Bonus Culture is Breaking the Bank (FED)

Weekly Commentary • Nov 06 2013
Bonus Culture is Breaking the Bank (FED)
David McAlvany Posted on November 6, 2013

About this week’s show:

  • Can the dollar hold above 79?
  • Deficit spending no longer the cure
  • Equity margin debt has broken all time highs

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: Back now from Coeur d’Alene, Idaho, and on our way, David, to Minneapolis, Austin, Chicago, New Orleans. This is just one of those times to dip into the studio, do a quick recording, and go back out. But we had a great time in Coeur d’Alene.

David: Yes, the rest of the month we’re going to be on the road and traveling, and some of our interviews will be on the road, as well, ending with about a week’s stint in Shanghai, and now I’m arm-wrestling with Don to see if he’ll join me in Shanghai for that week, some very interesting things happening with the Shanghai gold Exchange.

Kevin: You were a guest of the Shanghai Gold Exchange, is that not right?

David: That’s correct, and the China National Gold Corporation. And as they continue to very quietly accumulate ounces, we see what has been a long-term trend since the 1980s and 1990s, where the East has played a more dominant role in the physical markets. Now it is a defining, not just a dominant, but a defining role in the physical metals markets.

Kevin: You’re talking about an exchange that sees more than 1,000 tons of gold delivered this year through its exchange. That’s incredible. That’s an exchange that really didn’t play a big role 5-10 years ago.

David: And as we mentioned, we have the November 8-14 meeting. This is the Third Plenum session of the Chinese Communist Party, in which they will be laying out the specific strategy. Hopefully, the framework will be well-detailed, so that we understand what steps they are going to take to be transitioning toward an internally consumptive economy. Bottom line for us, of course, is that to the degree that they are not running trade surpluses, there is no recycling of those surplus dollars into the U.S. treasury market, we lose, in that sense, a major prop for our treasury market. And it requires that we are either not running a spending deficit anymore, or that the Fed is required to monetize that much more, 100, 200, 300 billion dollars more than they are already doing, through what is euphemistically known as quantitative easing.

Kevin: We cannot overstate how incredible a change that really is, the symbiotic relationship between ourselves and China for the last 30-40 years has been that we run a deficit with them, they take those surplus dollars and bring them right back to us. Now, we’re seeing them purchasing gold, we’re seeing them move to an internally consumptive economy, like you were saying. Let’s go to gold for a moment.

David: But before we do, I think this is where the Treasury just doesn’t even get this, the relationship between surplus and deficit countries. They are, this very week, criticizing China and Germany for running account imbalances. In other words, they are saying, “Listen, These huge surpluses, you shouldn’t be running them, it’s very destabilizing to the world economy.”

Kevin: “Why don’t you deficit spend like we do?”

David: The problem is, it’s two sides to the same coin. We run a deficit, they naturally run a trade surplus, so to be critical of their surpluses is naturally to look at what we are doing in the creation process. We’re part and parcel to these surpluses that are being created elsewhere, and of course, if you look at peripheral Europe, the same thing. You have deficit countries and surplus countries. Germany happens to be running a surplus. Well, there’s not a huge pat on the back for the Germans just because they’re running a trade surplus. That requires deficits on the other side, it’s an accounting equation, like two sides of an algebraic equation, one needs the other, otherwise it’s incomplete. This is, I think, what is fascinating. Bloomberg, this morning, is talking about the U.S. Treasury, and how they’re criticizing China and Germany over their trade surpluses. They don’t realize that we are part and parcel to the equation.

Kevin: David, the bottom line is, they just don’t get it. But one thing they do get is the gold. The gold is being transferred from the West to the East at such a large percentage, right now, of world demand, that it can’t be ignored. So, let’s look at the gold markets, and I’m not talking necessarily the price, even though the price has been interesting over the last week or so. If you look, we talked about a point-and-figure chart a couple of weeks ago, and gold has broken to the upside on the point-and-figure chart. It doesn’t mean it can’t still fall, but it is an interesting change in the trend that we haven’t seen in several years.

