, the U.S. downgrade issue is, frankly, what our foreign creditors are concerned about.  There is really a bifurcation of people who are looking at us from an external perspective, and then those from the inside perspective.

Kevin:  Okay, Dave, I’m going to cut you off here because the Americans, the people here in the United States, responded one way a couple of days ago, and everybody else responded another.  When money was coming out of the stock market in America, it was just going right into those bonds that had just been downgraded, those Treasury bonds.

David:  Which is ironic, because if you look at Greece, if you look at Spain, if you look at Portugal, if you look at anyone who has had a downgrade in the last several years, credit rating goes down, yields go up, the price of the bonds goes down, investors in those bonds are losing money.  How does this happen?  In the United States, credit rating goes down, bond prices go up, yields go down.  This actually doesn’t make sense, except when you look at the difference in behavior patterns, international versus domestic.  The managed money crowd, the institutional money managers, have a schema in mind that when equities come under pressure you rotate to a less pressured environment, which would be fixed income, and in this case, you are prioritizing liquidity, so you move into two, five, and ten-year Treasuries.

Kevin:  That is what they have been taught all their lives.

David:  And that’s what they did.  Now, in the international markets, we saw a little trickle into Treasuries, and a lot of trickle into German bonds, and a lot of trickle into gold.

Kevin:  Even the Swiss franc, let’s face it.  The Swiss are trying to devalue their currency.  They’re doing everything they can.  “Stop buying our currency!”

David:  Holy cow, you can’t believe the Swiss franc this week, it’s unbelievable.  It is as unbelievable as the move in gold, and what it says is that there are a number of operators in the world today who are looking past the smoke and mirrors, who could care less about a 400-point recovery in the Dow, and they say, “That’s great.  That helps me with my exit strategy.  I need to get out of dollars, I need to get out of U.S. denominated paper.  I don’t want to own equities, I don’t want to own bonds, and if the market is going to give me a gift, by all means, I will take it.

Kevin, I think when you look at these moves in parallel, there is a very interesting commentary to develop from it.  We don’t have a strong Treasury market, even though prices are reaching record highs.  We have a gutted Treasury market, as far as external sources of funds are concerned.  It is the internal behavioral models that we see driving money out of equities into Treasuries.  Externally, we are going to have a harder and harder time in the coming days, weeks, months and years, financing our deficits on the backs of our foreign creditors.  They are the ones who looked at that U.S. downgrade and said, “Balderdash.”

Kevin:  Yeah, “No Treasuries for me, I’m going to go to gold this time.”

David:  “Priced into the market?!”  I think not.  There is a real difference between the themes that are developing in the individual investor community, and I would include the individual investor community with the international investor community, where they are saying, “Listen, we’re the creditors.  It’s our money you are playing with.  Of course we care what your credit rating is.”  And it is the debtor on the other side saying, “We’re the debtor.  It’s your money we’re playing with.  Do we really care what our rating is?  We don’t care!  It’s not a big deal.  And you should not worry.”

Kevin, it is ironic that the debtors are telling the rest of the world there is nothing to be concerned about, and the creditors are saying, “Oh – my – word.   This is utterly insane.”

Kevin:  So, I can tell my bank, if I’m not paying my mortgage, “Hey, don’t worry about it, you’ve got to understand…”

David:  (laughter) “I’m as bad as I’ve ever been!”

Kevin:  That’s exactly right.

David:  Which may or may not be the truth, I’m not trying to throw tomatoes at you, but … (laughter).

Kevin:  Right, well okay.  Let’s go to the downgrades, then.  We just touched on it before, but this really is a series of dominos that have to fall, isn’t it?  The U.S. debt downgrade is probably step one in a number of other, maybe even weaker, securities.  If you could possibly go into that, I think people who own these things need to know.

David:  Yes, we have said this for weeks, this had nothing to do with default.  There was no option of default.  There would have been prioritized payments, there would have been a number of other alternatives.  Default was never in the cards.  Downgrade?  Of course.  We said that several weeks ago.  Downgrade?  Of course.  Why hasn’t it happened sooner?  That is the question.  And why did it stop at AA+?  Because it could be a lot lower, if you are looking at our balance sheet with an accurate appraisal.

Our debt rating was AAA, now its AA+, and what are the implications?  Kevin, first of all, mortgage-backed securities.  We have a system of debt which is tied and related to the Treasury.  Specifically, when you look at financing a mortgage, it is most sensitive to fluctuations in the ten-year Treasury.  Don’t tell me that with a downgrade, and ultimately, an increase in the cost of capital to finance debt, that is not going to impact mortgage-backed securities, at some point.  That is not something that will happen today, but eventually, you will see the knock-on effect from a downgrade in debt into the mortgage-backed security market.