David: That’s interesting. The Reserve Bank of India released a report basically saying that demand for gold appears to be autonomous, a function of several influences and factors in India. They go on to say, “The supply of gold, through organized channels, can be constricted, but buyers may take recourse to unauthorized channels to buy gold.”

Kevin: Sure, Pakistan. Look at Pakistani numbers.

David: This is in the DNA of a culture that is oriented toward hard work and savings. You don’t trust your savings to a central banker. Those are lessons that are learned the hard way in other parts of the world, and they are lessons that still have to be learned in our own culture. We have had the benefit of low rates of inflation for a long, long period of time, nothing that would be hair-raising, an 8%, 10%, 12%, 15%, 20% rate of inflation, which is what they deal with quite a bit in Asia from time to time, not year in and year out, but often enough that they say, “I’ve never met a central banker I fully trusted.” Isn’t that an interesting attitude?

Kevin: And why would you trust them, Dave? I was at a local bookstore this weekend and I see that Alan Greenspan has a new book out. It’s called The Map and the Territory. I flipped it over and looked at the back and it said, “Why I missed the crash of 2008.” It said, “No one with any meaningful role in economic decision-making, in the world, saw beforehand the storm that was coming.”

David: Kevin, that’s not an excuse, that’s an indictment. That just says that their models are so blinding that they have an inability to deal with what a man in the street is able to say, “Wait a minute, I think asset prices are moving up too quickly. I think home prices going up at a 12% rate, year in, year out, I can’t remember any time in my lifetime that that has happened.”

There are a number of things that are just very common sense that the average American would say, “Yes, I put my finger in the wind and I kind of understand which way it’s blowing, I kind of get what is happening here. It doesn’t take a Ph.D. to get it. In fact, the only ones who missed it, what he is basically indicting, is a whole cadre of Ph.D.s. If you have a Ph.D. you have a new endemic blindness, and you know what it is? It’s too much information in your head to make sense of the world as it is.

Kevin: It’s obvious that they’re not subscribers to the McAlvany Intelligence Advisor because Don was talking about it for a few years, and you were talking about it. Even in the Commentary we were talking about it before it fell apart.

David, speaking of not trusting central bankers, banks hold gold, they have reserves in gold. We’ve talked about Germany having reserve gold put here in America, and asking for it back, and we told them that it would take seven years just to deliver 300 tons back. But now this is transferring over to Europe and you have other countries starting to say, “Hey, where’s our gold, and what have you been doing with it?”

David: It’s very interesting to note that central bankers have been frustrated by this debt asset on their balance sheet. They figured that it could be doing something for them, and we began to see a trend in the early to mid 1990s, where out of the blue a product became available for our company, and generally available in the world – these large hoards of old gold coins that were selling near bullion prices. So we had tens of thousands, I think actually a couple of hundred thousand Swedish 20-kronor.

Kevin: And our clients now have them in their portfolios.

David: Finnish 20-marks. These coins were minted 100-150 years ago, in mint condition, had never left the central bank, and yet they were now circulating. And the question we had at the time was how it is possible that central banks would just release them? The beauty is, we do now have, in retrospect, a better understanding of how central banks manage their gold. In fact, they don’t keep it all on deposit, they lease a good portion of it out. The Finns, this week, acknowledged that, and the Austrian Central Bank acknowledged that last year, basically, they turned their gold hoard into a revenue stream by leasing it out for a small percentage fee.

What happens to the leased gold? This is really something that will develop over the next 3, 4, 5 years, as we see disclosures of an increase in the official gold held by the Chinese Central Bank. The big question will be how they acquired so much without moving the price of the metal?

Kevin: I think it is interesting, too, Dave, if you hold something on paper that says you own gold, it’s a whole lot different than buying that Finnish markka and putting it somewhere no one can ever find it again. That’s deliverable gold. Those poor folks who hold paper will find out that they don’t have the gold behind it.

David: And the irony will be when the Swedish and the Finnish, and the American public, and the Germans, and everyone who assumed that they had tons and tons and tons of metal stored, whether it was at Ft. Knox or with the Bank of England, what happens when they ask for it, as the Germans did, and it turns out that, “Oh, it has been leased, it has been lent, and it’s not immediately available?” There will be a recognition in the marketplace, and I think with this recognition, a panic, in price and in activity, a flurry for physical metals demand, as a consequence of the revelation that central banks have been leasing gold for years, and that is how there has been a massive shift in metals from one central bank to another without a move in price. This will be, I think, one of the great stories of the 21st century, and it will represent a touchstone, if you will, in the bankruptcy of Western countries.

Kevin: David, you’ve talked about how China has been taking in an unusually large amount of physical gold delivery. When you look at what people are doing right now, we’ve increased our food stamp dependency. They’ve increased their gold dependency. So something seems out of whack. Now, this last week they did cut back the food stamps slightly, what was it, 5 billion dollars from an 85-billion dollar program?

David: This is a reminder that the recovery in the U.S. economy is very subjective in nature. This is from the National Bureau of Economic Research. We were, in 2009, when the National Bureau of Economic Research announced, declared, told the world that we were in recovery, the recession was over, at that point we had 35 million participants in the food stamp program. Fast forward 2009 to the present, we’ve now been in recovery for a good number of years, and yet the food stamp program has expanded from 35 million participants to 47.7 million.

Kevin: So, we’re almost at 50 million food stamp participants, yet we supposedly have been in recovery now for four years?

David: The Heritage Foundation said this: “It’s important to put the proposed cuts in perspective.” (That’s the 5 billion dollars in cuts, out of the 85 billion.) Food stamp spending has doubled twice in the last decade or so. They say it doubled prior to the recession, between 2000 and 2007, and it doubled again between 2008 and 2012. So again, the Heritage Foundation points out that you have 5 billion in cuts, so essentially 40 billion over a 10-year period would be a 5% cut to a program that has grown by over 200%.

Kevin: That puts it in perspective. The cut is not much at all.

David: It’s not much. It’s a huge program, and again, what side are you on? The objective nature of the Federal Reserve would say, “Hey, we’re making great progress, we’re going to be able to cut QE.” And the Treasury would say, “We see signs of recovery.” You remember, even back in 2009 the language was of green shoots in the economy, and yet, from the subjective side, 12.7 million new participants since the recovery began, since the recession ended, ask those 12.7 million participants if things have gotten better or worse, not that that is the sum total of our population, but there is a trend here, and it’s very disconnected from the asset appreciation which has been part and parcel to the QE infusion of capital, 85 billion dollars spent a year to create a ballooning, a wealth effect, for the 1%, the 2%, maybe even the 5%, in society. But the vast majority of people in the country have seen no benefit and there are many, maybe not the vast majority, but at least 12.7 million, who would say they are worse off today than they were 5 years ago.

Kevin: So what you are saying is that quantitative easing is just really life support for a dying economy. Now, the dollar, you would think, with the 85 billion a month that is being printed, you would think that the dollar would break below that technical support level that it has been on, but it bounced last week.

David: (laughter) I feel like this is a conversation we’ve either had on air, or had in the office, which is, “Listen, if they don’t hold the line at 79, we’re going to find ourselves in a very desperate circumstance,” and by any means necessary, if I had to play the part of the Fed or the Treasury, you look at this and say, “It must be defended.” You fight and die on this particular point, the dollar must not go below 79. And lo and behold we have seen it rebound, we’re now in the low 80s. But where does it go from here? 81, 82? Frankly, it could be over before it begins. It would take a terribly hawkish comment from the Fed to jumpstart a dollar rally of size, and barring that, we do see the dollar’s half-life is limited, we do see the trend as down, and we do see that level of 79 being re-tested, and at some point, if not this year, certainly next, broken.

But again, we’re down to a market which is dependent on what the Fed says. We are always going to encourage you to look at what they’re doing more than what they’re saying, but the market will move in the short-run on the basis of language, and language only.