Kevin:  Then if we are connecting the dots, that is Fannie Mae, and Freddie after that, is it not?

David:  It is, and immediately, it has affected their bonds.  It won’t affect all mortgage paper per se, but it is affecting Fannie Mae and Freddie Mac paper already.  We are talking about a basic existential insecurity.  Think of it this way, Kevin.  If you want to look at mortgage-backed securities and assume that they are going to go unscathed, this idea of an existential insecurity, if your parent dies, or your parent is incapacitated, your structure of security, what you counted on, the implicit identity, or where you have explicitly relied on them – when they disappear, we are talking about a major psychological realignment.

Kevin:  It is a real maturation process, let’s face it.

David:  Isn’t it the same when all of the implicit or explicit guarantees tied to the U.S. government get readjusted?  When the debt is readjusted?

Kevin:  We have talked about before, the difference between federal government types of paper, which can be monetized, versus, for instance, municipalities, as those guys can’t print money.  Let’s face it.  La Plata County, Durango, Denver, Detroit – they can’t print money.  They either pay their bills or they default.

David:  And the argument goes that they have already made some tough decisions, and cut expenses already, but the problem is, they still face declining revenues in a recessionary environment.  If investor perception has shifted back to a double-dip mentality, you can be guaranteed that the consumer will avoid all discretionary spending.  So we are looking at revenues, both business and tax revenues taking a downgrade.  We mentioned earlier the downgrades have begun for select issues:  Oceanside California, Atlanta, Georgia, Miami Florida, Irving Texas.  We don’t have time to go through the list.

Kevin:  It would be like Johnny Cash’s song, I’ve Been Everywhere.

David:  (laughter) Right, right.

Kevin:  Now, the reality of a double-dip recession.  This is something that we are starting to hear a lot in the mainline media.

David:  And this is, I think, the difference, Kevin, between the way overseas markets have adjusted their appraisal of risk in the marketplace, and they are looking at the downgrade as a significant issue, whereas the U.S. investor community is writing that off.  Again, this is the debtor saying, “Are you kidding me?  Nothing’s changed.  We’re going to pay our bills.  Don’t worry if we’re a little late.  Don’t worry if our credit has been impaired.  It was only a few points.  Don’t hold that against us.”  The debtor is begging off the issue.  The creditor sees it for what it is.  A downgrade is a downgrade is a downgrade.

Here, domestically, what we are focused on is the reality of a double dip.  It has re-entered the consciousness of the investing public and we did see a strong rotation from equities to bonds, not as a reaction to the downgrade, but to the notion that happy days may not be here again, and it will be a long time to fix the real economy, to repair the jobs market, to rebuild demand for housing.  Just to linger on this point, it is a decidedly U.S. institutional bias that immediately rotates from equities to fixed income.  We mentioned this just a few minutes ago.  Assume it was Greece being downgraded, or Spain, or Portugal, or Ireland, and we are all too familiar with these cases from the past 6, 12, 18 months.  Do we see a rise, or a fall, in rates? Exactly, we see a rise in rates.  So, increased demand for debt obligations?  No, it’s a decrease in demand.  The difference in the U.S., for fixed income, is that fixed income is the first choice of a misinformed asset manager.

Kevin:  Well, it’s habit.  That’s what we were talking about earlier in a meeting.  People do what is habitually right, and they are going to go to fixed income if they are not going to be in volatile types of up and down types of investments.

David:  The only thing that can be said positively about that judgment is that it prioritizes short-term liquidity over long-term solvency, and they are assuming that if we get through this, then we can ask the solvency question, but for now, we need to prioritize liquidity.  So a move to Treasuries is justifiable on the basis of liquidity, but it does completely ignore the medium and long-term issues of solvency.

Kevin:  We have been very critical about the United States monetization of so much of this debt.  It is catching up to us in the form of inflation here, but especially inflation overseas, and you have talked about how the international markets react a little bit different.  They feel that inflation first in the dollar, so they go buy gold, or they go buy Swiss francs.  But the European Central Bank is following in our footsteps.

David:  Exactly.  We wrote about this last week in our Friday comments, that the ECB is monetizing debt aggressively.  They began with Portuguese and Irish debt, and extended it to Italian and Spanish debt thereafter.  They are buying bonds just like we have been buying bonds, like QE-I and QE-II.  We know this is inflationary, and we see the Bundesbank fuming.  The domestic German bank is absolutely going crazy, because Trichet has called the shots on this, and they are not happy.  They know that it is inflationary, and it is a real concern.