Kevin: And you notice, the language changes. Right as you get near that level, you’ll start to hear the hawks come out. A hawk is somebody who is going to talk about tapering back quantitative easing. We talked with Bill King last week, and taper is off the table, we all know that, but the talk is not off the table.

David: There are a couple of things that we will want to talk about, just a review of some of the things we talked about with King, because I think they were very important, but we also want to look at the distortion of incentives, short-term thinking in corporate America, major increases in share buy-backs, and what has been called a bonus culture by Andrew Smithers. Next week Andrew is going to be a guest on the program.

But here we are looking at Wall Street analysts who think that the world is coming up roses, tulips, maybe dahlias, pick your favorite flower. And it’s not that they’re 100% bullish, but what is interesting is that nearly 100% of analysts are bullish. 41% today would put a buy recommendation on the stock market, 24% would be a strong buy on the stock market, and about 28% would say, “We’re neutral. Hold.” Which is not a sell, it’s just hold.

Kevin: So if you put those together you are talking over 90% that are saying either buy or hold.

David: Close to 95% are positive to neutral, 5% are suggesting a sell. Give it a few months and what you may witness for the first time in market history is where the sell category is no longer even needed.

Kevin: Everybody is 100% bullish.

David: Right. Well, analysts are missing a few terribly important points. You have 4% that are in the underperform category, because remember, putting a sell recommendation puts a firm at risk of lawsuit, because they’re making an objective proclamation that that stock, they think, will go down, and therefore you should sell. So they’ve changed the language on that. Now it’s called, “underperform.” So you have 4% of analysts which suggest underperform, and that leaves just 1% with a strong sell category. These numbers are compliments of Cross Currents.

This week and next we want to explore a number of different issues that play into the equity market and how management seems to be moving the ball down the field, and analysts are having a heyday with it. Analysts look at this and just can’t get enough. They would be only too eager to say, “We’ve got an all clear signal, the economy is on the move higher, the stock market is on the move higher, you need an all-in bet on equities.”

Kevin: Strangely enough, the equities market is rising, yet you still see the insider selling, the executives selling more than they are buying.

David: Yes, as a corporate insider selling is not at record highs, but they are progressively increasing. From the June statistics, from the beginning of the year statistics, what we have now, and it’s particularly strong among the trading sardines, the Wall Street darlings, if you will. A lot of the technology shares are in that mix.

Kevin: Google, Amazon.

David: Facebook, Intel, QualComm, half a dozen other giants. The current numbers, again, are not as shocking as they have been in the past, but are still fairly sizeable, 387 liquidations for every one purchase, 387-to-1, that’s still a very strong ratio. Or in terms of shares, you are talking about 1 share bought for every 6,429 shares sold, and that does not include the very large and automatic sales from Apple. Again, close to 6500 shares liquidated for every 1 sold, that’s the sentiment indicator you get from corporate chiefs, CIOs, COOs, board members, those who are in charge of scoping out the future for an enterprise, and they are aggressively selling, have been for 18 months, With higher prices in equities, it has gotten more and more aggressive, and it’s just something to keep in mind.

Kevin: And this is the strange thing, Dave. When you look at the individual, you say, “What is the executive doing? He’s selling.” But then you look at the company decisions that these executives are helping to guide, and actually, a lot of companies right now are taking shares off of the market. They’re buying themselves up rather than investing in long-term plant and equipment, they are actually just investing in their shares and reducing the amount of shares in the market.

David: Next week I want to explore this idea of executive and management compensation with a British economist, he lives in the U.K., Andrew Smithers. He has argued that public companies in the U.S. and the U.K. are purposely managed for the short-term benefit of the operators of the business, and with less and less thought given to real long-term viability and competitive market share. Current investment in plant and equipment is the lowest it has been in the post-war period, and this is what is quite interesting. You have profit margins which are at their highest recorded levels ever and money is being aggressively deployed to buy back shares, and again, at a rate and at a level that is at all-time highs.

Kevin: So, let’s just explain for a moment. You have a certain amount of money in a corporation. You can either invest in the long-run – buy plant and equipment – and continue that expansion, or you can come in a buy up your own shares off of the market. That reduces the amount of shares for the public, but it creates much more equity in the company, itself.

David: What Smithers describes is a bonus culture, where an increase in the volatility of profits plays out very well for management, come bonus time. Even if you see volatility in profits to the downside, your increase from one year to the next will justify a sizeable bonus, but those share buy-backs have become a primary means of boosting earnings per share, and this does also factor in to how executives are compensated. It used to be fairly standard to have a decent-sized salary and a decent-sized bonus. Now you’ve seen an increase, not only in salaries, but an exponential increase in bonuses, those bonuses tied to short-term performance variables.

Kevin: So you are taking shares off of the market and you are creating fewer, so the earnings per share is going to be divided by fewer shares.

David: That’s exactly right. Total earnings divided by a fewer number of shares, that increases your earnings per share, and delivering the numbers that, in turn, deliver large bonuses. Some of those numbers are frightening, comparing the current levels of share buy-backs to investment in plant and equipment. Just as an example, he cites Q2, the second quarter and third quarter of 2012. Buy-backs, then and now, are about 400 billion a year, so if you are looking at the run rate, 400 billion a year, companies are, today, the largest investors in the marketplace for their own shares.

We’re not talking about going out and buying up the competition. We’re not talking about increasing capacity. There is no real investment in plant and infrastructure today. They’re shrinking the number of shares outstanding, hitting the number, playing the Wall-Street game, and being able to thereby get their big bonuses. So if you don’t appreciate how executive compensation works, you might think that it’s the best thing going. Look at this! We have a great franchise and we want to own more of it! If that were the case, executives wouldn’t, at the same time, be liquidating shares! Their own shares! At breakneck speed.

Kevin: This is what breaks the whole mechanism of this Keynesian phenomenon that the Fed and the Treasury are trying to put forth. They are quantitatively easing and printing a lot of money, it’s going into the stock market, it is not going into re-investment, or investment, into the future. Bill King talked about this, you’ve talked about this, the mechanism is broken. The money is being printed, but it’s not getting into anything that creates economic growth.

David: Keynes did think that you should step in, and if there was a major drop in the economy, a drop in “aggregate demand,” then that’s where you had government deficit spending. That was supposed to step in, fill the gap, until you had a new source of demand, or the old source re-emerge, and that would either be business spending, or consumption, that would be household consumption.

And at this point in the game, the Fed and the Treasury are very disappointed with corporate America, because you have all of these vast cash hoards which should be rolling into the economy via investment, and instead the trend has been to use low interest rates and cheaply borrowed dollars, which the Fed and the Treasury have delivered up, for the purpose of retiring shares, shrinking the number of shares outstanding, improving earnings per share, in that game of meeting and beating Wall Street’s quarterly expectations.

When the stock rises that allows for stock compensation packages to improve, bonuses expand, you have the multiple of the base salary. This is an amazing game! It was just redesigned in the last 15-20 years, and the unfortunate coincidence is that it is increasing management turnover. Nobody wants to stay at a company very long. They want to get what they can, while they can.

Kevin: Sure, you boost the bonus and then you leave.

David: Yes, you’ve shrunk the time frame for deliverable gold, again, what Smithers calls the bonus culture. And there are other issues we want to explore with Andrew next week. I’ve read Andrew for years, 12-15 at least, and I’ve found him to be an excellent thinker, excellent analyst, without an axe to grind.

Kevin: We’ve talked about the Q ratio. He wrote a book about that back in 2000.