Kevin:  And Citigroup.  They aren’t necessarily the bastions of wisdom, but these guys have looked at it and they have said, “This thing is going to take 2½ trillion dollars to even come close to starting to solve the problem.  Is Europe ready to do that?

David:  Kevin, just to clarify, it is not 2½ trillion dollars that Citigroup sees as a necessary bailout fund for Europe, it is 2½ trillion euros.

Kevin:  Which would top 3 for us.

David:  Yes, add 40%.  Concerned Europeans bought German bonds and gold.  The ECB is monetizing and where do you want to go?  You want to focus on your best bets.  In Europe, that is Germany, and in the world over, it still is gold.  We have inflation, and it is a global issue.  We have competitive devaluation, and it is a global issue.  We have pressures in the dollar, we have, of course, pressures with the euro, and we have individual investors trying to make clear-headed decisions in this environment.  Again, we come back to, “What’s your reference point?”  We look at the Dow-gold ratio as being absolutely critical, both to a purchase now, and to a liquidation tomorrow.  Not tomorrow, as in Thursday or Friday of this week, but as in tomorrow, a future date which may be months or years away.

There is a discipline, and that is what we are implying.  And there is a discipline when you begin to create a structure, an asset allocation model which takes into account both inflationary outcomes, deflationary outcomes, and growth-oriented, positive – Hey, we’re not just bad news bears – outcomes in the economy.  This is, I think, where investors are struggling.  “What is our strategy?  How do we do this?  What does this look like?”  Because, again, as they walk into the office of their money manager or their broker, they see this panicked look in their eye, and as you mentioned, the high trilling voices of CNBC and Bloomberg.  That is what they are getting with everyone they know who is associated with Wall Street.  A little bit of desperation, because actually, they don’t know what has happened.

Kevin:  Speaking of desperation, there are a lot of people who aren’t investors.  There are a lot of people who just live paycheck to paycheck, and they are angry.  I’m thinking about this Rasmussen poll right now.  There is a poll out that I think all of our listeners need to google.  Just type in Rasmussen and type in 17% after that, and it will come up, or Rasmussen 17%, 2011, if you want to.  But people are angry, Dave.  Would you describe what that poll was saying?

David:  Yes, in the opinion of one professional pollster, this is prerevolutionary, in his words.  There are only 17% of those in this poll who think that government has the consent of the governed, which is very powerful – only 17% of those polled think that government has the consent of the governed.  And this is even more interesting:  Only 6% polled think that Congress is doing its job.  Yeah, that’s prerevolutionary.  If you are currently a part of the political monopoly, and I am talking about the two-party system, you have to be asking yourself the question:  How do we ensure this duopoly, and keep out any challengers, whether it is the Tea Party crowd, or what have you?  I guess what we are suggesting is, politicians are reading this poll and they realize that things are going to have to get nasty if the power elite are going to keep their franchise.  I think we are talking about a fight between here and 2012.

Kevin:  What is amazing about this poll is that when you are talking about 17% of Americans believing that the government is actually representing them, we are talking about Democrats, and Republicans, and Tea Party people.  We are talking about everybody in that basket, because 17% does not represent any one group.

David, I am thinking of something that a liberal Washington Post columnist wrote about Obama.  He said, “The economy crawls, the credit rating falls, the markets plunge, and a helicopter packed with U.S. special forces goes down in Afghanistan.”  Two-thirds of the Americans are saying the country is on the wrong track, and that was before the market swooned.  He says, “Obama plods along, raising gobs of cash for his re-election bid, and he was scheduled to speak at two DNC fund-raisers Monday night, and varying little the words that he reads from the teleprompter.”  So even the Democrats, even the liberals, are saying, “Wait a second.  Who are these guys?”  There is a huge disconnect.

David:  Kevin, going back to that idea of the consent of the governed, and very few feeling like they are being represented.  You have political party A, you have political party B, and you have the middle class which is saying, “I think the politicos are going to need a message.  They are feeding at the trough while we, the middle class, are paying a very steep price for the overextended promises and poor planning, in both the fiscal and monetary areas.  So what happens in the next election cycle is largely a replacement of inept leadership.  Is that the story for 2012 as we head into the election?  I think certainly there is growing angst, and again, if you look at the Rasmussen poll, you say, “Wow.  17%?”  That represents the majority on the other side who have major problems with the way things are being handled.  And that’s the way they are being handled by both Republicans and Democrats.