David: I would say he wrote the book. Tobin’s Q, this is coming from a Nobel prize-winning economist, that’s where Tobin’s Q came from, but in terms of taking the idea and really translating it for a modern working era, he wrote the book on the Q ratio back in 2000. He argued that equities have never been so over-valued, and were likely to fall severely. Frankly, on that same measure, using Q, and we’ve talked about this before, particularly helpful today, because it’s consistent. In history, there is this mean reversion. It goes to over-valuation, then it goes to under-valuation, back to over-valuation, back to under-valuation, and it moves back and forth, above and below, a mean. And he would argue that today we are 65% over-valued in the equity markets. He rang the bell in 2000, he called it. He said, “We’re too expensive, stocks have to go down, this is absurd.”

And lo and behold, we are 65% over-valued today in the equity markets. We’re not quite to the extremes seen in 1929 or in 1999, using the Q ratio, or Tobin’s Q, but we are on a par with where the market was in 1906, in 1937, in 1968. 1968 was probably the bear market most similar to the one that we are in now. From 1968-1982, in nominal terms, you didn’t see much of a decline in equity prices. They just moved sideways for over a decade. But as you factored in inflation, that’s where it was one of the worst bear markets we had ever had, that 1968-1982 period. So, again, we are on par with 1906, 1937, and what we went into in the bear market of 1968-1982.

Kevin: The theory of John Maynard Keynes, and we bash him a lot, because it doesn’t seem to be working, but Keynes did say that if you come in and stimulate the market and it turns into growth, it can be sort of an emergency procedure, and then you dip back out. Bill King talked about that last week. But if you look at Britain, if you look at the United States, if you look at Japan, Smithers talks about them and he calls them the Keynesian Trio and he says it’s not working anymore, it’s just not stimulating the system.

David: And this is central to his argument. We’ll unpack this next week. He argues that policy-makers have confused a massive structural concern with a short-term cyclical issue, and thus you have central bank and fiscal policies that are aimed at the wrong target to begin with, they’re not generating the expected growth in the economy, they’re not bringing jobs back into the equation. We have a “jobless recovery” and he does say, “Yes, listen, the U.K., U.S., Japan, they’re maxed out. They’ve done all that they can do in terms of deficit spending, and from this point forward, if they continue in that vein, inflation is inevitable.

Now, he says there are other parts of the world where they haven’t been running the same kind of deficits as these three have, and perhaps they could run some deficits and substitute for the demand that the global economy is so lacking, as a stopgap measure. Eventually, though, we have to still ask the question: Are we simply trying to recreate the bubble period of the 2000s, where we saw growth on steroids because of the amount of debt in the system, because of expansion of off-balance-sheet liabilities in the banking sector, shadow banking, if you will, expansion in the derivatives market?

The financialization of products, this is what we had in terms of the alchemy of finance, where every bank was slicing and dicing and taking one product, turning it into ten products, charging fees for the ten products, even though you only had one underlying asset in question. All those games – is that really what we want to go back to? Is that what we’re holding out for?

Kevin: Tobin’s Q may be one way of measuring whether you are over-valued on the stock market, but something even less complex than that is just looking at margin debt. Right now, stacking is what people are doing. They are saying, with a dollar I want to buy $10 worth of stocks, because it’s not going down.

David: “It’s as good as it gets, we’ve gotten an all-clear from the Fed, we know that it’s only up from here.” You listen to Wall Street, and it’s only strong prognostication. Well, there are a few more in the audience that are noticing that margin debt has breached all-time highs, and we’re beginning to see a few more articles in the mainstream media on that. Not only has it reached all-time highs, breached the all-time highs, as a percentage of stock market capitalization, you now have more margin debt, relative to the total size of the stock market, than we had. It has now eclipsed the runaway speculative market of 1929.

Kevin: So it’s higher than the 1929 crash year.

David: Yes. And Alan Newman points out that there is nothing in the margin stats that helps us precisely to predict a market top. But he reflects on the three previous peaks, followed successively by the crash back in 1929, a 90%, let’s call it 89%, to be precise, and then more recently, a 50% decline, and then most recently, here within the last decade, another 50% decline in equities.

Kevin: But maybe it’s different this time, Dave. Maybe this time we’re going to get away with this margin debt and not have the crash that this always has predicted in the past.