Kevin:  Obviously, the solution is not going to come in the hands of the politicians that exist right now, so we have to wait at least a year-and-a-half before anything starts to change that direction, but one of the things that we can predict is the predictable behavior of the Federal Reserve.  They are only given so many tools.  They can either lower or raise interest rates, or they can do something about creating money.  There are different mechanisms to do it, but those are really the two things.  They are just here to inflate, basically.

David:  Yes, and I think that is what remains predictable behavior.  Supporting asset prices at the expense of the dollar, I think, was probably the most predictable thing coming into this FOMC meeting, and certainly looking ahead to Jackson Hole and the remainder of the year, they will support stability, and I think you will find the cost for that will be in the U.S. dollar.

Just to play devil’s advocate here, Kevin, let’s imagine the mind of the Fed chief.  Deflation-sensitive, inflation-hawk, surrounded by inflation doves, a clear majority of doves all across the regional Fed banks.  What happens between now and the end of the year is probably not going to look like 1937.  We can say that much.

Kevin:  1937.  Please give us an example of 1937 so that our listeners can correlate that with now.

David:  Yes, the tightening of monetary policy in 1937 is believed, by some, to have relapsed the economy into a decline, like that of the earlier period in the 1930s.  That is highly unlikely, Kevin, given the leadership that we have at the Fed today.

Kevin:  So what you are saying is, deflation, or tightening up on the dollar, is a very low probability at this point.

David:  Yes, if you look at 1937, that is sort of the classic behavior that Bernanke wants to avoid.  He does not want to tighten at just the wrong time.  He is going to accommodate beyond when he probably should.  Tempting the deflationary fates seems a very low probability event.  He is going to choose the lesser of two evils, looking at inflation and deflation, and putting in a high level of confidence in the machinery, both the middle machinery, amongst all the Ph.D.s there, as well as their actual credit-creating machinery.  I think that is what they are going to assume, that they can control inflation, that they can leave the bias toward accommodation.  If they need to, between now and Jackson Hole, or after Jackson Hole, they can announce asset purchases, liquidity provisions, or other temporary market manipulations to keep investor sentiment buoyed.  But no, they are not going to let deflation occur on Bernanke’s watch.

Kevin:  I think we should talk just briefly before we finish the show up, about what the options are that the Fed has.  What is in the tool box?  This week there has been an awful lot of talk about this Federal Open Market Committee announcement, but in reality, Jackson Hole is coming up in 2 or 3 weeks, and Bill King said that that is critical.  Jackson Hole was where Quantitative Easing was announced back in 2010.  It was the last part of August last year, and it is the last part of August this year.  This is where the brain trust, if you want to call it that, gets together and they say, “Okay, what do we really need to do, and how do we announce it?”

David:  I think some of the probable things to occur, if we begin to see a crack-up with certain financial institutions here in the U.S., is go back to asset swaps where the balance sheet of the Fed remains the same, but they swap short-dated paper for long-dated paper, or they swap quality paper to put on the bank balance sheet, and take on the toxic paper onto the Fed balance sheet.  It just relieves pressure in the marketplace.

Kevin:  Then there are interest rates, and they have already said they are not going to raise interest rates.

David:  Right.  That’s an option, but again, looking at our outstanding debt, that creates more of a problem for them in terms of an increased cost of borrowing on the existing debt and a harder time rolling over existing debt, so it would squeeze the equity markets.  I think that is the one thing that they would not want to do.  Raising rates at this point would squeeze the equity markets, which would be counterproductive.  I guess a third option would be to quit paying on excess reserves.  Banks across the country have roughly 1.6 trillion dollars in excess reserves.

Kevin:  They are getting a quarter of a point on that from the Federal Reserve, just having it in reserve.

David:  Yes, so the Fed can say, “No, to stimulate the economy what we are going to do is change course there, and quit paying, or reduce the payment on excess reserves,” and that, in theory, would encourage the banks to start lending again, the point being that they would try to stimulate lending, and thus, the economy, by ending their excess reserve subsidy, if you will.

Kevin:  So the idea is, if I’m a banker, and I’m making a quarter of a percent, risk-free, from the Federal Reserve, and I’m sitting on excess reserves and that is what I am making, if they cut that down, this is one of the things that we have talked about possibly launching this money that has been held back, almost like water behind a dam, into the economy.  It seems like that is a double-edge sword, Dave.  In one respect, you would have a recovery feel when you had all that liquidity getting loaned out, but wouldn’t that spark an inflationary run that we have never seen before?