David: One thing that you can’t predict is how insane markets can become, and how irrational investors can become. Perhaps the Fed is distorting the picture beyond what most of us have an imagination for. I would agree with you, we aren’t going to see it different this time, but the danger of Fed activity today is that they are experimenting with monetary policies that have never before been implemented on this kind of a scale. The consequence has been to inflate asset prices, and if they should fall, this is the real issue, if you set asset prices on such a high perch, when they fall, they fall farther than they would have otherwise.

The core issue there is that because you have combined this backdrop of indebtedness, household indebtedness, corporate indebtedness, at the national level, indebtedness, when you have a collapse in asset prices, you are inviting a depression, not a recession, into the picture. So debt is that backdrop issue, a fall in the price of assets, that causes hemorrhaging in the debt markets, with a knock-on effect, felt in the banking and financial community, as a result of having leveraged balance sheets. You have the financial industry, which has all this leverage, and the debt that is backing it, all of a sudden a decline in asset prices, and what may have felt good on the way up, a double dose of leverage helps increase your profitability and your returns. But, it’s a double dose of punishment. It hurts, it’s painful, on the way down.

Kevin: That takes us to something that Bill King talked about last week. He talked about a chart formation called a rising wedge. He even said you can Google it and see that that is always an indication that you are going to either have a major break down, but it can also indicate that you are going to have a major break to the upside, in the stock market.

David: When we talked about the chart of the S&P 500 and classically, it is resolved with either a major move, typically lower, but, you know, with Fed intervention at record levels, you could also see a breakout in the other direction.

Kevin: Free money.

David: Yes, and we’re not talking about a mild-mannered sort of gradual step higher, we’re talking about a short-covering generated jump to record highs. Keep in mind, that’s not really the recipe for sustainable growth in an equity portfolio, more in keeping with sort of a last gasp, and the placing of a high water mark. Well, that would likely be remembered as sort of a manic peak.

Our opinion, consistent with Bill’s last week, the odds favor a move lower, with volumes being one indicator, volumes of shares traded on the New York Stock Exchange continuing to decline. You realize, Kevin, that over the last decade we’ve seen volumes decline on the New York Stock Exchange by between 50% and 60%, off of their peaks. They accelerated into 2006, 2007, 2008, and off of those peaks, we are now at the same levels that we were circa 2000-2001.

Kevin: And this is including the high-frequency traders and a lot of the shares that are being traded just by computer.

David: Well, right. And that’s where the majority of volume is coming from. 60-70% of existing volume is not from individuals buying mutual funds or buying individual shares, it is algorithm traders, it is Wall Street trading their own book, not your money, their money. It’s interesting. The decline in volumes is to us a real telltale. When this market turns and rolls over, it’s going to be ugly. The Fed’s footprint? That is the major footprint in the market.

We did talk about the S&P 500. Well, compare the S&P 500, that chart, and if you were to overlay a chart of the Fed’s SOMA, , (chuckle) that’s the ironic acronym for the System Open Market Account, this is not a drug that you get to keep your mind numb, as found in A Brave New World. No, the Fed actually has this thing called SOMA, the System Open Market Account. If you overlay that with the equity market, the S&P 500, you observe that Fed activity begets market activity, and when the Fed pauses for any time at all, so does the market.

So we’re in this strange environment. Stocks are dependent on the ebullient sentiment generated by QE. To the degree that QE is in motion, the stock market is in motion. If it pauses, the market pauses, even declines. This is sort of the Catch 22 that we are in. Where and when do you take the hit? The Fed has to decide. If they do taper, you understand that the market has grown grossly dependent on what the Fed is doing in the economy.

Kevin: And Bill King pointed out that Janet Yellen is so easy-looking, as far as from her past speeches.

David: Easy-looking, not easy on the eyes, that’s not what you meant.

Kevin: (laughter) Easy from an expansionary monetary point of view, that she may have to pull sort of a miniature Volcker event just to try to get the market’s attention. That puts danger in the market, as well, because just as soon as you start to assume too much of any one thing, the market is going to show you something different.

David: Bill points out two things this week, and he says these are bell-ringers. If you look at the financials ETF, if you look at how the financials are trading, and look at the Russell 2000, an even broader cross-section of stocks than the S&P 500, both of these sectors, if you will, or cross-sections of the financial world, they are diverging from the S&P.

Kevin: They’re starting to fall.

David: They’re moving lower while the S&P is still moving higher. That, to him, is a warning sign. Couple this with the divergence between high-yield bonds, where they are moving lower. And the S&P is still moving higher. These are where you have telltales which indicate money is becoming more risk-averse and taking profits, even as the indexes draw the public in and the mass media continues to sound the drumbeat. “Here’s how you make money in the market. Just put more money to work. You were only so foolish to have it all sitting in cash, all these months and years.” There is sort of a sucker attraction at these prices because it seems inevitable. “Tomorrow is only going to be as good as yesterday was, and I’m just so regretful that I didn’t participate.”

This is where the public comes in and proves themselves the suckers. You have higher nominal prices. Why do I mention the 1968-1982 period? That bear market is like the bear market we have today. In nominal terms, the market was doing fine between 1968 and 1982. There was volatility. It went up, and it went down, and it went up, and it went down, but over the years, from 1968 to 1982, it really did nothing. You didn’t lose ground, you didn’t gain ground, it wasn’t that bad of a picture. When you factored inflation into the equation, that’s when you found yourself with greater than a 50-60% loss, being an equity owner.

And that is what we see transpiring today. If you look at the S&P 500, and let’s be generous and pick the index which has put in new all-time highs, if you price it in real terms, that is, factor in inflation over the last decade, you still see a chart that is in decline. It is decaying. And just like that 1968-1982 period, inflation accelerates at the tail end and caps what is a decade or two of utter disaster.

Kevin: We’ve talked about the gold-to-Dow ratio, and David, during that same period of time, from 1966 at least until 1980, we saw the Dow worth 30 ounces of gold in 1966, moving all the way down to 1 ounce of gold in 1980.

David: And it will only give you one opportunity. If you missed the beginning of the trend, and you didn’t buy gold at $35 an ounce (my dad did, many of our listeners did, as well), if you weren’t so lucky as to buy gold at $35, $40, $50, $60, $70 an ounce, the market gave you one opportunity, one double-take, and that was 1976. It had gone up over 460% and the market retraced 50%. It dropped from $192 down to just below $100 an ounce. That was your last opportunity before all of those major trends worked their way through the marketplace. Equities took it on the chin, in real and nominal terms, and gold had its move from, let’s call it $102 up to $875. That was the final move of the bull market in metals.

Then what does that look like fast forward to the present? The transition year, like 1976, was likely 2013. 2014-2018, this is the timeframe in which we see the final moves of many of these markets, whether it is a major reversion to the mean in the bond market, where interest rates move higher, bond prices move lower. The dollar takes that step low, the 79 level, and goes into the next phase of bear territory on the dollar euro index. Gold, moving into its next and final move higher, again, short-term progress has to be made, gold has to get above $1430, $1540, $1700, $1900, these incremental steps, but then breaking into new territory.

I would argue that this is where, ironically, even though I would encourage you to be adding ounces today, you need to be thinking in terms of an exit strategy. When you buy something, you need to know what to do with it, how and when to dispose of it. I would confidently be adding ounces at these levels, but with an idea that what happens over the next months to years will happen on an accelerated basis, not unlike what we saw in the 1970s. Inflation is of that nature. You go from zero expectations to the expectation of inflation, feeding on and multiplying the concerns, and becoming a self-fulfilling prophecy leading to even greater rates of inflation.

The argument we have to dissect with Andrew Smithers this next week is: How do we, the Keynesian Trio, step back from deficit spending, which if we continue on this course will lead to inflation, and will anyone else step up to the plate to do the same? Is that a long-term workable solution? In our opinion, no, but it may buy enough time for other elements in the global economy to recover.

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