David:  Yes, if you think of the tsunamis that we have had, in 2004, and then more recently, the one in Japan, you have this amazing surge, and the first look is, “This is interesting.”  And then it keeps on building, and building, and building, and building.  The idea is that 1.6 trillion in excess reserves actually has a significantly larger footprint in the marketplace, as much as 7 to 10 times, at least according to a finance professor friend of mine, 25 years a finance prof, all around the world.  He does private consulting today.

Kevin:  So what he is saying is that 1.6 trillion could turn into more than 10 trillion dollars worth of rotation.

David:  Exactly.  Or 16 trillion.  So what seems, on the front end, as positive, as it slowly trickles out of bank reserves into the economy, ends up being hyperinflationary.  A bit of a problem.  Yes, that’s the death of the dollar.  Yes, you want to own gold in that environment.  Again, it is a theoretical concept tied to the velocity of money, an extreme increase in the velocity of money.  So there is point and counterpoint to that, Kevin.  Maybe they do take way the 25 basis points they are paying, maybe they just leave it as it is.

Kevin:  There is another tool in the toolbox that we have really all learned the language of over the last couple of years, and that is quantitative easing.  The question has been, to many of our guests, and I know I am still thinking about it:  Is Quantitative Easing III right around the corner?  Is that something that you think may be announced after Jackson Hole?

David:  Kevin, I think what is interesting is that QE-I was effective,  QE-II was unnecessary, and QE-III has been utterly discredited as something that could happen in the future, unless, of course, there is an adequate amount of pain to justify any activity in the marketplace.  I think this is what is very interesting about a democracy and a place where we have, largely, freedom of the press.  When you begin to get the vibe that the general public isn’t happy, and in fact, they could erupt volcanically, if something is not done now, that’s when the Fed may just say, “Yeah, QE-III makes a lot of sense, and we’re just going to spend a lot of money that we don’t have, and yes, that is called monetization, and you are going to love it, you’re going to love it, because you are asking for it, and you are the hook for it, and it was your idea, and we are just going along with the general zeitgeist.”

Kevin:  Well, inflation does not hurt in the beginning.  Inflation actually makes you feel better.  It’s a little bit like taking that extra shot of whiskey for the alcoholic, but it’s not going to solve the problem.

David:  Pain is something that redefines legitimacy, and I think that is what we have to keep an open mind to.  What will the Fed do?  It depends on the circumstances at the time.  It really depends on the circumstances at the time.   If the market is relatively normal by the time we get to Jackson Hole, nothing will be done.  If we are going nuts and we have lost 2000 points on the Dow, and we are scraping close to 9500, you are going to see the whites of their eyes, you are going to see the sweat beading on their foreheads, and they are going to do what any smart person would do – spend money you don’t have.  Put the fix in.  Get the plunge protection team to work.  “How much liquidity do you need?  Where do you need it?”  We saw this in 2008.  We will see them make available trillions that you can’t imagine existing.  They were, at one point, making available close to 30 trillion dollars in liquidity.  You may say, “Well, it didn’t even exist.”  And you are right, it didn’t even exist.  And that’s what it took to soothe and to calm the market nerves in 2008.  You think that’s off the table for 2011 or 2012?

Kevin:  Probably not.

David:  Absolutely not.  The pain will define their course from this point forward – corporate and national pain, because that is the only thing that they can hide under.

Kevin:  David, coming full circle, to end the program, imagine you have someone who is looking at you right now, over the table, saying, “I’m hearing all this crazy noise.  What do I do?”

David:  I think the first thing that you do, Kevin, is take a look at the DVD we just produced this year.  It is free.  We send it out to hundreds of thousands of people all over the world.  If you haven’t seen it, you can watch it online, or you can request a physical copy of it, and just get some perspective.  Take an appraisal of where we are, and where we are going.  Make sure that you have decent facts in front of you before you start strategizing, and then begin to strategize.  Begin to put together an asset allocation that is bullet-proof, that works under any circumstances – good, bad, ugly – and I think, begin to adopt the disciplines necessary to succeed in a very challenging economic environment.

Things are going to get a lot worse before they get multiples better, and I do think things are going to get a lot better, a whole lot better.  But not before we see a tremendous squeeze in the political system, a tremendous squeeze in the financial system, a tremendous squeeze in the stock and bond markets, and I just hope that folks are keeping level heads and setting about this the right way, with a strong strategy and a strong frame of reference.

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